Suppose that you and I are going to lunch. You’ve come to an unfamiliar place, the weird small city in which I live.
You have no idea what to make of the restaurants here. Of course, you recognize all the familiar names like McDonald’s or Subway, but we’re trying to dine, not just fill ourselves with a sufficient number of calories.
And so I ask you, “what kind of foods do you like?”
“I’ll eat anything,” you say, hoping to remain democratic in our choice of restaurants.
“No you won’t,” I reply, “Just give me some ideas. Asian food? Mexican food? German-American steak and potatoes like a champ?”
Likely (I’ve studied this conversation, I swear) you’re going to find a few of those choices to be poor. And you’ll make it known. You didn’t realize how much you disliked Mexican or American foods until I brought it up. Yuck!
Weeding before Planting
This is how most decisions work. You have to weed out the bad choices first, so as to improve the odds of success. If you’re no fan of Mexican food, removing those from the list of possible restaurants immediately improves your experience.
We just moved from a pool of restaurants that would give us a 0-10 out of 10 experience to a 2-10 out of ten. Maybe even better. Of course, I’m not talking about my ability to keep you entertained, just the quality of the food and atmosphere – attributes of the restaurant.
Once we do our broad-based weeding, we can then work through my knowledge of local eateries. If you say that you totally dig Asian restaurants, I can start thinking about the best Asian restaurants in town. Or, more accurately, I can throw out all the bad choices so that only a few good choices remain.
A Random Restaurant Walk
Before I removed possible choices, the potential experience could be rated from 0-10 out of 10. It was truly a random walk. However, after weeding out poor choices by category, and then poor choices within the selected category, we’re solidly at a 6 or better. We’ve improved our possibilities for lunch not by selection, but by disselection.
This is key.
In investing and in eateries, it isn’t what you pick, but what you do not pick. My portfolio consisting of less than ten positions may make it appear as though I hand picked only a tiny fraction of the publicly-traded companies listed on the market. However, I see it differently – I removed several thousand and only a handful remained.
How to Outperform
We need not overly concentrate to make a good investor a great investor. In fact, with two simple changes to the Total Stock Market Index, I can have you outperforming in no time.
Here’s my simple, no nonsense way to outperform with the Total Stock Market Index:
- Remove airlines – As Warren Buffett says, “If capitalists had been present at Kitty Hawk when the Wright brothers’ plane first took off, they should have shot it down.” Airlines require large capital expenditures, have serious volatility due to fuel prices, and operate on tiny margins. In total, the airline industry gave investors negative operating earnings of $34 billion since 1947. This business is fundamentally flawed.
- Remove shippers – Next, I’d remove every bulk-dry shipping company from the list. As I explained in an article about economic moats and Warren Buffett’s lie about railroads, sea shippers have no economic advantage. I encourage you to read through the list of the world’s biggest super tankers to see how many sailed for fewer than 10 years. Every economic cycle, shipping companies build too many ships. In every contraction, they scrap ships built to last for 50 years after a short lifespan of only 10 years. It’s a stupid business to be in. Again, high capital expenditures, no moat, and small operating margins.
The Total Stock Market Index with shippers and airlines removed will beat the Total Stock Market Index in the long-run. I have no doubt in my mind that this is true. And, remember, I did not pick a single stock. I merely removed two obviously terrible industries where individual firms only earn money when other firms in the industry lose money.
I am not suggesting that this portfolio will outperform for every day of the week for the next 20 years. There are plenty of fools who buy airline and shipping stocks on the basis of improving industry fundamentals, which are always temporary. Of course, this is irrelevant for buy and hold style investing, since, over the course of decades, one can expect the cumulative earnings in airlines and shipping stocks to be barely positive, but more likely, negative.
In less than 5 minutes, I constructed a portfolio designed to outperform. If you believe what you hear from passive investors, I have done the impossible. Forbes should be calling me in 5 minutes to do a cover story, and my fund will live in infamy as a fund that outperformed the market over 50, 60, 70 years.
So, with that, I’ll let this go. Just remember – stock picking has nothing to do with what you pick, but what you leave out. You need not be a stock picker to beat the market, you need to be a stock remover. It’s not the good stocks that you buy that make the difference – it’s the bad stocks you abandon that drive total returns.