‘This is the single worst time to be a passive investor’: veteran investor

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Warren Buffett's Berkshire Hathaway should scale back its passive investment in the S&P 500 (^GSPC) and plow it right back into Berkshire stock (BRK-A, BRK-B). That's because the environment for stock picking is ripe for a shift away from passive investing, which could suffer a decade of low or nonexistent returns.

"This is the single worst time to be a passive investor in since they started passive investments... The [S&P 500] index is highly likely to not make money over the next 10 years," said Bill Smead, chief investment officer of Smead Capital Management, during the most recent Yahoo Finance Plus webinar on Wednesday. "Whether you look at historical price earnings ratios, whether you look at the normalization of interest rates, whether you look at ridiculously high levels of participation by individual investors — compared to household network going back for decades, it all points to the same thing. The markets are not designed to make the majority succeed."

'You have to be a deviant to outperform'

In investing parlance, alpha is the return above and beyond a benchmark, such as the S&P 500 — in other words, a trader's edge. By definition, an investor in an ETF that tracks the index, such as the SPDR S&P 500 ETF (SPY), will see no alpha. But an active trader needs to find alpha by thinking differently.

"Alpha comes from deviation. You have to be a deviant to outperform — not a non-deviant," said Smead.

Not all stock pickers are alike. Cathie Wood's ARK Innovation ETF quickly became the world's largest actively managed ETF, with $28 billion in assets under management at its February peak. Over the last year, the fund loaded up on high growth names like Tesla (TSLA), Square (SQ) and the Grayscale Bitcoin Trust (GBTC).

Smead prefers a more value-focused approach that also incorporates growth strategies. He uses a few recent examples to warn how quickly momentum trades can reverse. "[W]hen money comes out of popular growth stocks, it's like a fire hose. And the companies that it's going into are a teacup. You're pouring water from a fire hose into a teacup. And that's also part of what happened with Reddit and Archegos," he said.

Many of the names that Archegos Capital Management owned prior to its spectacular blowup were value names that benefitted from huge surges before epic collapses. Smead managed to profit from the two his fund owned, Discovery (DISCA) and Macerich (MAC), but he would have preferred they hadn't gone so far so fast. (The Smead Value Fund is up 21% as of March 31 after gaining 66% over the trailing four quarters.)

"When you own what is a meritorious and undervalued common stock, the ideal circumstance for you is for that undervaluation to get worked off over an extensive time period of say, two or three, four years," Smead said.

Nevertheless, he still likes Discovery and uses it to explain why a business' free cash flow — the cash coming in minus the cash going out — is the most important metric to find undervalued companies.

"[Discovery's] business of creating unscripted television costs 10% of scripted television, and therefore it is incredibly profitable and generates massive free cash flow," said Smead, who has a final warning for investors who have been rewarded by high-growth names.

"[Y]ou should always be very nervous when a stock goes parabolic," said Smead, who was surprised at the consistent returns of high-growth names over the last five years. "That is one of the most unusual things I've seen in my 41 years in the business. And asking for that to happen regularly is a ticket to lose significant amounts of your capital."

2021 Berkshire Hathaway Annual Shareholders Meeting
2021 Berkshire Hathaway Annual Shareholders Meeting

Jared Blikre is an anchor and reporter focused on the markets on Yahoo Finance Live. Follow him @SPYJared

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