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Should You Mess With Individual Stock-Picking?

Brian Feroldi, financial expert and writer at The Motley Fool, shares insights from his new book "Why Does the Stock Market Go Up?"

On this episode of The Long View, Brian Feroldi discusses stock-picking, advice for individual investors, and his breakdown of the stock market.

Here are a few excerpts from Feroldi’s conversation with Morningstar’s Christine Benz and Jeff Ptak: 

Why Does the Stock Market Go Up?

Ptak: So, maybe to go back to your question, why does the stock market go up, what's sort of the most succinct explanation you could offer someone for why the market goes up? You have someone like your mom, right, who maybe is sort of fearful of the market, or just plain doesn't understand it, but they do want to understand why does the market go up. How would you answer that?

Feroldi: Well, I've been wrapping my head around that very topic. It's a quite complex thing to try and to explain to somebody. So, I broke it down by getting into the individual components, and I started by talking about a fictional coffee company in the book. I think if you start at the individual business level, and specifically the simplest business that I could think of, which is a coffee company, you can then scale it up into the stock market.

So, why does any business that has generated strong returns over long periods of time go up? We both know the answer to that question is the business behind that stock grows its revenue, expands its margins and increases its profits dramatically. Take a look back at any of the best-performing stocks of all time – Apple, Microsoft, Amazon, Netflix, et cetera – and ask yourself, well, why are these companies worth so much more today than they were 10 years ago, 20 years ago, 30 years ago? The answer is their businesses are many, many, many multiples bigger today than they were 10 and 20 years ago. I think that that concept is relatively straightforward to understand to somebody and you can make them understand why those stocks gradually went up over time as the businesses were succeeding.

So, I just take that very simple concept, explain briefly what the most simple valuation metric that I could get across, which was the price/earnings ratio, and then, I say, all right, so here's how a business grows in value over time. The stock market works in the exact same way. If you look at the long-term history of the S&P 500, it's very clear that the price goes up over time. What's often hidden from our view is that people don't see the earnings of the S&P 500 and how that has trended over time. So, that's what I tried to do in my book. I tried to just make the very basic connection between stock prices and business earnings and explain the bull case for why earnings have grown at the S&P 500 for more than 100 years and lay out the case why I think they will continue to grow for the next 100 years.

Individual Investors and Individual Stocks

Benz: I wanted to ask about stock investing for individual investors. At The Motley Fool you write about individual stocks quite a bit and individual stock investing is a key focus of your book too. Do you think buying and holding individual stocks is a reasonable path for small investors, especially I guess, when you consider all we know about the failings of professional money managers. The question is like, why would individual investors do any better with that activity?

Feroldi: So, if somebody comes up to me that I don't know well, and they say, what should I invest in? My answer in the stock market is always the same, index funds. If you just – if the average person just dollar cost average into index funds for 10 or 20 years, I'm extremely confident that they will do very well with their money over long periods of time. So, I think that that is the right choice for 98% of the population. However, there's that 1% to 2% of the population that for whatever reason, like myself, are just interested in business, are interested in in stocks. And I think it is worthwhile for the people that have the time and the inclination to do the research and to buy individual stocks, I think that that is a viable strategy for building long-term wealth.

Now, if you look at many of the studies that come out, especially on mutual fund managers, the data is very clear that most mutual funds underperformed the index over long periods of time. So, why the heck would an individual have any better look at that? Well, I firmly believe that individual investors have a structural advantage over mutual fund managers. Namely, individual investors are investing their own capital. They don't have to explain or justify their moves to anybody else. They have no career risk, right? They don't have to explain why they own ABC stock, or why ABC stock is underperforming to anybody else. And because they're investing their own capital, and they're not going to fire themselves, they can truly focus on a 3, 5, 10 and 20-year time horizon when they're making an investment. And if you look back at any of them, the best-performing stocks of all time, all of them without exception went through periods when their stock went down dramatically. I mean, Amazon in the wake of the 2000 crash peak to trough fell 92%. That is a whole lot of pain that Amazon put its investors through. And if you're a professional money manager, and you're having to hold through that, you can bet that your investors are going to be pointing at that and saying, why do you own this stinker, right? And it's really hard thing to justify to other people why you own a stock. However, when you're investing your own money, and you're picking your own individual stocks, you can truly ignore that short-term viability and invest with the long-term in mind. So, while I don't think the effort of picking your individual stocks is worthwhile for everybody, for a very small percent of the population, I think it's a perfectly viable strategy.

Should You Mess With Individual Stock-Picking?

Ptak: Besides patience and nerve, what do you think are the key characteristics or personality traits that someone should have if they're aiming to be successful in individual stock investing? And on the flip side, who do you think should just avoid delving into individual stocks? It's a large group. I think you said 98%, 99% of people should just be indexing. And so, what are the traits of the people that ought not to mess with individual stock-picking?

Feroldi: There's a lot of skills that you need to develop if you're going to go through the process of picking your own stocks. You need to study accounting, you need to study history, you need to be able to think through business models, you need to think through risks, you have to study your own psychology, you have to study your own behavior. And it's worthwhile to look at some of the greatest investors of all time and really learn what they did. That is a whole lot of effort that people have to go through if they want to buy individual stocks and try and outperform over the long term.

So, the number one characteristic that you need is interest in doing that, because that is a time-consuming process. And for most people, the idea of digging through a 10-K, or listening to a conference call would just bore them to tears. So, it's not something that you can do a little bit. If you want to pick your own stocks, you do need to put the time and energy into learning how to do it correctly. So, to me, that's the number one thing. You have to be interested in it enough to do it more than you'd want to do any other activity.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.