Scalper1 News
We’ve all been told outright lies about the stock market that do not square with the evidence. Today, we’re going to debunk some insidious lies. Lie #1: “Superior returns come from stock picking.” This lie is especially dangerous because it is partially true. High returns can come from stock picking. But higher returns most often come from not picking stocks. For example, if you had been smart enough to predict that Apple (NASDAQ: AAPL ) would trounce most of the S&P 500 after the unpleasantness of the financial crisis, you would be a great stock picker – you just wouldn’t be very bright at generating extremely high returns with a solid MAR ratio (CAGR/Maximum Drawdown). A 50/50 portfolio of leveraged S&P 500 and leveraged long duration government bond exposure would have trounced Apple. Take a look at 50% ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO )/50% Direxion Daily 30-Year Treasury Bull 3x Shares (NYSEARCA: TMF ), rebalanced weekly, vs. the performance of Apple. It’s not even close. And that’s holding stocks and bonds! The dramatic diversification not only provides Apple-trouncing performance but also does so with much higher Sharpe and MAR ratios. (click to enlarge) Click to enlarge Which leads us to: Lie #2: “Focus investing leads to the highest returns.” Absolutely not. As we have seen above, holding two major asset classes is the opposite of Phil Fisher style focus investing. If holding Apple (the greatest growth company of all time) since the summer of 2009 is not as good as holding two leveraged ETPs which give exposure to stocks and bonds, focus investing is not optimal. Focus investing may be better than holding the entire S&P 500, but it is not as good as holding the entire S&P 500 and long duration government bonds – i.e., dramatic diversification boosts returns more than focus. Remember, correlations between asset classes are, as a rule, more persistent than company earnings growth. Lie #3: “If you’re going to pick stocks, you need to predict earnings.” This lie is especially dangerous. Guessing quarterly earnings is a loser’s game. Here’s what’s better – measure the number of competitors in an industry. Long’s Law is the ultimate reductionist statistic which is predictive of sustained company outperformance. Long’s Law states that long-term free cash flow margins (FCF/revenue) in any industry over a multi-decade time frame tend towards the inverse of the number of competitors in that industry. Dozens of seemingly predictive statistical ratios really collapse causally to one number – the number of competitors in the industry. And there are the added benefits of determining if the measured outperformance is sustainable, and if and when the outperformance is threatened (the entrance of meaningful new competition, etc.). For example, in an industry with three competitors, FCF margins will tend towards 33.33% or 1/3. However, Economic “Laws” should best be termed Economic “Tendencies.” The rule roughly holds across a vast array of industries. But why is this important? FCF margins directly impact the sustainability of high long-term Return on Assets (ROA) rates. And longer term, sustained high ROA numbers dictate the unlevered return of a business. But the key word is “sustainable”. And high FCF margins, according to Long’s Law, are only sustainable longer term in industries with few substantial competitors. But what are examples of publicly traded companies that might rank very highly under Long’s Law? Here is an illustrative, but by no means complete, list below: Major Payment Networks (Network Effect Businesses) Visa (NYSE: V ) MasterCard (NYSE: MA ) Major Futures Exchanges (Network Effect Businesses) CME Group (NASDAQ: CME ) Intercontinental Exchange (NYSE: ICE ) CBOE Holdings (NASDAQ: CBOE ) Major Credit Rating Agencies (De Facto Regulators) Moodys (NYSE: MCO ) McGraw-Hill Financial (NYSE: MHFI ) Get the picture? Don’t predict earnings. Measure the number of competitors in the industry. Longer term, margins and sustained earnings growth follow the lack of or the brutality of competition in an industry. The robber barons understood this, and you should too. And you don’t even need to pick stocks, but if you’re going to, pick oligopoly businesses with few competitors. You’ll earn much higher returns than the major equity indices over time, but without the need to guess quarterly earnings. Why are these 3 lies so persistent and widespread? It’s because they are partially true. But if we want to optimize returns, we need to discard these lies, and replace them with evidence-based thinking. Thanks for reading. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
Scalper1 News