Seeking Alpha

An Open Letter To Stock Pickers

by: Erik Conley
Summary

Stock pickers get a bad rap in the investment community. This deserves an examination of the record.

The first thing a retail investor must acknowledge is that he/she is starting out with a distinct disadvantage relative to professional investors.

I think the better way to develop an edge is by taking advantage of the limits that govern large institutional investors like mutual funds and pension plans.

Stock pickers get a bad rap in the investment community. This deserves an examination of the record.

Stock pickers have a very tough job. With 100 million investors competing in the stock market arena, the $64,000 question for stock pickers is this - do you have an edge? And if you say yes, why do you think so?

Is it just vanity, or overconfidence that makes you think you have an edge, or do you know things that the other 99,999,999 investors don't? The way you answer this question could spell the difference between your lasting success or your ultimate failure. Wall Street is littered with the bodies of stock pickers who shined brightly for a while before they crashed and burned.

The rarity of stock picking prowess

I fancy myself as an above average stock picker. My track record speaks for itself. Notice that I didn't claim to be one of the best, or a stock picking savant, or a stock market genius. I have humility and respect for the power of the market. The day I start to believe that I've got it all figured out is the day I will begin my fall from grace.

Why is humility important for a stock picker? Because it acts as a braking mechanism for the human tendency to believe that you are better than you are. Studies show that 80% of drivers believe that they are above average. Obviously, this can't be the case. My own study of retail stock pickers showed that 65% claimed they beat the market by an average of 4 percentage points per year. Upon further investigation, their account statements said otherwise.

Skilled and successful stock pickers are out there

In my professional career, I've come across a few highly intelligent, highly skilled stock pickers. I know for a fact that they exist. One firm I worked for had an entire corral full of these skilled people, and while I was working there, their assets under management skyrocketed from $1 billion to $12 billion in just 3 years.

What was their edge? As boring as this may sound, I believe their edge was in their process. Once per week they held an Investment Committee meeting. The portfolio managers and analysts gathered around a large oak table and spit-balled ideas. They used the Socratic method, which involves putting forth an investment thesis and having the rest of the room try their hardest to poke holes in it. Kind of rough, but very effective.

At the end of these weekly sparring matches, there emerged a few promising ideas, which the portfolio managers then went on to further vet them with their sources of choice.

The end result was outstanding. Roughly 90% of the ideas pitched by the analysts were rejected, and the other 10% ended up in the mutual funds that these managers ran. That's what an edge looks like. What's your edge?

A retail investor can develop a meaningful edge

The first thing a retail investor must acknowledge is that he/she is starting out with a distinct disadvantage relative to professional investors. That's rather obvious, but it doesn't prevent retail types from believing that they are smarter, faster, better than the competition. I say that this is a big mistake, It's hubris, and hubris is a notorious performance killer.

I think the better way to develop an edge is by taking advantage of the limits that govern large institutional investors like mutual funds and pension plans. For example, these behemoths are slaves to investment committee meetings. Nothing gets done until the boss signs off on an idea after days or weeks of debate. A retail investor has no such constraint. Take an idea, do your due diligence, and pull the trigger. That's an edge.

Another edge is that a retail investor can go anywhere, buy anything, and not have to answer to the boss. This is what hedge funds do. They have a wide berth within which to operate, but they too must answer to the boss. A retail investor doesn't have that constraint.

One more edge before I wrap up. Fees & Expenses. Professional investors must recruit and hire the best and brightest minds in the world. That doesn't come cheaply. Payroll is the largest expense item for most fund organizations.

Furthermore, when a portfolio manager puts together a series of successful, market-beating years, he or she will renegotiate their compensation package accordingly. This is why mutual fund fees are still so high.

But a retail stock picker doesn't have this expense. He or she captures 100% of the net gains in the portfolio and pays Uncle Sam for the privilege.

My advice to all you stock pickers out there

First, be aware that you are facing an uphill battle. Unless you're prepared to spend lots of your free time, and lots of your money on developing your edge, you would be well-advised to stick with low cost index funds. Trust me, you'll be much better off.

If, on the other hand, you believe that you truly have an edge, then by all means go for it. You will need some essential tools, like a clearly defined Investment Policy Statement, a detailed Plan B for bear markets, and someone who knows you very well who is willing to tell you that you're about to do something really dumb. That's the Socratic method.

Gut check. Did you buy any of these stocks after the last market bottom in 2009?

Can you guess which stocks were the best performers since the market bottom in 2009? I bet you can if you happened to own one or two of them and have held them for the last 10 years. But how likely is that? Not very, in my opinion. More likely is catching a stock that's on fire and selling it way too soon. This is the retail investor's curse.

Here are a few stocks that have shined since the bottom in 2009, how many do you recognize?

  • PATK Patrick Industries. Up 2,300% per year since March 2009.
  • SNBR Sleep Number Beds. Up 1,800% per year since March 2009.
  • CAR Avis Budget Rent-a-Car. Up 900% per year since March 2009.
  • TREE Lending Tree. Up 800% per year since March 2009.
  • ULTA Ulta Beauty Inc. Up 700% per year since March 2009.

If you are a retail investor who likes to pick stocks with the goal of beating the market, the list shown above should give you comfort. It can be done.

But there's also a downside. I won't list them here, but you can see all of the stocks and all of their performance records since 2009 by clicking the link below.

https://1drv.ms/x/s!AlbozmxskaQgikfnyrQQ9xpR7ZLV

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.