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Malcolm Gladwell is a fantastic writer and his new book, David and Goliath, got us thinking about his current thesis: David as a poster child for underdogs is a mistake. Gladwell contends that David had significant advantages over Goliath. In true Gladwellian form, he incorporates a myriad of disciplines to defend his thesis. And in true Smeadwellian fashion, we would like to add stock picking to the list of disciplines that strengthen Gladwell's argument.

Like any good bible scholar, Gladwell explained the strengths of David and weaknesses of Goliath. David was an expert "slinger" and had years (think 10,000 hours) of practice hurling stones at much smaller and faster wild animals. Goliath, conversely, was estimated to be almost seven-feet tall, but appeared to be of poor eyesight and very immobile. David defeated Goliath, Gladwell argues, because he never had to physically engage him by utilizing his strengths and neutralizing Goliath's physical superiority.

By now you may know where I'm headed. We at Smead Capital view stock picking or active management as David, even if it has, or rather because it has lost to the Index as a group over the last 13 years. The Goliaths of the investing world are the indexes, which include companies like Vanguard, BlackRock and State Street, among others. They are huge in size and control massive amounts of capital in their mutual funds and exchange-traded Funds (ETFs). As of November 30, 2013, Morningstar.com reports that 64% of all assets are indexed in the Large-Blend US equity category. This totaled $1.15 trillion invested in passive large-blend funds and ETFs. They, like Goliath, have obvious strengths. First, indexes have lower fees leading to lower annual operating expenses. Second, they keep their turnover low and stay away from trading expenses. Lastly, large-cap indexes hold their winners to a fault and milk their best performing stocks over the decades.

Passive strategies also have weaknesses like Goliath. First, they can be slow to move. It's our observation that mergers, bankruptcies, and dismal stock performance are the only ways to get out of an index. It seems that every five to ten years the S&P 500 Index gets over-loaded with the most popular companies of the prior years. In 1999, it was tech and telecom stocks. Indexes, unlike the active managers were not nearly as nimble and could not adjust their portfolios quickly. In 2008, the overload was in energy, basic materials and heavy-industrial/international conglomerates. To us, tech looked like it was a "crowded trade" on January 5th, 2014. Barron's Big Money Poll showed recently that over 30% of those polled think tech will be the best sector of the stock market in the next year and only 1% felt it would be the worst. Concept stocks in tech now go public at multi-billion dollar market caps and prideful popular tech stocks trades at high absolute prices and fairly outlandish P/E ratios. The S&P 500 owns 18.5% of its assets in tech stocks and has recently added some of the most expensive ones to the index.

We have reminded investors before of the advantages we believe David has in stock picking. Active managers can screen for factors, which have shown over long stretches to be affiliated with market outperformance (alpha). Valuation matters dearly and numerous academic studies reinforce this notion. Active managers can seek to buy cheap stocks from among the 500 companies in the index. We maintain that strong balance sheets are correlated with long-term success in stock picking, as are companies with long histories of sustainably high levels of profitability. Businesses, which generate high returns on equity and produce high free cash flow are also on the list. Lastly, active managers can become strong in analyzing businesses for long-term competitive advantages, which Warren Buffett coined as "moats." A wide moat protects the balance sheet and sustainably high profitability. One caveat: we believe these factors require long durations of ten years or more to get at these academic advantages and you must ignore what is going on around you.

With all these advantages, why has David been getting beat in the stock market by the index Goliaths? A) The spread between their annual operating expense and the indexes has been too high. Studies show large-cap US equity funds average 1.3% of annual expense. B) We believe active managers are way too active. Turnover among large cap managers averages 62% vs. 5% for the S&P 500. This causes 86 basis points of trading cost for the average large-cap fund. This is a total expense of 2.16%, a set of heavy armor that even good stock picking has a hard time overcoming. C) Heavy turnover causes over-thinking of the portfolio and leads to prematurely cutting off many of a manager's best long-term success stories. In the Bible, love covers a multitude of sins. In portfolio management, stocks which quadruple and/or even ten-fold increase in price, cover a multitude of 30% losses on individual holdings. D) Active managers have mimicked the index to protect existing capital. Studies have shown recently that having high Active Share (the percentage difference between a portfolio's composition and the benchmark's) has been correlated with long-term outperformance. This means that the less your portfolio looks like the index, the more likely you are to outperform. Think of it as a conviction level. David had conviction and it was enough to defeat Goliath.

Gladwell was kind enough to explain why active managers tend to underperform. He used the example of a real person with stage name of Caroline Sacks. She was an incredibly bright young woman with a passion and love of science. With brilliant grades and unparalleled SAT scores she chose the Ivy League School, Brown University, over her in-state school, the University of Maryland. When she took chemistry and organic chemistry at Brown, she was humiliated with lower grades (B-) than she had ever had. It caused her to switch to a major outside of science, her original love. The ridiculously high competitiveness of a school with nothing but brilliant kids got her away from her original passion. Gladwell argued that her mistake was putting herself in the hyper-competitive situation in the first place. If she had gone to Maryland, she would likely have had more confidence and stayed with her first love, he theorizes. Gladwell says, "She chose to be a little fish in a big pond, rather than a big fish in a little pond." Brown had a big pond of brilliant science majors and Maryland a much smaller pool of science prodigies.

We believe the gathering of assets in the stock picking industry works the same way as the most academically rigid institutions. We contend that active managers are too active because of the pressure they feel to perform well every year, rather than relying on the ten-year numbers to justify their base of capital. They seem to change investments too often and give up trading costs, cutting winners off in the process. They all go to Brown and most should go to Maryland, where they would likely have more long-run confidence. At Maryland, they could practice having David-like faith in the companies which academic studies show do outperform the index pre-expenses. You want to be a big (Active Share) fish in the small (low-turnover) pond. The closet indexers are little fish in the big pond dominated by passive participation.

We at Smead Capital Management believe that the key to success in stock picking is to do what the index can't do and replicate what the index does well, as much as you can. We want to build economies of scale to drive down annual operating expense, keep turnover at a minimum and ride our winners to a fault. But we want to do this with a portfolio selected based on our eight criteria which feature the factors we described above. In a way, it could be the best of Gladwell's world.

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. This article was written by Bill Smead, CIO of Smead Capital Management. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

Source: David (Active Management) Vs. Goliath (Passive Indexes)