Why Everything You Think About Stock Picking is Wrong

by JT McGee

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:

  1. 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.
  2. 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.

{ 14 comments… read them below or add one }

Canadian Couch Potato May 15, 2012 at 14:26

Let’s leave aside the the fact that the market knows what you know about the difficulty of these sectors and has priced the stocks accordingly. The real question is, how do you build a portfolio of stocks that excludes just these companies you don’t like? The Vanguard Total Stock Market ETF includes about 3,300 others stocks. Do you suggest buying these individually?

Reply

JT McGee May 15, 2012 at 15:15

Don’t mention something then leave it aside. That’s no fun. Airlines are proof that efficient market hypothesis is hogwash. If markets were efficient, an industry with negative earnings would be worth zero. If you index to get diversification, why would you diversify into an industry that cannot make money? Who cares if you own 10, 20, or 2000 companies if every single year the total sum of earnings is negative?

You need not buy them individually. Here’s one way: short out the parts you don’t like. Use the capital to average into the rest of the index. Much easier. Alternatively, go long the TSM Index then short the Bloomberg Index of shippers and DJ Airline Index proportional to their representation in the index. Two additional trades. No sweat.

It should only be a matter of time before the market realizes the insanity of owning airline and sea shipping securities. Any rational ETF issuer should hop all over this by creating a fund that buys the TSM Index less airlines and sea shippers. We’ll talk Buffett into the idea of proving his thesis (at least as far as airlines, I don’t think he’s said anything about shipping companies) with an index. I’d be all over it.

Would you invest in a TSM Index that does not include airlines or sea shippers?

Reply

Canadian Couch Potato May 16, 2012 at 15:50

“It should only be a matter of time before the market realizes the insanity of owning airline and sea shipping securities.” It is indeed a wonder that such an obvious market inefficiency has not been exploited by a hedge fund somewhere. Could it be because it’s not an easy as it sounds?

You’re not the first person who has suggested starting with an index and simply overweighting the “good” companies and removing the “bad” ones. I would suggest you try executing this strategy for five years and seeing whether it works the way you think it will. I wish investing were that simple.

Reply

JT May 16, 2012 at 17:39

It is as easy as it sounds. Find a place to get either the TSM Index or similar (Russell 3k?) holdings and we’ll keep the list. I’ll go through and cut out all the shipping/airline stocks and then we can keep track. Should be pretty simple. Remind me 5, 10, even 20 years in the future to do an update and I will. All I need is an Excel sheet of holdings. Vanguard doesn’t make public their end of day holdings in their TSM Index (or any fund), unfortunately…at least not in a spreadsheet. You actually get an INCREDIBLE head start, since if the economy recovers in the short-term there will be plenty of people chasing “turnaround” stories in industries that have gone only one way throughout history: down.

I wouldn’t use this strategy because I’d prefer to limit my selections even further. Still, for indexers, this is a winner! I don’t know why you are comfortable investing in every single company in an industry that has for decades (coming close to a century now!) lost money with no real fundamental changes during the period. It’s insanity. Why pay good money for future streams of negative cash flows?

Reply

Jonathan May 17, 2012 at 09:54

Is there a way you can look at how this strategy would have worked in the past? I know Old Limey who comments at freemoneyfinance has a database and can tell you the values of any security (or at least the ones he tracked) on any day since the early ’90s. It would be interesting to see the results.

Reply

JT May 17, 2012 at 10:07

Hmm, maybe I can get FMF to get me in contact with him. Depending on the database quality, it should be pretty easy to backtest.

Looking back is going to be really unfair, though. Shipping companies have lost 80-90% of their value in the past 5-10 years. Check out DryShips, and then all the related securities listed below the chart. All of them have dropped like rocks: http://www.google.com/finance?q=NASDAQ:DRYS

Checking the past history for airlines is hard because they go bankrupt, then relist. Delta Airlines has been around forever, for example, but public history goes back only to 2007 when it was relisted and it has since declined by nearly 50%. So one has to account for the -100% original return, and then the -50% return since the stock came back to the market: http://www.google.com/finance?q=dal Same with Republic Airways. Hell, airlines go bankrupt so often that Wikipedia has a list for it: http://en.wikipedia.org/wiki/Airline_bankruptcies_in_the_United_States Bankruptcy is business as usual.

I’d be willing to test this going back and forward. Maybe one test ex-airlines, one test ex-shippers, and one test ex-both industries. I fully expect the strategy to outperform in every test, both forward and backward.

Reply

PK May 19, 2012 at 10:28

Why not just use the Google quotes? You can’t get daily closing prices, but you can get weekly – that’s close enough if you go back 10-20 years.

Darwin's Money May 17, 2012 at 22:01

Oh, how I used to love shippers during the commodity boom years. You could pick up a fat 10% yield and 50% share returns annually… and then boom. I guess if you pick the cycles right, even airlines and shippers can outperform. The question is just how efficient the market is in fairly pricing these sectors.

Reply

Robert @ The College Investor May 20, 2012 at 01:46

I love shipping as a cyclical play. I got in near the bottom in 2010 and have been enjoying an upward rise!

Reply

JT McGee May 22, 2012 at 15:12

Hmm, as a cyclical, it sounds okay. Thing is, if I can’t hold it for 20 years, I don’t know why I’d want to hold it for 2 years.

Reply

101 Centavos May 20, 2012 at 09:18

TeeKay Tankers has been a bit of a dog for me, although one with a fat and reliable dividend. Its sister holding TeeKay LNG on the other hand, has outperformed the market over the last 10 years. But yes, it’s a lone bright light in a sea of foundering companies (apologies for the lame metaphor).

Reply

JT McGee May 22, 2012 at 15:11

I dig the metaphor, because it’s true. Single companies can make money in these industries, but if you have to buy the whole industry, you might as well leave it out.

Reply

Marie at FamilyMoneyValues May 20, 2012 at 19:33

I’m looking forward to that Forbes cover story!

Reply

JT McGee May 22, 2012 at 15:10

It shouldn’t be too long from now. 😉 Too bad I just dropped my subscription.

Reply

Leave a Comment

*

Previous post:

Next post: