The forthcoming golden age of stock picking

We don’t go much for rank speculation here at Abnormal Returns, but let’s try this one on for size:

The coming decade is going to represent a golden age for stock pickers.*

Let us explain.

Ever since Businessweek magazine put out its now infamous “Death of Equities” cover story in August of 1979 equities have represented the go-to asset class for investors and speculators alike.  For the moment let’s leave aside the housing bubble of the mid-2000s for now.

The rise of the self-directed 401(k), the emergence of discount brokers and the proliferation of news/data sources via the Internet all played a role in making investing both cheaper and simpler.  With costs coming down it shouldn’t be a surprise more investors chose to direct their own investments.

There were of course blips along the way.  The October crash of 1987, the Internet bubble of the late-1990s and early 2000s and most recently the credit/economic crisis of 2007-2009.  For the most part investors stayed the course and continued to invest faithfully in the stock market.

The last couple of years has seen investors faith tested like never before.  The most recent example being the “flash crash” last week that if nothing else showed the extent to which algorithmic trading has become a driving market force.  Some have gone as far as to use the flash crash and the resulting volatility as a reason to get out of the stock market altogether.

The numbers show that volatility is not necessarily related to future equity market performance.  (It does seem that market volatility is related to the future dispersion of alpha.**)  However if enough people come to believe that they are playing a rigged, volatility-filled, computer-driven game of some sort then this could in fact become a self-fulfilling prophecy.  The activity on Thursday could represent a tipping point of some kind.

This volatility seems all the more meddlesome in light of the growing belief that the equity risk premium is likely to be lower in the future than it has been in the past.  Whether you attribute this to risk-seeking behavior on the part of individuals or simply an artifact of  history, in either case it makes the potential rewards of the stock market seem not worth the risk to many.

One could argue that we have already seen a retreat by investors from picking individual stocks into collective, diversified vehicles like mutual funds and exchange-traded funds.  Furthermore post-Internet bubble it seems that speculative activity on the part of individuals has been funneled into trading ETFs and more recently foreign exchange.  Individual stocks seem to be the artifact of a long gone era of investing.

Therein lies the opportunity.  With everyone focused on the global macroeconomic situation it seems as if good old fashioned stock picking is being forgotten.  Rather than fixating on the downside of volatility maybe investors should be focused on the opportunities created by said volatility.

Who wouldn’t have wanted to buy Accenture or Procter & Gamble at $0.01 on Thursday?  These are clear anomalies but the broader point still stands.  If the market is going to go through periodic episodes of volatility that bring down the prices of all stocks (good and bad) doesn’t it behoove investors to take advantage of these opportunities?

The backlash against high-frequency trading is likely to only grow over time.  Some prominent commentators are calling for Wall Street to get back to its bread-and-butter business of funding new businesses and allowing investors to profit from long-term investments therein.  If the capital markets were changed in this manner it would make stock-picking all the more attractive as an investment process.

While the last decade has seen financial data and research available now more so than ever via the Internet it has also seen Wall Street firms cut the amount of resources they devote to covering small cap companies.  Absent any coverage from Wall Street these firms struggle to get their message out to investors making for opportunity.

Asset allocation isn’t everything.  There is room in many portfolios for active stock picking strategies.  It is beyond the scope of this post to get into this topic, but suffice it to say that most stock picking comes down to finding companies whose future cash flows are worth more than their current stock price.  We live in complex times, but in a certain sense stock picking comes down to this simple proposition.

James Hamilton at Econbrowser discussed recent market volatility and wondered whether it made sense to follow the same sort of strategies the computers were already following.  He concludes:

And my advice for sane humans trying to deal with such a crazy market is this: as a first step, ignore all the other beauty-contest judges, and ask yourself whether the flow of future dividends you expect to receive by itself would be adequate compensation to you for your investment, given the risk associated with not knowing exactly what those dividends are going to be.

If it is, then allow yourself to relax as the computer programs written by the other contest judges try to devour each other.

If it’s not, then you’re in the wrong place at the wrong time.

In short, you can’t beat the computers at their own game.  Instead you need to play an entirely different game.  One that puts a longer-term focus on individual companies and their underlying values.  Otherwise the volatility inherent in this kind of market will eventually wear you down or wipe you out.***

*It should be noted that a golden age of stock picking does not necessarily mean good times for the stock market as a whole.  One could imagine a decade-long trading range, like the 1970s, ripe with stock picking opportunities while the indexes tread water.

**Update, see:  Weigand, Robert A., Gorman, Larry R. and Sapra, Steven G., “The Cross-Sectional Dispersion of Stock Returns, Alpha and the Information Ratio” (January 21, 2010). Journal of Investing, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1444868

***This post is entirely speculative in nature.  Nothing herein should be construed as investment advice.  You and you alone are responsible for making your own investment decisions.

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