Of course you can, and it isn’t that hard. I read a recent study that showed that over 50% of portfolio managers over a 10-year period under-performed their benchmarks. I’ve read other studies surveyed over longer periods of time that the number is more at 70%. These managers usually have MBAs from top schools, are CFA charter holders and are paid very well, so why does this happen.?!?!? Because they are human and the current system works against them. Here are a few of the reasons I think this occurs.

1) In a Vanguard study, they figured out that one of the biggest factors working against active managers was cost. That 1.5% average mutual fund fee was most of the difference between their results and the averages.

2) Investment funds are encouraged to manage more money and therefore increase revenue. This can force a manager to spread out the funds over a greater number of stocks because they don’t want to own too high a percentage of any single stock. In many cases this over diversification is mandated by clients, to their detriment. I believe the average mutual fund has well over 100 stocks in its portfolio. But if you have over 100 stocks in your portfolio, are you really an expert on all 100 companies? I doubt it. Some people in my field playfully call this diworsification.

3) Investors are emotional. When something is popular, its easy to go along with it, but being an independent thinker is difficult in this business because it might be counter to what everyone else is doing. If everyone is mediocre and you temporarily under-perform even slightly as an independent thinker, you might get fired for sticking out and being different, but your strategy might be the best one in three months and you were just early. A person who fears for their job security will not stick their head out and therefore limits his ability and returns.

4) The system works against investors. My company currently only deals with high net-worth individuals and some foundations but I did my research on institutional money. Institutions who don’t manage their own money will farm out this service to dozens of managers. Again, more diworsification. Institutional also like to compartmentalize every strategy available, meaning, a percentage of the funds go to small cap value, small cap growth, mid-cap value, mid cap growth, large-cap value, large-cap growth, emerging markets, international markets, retail REITS (real estate), Hotel REITS, etc…… you get the idea. All these things confine what a competent manager can do.

Simplified Example: I run a small-cap value fund that stipulates that stocks be in the $500 million to $1 billion range. If I find a great company that is $450 million, I can’t invest. Or if I find a company that is $900 million in market capitalization and I think that it will triple to $2.7 billion, once it goes past that $1 billion mark, I would be pressured or maybe even required to sell because it does not fit the criteria. Very limiting! The reason institutions do this is because they are fearful of overlap.

So how does one beat the market? Here are some simple solutions that are already well known in the industry but infrequently practiced because of “the system”.

1) Don’t over diversify. A portfolio of 30 stocks statistically is enough to appropriately spread out non-systematic risk (company specific risk, i.e. a fire at a factory).

2) Focus more on small- and mid-cap stocks. Individual research is more valuable in this area because large brokerage analysts focus on larger companies. Its easier to find a diamond in the rough. Small- and mid-cap represents companies in the $500 million to $10 billion so there are plenty of companies to choose from. And these are not dinky companies either. Many are of niche products and may even be the dominant company in their industry. These smaller companies also tend to be more focused making them easier to evaluate and can lead to faster growth.

3) Buy value. In my “Seven Signs For Superior Stock Selection” page, I mention qualities that have shown to enhance returns. But studies have also shown that just buying a portfolio of inexpensive stock compared to its book value or earnings can lead to above-average returns. In many cases, volatility also decreased. Higher returns and lower risk? It doesn’t seem possible, but this has been shown in many academic studies.

4) DISCIPLINE. Even if investors implement these pointers I’ve laid out, people can get emotional and chase after returns or liquidate position when things aren’t going their way. Numerous times in my career I would have conversations with portfolio managers and analysts that espoused what I have been saying on this blog, but sometimes they would get enamored with a stock with such a great story that they would bend the rules and not adhere to their original strategy. I also found it funny that two different funds would call me about a different stock; one being a value fund, the other a growth fund. They categorized it as what they wanted it to be.

What about the Efficient-Market Hypothesis (EMH)?

The hypothesis asserts that financial markets disseminate information efficiently; therefore markets are priced appropriately and immediately when news is made public. This hypothesis was widely accepted by academics for decades, meanwhile, Warren Buffet was accumulating billions of dollars. Studies have subsequent shown that a simple portfolio of low P/E stock can outperform the market with the same or less risk. More importantly, the hypothesis has one fundamental flaw which is that it assumes the markets are rational. People and their decisions make up the market, and they CERTAINLY are not rational. During my professional career I have survived the internet bubble of the late 90’s and the most recent real-estate bubble. I repeatedly heard pundits on TV, magazines, and newspapers warning about a possible deflation in these markets. The problem is that there was a heard mentality. People were making money and everyone wanted a piece of it. If they heard what many experts said, they ignored it. For those who vilified every financier involved in the real estate bubble, I feel for them because even if they knew things would end poorly, they were put in a tough position. Can you imagine going to your boss who is providing you with large bonuses and is probably making millions himself and telling him that he should turn away business because it might lead to a speculative bubble that would pop and possibly take down the entire economy? NO, that person would have been fired immediately. There was demand for mortgages and their securities and people provided a service. Greed was the culprit. Greed from speculators and then greed from people who jumped in because they thought they could make an easy buck. Everyone who tried to make money off rising real estate prices is to blame to some extent, but not one individual, in my humble opinion. As for the EMH, many academics are mainly in agreement with me and have poked plenty of holes in the Efficient-Market Hypothesis.

Tags: diversity, efficient market, midcap, smallcap, value stocks