Beating the Market is Simpler Than You Think

Mohammed is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When I first started learning about investing one of the themes that I regularly came across was that individual investors as well as professional money managers tend to under perform the market and are therefore better off investing in a low cost index fund. The basis for this assertion is what is known as the efficient markets hypothesis which holds that since there as so many actors in the financial markets and since any public information about the past or future of the underlying security is known by almost everyone at once and hence likely to be priced in, stock picking and timing strategies are useless.

However, I tend to disagree with the theory. While I do agree that efficient markets consisting of many players and good information dissemination tend to price securities more accurately and reflect the current information available as well as make arbitrage and short term trading more challenging, I don’t believe that it prevents individuals from being able to beat the market consistently.

In fact beating the market can be quite simple.  One way to do so is:

Choose several promising and growing industries and invest in the clear leader and strongest company in said industry. 

To demonstrate this we’ll do a back test ranging back one decade, a decade that has been quite difficult for the US financial markets mind you.  

The Test

We’re going to imagine that we have traveled back in time to October 1, 2002 with $50,000 to invest. Our memory has been erased, so we can’t just load up on Apple shares and relax.

We are going to invest our $50,000 in 5 stocks in different industries equally weighted

I know, I know “In hindsight vision is 20/20.” 

To demonstrate how simple beating the market can be, we’re going to adopt these rules.

The Rules

1)  Strong Household Name, Everyone should know about the company whether they are a high school sophomore or a 70 year old grandmother.

2)  Clear Industry Leader: Everyone knows or at least can tell that this company is financially strong even if they don’t know how to read a balance sheet.

3)  Large Market Cap: We are not looking for companies that are going to be the next big thing. We are looking for companies that are the big thing.

4)  Simple Business Model: Everyone can understand what the company does and how the company makes money, nothing fancy.

5)  Stable Dominant Position: The company is not easily displaced and it can protect itself from competition.  

That means you’re not going to see anything like XTO Energy, Monster Worldwide, Chipotle, or Gilead Sciences in this portfolio.

Our Stock Picks are all going to be well known companies by non-stock market folk that are known to be great. In fact the portfolio that I’m going to show you could probably be made by a 10 year old kid.   

The Stock Picks

McDonald's (NYSE: MCD)

Industry: Quick Service Restaurants/ Fast Food

Initial Investment $10,000

The fast food industry is an attractive place to look for growth stocks. Peter Lynch mentioned this fact in his book “Beating the Street” in which he talked about how Taco Bell made a great investment during the 1980s, but when it comes to fast food McDonald’s is the clear industry leader.

In short McDonald’s has proven itself to be better than all the other big fast food chains, especially the ones specializing in burgers such as Burger King and Wendy’s in serving customers better as well as at making large sums of money. Newer restaurants such as Chipotle will take decades to expand their store network to be able to challenge McDonald’s.

The Golden Arches also happens to be one of the most recognizable icons in the world. That’s due to McDonald’s success in both domestic and international markets. McDonald’s was one of the earliest companies to conquer the eastern front when it opened its doors in Russia in 1990 after the fall of the Berlin wall.

Coca Cola: (NYSE: KO)

Industry: Beverages/ Fast Moving Consumer Goods

Initial Investment $10,000

How many products from the 19th century are still popular? I don’t know if Apple’s iProducts lineup are still going to be the leading consumer technology products 10 years now, but I am willing to bet that a lot of people will be drinking soda from a certain red can or bottle. I cannot think of any company or brand that has been used by more people around the world than Coca Cola.

It also happens that Coca Cola is Warren Buffett’s Berkshire Hathaway’s largest holding since 1988. Warren Buffett was quoted as saying if you gave me $1 billion and told me to compete with Coca-Cola, I will tell you that it can’t be done.

Nike (NYSE: NKE)

Industry: Athletic Wear

Initial Investment $10,000

Nike, named after the Greek Goddess of Victory, is the leader of the Sports Wear industry. If you use an iPhone or an iPod, you probably noticed the app.  Nike and Apple actually happen to be partners, but they also share something else in common. They both are able to manufacture items that don’t cost them much and then are able to use the power of their brand to convince consumers to purchase that item at a much greater price.  In 1995 researchers from the Washington Post estimated that a pair of Nike "Air Pegasus" sneakers that retailed at $70 cost Nike $20 to manufacture. Nike just like Apple also outsources all of its manufacturing to third parties mostly in South East Asia.

Remember Air Jordans from the 80s which helped spark Nike's success? Nike is able to purchase a huge amount of celebrity endorsements. People want to purchase the brand that is endorsed by their favorite sports star or athlete. Nike spent over $1.44 billion on celebrity endorsements in 2003, a smaller competitor cannot compete with that.

 Boeing (NYSE: BA)

Industry: Aerospace & Defense

Initial Investment $10,000

While Boeing has a defense division, I included it in the portfolio mainly for the commercial passenger jets that it manufactures and that everyone is familiar with. Most people in the United States and a significant percentage of people worldwide have probably been carried by a Boeing Jet at least once in their lifetime.

Boeing, as well as the airlines, was affected by the tragic events of September 11. However, it was pretty clear that people were not going to go back to crossing the Atlantic in steam boats due to a terrorist attack, Boeing was going to rebound somewhat sooner or later. Then CEO, Allan Mulley, instituted a participatory planning approach where he would hold strategy sessions once per week with 30 top level executives and add 60 new lower level managers every week. This planning process helped Boeing get through the slump and develop the 787 "Dreamliner" which became the fastest selling plane in the company's history to date. 

Boeing also happens to be in a heavy barrier to entry, capital intensive industry. Not any company can just set up shop and make Boeing's products irrelevant in a few years time such as with operating systems, smart phones, restaurants, etc.

Disney (NYSE: DIS)

Industry: Entertainment & Leisure

Initial Investment $10,000

Disney has been a pioneer in the entertainment industry from the early 20th century and throughout the decades since.  The company has been getting stronger and stronger and bigger and bigger. In the decade before 2002, Disney was able to increase its revenue by more than three fold.

Walt Disney Studios in the 1990s, one of the big 6 movie studios, created Blockbusters that grossed hundreds of millions of dollars. The "Lion King" which grossed $952,000,000 at the box office, still holds the record to this day as the highest grossing hand drawn animation movie of all time.  Disney Studios continued its success in the 2000s such as with its series "Pirates of the Caribbean" originating from an attraction within its parks. Disney acquired Pixar Studios in 2006 and Marvel in 2009 which gave it ownership of mega franchises such as" Toy Story" and "Iron Man."

Disney opened Disneyland in Anaheim, California in 1955 and now operates Parks and Resorts around the world such as in France, Japan, and Honk Kong, alongside Orlando and Anaheim. A Disney Park is probably the only Amusement Park in the world that someone is willing to travel thousands of miles with their family just to visit. Disney Parks were one of the least affected theme parks from the financial crises and most were able to increase their attendance at the time. In 2009, more than 119 million people worldwide visited Disney Theme Parks.

Disney also has a media division which today generates the biggest percentage of Disney’s revenue among its different divisions and a huge chunk of its profits. The Disney Channel pretty much usurped Cartoon Network and Nickelodeon in the 2000s. However, kids' entertainment and the Disney Channel only make a small portion of Disney’s media assets. Disney is the parent company of ABC which produced the hit series Lost. Disney also owns the sports network ESPN that broadcasts something that we can be sure people will always tune in to; live sporting events.

The Results

Stock

Purchase Price October 1, 2002

(Adjusted for Dividends)

 Price as of October 31, 2012

Beginning Amount

Ending Amount

ROI

CAGR

MCD

$17.50

$86.71

$10,000

$49,549

395%

17.3%

BA

$32.01

$71.11

$10,000

$22,215

122%

8.3%

NIKE

$21.59

$91.15

$10,000

$42,218 

322%

15.2%

KO

$21.92

$37.04

$10,000

$16,898

69%

5.4%

DIS

$20.72

$50.08

$10,000

$24,715

142%

9.2%

*Historical Prices are from Yahoo! Finance,  splits and dividends have been adjusted for

 

 

Beginning amount

Ending Amount

ROI

CAGR

Portfolio

$50,000

$155,600

212%

12.06%

S&P 500

$50,000

$102,000

104%

7.48%

*S&P 500 annual return was calculated by using Dr Robert's Shiller Data and accounted for reinvesting Dividends.

So there you go, we followed the rule of investing in industry leaders and maintained the above selection criteria and we managed to beat the market by 450 basis points on an annual basis and generate a total return on investment that is 108% greater.

Out of our 5 stock picks which are some of the most well known and closely followed corporations in the stock market, Nike and McDonald’s both strongly outperformed, Boeing and Disney slightly outperformed, and only Coca-Cola slightly underperformed the S&P 500 over the past 10 years.

Conclusion

So it turns out that in order to beat the market you don’t have to pull a Gordon Gecko and trade on insider information or have supercomputers that can execute trades in nano-seconds such as the ones in Goldman Sachs. Nor do you have to use a ton of indicators and over analyze everything which will usually lead to analysis paralysis.

Sometimes it helps if you just manage to keep things simple.


Pirlo0o has no positions in the stocks mentioned above. The Motley Fool owns shares of Walt Disney, McDonald's, and Nike. Motley Fool newsletter services recommend Walt Disney, The Coca-Cola Company, McDonald's, and Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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