Dear Reader,
I just don’t understand why people invest in ‘tracker’ funds. Why pay someone to merely replicate the performance of the index?
A friend I was talking to the other day was singing the praises of this kind of ‘passive’ investing. He made the point that you may as well go passive since few active fund managers can beat the index over a sustained period. And that’s fair enough.
But to me it misses an even more important point. And that is that it’s perfectly possible for individual investors like you and me to beat both types of fund by picking suitable stocks. I’ll show you what I mean and what to look for to achieve consistent, market beating returns.
Let us look at this a little more closely. Firstly, how index funds compare with actively managed funds. John Bogle, who founded the well regarded Vanguard Group of index tracking funds, has done a detailed comparison. The arguments in favour of index funds over actively managed funds are convincing.
Why investing in funds costs you money
For example, he followed all 355 equity funds existing in 1970 over the period 1970 to 2005. Of these, 223 did not survive to 2005 and only 24 of the remaining 132 beat the market by at least 1% per year. Just nine of those 24 beat the market by at least 2% per year and 2 beat it by 3% or more.
Choosing one of the few outperforming funds also proved to be difficult. Bogle looked at the 20 top performing funds in each year from 1995 to 2005. He found that the average rank of these top 20 funds in each following year was 619!
One of the reasons the funds did so badly is their high costs. And these costs are compounded over the years. Another reason is that funds advertise most strongly when the markets are reaching a peak. That means most investors invest more at a time when shares are expensive rather than cheap.
Finally, large funds find it difficult to invest in the stocks that are most likely to show the best share price growth. The reason for this is also one reason that stock picking works for the intelligent individual investor.
The problem for a large fund is that it does not want to invest in too many stocks. Otherwise the manager cannot keep up with them all. But neither does it want to invest in too few. Otherwise it would be insufficiently diversified and too exposed to a potential problem in just one company.
So let us assume that the manager has 50 stocks in a £1bn fund. That is £20m per company on average. Now the manager will probably not want to own too large a percentage of any one company’s shares. This means that, for a 3% share worth £20m in a company, he is limited to companies with market cap over £660m. This figure will be even higher for a larger fund.
This means that the fund must of necessity be concentrated in larger companies – the FTSE 100 if it is a UK fund. Indeed, many so called active funds are ‘closet’ trackers but with charges much higher than those of any tracker.
The best way to consistently beat the market
Now let us look at the case of you as an individual investor. You have several advantages. These include the freedom to pick stocks from any sector and any market which includes mid-cap and smaller stocks. And you do not have to pay initial or annual fund charges.
You also have an advantage over the index fund since you can decide how much you invest in any one company. The index fund has to invest in proportion to the company’s market cap.
But all these advantages only give you better performance if you pick stocks wisely. There are a few simple rules to follow that will help in this. Of course, a company’s valuation needs to be reasonable to start with. But there are other important things to look at...
The first rule is to select companies with financial strength – look at the balance sheet and cash carefully. Then make sure the company is growing profitably and has a leading market position in its niche. And make sure that it is doing well in overseas markets as well as the UK – there is much more risk if a company is limited to the UK market.
The company also needs to have a sustainable edge in its market. This usually means it re-invests in its own future. Put another way, it is sufficiently profitable to be able to invest a sizeable proportion of its revenues in new products and services coming out of R&D. This kind of re-investment can have a dramatic positive impact on the share price down the line.
In the Research Investments newsletter, we picked out Immunodiagnostic Systems (ticker: IDH) in February based on these criteria. It’s risen 199% since then. Alterian (ticker: ALN) is another which is up 103% from its recommended price in April.
What’s the common factor for these and many of the other successful shares we’ve recommended? It’s that these companies invest in their own research... their expertise... their development.
They invest in their future and the future of their investors. And as a result they will do far better on the stock market than companies that don’t.
Good investing,
Dr Michael Tubbs
For The Right Side
Editor’s recommendation: Dr Michael Tubbs writes Research Investments. It recommends companies that invest heavily in R&D for new products and services that give them a competitive edge in the market. This strategy is so beneficial to the companies and their investors, we’ve taken to calling this kind of investing in the future ‘invisible dividends’. And they work. Since the service launched in January, the 14 stocks in the Research Investments portfolio have, on average, gained 45%, beating the index by over 23%. Look out for Dr Tubbs’ brand new report due out on 6 October. He’ll name his top three ‘invisible dividend’ stocks to buy into NOW.
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