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- Stock pickers who trade based on company fundamentals have fallen out of favor in recent years amid the rise of passive investing.
- The equity-strategy team at Bank of America Merrill Lynch argues that stock-picking is set for a roaring comeback, and offers seven tips for investors looking to take advantage.
- Visit Business Insider’s homepage for more stories.
You’ve heard it before. Traditional stock-picking is dead. Long live the machines who rely on complex algorithms to decide what to buy.
Bank of America Merrill Lynch is here to throw water on this simplistic assertion.
While the firm concedes that so-called passive managers — who largely ignore fundamental analysis — will continue to grow in size, it also sees ample opportunity ahead for active investors.
BAML’s take boils down to one main piece of data: Stocks are more differentiated now than they have been since the financial crisis. Those idiosyncrasies, in turn, create price dislocations that can be readily exploited by traders.
This is shown in the chart below, which also finds that sectors have actually been more differentiated than stocks throughout much of the 10-year bull market — until now.
Bank of America Merrill Lynch
But ripe conditions aren’t enough for a stock picker to crush the market. They still need to make correct investing decisions. That’s where the equity strategy team at BAML comes in.
Savita Subramanian, who runs US equity and quantitative strategy at the firm, has put together a handy seven-part list of steps investors can take to give themselves the best chance to outperform. They are as follows.
(1) Pick your battles
"Industry groups with high performance dispersion (spreads) and low intra-stock correlations may offer the most opportunity for stock-picking," BAML said in a recent client note.
The firm notes that the sectors that fit this bill are tech, healthcare, and both consumer staples and discretionary.
(2) Add some ESG
"Overlaying ESG scores to a quantitative framework can also help add alpha and lead to better risk-adjusted returns," BAML said.
BAML has been stressing for months that ESG is an increasingly important signal for investors. In a September 2018 report, Subramanian predicted that flows into ESG funds over the next few decades "could be roughly equivalent to the size of the S&P 500 today."
(3) Focus on stocks that act like stocks
This suggestion comes back to the central idea that certain stocks have been increasingly trading on factors outside their core fundamentals.
"By simply limiting the universe of stocks to companies with above average ‘idiosyncratic,’ or company-specific risk, we found that these attributes were rewarded by a much wider margin," BAML said.
This dynamic is shown in the chart below:
Bank of America Merrill Lynch
(4) Take the road less traveled
This particular recommendation easier said than done. Of course everyone wants to identify the contrarian idea that everyone else is missing. But BAML has some suggestions that could give you a leg up.
"Avoid sell side crowding," the firm said. "The more eyeballs on a stock, the less alpha you’re likely to harvest — our analysis suggests this is true."
BAML continued: "When we cut down our universe to stocks with fewer sell-side analysts covering the stocks — arguably a less efficient universe — fundamental signals dramatically improved."
(5) Lengthen your time horizon
This recommendation is offers something unique to stocks.
"As investment time horizons lengthen, the probability of losing money in stocks generally decreases," BAML said. "Other asset classes (for example, commodities) do not sport such characteristics."
BAML provides the following chart to support this idea:
Bank of America Merrill Lynch
(6) Know your biases
BAML says it’s important for investors to know which sectors they’ve historically been both overweight and underweight, so they can make informed decisions in the future.
The firm notes that, over the past 10 years, fund managers have been "chronically" overweight consumer discretionary, healthcare, and tech. On the other side of the ledger has been mega-cap stocks, which have been underweight.
(7) Tilt towards proven winners
"Long-only portfolios managing against the losing benchmark tend to have an unfair edge in that they can tilt their portfolio to stocks in the winning benchmark," BAML said. "History suggests that this is a common practice — style funds tend to outperform during periods in which their style benchmark is the laggard, and vice versa."
The firm continued: "And, large cap funds tend to outperform when small caps are outperforming large caps, and vice versa."
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Source: Business Insider – jciolli@businessinsider.com (Joe Ciolli)