Trying To Beat The Market Is A Fool's Errand
Proponents of indexing as the best investment strategy seemed to take great delight in reporting how the vast majority of professionally managed portfolios (mutual funds, separately managed accounts, hedge funds, ETFs, etc.) fail to outperform the S&P 500. Therefore, they argue, it is best not to even try. Investors should simply invest in index funds and forget about it.
At first glance, this would appear logical because in truth their statistics are true and valid. On a total return basis, the vast majority of investor funds that are professionally managed do in fact underperform the S&P 500 on a total return basis. However, with this article I intend to illustrate that there is a significant flaw with this line of reasoning.
Prominent Reasons Why Active Management Often Fails to Outperform
However, before I delve too deeply into discussing the great flaw, I would like to comment briefly on a few extenuating reasons why many actively managed accounts might underperform. For brevity's sake, I am not going to try to list all the extenuating circumstances, for that would be the thesis for a separate article. In other words, a comprehensive discussion would be too extensive, and not the true focus of what I intend to offer with this article.
Some of the most prominent reasons for failure to outperform are management fees and costs, over-diversification, restrictions imposed by investment policy statements, and perhaps the biggest factor -being victims of their own success. The first couple of reasons are self-explanatory, therefore, I will limit my focus to the last reason I presented.
For example, a small and newly created mutual fund might put together an extraordinary track record over its first few years of existence. This extraordinary record could be a function of both its small size, and perhaps the fact that it was created during an attractive market environment. In other words, it was created at a time when stock valuations (prices) were low.
However, assuming they do in fact create a great record, that will often attract significant amounts of new money. But it is quite possible, and perhaps even quite common, that their greatest inflows will come during a time when the market environment has become unfavorable. In other words, they get a bucket load of money at precisely a time when it's difficult for them to invest it at attractive valuations. However, invest it they must. Consequently, future performance will suffer as a result.
In contrast, if a mutual fund produces a poor track record over a certain period of time, it will often suffer extensive liquidations. These liquidations are then theoretically occurring at precisely a time when their better judgment would suggest buying stocks over selling them. In other words, they are forced to sell undervalued selections instead of the more prudent strategy of buying or at least holding on. I could go on, but I hope the reader gets the point. Active managers face numerous extenuating circumstances that the "market" is spared.
I want to be clear that I am not attempting to justify underperformance. Instead, I am simply attempting to illustrate a few prominent reasons why it happens. Moreover, what follows will deal with what I consider to be a more important concept which I will frame in the form of a question. Should investors even concern themselves with trying to outperform the general market on a total return basis? My answer is emphatically no, and my reasons represent the main thesis behind this article.
Basing Portfolio Design on Need
I did not title this article as I did to be provocative. Instead, I believe the title puts a spotlight on the importance of how I believe portfolios should be properly designed and constructed. Rather than worrying about beating the market, I believe that portfolios should be designed based on the individual investor's specific goals, objectives and risk tolerances.
With that said, I am also suggesting that an S&P 500 index fund may be a completely inappropriate investment choice for certain investors. There are numerous reasons why I believe this to be true. However, my primary reason is because the S&P 500 index may fail to meet a specific investor's goals, objectives and risk tolerances on many fronts. I will elaborate more on this important point later in the article. But first, allow me to present a 20-year earnings and price correlated F.A.S.T. Graphs™ of the S&P 500 index with performance to establish a benchmark that I will later utilize to support my thesis.
I chose the following 20 calendar year Earnings and Price Correlated graph of the S&P 500 for several reasons. First of all, the 20-year graph represents the full extent of the data available. Second, it also represents a starting period when the S&P 500 was reasonably within a range of its earnings justified fair valuation. Therefore, as I will show in a moment, long-term performance will closely correlate with earnings growth as price follows earnings over the long run. Moreover, the graph also vividly reveals periods in time when the S&P 500 became overvalued with price deviating from the orange line. But regardless of the timeframe I used, the most important metric I want to establish is the S&P 500's current dividend yield of 1.8% (red circle). This will be a focal point of this article as I proceed.
For those sticklers for detail, I also include the following graph plotting the historical year-end P/E ratio of the S&P 500 over this 20 calendar year timeframe. Note that the beginning P/E ratio of the S&P 500 was 17.6. This would indicate that it was in fact modestly overvalued based on my fair value calculation of a P/E of 15. In other words, the S&P 500 was, based on my standards, moderately overvalued at the beginning of 1994, but only modestly so. In other words, the S&P 500 was not overvalued enough to invalidate my thesis.
The following 20 calendar year performance over this timeframe is presented below (Note: The precise dates of this performance measurement are from December 31, 1993 to the S&P 500's close on October 15, 2013). Furthermore, the following performance report separates total return into its two components. The capital appreciation component of 6.7% per annum correlates closely to the 7.1% earnings growth rate, adjusted for the modest premium valuation mentioned above.
But the most important metric, and the second component of total return, that I would like the reader to focus on is the dividend income stream that the S&P 500 produced. Not only will this represent an income benchmark, it also simultaneously illustrates why I contend that the S&P 500 may not be an appropriate choice for certain types of investors. ( Clue, the S&P 500 with a current yield of only 1.8% would not cover the income needs of retired clients in need of a minimum income provided from a yield of 3% or better).
However, not providing enough current yield may not be the only reason that an S&P 500 index fund may be inappropriate for retirees in need of income. There are also the issues of inappropriate levels of risk, as well as several specific constituents in the S&P 500 that retirees should never own. In other words, it doesn't matter that they are hidden within the construct of an index of 500 companies; they are simply inappropriate stocks that retirees should avoid.
The only way to see this clearly is by dissecting the S&P 500 index through a careful review of each of its 500 constituents. Some may feel that this is a task that is beyond their ability or even desire to attempt. Fortunately, Premium subscribers to F.A.S.T. Graphs™ can complete this task rather quickly, efficiently and easily. By going to the 16 Provided Indexes and Portfolios I was able to review each of the 500 S&P 500 constituents in approximately 30 minutes. Frankly, it was an eye-opening exercise.
Once I went into the Portfolio Review section I created the following report that organized the 500 constituents of the S&P 500 in order of highest performance to lowest over the last 20 calendar year timeframe. The annualized performance number on the portfolio review is a total return calculation that includes both capital appreciation and dividend income. My purpose of organizing the S&P 500 in this construct was so that I could garner a detailed and precise understanding of where performance (total return) came from, how it was generated and which constituents outperformed versus which that didn't.
Since the total analysis is beyond the scope of this venue, I offer the following excerpts in order to make my points. First, I present the portion of the report comprised of the top 15 S&P 500 constituents that generated the highest annualized performance. Here I would like to acknowledge that there are some imperfections with this analysis. For starters, not all of the best performers provided the full complement of 20 years of performance. In fact, most the top 10 constituents provide records for only as little as 3 years out to 17 years.
However, the primary purpose of this analysis was for me to identify not only what companies, but what types of companies were producing the S&P 500's outperformance. Frankly, I can state with great confidence, that the vast majority of these top 15 candidates presented in my partial report below are emphatically inappropriate investments for retirees desirous of an adequate current dividend yield, and the opportunity to see that dividend income stream grow over time.
Additionally, these were not the only S&P 500 constituents that I felt were inappropriate for the dividend growth investor to own. There are over 100 S&P 500 constituents that pay little or no dividends. Clearly these are not appropriate investments for those seeking income. As I went through each of the 500 constituents, I found numerous other examples of inappropriate companies. But for now, I offer the following 15 best-performing S&P 500 constituents as measured by the highest annualized performance (Note: not all of the following names provided performance over the entire 20 year timeframe).
For brevity's sake, I offer the following two example S&P 500 constituents that did include a full 20-year record that I feel clearly illustrate that, and why, they are not appropriate for income seeking investors. My first example is Monster Beverage Corp (MNST). Clearly, as the graph reveals, this is an incredible growth stock. However, it should also be clear that it also represents a much riskier type of investment than a blue-chip stalwart dividend growth stock like Coca-Cola (KO) or Clorox (CLX) (I will provide graphs on both of these later). Not only does it not pay a dividend, price volatility is also rather extreme at times.
Monster Beverage Corp
Celgene Corp (CELG)
My second example, Celgene Corp, also represents a similarly inappropriate holding for the retired dividend growth investor. Although both of these examples represent solid growth stocks with powerful long-term performance histories, they may or may not provide the income that a retired dividend growth investor would need to live off of.
Therefore, it would only be through the harvesting of shares that any income could be had. Frankly, that is a job easier said than done, at least in my opinion. On the other hand, both of these would have been great choices for investors with a goal of achieving aggressive above-average long-term growth of capital. But that fact alone does not make them appropriate low risk, conservative income-producing investments that those in retirement need.
My next Portfolio Review excerpt of all the S&P 500 constituents skips all the way to the bottom in order to review the 15 worst performing companies in the S&P 500. Once again, based on a thorough review of each, I would emphatically contend that none of these names belong in the portfolios of income seeking retirees. Of course, that statement is notwithstanding the horrible performance that each produced over the past 20 years.
Here I will present 3 examples of the bottom of the 15 worst performing S&P 500 constituents that I believe are inappropriate holdings for retirement portfolios. I will let the graphs speak for themselves, and only state that their poor long-term earnings histories (the orange line) and poor long-term dividend records (the pink line) clearly validate why they would be inappropriate investments for retirees.
JC Penny Co (JCP)
Goodyear Tire & Rubber Co. (GT)
Motorola Solultions Inc (MSI)
The Need For Income And Why The S&P 500 Is An Inappropriate Choice
Up to this point, I have been suggesting that the S&P 500 may not be the appropriate choice for retired investors seeking income. Moreover, I contend this to be true regardless of the fact that the vast majority of actively managed portfolios don't outperform the index. This is true primarily because for the retiree in need of income to sustain an acceptable standard of living, total return is not the answer. Instead, total income is of paramount importance. Consequently, and most importantly, the S&P 500 simply does not generate enough income to get the job done. However, the only way that it could generate enough income for the retiree to live off of would be through the harvesting of shares to generate the needed cash flow. This creates several problems and challenges for the investor.
For starters, the very act of harvesting shares each year to meet income needs reduces the amount of investor capital available for distributions. Consequently, even if the S&P 500 does outperform, the effect of reducing shares diminishes its ability to produce an adequate income stream to an even greater extent. The following comparison of the S&P 500 versus a rationally constructed dividend growth portfolio illustrates my point.
With this analysis I am contrasting the S&P 500 offering a current yield of 1.81% with a dividend growth portfolio designed to provide a minimum need of 3%. Thereby illustrating the negative effects created by the necessity to harvest enough shares to make up the difference between 1.8% current income and the need for a minimum of 3%.
Assumptions for the S&P 500 analysis
- Invest $1,000,000 at a current price of $1,703.20 with a $30.89 annual dividend - or a current yield of 1.81%.
- Minimum initial income requirement of $30,000 with future annual income requirement needed to grow at 3% to compensate for inflation.
- Price of the S&P 500 grows at 6% a year, dividend also grows in line - 6% a year.
- Any income need that is not met by S&P 500 dividends are supplemented by harvesting shares.
- All transactions are assumed to be frictionless (no taxes or trading costs) and are done on an annual basis.
How Forced Harvesting Diminishes The Record Of The S&P 500
A Blue-Chip Dividend Growth Portfolio With A Starting Current Yield Of 3%
Assumptions for the DGI Portfolio....
- Same $1,000,000 to invest at a hypothetical share price of $1,703.20 - therefore both scenarios begin with 587.13 shares.
- Current yield is assumed to be 3%, which equates to a $51.10 per share dividend.
- Require same amount of income to start - $30,000 with future annual income requirement needed to grow at 3% to compensate for inflation.
- Price of DGI basket grows at 6% a year, with dividend growing at 6% a year - same as S&P 500.
- Thus start with same balance, same number of shares, and end with same ending share price.
- If income need is exceeded by DGI dividends, additional shares are added.
- All transactions are assumed to be frictionless (no taxes or trading costs) and are done on an annual basis.
How Meeting The Income Need Enhances Total Return
Beating The S&P 500 On All Fronts The Conservative Way
My previously presented analysis was hypothetical in nature and based on the assumptions made. What follows next is also hypothetical, but the difference being that it offers real-life examples of actual blue-chip dividend stalwarts, most of which (16 out of 20) have beaten the S&P 500 on a total return basis over the past 20 calendar years. However, and most importantly supporting the primary thesis of this article, 100% of which have generated more total dividend income than the S&P 500 has over the past 20 calendar years.
Now, before I present the following analysis, I have a few words for the diehard advocates of indexing who might cry foul by arguing that I have cherry picked the portfolio. If it is appropriate to argue that indexing is the best way to invest based on historical evidence indicating outperformance, then I will counter that argument by saying it is also appropriate to build a portfolio of individual stocks based on their historical outperformance over the S&P 500. What's good for the goose is good for the gander.
The following Portfolio Review is comprised of 20 blue-chip dividend growth stocks that together provide an average current dividend yield of 3% per annum. The S&P 500 is included as a 21st ticker for comparison purposes. The reader should note that only five of these selections have underperformed the S&P 500 on a total return basis (annualized performance).
As an interesting aside, a comment made on one of my recent articles suggested the idea of throwing out the worst performing stocks in the S&P 500 thereby creating a portfolio that could outperform. The following portfolio is presented in the spirit of that idea. However, I have taken it one step farther. Since the focus of this article is on providing the appropriate equity investment choice for dividend seeking retirees, I created a portfolio of 20 dividend paying blue chips, each with a current dividend yield that was greater than the current yield on the S&P 500.
The following performance history is the typical total return performance calculations that are reviewed in all the studies citing indexing outperforming active managers. I have highlighted each year that the portfolio underperformed the S&P 500 on a total return basis. Note that the annualized performance of the portfolio significantly outperformed the S&P 500 even though the portfolio underperformed the S&P 500 no less than nine times out of twenty, with one year a virtual tie.
However, and most importantly as it relates to this article, annual dividends (the income component) is not separately revealed. Later I will show a year-by-year comparison of the portfolio's total dividends to the S&P 500's total dividends.
The following portfolio appraisal shows the date-to-date performance of each of the 20 Fools Errand portfolio constituents. Note dividends have been accumulated and not reinvested.
In order to provide greater insight into the power of a well-constructed dividend growth portfolio, I provide the following 20 calendar year Historical Earnings and Price Correlated graphs plus their performance on six prominent dividend paying blue chips. For fairness, I have included some that have outperformed the S&P 500 on all fronts, as well as two that underperformed based on total return. However, all six of these examples provided more cumulative total dividend income than the S&P 500. This last point is ignored by the standard total return calculation. However, for the dividend growth investor it is the most important performance measurement.
PepsiCo Inc (PEP)
Consolidated Edison (ED)
Consolidated Edison versus S&P 500 - Dividends Reinvested
As an interesting aside, even Consolidated Edison would outperform the S&P 500 if the dividends of both were reinvested.
Summary and Conclusions
The primary purpose of this article was to pressent the argument that trying to build a portfolio based on the idea of outperforming the market is not necessarily the appropriate course of action. Although total return is certainly a consideration worthy of investor attention, it should not necessarily be the driving force behind constructing an appropriate portfolio. Considerations for the amount of risk investors are willing to take should also be part of the thought process.
Moreover, total return does not necessarily represent the final answer. The amount of income a portfolio is capable of generating may take precedence over capital appreciation. This would be especially true for the prudent retiree desirous of creating a portfolio capable of meeting their long-term needs for income. For these investors, it would be nice to get some capital appreciation along the way, and certainly desirable. However, you cannot spend capital appreciation unless you are willing to harvest some of your principal in order to get it. Moreover, if you harvest principle, then you are simultaneously left with fewer assets (shares) with which to generate income in the future.
The moral of the story is that a portfolio should be designed with the intention of meeting the needs of the investor designing it. If in the accumulation phase, then going for maximum capital appreciation may be a good course of action. However, once the need to harvest income from your portfolio kicks in, then focus should shift to dividend income over capital gain. In short, there is more to building a portfolio than focusing on total return only. Therefore, trying to beat the market may, in fact, be a fool's errand.
Disclosure: Long KO, CLX, PEP and ED at the time of writing.