Why some people buy individual stocks when most feel impossible to do

[Totoro]

Interesting link, thank you!

4% from a historical perspective is very conservative, true, but not unthinkable. I'm also worried about sequence of return risk, and of course history repeating itself is no garantuee.

For example:

• 1963 - 2013 : 5.90% - 40 years, seems fine
• 1973 - 2013 : 5.80% - 40 years, seems fine, but ..
• 2000 - 2013 : 1.17% (!) - shorter, but still 13 years, can't withdraw too much in the mean time. Sequence of returns matters.
• 1929 - 1949 : 2.09% - 20 years, enough to wreck a retirement (yes, 1929 and a world war in there)
• 1992 - 2008 : 4.11% - 16 years .. although with 2012 included it is 5.6%.

I know you also have 1979 - 1999 (13%!).



So 5.5% as probable return and 4% as "safe" doesn't seem unreasonable to me, certainly in the earlier years.


Of course, I am hoping for a 6% - 7% too and would be very welcoming of such an outcome

[RISP]

Update: Judging from Professor Siegel's resumé, I believe we are looking for this paper: "The Superior Risk and Return Characteristics of Dividend-Weighted Stock Portfolios," (with Jeremy D. Schwartz and Luciano Siracusano), WisdomTree Investments, March 2006, 63 pages.

So far, I failed to find it online, and apparently it was never published in any journal. I emailed Professor Siegel about it. Will keep you updated if/when he replies.

[photoguy]

I had forgotten that Siegel has been involved with Wisdomtree. On bogleheads and other sites there is often some discussion about using wisdom tree funds to fill in various value slices not available except through DFA (which requires an advisor).

Also there are some online tools that can show one the factor loads for various funds. E.g. if you put in DLN (wisdom tree large dividend fund) here: http://www.portfoliovisualizer.com/factor-analysis

It does indeed show beta < 1 (exposure to overall market returns) and value = 0.3 (which leads to higher expected returns)

[Options]

"Accept the fact that you are unlikely to beat a market where prices are set by the consensus of thousands of professionals and where you pay a steep price for every attempt."

--Gary Gensler

[Running_Man]

Quote:

Originally Posted by Options "Accept the fact that you are unlikely to beat a market where prices are set by the consensus of thousands of professionals and where you pay a steep price for every attempt." --Gary Gensler

This is hysterical in that he is presently manager of an actively managed fund and made his whole career at Goldman Sachs exploiting markets. Of course he made that quote when he was unemployed and trying to sell his book. That is a statement which is proudful in nature saying, "the average man cannot do as I have done, it takes too much talent". He and his ilk are in a totally different market than the one I participate in, and he is a servant to the whims of his customers and to earn his high pay must pretend to offer high value, I answer only to a very reasoned individual whose only pay is the result of dividends paid through ownership of corporations .

But enough of that, here is a simple example of how one can use dividends to spot potentially underpriced stocks, but even if the security does not rise in value the dividends still can rise faster than the inflation rate leading to an improvement of the individuals standard of living through ever increasing dividends at a faster than inflation rate which I think is most important portion of stock ownership. I will use a stock I recently selected to prove I am not cherry picking a situation.

Using the Value Line market survey, limit yourself first of all to only the stocks that pay dividends and are yielding more than 1.5% but preferably over 2%. Next only take stocks that are 1 or 2 for safety at least 3 for timliness and B+ or better for Financial strength as we want suitably strong and reliable companies. Next take companies where Price stability and Earnings predictability are both above 65 and at least one of these above 75, this gives us a predictable base to build on for forecasting results, finally pick companies with a rising dividend or difinitive plans for a rising dividend.

So one company that met this criteria was AMGN At the time I reviewed as a possible replacement for JNJ it was at a price of $144 and yielding 1.7 percent but the long term outlook for dividend increases was 15% and that would be a slowdown from the past couple of year increases. Other research showed the rise in earnings and increase of the dividend payout ratio would support the 15% dividend increases expected for the forseeable future. As a biotech company with a solid dividend policy this makes for a very good diversification candidate to an income portfolio. But what is it really worth?

I determine through other research that it is reasonable to expect the 15% dividend growth to last 10 years and that if then the dividend were to flatten out to only 2-3 percent above inflation at that point it should still in 10 years sell at a dividend yield at worst of 4 percent. So that would mean in 10 years the stock would sell 25 times the dividend which I expect to be $9.87 or $247 dollars. If you then discount that price back by 3 percent per year for the risk free return you get $182 dollars, then add the dividends discounted for the next 10 years of 47 dollars for a present value of Amgen of $229 dollars for full valuation. The Amgen fell below 130 per share earlier this month making the yield 2 percent and the potential even more enticing so I purchased at $129.65.

As time passes and my budgeted assumptions are measured against the market AMGN will move towards the price I expect if my budget is accurate. Factors that would change this are the risk free return, dividend policy, earnings outlook or a change in the board resulting in a dividend policy change. However if in one year everything is according to my budget the dividend would be $2.81 and expected growth would still be 15%. What happens in the market though is the realization that the dividend growth is more sure so the dividend yield might move from 2 percent to 1.7% Meaning in one years time i will earn the 15% increase from the dividend yield/ earnings valuation and also 20 percent for the stock falling in yield from 2 percent to 1.7% and still have a company that is undervalued, just not as undervalued as the buy point. If the stock has fallen so the yield is now over 2% then as long as the assumptions for dividend, risk free return and earnings growth are still valid I am in no peril. The key is to find stocks that are growing the dividend and paying for a predictable performance in an underpriced dividend moment.

Now when AMGN actually announced they are increasing the dividend 30% next year, assumming the remaining 9 years will be 15% growth yields an additional immediate increase in NPV of $30 or a total of $259. The closer the stock gets to that level the less upside is left and the more likely there are other better opportunities, giving you a chance to sell high. This is why I sell when the dividend yield based on the coming years expected dividend is below 1.5% which in this case yields a price of $215.

The key is to limit yourself to predictable companies and develop reasonable assumptions and measure future progress against your assumptions. This process will work no matter what the stock is. However simplistic this system seems, I am highly doubtful there is much analysis of stocks being done with this filtering and valuation criterea, as a matter of fact most purchases of AMGN are probably driven by the BIOTECH ETF and other ETF and indexes purchasing and selling in the market. The big players that can change prices are the unencumbered hedge funds and managed funds that by their nature have a 1-2 year focus as their long term focus but frequently can't get past the next end of the month fears.

Just for info purposes if the risk free discount were to be 4% then under the present scenario the NPV I am using is $235 at 5 percent it falls to $215 so while there is an interest rate sensitivity to this stock it is not severe nor even sufficient to worry about in purchasing the stock at $129.65

[galeno]

In our 31 years of investing we've used managed mutual funds (12y).


We used individual stocks (11y). During this time we beat the Wilshire 5000 index by more than 6% per year.


Since 2006 (9y) we became Bogleheads and use cheap index funds. We like this approach because it's simple, cheap, and well diversified. With cheap and simple index investing we should get an excellent total return with almost zero stress.

[Running_Man]

This is a six month followup to my recommendation and logic behind buying AMGEN. Since then AMGEN has now over performed to both my and market expectations. They have raised their guidance on earning to $9.50 +- 0.15 from 9.35 and despite currency issues their earning continue to grow. I have listened in my day to many corporate conference calls, and I am not a medical or biotech specialist but they and especially Mr Hooper are extremely impressive management team. I am quite pleased to be invested with those as the fiduciaries of my investment.

The quarterly call was very interesting today and they are very confident going forward for the remainder of this year and indeed with new product launches out to 2017. So for the foreseeable future the 15% growth appears to be a minimum. The experts seem on the call seemed incredulous on the results and management expectations and it was fun listening to MBA types from Goldman Sachs and Morgan Stanley literally asking for help in trying to understand how AMGEN was doing as well as it was doing. Based on the questions I heard and using the intuition of listening to many calls, I expect a whole lot of upgrades coming on AMGEN which probably will bring the stock closer to it's true value of $245+per share.

As for it's Value Line metrics it has maintained all of them and is top rated stock in Financial Strength, Safety, Earnings Predictability and has good timeliness rating. Nothing from either reported results, external financial forces nor the Value Line metrics indicate anything other than this stock should continue to move towards my expected values.

Now in comparison to someone who would be prefer the simpler and easier indexing, AMGEN as a part of an individual stock portfolio presently yields more than VTI, it is growing faster than VTI and the economy, while the dividend should be increasing about 3X faster than VTI.

In other words I still like AMGEN

[RISP]

Quote:

Originally Posted by Running_Man Now in comparison to someone who would be prefer the simpler and easier indexing, AMGEN as a part of an individual stock portfolio presently yields more than VTI, it is growing faster than VTI and the economy, while the dividend should be increasing about 3X faster than VTI. In other words I still like AMGEN

You are not seriously comparing an individual stock to a diversified stock portfolio, are you? Hint: Non-systematic risk.

[target2019]

Quote:

Originally Posted by Running_Man Now in comparison to someone who would be prefer the simpler and easier indexing, AMGEN as a part of an individual stock portfolio presently yields more than VTI, it is growing faster than VTI and the economy, while the dividend should be increasing about 3X faster than VTI. In other words I still like AMGEN

I understand the attraction. I'm familiar with Medtronic MDT, which has more muted results. The price has taken off after a long period of waffling. I think most would be concerned that any individual company could fall into a funk like Medtronic did after the recession. Looks like it took 5 years to come back on price. Granted, the yield % was growing, but not everyone can hold shares and live off yield.

Thanks for following up. I see that AMGEN is a part of your stock portfolio.

[Running_Man]

Quote:

Originally Posted by RISP You are not seriously comparing an individual stock to a diversified stock portfolio, are you? Hint: Non-systematic risk.

umm no, I was stating that AMGN is a good example of selection of how exactly individual stocks are superior in my mind to index investing.

[RISP]

Quote:

Originally Posted by Running_Man umm no, I was stating that AMGN is a good example of selection of how exactly individual stocks are superior in my mind to index investing.

How so? Unless you use individual stocks to build a diversified portfolio, they are not comparable to an index approach. You cannot expect to outperform the market without acknowledging that you are taking on significant non-systematic risk in the process. (Which isn't very smart, because this is the one risk you can avoid simply by diversification).

And if you do use individual stocks to build a truly diversified portfolio, then you are, well, indexing.

[Totoro]

Quote:

Originally Posted by RISP You cannot expect to outperform the market without acknowledging that you are taking on significant non-systematic risk in the process. (Which isn't very smart, because this is the one risk you can avoid simply by diversification). And if you do use individual stocks to build a truly diversified portfolio, then you are, well, indexing.

That's a bit of a circular reasoning no?

Might sound blasphemous to some, but one can actually reduce what you call systemic risk by concentrating their portfolio.

The underlying assumption of diversification is independent and random performance of stocks. One could argue that both assumptions are false. Stock correlations are present, and better companies outperform bad ones.

Choosing a well-researched great company at bargain prices can be a much lower risk approach than just buying everything without any knowledge and hoping for the best.

Diversification is only smart if you don't know the value of what you are buying. The better you know, the more stupid it is to diversify.

Whether or not one is a) able to precisely value a company and b) has to courage to act on it determines the best approach, including to what degree one should diversify.

How you can determine a) and judge b) is a matter of temperament and skill. Odds are against you (many more people have "B" without having "A", but it can be done. Why some people go for it (the topic at hand) and others don't is a confidence thing I guess.

I'm personally on the fence with regards to my skill in A (so far so good, but there hasn't been a downturn test yet), and have demonstrated a moderate willingness for B. So diversification makes sense for me.

[phil1ben]

I only buy individual stocks and individual municipal bonds. Except for commodity or currency based ETFs I do not buy funds. I do it for the following reasons:

1. I like to be able to trade based upon my own instincts and analysis of current news;
2. I can time my gains and losses and application of any carryover to personally suit my needs;
3. I can quickly move in and out of an individual position;
4. With respect to bonds, I understand my risk at the inception of a trade in that I know (borrowing a default) that I will get full principal back at maturity or call;
5. No fees other than minimal trading fee through Schwab; and
6. I enjoy the process of analysis and trading.

The above has worked well for me for 30 years. I am 55. Have been FI for many years but am still working. I own my own business. I have been able to diversify as I see fit. I realize the above is not for everyone but those are my reasons.

[RISP]

Quote:

Originally Posted by Totoro That's a bit of a circular reasoning no?

I don't think so. Let's compare apples to apples; that's all I'm asking for. You can't say "this individual stock is superior to the market because I expect it to perform better" (I'm paraphrasing here) without taking into account that it is also a lot riskier to hold one stock (or a few), compared to owning the whole market.

Quote:

Originally Posted by Totoro Might sound blasphemous to some, but one can actually reduce what you call systemic risk by concentrating their portfolio.

I guess you mean non-systemic risk. Systemic risk, or market risk, cannot be avoided or mitigated, unless you choose not to invest at all.
I'm not a religious person, so to me the above is not blasphemous, just illogical. Examples of non-systemic risks are employee strikes, or regulation changes. I don't see how what you call "better" companies would be immune to those.

Quote:

Originally Posted by Totoro The underlying assumption of diversification is independent and random performance of stocks. One could argue that both assumptions are false. Stock correlations are present, and better companies outperform bad ones.

Now I don't have my old textbooks with me, but I don't think that's true. Diversification works for all types of assets which do not have a correlation of 1. It doesn't have to be 0; unless the assets move in perfect lockstep, diversification has its merits.

Quote:

Originally Posted by Totoro Choosing a well-researched great company at bargain prices can be a much lower risk approach than just buying everything without any knowledge and hoping for the best.

Not hoping for the best. Expecting the usual.

Quote:

Originally Posted by Totoro Diversification is only smart if you don't know the value of what you are buying. The better you know, the more stupid it is to diversify.

Not true; see the example of a taxation or regulation change.

[gerntz]

Quote:

Originally Posted by Running_Man umm no, I was stating that AMGN is a good example of selection of how exactly individual stocks are superior in my mind to index investing.

First, I do zero research on stocks & use indexes.

But cherry-picking one stock vs. an index to look backwards with to try to make a point is a mere anecdote & thus invalid for demonstrating anything other than the stock did well. Certainly doesn't demonstrate stock-picking is better than indexing.

Now name 10 stocks today & compare vs. an index or indexes that cover the same type stocks & see 1-5-10 year results & win, then you have something.

[Totoro]

The point where we diverge I think is that it can be alot less risky to own one company vs. the whole market.

As a theoretical example: suppose a listed company only has cash worth 100 B$, and is listed for 40$B. It has nothing else (no employees, production, ..).

Buying that company, delisting it and getting the cash out has virtually zero risk.

In the past the rough equivalent of that scenario (e.g. extremely undervalued real estate hidden in the balance sheet) has existed.

How would diversification help you here? It's not stupid to put all your money in one place if that place is safer and offers higher returns than all the alternatives.

Since few opportunities are so clear cut it does make sense to diversify usually though. It is a margin of safety one can build in if required.

The question then is whether one believes you can narrow down the certainty of value enough to not need the diversification route in practice.

Some people think they can, others don't and everything in between. Extreme at the one end means indexing only, extreme at the other end means concentrating in one company.

Another example, a bit more practical: suppose I invest in two companies to diversify. And then these two companies merge. Has my risk profile changed? Should I sell half my holdings and find another company to diversify?

Diversification has its merits (I use it myself!), but it's just another tool, not always the best one for everyone in my book.

[Dash man]

I'm a fan of both stock picking and diversifying using index funds. The index funds are in our 401k accounts and we stock pick in our taxable brokerage account. We consider ourselves diversified in our individual stocks too because we own about 25 stocks across several industries, and buy what we believe are the best. Index funds unfortunately also bring along loser stocks with them. Our largest gains have been in the individual stocks over time and they are what have made us very comfortable. None of them are the sexy stocks you hear about on the business news channels, but have done very well over time. Accumulating shares in the strongest companies does allow your portfolio to grow faster than index funds, but it is a riskier game overall because there are unknowns that can hit any company. Fortunately for several of our picks, the unknowns have been positive.

[Fermion]

Quote:

Originally Posted by Totoro The point where we diverge I think is that it can be alot less risky to own one company vs. the whole market. As a theoretical example: suppose a listed company only has cash worth 100 B$, and is listed for 40$B. It has nothing else (no employees, production, ..). Buying that company, delisting it and getting the cash out has virtually zero risk.

One might think this example has no risk but unless you are in total control of said company, there is always some hidden risk. The company may fall under some litigation for past product/service, they may choose to poorly invest the cash (this has happened to me more than once...the worst case being a mining stock that had 2x more cash than market cap and lost it all trying to build/expand their mines)

[samclem]

Quote:

Originally Posted by Dash man Accumulating shares in the strongest companies does allow your portfolio to grow faster than index funds . . .

Somebody should tell this to the majority of active fund managers, who consistently underperform their appropriate indexes. "Accumulate shares in the strongest companies" . . . they just didn't know this neat trick!

[haha]

I do not understand why people participate in these discussions. Every investor knows here he or she stands. Can anyone think that they are going to discover some new fact here, that they have never run across in the previous years of being an investments junkie?