No One Can Beat the Market

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no one can beat the market a maxim of wall street

Despite what many people will say, particularly folks in the index fund industry like Vanguard founder John Bogle, a do ­it ­yourself investor or money manager can beat the market, even over long periods of time. The problem is that beating the market is so difficult that most people shouldn’t try. It’s true that for long­term investment advice, you could do a lot worse than to park your money in a low­cost Vanguard index fund and not think about it more than once a quarter. But some mutual fund managers have proven that superior performance can be bought or mimicked.

Consider the legendary Peter Lynch, now retired but often seen on Fidelity commercials alongside Don Rickles. At the helm of Fidelity’s Magellan Fund between 1977 and 1990, Lynch earned annualized 29 percent returns against 15 percent returns for the S&P 500. Since he retired undefeated, one could argue that the market would have caught up with Lynch had he stuck around. But, the values he left on the fund, followed by successor managers like Morris Smith, Jeffrey Vinik, and now Robert Stansky, have continued to pay off.

Since Vanguard started its [S&P] 500 Index Fund (the first of its kind) in 1976, it has returned 11.9 percent annually. Magellan has returned 19.4 percent a year in that time period. One in three funds around since 1976 have managed to consistently beat Vanguard’s cheap and easy index. That still means the odds are against an investor who wants to try, but there are lessons to be learned from the masters who have succeeded.

The first lesson is that value investing works. Magellan, whose holdings have an average trailing price­to­earnings ratio of 20 on its portfolio, is the priciest fund in the bunch. The average stock in the Sequoia Fund, which has returned 17.8 percent average annual return since 1976, trades at 18.7 times earnings. The typical Davis New York Venture Fund holding trades at 16.5 times earnings, and its portfolio has earned 16.4 percent since 1976. The S&P 500, even in the depressed conditions of early 2003, traded at 28 times trailing 12­month earnings.

Like the index they strive to beat, small­cap stocks make up an insignificant portion of these portfolios. Just 3.2 percent of the $16 billion Davis portfolio has been invested in stocks with market capitalizations under $2 billion. Magellan has just 0.4 percent of its $60 billion in such stocks and Sequoia has less than 2 percent of its $3.6 billion fund invested in companies worth less than $2 billion.

A final point of similarity for these value managers: They all admire Warren Buffett, who famously remarked that the proper holding period for an investment is “forever.” The Davis New York Venture Fund, the most active of the trinity, and managed since 1995 by Christopher Davis, turned over 22 percent of its portfolio last year. William J. Ruane’s Sequoia Fund turned over just 7 percent, and it only owns 18 separate securities.

Now, here’s a problem: Old funds tend to close. (Magellan and Sequoia aren’t taking money.) But a good value investor can beat the S&P for decades, and there are other managers out there. If you want to do it yourself, follow the example of the best by building a portfolio that trades at less than 20 times earnings, shows no more than 2.7 times book value, and has a dividend yield of at least 1.3 percent. That should lead you to good stocks you can hold onto for a long time.