You can beat the stock market but it takes more than just watching five minutes of CNBC
Shares of Apple plunged 40% through the first few months of 2013 before surging 136% over the next two years. Shares of hot stocks like Netflix and Tesla frequently fall double-digits before rebounding.
That kind of stock market madness would seem to reject claims by some investors that you can’t beat the stock market, that you can’t analyze stocks for returns much better than the overall stock market.
Can investors find great investments through analysis or are stocks always priced exactly where they should be given all available information?
I’ve built this investing blog on the idea that investors don’t need to ‘beat the market’ even it’s possible. One of my stock market basics is that beating your own personal investing goals is much more important than an arbitrary return against the overall market.
Then again, why not reach for higher returns if you can?
The American Future Fund I set up on Motif Investing has jumped 23% this year, beating the stock market by more than 10% through mid-November.
Most investors don’t have the time spent by an army of investment analysts that dig into financial statements to make money on stocks. The good news is that you don’t need to get a job on Wall Street to find the best stocks.
I’ve found three investing strategies that have consistently worked for me and can help to pick stocks that outperform the market.
This article is the 15th in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.
I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. The book is an amazingly concise yet thorough education in investing for both defensive investors and those that want to reach for higher returns.
Graham goes further into how to pick stocks and whether it’s possible to outperform the market in Chapter 15. We’ll cover Graham’s argument against stock-picking as well as his ideas on finding investments. Then I’ll share the three best investing ideas I’ve found that have consistently worked for me.
Why is it so Difficult to Beat the Stock Market
You’ve no doubt heard one of the many studies that find most money managers are not able to produce returns above those in the overall stock market on a consistent basis. This has led to the belief that it’s not possible to pick stocks that have a better chance of beating the market.
In fact, it’s grown into a theory about the stock market called the Efficient Market Hypothesis. I won’t go too far into the theory except to list out the three levels.
- Weak efficient markets says that stock prices reflect past price movements and trends, that you can’t beat the stock market by picking stocks based on technical analysis.
- Semi-strong efficient markets reasons that stock prices reflect all public news and information, that you can’t beat the market through analysis of information in financial statements or other sources.
- Strong efficient markets says that even non-public information is immediately baked into stock prices, that you couldn’t pick stocks even if you knew behind-closed-doors information that nobody knows.
Most people agree that the ‘strong’ form of EMH isn’t true. Company executives are often investigated after making millions by trading shares based on their privileged information.
What about the other two parts of EMH that say you can’t pick stocks by analyzing past trends or financial statements?
I’ve always been skeptical of technical analysis, looking at past price trends and trading stocks to make a profit. A lot of investors claim to make money trading in and out of stocks on price trends but there are just as many investors that have lost millions.
I do think you can use analysis to find stocks that will outperform the rest of the stock market. It’s been proven not just with investment analysts like Peter Lynch and Bill Miller but I’ve done well with two strategies I’ve used over the years.
3 Ways to Pick Winning Stocks
Most of Graham’s ideas to pick stocks in the chapter are outside the reach of most investors. Graham talks about analysis of workouts, hedging and special situations as investing strategies he’s used to beat the stock market.
These three strategies involve some pretty detailed math and insight into corporate finance, much more than most investors have time to learn. I’ve talked about using options investing strategies to hedge your investments but that’s the extent most investors will want to go with Graham’s ideas.
1) My favorite investing strategy doesn’t revolve around picking stocks but involves taking advantage of long-term trends. Watch the economic news for five minutes and it becomes clear even the economists don’t know where the market is going over the next year.
Look further out though and it’s much easier to see the bigger factors that will drive sectors of the economy.
I’ve used the idea to create my American Future Fund, investing in the three sectors that will most benefit from long-term trends. Looking further out for your investments removes all the noise in the markets and takes advantage of bigger forces that will benefit all stocks in a sector.
2) Another strategy I’ve used that has beaten the market is by piggy-backing on Warren Buffett’s stock-picking genius. Big-money investors like Buffett are required to disclose their investments every three months in a 13-F form with the SEC.
I follow Buffett’s disclosure and then pick the best stocks from the list for my stock fund on Motif, The Warren Buffett Way. Buffett credits Benjamin Graham as his investing mentor so using the strategy is like using the tips in The Intelligent Investor and then narrowing the investments further.
3) Graham talks often about investing in companies selling below their Net Current Assets Value (NCAV). The NCAV is the value of cash and other short-term assets on the company’s balance sheet minus all its debt and other liabilities. Basically, it’s like buying the company at a huge discount and getting all its property and brand for free.
Finding these stocks is more difficult than the two strategies above and take more analysis. Using the Morningstar stock screener for ‘current assets greater than total liabilities’ offers more than 5,400 companies with more than 2,000 based in the United States.
To narrow the list to a manageable few investments, I add a few more criteria to the screen including:
- Market capitalization over $2 billion to limit to mid-size and larger companies
- Price-to-Book value of less than 1.0 to further limit the search to value names
This screen narrows the list down to just seven stocks. The problem with the NCAV investing strategy is that it still involves a level of analysis beyond the simple screen. Many of the stock picks from the screen are cheap for a reason because of poor business fundamentals or other reasons.
None of the current seven picks looked like good investments but that doesn’t mean the strategy doesn’t work. In fact, the evidence suggests that you can make very high returns if you use the screen to pick a couple of stocks each year and hold them for about a year. I’m following the strategy and will update the blog with what I find.
Grab your copy of The Intelligent Investor and follow along with our chapter-by-chapter review.
Finding investments that beat the stock market isn’t easy but I do think it’s possible. You don’t need to become a full-time investment analyst and you don’t need to use the complicated financial chemistry in hedging or special situations that have worked for Graham. Instead, combine the stock market basics we talk about here on the blog with a few simple strategies to pick winning stocks.