How to Beat the Market

Up ArrowIf you’re an investor in the share market who’s managing your own money, I probably wouldn’t be too far off the mark to say that you’ve probably asked yourself this question at some point in time: How do I beat the market?

To answer this, we first have to look at the two ways you can choose to participate in the stock market: You could either buy an index fund that passively tracks a broad market index without any stock-selection input from a fund manager, or buy shares of individual companies.

Index funds

In Singapore, one of the most widely-followed market indexes would be the Straits Times Index (SGX: ^STI), which consists of 30 of some of the largest publicly-listed companies in Singapore. Over the past 25-plus years (coming to 26, actually) since the start of 1988, the index has gained 272% from 834 points to around 3,100 today.

That works out to an average annual return of around 5.2% and if dividends are tacked on, we can reasonably expect 7-to-8% annual returns from the index.

There are currently two exchange traded funds (ETFs) that track the Straits Times Index, namely the SPDR Straits Times Index ETF (SGX: ES3) and the Nikko AM Singapore STI ETF (SGX: G3B). The former has been around since April 2002 and since its inception, it has achieved an annualised return of 8.45% as of 30 Nov 2013 after factoring in dividends.

The long-run history of a stock market index – 7% to 8%, in the case of the Straits Times Index – gives investors a good gauge on reasonable expectations for future market returns. Both ETFs, by virtue of their mandates of tracking the Straits Times Index and their relatively low tracking errors, would likely be able to closely mirror the index’s gains going forward.

By definition, if you choose to invest in index funds, you’ll only be able to achieve market returns and have no way of being able to beat the market.

Individual shares

For individual shares, there are two broad scenarios in which they can generate returns for shareholders: 1) A company’s share price grows along with its growing business over the long-term; and 2) share prices rebound from irrational lows

In the first scenario, as a business grows its cash flows and profits, its real economic value (a.k.a. intrinsic value) increases in tandem over time. The trick here is to find companies that can grow their cash flow and profits at rates far higher than that of the market average and to ensure that the price you’ll be paying for those shares gives ample room for such growth to be reflected in growing share prices.

And, one such way of doing so would be to look at shares that have price-earnings ratios that are lower than your estimate of its future earnings growth.

For the second scenario, there might come a time when shares of a stagnant or even crumbling business falls way below its real – albeit shrinking – economic value. I’ve written about such a situation that was seen with American oil-tanker outfit Frontline. In such cases, investors can then profit when the company’s share price starts to rebound from irrational lows.

How to beat the market

We now come to the one of the most important questions you, as an investor, have to ask yourself: Can the individual shares I’ve picked be reasonably expected to do better than the market’s average returns over the long-run, based on whichever scenario I’ve used as my basis for selection?

Being able to answer ‘yes’ to the question is how you can beat the market. But at the same time, don’t forget that there’s great opportunity costs involved with picking the wrong shares, if they eventually end up losing to the market.

So, don’t just pick individual shares blindly. Always ask yourself that important question I mentioned earlier. That’s the way to beat the market.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.