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(Stefan Hermans)
(Stefan Hermans)

Fabrice Taylor

Forget casting a wide net: A few good stocks can beat the index Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.

On any given day, stocks do one of two things: They go up, or they go down. (Occasionally, they do nothing but that’s so rare as to be insignificant.)

But when we say “stocks fell yesterday,” or “the market closed higher last month,” what we’re really saying is some stocks went up or down, or maybe even most stocks. Notably, we’re referring to the major indexes, such as the S&P/TSX or the Dow. It’s not that all stocks did the same thing.

I realize that’s not exactly stop-the-presses material but it’s an important point for investors, many of whom have decided to be stock pickers but end up with a portfolio that just does what the index does. There’s really no point in doing so; it’s expensive and risky compared with buying the index through an exchange-traded fund.

To illustrate, consider that the S&P/TSX fell 11 per cent in 2011. If you built your own portfolio of bigger Canadian stocks and got a similar result, you’re not doing well, particularly if you compare the cost of an ETF to your commissions and other expenses, including your time.

If you’re picking the right stocks, though, the headline that says “stocks fell last year” is meaningless. The top 10 stocks in the index produced very healthy double digit returns in 2011.

Randomness or luck probably play a role when you’re talking about so few companies, but even the top 50 beat the index handily. Does it take only dumb luck to find the roughly one in five companies whose shares will do well? I doubt that. It takes hard work, skill and common sense.

Even if you take out commodity shares, which are subject to big swings, you could have built a portfolio of shares last year that not only beat the index but produced surprisingly good returns of 20 points or even more. Not all will be in the index; there are many fine companies that are too small for the index. As I’ve said in this space before, size does not necessarily equate to risk in the real world. Is a North American liquor retailer with a market value of $400-million really riskier than a $23-billion life insurer? The liquor retailer’s annual report has one-tenth the number of pages. The insurer’s is incomprehensible to the vast majority of people. Those are your first clues.

If you buy the index, you’re getting lots of the insurer and none of the liquor retailer.

The truth is that the big indexes, as prestigious as they are, aren’t short on rot. Furthermore, they tend to be full of the biggest, most liquid and therefore most widely followed stocks. And because they get a lot of attention and trade relatively freely, they tend to be well-priced, if not overpriced.

Yet, as a smaller do-it-yourself investor, liquidity isn’t that important to you. You are not a $10-billion fund that has to buy a million shares of a company to make it worth your while. You can buy a much smaller number, and therefore you can buy less liquid names.

So why are you buying the big ones, whether it’s the index or large caps of your own choosing? The price of liquidity is high, especially in Canada. If you don’t need it, don’t buy it. You probably don’t fly your family business-class for a vacation. Why pay for liquidity that only big investors need?

The answer is, at least in part, because conventional wisdom says it’s safer, that indexes are diversified and liquid and therefore less risky. There’s some truth to that, but it’s overrated unless you want to be a passive investor.

If you’re doing your own work anyway, get rewarded for it.

To accept this idea is to go against powerful conventional wisdom. The banks want you to buy their index funds (or their managed funds, which are often just closet index funds). Big global finance firms want you to buy their ETFs, and they spend a lot of time and money telling you how great they are. For some they are.

But if you want to pick stocks, the index is not the market, and if you plan on doing your own work particularly, you don’t have to be captive to it.

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