Can individual investors beat the market? Yes, individual investors can definitely beat the market if they consistently invest in undervalued assets that they understand better than some market analysts. It doesn’t mean everybody will do it, and it doesn’t mean that it is easy, but it is possible.
Here is what individual investors need to do to beat the market consistently.
How to beat the market?
The strategy I will lay out before you can beat the market over the long term. By long-term, I mean decades or longer. It works in the long term because, during the short term, markets are highly volatile and unpredictable.
Over the long period, however, market volatility doesn’t matter as much, and good quality businesses rise to the top while poor businesses become irrelevant. There are, of course, exceptions, but it’s wasteful to devote time to those.
So how do you consistently beat the market?
Find high-quality businesses & invest in them early on
What exactly is a high-quality business? Many books have been written to answer this question. Books like Good To Great, Built To Last, In Search of Excellence and many others.
So the topic can get complicated, but here are a few key ingredients I typically look for:
The profitability of a business actually mitigates risk for us as investors. Businesses that can reinvest their profits to grow are doing it more sustainably than businesses that constantly need to rely on outside financing to fuel their operations. That doesn’t mean startups don’t make great investments; they do, but there is a reason they don’t measure venture capital returns to S&P500; risk profiles are vastly different. You will always be taking on more risk when investing in an unprofitable business.
How do I quickly check if the business is profitable?
I like to see a positive, upward trending Normalized Diluted EPS (Earnings per Share) over the years.
To get that information, you can check company’s annual returns over the last 5-10 years by visiting the SEC web site over at SEC.gov | Company Search Page or use a service that aggregates that information for you in a nice and presentable way.
Here is an example of a company with a long history of growing earnings per share, Google.
Positive and growing operating & free cashflow
Similar to profits, I look for businesses that generate positive cash from its operations. You might have heard the expression, “Cash is king”. Cash flow helps companies grow, pay dividends and pay down debt. You can analyze operating and free cash flow per share.
Here is an example from Google again.
Free Cash Flow is operating cash flow minus any cash needed to maintain or buy equipment. Free cash flow is “free” of all internal and external obligations.
It is important to keep in mind that free cash flow must be truly free and not because the company decided to postpone certain expenditures. So it is a good sign to see free cash flow dip from time to time even if earnings grow consistently. That means the company is spending cash on improving internal operations. Cash hoarding for the sake of hoarding cash is not a positive sign.
Businesses with a strong moat
As Warren Buffett defined it, an economic moat is a company’s competitive advantage that protects it from the competition, just like a moat protects a castle.
To figure out what the company’s moat is, answer this question. “What is stopping other businesses from entering the market?”
The key… is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.
Most common moats today are Network Effects, Cost Advantages & Resource Moats.
A network effect means that the service is used by a lot of people and that becomes an advantage. Think of technology like a telephone or Facebook. The more people use them or are active on the platform, the more valuable this business becomes. Companies that have successfully achieved a certain level of the network effect are tough to compete with unless the new service entering the market is so much better than a large portion of people are willing to switch.
Cost advantage is a straightforward moat that a company can achieve by establishing a lower cost for customers. They can do that because of their size (Amazon, Walmart etc.) or because of innovative cost cutting. Size typically matters.
Having a resource moat is having access to a resource that other companies don’t have. Resource is a general term that can mean an actual resource like oil for example or intellectual property that the company protects with use of patents and so on.
There are also other moats like a strong brand name, talented workforce, access to specific scientific knowledge, and others.
Businesses with high insider ownership
Businesses that company officers and employees own tend to perform better over the long run than businesses that the public & outside investors own. It comes down to the alignment of goals and incentives. If top management and employees are also owners and not just hired guns, they simply care more. The company’s size typically plays a part as smaller companies are more likely to be owned by insiders, but that is not always the case. There are several large family-owned operations that to this day retain high family ownership like BMW, Tyson Foods, Koch Industries, and many others.
How do I find out if a company has high insider ownership?
Quickest way is to look the company up on Yahoo Finance. Then go to Holders and then Major Holders.
Here is an example of a company with high insider ownership:
Insider ownership is also disclosed on annual reports.
Companies with growth potential
I don’t mean only to buy high-growth companies. Obsession with high growth can lead to disastrous financial decisions by the management. I mean, invest in businesses that clearly outline their growth trajectory and understand their growth potential. Historical growth doesn’t mean the company will keep growing, but it is a good indicator that the company knows how to grow. Companies will always discuss growth in their 10k and various investor presentations. How the company finances growth is also important. I mentioned earlier that having plenty of free cash flow is great for growth because the company can use leftover cash flow. Companies can also borrow money to grow, but they have to do it sustainably.
Be cautious of companies that only see growth through acquisitions. There is nothing wrong with growing by acquiring competitors but companies that solely rely on acquisitions can be dangerous because not only do they need financing to grow but acquisitions usually pan out worse than management expects.
Once you find a good business that fits these criteria, the next step is to understand the price you pay for it.
Buy companies on sale
Warren Buffett said:
Long ago, Ben Graham taught me that – Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
Price we pay is crucial. It doesn’t matter if you find a great business with a strong and wide moat, high insider ownership that is profitable and growing fast if you overpay, it might never generate a good investment return.
There are probably a thousand books written on how to value a business. It may seem overwhelming, but it doesn’t have to be. CFAs, MBAs, and investment professionals will have everybody believe that what they do is out of reach. That they have special skills that allow them to see through financial statements with clarity. The reality is, they use the same tried and true valuation techniques that have worked for decades.
Look at key metrics
There are key metrics that are worth analyzing. These are typically ratios that we can look at from historical and relative perspectives. By historical I mean we look at a metric and see what the metric was like in previous years. Relative means we compare one company’s metric to its competitors to see if it is justified.
The ultimate goal is to find a great business that has low historical and relative key metrics.
The most popular, easiest to understand, and the most overused ratio is the Price-to-Earnings ratio. There are certainly limitations to PE ratio but it is still a valuable metric that we can quickly check.
Normal PE ratio
There is a concept of a normal PE ratio that a company typically trades at. Whenever the company falls below its normal PE ratio, it presents an opportunity, especially if earnings don’t change, but the price falls. Unjustified price falls that bring the P/E ratio down are great first indicators.
Here is an example of Google’s PE ratio over the last ten years. On average, Google sells for 30x earnings. In March of 2020, during the height of the COVID-19 pandemic, however, the PE ratio dropped to just over 20.
If you bought Google at that time when it was hitting low PE and held it until today, you would have made 135% in just over a year.
Of course, hindsight is always 20/20. It was impossible to predict how COVID could impact Google’s advertising revenue if advertisers significantly cut their ad spending. So it is easy to look back, but this also shows that when a great business sells for cheaper than it usually sells for, it is worth looking into it further. If you could figure out that the price drop is short-lived and that the economies will eventually recover, you could have bought Google at a bargain compared to what it used to sell for.
Similar to the PE ratio, EV/EBITDA is another common valuation metric. Unlike the PE ratio, it takes into account debt and excludes interest expenses, depreciation and taxes. It is better suited for companies that have more debt as a source of their financing.
The same logic as PE applies. Look at both historical EV/EBITDA for the company you analyze as well as industry and competitors.
Here is another example for Google vs. Other tech names.
Price to Free Cash flow
Another valuation metric I often use is Price to Free Cash flow. Similar to PE ratio or EV/EBITDA, it can quickly help me understand where today’s stock price falls relative to history and competitors.
Here is Google again with an average historical P/FCF of around 30 and a dip in 2020, again highlighting great opportunity.
If possible, look for a high dividend yield
I have a separate post on dividends stocks vs. S&P500 that you can read here: Do dividend stocks beat the market? S&P is a poor dividend income generator.
Currently, the dividend yield on SPY (S&P500 ETF) is 1.31% if you can find a company that pays well in excess of that and is selling at a discount, you can guarantee yourself stable future income along with capital appreciation.
Beating the market should not be the ultimate goal
Different investors will have different goals depending on their stage in life, risk tolerance or simply when they might need the money out of the markets. Just beating the market is a somewhat pointless exercise. What if dividend income is more important than capital growth for you? What if capital preservation is the goal? Your portfolio should always reflect your own goals.
That said, if you go out, look around at businesses you frequent, come home, see if it is a publicly-traded business. Do some research, and eventually, you will stumble upon a great business. It doesn’t matter if the business is small or giant; put it on your radar because there will likely be instances when the market will misprice it and when it does, you buy and hold it. Do the same with high dividend-paying stocks when they go out of favour, and over the long-term, you are almost guaranteed to beat the market, if that is your goal after all.