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Can everybody succeed at stock picking? No. Success requires experience, education and focus, as well as freedom from the constraints of illiquidity.

The opportunity in stock picking really hinges on the question of efficient markets.

Read: 5 reasons why stock picking is dead

If markets are efficient, then market moves are best described by a random walk with a log-normal distribution of returns, and there’d be no gain through stock selection.

Under a log-normal distribution curve, we would see a 5-standard deviation move in the market about once every 7,000 years. In one month alone—October 2008—there were five 5-standard deviation moves.

So, you have to question the efficient market hypothesis.

But what about the underperformance of active managers?

Stock picking isn’t easy. Many mutual funds underperform their respective benchmarks. Critical to differentiating performance is the ability to choose from a broad spectrum of market capitalizations, and construct a portfolio that’s different from the index.

The economics of our industry, however, encourage funds to focus more on gathering assets than outperforming.

As a result, many funds become so large they’re unable to construct a portfolio that’s different from their benchmark, or if they do they’re unable to move efficiently to take advantage of new information because of size.

Read: Taking stock of change

That said, the failure of some to achieve outperformance doesn’t mean it can’t be done.

High correlations

How do you win when correlations are so high?

Detractors of stock picking often cite the impact that macro forces have on increasing the stock correlations. In periods when they’re high, it’s difficult for active investors to outperform because everything is moving in lockstep. However, these correlations are often measured over short periods of time—60 or 120 days.

Longer periods are more relevant for stock investing—one, three, or five years. That’s when correlations break down, even within highly correlated sectors like energy. Over the past five years, the energy index is down 25%. But within the index, Imperial Oil is practically flat, while Encana has lost almost two-thirds of its value.

Correlations don’t hold over the long term. This is because while stock prices may move in together in short term, company performance levels don’t.

Read: Lower portfolio risk by screening for quality

So when prices move in lockstep, the mispricing of some securities becomes more exaggerated. When the correlations decline as fear abates, there are significant differences in the price movements of securities, and stock pickers have a huge opportunity to outperform.

In 2008, we bought stocks that traded at less than the cash value on their balance sheets, while generating growing levels of free cash flow. When correlations were high, these stocks traded down and we bought more.

Over the following year, some of these securities tripled in value while North American indices were up between 20% to 35%.

Effective stock picking is less about identifying the best or worst companies, and more about identifying when those securities are mispriced.

What about ETFs?

ETFs’ impact on markets is effectively the same as broad macro events. The increased use of ETFs in the short term increases correlations of security prices and the mispricing of individual securities.

Stock prices will eventually reflect the fundamentals of companies, which are driven by macro issues and micro factors. Stock picking doesn’t mean ignoring the macro picture—it means taking all information at your disposal, and using it to identify temporary mispricing.

Read: Offer cash alternatives to clients

While ETFs can play a valuable role in investing, the investor can’t mitigate risk by adjusting exposure to danger areas.

Many of us remember how Nortel impacted the TSX in the late 1990s on the way up, and then in the early part of the 2000s on the way down. In this case, an index investor tacitly accepted increasing exposure to an increasingly risky company.

Indices don’t care about risk, reward or even diversification. Effective stock picking allows the investor to avoid the particularly risky plays that comprise a part of the index and even profit from the torpedoes.

So now that everyone is piling into macro-related funds and ETFs, there’s nothing I’d rather be doing than finding the mispriced opportunities.

Andrea Horan, CFA, Principal
Prior to helping found Agilith Capital, Andrea Horan was a founding partner at Genuity Capital Markets where, as a member of the Partners Committee and Director of Research, she built and managed a department of 15 analysts. She has been engaged to speak at a number of industry events, contributed to investment publications on the subject of media investments and provided expert advice to the CRTC and the Canadian Federal Government.
Originally published on Advisor.ca

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