How Stock-Pickers Can Outperform Index Funds

At Morningstar, we've long extolled the virtues of index funds, and with good reason. Low costs and an ability to avoid underperforming the market are no small feats. However, we think that investors who are willing to invest a little time to assemble a portfolio of attractively valued, high-quality companies can outperform an index fund--with lower expenses. Our strategy? A "coffee can" portfolio, which neatly marries the benefits of indexing with the value stock-picking can create. Below, we'll stash some of Morningstar's equity research into a coffee can strategy and suggest a 10-stock portfolio that we think a stock-picker could buy today with a high probability of outperforming the market indexes over the next decade. But before we do that, let's review the competition.

The Virtues of Index Funds
And indeed, index funds present brutal, ever-present competition for stock-pickers. Recent  Morningstar research concluded that index funds based on the S&P 500 delivered higher returns than about 75% of all actively managed large-blend funds over the past decade. By buying the stocks in a representative index like the S&P 500 and simply holding them, an index fund can easily provide market-matching returns. What's more, the best index funds do this at very low cost, thanks to low turnover, the absence of research expenses and fewer capital gains taxes. As costs are a critical drag on investment returns, investors with below average costs are more likely to reap above-average returns. So investors who don't want to make frequent investment decisions can simply buy an index fund, and sleep soundly knowing their returns will match the market.

What could possibly be wrong with this rosy scenario? Quite a lot, actually. Index funds aren't the lowest-cost option, and blindly tracking the market can be hazardous to your wallet because markets get horrendously risky at times, and index funds can't help but reflect these risks. To elaborate, we need to take a detour through countryside that index fund proponents rarely visit.

Valuation: Fair Value Estimates 101
Valuation is the process investors use to trade current consumption for future consumption. A rational investor won't make this sacrifice unless the promised reward--the present value of future consumption the investment promises to return--is sufficiently attractive. To help investors with this decision, Morningstar invests considerable effort to produce fair value estimates for more than 1,500 stocks. We do this by discounting the future cash flows we expect each stock to create, converting the future cash flows to today's value. While we most commonly use our fair value estimates to help investors buy with a margin of safety, constructing a simple price/fair value estimate ratio illustrates how our fair value estimates also help investors balance consumption and returns. Let's compare  Coke (KO) and  Servicemaster :

Table 1: Fair Value Estimates 101
	Recent price	Fair value estimate	Price/ Fair value
Coke (KO)	$44	$54	0.81
Servicemaster	$13	$10	1.30
Data as of 06-08-05.

An investor who buys Coke today for $44 receives $54 of value--exactly the margin of safety we're looking for! But, more importantly, we can generalize this result with the price/fair value ratio. This shows us that today's Coke investor pays $0.81 for $1 worth of investment value. Conversely, a Servicemaster investor is effectively spending $1.30 to buy a $1 worth of stock. This is the path to the poorhouse--and extremely risky. Surely, no sensible investor would contemplate this, would they? (If you would like to exchange $1.30 for a crisp $1 bill, please call my office. I'll happily accommodate you as many times as you wish.)

Holes in the Index Fund Facade
What's true of individual stocks is also true of collections of stocks--like markets and the index funds that track them. If we examine our price/fair value ratio a little further, we can uncover one of the nasty secrets of index funds--at times they can be horrendously risky.

Just as we value individual stocks, we can value the entire market (or a representative index) by summing the fair values of the component stocks, then applying the same weightings. Since Morningstar began rating stocks in August 2001, we've tracked the market's aggregate price/fair value ratio, and a glance at the data helps illustrate the potential risk index funds present. Since 2001, we think the market's aggregate price/fair value has fluctuated between 0.78 in October 2002 and 1.14 at the end of 2004. So anyone who bought an index at the end of 2004 effectively paid $1.14 for $1 worth of stocks. Ouch! If we peer into the more distant past (albeit without our price/fair value reference point) we can surmise that investors who bought an S&P 500 index fund during 1999--when that index varied between 1,200 and 1,470--probably paid a lot more than $1.14 for their $1 worth of stocks. It's not surprising that 6 years later, these investors are still underwater. Such are the perils of investing without a margin of safety.

So tracking the market's return with an index fund can come with a heavy price. And as Morningstar's aggregate price/fair value ratio is currently above 1, the risks of an index fund investment look high. What's more, many pundits have argued that the market is substantially overvalued at present, which suggests that these risks may be substantially higher--and that investment returns may be lower for quite some time. Even if the market is fairly priced right now (we think the S&P 500's current price/fair value is about 0.99) that leaves little margin of safety for an index fund investor. Of course, the flip side is that there are periods in which index funds can make wonderful, lower-risk investments with attractive margins of safety, such as in October 2002 and, arguably, early 1995 or any time in 1982. The trick is to know when the indexes are attractively priced, and for that you need quality research.

Another problem with index funds is that even though they are actively managed (committees choose which stocks belong to an index) the stocks are not selected on the basis of investment merit. This is not a criticism of indexing per se, but rather serves to highlight that the stocks are chosen to reflect the composition of industries and the general economy. But since there can be a world of difference between the best business in an industry and the worst--as well as the most and least attractively valued--we think the active stock-picker can benefit simply by avoiding trouble. Both Enron and WorldCom were once in an index. A more subtle problem is that capitalization-weighted indexes will, by definition, force index funds to make relatively larger investments in overvalued stocks--and smaller investments in undervalued stocks. This is exactly the opposite of what we want. (Interestingly, a new type of index, termed a 'fundamental index' tries to negate this problem.)

Perhaps most intriguingly of all, index funds aren't the lowest-cost investment option. To explore why, it's time to meet a self-described "dinosaur."

Bob Kirby's 'Coffee-Can' Portfolio Strategy
The investment community owes much to the late Bob Kirby. In addition to his unique ability to deliver penetrating insights with gentle wit, Bob was the longtime chairman of Capital Guardian, the firm behind the American Funds family, an organization we've long admired. Kirby's Coffee Can portfolio is an excellent example of the insight he brought to our profession. (His original article appears in this book, as well as the fall 1984 edition of The Journal of Portfolio Management.)

Kirby's coffee can concept combines ultralow costs with the benefits of intelligent stock-picking. In earlier times, many investors simply put all their money (e.g. stock certificates) in an old coffee can--and never touched it. This eliminated transaction, administrative and many other costs. There was no fee for an index fund manager, no index license fee, and (for the most part) no capital gains tax to pay. An investor's success was primarily determined by the wisdom of the investments chosen for the coffee can.

Our Coffee Can Portfolio: 10 Stocks to Outperform the Market
Of course, execution is the tricky part. We figure that a coffee can stocked with quality businesses purchased with attractive margins of safety--that in aggregate, offers a lower price/fair value ratio than the index fund--will earn higher returns with less risk over the long term. We also recognize that it takes a certain temperament to retain conviction in your investments and tune out "noise" that can weaken such buy-and-hold strategies. No one ever said making money in the stock market was easy.

So with that in mind, we've used Morningstar's equity research to pick 10 stocks for own coffee can. We've limited our selection to stocks with the narrow or wide moats needed to protect returns over time, and we've avoided stocks with above-average risk. Most importantly, we've made sure that every stock offers an attractive margin of safety, so that the aggregate price/fair value ratio is less than the "competing" index fund. Note that there is no need to pick all the stocks for a coffee can at once--this just makes for a useful illustration. An investor is likely to do just as well by adding carefully selected stocks over time, particularly if you are waiting for quality businesses to reach attractive valuations. We think the real key is choosing wisely and having the fortitude to sit tight. Just like those old-timers guarding their coffee cans.

Here are the 10 stocks we've selected for our coffee can:

Table 2: The Coffee Can Portfolio
	Recent price )	Fair value estimate	Price/Fair value
Berkshire Hathaway (BRK.B)	$2,766.00	$4,000	0.69
Colgate Palmolive (CL)	$49.80	$60	0.83
Diageo (DEO)	$59.29	$71	0.84
Federated Investors (FII)	$29.17	$43	0.68
Fifth Third Bank (FITB)	$42.03	$57	0.74
InterActiveCorp (IACI)	$25.81	$40	0.65
Iron Mountain (IRM)	$28.18	$39	0.72
CarMax (KMX)	$25.87	$49	0.53
Novartis (NVS)	$49.34	$58	0.85
Strayer Education (STRA)	$84.71	$117	0.72
Coffee Can Portfolio			0.72
Vanguard 500 Index (VFINX)	$110.45	$112.05	0.99
Coffee Can as a % of VFINX			0.73
Data as of 06-08-05.

Will our coffee can portfolio beat the market over the next decade? Will we enjoy lower costs than our comparison index fund? We like our chances. After all, by investing in our portfolio we've bought $1 worth of value for $0.72, while a simultaneous index fund investor paid $0.99 for $1 worth of stocks. Of course, the proof is in the results, and these we'll track over time. We doubt we'll resolve the index/stock-picking debate, but we do expect interesting results--and investment returns.