Why I’ve switched from index funds to individual stocks

When I started my investing career I invested exclusively in index funds. I knew enough to avoid actively managed funds and their high fees. I had also read about the efficient market hypothesis and I KNEW that it was impossible to beat the market. And because I started investing when I graduated from college I wanted to concentrate on my career and spending time with my friends rather than researching investments. Index funds were a great choice at that stage of my life.

As the years passed I continued to invest new money in my index funds. I set an asset allocation and rebalanced quarterly. I saw my investments rise from 1998 to 2001, drop precipitously during the tech crash, rise again through 2008, plummet again during the financial crisis, then recover over the next few years. I never sold, despite getting whipsawed by the market. I was (and still am) satisfied with the performance.

So why did I switch from funds to individual stocks? I have 5 reasons:

Fees

Even though my index funds carry incredibly low fees, those fees are paid annually.  Here are my funds and their expense ratios:

  • VEMAX – Vanguard Emerging Markets Index Fund Admiral Shares – .15%
  • VEUSX – Vanguard European Index Fund Admiral Shares – .12%
  • VIMAX – Vanguard Mid-Cap Index Fund Admiral Shares – .08%
  • VSMAX – Vanguard Small-Cap Index Fund Admiral Shares – .08%

These fees are charged regardless of performance. Every year, as the value of my investments went up, so did the yearly fees I was paying. This wasn’t a concern when my yearly fees were $10/year, but with a total portfolio of just over $2M I’d be paying $2,000/year in fees. And since I calculate I need $3M-$4M in investments to retire, I’d be looking at $3,000 – $4,000/year in fees alone. I’d be happy to pay those costs if I thought my index funds were providing a better investment vehicle, but in fact, I think they are providing a worse investment vehicle than individual stocks.

Of course, there are fees when purchasing individual stocks as well, but these are limited to commissions when the stock is bought or sold. For the last year I’ve paid no commissions on my stock purchases because I have a significant amount of money invested in Vanguard index funds. Before I had free trades I was only paying $7/trade. Given that my minimum trade size today is $2,000, a $7 fee is a .35% expense. That’s still higher than the fees for my index funds, right? Well, yes, that’s true…for the first year. Don’t forget – you only pay the commission when you buy or sell the stock. If you hold the stock for 10 years then the commission is amortized over those 10 years and you’ve effectively paid a .035% yearly expense ratio, which is significantly below any of the funds listed above.  And if you purchase in larger blocks, or have free trades then your expense ratio is even lower (or nonexistent).

You can also get free trades a variety of ways.  Robinhood, Loyal3, and recent online trading platforms provide free trading with only minor restrictions. Using these platforms reduces fees for individual stock investing to $0/year.




Predictability of income

The payouts from my index funds vary wildly from quarter to quarter and year to year. For example, let’s look at the payouts from the Mid-Cap Index Fund since the beginning of 2012 (I chose this fund because it’s my largest fund investment):

Mid-cap Index Fund Distribution per share
2012 2013 2014 2015 2016
Q1 $0.012 $0.024 $0.028 $0.033 $0.035
Q2 $1.426 $0.000 $0.000 $0.000 $0.580
Q3 $0.024 $0.000 $0.000 $1.397
Q4 $1.575 $1.575 $1.938 $0.750
Yearly Total $3.037 1.599 $1.966 $2.180

If we show the table above as a percentage change from the same quarter the previous year we get:

Mid-cap Index Fund Distribution per share % change from previous period
2012 2013 2014 2015 2016
Q1 100.00% 16.67% 17.86% 5.76%
Q2 -100.00% 0.00% 0.00% N/A
Q3 -100.00% 0.00% N/A
Q4 0.00% 23.05% -61.30%
Yearly Total -47.35% 22.95% 10.89%

What do we see? Well, the payouts were all over the map. This fund’s prospectus says it makes distributions quarterly, and we can see that in 2012 we received one payout per quarter, as expected. However, the size of the payout varied wildly, from $.012/share in Q1 to $1.575/share in Q4. If you held the fund in 2012 and analyzed the quarterly payouts you’d reasonably conclude that the manager was adopting schedule of small distributions in Q1 and Q3 of each year and larger distributions in Q2 and Q4. No problem – we can plan for that as long as we keep sufficient cash to cover the ups and downs, right?

Well, then 2013 came, and the 2013 Q1 distribution was double the 2012 Q1 distribution. Awesome! Our income is growing! Q2 rolls around and we expect it to be one of the big distributions for the year…and we got nothing. Zero distribution. For whatever reason, the manager of the fund decided no payout was in order. We are forced to use some of our cash on hand to cover the shortfall, but we expect to get a small distribution in Q3 to get back on track. Instead, we once again get..nothing. Then in 2013 Q4 we get the same distribution as 2012 Q4. Overall, 2013 is 47.3% LOWER than 2012. This is despite the actual shares of the stock up by 35.15% for the year 2013!

In the first quarter of 2014 the distribution is up 16.67%. Fantastic. Maybe every this is back on track, right? Nope. Q2 and Q3 are once again empty quarters. No distribution at all. In Q4 our distribution is quite a bit higher than the previous year – it’s up by 23.05%. Year over year we find that 2014 is 23% higher than 2012.

In 2015 we see that the Q3 dividend has been reinstated and the 2015 total distribution is 10.9% higher than in 2014, but still lower than 2012.

In 2016 we’ve FINALLY seen the Q2 distribution reinstated. We still have no idea if distributions will be paid for Q3 and Q4, and if distributions are paid we have no idea how big (or small) they will be. There’s just no consistency to the payouts, which means you can’t count on them in your budget.

Let’s compare those same quarters to one of the individual stocks I’ve owned the longest – Lockheed Martin (LMT):

Lockheed Martin dividends per share
2012 2013 2014 2015 2016
Q1 $1.00 $1.15 $1.33 $1.55 $1.65
Q2 $1.00 $1.15 $1.33 $1.55 $1.65
Q3 $1.00 $1.15 $1.33 $1.55
Q4 $1.00 $1.15 $1.33 $1.55
Total $4.00 $4.60 $5.32 $6.20

And as a quarter over quarter percentage change:

Lockheed Martin dividends change per quarter
2012 2013 2014 2015 2016
Q1 15.0% 15.6% 16.5% 6.5%
Q2 15.0% 15.6% 16.5% 6.5%
Q3 15.0% 15.6% 16.5%
Q4 15.0% 15.6% 16.5%

That looks a lot better, doesn’t it? Our income was consistent each quarter of each year. You can plan for this income. You can budget with this income. You can be pretty sure that if Lockheed decides to pay $1.80/share in 2017 Q1 that they’ll pay $1.80/share in Q2, Q3, and Q4. In addition, each year was higher than the year before. Yes, this was a particularly good set of years for Lockheed, but the actual numbers aren’t important. What’s important here is the trend – consistent dividends each quarter, with increases each year.

If you want to retire and have your money be guaranteed to last forever you need to never touch the principle. Consistency of income is vitally important.

Taxes/Control

In a mutual fund (whether an actively managed fund or a passive/index fund), the stocks held by the fund are bought and sold at the manager’s discretion. The manager’s focus is maximizing returns, not minimizing taxes. With individual stocks you can decide to sell a loser to generate a tax loss to offset the gains in a winner. You could even use tax optimization techniques like selling a stock to recognize the stock, waiting 30 days (to avoid the wash rule) and repurchasing it.

With mutual funds you sometimes you even have the strange situation where your fund is down for the year, but because the fund manager sold stocks that had appreciated and held the losers, you’ll be forced to pay capital gains taxes on the recognized gains.

Or, you can decide not to sell your stocks at all. If you never sell your stocks you’ll never generate capital gains. The turnover in my portfolio is in the low single digits. When I buy a stock I expect to hold it forever. I think of buying a stock as buying a piece of a business that I’ll never sell. I’m buying the stock for the income (today and in the future) and I plan to live off this income. The plan is to have no capital gains taxes. However, if I DO decide to sell a stock, I can time it appropriately. I can sell it in a year I plan to have less income, or I can group my tax deductions to have the maximum deductions (prepaying property taxes, for example) in a year I sell stocks with large gains. In short, owning stocks directly gives you more control over the timing and size of taxes.

Higher quality

I’m not a believer in market timing, but I DO believe that it’s smart to identify stocks that are significantly over valued and avoid them. For example, Netflix currently has a P/E (price/earnings) ratio of 283.43 as of July 29, 2016. That’s absurd. In the last 12 months Netflix’s sales have been $7.6B with profits of $140M. Profits in Q2 were up 50% from the previous year. That’s great growth. However, if we assume that eventually the P/E ratio of the company will come down to a still-high 28.3 at some point in the future, Netflix’s profits have to increase by 10x just to grow into this price at a P/E of 28.3.

Just to give you an idea, assuming that Netflix is able to maintain a 50% growth in profits per year (a VERY high growth rate for any company, much less a company with $7.6B in sales) they’ll need 5.7 years to increase their profits by 10x. Yes, it’s unlikely that a company with a 50% growth rate will be priced at a 28.3 P/E ratio, but it’s also unlikely Netflix will maintain a 50% growth rate for that long.

It’s far more likely that over the next 10 years the rate of sales growth will slow come down to something around 10-15%, which would cause the P/E ratio to compress down to the 28.3 I mentioned earlier. At less than a 50% growth rate it will take even longer than 5.7 years to increase profits by 10x to grow into today’s valuation.

Buying Netflix today is essentially betting that, assuming everything goes perfectly, your shares will be worth the same in 5.7 years that they are now. And if things go less than perfectly your shares will be worth substantially less than they are now. That’s insanity.

When you buy an index fund you get the good with the bad. I don’t claim to be able to pick the next market beating stock. However, I do think it’s relatively simple to identify the stocks that are an exceptionally bad investment, or exceptionally risky, or exceptionally overpriced, and avoid those stocks.

In addition, I think there are certain industries that are inherently better investments than others. Car manufacturers, shipping companies, and airlines are consistently terrible investments. Banks are just vehicles for profiting from leverage, and they tend to blow themselves up every generation or two. Technology companies are tough investments because they have to consistently come out with the next big thing to avoid being eclipsed by their competitors.

I prefer to invest in industries where there is little to no change or where there are massive demographic tailwinds. Consumer staples tend to make great investments. A Hershey’s chocolate bar today is almost identical to the Hershey’s chocolate bar from 50 years ago. Same with Cheerios, or Kleenex, or Coke, or Tylenol. These are cheap to manufacture, require very little ongoing R&D investment, and there’s a very low risk of another company coming along in 5 years and making Kleenex obsolete. The pace of change in technology is too fast and picking the winners is too difficult. After all, remember former technology leaders such as Blackberry, Nokia, Garmin, Yahoo, and Commodore?

People are living longer and the population is growing. Investing in companies that provide medical care or long-term care facilities would seem to provide a tailwind to companies in the healthcare field. This includes companies like Johnson & Johnson (pharmaceuticals and health care products) and Omega Healthcare (skilled nursing facilities), both of whom I hold in my portfolio.

When you purchase individual stocks you can avoid the Netflix of the world and concentrate on blue chip stocks with narrow ranges of possible outcomes. I’m not willing to select a stock that might go up by 100% if I’m right about my analysis or drop by 50% if I’m wrong. I’d rather find companies that are consistent, easy to analyze, are highly likely to have higher earnings in the future than they have today, and then buy those stocks at reasonable valuations.

Higher Income

The dividend yield on the S&P 500 index was 2.05% on July 29, 2016. The yield on my portfolio was exactly 3% on the same date. Given that I strongly believe you should only live on the income from your investments and never touch the principle, my portfolio is significantly easier for me to live off of than a S&P index fund. In addition to generating a higher income, I strongly believe that my portfolio is of higher quality than the S&P. I don’t have any ridiculously overpriced stocks like Netflix. All of my companies are profitable and, with only a few exceptions (REIT and tobacco companies), have credit ratings of A- or better.

I select dividend paying companies because I believe that paying consistent and growing dividends is proof that a company has a strong business model.

A friend of mine once dismissed dividends by saying that companies pay dividends because they can’t think of anything better to do with the money. I disagree. A business pays dividends because the business is making so much money that the business can afford to make investments to grow the business and STILL have money left over to return to the shareholders of the company. A long-term history of paying dividends is proof that the company has a successful business model.

By not buying any of the 77 companies in the S&P 500 that don’t pay dividends it’s pretty simple to put together a high quality portfolio that pays a 3% dividend and has plenty of potential growth for future years.

 

Conclusion

So there you go – my 5 reason why I’ve switched to individual stocks from mutual funds.

What do you think? Do these reasons seem valid to you? Are there other reasons to stick to mutual funds instead of selecting stocks?

5 thoughts on “Why I’ve switched from index funds to individual stocks

  1. 100% spot on! This is why I also transitioned from pure index investing to dividend growth investing. Yes, dividends can get cut but at least they are tied to the real business fortunes as opposed to safe withdrawal rate studies that are purely based on historical data, and thus probabilistic in nature. Dividends are an excellent feedback mechanism for your portfolio and a real measure to live on. Living on dividends has clear advantages over living on SWR (say 4%) in my view.

    1. I absolutely agree with your comment on safe withdrawal rates, and I have an upcoming post on that very topic. In short, any mechanism of withdrawal that requires you to touch your principle is risky. Any mechanism that doesn’t provide growth at least equal to inflation is risky.

      The only truly safe withdrawal scheme is to live off an income stream that grows at least as fast as inflation.

  2. Why not use low cost tax efficient ETFs, i.e. BlackRock’s iShares. Although they carry a very low mgmt fee, as little as 4bps, They otherwise have all the benefits that you mentioned from individual stocks… tax efficient, control, etc. plus you get instant diversification.

    1. You make a good point – ETFs have significant advantages over mutual funds. However, they do still charge a mgmt fee (although it can be vanishingly small, as you point out). More importantly to me, I don’t want to buy an index of funds when I believe that a large portion of the stocks that make up the index are significantly overvalued.

      Another advantage of ETFs over mutual funds that you didn’t mention – ETFs actually pay out all the dividends collected by the stocks that make up the ETF, and they usually pay out on a quarterly basis. It’s about as close as you can get to actually owning the underlying stocks.

  3. Why not use low cost tax efficient ETFs, i.e. BlackRock’s iShares. Although they carry a very low mgmt fee, as little as 4bps, They otherwise have all the benefits that you mentioned from individual stocks… tax efficient, control, etc. plus you get instant diversification.

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