Money Matters, Simplified.
Is Stock-Picking Dead?
Sun, 03/21/2010 - 12:43 by Alex Dumortier
Last month, I attended an investment conference in New York that brought together some of the luminaries of the value investing world, including Marty Whitman, the founder of Third Avenue Management and one of the deans of the business and William Browne of Tweedy Browne -- the company that used to execute trades for Ben Graham and Warren Buffett. As I listened to the panels of elite stockpickers, I was left with an unsettling question: As companies and governments continue to juggle with the aftermath of the greatest financial crisis since the Great Depression, is stock-picking dead?
Top-down or bottom-up?
Specifically, I was thinking about the investment implications of the sovereign debt burden of advanced economies. Under ordinary circumstances, the risks associated with government debt are not something value that investors spend any time thinking about -- but these are anything but ordinary times, and investors need to think about them.
Apparently, my concern wasn't academic. John Botham, the European equity head at Aviva Investors told the Financial Times at the beginning of this month that bottom-up stock pickers have been caught flat-footed as top-down, macroeconomic factors continue to drive stock returns this year.
Stock picking still matters, and significantly so
However, as I began to give the matter more thought, including an examination of specific data, it became clear to me that stock picking still matters and, in fact, it matters quite a bit more now than it did during the worst of last year's market downturn. Here's why.
What happened since March 2009
Since the March 9 market low in 2009, the spread in individual stock valuations has widened substantially across nearly all sectors, with energy, materials, health care, and telecoms experiencing the largest expansion. The following table illustrates this phenomenon on a sample of five well-known stocks in the health-care sector:
Company | Forward P/E at 2009 Market Low* | Forward P/E Today* |
|---|---|---|
Johnson & Johnson (NYSE: JNJ) | 8.6 | 12.0 |
Bristol-Myers Squibb (NYSE: BMY) | 7.6 | 10.3 |
Eli Lilly (NYSE: LLY) | 6.2 | 7.4 |
Merck (NYSE: MRK) | 5.6 | 9.5 |
Pfizer (NYSE: PFE) | 5.4 | 7.6 |
Range | 5.4 - 8.6 | 7.4 - 12.0 |
Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's as of March 5.
*Based on Current Fiscal Year 1 earnings-per-share estimates.
Two reasons why stock picking ability matters now
These numbers exemplify why the ability to select individual stocks was much less important last March than it is now, for two reasons:
- Stocks were much cheaper then, as a group and on an individual basis. With a greater margin of safety, the likelihood of making a mistake when selecting a stock was much lower.
- The range of valuations was tighter. To illustrate the impact of this, let's take a look at an example from another sector, energy: At the market low in 2009, the P/E of Devon Energy (NYSE: DVN) and that of Pioneer Resources (NYSE: PXD) were identical at 3.6; last Friday, the former was 10.0, while the latter had risen to 18.3. If you had to choose between the two last March, you could concentrate on selecting the higher quality company. Today, things are much trickier -- you'd have to make a more complex judgment concerning what each stock is worth in order to determine the one that is more attractively priced.
Easy money out; hard work back in
At (or around) the market low, the key decision was to have exposure to stocks, period -- not which stocks to own. Now that stock valuations have widened out, the latter decision takes on a lot more importance, and stock-pickers are back in business. In a market in which the easy money has been made, investors must now recommit to the hard task of sorting through the market's offerings to find individual stocks that offer distinct value.
© 2010 UCLICK L.L.C.
