The Road to Alpha: Take the Benefits of Indexing and Invest for Value

Proponents of the efficient market theory tend to make one main argument: If most market participants have underperformed the broad market averages, why won’t you? Essentially, I believe the value approach isn’t what the majority of market participants are using. In fact, according to Professor Greenwald of Columbia, fewer than 10% of investors are value investors.

I believe value investing is the only legitimate, high probability approach to beating the market over the long run. Buying an asset for below its true value and avoiding excess trading activity is naturally a favorable-probability endeavor. However, this statement makes two assumptions: 1) that you are capable of finding an asset’s conservative value; and 2) you won't be shaken out of the position by the market.

I believe it is the difficulty of embodying these two traits that makes value investing so difficult to practice. For example, I’ve spoken with a tremendous number of investors who simply believe the market can’t be wrong. They say, if Home Depot (HD) is as big and widely followed as it is, how can it not always reflect its true value? (I answered a question of this type in this post.) I have also spoken to many investors who simply can’t stomach holding a position with a quotation loss of 10, 20, 50% -- it’s not easy. Lastly, many investors want excitement. I’m the first to tell you that waiting for a stock with significant land reserves to begin liquidating isn’t as much fun as trading Baidu (BIDU), but it’s a much more favorable odds scenario.

Then the question arises: Why do the wide majority of market participants underperform the indexes? I think the answer is relatively simple: their activity doesn’t resemble the favorable characteristics of an indexing strategy; namely, a long term focus leading to much lower taxes and commissions. Study after study has shown that mutual funds with lower turnover rates generally outperform mutual funds with higher turnover rates. Why? Because funds with low turnovers resemble index funds, which are the consistent long term performers of the market.

Therefore, the best way to outperform the market is to take the benefits of indexing, eliminate its drawbacks (the "capitalization-weighted" approach), and create a portfolio. A multitude of ETF (exchange traded fund) offerings essentially follow this logic. For example, Wisdom Tree’s dividend ETF offering has essentially realized the benefits of indexing -- a long term perspective and relatively low turnover -- while adding an element that tends to outperform the normal index: only allowing dividend-paying stocks versus a capitalization-based approach. I recommend readers interested in Wisdom Tree’s common stock (WSDT) check out Altucher’s take in this TheStreet.com article.

While these ETF offerings are certainly interesting for the passive investor, I believe the more active investor can achieve a much more significant alpha (market outperformance) if they are willing to utilize the benefits of indexing, eliminate the drawbacks of indexing, and throw in a value investing focus.

Again, the key benefit is low turnover, which leads to much less paid in both commissions and taxes; and the key drawback is the capitalization-based position sizing approach. How can the value investor replace this approach with more favorable characteristics in his or her portfolio? I believe the investor would be much better off selecting stocks on the basis of valuation, placing a bigger bet on a stock with a greater discount to its intrinsic value (or a more immediate or definite catalyst) and owning much fewer stocks than the index.

While I understand the purpose of an index is to own a large basket of stocks, I don’t believe this approach should be mimicked by individuals (or funds) in their active-investment portfolios. Imitation of the diversification of these indexes, often to the extent of several hundred stocks, is a recipe for mediocrity. It forces the manager to own many stocks he doesn’t know too well and that aren’t trading at a discount to their intrinsic values. A manager who focuses only on stocks he believes trade at a significant discount to their intrinsic values (60-75 cents on the dollar) will find himself with far fewer positions than the index and, quite likely, his peers.