3 Ways To Avoid The 'Rigged' Stock Market

Includes: BRK.B, CL, GE, IBM, JNJ, MSFT, PG
by: Tim McAleenan Jr.

How many times have you ever heard someone compare stock market investing to a casino, or claim that the stock market is rigged against the little guy ever having a chance of accumulating meaningful wealth? When someone makes this kind of claim, they usually cite to one of three occurrences to make their point:

1. They may point to crazy short-term phenomena in the market (like high-speed computer trading) to point out that the individual investor does not have a chance to compete.

2. They may cite the high compensation received by CEOs, other executives, and other "insiders."

3. They may point to the poor performance of many individual stocks within the S&P 500 over rolling ten-year periods such as 1999-2009, 2000-2010, etc.

This article at The Guardian does an effective job of explaining the concerns about high-speed trading that have concerned some investors about the credibility of the stock market:

The problem is that computer-inspired disasters are happening too often, especially in the US. The botched Facebook (FB) flotation caused a $356m loss at UBS, for which the Swiss bank is suing Nasdaq. Then there was the extraordinary "flash crash" in the US on 6 May 2010 when the Dow Jones industrial average lost $1 trillion of market value in half an hour and the share prices of some major multinationals plunged almost to zero. The loser in such events is general confidence in the strength of markets' infrastructure.

Again, it might be argued that the dust settles quickly (although the lawyers will have fun for ages in the Facebook case) and normal service is resumed. But will that always be so? That's the worry. "The flash crash was a near miss," Andrew Haldane, the Bank of England's executive director for financial stability said last year. He argued that an uncomfortable truth had been revealed about the state of knowledge of modern markets: "Not just that it was imperfect, but that these imperfections may magnify, sending systemic shockwaves."

There is no doubt that this is a real problem that needs to be addressed. The market systems need to have integrity, because things can quickly fall apart when trust in a system falls apart (just ask someone living in Cyprus right now). There is general agreement on that point.

But just because the markets can be manipulated in the short term should not serve as a basis to deter someone from establishing stock ownership. This is because if you make an investment for the long term and focus on the performance of the business, then short-term fluctuations (wild as they may be) are only hiccups throughout the process of wealth creation. One of the craziest examples of this occurred in 2010 when Procter & Gamble (NYSE:PG) fell from $62 to $39 per share in the flash crash.

Certainly, it can be alarming to see a stable blue-chip holding drop 30-40% in a matter of hours. But no matter what price Procter & Gamble traded at in 2010, this fact remained true: each share represented $1.80 in annual dividends and $3.53 in annual earnings. The performance of the business itself is not affected by fluctuations in the stock price, and if you build a portfolio that focuses on the earnings and dividend growth, then you can put yourself in a position to absorb a wild fluctuation in the stock price. Even though Procter & Gamble fell to $39, the dividends did not miss a beat (and they have not missed a beat since 1957). When you remember that a stock price is only what someone else is willing to pay to take away your ownership, it is much easier to "approach volatility philosophically," as Charlie Munger said to CNBC in 2009.

The next concern that can sometimes deter investors from stock ownership is the compensation of CEOs, executive, and other "insiders." The best way to deal with this concern is to buy companies where the underlying business is incredibly strong, and can withstand abuse. IBM (NYSE:IBM) and Colgate-Palmolive (NYSE:CL) both lead their peers in terms of executive compensation (the executives' compensation is tied to earnings per share growth, hence the management of both corporations tilt in favor of continuously running stock buybacks), and yet they have delivered strong returns to investors over the past decade.

And yet IBM has managed to return 11.71% annually to shareholders since 2003, and Colgate-Palmolive has managed to return 9.26% annually to shareholders since that time frame. While the best defense against high executive compensation is to buy something like Berkshire Hathaway (NYSE:BRK.B) that does not engage in the kind of share dilution that is typical in corporate America, the next best defense is to own the kinds of excellent companies that have the underlying business strength to tolerate high executive pay and still deliver strong results.

A third reason why some investors may argue that the "stock market is rigged" is because the ten-year returns of many companies from 1999-2009 or 2000-2010 did not seem particularly impressive. This would be a meaningful indictment of long-term investing if not for the fact that many of the largest blue-chip stocks in corporate America traded at excessively high valuations around the 1998-2002 period.

Looking back on it, they were crazy times. Johnson & Johnson (NYSE:JNJ) traded at 31x earnings in 1999. General Electric (NYSE:GE) traded at 40x earnings in 2000. Microsoft (NASDAQ:MSFT) traded at 53x earnings the same year. It is hard to build wealth when you excessively overpay for mega-cap American companies because they usually cannot deliver the kind of double digit growth that is necessary to overcome excessively high P/E valuations. The fact that some investors reaped sub-par returns with these kinds of blue-chip stocks is no conspiracy. There is a reason why Benjamin Graham always instructed his students to ask "On what terms? And at what price?" when considering a potential investment. The P/E compression when a blue-chip stock goes from 31-53x earnings to 15-20x earnings can explain much of the poor performance. This is no evidence that the stock market is "rigged." If you pay twice what an asset is worth, it is going to take 5-10 years for the earnings growth of the underlying business to catch up in a way that will allow you to reap meaningful total returns from that point forward.

If you can identify what your potential concerns are with investing, it is easy to get ahead of the game. If you are bothered by short-term computer glitches that can manipulate the markets, then a reasonable solution to that concern is to become a long-term investor that focuses on earnings growth instead of price fluctuations. If you are bothered by excessive executive compensation, then it is likely worthwhile to invest in the kind of blue-chip businesses that can withstand a lot of abuse (the more time-consuming alternative is to comb through individual financial statements to find firms with low or moderate executive compensation). And if you are concerned by the poor returns of many investments from 1999-2000 through 2009-2010, then you should do well to keep in mind how incredibly high the valuations of many S&P 500 companies were at the turn of the millennium. There are some legitimate concerns that the stock market has become a "rigged casino," but if you define explicitly what it is that bothers you, you can likely craft a long-term strategy that sidesteps these concerns.

Disclosure: I am long GE, PG, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.