Beat Index Funds Every Year

Extraordinary claims require extraordinary proof. With a title such as the one on this post I think we have risen to the level of extraordinary.

Before I share the secret I need to clarify a few issues. First, beating any given index as your measure does not mean you will never have a down year. Second, it is theoretically possible to underperform the index so it stands to reason you will periodically. We use an annual average here when determining if we beat the index. Third, we will not use any fancy (the word for risky) derivatives. This article is not about trading in options or futures. We will only discuss which stocks to buy and hold. No more.

Also, you need to know where I get my information from. Am I so smart I thought this up all by myself? Of course not. The two main sources of this secret comes from none other than Peter Lynch, perhaps the best mutual fund manager of all time, and Warren Buffett, perhaps the best investor of all time.

Other Attempts at Beating the Index

Investment managers have worked hard to beat their benchmark index from the beginning of time. Then came the auto-processes.

Beating the Dow (Dow Jones Industrial Average: DJIA) was made easier with investment vehicles that invested in the 10 highest yielding stocks of the 30 stock average. The so-called Dogs of the Dow theory did seem to beat the DJIA in an above average number of years and by a nice amount.

The advantage the Dogs of the Dow enjoyed for a short period of time was reduced by the fees charged by the Dogs of the Dow investments. That, and the inconsistency of the Dogs to outperform in the last decade for several years, has made the Dogs a less common strategy these days. However, with low trading costs an investor would do well buying the Dogs of the Dow and adjusting as the names on the list change. Keep the Dogs in mind as we flesh out beating the indexes.

There are a million or so other “secrets” to get rich quick on Wall Street that perform much worse than the Dogs. Investment newsletters all seem to claim they have an edge over the crowd. People seem to fall for the schemes with lots of moving parts and elevated risks. I see these folks during tax season every year. They have capital loss carryforwards in the stratosphere. Not many success stories I can verify in this crowd.

With all these theories on how to beat the market failing, it is no wonder people threw up their hands and embraced index funds. It’s not a bad strategy, by the way. Matching the broad-based indexes has provided plenty of wealth for investors for a very long time. I still recommend index investing and my retirement funds are exclusively in index funds.

All this said, there is still something nagging in the back of the brain. There must be a way to beat “average” for long periods of time. If it were not so, explain Warren Buffett or Peter Lynch or the small number of people who smack it out of the park in what seems like an effortless homerun?

Peter Lynch

Peter Lynch made a name for himself in the investment arena when he managed the Magellan Fund at Fidelity from 1977 to 1990 where he achieved an eye-watering average annually gain of 29.2%. That more than doubled the S&P 500 index over the same time period.

Lynch devised a formula for categorizing stocks as fairly-valued, over-valued or under-valued. You can use his calculator here. The process was simple with the calculator. All you need to do is dig through all the stocks in an index to discover which ones are under-valued.

Easy. Right?

Maybe not. Lynch made clear why so many people lose investing in stocks. He said the:
“Key to making money in stocks is not to get scared out of them.“

Finding under-valued stocks is not enough. You have to stay the course.

Peter Lynch also loved investing in Savings & Loans going public (a big thing back in those days). Since the money raised selling shares stayed with the newly public bank, it was like making an investment and finding your money in a desk drawer in a side office. It was a good deal (one this author jumped into whenever the opportunity presented) while it lasted. Those easy money days are gone.

Yet, there is something about Lynch’s investment philosophy we can’t quite put our finger on. Something is missing or everyone in the crowd would use Lynch’s formula and pull ~30% annually on average.

Warren Buffett

Warren Buffett has an even longer track record of outperformance. His claim to fame is the “margin of safety”. He has no magical formula you can plug numbers into the way you can with Lynch.

Listening to Buffett on YouTube videos for a long period of time gets one to thinking. He has lots of rules and ways to value a business.

Like Lynch, he is a value investor. (Hint, hint.) He wants to buy businesses at a discount, but, again like Lynch not getting scared out of an investment, sticks around for a long time even if the current market price of the business he owns is over-valued.

Yes, Buffett sells some of his portfolio from time to time, especially if the story changes. If the story is still the same he will not sell just because the stock is trading higher. He bought Coca-Cola (KO) in the early 1980s and has never sold. The story never changed so there was no reason to sell. He bought right so the current stock price is meaningless. What matters is his share of the profits. Oh, Buffett loves his dividends.

Warren Buffett does have two simple rules you must always follow. They are:

Rule 1: Never lose money.

Rule 2: Refer to Rule #1.

Once again, if it was so easy, everyone would be doing it! Still, there is something there under the hood. Something that is unsaid, but screaming for attention.

Thinking Outside the Box

Most people have no idea how to solve a problem. The crowd attacks problems the same way. It usually involves bull work and is counterproductive.

Warren Buffett’s right hand man, Charlie Munger, explains how you attack problems. It is also the final piece of the puzzle to beating the index.

Munger loves to turn problems around and look at them from the side, or even better, for the opposite side. By looking at the situation from the other side, or at least a different angle, you can often see the answer is obvious. Sometimes it is the only way to solve the problem.

So let’s apply this is simple terms to investing so we can beat the index.

How do most people look for a good stock (business) to invest in? How do you find a good business to invest in?

Do you buy FAANG stocks because they are popular? Do you buy stock in a company because you use and like their product? (Peter Lynch loved checking in on prospective businesses and trying their wares. If he liked the product or service he knew he would love the stock . . with some caveats, of course.)

Let me guess, you buy a stock after reaching exhaustion (or everything looks somewhat good) and buy in that mentally weakened state. There is a lot of work in searching for the perfect investment that is sure to wear you out and probably means you eventually settled for whatever looks good or was mentioned by a friend or in the news. You don’t need the perfect stock that performs all others; you need a business that will perform well over long periods of time!

Change the goal and you change the rules. If, instead of looking for the best stock ever, you merely had a goal of beating the index. That changes the rules a lot, doesn’t it? And keep in mind beating broad-based indexes even by a single percent has massive long-term results!

Because you are not looking top down, you are looking bottom up, you can find excellent businesses to buy and own for a long time. Beating the average is not about finding the best of the best winners every year! It is about avoiding the clunkers. (Remember Buffett’s two rules!!! The secret is buried in there when you understand what he was saying.)

Winners are harder to find. But losers? Some are hard to spot and others stand out like a sore thumb. These deadbeats will break the Buffett rules and put you in the position of catchup. Hard to beat the indexes coming from behind.

Avoiding the underperformers is the secret to beating the index. Yes, over a single year the investment style can fail, but over modest timeframes and longer it outperforms and by a lot. Even more than the Dogs of the Dow.

Example: Recently retail companies have had a hard time matching the market. Amazon, and every online seller this side of the Mississippi is in on the game. Makes it tough for traditional retailers to match the index over any reasonable timeframe. Unless the story changes, most retail is out.

Example: We can apply this to social media businesses. You might not want to buy Facebook (FB), but are you best advised to skip Pinterest and/or Twitter? I think the second tier and lower social media sites are a nonstarter.

Warren Buffett admits he misses many incredible investments. He also misses nearly all bloodlettings! And that is the important part of investing. Never lose money. And for the love of God, do not lose your seed money. Starting over is never any fun.

The trick to beating the index is to eliminate the clunkers. Yes, one might slip through now and again, but keeping 99% of the riffraff out improves your investment performance by magnitudes of order.

When you start looking to eliminate instead of include, finding businesses worth owning becomes easier. Buy good companies? Sure. But where do you find them in the mountain of securities? If you keep eliminating, you eventually come down to a small list that has real power to outperform beat the indexes.

And it is easier than ever to invest in your list. Trading fees are near zero now so buying a single share of each business on your shortened list does not cost massive fees (on a percentage level).

Your list, by the way, will not contain half the businesses listed in the S&P 500 index. When you start eliminating you discover quickly that most are easily removed. The bulk of the S&P 500 index move each year is dominated by a relatively few listings. By eliminating obvious underperformers you stand an excellent chance of beating the indexes and getting rich a lot faster than the way popular media pretends it is done.

Have fun scratching names from your list.

Recommended Reading

Beating the Street by Peter Lynch: If you want to understand how Lynch thinks when making an investment this is required reading.

The Snowball: Warren Buffett and the Business of Life by: Alice Schroeder: Learn the thought process that Warren Buffett used to build his financial empire.