How to Beat the Stock Market

Is a great company a great investment?

My life has been changed by great companies. Days start with my iPhone, listening to a podcast, and checking emails. Family discussions on historical events are quickly resolved with a Google search. Afternoons often include a delivery of my latest purchase on Amazon. As evening arrives, I cozy up to my favorite programs on Netflix. As I fall asleep, I marvel at the ubiquity of these great companies. Why didn’t I invest in them years ago? Their current success now seems so obvious. I wonder whether it is too late since they are still great companies, dominating their competitors.

To beat the market, should I buy great companies that are growing fast?

A strategy which may seem logical would be to invest in great, fast-growing companies. Picking them is easy: Apple, Amazon, Alphabet (Google’s parent company), and Netflix come to mind. Their past success has led them to be some of the most valuable companies in the world. But investing now is buying into their future success, not their past.

The risk is paying too much for future profits

To beat the market, you need to see opportunity before everyone else. While many of us are confident in our skills, beating the best thinking of a large number of investors is hard. Malcolm Gladwell’s book, “The Wisdom of Crowds,” is a useful reminder. Investing to outperform the overall stock market requires two factors: 1) disagreeing with the consensus of a company’s future earnings or the value of their assets, and 2) determining a catalyst that will bring investors around to your view.

The risk of buying today’s popular growth stocks is that their future growth disappoints. When you are at the top, it is hard to stay there. In 2004, the two most valuable public companies were General Electric and Exxon. I am sure investors who bought those stocks fifteen years ago did not expect their fall. Even the largest, most successful firms may become complacent, failing to innovate or adapt to changing consumer preferences or regulations.

Better to buy earnings or assets at a discount

A better investment strategy is buying stock in companies that are undervalued by the market. Why buy something at premium prices when there are good investments available at discount prices?

For example, Russell Investments calculates that buying Amazon or Netflix stock today is buying the expectation that their earnings will continue to grow at 30% a year for the next decade. By contrast, an investment today in either Bank of America or Lennar, a leading home builder, implies no growth in earnings. For these two stocks to outperform the market, their future growth must only exceed the expectations of no growth. Amazon and Netflix are much more interesting companies than a bank and a builder, but beating 30% growth is a higher hurdle than finding ways to generate some level of growth.

Research indicates that “value” stocks outperform “growth” stocks over time

Stock markets provide scientists with lots of data. There are 8,000 publicly traded stocks in the U.S., and daily stock market data goes back more than a century. Thirty years ago, two University of Chicago Professors, Eugene Fama and Kenneth French, researched whether there are factors that might explain the excess return of some stocks. They divided all stocks across a number of dimensions, one of which was based on market value compared to book value. Stocks trading with relatively high market-to-book values are referred to as “growth stocks.” The rest are called “value stocks.” Fama and French discovered that value stocks tended to outperform growth stocks, an insight which earned them the 2013 Nobel Memorial Prize in Economic Sciences.

Dimensional Fund Advisors, a firm whose success has been driven by their research, calculated that 82% of the time value stocks outperform growth stocks over ten year rolling periods.* An explanation for this persistent anomaly is that investors tend to pay too much for future growth. They bid the stock price up, assuming the high growth will continue far into the future.

A strategy that works 82% of the time underperforms 18%

No investment strategy works all the time. We are currently in one of the longest periods of value stock underperformance. The last period of this length was the tech boom/bubble ending in 2000 when investors bid prices up on growth stocks focused on the internet and the “new economy.” Now the leading growth stocks are Apple, Amazon, and Google.

While it is likely that we are in the midst of an exceptionally long period favoring growth stocks, one must consider the small possibility that there has been a structural change to economies. It is possible that only a few companies will dominate profits for the next decades and exceed the lofty growth rates implicit in their current stock prices. It is possible, but not probable since it has never happened before. Dominant companies have changed from decade to decade. Ford and GM were once among the most valuable companies. So were Exxon and IBM.

Beating the market requires conviction and patience

Whether you believe that buying growth or value is the way to beat the market, it is critical to hold to your strategy. No strategy will work all the time, and switching each time your strategy stops working is sure to fail. Research has proven that investing in undervalued stocks wins more often than not, but a decade-long losing streak is a long time. Time will tell whether those who have had the conviction to keep holding undervalued stocks will once again beat the market. The odds are in their favor.

*based on data from 1926 through 2019.

Lex Zaharoff, CFA

Lex joined HTG in 2014. With over 30 years of experience advising wealthy families at four major private banks, Lex provides clients with a unique perspective on the art and the science of investing to achieve one’s financial goals.

As Adjunct Professor of Finance at NYU’s Stern School of Business, Lex teaches the MBA course on wealth management. He has a BSE from Princeton University and an MBA from Harvard Business School.