Answer This One Question Before Buying Any Stock

Investors are faced with a near-endless list of questions as they prepare to buy a stock:

• Am I getting a good price?
• Does it pay a dividend?
• Did the company beat on earnings last quarter?
• Is the analyst(s) “strong buy” recommendation legit?
• Does the company have strong prospects?
• What’s the short interest?

How many of us have asked these questions, plus many more, before hitting the send button on an order?

These questions are important. But before spending any time uncovering the answers, investors should answer this one first:

Over the next 5+ years, does this stock have a high probability of beating the S&P 500 index?

Let’s take a look at why this one question reigns supreme.

A Formidable Opponent

History shows that the S&P 500 index (aka market) is a formidable investing opponent, and often the stick by which most professional money managers and hedge funds are measured.

The market is such a strong opponent because investing is a long-term game. It can be equated to a marathon that never ends. The market and investors, both retail and professional, are participants each sporting a race bib.

Some investors are sprinters, getting off to a strong start only to gas-out at mile 5. Others are mid-endurance runners and can keep a decent, albeit slower, pace longer than the sprinters. They may make it to mile 13 before calling it quits.

There are even those who are true marathoners, such as Warren Buffett and Charlie Munger, who are able to maintain a consistent pace through mile 26.

But the market is a runner who never gets tired, never slows down, and never quits. The market puts one foot in front of the other…always.

Many investors have beat the market to mile 5, 13, and even 26, but it’s very difficult to keep pace with the market in a race that has no end.

A Dismal Scorecard

Each year, S&P Global publishes a report titled “S&P Indices Versus Active Funds (SPIVA).” You can find the mid-year 2022 SPIVA report here. The report summarizes the performance of equity funds (i.e. small, mid, and large-cap funds) against their S&P 500 peer.

For example, large-cap funds may be measured against the S&P 500, mid-cap funds may be measured against the S&P 400 Mid Cap, and so on. The report is an apples-to-apples comparison between actively-managed equity funds and their passive S&P 500 peer.

The data is enlightening. Very few actively-managed equity funds beat the S&P 500 over the long term. In fact, over a 15-year period, 90% of actively-managed equity funds underperformed the S&P 500.

This means only 10% of professional money managers are able to keep pace with the market in the marathon race that is investing. Put differently, there’s a 90% probability the S&P 500 outperforms professional money managers.

Keep in mind, passive index funds have a very low expense ratio (Fidelity’s FXAIX is only 0.02%), while actively-managed funds can push well above 1%. So investors are paying more to profit less.

If You Can’t Beat Them, Join Them

If professional money managers and hedge funds can’t beat the market, what’s the probability the retail investor can? Probably not great, which is why this single question is so important.

Over the next 5+ years, does this stock have a high probability of beating the S&P 500 index?

If you’re unable to answer with a resounding “yes,” you may want to consider buying the index. Because if you can’t beat them, you may as well join them.

Building Conviction

Being able to respond to this question requires work. It certainly shouldn’t be answered in a matter of minutes. More like a matter of weeks or months.

The foundation of “a resounding yes” is conviction. It takes strong conviction in the company and stock to answer “yes” to this important question. Especially considering the enviable record of the S&P 500.

On average, the S&P 500 returns around 10% per year, so building a case for why a stock will perform better than 10% is critical. You’ll need a few tools along the way.

Here are a few questions to consider:

• Is the stock standing on 4 solid legs?
• Has past performance been strong and predictable?
• Has the company provided long-term financial goals?
• Are financial statements strong (balance sheet, income statement, cashflow statement)?
• Is the company friendly toward shareholders?
• Can I forecast a reasonable path to annual returns greater than 10%?
• What would cause the investment to go terribly wrong?

This is just a sampling of questions investors may want to consider before taking up a position in a stock. Finding the answers to these questions will help build conviction. And if done correctly, strong conviction can lead to market-beating returns.

Bottom Line

Many investors are easily enticed to buy stocks based on momentum, recommendation, gut-feel, etc…, but fail to look at the bigger picture. Investing is a race. It’s important to understand your opponent and to place your bet on the horse with the greatest probability of winning.

If you’re able to build conviction in a stock and answer “yes” to our one question, then put your money on that horse. But if you’re otherwise unsure, hop up on the S&P 500 and ride past 90% of the competition.

About the Author:
Caleb is a certified Project Management Professional (PMP) and founder of The Hindsight Investor. He’s employed by a Fortune 150 company and one of the largest electric utilities in the world. Caleb manages a team of Project Controls professionals with responsibility to control scope, schedule, and cost for projects preparing the electric distribution grid for green-enablement. Caleb founded The Hindsight Investor after discovering a passion for investing and personal finance and aims to create content that provides value to like-minded readers.