There are so many discussions amongst investors and academics about beating the S&P 500 and if it’s even possible. I not only think it’s possible, but likely for someone who has a decent knowledge of accounting and finance, calm temperament, and a long-term mindset. If an investor owns great businesses, and buys them at fair or better prices, then he or she should have an excellent chance of beating the index over the long haul. This is not to say it can be beat every year or quarter, as that probably is impossible. There will be some quarters and even years of underperformance. Some years the portfolio may underperform by a wide margin. In order to outperform the market there are a few things an investor must understand first.
Many academics have proclaimed that the market cannot be beat because all available information is already priced into stocks. They claim no amount of study or knowledge can overcome this. All the participants (the market) know all available information about a company and therefore stock prices always reflect this and adjust almost instantly. This is commonly referred to as the Efficient Market Hypothesis. Academics claim anyone purchasing an individual stock is gambling, and if they do happen to outperform the index, they just “got lucky.” Many famous investors such as Warren Buffet, Peter Lynch, and Joel Greenblatt regard this theory as utter nonsense and have proved it through their investing acumen.
This theory is nonsensical on several fronts. For one, many market participants are ruled by two emotions, fear and greed. The market often swings like a pendulum between these two extremes. Were all stocks perfectly and efficiently priced in March of 2009? How about in January of 2000? Did stock prices accurately reflect all known information? Some really solid, conservatively capitalized companies such as Nike and Starbucks were trading at around 10x earnings in 2009. They were priced as no growth companies and both had long runways for growth and still do to this day. Those are just two examples of many stocks that were trading at ridiculously low valuations. Many other companies had valuations that really did not make sense as they were extremely low and devoid of any sensible analysis.
On the other end of the spectrum, there was the Dot.com boom of the late 1990s. In 2009 when unjustified pessimism priced companies too low, the greed of the late 1990s priced companies in a way that sometimes assumed unattainable levels of earnings growth for long periods of time. Were companies with little to no earnings worth $40-$50 billion dollars of market value? Even many of the non-internet blue chips were obscenely overvalued. One of the best blue chip stocks, Coca-Cola, traded at 60x earnings at one point. Some basic math would tell an investor they couldn’t grow at 30%+ for many years which was what investors were implying with that kind of valuation. Stock prices were definitely not reflective of future earnings potential, they were just driven up by maniacal speculators. Many academics shrug these obvious mis-pricings off as “anomalies,” yet they happen fairly often if people are paying attention, although not often to the extremes of 2000 or 2009.
How does an investor beat the market? There are four main factors. I would look for high quality businesses, fair or better valuations, small to medium market capitalizations, and a long time horizon (10+ years).
For a high quality business I would look for high returns on equity and capital, strong free cash flow generation, a long history of high returns on capital implying a strong competitive advantage, and a strong balance sheet. These characteristics show a company is able to weather recessions and prosper in all economic conditions. If a company can combine a 20%+ returns on capital, free cash flow in excess of net income most years, and have little to no debt, it is very likely to be a high quality franchise. A few examples of these would be Mastercard, Boeing and Alphabet.
Valuation is more subjective and difficult to figure out what a “fair price” would be. A P/E ratio of 25 would be very high for a mature, mega-cap company with few avenues left for growth. For a company that earns a 50% return on capital, has a small market capitalization, and has a long runway for growth, a valuation of 25x earnings could be the deal of a lifetime. In a nutshell, an investor needs to have a fairly good understanding of accounting and finance in order to be able to come up with an approximate value of a business. I prefer a discounted cash flow analysis, but there is no “correct” way of valuing a business, nor will an investor ever get a perfectly precise number, only a range of values. Sometimes price/earnings, price/free cash flow, or EV/EBIT will work just as well. Just make sure all of them suggest a fair price, or better yet suggest undervaluation.
Company size is also a little more subjective. Mega-cap corporations will have a harder time beating the market over a long time period due to sheer size. If a company is making $20 billion per year in after-tax profit, it is going to be extremely hard to find opportunities to grow earnings in the high single digits or low double digits for a long period of time. It can be done as today’s tech companies are showing, but it isn’t easy. Small to mid-cap companies that are high quality are going to have a few more opportunities to grow than the mega-caps. If an investor’s goal is to outperform the index, then trying to find a few small cap gems to do most of the heavy lifting would be wise as long as they are held for a decent amount of time.
A long time horizon is a must as most of the market is fixated on the short term. This is the one huge advantage an investor has over the professionals. This is so important I will expand upon this in another post. When I define a long time horizon, I am talking about at least 10 years, if not much longer.
Another non-practical, almost joking way to beat the index is to find 10-20 of the worst businesses in the S&P 500. Find businesses that have awful returns on capital, need constant reinvestment of earnings just to maintain earnings and competitive position, generate little to negative free cash flow, have large boom and bust cycles, no pricing power, and have a history of massive earnings fluctuations and dividend cuts. Once you have found these 10 or 20 sub-par operations, buy the other 480-490 and hold for 10+ years. Granted, this is pretty impractical and you won’t beat the index by a lot, but an investor would outperform. This would be more of an option for someone who is already fairly wealthy, as it is impractical if not impossible for someone with $5,000 to invest to buy 480-490 individual companies.
If someone had a goal of really crushing the market, which I define as outperformance of 6%-10% or more per year on average, then buying and holding great companies may not work. If someone wants 16%-20% annual returns they would need to focus almost exclusively on small and micro-cap stocks and own a fairly concentrated portfolio of maybe eight to ten stocks. Owning 30 different stocks and expecting the portfolio to compound at 20% per year isn’t realistic. Owning eight or nine stocks gives an investor a much better chance, if the investor is extremely skilled. Some turnover would be needed as well. An investor would have to have a good sense to when a small company isn’t growing as fast and then selling the position to redeploy the funds into a different, faster growing company at a reasonable price. This is certainly a difficult method, but growing wealth at high rates for many years takes much skill and knowledge.
Buying high quality companies at decent valuations should have a strong chance of outperforming the S and P by 1%-3% per year over the long term. Nothing is certain, and some companies may even fail outright. That shouldn’t matter as long as the investor has some diversification and allows the winners to run. Suppose someone went back to the beginning of 1986 with $100,000 and bought 6 companies. Furthermore, that person is going to concentrate the portfolio into the worst choice in hindsight. The investor decides to put 50% of the portfolio into J.C. Penney, and then buys 5 different stocks, Wells Fargo, Hershey, Boeing, Exxon, and Johnson and Johnson. He puts 10% into each of those. J.C. Penney, while not yet bankrupt, has been a total disaster. The starting $50,000 bought 10,352 shares that are now worth ~$14,000. He or she would have collected a decent amount of dividend income over the years, but the dividend was cut in 2000 and eliminated in 2013. This would seem like a total nightmare and would confine the portfolio to very low or even negative rates of return. Obviously, this portfolio couldn’t have possibly beaten the market with such a high weighting to a very poor investment. As it happened the other companies more than pulled their weight. As of Feb. 4th, 2019, the portfolio compounded at 8.47% vs. 7.48% for the S&P 500, without dividends reinvested. Sure, the five successful stocks were solid winners but none was unheard of at the time, or required a significant amount of digging to find. Don’t listen to people that say the market can’t be beat. It is very possible for someone who is willing to put in a decent effort, and buys a few solid companies and holds them for a long period of time.