A Good Idea Can Only Be Successful For So Long

In investing, a good idea can attract such a large following that its success becomes its doom. Crowded trades ultimately stop working because they eliminate the inefficiency that the earliest to the table were able to exploit for gain.

Until recently, a successful strategy involved buying and holding stocks of quality companies. Stock picking has gotten harder in a period of surging markets, even for seeming investment geniuses whose strategies have served them well in the past.

Yale economist Robert Shiller recently wrote in The New York Times that that most investors might be better off not trying to find the next investing genius and instead stick to a simple market portfolio – one that tries to match the market not outperform it.

That’s because investment managers inevitably go through some rough patches. Shiller writes about people who have tried to replicate the style of Warren Buffett. He cites a 2008 study by Gerald S. Martin from American University and John Puthenpurackal of the University of Nevada Las Vegas, who found that stock prices of companies newly appearing in Berkshire Hathaway’s quarterly holdings reports get a one-day bump of 4 percent. And they found a replication strategy from 1976 to 2006 outperformed the market by 10 percent or more a year. But even Buffett’s investment performance has dimmed somewhat in recent years.

Another well-known investor, Joel Greenblatt, has analyzed manager success and concluded that more than 75 percent of star managers spent three years at the very bottom rung of performance, and short-term-minded investors fled. Had they stuck with the managers, they would have rebounded. Managers in his analysis outperformed over the longer run.

That speaks to a much larger issue. Investors can be impatient and that can cost them, both in terms of fees for switching between managers trying to arbitrage the next hot streak, and in lost momentum when it comes to long-term performance. Success in investing means sticking to your plan even if things aren’t working out in the near-term. I've seen this time and time again with those investors who utilize the stock selection models I run and make available to investors both in the U.S. and Canada.

Given the fickle nature of markets, strategies that outperform all the time should be viewed with extreme skepticism. As Shiller notes, the world is too complex for any one strategy to work all the time. This is especially important today when so many managers are having trouble keeping up with market benchmarks.

This is perhaps why people have flocked to passive investing, something Buffett and others have endorsed for those who don’t have the time and resources to devote to picking managers.

Sure, it’s still possible to beat the market on your own, but that requires a degree of savvy, and discipline that most investors don’t have and many make the mistake of overestimating this ability.

Since 2010, I've been running a Canadian equity portfolio that holds the top ten stocks that pass the stock picking methodology outlined in the book Buffettology. This strategy, which seeks to emulate the approach once espoused by Warren Buffett, has an annualized return of 14% vs. an annual return of 3.7% for the TSX (price returns only), but it is very likely only a small percentage of investors have had the discipline and gumption to stick with the model over that period of time. Following a concentrated and active managed portfolio is risky, takes effort and discipline and, like all good investment strategies, even this model will eventually trail the market over 1, 2 or perhaps even three-year periods of time.

The table on the previous page lists the top-rated stocks using our Buffett-based strategy. This strategy looks for companies with consistent and predictable earnings, high returns on equity and capital, reasonable levels of debt and share buybacks. The strategy then looks for stocks that have the potential to generate at least 12% returns, per year, over the long-term.

A few years ago, Shiller compared the game of beating the market like trying to break into tournament chess. A skilled player knows what the odds are of winning, but a novice has no idea. "For most people, trying to pick among major investments might be a mistake because it's an overpopulated market. It's hard," Shiller said. "You have to be realistic about how savvy you are."

Ask yourself if your goal in investing is to beat everyone else or if it is to develop a balanced portfolio at a risk tolerance that works for you and an expense you can live with. Doing that and staying the course during the inevitable ups and downs will give you the best chance of achieving your long-term investing goals.

John Reese is founder and CEO of Validea.com and of Validea.ca.