Motley Fool Hidden Gems Investing - How to Beat the Market

Episode Date: August 5, 2023

Everybody wants to beat the market. But how does one actually … beat the market?    Ricky Mulvey and Anand Chokkavelu got together to explore different camps within the world of investing – from short-term traders to buy-and-hold-for-lifers, value hunters to growth gurus. They discuss: Distinguishing between luck and skill when evaluating high-profile investors The power of being a smart contrarian  And which traits make for a truly successful market-beating strategy Host: Ricky Mulvey Guest: Anand Chokkavelu Producer: Mary Long Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. If you find what a narrative is in the market versus what you think the narrative actually is for a company and where there might be more nuance and complexity, I think that's where maybe more of the modern value of investors reside. Finding the variant perspective. I'm Mary Long, and that's Motley Fool Money producer, Rikki Moldy. Rikki caught up with our very own Anand Chakravallu to take a look at different investing strategies and determine if there really is one best way to beat the market. They discuss following in the footsteps of investing greats, knowing when to not try something at home, and what past patterns can

and can't tell us about future returns. We can't guarantee that you'll beat the market, but we can tell you about some folks who have. Joining us now is Anand Chakravallu. Anand, good to see you on this weekend. Great to see you, Ricky. So the hardest part about beating the market or declaring that someone has beaten the market is seeing if it's like luck versus skill. Yeah, it's very, very hard to separate the two. You know, that's why you have all these comparisons to monkeys throwing darts and flipping coins. But we do know two things.

The longer someone beats the market, the more likely it's skill. And then the more people who beat the market using similar strategies, the more likely it's skill. Fair enough. But what do you think is the timeline? If someone has beaten the market over X time period, you're ready to hand them a sash and a crown saying, congrats, you've done it. For me, there's no magical timeline for this. Honestly, someone could be lucky their whole investing life. But I'm a heck of a lot more interested in learning from someone who's publicly beaten the market for 50 years versus, say, someone who tweets that they've beaten the market for 50 days fair enough i mean i don't know i

think five years might be kind of fair at this point that would take you back to mid 2018 so you've had you've had at least one full cycle with mostly a bull market leading up to the crash of 2020 then the pandemic hype and then sort of back to a bear market and then this very strange odd bull market that we're in right now. Yeah. I guess I always think of the fund manager, Bill Miller. He's a growth investor who had 15 straight years of beating the market. Then he fell off a cliff. I actually don't know where he's at these days because it's been a long time since then. But I guess for me, I'll always ask for more data. So let's look at some ways that people have actually beaten the market. And you can do it

through some algorithmic models, or you can look at some great investors who maybe are able to pull off moves that, let's say, the average investor like you and me cannot. Yeah, that's right. Maybe some hedge fund algorithmic models can beat the market. Maybe someone like George Soros can beat the market, making macro trades like his famous shorting of British pound and becoming the man who broke the Bank of England. But so what? Knowing there are passenger planes that can theoretically go 1,500 miles per hour, doesn't help me find a practical alternative to booking Southwest. That's a very good point. And then the other thing that's worth looking at is now getting into the fundamentals of how people invest. This is the short-term traders versus

the long-term investors. Yeah. Short-term, you can define as day trading, swing trading, which is kind of like weeks-long trading versus buying and holding for years and decades. I'd say there's a lot of noise in the short-term, but in the long-term it's more likely to come down to whether the company is strong and has a competitive advantage versus its peers. One thing on that short-term, the thing is, even if short-term works, there are taxes which are stacked against you. Every time you book a gain, you pay taxes. So the more often you do this, and you're only holding short-term, you get dinged with taxes each time.

And because you get a lower capital gains rate for long-term holdings versus short-term holdings. So you're not only getting hit more often, you're getting hit in larger amounts. But I also don't have what is essentially like infrared cables or not infrared cables, but like the super speed cables that are able to grab market data in order to get a penny off a trade from a buy order and a sell order. Yeah. And I can't make AI algorithms to help me. And also, while there may be those things, this is going back to those planes, but there are also, hey, traders over a different period of time, I can't explain it as well as Nassim Nicholas Taleb. He wrote The Black Swan, but I actually liked his book Fooled by Randomness. They're both part of a series, but it covered some of those topics. And he was a Wall Street trader. And he talks vividly

about different wall street traders he knew who were doing great for a while each year they'd book huge bonuses everyone would be jealous and then they'd blow up in epic fashion one right after the other so even the success stories given enough time can be unsuccessful stories i mean since i'll stop you on fold by randomness for a little bit what are some of your like big takeaways from from reading that yeah i mean basically so he had like five books i think it's the incerto series and it basically all makes the same point it's that black swan point that we underestimate the long tails and that and that that's what happens in in these trading type of things of like you know the best chart thing he had he had this awesome chart of the health of a turkey over time

he plotted it and then it falls off a cliff on thanksgiving so right these that's kind of his whole thing. There's his five books. It's the metaphor of what picking up nickels in front of a steamroller. We talked about it on a previous episode this week with Bill Mann talking about a mortgage real estate investment trust company. This is a little bit of a side tangent, but it reminds me of basically when CEOs will start a conference call in two ways. The first of which is reflecting on business performance and discussing how great they're doing. And then the second way is offering a reflection of the macro environment. Right. And you can guess how the business is doing in that scenario, right?

It's a higher interest rate environment on it. Let's take a look at maybe the technical analysis versus the fundamental analysis that investors use to try to achieve this goal. They sound pretty similar, but they're very, very different. Yes. So let's define our terms, right? So fundamental analysis is when you look at the underlying business to figure out how valuable a stock is. Things like sales growth, profit margins, the quality of the management team, PE ratios, price to sales ratios, competitive advantages. Basically, all the things we talk about on this podcast.

Technical analysis, on the other hand, ignores fundamental analysis completely and looks purely at a stock's past price movements and volumes to find patterns and trends in order to predict near-term stock moves. You'll hear a lot of smart-sounding jargon like simple moving averages, support and resistance levels, and momentum indicators, and other colorful terms like candlestick, Elliott wave, double bottom, head and shoulders. Ricky, I think you did some research on Elliott wave. Yeah, let's break it down because I don't want to just gloss over it. So the Elliott wave is basically a belief that investor sentiment has predictable patterns and that a trader could basically trace this wave in order to make a profit.

Now, here are the rules of the Elliott wave. And we're looking at five movements, up, down, up, down, and then question mark. All right. Wave two cannot retrace more than the beginning of wave one. Wave three cannot be the shortest wave of the three impulse waves, one, three, and five. Wave four does not overlap with the price territory of wave one. That's where we started. Wave five needs to end with momentum divergence. Are you with me? Absolutely. I mean, why wouldn't you be? I was going to define a double bottom and give an

example like that. It's kind of a W-shaped pattern in a stock price, but I don't need to. That was perfect. I think that gives you what you need, where it's these pattern things. I simply don't get it. If you want to get technical about it, it sounds like a great case of apophenia to me. That's where humans see patterns and meaning where there is none. This might be a bad analogy. Maybe we'll even cut this out. But it's a football analogy. It's third and 14. The last two plays have been runs for losses. A technical analyst might say, This one's going to follow the pattern. It'll be another run. A fundamental analyst might say, that's ridiculous. It's going to be a pass because you're very unlikely to gain 14 yards on a run.

Yeah. The technical analyst is basically looking at what long-term investors would describe as independent events and then trying to ascribe meaning to them for the future. Yeah. And completely ignoring the income statement, the balance sheet, cash flows. Now, we've gotten the long-term, we've gotten the short-term, so we're going to stick with long-term. That might be a surprise to Motley Fool listeners, but we're going to stick with the long-term on this one. Now, you have the two camps. These two camps do not like being divided amongst themselves, but the two camps are value investing and growth investing. In both of these, people have successfully beaten the market using both methods.

Right. Unlike the other two where, hey, we're for long-term, we're for fundamental, not technical. Value investing versus growth investing gets a little interesting. Spoiler alert, it's both. But let's talk about value investing. The best case for value investing was made back in 1984. Believe it or not, almost 40 years ago, Warren Buffett wrote The Superinvestors of Graham and Doddsville. That's Benjamin Graham and David Dodd who wrote the book Security Analysis, the original work of value investing back in 1934. So you add those two, right? 50-year anniversary, about 40 years ago. It's almost 90 years since that was written. As Buffett puts it, this brand of value investing is simply, look for values with a significant

margin of safety relative to prices. So in this kind of treatise, The Superinvestors of Graham in Doddsville, Buffett kind of addressed coin flipping and data mining versus knowing who's going to win beforehand. So basically what he's saying is all these people who followed what Graham and Dodds said, the proof is in, he knew these people and sure enough, they beat the heck out of the market. And he showed that using their returns over time. He had a group of nine people, including himself and his partner, Charlie Munger, even when they were working independently. You had stuff like Tweedy Brown, which is a famous mutual fund now, Walter Schloss, Bill Ruane of Sequoia Fund. Not to be confused with Sequoia Capital, the venture cap firm. This

is a value investing mutual fund. And then a bunch of other places. And he gives the long-term track records of each and how handily they beat the market. You're talking like double and triple times the market in lots of cases. I mean, the pushback on that, though, this was in the 80s before you had the power of the internet. And that is when one could go to a library and check through a financial report and see that a stock is now trading at a discount to book value. It's very easy to find that margin of safety. And then you can make a profit by looking through the couch cushions, if you will. And I don't know, I don't think that particular style of value investing maybe works today. Now that you have algo traders and that information

is readily available to everyone, it's harder to have that information edge. Now, I'm not saying that is a, I think there's a different version of value investing that still works, but I think that older school version is much more difficult to pull off. And in fact, Buffett went away from the pure Graham style of investing. I mean, because those net type of things, those really numerical things. Because yeah, like you said, back then, I mean, you didn't have the access to information everyone has now. And I think even in 1984, if you reread that definition Buffett gave, he makes sure to kind of make it general enough that it's kind of timeless. Look for values with a significant margin of safety relative to prices. So basically buying for

less than it's really worth. And we'll see that a little with growth investing. It's worth giving Buffett some credit here, because even though right now he's shooting with an elephant gun, he can't look at smaller cap companies with the amount of money that Berkshire has, and yet Berkshire's still beating the market as an asset manager. Over the past five years, Berkshire B-class shares returned about 75%, while the S&P 500 total at the time of this recording returned 61%. That's without dividends, so you can bump that up a little bit, but I still think that he's making a strong case for his style of investing. Oh, absolutely. And if you look at the long, long track record, I mean,

he's still over decades and decades, like 20% about double the market. It's amazing. So maybe the new style is looking for more, let's say, places that investors are ignoring, even though the information is out there. There's still plenty of areas where people ignore because it's boring or it's harder to understand. And then there may also be cases where I think investors and just people have a very short attention span. So if you find what a narrative is in the market versus what you think the narrative actually is for a company and where there might be more nuance and complexity, I think that's where maybe more of the modern value investors reside. Finding the variant perspective.

Yep. The tactics change, but the strategy overall stays the same. All right. Let's look at growth investing and how people have beaten the market using that style. Yeah. To simplify, whereas value investing focuses on price, growth investing focuses on, you guessed it, growth. Value investing is about the floor, growth investing is about the ceiling. So put another way, value investing is often about base hits, while growth investing is more often about a few multi-bagger home runs making up for a lot of strikeouts. So on-base percentage versus slugging percentage, right? Yep. And you might have to contend with a little bit of a loftier valuation. Last week, we welcomed David Gardner and Tim Byers on the show to talk about the

fundamentals of rule breaker investing. I think this is kind of what you are hinting at with this description. Absolutely. 100%. So to be fair to growth investing, we ran down a whole list of those super investors of value investors. Well, here are some of the growth investors, Peter Lynch, Thomas Rowe Price Jr., who founded T. Rowe Price, so the man, not the company. You know what? We'd be remiss on this podcast not to mention the Gardner brothers, Motley Fool's Returns and Stock Advisor and Rule Breakers. They speak for themselves. Philip Fisher. If you haven't heard of Philip Fisher, Buffett says his investing style is 85% Benjamin Graham, 15% Philip Fisher, so kind of blending those value and growth properties.

They're just different flavors of the same ice cream though. In either case, that Buffett definition kind of holds, maybe not the margin of safety so much, but you're just trying to buy a stock for less than the business is truly worth. Yeah. I think in the growth style, it's more bets on companies that could have an an explosive potential farther in the future. And you have a higher, let's say, a higher risk tolerance from folks who are looking to buy maybe an ETF. And because you have a higher risk tolerance, you're allowing yourself more losses for a couple of big home runs. But I think you made a really good point that is a theme here, Anand, which is that both styles work. I mean,

even in the case of Buffett, he's made bets on Chinese electric car manufacturers with BYD. He's played ARB games with Activision Blizzard. You don't have to follow a strict philosophy in order to pull this off. And I think if he was born now, or say 20 years ago, versus when he was born in 1930, I think he'd have a slightly different style. I mean, I think he'd figure it out quickly and stick to it. but I think you have to adapt to what is available in the market and what the information is. Yeah. Buffett also breaks some of the rules about portfolio concentration.

Yes. We should talk about that. Should you own very few stocks or a ton of stocks? Yeah. We were talking about this before the show. You have your Peter Lynch side, which is when he was running his fund at Fidelity. At one point, he had, what is it, 1,400 stocks. And you brought up a good point, which was before this recording, which is we don't know what the top concentration was, but that is vastly different from Buffett's letting his one winner run tremendously. Yeah. I mean, if you look at his portfolio now, the publicly owned stocks that he has in his portfolio, he also owns businesses within Berkshire Hathaway, but almost half is in one stock, Apple, 47%. And if you look at his top

10 holdings, 86% are in those top 10 holdings. Even as we give the Peter Lynch example, it's definitely easier to beat the market with fewer stocks, because diversification generally takes you closer to that market average, but it's also easier to spectacularly lose to the market with fewer stocks. If you're Warren Buffett, you probably want to be concentrated. If you're managing other people's money and charging them a fee because you think you can beat the market, yeah, you want to be concentrated. Those people can also own other things to diversify themselves. So that makes sense. But as an individual investor, you're managing your own money and your own life, and you have to be comfortable with the risk you're taking on.

So one practical solution, if you want to be concentrated, but also mitigate risk, you can buy low-cost index ETFs for part of your portfolio and then buy a concentrated group of stocks that you've studied and you love with the remaining portion. For example, someone indexing 90% of their portfolio can be about as concentrated as they want with the remaining 10% because they'll still be well-diversified and they won't be taking a huge risk. Yeah. I wonder with the Buffett example, how much of that is a don't try this at home with basically half of the concentration in one stock. It works spectacularly well with Apple, but there may be other examples of fund managers or individual investors who

went super concentrated in one area and it just didn't work out for them. But that's not as fun of a story to talk about. Yeah. And by the way, there's a reason Buffett is indexing his wife's, when he goes away, he's indexing the money that she'll have. Yeah. Okay. Okay. I think there's a little bit of machismo with that. Because with Buffett, if you're doing the index for all of your money after you die, there might be a little bit of a no one can do this as well as I can mentality. It's the dividend thing. I really like companies that pay me a dividend, but I will never pay one because I am a superior capital allocator. And you know what? He might be right about that. I've talked to myself in a loop back to agreeing

with him. Yeah, no, I, you know what? I pretty much a hundred percent agree with everything you just said, but, and it's the thing of, of, Hey, you know what? You can't do what Warren Buffett does, right? Like, you know, Ricky, you're a basketball player. You know, some of the things Michael Jordan did, you know, might not be exactly what you need to follow. Yeah. It's, it's called the analogy would be goaltending. It is a foul that I simply cannot commit because I am not able to jump above the rim and swat a ball out of the air on its way down. There's something there. But let's talk about actively managed mutual funds. It came up a little bit earlier. Obviously, your Peter Lynch investor would be a big fan of that, in part because he ran an actively

managed mutual fund. But some folks are able to beat the market by picking the jockey. Yeah, absolutely. So here's the thing about mutual funds is there are two problems with trying to beat the market by picking a group of actively managed mutual funds. So one, there's a logical fallacy, right? Where if you're skilled and experienced enough to pick the market-beating fund managers, which remember, almost none of them beat the market over a long period of time. The percentage is like 80% or higher that don't. And I think it gets higher the longer period you look at. So if you can pick these winners, you're probably skilled enough to pick market-beating stocks because you'd have to kind of know the two. And then the second thing

is that, and it's probably the more important thing, is that mutual funds are structurally, they're set up to fail. Not on purpose, but they are. Because even if you find a young market-beating fund manager, once the fund gets bigger, it's harder to beat the market. We talked about that with Buffett and having to use an elephant gun. Buffett said that if he had a smaller million-dollar portfolio, he could get 50% annual returns. I believe it, but Berkshire Hathaway has been the size of a large mutual fund the last few decades, and he's noted it, and the performance has shown. It's just trying to stay in line with the market. And then a second thing that's problematic structurally is, even if you personally have

the stomach for down markets, your fellow mutual fund holders get scared and pull their money out right when they should be putting money in at the lows of the market. When they pull their money out, your star manager has to sell those now undervalued stocks. And then it's the opposite when those folks throw their money back in at market highs. And then the third thing is the fees are much higher than passive index funds. So you're getting charged for this structurally complex beast. And it sort of takes away from the ingredients we've described of beating the market, one of which is an understanding of value, a willingness to be a contrarian, maybe a smart contrarian, because often the crowd is usually right. And then also that long time

horizon. In the Lynch book, which we covered in a book club, he points out, and I think it holds true, his biggest gains tend to be past year three of owning a stock. What is the conclusion? Where did we end up on how investors can beat the market? Yeah. So to sum it all together, there are lots of paths up the mountain. Both value and growth can work. Dividends can work. Both a concentrated or diversified portfolio can work, et cetera, et cetera. But long-term buy and hold beats short-term trading. Fundamental analysis beats technical analysis. Most importantly, finding and sticking to a system beats going all over the place. And if all of that is too complicated for you, ain't nothing wrong with matching the

market with a passive index fund. We've been talking about beating the market, but matching the market's great. Historically, that's meant doubling your money every decade or so. I'll also throw in, I think it's the willingness to look where others are not in railroad stocks. Railroads have consistently beaten the market for a very long time. I don't know if that'll continue that way, but they have a track record. Anand Chakravallu, always a pleasure chatting with you. Thanks for joining us today. Thanks, Ricky. Always a pleasure. As always, people on the program may have interests in the stocks they talk about,

and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow. Thank you.