Last year should serve as a stark reminder to investors of the havoc extreme volatility can wreak on a portfolio while illuminating the increasing challenge of achieving true diversification. Passive investors especially have been caught off guard, thinking their “diversified” index funds would protect them from the volatility of the market. While some active managers may be better equipped to navigate through a transitioning market, it’s nearly impossible to choose which ones will outperform. It may seem bold to many investors, but now may be the best time to invest in individual stocks. Let me explain why.
Has the Sheen Worn Off of Index Funds?
Since the catastrophic stock market crash of 2008, investors have flocked to index funds as a haven from high investment costs and market volatility. And, to the dismay of much of the investment world, they have delivered, outperforming actively managed funds while charging a fraction of the fees. After a nearly ten- year run of positive returns, it took another steep market decline in 2018 for passive investors to realize that index funds can actually lose money. In fact, index funds by design are almost certain to suffer 100% of any market decline.
Diversification Becoming More Elusive with Index Funds
Aside from their low cost, the main selling point for index funds has been the instant diversification they provide, enabling investors to buy a stake in each of the 500 companies that comprise the index. As a result of recent volatility in the index, many investors are beginning to realize they are not as diversified as they thought. The S&P 500 is a weighted index, which means companies with the largest capitalizations are overweighted in the index. It also means that, as more money flows into index funds, the managers must apportion it according to stock weightings, which pushes the valuations of stocks like Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), Netflix (NASDAQ:NFLX) and Alphabet (NASDAQ:GOOG) even higher.
It is now to the point where the top ten companies in the S&P 500 are responsible for the majority of its performance. In fact, these ten stocks accounted for more than 100% of the gain in the index for the first half of 2018. The problem with owning these ten stocks in an index is investors have no risk control – no to pare back their exposure to overvalued stocks – leaving them completely vulnerable to the downside. The question index fund investors must ask themselves is, if they were to invest in ten stocks, would these be the ten stocks they would want to own? For index investors who shun volatility, probably not.
Now May be the Time for Individual Stocks
As scary as it might seem to many investors, investing in individual stocks offers the opportunity to generate higher long-term returns with effective downside protection. Instead of having to own good companies along with the bad in an index, investors can focus on identifying high-quality, well-managed companies with strong balance sheets, solid growth prospects and a demonstrable ability to create value for their shareholders.
Buying Value Stocks Can Reduce Market Risk
The key to selecting these “value” stocks is to identify companies selling at a deep discount to their intrinsic value, which is the calculated or true value of a company that has yet to be recognized by the market. This reduces investment risk because, while offering a high ceiling for capital appreciation, it raises the floor on potential price declines. If you can buy a stock for half of what it is actually worth, there is not much downside.
It’s essentially the investment approach used by highly successful investors, such as Warren Buffett. For Buffett, and other value investors, an investment in a stock is actually an investment in the business, which they expect to hold for a long period of time. Companies that have the capacity to generate a high level of free cash flow and the willingness to reinvest capital in their growth, tend to compound that growth over time.
Many high-quality companies fly under the radar of the media and investment managers because they don’t make headlines. Instead, they quietly create value for their shareholders. As an example, Danaher Corp. (NYSE:DHR) is one of the better-performing stocks versus the S&P 500 you’ve probably never heard of. The stock hides in a category – industrial conglomerate – not very high on investors’ or the media’s radar. Manufacturing companies have generally been out of favor for a while. Yet, Danaher has quietly and consistently churned out hundreds of different high-demand consumer products for more than 30 years and its stock growth has outpaced the S&P 500 by 100% during that time.
As for diversification – which is always important for minimizing portfolio volatility – a portfolio of 10 to 20 stocks across a few sectors and global regions is more than sufficient. In fact, studies have shown that much more diversification than that actually diminishes return potential without further reducing volatility.
Some investors may feel more comfortable maintaining an allocation of different index funds for purposes of capturing returns across a variety of sectors or regions. By adding well-selected and undervalued individual stocks, they can substantially increase the potential long-term returns in their portfolio while further protecting it against sharp market declines.
