Prioritizing Stock Selection

Michael Santoli's column this week focused more on ETFs than usual. He talked about stock picking not having been rewarded in the last few years due in part, he says, to "the dominance of macro, rather than company-specific factors, in driving returns."

He went on to support his argument with stats about the number of funds in various categories (large cap, mid cap and small cap) that have lagged their respective benchmarks over the last three years. He says this creates a desire to just use index ETFs to merely capture the exposure.

Actually I think this is a flawed argument. Most mutual funds have to be close to fully invested often having limits to how much cash they can raise. This is a similar dilemma as exists at full service brokerage firms where brokers place assets with outside managers. In both cases the mandate is invest this money (there will be exceptions here and there) so this means the money has to be invested. The managers in question must assume that the asset allocation decision has been made and for all the manager knows money in their fund could be part of an asset allocation where they have the only 10% targeted to equities. That a bunch of funds lagged their benchmarks during an anomalous period is at best incomplete information.

His macro conclusion could be correct, I just don't think the mutual fund results are much of an indicator.

As to the bigger point about stock picking, being a top down investor I am inclined to mostly agree but I would probably always think that--I don't think the term stock picker's market holds much water. The top down line of thinking is very easy to understand; the most important decision is whether to be in the market at all. Forgetting taxes and commission drag for a moment, if you knew the broad market was going to cut in half, the best thing to do would be to sell out and wait for the decline instead of trying to find the few stocks that would somehow go up.

In the real world we do have taxes and commissions and we can't know that the market will cut in half but we can heed warnings from the market about elevated risks versus other points in the cycle and practically speaking we can reduce net long exposure one way or another.

Basic top down theory would say that picking countries, sectors and themes would be less important than being in the market or not but more important than stock picking. If you only made one active decision in 2008 and it was to avoid financials you fared much better than the S&P 500.

Stock picking being least important is far from unimportant. The first thing that comes to mind here is dividends. While dividends are not the most important thing in a year like 2009 when the market goes up twenty-something percent, they are very important most of the time. Here the conversation could include sustainability or growth but either way I am a big believer in adding some basis point versus the benchmark, this matters during most of a typical cycle, and this is done at the stock picking level--it is very difficult to get a 3% yield in a portfolio using ETFs and still being properly diversified.

Also every segment where you might be inclined to use an individual stock instead of a fund of some sort will have some names that are "right" and some that are "wrong" and sorting this out correctly more often than not will also be a big, long term difference maker. As one example, over the last five years Hewlett Packard is up 22% which looks like a fantastic result given the 1.7% increase of the S&P 500 until you realize that in the same time Apple (AAPL) is up 444%.

It is also easier to increase or decrease portfolio volatility with individual stocks. While this is not as important as being in or out of the market I do believe it to be quite important and again it is about stock picking.

Today, tomorrow and Wednesday I will be taking a class at the Arizona Wildfire Academy which I am looking forward to. It has been a few years since I took a class so it should be fun. Fortunately the college campus where it is held has wifi and my phone should keep me in touch as well.