Stock Picking: You Can Beat the Market Over the Long Term

This blog war post is in response to "The Market is Not Perfectly Efficient, But You Still Can't Beat It" by Charles D. Ellis.
Charley and I agree about two things: (1) market efficiency is a matter of degrees, and (2) most investors have terrible timing when it comes to manager selection. Let's dig deeper and see if we can identify more common ground.

I contend that the market is more efficient over short time frames and less efficient over long time frames. Over the short term, it is very difficult to find discrepancies between price and value. But get a room full of professional investors and ask them what the fair value of a company is five years hence, and you'll get a wide range of opinions, some more sensible than others. When you extend the time horizon, the stock market's inefficiency begins to reveal itself.

Our team at Legg Mason Capital Management studied the largest five hundred stocks over the forty year period from 1970-2009. During that time, on average, about 2% of the stocks doubled in one year. About 15% doubled over rolling three year periods and about 30% (150 of 500 stocks) doubled over rolling five year periods. The average five-year return of the basket of stocks that doubled over five year periods was 198% (162% median). By comparison, the average return of the S&P 500 Index was 50%.

From my perspective, the degree of market inefficiency is much less for periods of one year or less but increases both measurably and starkly as holding periods are increased to three and five years

An investor who is skilled at identifying stocks that will double over five years therefore has an opportunity to add value for his clients. Now, it is admittedly not easy work, and Charley is correct when he says that these investors are rare. You need expertise in capital markets theory, competitive strategy and analysis, financial and managerial assessment, valuation, and decision making. I tossed out the names of Warren Buffett and Bill Miller. Charley rightfully adds the fund managers at Capital Group Companies. Yes, only a few investors have been able to beat the market over time, but that is different from saying only a few can beat the market over time. Although I would never expect a majority of investors to outwit the stock market, neither do I think it is impossible to increase the overall number of individuals who could successfully outperform the market. As I argued earlier, it is largely a question of investment approach.

What should be debated is why there is such an overwhelming number of investors who decide to practice short horizon arbitrage where excess returns are less compared to the fewer number of investors who practice long horizon arbitrage where the excess returns are greater?

I agree with Charley's distinction between the "sensible" investors, who can "recognize and take advantage of the knowledge that the market is not perfectly efficient," from the "normal" investors who "will not improve their investment results by trying to beat the market." Buffett made a similar distinction between the "know-something investor" and the "know-nothing investor." The "know-something" investor is an individual who understands business economics and the difference between price and value. Based on that knowledge, the "know-something" investor constructs a concentrated low-turnover portfolio of mispriced companies that is held long-term. The "know-nothing" investor does not possess this knowledge or skill.

Charley is to be commended for identifying the challenges "normal" investors face in selecting mutual fund managers. Not only do the vast majority of equity mutual fund managers generate returns that are less than the benchmark, but individual investors who select mutual funds generate returns that are less than the mutual funds they select.

How so?

As Charley points out, investors "destroy over 25% of the returns earned by the funds they own by selling funds that have done poorly while buying funds that have done well - all too often way too late in both cases."

In my 1985 signed copy Investment Policy: How to Win the Losers Game, Charley tells us the reason we study market history is to protect our portfolios from ourselves. Nothing could be more important. The mistakes investors repeatedly make are behavioral in nature. Selling what causes discomfort only to buy what gives pleasure is a strategy of selling low and buying high.

We know the average major league baseball player does not hit above the major league average. Yet we can identify hitters who are clearly above average over time despite the fact they all go through slumps where performance falls off. Warren Buffett identified the corollary with investment managers in his popular 1984 article titled The Superinvestors of Graham- and-Doddsville.He reminds us it is possible to identify managers who follow a good process and have built a good long-term record. The question is what to do when the manager, like the baseball player, goes through an inevitable slump.

Even institutional investors seem unable to stick with good money managers who are going through slumps. My colleague Michael Mauboussin reminds me the academic explanation for this tomfoolery can be found in The Selection and Termination of Investment Management Firms by Plan Sponsors, by Amit Goyal and Sunil Wahal. These finance professors studied the decision-making process of 3,400 professional investors in retirement plans, endowments and foundations. Goyal and Wahal discovered that plan sponsors tended to hire managers who had above-average performance in the most recent period and to fire managers who had below-average performance in the most recent period. They also discovered that, on the whole, the managers who were fired performed better than their successors who were hired in the subsequent years.

So here again we are left with my nagging question - "Are markets efficient or is the investment approach necessary to beat the market difficult to apply?"

I think by now we know the answer. The markets are not perfectly efficient and the investment approach necessary to beat the market is very difficult to apply. But just because something is difficult does not mean we all throw up our hands and index our investment decisions. A second strategy would be to identify successful investors who have a great process. This would include a valuation approach to stock selection, a concentrated portfolio, and a long-term oriented approach to investing.