Individual stock picking is considered to be too risky for the “passive investing” crowd. Let’s call them that.
This passive investing crowd seeks to mitigate that risk by buying the index (e.g. S&P 500) and holding for the longer term. They also expect to make a handsome profit by doing so.
Let’s just say that they expect this to be a low risk high upside strategy.
The S&P 500 is made up of 500 individual stocks, hence the name. So actually buying the S&P 500 carries the risk of 500 individual stocks, relative to their respective weight in the index.
In fact, the top 5 companies in the index carry a total weight of 23%.
- Apple, 6.2% weight.
- Microsoft, 5.9% weight.
- Amazon, 3.9% weight.
- Google, 4.5% weight.
- Facebook, 2.4% weight.
All 5 are technology companies and massive beneficiaries of the internet boom, online search and advertising, globalization, the dominance of the smartphone, social networks and online shopping.
Since 2020, they have also benefited from covid-related tailwinds, which further increased their share prices as the quarantine and restrictions boosted their businesses.
It is self-evident that passive investors do take individual stock risk, as the index has obviously benefitted from the business trends mentioned above.
Not only have passive investors benefited tremendously from the business growth of individual stocks, they have also benefited from the expansion of their price multiples.
Just how much have the share prices of these companies rallied since January 2015? (6 years and 10 months ago)
- Apple, 5.2x
- Microsoft, 6.34x
- Amazon, 10.5x
- Google, 5.25x
- Facebook, 4.2x
These are amazing returns, and they have driven most of the returns of the S&P 500 as well.
How have price multiples behaved? (I will use P/E or P/S relative to company best fit)
- Apple P/E, from 13.5x to 28x (2.08 times expansion)
- Microsoft P/E, from 16.6x to 36x (2.17 times expansion)
- Amazon P/S, from 1.6x to 3.8x (2.38 times expansion)
- Google P/E, from 25.6x to 30.4x (1.19 times expansion)
- Facebook P/E, from 71 to 25x (0.35 times expansion)
The only company which did not benefit from share price leverage due to multiple expansion was Facebook, as its sky high P/E of 71x compressed to 25x during the time period.
When transitioning from a high growth company to a slower growth one, price multiples should contract as in the case of Facebook.
Apple, Microsoft and Amazon have grown tremendously during this time period, but their price multiples expanded signalling an increase in expected future growth. I don’t think so.
They had an at least a 2x multiple expansion, while Google’s was just 1.2x.
This means that at least half of the returns for Apple, Microsoft and Amazon were due to multiple expansion. That’s a lot of market value for just one ratio!
The passive investor crowd must have been ecstatic? during this massive rally, but I wonder why. They can’t use one of the most important tools for an investor, active portfolio management.
The point is, they are self-proclaimed passive investors. They cannot sell and capitalize on this massive rally. The profits made from the multiple expansion will reverse and turn into losses when multiples contract.
All they stand to benefit from their equity investments (i.e. the index), is the total return over the life of the asset, adjusted for the price they paid for it.
A passive investor would say, “Yes, that is fine by me!”
Only if it were that simple… There are many pitfalls in this process.
Passive Investing Virtuous Cycle
First, most investors allocate capital to passive strategies simply because they are doing well at the time. As more people allocate capital, passive funds must buy the underlying securities – further increasing their value.
As their value increases and gains are made due to this structural dynamic, the superiority of passive investing is “proven” (caveat emptor), attracting more capital and so on.
What are the implications of being a passive investor?
You are price agnostic. Literally it means you are willing to pay any price for a company, as long as it’s in the index that you are passively investing in. That is not prudent investing.
You blindly trust the index. You put your money down to buy the index, by simply trusting that the index is the best place to put your money in. You have no business opinions of your own.
Trends can kill you. In a given time period, multiples can expand significantly further increasing the returns for holders. This however will have the opposite effect when multiples contract, causing reduced returns (IRR) or even losses (negative IRR over a certain period) for those buying at high multiples.
You can’t correct your mistakes. In fact you don’t even believe you can make mistakes. An active investor can change his mind about a company and just sell. A stock doesn’t know you own it.
You are a pro-cyclical trend follower. The rally of the past 10 years has greatly benefited from cheap money. Whether low rates stay for long or not, the party can’t go on forever. You take the bull market for granted.
When you are asked why you are doing this, you simply state past performance. Of course, because money follows performance.
And money will follow it out the door when performance starts to lag
“But active strategy performance has been lagging passive performance significantly in the past decade”, the passive investor disciple will say.
We have established that money follows past performance, and that good performance has a tendency to create bad performance in the future ?
Even if earnings theoretically always increase over time, prices can drop and cause losses for long periods of time.
It’s all about forward IRR
Business progress and value creation is one thing, price movements are another. Prices follow value over time, but there are some serious divergences along the way. Even if you buy the best companies in the world, a too high price can make you lose money very time!
Now that prices have rallied, the future expected return (i.e. the IRR) on those companies is much lower than before. Those who bought earlier are happy, but those who bought later will have a problem in the future.
Active Vs Passive
Passive strategy performance is riding high due to this price to value rally. This performance will mean-revert and decrease going forward.
An active manager is free to manage his overall portfolio forward IRR as he sees fit. If forward IRR is not good enough, he can sell some names and increase his cash, or allocate to better IRRs.
If one of his companies drops in price due to reasons he considers to be not too material, he can allocate more capital to it and get a better forward IRR on that extra allocation.
A move from $8 to $12 is good, but a move from $4 to $12 is great!Peter Lynch, legendary equity investor.
You can’t beat me
I spend 10 hours a day researching companies and sectors. I work to weigh current valuations to future growth and potential. I seek to make educated and unemotional investment decisions.
When I am wrong I correct my mistakes with portfolio management in an unbiased and logical way.
I don’t buy into the hype or get scared from stock market routs or sell-offs. Volatility is my friend and I try to use it as efficiently as possible.
I have a long-term commitment to equities and the stock market. I am not in it for a quick buck and so my thinking is long-term and business oriented.
For me, it’s about value creation and business. It’s not about relying on pseudoscience, false certainty, investment fads or simply buying the dip.
Too Long, Didn’t Read
If you think a pre-packaged passive holder of 500 or so stocks can beat my performance over time, you have another thing coming.