(Dear blog reader, I apologize for my silence the past three weeks. I was on an international book promotion tour. I am back.)
The sensational blog heading is from a front-page article of the Wall Street Journal (October 18, 2016), followed by the following excerpts: “Investors are giving up on stock picking. Pension funds, endowments, 401(k) retirement plans and retail investors are flooding into passive investment funds, which run on autopilot by tracking an index. Stock pickers, the archetypes of 20th-century Wall Street, are being pushed to the margins. Over the three years ended August 31, investors added nearly $1.3 trillion to passive mutual funds and their brethern—passive exchange-traded funds—while draining more than a quarter trillion from active funds, according to Morningstar Inc. … The upheaval is shaking Wall Street…. Hedge funds, which bet on and against stocks and markets world-wide and generally have higher fees than mutual funds, haven’t outperformed the U.S. stock market as a group since 2008, … Index funds’ expenses are a fraction of what active funds charge—sometimes 1/30th or less. … Stock pricking in its current form ‘is no longer a growth industry.’ … The stock pickers can’t pick stocks well.”
So says the Wall Street Journal, and the massive funds flows from active to passive investments backs it up. So, is it the beginning of the end of financial analysis and stock picking? I don’t think so.
To demonstrate my point, lets drive the argument ad absurdum (to absurdity): Suppose all investors’ funds are moved to passive investments. No more active investment; no more research of individual companies, leading to earnings forecasts and stock valuation. How then will the values of GE, Intel, or Walmart, major components of the indexes used for passive investments, be determined? How, without fundamental research, will the capitalization of these and other public companies reflect changes over time in enterprise performance and competitive position? They won’t. Gradually, the values of companies in the various indexes will get detached from their real (fundamental) values. Failing companies with deteriorating earnings and cash flows will continue to attract investors’ funds, and successful enterprises whose performance is unknown to investors will be starved of investor’s funds. Dividends and capital gains will fall dramatically, and the returns on passive investments will evaporate. Not only will investors suffer, the whole economy will deteriorate because of the gross misallocation of investors’ funds. This is obviously an untenable situation.
What will reverse the seemingly unstoppable flow of funds to passive investments and the demise of stock pickers? The large discrepancies opening up between the unrealistic market values (capitalization and share prices) of companies, and their real, fundamental values, based on performance and growth prospects. Undervalued companies in the index will attract hedge funds and particularly private equity investors taking these companies private. Overvalued companies will be unable to justify the elevated share prices with their meager earnings, cash flows, falling subscribers, or the absence of new products. This underlying economic process, ignored by all the hoopla around the massive funds flow to passive investment, means that the more money flows to passive investments, the larger the need for fundamental research (stock pickers) required to support and substantiate the values of companies in the indexes. And yet, the Wall Street Journal is right stating that “Stock picking in its current form is no longer a growth industry.” (emphasis mine). As I made clear in previous blog postings, and in my book, The End of Accounting …, current financial analysis and stock picking methodologies, based on accounting numbers, are passé.
As more disappointed investors move to passive investments, the need for a new way of investment analysis and breed of stock pickers will grow. Stock picking isn’t dead; it just has to change dramatically. More on this in subsequent postings. Stay tuned please.