February 2012

Our overall investment approach is to diversify investments both across and within asset classes.  Within equity asset classes, we invest in the best stocks for the long term to obtain broad market returns commensurate for the risks taken.  This is known as a ‘passive’ strategy that we additionally structure to gain higher exposure to Small and Value companies. 

Another investment approach is to solely invest in the best stocks, buying them before anticipated rises in price and selling before anticipated falls in price.  This is known as an ‘active’ strategy.  The active strategy sounds like a sure winner in theory, but the reality is that no-one has found a foolproof method of consistently selecting these ‘best stocks’.

Stock brokers are one group of investors that generally believe in active investing, and therefore regularly produce recommendations of what they believe the ‘best stocks’ are and their price targets for those stocks.  The new year is a common time for these picks to be made and, on 27 December 2010, the NZ Herald indeed published stock brokers’ picks for the best performing New Zealand stocks for the coming 2011 (http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10696689). 

Below is a summary of their recommendations:


The first point to note about these picks is that between them, these seven brokers selected 25 different stocks.  If there were companies that were clearly stronger than others then you would expect only five to ten different stocks to be chosen.  By selecting 25 stocks, the brokers themselves illustrate how subjective the ‘art’ of stock picking is. 

A sceptic could argue that in situations like this, brokers purposefully select a wide range of companies as their income depends on brokerage.  Higher volumes of stock trading lead to higher broker revenues.
A further point to note is that, on the face of it, many of these individual stocks seemed like prudent selections at the time: Fletcher Building was expected to profit from the Christchurch rebuild; Contact Energy was expected to profit from increasing electricity costs; Auckland Airport is an effective monopoly and was expected to profit from increased tourism and the Rugby World Cup; Restaurant Brands’ products are a seemingly recession-proof earnings stream; Tower was expected to lift premiums post-earthquake, while searching for acquisition targets; and Westpac is one of the four Australasian banking pillars, a worldwide bank in its own right.  However, as we shall see, what is expected in financial markets does not always eventuate.

The Results

The table below summarises the return (including dividends but excluding any brokerage that would be charged for purchasing or selling the stock) for the 2011 calendar year:


As you can see, there is wide range of results, both by individual stock returns and by total broker returns.  McDouall Stuart led the way with Diligent’s 183% return contributing to its own 38% return.  At the bottom end of the ladder Forsyth Barr’s Pumpkin Patch pick returned -59%, helping its overall return slide to -13%.  The volatility between this range of returns is incredible.

Several more observations can be made:

• Diligent and the NZX were the standout performers yet they were each only selected by one of the seven brokers.
• All of the seven brokers selected a stock that returned double-digit percentage losses.  In total, 11 of the 25 stocks suffered losses of greater than 10%.
• The NZX 50 Index fell by 1.04% during the year.  In total, four brokers’ picks resulted in negative returns with three of these underperforming the Index.
• An equal weighting of all 25 stocks selected by the brokers would have returned 4.2% for the year.  Excluding Diligent this drops considerably to -3.2%.
• The returns would be lower if trading costs were included in these results.

The Message

It's a tough business isn't it?  And remember these are major New Zealand brokers with expert analysts, mountains of data and sophisticated forecasting tools.  So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future!  The results tend to suggest luck had a greater role to play than skill.
The second lesson is you don't really need forecasts to succeed as an investor.  An index approach combined with further diversification across asset classes provides a cushion in down times and ensures you are still positioned to reap returns when riskier assets come back into demand. 

The third lesson is that active investing is especially volatile and more costly than a passive approach.  Yes, individual results can be astronomical but they are just as likely to be catastrophic.

The final lesson is that when it comes to forecasts, the only one really worth counting on is that ‘things change’. What's more, they often change in ways we least expect.

Disclaimer

“The opinions expressed in this article are those of Stewart Group’s advisers and should not be considered as advice. Investors should obtain professional advice regarding their own financial circumstances and objectives before making any investment decision.  Under the Financial Services Act 2008 a copy of our Disclosure Statement is available on request and free of charge."