Bank of America: How to beat the stock market

According to Bank of America, a shift is currently taking place in the stock market that could make it easier for investors to beat the market. The bank found out.

• Bank of America sees passive investing gaining ground over active investing
• Active stock picking can offer opportunities
• Greenlight Capital founder David Einhorn comes to similar conclusions

Bank of America has identified a shift in the investment world, strategist Savita Subramanian explained in a client report obtained by MarketsInsider. The analyst speaks of a change from active investing to passive investing.

However, this change coupled with some structural catalysts could help active investors beat the market, says the strategist. For example, the “brain drain (20% fewer salespeople) and asset flow (40% fewer funds) from active, fundamental investments to passive investments and private equity” would suggest that “stock markets are less efficient and therefore more alpha -offer potential,” said the BofA expert. Specifically, Subramanian sees advantages here for investors who actively select stocks.

In her analysis, the strategist divided the market-wide US index S&P 500 into two groups: those stocks that moved primarily on company-specific news and those that moved more based on macroeconomic circumstances and would have lower company-specific risk.

Some industries are more worthwhile for stock picking

Depending on the industry, there are segments in which active stock selection is more worthwhile than in others: “Consumer goods, technology and healthcare companies are sectors in which stock selection can be more successful, while sectors such as financials, utilities or raw materials companies are of macroeconomic importance cycles in interest rates, inflation and economic growth trends,” summarizes Subramanian.

Additionally, Bank of America found that the stock market was more inefficient for companies that received less coverage from Wall Street analysts. Meanwhile, less efficient stocks would come with greater opportunities and risks. This suggests that active stock picking should place a particular focus on less popular stocks that are not covered by large numbers of analysts: “When we limited our universe to stocks with less sell-side analyst coverage – which is arguably a less efficient universe – “The performance of fundamental factors improved dramatically,” said Subramanian.

Long investment horizon is an advantage

What would also help investors to outperform the market is a long investment horizon, the strategist also reminds us. The BofA expert criticizes the fact that more and more investors are aiming to make big profits in the shortest possible time and are therefore becoming increasingly short-sighted. However, this attitude would be out of place in the stock market: “We remember that if you increase the holding period from one day to one, the probability of losing money in the S&P 500 drops from a coin toss to a 2-sigma event Decade extended,” the strategist points out.

David Einhorn sees the stock market “as fundamentally broken”

Meanwhile, Subramanian is not alone in her assessment that a market increasingly dominated by passive investments offers an opportunity for active stock picking. Greenlight Capital founder David Einhorn complained in the “Masters in Business” podcast that passive and algorithmic investments were making value investing increasingly difficult. Instead, it would almost be better to bet on overvalued stocks straight away. His conclusion was therefore sobering: “I see the market as fundamentally broken.”

The value of a company becomes less important

Due to the increasing popularity of passive investment products such as index funds, there would be fewer and fewer investors who would trade stocks based on their individual merits. This in turn makes it difficult for value investors like Einhorn to find undervalued stocks that would close their valuation gap in the long term. The problem is exacerbated by trading algorithms, which focus almost exclusively on short-term price movements and not on the company’s underlying fundamentals. The “value” of a company and a forecast about what price a share should have in the future no longer play a role here.

Disciplined stock selection

For this reason, Greenlight Capital has now started to realign its original value investing strategy. The team around Einhorn is now even more disciplined when selecting stocks. Greenlight Capital would no longer buy shares that were trading at ten or eleven times expected earnings. You would buy companies at four or five times earnings. However, due to the dwindling number of active investors, one can no longer count on the undervalued company being “discovered” by other investors and therefore increasing in value in the long term. After all, “a bargain that remains a bargain would not be a bargain,” as the Greenlight founder refers to a saying.

For this reason, the focus is on companies that carry out share buybacks and have a cash flow that is sufficient to buy back 10, 15, 20 percent of shares over time. Within four to five years, the company would either no longer have any shares that it could buy back, or the shares would have increased in value. In this way, you can pay for your investment in the company yourself. Because “when this money comes back to us, it will increase over time,” explains Einhorn in the podcast.

Fewer competitors

“Passive investors have no opinion on value. They assume someone else has already done the work. And then there’s what’s left of active investing. The value investing industry has been completely destroyed.” says Einhorn resignedly. But this would also create opportunities. There are now significantly fewer competitors on the market and companies for which one would have had to pay ten or eleven times their earnings in the past can now be acquired at four or five times the expected profits. And even if one generally has the impression that the market is very expensive, this would not apply to the stocks that Greenlight Capital is betting on.

Pursue your investment intention as clearly as possible

Einhorn also had a tip for investors, namely to be as straightforward as possible in their investment ideas: “If you want to be bullish on oil prices, don’t buy ten oil stocks. Buy oil.” In this way you would either be right in your assessment or not, but you would have gotten exactly what you wanted. While when investing in an oil company, it is also possible that the share will lose value because the company has committed something wrong. Here you wouldn’t always have the necessary insights in advance.

Editorial team