The Case For Buying Individual Stocks

I was reading another very interesting note from the Monevator blog, concerning the diminishing participation of the household investor in buying individual stocks in the US stock market. Felix Salmon in his blog goes further and comments

"I think that what we're seeing is the slow death of the stock-market investor - the kind of person who subscribes to Barron's, idolizes Warren Buffett, and thinks of stock-market investing as a do-it-yourself enterprise. During the dot-com bubble, lots of people thought they were really smart when it came to stock-market investing, and then after the dot-com bubble burst, the rise of discount brokerages helped encourage new people to step in to the market and try their luck."

There are a lot of forces pushing against buying individual stocks these days. Exchange Traded Funds are becoming more and more the mainstream investment vehicle for investors and for justifiable reasons (low cost, somewhat easily tradable, outperformance vs. actively managed funds etc.), even though I do have some issues with the direction ETF's are evolving. It seems the whole concept of long-term investing, and even value investing is being challenged. In other words, why bother buying individual stocks?

What's ironic is that you'd think the stock market has been in a deep funk since the financial crisis in 2008 as a result of investors motivation to avoid stocks, but most major global stock market indexes, including the US and Canadian markets have more than doubled since then. I don't think it's because investors didn't want to own stocks, it was more just downright fear losing a huge chunk of their savings–again!

There's nothing different between individual stocks and an ETF/index fund in terms of the mechanics of execution, however when you peak under the hood, there's a lot of differences and in many ways, the traditional stock ownership still more than hold its own as an effective and lucrative investment vehicle. Below I make a case for buying individual stocks.

Individual Stocks Are More Tangible
When you buy stock in McDonalds or Coke or Apple you can see the product. You can touch and taste a Big Mac. You can see if there is demand for the product by going to a store or a vendor that sells their products. You can confirm quantitatively and qualitatively how effective the company is in using its capital. When you buy an ETF for the TSX 60 index you can also see individually each of those companies, but it's harder to determine if collectively they are more valuable.

Easier to analyze
Behind individual stocks are living, breathing companies and each publicly traded company must present audited financial statements. You can evaluate the performance of the company using various ratios to assess its liquidity, debt capacity, and operating performance. When you buy an ETF, you are buying in the case of the S&P500 index, 500 companies. Do you have time to analyze 500 companies? It's pretty difficult to do a fundamental analysis of business prospects for each company unless you've got an army of analysts. The only thing you can evaluate is the technical performance of the index and that gets into reading charts and analyzing trading volume, which gets into pretty abstract assumptions. When you buy specific stocks, you can select your own comfort level of risk/return and your own balance of growth/income.

Buying Quality
You invest because you want to make money so logically you will want to allocate your savings to high quality investments that will have a higher probability of creating tangible wealth. When you buy individual stocks, you have an opportunity to build a portfolio containing the best run, best managed, best performing companies. When you buy an ETF that for example tracks the TSX/S&P Composite Index, the reality is a good proportion of the stocks that make up the index are not very good companies, and some even unprofitable. Back in the day when I was doing more investment research work and publishing my annual rankings of the top wealth creating companies in Canada, on average Ω the companies did not generate tangible wealth. Don't you want to buy the best of the best? Another way I view this is from a real estate perspective. If you were investing in properties, wouldn't you want your portfolio to contain the best properties you could find at a favourable price? Why would you want to include bad, sub-par properties (tax treatments aside)?

The Risk/Reward Tradeoff
Of course there is a greater opportunity to earn higher returns through individual stocks versus an ETF. As discussed above, when you buy an ETF you will be buying some bad apples and that will impact your overall returns and if you are aware of this and OK with it, then it's all good. Buying an ETF is equivalent of roulette where you put a chip on every number, essentially guaranteeing a payoff, but it won't be as great as if you put your chips on a few numbers or bet on a colour.

Easier to Exploit Fear In The Stock Market
As Warren Buffett has opined many a time, the best time to get into the stock market is when there is blood on the street. It makes total sense when you think about it at a company level. Flash back to 2008 when the stock market was crashing and the indexes were going down triple digits on any given day. When stocks on the Dow Jones Industrials Index were falling, did that mean that the people who worked at Cisco Systems or Home Depot did something so fundamentally wrong to warrant the drop in their stock price? Did the nature of the business, their strategy, their marketing plans, and their HR policies change because the overall Dow Jones index fell so viscously? Chances are it didn't. As a result, stocks get mispriced and so opportunities arise for patient investors who have done their homework and can filter through the fear and noise of the day-to-day minutiae of the market to pick up some great companies on the cheap. With ETF's you can also exploit fear, but you have to go up the food chain of information and consider more macro events and sentiment indicators.

It's Cheaper
The days of $100 dollar trading fees are over. Because of technology it is a lot cheaper to buy and sell stocks. You can pay between $4-$10 per trade now. With individual stocks there are no additional Management Expense charges which come with ETF's and mutual funds. In other words you are keeping more money in your pocket through individual stocks.

You Get Out What You Put In
Buying individual stocks takes a lot of time and work. When I started investing, it took me at least an hour to analyze a company. Now that I've automated a great deal of the number crunching and data input, I can do the same analysis in a fraction of the original time. With ETF's it is possible to build a very efficient, and productive portfolio with a few core, vanilla, simple ETF's that you can rebalance a couple of times a year. The problem is ETF's are much more greater in size and complexity as the new generation of ETF's carry an active management component, so you need to spend more time pouring through an ETF's prospectus to understand the technical issues around the operation of the ETF. The key for being more productive in analyzing companies is having a good understanding and literacy of what drives wealth creation in our capitalistic society. Once you do, it becomes repetitive, and iterative.

The Feeling When There's a Payoff in Sight
The best and only emotional thing about investing in individual stocks is the feeling you get when you put in the work and the stock pays off. For me it's a rush, when I find a great company that has been performing well, generating tangible wealth, and buying the stock and selling it at a profit. It's such a feeling of accomplishment. I've never felt that way when I bought an ETF and sold it for a gain.

The Bad Points For Owning Individual Stocks
Buying stocks is one of the most risky investments out there because you could lose your entire investment. You will lose money investing in stocks. The key is controlling the loss and understanding your risk tolerance in terms of what return you are comfortable with and what maximum loss you are willing to bear without freaking out.

To a certain extent investing in stocks requires access to the right types of information and for the average investor, they may not necessarily have the time or the resources to dedicate to analyzing and evaluating companies. Traditionally the information has been under the control of the brokerages. Technology through smartphones/tablets, the Internet, instant messaging alerts have leveled the playing field immensely.

I'm not trying to pick on ETF's and call them inferior investments. The traditional vanilla ETF's that track the major indexes make wonderful investments for investors who cannot commit the time to analyze companies. They provide nice diversification, at a cheap cost and outperform more than 75-80% of professionally managed funds. There are numerous ETF Couch Potato strategies that can be long run value creators. Like anything there are tradeoffs in buying individual stocks versus a passive strategy and vice versa. As ETF' s become more mainstream and more complex, they will also require more analysis and due diligence, which at the end of the day still makes the traditional individual stock a more simplistic and elegant method to creating wealth and achieving our financial goals.