On December 8, 2017, Jason Zweig wrote a fascinating column in The Wall Street Journal titled "Index Funds Rule the World, But Should They Rule You?" The article questioned the dominance of index funds and suggested there might be opportunities in the market’s smallest companies.
My son, who shares little of my investing interest, told me about this article. I was intrigued. Here’s my story.
Mr. Zweig pointed out that there are "orphan stocks"—mostly very small micro-cap stocks under $100 million in market capitalization that generally aren't owned by index funds. Therefore, these mostly abandoned stocks can sell below their fundamental value.
But if for any number of reasons they grow, index funds may be forced to buy them. In theory, this structural pressure should raise the price of these stocks, possibly more than their fundamentals might justify.
I decided to give it a try. I limited myself to two stocks and not a lot of money (about 1% of our life savings). I promised myself that no matter the pain, I would not sell them, arguing that regardless of the results, I would learn something.
I still own one of those stocks. It is up three and a half times from what I paid for it, and last year it was added to the Russell 2000 index.
The second stock I bought dropped dramatically, and then rebounded when a foreign company purchased the entire company. I was now two for two. Feeling a bit more confident, I slowly started buying other orphaned micro-cap stocks, fifteen in total, nine of which I still own.
There’s some additional background that may help with my exercise. Modern Portfolio Theory (MPT), one of the foundational theories of modern investing, was developed decades ago. The details are extremely complicated, but essentially it says two things:
First, over time, higher risk investments can provide a higher return. That is, investors are generally paid for the risks they take. For example, U.S. Treasury bonds pay little because they are so safe. Other sectors such as micro-cap stocks and emerging markets tend to provide higher returns to compensate for their risk.
Second—and this is critical—if you own multiple low-correlation assets, your overall risk is reduced, but your expected returns are not. That is, you get at least some of the value that comes from owning higher risk assets but without all of their downside. This is the argument for asset allocation, the strategy of dividing your investments among different asset classes to balance risk and return.
This is what I've commonly done with my investments. No matter how bad things can get, I normally have another investment, such as I-Bonds or REITs, shoring up at least some of my portfolio.
Micro-cap stocks are inherently high-risk investments. But MPT suggests that over time, having some micro-cap stocks in a broad portfolio can reward their investors with a higher return. Diversification with other mostly uncorrelated investments reduces (but does not eliminate) their risk. That is, an investment like this can raise your total portfolio return without adding comparable risk.
I quickly learned some issues with orphaned stocks. They may not regularly trade. It may be difficult to get timely financials. And they can lose a lot of money very quickly.
I soon limited myself to stocks with steady or growing revenue, somewhat stable prices and that trade on either the New York Stock Exchange or the Nasdaq. Let’s say I’m trying to buy very small companies that seem to be doing well but are not overpriced. They have real people working for them providing real goods and services to paying customers.
As usual, I avoid assets that I don't understand, such as utilities or alternative health products, and I avoid hot markets such as AI and gold. I'm drawn to sectors that have some obvious purpose, such as healthcare, industrials and energy.
But probably most importantly, I score all my stocks based on some standard valuation and financial metrics, and I trust this simple scoring more than my instincts.
I've learned a lot with this exercise, but most importantly, I found that MPT does seem to work. When mixed with other, more traditional investments, they can increase your returns without much increase in volatility.
This is another lesson from stocks. While they can’t go lower than zero, they can rise any amount short of infinity. Yes, that may be simple thinking, but in my sample case, about a quarter of my stocks have lost some money. But six of them have at least tripled, far exceeding my losses.
Please note that, statistically, the median micro-cap stock often underperforms the market and that it is not unusual for them to never grow, and to quietly disappear.
There are endless claims that index funds will almost always outperform individual stock portfolios, on the argument that most gains come from very few stocks. In this theory, winning is a matter of luck.
But this has not been my experience. For years, I’ve repeatedly checked this claim on all my stocks, and the story is the same: Over larger time periods, although a majority of the gains are from a minority of the stocks, this minority isn’t small but instead is rather significant. Gains aren’t contained to a couple of lucky buys, but across a broader segment.
I also have frustrations with the fundamental mechanism of indexes, where they own more of overpriced stocks and less of undervalued stocks. I understand that this is due to their structure, but I don’t have to like it.
For example, today the S&P 500 index has about 30% of its value in less than a dozen huge companies, which many valuation models currently consider to be expensive. Indexes love ‘buying high,’ but not me.
I have slowly purchased these orphan stocks over many years, have occasionally made sales and some repurchases, and have sold several outright. I have limited them to a small percentage of our life savings, always prepared to eat a heavy loss.
But according to Quicken, the average annual return of my orphan micro-caps over these eight years, including unrealized gains, has been 39%, beating the average annual return of the U.S. broad market (Russell 3000) over the same period by 26 percentage points. Although there were some better years, my orphan stocks only trailed the U.S. market in one year (2022) and I’ve only realized nominal losses on a couple of stocks.
There are many easy challenges to this record—luck, small sample size, odd concentrations, small company premium, unacceptable volatility, a micro-cap boom. It is entirely possible that this has been a favorable eight-year window for micro-caps, and that another time would produce vastly different results.
I accept all of these as reasonable or even probable. But I obsessively track all my individual stocks and have casually noticed a pattern that individual orphans are highly volatile on a daily basis but collectively are not as scary as advertised.
All but one of my orphan stocks has been U.S.-based, and all were in just five sectors. Most of my investments were in industrials, healthcare and IT (electronics), and almost all the gains were in these areas.
A look under the hood, however, can be scary. It's not uncommon for a stock to drop in value by 50%. Rising or falling by double digits is also common, sometimes in a very short time. This is stomach-churning turmoil that has to be ignored.
But over time and across multiple investments, my returns suggest that they are tolerable in small amounts as part of a diversified portfolio—which is what MPT claims. Yes, arcane language and formulas would dispute much of this—remember that everything today is about indexes—but this is what I’ve thought forever: Indexes aren’t the only game and they have flaws.
My experience in no way suggests that picking stocks is easy or successful. And you can look no further than professionals to show how poorly stock picking normally goes. I recommend it to no one, if only for the angst.
I have learned some investing lessons. First, never own anything you don't understand, whether Apple or bonds or bitcoin. Second, challenge the basics of any company. Are the goods or services sound? Would I work for such a company? Most of the orphan stocks I have purchased have had very little or no long-term debt, solid revenue, and real customers—that is, in a way, my purchases are somewhat conservative, albeit small.
Decide on three or four metrics that you trust as fundamentals that represent a typical company, and then monitor your stocks by them. If a stock seems to be priced far too high or its finances are questionable, consider selling at least some of it regardless of its recent record.
If a stock drops a lot, before considering a sale, first consider whether you would otherwise buy it. If you would, then don't sell it, but do consider another purchase.
Journal your buys and sells. Write out why you are making your transaction, and then look back for patterns. If nothing else, it might slow you down from a bad move.
Finally, there's another life lesson I've lived by, and that is to not overcomplicate things. In investing, don't agonize over daily price swings. Never time the market—it's a losing game. Activity is not your friend—when in doubt, do nothing.
If I know nothing else about an individual investor, my investing advice is to buy and hold low-cost index funds across a couple of areas, such as U.S. stocks, international equities and bonds. Then rebalance them every year or two. Over time, you won't just do well—you'll outperform most of your friends and nearly all of the overpriced managed equity funds.
But, as Mr. Zweig notes in his article, even ardent proponents of index funds will purchase some individual stocks just “because it’s fun.” To anyone who wants to do this, it isn’t rocket science—it does not require some special genius. And with some work, you too can learn something—and maybe make some money.
No comments:
Post a Comment