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Is beating the pros possible? Yes! In this six-part series, Jason Del Vicario, CFA, portfolio manager, and Steven Chen, MBA, analyst, at HillsideWealth | iA Private Wealth Inc. will explain why - and how - a concentrated portfolio of global high-quality stocks gives the long-term investor the best chance to outperform both broadly diversified indexes as well as professional money managers.

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

- Charlie Munger

We believe that stock picking is about subtraction – that is, disassociating the portfolio from anything complex, irrelevant, or speculative. In the end, investors should try to limit their focus within a small set of easy-to-solve problems that are only meaningful to the long-term return of holding shares.

Share prices follow a random walk in the short run but reflect the return on capital of underlying businesses over the long haul. What would it take for a mediocre business to generate sustainable, high returns on capital over the next ten years? It depends on quite a few factors: competitors, customers, suppliers, management, industry, market, and sometimes regulators. All these variables would, in aggregate, have to change in a way that is so “right” for the business to deliver nicely for its shareholders. Studies (such as the ones conducted by S&P Global and McKinsey) often suggest a fairly low chance for a company to dramatically uplift its profitability profile on a sustainable basis. Hence, whether, how, or when a business would materially improve its sustainable return on capital is usually a difficult question and should be cut out from our investment process.

Rather, what if there is a company that has been consistently generating high returns on capital? The decision-making process for incoming investors could be much simpler. The main concerns are now replaced with durability of the company’s competitive advantage, predictability/understandability of the business model, and longevity/stability of the industry/market, none of which requires a change of anything (internally or externally). As a matter of fact, no change at all is preferred.

To put it another way, betting on winners to keep winning is fairly low-risk and high-reward compared with betting on followers to catch up or losers to turn around.

By “winning” here, we mean not only market success in terms of serving customers but also financial success for shareholders. We recommend enterprising stock investors only deal with quality companies, which have the highest probability of delivering high returns on capital on a sustainable basis in the long term.

The quality-focused approach may sound straightforward, but it is worth noting that subtraction is typically against our human nature. Instead, our default is addition – that is, over-complicating things. Think about program-driven financial modelling with the attempt to forecast almost everything. Worsening the situation for professional investors is the career pressure, where performances are usually judged on a quarterly (if not monthly) basis, so that pros cannot afford to risk deviating from the benchmark too much for too long; hence, their tendency to hug the index. Meanwhile, quality companies are scarce.

Consequently, investment professionals spend way too much time on speculation. Retail investors have a considerable advantage in this regard.

By now, some of you may have wondered: isn’t it an edge for pros to have the resources for predicting the macro economy and the stock market? Well, much as these are indeed meaningful factors to stock investors, we found nobody is able do that with consistent accuracy. However, a focus on quality companies can come to our rescue to solve the predication dilemma.

For example, we favour market leaders, which tend to gain market share during a recession (as weaker players are likely to get wiped out), and therefore, may generate even greater long-term shareholder value. Similarly, a cash-rich, debt-free business model can leverage stock-market downturns to repurchase more shares. Also, high-margin, low-capital expenditure companies fare better than others in an inflationary environment.

Lastly, companies that are run and owned by founders typically feature strong operational and capital allocation decisions as a result of the long-term mindset. As Charlie Munger once quipped: “show me the incentives and I’ll show you the behaviour.”

In a nutshell, we believe that investors can add significant value to their portfolio by subtracting the unknowable and the less predictable.

Stay tuned for our third installment in this series.

How to beat the pros, Part 1: Choose the right number of stocks to hold

This information has been prepared by Jason Del Vicario, Portfolio Manager, and Steven Chen, Global Analytics Associate, for iA Private Wealth Inc. Opinions expressed in this article are those of the authors only and do not necessarily reflect those of iA Private Wealth Inc. iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.

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