Why Picking Your Own Stocks Can Improve Your Portfolio

Life is more than average.

The prevailing wisdom is that no one can beat the market. After all, only one-third of professional fund managers outperformed their index benchmarks over the past 10–15-year period. The obvious conclusion is that if most professionals cannot beat the market, the average investor should not attempt to pick stocks and simply invest in index funds. This mantra was drummed into me and likely into you. But like you, I read about market-beating investors like Buffet and Soros. I had no interest in the average. I wanted to see how successful investors made money in stocks and if I could also learn to pick stocks.

I went to work in the world of equity research. On Wall Street, our job was to find companies that would outperform (or underperform) their peers, then sell those stories to our hedge fund and asset management clients to help them make money. I did this work for nearly a decade, advising some of the world’s largest and most successful investment funds on stocks for their portfolios.  

As an analyst, I learned that the qualities of the business, and the type of industry it operates in, ultimately determine the stock’s long-term returns. Fundamental analysis, in a nutshell. With that toolkit, I learned to identify stocks likely to outperform or underperform. On Wall Street, there is an underlying framework that professional investors use to evaluate stocks. It’s a combination of the business’s prospects, the investor expectations, and the stock’s valuation. When these factors are all aligned in a certain way, you have a stock that will likely outperform.

Investors can successfully pick stocks using a fundamental approach. I’ve seen my clients do it, and I’ve done it myself. In this book, I’ll walk you through this exact process. You’ll learn through the eyes of our equity research team and our clients with detailed case studies of how we used fundamental analysis to pick stocks. I’ll share how I made successful investment calls on MSCI and the tanker industry. So, if you’re like me and have no interest in being the average investor, then this book is for you! My goal here is to teach you the fundamental stock investing process I learned from Wall Street. I hope you enjoy reading it as much as I did in putting this book together. I am confident that with this fundamental foundation, you will be better prepared to pick the best stocks for your portfolio.

Making asymmetric bets.

Here’s the first secret I learned about investing: all it takes to achieve market-beating returns is one or two well-placed bets with a portion of your capital. The reason is that throughout history, the best businesses have grown their profits faster and far longer than other companies. The returns of these stocks drive the returns of your portfolio. Researchers found that from 1990 to 2012, U.S. mutual funds that concentrated in one or two stocks in each sector tended to have better performance. Warren Buffett’s long-standing investment strategy at Berkshire Hathaway is to find a few good businesses with stability that will last. He expects these stocks will grow to dominate its portfolio. This happens because the best companies often show increasing returns with scale. Meaning the companies that get ahead, get further ahead.

Power laws are visible in the distribution of historical stock returns, meaning a small handful of companies have very high returns. In a study of the U.S. stock market, researchers found that just 4% of stocks have accounted for nearly all wealth creation since the 1920s. It’s even more extreme internationally, with less than 1% of stocks accounting for all wealth creation since the 1990s.  The implication is that a few investments with vast potential can drive higher returns for your portfolio. Get the right stock, and the payoffs are significant.

So why not combine index funds with stock picking? Once you are trained to identify stock opportunities, you can add stocks to improve the risk-return performance of your portfolio.

Imagine you started with a $10,000 investment portfolio in April 2016. We’ll take 10% of the portfolio ($1,000) and invest it in either 1) a unique leader in an industry, 2) a leader in the index, or 3) a random stock that unfortunately goes bankrupt. Let’s compare the outcomes of the three seven-year scenarios.

Here are the stocks we’ll use, with a brief investment pitch.

Industry leaders.

Professional Services: CoStar ($CSGP): In 2016, CoStar offered the most comprehensive dataset for the U.S. commercial real estate industry. This included propriety data on things like places for lease, sales information, tenants’ information, and so on. CoStar had acquired several data providers and marketplaces to build this dataset. By this point, no data providers could match CoStar’s breadth of data. You recognized CoStar’s competitive advantage comes from the proprietary real estate database. CoStar’s operating margins (25%) were also much higher than other real estate businesses, such as brokerages (15%) or commercial developers (15%), which have higher costs and more competition. CoStar’s leading position would enable it to grow consistently and acquire new marketplaces and datasets.

Capital Markets: MSCI ($MSCI): The U.S. Department of Labor expanded the fiduciary requirements for financial advisors in 2016 (meaning they legally had to look out for their client’s interests). As a result, more advisors recommended low-cost products such as exchange-traded funds (ETFs) or index funds. These funds used indexes to create portfolios (as opposed to managers). The indexes were provided by three major companies: S&P Dow Jones Indices, FTSE Russell, and MSCI. Seeing the growth of index funds and ETFs, and knowing how essential indexes were to these funds, you expected the index industry to grow strongly. MSCI stood out because it had a higher growth outlook and a more subscription-like model.

Biotechnology: Exact Sciences ($EXAS): In 2015, the Cancer Society added a new DNA test called the Cologuard to its recommended colorectal cancer screening tests. The product was developed by Exact Sciences as a non-invasive, at-home alternative to the colonoscopy screen. You believed this Cologuard had vast potential given the ease of use and positive performance characteristics. At the time, Cologuard represented roughly 2% of the market for colon cancer screening. Management believed the product could be used by 40% of the market. Cologuard’s adoption would drive tremendous growth for Exact Science’s value.

Specialty Retail: Restoration Hardware ($ R.H.): By 2016, Restoration Hardware was several years into a new growth strategy. CEO Gary Friedman, who was a successful operator in the space, was in the process of transforming the business into a modern, upscale furniture brand. You heard of his earlier success at Williams-Sonoma, where he expanded the company to become a national brand with unique product presentation strategies. At this point, Restoration Hardware had already achieved industry-leading revenue and earnings growth rates. So you decided to bet on Gary Friedman’s leadership, believing in the growth potential of the Restoration Hardware brand.

Here are the returns (April 2016–April 2023) of $1,000 of these unique leaders’ stocks:

• CoStar ($CSGP): $1,000 to $3,700
• MSCI ($MSCI): $1,000 to $7,500
• Exact Sciences ($EXAS): $1,000 to $9,600
• Restoration Hardware ($ R.H.): $1,000 to $5,500

Market leaders.

Apple ($APPL): In 2016, Apple was the clear smartphone market leader. If you were in the USA, you likely saw people using their Apple iPhones and MacBooks every day. The Apple ecosystem was continually expanding with new products, like the Apple Watch and the Apple entertainment services. Warren Buffett’s Berkshire Hathaway also made a well-publicized investment in the company. So you looked into the reason for their investment: the Apple business was beginning to look more like a subscription to consumers (as opposed to products). This meant its earnings growth was becoming more predictable, making the stock an attractive investment.

Google ($GOOGL): Google was the number one search and video platform. You saw this as a dominant, almost monopoly-like market position. There were network effects; the platform became more valuable as more content was added to the Google search database and YouTube. Google had recently separated these advertising-driven businesses from its venture-related investments, showing investors its search and video business were also highly profitable. You expected Google’s growth in advertising to continue (unchallenged), making the company more valuable.

Microsoft ($MSFT): Satya Nadella had recently taken over as CEO of Microsoft and shifted the company’s strategy to focus on fast-growing enterprise and cloud-based services. Looking into this new strategy, you noticed the strong growth of Microsoft’s business, Azure. You believed Microsoft’s cloud software had a vast market potential, which would drive Microsoft’s earnings growth and increase the company’s value for many years.

Here are the returns (April 2016–April 2023) of $1,000 of these index leader stocks:

• Apple ($AAPL): $1,000 to $6,000
• Google ($GOOGL): $1,000 to $2,700
• Microsoft ($MSFT): $1,000 to $5,100

The zero stock.

Wirecard ($WRCDF): You invested in Wirecard, a fast-growing payments company, not realizing it has used fraudulent accounting to boot its earnings for many years. The company filed for insolvency (the German equivalent of bankruptcy) in 2020, and most of its assets sold off, leaving equity holders with nothing as the stock was now worthless.

More upside than downside.

Let’s compare the returns of the three scenarios and assume you invested the remaining $9,000 into an S&P 500 Index fund like $SPY. ($9,000 invested in $SPY turned into $18,000.)

Best case: You trained yourself to recognize great stocks. You pick $MSCI to invest $1,000. Your portfolio goes from $10,000 to $25,000 (150% return).

Worst case: You followed the crowd and picked a stock that went bankrupt to $0. Your portfolio goes from $10,000 to $18,000 (80% return).

Lazy case: You picked one of the leaders of the S&P 500 index (we’ll use $GOOGL). Your portfolio goes from $10,000 to $20,000 (105% return).

Baseline: You don’t pick any individual stocks and invest everything with the S&P 500 index. Your portfolio goes from $10,000 to $20,000 (100% return).

This is why stock-picking can improve your portfolio’s risk-adjusted returns. There is more upside than downside in the potential scenarios. The best-case returns of 150% are relatively higher than the worst-case returns of 80% compared to the 100% return baseline. This is because the maximum downsize of the worst stock is capped (-100%), while the potential upside of the best stock is several orders higher (+300%).

References

Cremers, Martijn, and Antti Petajisto. “How Active Is Your Fund Manager? A New Measure That Predicts Performance.” SSRN, March 21, 2006. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719.

Bessembinder, Hendrik. “Wealth Creation in the U.S. Public Stock Markets 1926 to 2019.” SSRN. W.P. Carey School of Business, February 25, 2020. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3537838.

Bessembinder, Hendrik, Te-Feng Chen, Goeun Choi, and K.C. John Wei. “Do Global Stocks Outperform U.S.S. Treasury Bills?” SSRN, July 9, 2019. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3415739.

Goldman, Eitan, Zhenzhen Sun, and Xiyu (Thomas) Zhou. “The Effect of Management Design on the Portfolio Concentration and Performance of Mutual Funds.” Taylor & Francis, December 27, 2018. https://www.tandfonline.com/doi/full/10.2469/faj.v72.n4.9.

Arthur, W. Brian. “Increasing Returns and the Two Worlds of Business.” SFI WORKING PAPER: 1996–05–028. Santa Fe Institute, n.d. https://www.santafe.edu/research/results/working-papers/increasing-returns-and-the-two-worlds-of-business.