The Case for Active Investing – The Million Dollar Difference


Thirty years ago one rarely heard about “index funds.”  They were around, but very few people invested in them. They have become increasingly popular over the years, and for good reasons.

Index funds merely copy the indexes we active managers are trying to beat.  Collectively, active managers are the market, so together we should roughly equal the market.  But when fees and trading costs are subtracted from returns, the average active manager will trail the market.  It shouldn’t come as a surprise to learn that studies of performance show 60%-80% of actively-managed mutual funds fail to beat their benchmark in any given year.  This weak track record has given rise to indexing as an alternative.

It’s been said, “genius is a bull market.”  Investing is never easy, but the wind is at one’s back when the average stock is moving up.  The trend toward indexing seems to have gained most of its steam in the years following the tumultuous 2007-2009 bear market.

Fans of indexing might want to recall that the S&P 500 index took 10-3/4 years to get back to record territory on a sustained basis after the peak on March 24, 2000.  And that long period of zero return includes dividends!  But that’s what it means when you try to equal the market – you’re also going along with the occasionally sharp drops.  Other studies have shown that investors who try to dodge the bad years actually harm their portfolios much more than they help.  This is known as “market timing.”

I don’t know about you, but I’d find it hard to go over a decade without making money on my investments.  Thankfully, Provident clients didn’t have it so bad.  Our typical client was up 49% (unannualized and after all fees and expenses) during a period when the S&P was up 2%.  A $1 million portfolio with us would have been worth $470,000 more than an index fund.  Indexing doesn’t look so great in this context.

What does indexing look like today?  I took a thorough look at the top 100 companies in the S&P 500.  Collectively, they comprise 64% of the value of the S&P.  Here are some “fun facts” about the median company in the S&P 100:

  • Sales grew by 5% annually for the past ten years. However, 15% of the top ten are smaller today than they were a decade ago.
  • Sales grew 2.7% in 2016. 42% of the top 100 saw their sales decline.
  • Median earnings per share growth was 6.3% last year, while 31% of the top 100 companies saw lower profits.
  • The median P/E is 21.7.

Contrast that with the median company in a Provident portfolio.  Sales grew 15% annually for the past decade.  In 2016, sales grew 8.8%.  Sales declines occurred at only one-third the rate of the S&P.  Profits of the median Provident holding increased 9.0%, with fewer seeing decreases.  The median P/E is 22.4, slightly more expensive than the median stock in the S&P.

With sales growth 3x the S&P 100 and profit growth 40% greater, our client portfolios are in good shape to outperform the market.  That doesn’t always happen in the short-run, however.  Companies in the S&P 100 that saw their sales decline last year were actually more likely to provide above-average stock performance than below-average performance.  The lesson isn’t to chase losers, but that in the short-run just about anything can happen.

And it should come as a relief to know that much of our historical outperformance has come during those periodic down markets when index investing leaves one exposed to the full brunt of a bear market.

Does indexing ever make sense?  Sure.  Part of the way we beat the market is by focusing on a diverse range of companies that have certain desirable characteristics including growth of sales and profits, plus a reasonable valuation.  Most mutual funds buy a larger range of companies, which waters down the returns of the most promising holdings.  Investors compound the problem by diversifying among many mutual funds.  This overdiversification makes it virtually impossible for the mutual funds to overcome the drag of their own fees.

It comes down to what I call the “beat ‘em or join ‘em” approaches.  Beating it means intense focus like we do.  It is almost impossible to beat the index if someone has exposure to all the companies in the index.  In this case, index investing would be a better choice than holding 5 or 10 mutual funds.

The best outcome is to have someone in their corner that can beat the market over the long-term.  A $1 million investment with Provident on 12/31/99 would be worth $3.23 million today while the same investment in the S&P would have been “just” $2.25 million.  That’s a million dollar difference, and that’s the case for active investing.

 

Scott D. Horsburgh, CFA