Now that investors are reconsidering active stock picking and are especially interested in value stock strategies, let’s analyze where excess stock market returns come from. Excess return, or alpha, comes in four basic ways. Alpha can come from stock selection, selection timing, concentration and long holding periods.
Even though there are many styles of investing, alpha can come from stock selection within your style. Alpha is a deviation from whatever benchmark you are choosing. Therefore, to generate “abnormal returns” you must deviate from the benchmark. Consistent long-term outperformance must come from well-selected deviance. Owning stocks which deviate can mean you take your lumps from not owning the securities that have already gained favor in the marketplace or, like in the last three years, not owning enough of the popular stocks when they dominate everything else.
Regardless of your investing style, alpha can be generated by “buying at points of maximum pessimism,” in the words of the great investor John Templeton. This is true regardless of your stock picking style. Templeton said, “If you wait for the light at the end of the tunnel, you’re too late!” You take your lumps by being early in stock selection.
Commonly held academic studies have shown that the benefit of diversification reaches 93% at the 20th common stock. The lumps you take in concentration come in the form of volatility. Accepting the lumps in volatility is exactly what most people who search for good stock picking try to avoid. Professional/institutional investors try to find deviant stock pickers and attempt to avoid volatility. The great investor Bill Miller says, “volatility is the price you pay for performance!”