For the last five or six years, shareholders could sit back and watch their stock valuations climb with the rising tide—but they can’t do that now.
With large discrepancies in the performance of stocks within the same sectors so far this year, many investors are finding themselves in the epicenter of a stock picker’s market.
The chart below shows implied correlations of the S&P 500 stocks. Simply put, the higher the correlation, the more stocks are trading together. In the years immediately following the 2008 financial collapse, correlation peaked as stocks traded in tandem.
“Since the financial crisis, stock picking has changed quite a bit,” said Stephen Weiss at Short Hills Capital. “If you look at 2009, when the market started to go higher, you could buy anything and the market would go up. Then 2010, 2011 you really had to know what you were doing. Last year same deal, you could just buy anything and it would go up.”
A quick look at the index shows that correlation levels are back to where they were before the crisis. As a result, many traders are looking to companies’ specific fundamentals to find opportunities to outperform the broader market.
Investors who do their homework can reap big rewards, according to Weiss.
“Stocks that are shorts are actually going down, and stocks that are quality—that are based on quality companies—are going up,” he said. “So this is why they call it a stock picker’s market, and that’s more true this year than it was last year or in years past.”
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The market this year has already shown a divergence within specific industry groups. In pharmaceuticals, Merck is up almost 11 percent just this year, while Pfizer has gained only about 4 percent. Despite both companies missing on fourth-quarter earnings, some analysts say Merck has stronger products in the pipeline.
A similar story plays out in the financial sector. Bank of America, which reported a surge in fourth-quarter profits, has seen shares increase by more than 6 percent in 2014. Meanwhile, shares of Citigroup, Morgan Stanley and Goldman Sachs shares have lost about 5 percent or more.
Many investors, of course, look past short-term returns in search of longer-term growth opportunities. IBM, for example, is down about 2 percent so far this year, but Martin Leclerc, portfolio manager at Barrack Yard Advisors, said he sees potential in the stock because of the company’s free cash flow yield.
“Our goal is to buy great businesses at good prices,” he said. “In the information technology area, IBM and Cisco are great companies. I’ve seen the free cash flow yield of a stock comport in a general way with its long-term rate of return. The free cash flow yields on IBM and Cisco are around 10 percent.”
(Read more: Traders in hunt for real economy)
Looking at the overall market, Robert Luna of Surevest Wealth Management said that stock-picking could maximize profits through the next two years.
“I think this year you’ll finally see for the first in about five or six years where active management does outperform,” he said. “Whether you’re picking individual stocks yourself or looking for the mutual fund managers who are able to do that for you—that’s where investors want to be domestically.”