by Jason Bodner
January 20, 2021
Many think it’s impossible to beat the market. It’s an unobtainable goal, a myth, a “Unicorn.”
The “efficient-market hypothesis” (EMT) basically says that it’s impossible to beat the market. In college, finance students learn that asset prices reflect all available information, so beating the market consistently on a risk-adjusted basis is impossible, since market prices can only react to new information.
I don’t think you believe that, or you wouldn’t be reading this.
The record shows that a handful of money managers beat the market consistently. Most fail over the long run. But a familiar few market-beaters keep appearing over the decades – names like Warren Buffett.
How does he do it? I think the answer lies in the power of small numbers. To beat the market, you only need a few big winners to cover all your losers (and then some).
I’m no Warren Buffett, but people ask me the market beating question, too. When I tell them that I think it’s possible through superior stock picking, they want to know how. My approach is by tracking what I think the Big Money investors are doing.
When I get buy signals in my proprietary system, I have a good hunch that Big Money is moving into a stock. When the signals show up on the stocks with the best fundamentals and technicals, I pounce. But here again, the winning concept is small numbers: I may only end up with 20 or so stocks out of 5,500!
Then invariably I get the question: “When do you sell?”
This answer really depends on who is behind the wheel. For me, it’s simple: Never. It sounds insane, but remember what Warren Buffett said: “Our Favorite Holding Period Is Forever.”
My premise is simple: I spend all of my time and energy weeding out the wheat from the chaff. I devote my professional life to identifying outlier stocks in the vast sea of mediocrity. Once you find the keepers, you never want to let them go. It’s like managing a sports team: If you know you’ve got Michael Jordan, you keep him forever. If he has a slump for a few games, you’d feel pretty stupid if you traded him.
It’s really that simple for me. I spend all my energy finding the best stocks to buy, so I never have to sell them. In my own portfolios, I can tell you the rule holds true: a small number of carefully selected stocks consistently outperform the market. Within the portfolio, the 80/20 rule seems to apply: 20% of the stocks make up 80% of the gains. In other words: a few big winners dominate the gains. Just like 20% of a company’s sales force often account for 80% of total sales – also known as “The Pareto Principle.”
Here’s the other crazy part: If you never sell, you don’t have to fear a market correction. Yes, the paper value of your portfolio will likely wane when stocks come under pressure. But to quote my good friend Louis Navellier, “Great stocks bounce like fresh tennis balls, while bad stocks thud like rocks.”
When markets pressure stocks, they tend to pressure all stocks, even the highest quality ones. But when markets finally turn higher, the best stocks recover the fastest. Generally, they tend to rally to new highs.
Let’s go a step further: If we never sell, and no longer fear corrections, should we welcome them? Yes!
Remember Buffett again: “Be fearful when others are greedy, and greedy when others are fearful.”
Loose translation: Buy when everyone’s selling.
That’s all well and good, but the trick is to have cash on hand to buy stocks when they go on sale.
That brings us to little-known secret. Warren Buffett didn’t become ultra-rich by just being a great stock picker. He also always had cash at the ready. How can you buy stocks after a 50% market crash if you’re fully invested? Buffett recognized early on that blood in the water equals opportunity, so he bought an insurance company, his original source of riches. When you own an insurance company, people pay you monthly premiums. The insurance company has a responsibility to invest this accumulated cash, known as “the float.” Insurers build up this “float” and then greedily buy great stocks when no one wants them. It is a great way to build wealth long term. The trick to corrections is always having available cash to plow into the market.
We mere mortals can’t just buy insurance companies, but we can save cash to be ready for when stocks crash. That’s when to grab the best stocks at a discount. And for those who fear that “it’s different this time,” remember: Stocks have always recovered from past crashes. The S&P 500 index has rallied +65% since the March 2020 COVID lows. It rallied an astonishing +357% from the March 2009 lows of the Great Financial Crisis. The two latest black swan events recovered healthily and then some.
My theory is, to beat the market, you only need a handful of great stocks. You don’t need to trade often, and you need to be patient. Great buying opportunities rarely come around. You need to be ready when they do.
The recipe is simple, but like anything in life, it’s all in the execution.
Here are two closing words to remember: Patience and Process.