Funds often best, but you can pick your own stocks, too

October 12, 2003|By Carl Sibilski | Carl Sibilski,MORNINGSTAR.COM

Dear Analyst,

I can't possibly know as much about stocks as the professionals. Is it just better for me to quit picking stocks myself and buy a mutual fund instead?

- Ben H.

There are many reasons why individual investors might want to own mutual funds. These investment vehicles can quickly diversify your portfolio and give even the smallest investors access to professional management. But individuals have some very powerful advantages when it comes to picking stocks, so don't give up just yet.

My business school securities analysis professor drilled into our heads that in order to really make money in the markets, you have to be both right and different from everyone else. That's probably one of the simplest and best stock-picking lessons I've learned.

For example, if you buy Starbucks (SBUX) because you think the company can grow at a double-digit rate over the next five years, you'll be right (or at least I think you'll be right), but you won't earn a substantial return on your investment because most of the market already thinks the same thing and has accommodated that information into the stock price.

That's why Warren Buffett likes to say, "you pay a high price for a cheery consensus."

So, if you don't have the huge resources that mutual fund managers have at their disposal, how can you possibly gain an edge on them?

The average annual portfolio turnover for mutual funds is about 110 percent. Read a bit differently, on average, mutual fund managers hold their positions for less than a year. And this is in the face of a slew of advertisements that preach the virtues of taking a long-term investment approach.

Despite the well-publicized problems in the fund industry, I think, most fund managers have good intentions. I believe they do whatever it takes to keep their jobs, and their jobs all too often depend on quarterly report cards and a host of other issues such as market-tracking errors, which measure how much the fund's performance deviates from a benchmark index.

Let's think about this for a moment. How can a manager be right and different and minimize tracking errors? It's nearly impossible.

That's why a lot of mutual funds are nothing more than modified index portfolios. For example, a manager who is bullish on retail companies might overweight that sector and choose to underweight a different sector, such as technology, because he's bearish. That way, if all goes well, the fund beats the index. If not, at least it doesn't lag behind by a substantial amount. Individual stock investors, however, don't have to worry about benchmarks, so if tech stocks look overvalued, they don't have to own them at all.

Competition with the index also tends to force fund managers into a very short-term game. We know that in the short run, stock prices are extremely difficult to predict, but in the long run, they are highly correlated with business fundamentals. Unlike individuals, who don't have to answer to an investment committee or angry shareholders with oftentimes limited memories, fund managers are pretty much forced into playing this loser's game.

Those who refuse often get the ax as Robert Sanborn of Oakmark did in March 2000. This manager bucked the masses and refused to hold overvalued tech stocks, sticking vigilantly with his value picks Mattel (MAT) and Philip Morris (now Altria Group [MO]). Ironically, since his departure at the height of the tech craze, both of these stocks have run up 100 percent. (I don't have to mention what happened to tech stocks.) Looking back, an honorable long-term investor such as Sanborn would be a big hero today, but unfortunately, he ran out of time.

In order to be right and different, you have to be able to control the emotions of greed and fear.

By definition, an undervalued stock is one you think has a better outlook than the rest of the market expects. But it's often difficult to bring yourself to buy undervalued stocks because the whole market is usually reacting to some very convincing bad news about the company's prospects. Individuals have to answer only to themselves (or their spouses), but often, as mentioned above, fund managers have to answer to an investment committee.

These committees can be brutal places to defend investment ideas, especially when committee members can easily point out that a fund manager is deviating from the rest of the investment community.

For example, the best time to have bought Philip Morris was in the spring of 2000, when Morningstar readers flooded our discussion forums with messages predicting its bankruptcy in response to fears that a Florida court would spell the end for the tobacco giant.

More recently, McDonald's (MCD) became ridiculously cheap this past spring after reporting its first quarterly loss and a long period of declining same-store sales. Everyone thought the company would never be able to right itself.

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