Why It Can Be Self-Destructive To Compare Yourself To The S&P 500

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 |  Includes: ABBV, ABT, IBM, JNJ, SPY
by: Tim McAleenan Jr.

Summary

Many high-quality investments, such as Johnson & Johnson and Abbott Laboratories, underperform against the S&P 500 for extended periods before delivering long-term outperformance.

In IBM's case, the company has been growing at 9-10% annually while only delivering 4% returns, suggesting it could be foolish to sell a growing company prematurely.

If you are personally underperforming against the S&P 500, it can be tempting to engage in the practice of "selling low" by exiting a stock at an inopportune time.

In 2012, the S&P 500 (NYSPY) gave investors annual returns of 16.00%, including dividends in the total return calculation. During that year, Johnson & Johnson (NYSE:JNJ) gave investors a total return of 10.51%, and that includes dividends. In 2013, the S&P 500 returned 32.39%, while Johnson & Johnson has returned 35.31%.

During both of those years, I owned Johnson & Johnson stock and spent a lot of time watching the shares of the company underperform from a capital appreciation standpoint relative to the S&P 500. Instead of worrying that I was somehow missing out, I came to enjoy the income growth that is inherent when you are receiving 3.5% of your investment amount back in the form of cash dividends, which adds new shares that nicely complement Johnson & Johnson's annually growing dividend during my time of ownership.

I figured when the significant capital appreciation inevitably came, those reinvested dividends would have a turbo-charged effect when it comes creating wealth, and after the stock price appreciated, I could make a determination about whether I wanted to reinvest the dividends elsewhere or pump them back into more shares of Johnson & Johnson (e.g. maybe I'd want to put the JNJ dividends into a stock with higher earnings per share growth like Visa (NYSE:V), better valuation like IBM (NYSE:IBM), higher immediate income like BP (NYSE:BP), or maybe I would spend the dividends and do fun things to enjoy life because there is no reward for being the richest man in the cemetery).

So far in 2014, the S&P 500 has returned 16.96% while Johnson & Johnson has returned 24.09%.

This is why I find it foolish to compare my own portfolio performance to that of the S&P 500 at large. Because price change is such an important ingredient in total return, and because price only reflects what other people are willing to pay for an ownership interest at a particular point in time, it would seem unwise to measure my success against changes in price quotations rather than changes in business performances of the companies I own.

When someone says that it is necessary to compare one's portfolio to that of the S&P 500, I can't help but wonder: Is that really your goal-to spend your life trading barbs with the S&P 500 year after year? Or is it build an income stream that lets you lead the life you want on your own terms, be it from organically living off dividends or from having such a sizable nest egg that you can sell your shares perpetually and still do fine?

And plus, if you're underperforming the S&P 500 at a given point in time, what are you supposed to do that information? Presumably, people who advocate tracking individual performance against the S&P 500 suggest doing something in the event that you're underperforming the baseline index. To me, that sounds like a formula for selling low.

Imagine if I looked at Johnson & Johnson at the end of 2012, and said, "You know what, these shares have been lagging the index by five and a half percentage points, time to let them go. Better buy the S&P 500 Index, because after all, it's been doing better than my individual selection." If that was my attitude, I would have missed out on the three percentage points of outperformance in 2013 and the seven percentage points of outperformance so far in 2014. I know Johnson & Johnson is a high-quality asset with likely earnings growth of 8-11% over the long term and a dividend growth rate to match; I don't need to parse its relationship between the S&P 500 to determine whether it's an intelligent investment. I'd rather focus on my own goals and march towards them rather than worry about whether someone out there is getting richer at a faster rate.

Sometimes, the undervaluation can last for years and years. For most of the 2000s, Abbott Labs (NYSE:ABT) traded in the $40 per share range, having trouble keeping pace with the S&P 500. If someone was using that as a measuring stick rather than taking solace in owning an excellent business that had been raising dividends every year for decades, at what point would they have thrown in the towel? After three years of S&P 500 outperformance? Five? Ten? If they did, they would have missed out on the rapid wealth creation that came after the announcement of the Abbvie (NYSE:ABBV) split, and would have instead captured Abbott's years of underperformance against the S&P 500 and then switched to the index just in time to see the stock spinoff that would have made sticking with Abbott Labs a better investment.

To give a current example in the moment, I own shares of IBM. Since the start of 2013, it has averaged returns of 3.57% annually. The S&P 500, meanwhile, has average returns of 21.10% annually from the start of 2012 through July 28th, 2014. I can look at IBM's fundamentals and see that the business has been increasing profits per share at almost 10% annually (about of this coming from stock buybacks) during the time of my ownership, and given the actual profit growth of the firm during my time of ownership, it would seem foolish to associate those 3.57% annual returns with economic reality and sell the shares.

When you see a business growing faster than its stock price (assuming the stock wasn't overvalued to begin with), you should buy more if you are a value investor and enjoy the opportunity presented rather than lament the relative outperformance of the S&P 500 during that period of time.

For those of reasons, I see limited appeal in comparing my own performance to that of the S&P 500. Over the past twelve months, I have beaten the S&P 500 by five percentage points, but believe it or not, that doesn't change anything. People don't come up to me in bars, whispering, "Oh my gosh, there's that guy who's beating the S&P 500. Let's get his autograph." There's not much personal satisfaction from beating the S&P 500, because it's an ephemeral accomplishment by nature-by the end of August, a few price changes could have me underperforming. Instead, I focus on what does bring me personal satisfaction, and that is coming closer to reaching my personal goals. So I stick with that as an objective, and measure myself according to that.

There's also an element of dangerousness to comparing yourself against the S&P 500, because it suggests that you must do something when you are underperforming. That sounds like selling low, one of the notorious causes of retail investor underperformance over the long term. Instead of worrying about price changes, I'd rather focus on changes in business fundamentals over the long term, and build a collection of assets that regularly churn off income in the highest probability way. Dividend checks from Nestle (OTCPK:NSRGY), Colgate-Palmolive (NYSE:CL) and Hershey (NYSE:HSY) have an element of permanence backed up by decades of dividend growth that seems much sturdier than parsing points between an individual's portfolio and that of the S&P 500 Index.

Disclosure: The author is long IBM, JNJ, BP, V. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.