The domestic stock market is the most familiar of the capital markets to the average investor, perhaps because it is the most accessible. The financial news reports on daily fluctuations in the market, and commercials offer easy access to trading. Most investors are familiar with the stocks of companies like Amazon ($929 billion in market capitalization) and Apple ($964 billion), but far fewer follow the action in assets like Belgian government debt ($494 billion outstanding)1 or daily price movements in U.S. student loans ($1.6 trillion outstanding)2. However, there’s far more to consider when investing in stocks than simply a familiar name.
WHEN AND WHY WE INVEST IN INDIVIDUAL STOCKS
With so many investment professionals engaged in stockpicking and more resources devoted to the task, it has become increasingly difficult to beat the market over the years. Many investment managers have been moving to a completely “passive” approach, using only index investments that effectively mimic the performance of the market. In most asset classes, we utilize a blended approach, using low-cost “passive” investments to track the results of the index, while paying a reasonable price for a few sensible, consistent “active” strategies that we think can outperform the market over a full economic cycle. We think this has the potential to provide clients with the best of both worlds—core positions that provide low-cost exposure across asset classes with satellite positions providing an attractive combination of cost and performance.
Importantly, an active strategy may increase the probability of outperformance, but it typically produces greater deviations from the benchmark than a purely passive approach, as shown in the chart below. Even if we are successful in our goal of outperforming the index on average, the process introduces a meaningful chance of under-performance in any given year.3 Furthermore, it’s extremely difficult to outperform market benchmarks. Thousands of other investors (and increasingly, powerful computers) are competing to achieve the same goal.
A PROCESS FOR SELECTING STOCKS
Investing is both an art and a science. As such, our security selection is guided by a quantitative and qualitative investment process. Our quantitative screening model incorporates growth expectations, valuation, profitability and market sentiment. Several metrics within each of these four categories are calculated,4 and each stock’s overall attractiveness is ranked relative to its sector peers.
We then perform a qualitative analysis on our short list of candidates. We are seeking to answer four questions with respect to each potential investment:
1. Does the company have any advantages over its competitors?
2. How fast can the company grow its earnings over time?
3. What do we think the company’s stock is worth?
4. What are the risks of an investment in the stock?
Finally, we assess the state of the economic cycle. We have learned from experience that businesses in many sectors are more dependent on cyclical factors than any company-specific variables, and we regularly adjust our exposure accordingly. It’s much easier to swim with the economic tide than against it.
• A blend of active and passive strategies can provide an attractive balance between cost and performance.
• Individual stocks can be useful in certain portfolios but are not always the best choice for investors.
• Our approach to stocks utilizes both quantitative and qualitative metrics and analysis of both macroeconomic (global) and microeconomic (company-specific) variables.
2 Federal Reserve Bank of St. Louis
3 Chart assumes managed portfolio annual alpha = 1.0%,
tracking error = 2.6% vs. index fund average alpha = 0.0%,
tracking error = 0.5%
4 Examples of these metrics include enterprise value/free cash
flow, consensus EBIT growth, and insider activity Key takeaways