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"To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that 'in any sort of a contest -- financial, mental or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try.' I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted." –Seth Klarman, hedge fund manager (Baupost Group) and author of "Margin of Safety."

Now to be sure, I want to start this article with a huge caveat. Index investing could quite possibly be in the interest of most investors. Barclays research reported that during the secular bull run of the 1980s and 1990s (back in the days when stocks were returning just under 10% a year), the average investor earned just around 4% on their investments. Why is this? I would guess the answer is twofold:

  1. Most of the U.S. does not have the temperament to hold onto our stocks through difficult stretches. In 2008-2009, Coca-Cola (NYSE:KO) fell to $40 per share. For every share of stock that someone buys, someone else has to be selling it. If you were selling Coca-Cola at $40 because you couldn’t handle the market fluctuations, you shouldn’t be surprised when you achieve subpar returns on your investments.
  2. A lot of people do the opposite of the adage "buy low, sell high." Gold seems to be a good example of this. Usually, the worst time to get in on an investment is when "everyone and their mother" is talking about it. And that seems to be the case with gold today. I was talking with a janitor last week who was excitedly talking about how he made $4,000 from the gold coins he sold. I have no idea what’s in store for gold’s futureit could hit $3,000 an ounce for all I know (it’s not like the U.S. Treasury has slowed down the printing presses), but I can tell you thisthe investors who do the best are the ones who bought gold when it was out-of-favor at $500-$600 an ounce. Now that it’s incredibly en vogue, the margin of safety is no longer. When you buy an asset after a great run-up, you’re greatly decreasing your margin of error. If you buy gold today, you’re not buying low and selling high. You’re buying high and hoping to sell higher.

And heck, it’s not like the professional mutual funds have been doing much better. Depending on the statistics you cite, anywhere between 70-90% of active mutual funds underperform the indices. And when you factor in the fees, it’s that much higher of a mountain to climb. So I’m not trying to argue against the benefits of the average investor dumping a lot of their savings into the Vanguard Total Stock Market Index.

But I do think that, for many types of individual investors, they can aim to outperform the indices. If you’re the type of person who can hold through downturnswhether it be 1987, 2001, 2008-2009, or today, and if you have the discipline to search for undervalued companies and hold them for the long-haul, I think you can come out ahead of index. If you can eke out an extra 1% or 2% over the average market returns during your investment lifetime, it can make a world of a difference. Over the course of 40 years, 9% returns on an initial investment of $100,000 would turn into $3.6 million. If you could earn 10.5% over that time-frame, you would have $6.5 million. Over the course of your investing lifetime, that measly 1.5% annually could almost double your money. Of course, that’s a double-edged sword; if you underperform the market by that much, you’re putting yourself in a position to literally lose millions over an investing lifetime.

Personally, I would have no desire to own an S&P 500 index. It would bother me to know that I was purchasing a small fraction of stocks that I have absolutely no faith in. I do not anticipate that Eastman Kodak (EK) will deliver solid returns over the long-term, so why would I want to put my hard earned money into it? I think Kroger (NYSE:KR) is going to lag the market over the coming decade, so I would hate to know that part of my investment was going into the company. And heck, I wouldn’t want to touch the entire airline sector. Bob Crandall, the former CEO of American Airlines, once said, “I don't invest in airlines. And I always said to the employees of American, 'This is not an appropriate investment. It's a great place to work and it's a great company that does important work. But airlines are not an investment.” In the entire history of its existence as a sector, the airline industry has not made money, so why would I want to index and accumulate an ownership stake in Southwest Airlines (NYSE:LUV)? It doesn’t interest me. I could very well be wrong, and Southwest could go on a tear this decade, quadrupling in value, but I’d be a fool to invest in stocks I don’t honestly think will do well. And as I continue to go through the S&P 500, I can easily weed out 100 companies that I think will lag the overall market over the coming decade.

And another drawback I see is that indexing also forces you to buy companies that you consider overvalued. I think Tiffany & Company (NYSE:TIF) is a fine jewelry maker poised to make strong profits in the future, but I don’t want to pay $70 per share for it. But when you purchase an index, you have to buy it warts and all, and that includes the companies currently trading at prices that you might consider unreasonably high.

But as you continue to go through the S&P 500, before you know it, you’ll be looking at a short list of about 20-30 that you really like, and think are poised to outperform the market. And this begs the question, “Why not buy those stocks individually?”

For instance, when I look at a company like Intel (NASDAQ:INTC), my eyes pop out when I see that it has raised its dividend by 28% annually over the past ten years (yes, that’s not a typo), and it’s only paying out 38% of its earnings over the past twelve months as a dividend. And Intel currently offers a 4.31% dividend yield, and an 11% earnings yield. That gets my attention. Personally, I’m fairly confident that Intel will beat the market average over the coming five to ten years. And if I can find a dozen or two stocks that fit Intel’s profile, why should I buy an index fund that saddles me with stocks that I don’t like, don’t believe in, or consider overvalued? I think that if you’re a reasonably disciplined person with both a good temperament and an eye for value, you ought to give individual stock-picking a look.

Source: The Case For Individual Stock Picking