The FTSE 100 index has been in existence since 1984. And throughout its almost-40-year history, this evolving collection of companies has delivered an average return of approximately 8.9% annually. Over the long term, that has led to some substantial wealth generation, even for investors who know very little about the stock market.
Yet recently, the index hasn’t exactly been a stellar performer. In fact, over the last five years, a £1,000 investment in an exchange-traded fund tracking the FTSE 100 would be worth around £1,030 today (excluding fees). When including the additional income generated by dividends, the investment rises to around £1,250.
This translates into an average return of 5.7% on an annualised basis. Needless to say, that’s below its historical average. And by today’s standard, it barely beats the 5.1% inflation rate. So the question is, how can I enjoy higher returns to grow my wealth faster?
Beating the FTSE 100 through stock picking
The stock market has its ups and downs. There will be periods of poor performance, and every so often, a market crash will rear its ugly head like the one seen in March 2020. But when looking at some individual companies in the past few years, plenty have put the FTSE 100 to shame.
Looking at my own portfolio, several of my UK shares have outperformed the blue-chip index as a whole, and not by a small margin. Two, in particular, Alpha FX and Somero Enterprises, have generated triple-digit returns over the last five years.
Of course, stock picking is not a risk-free endeavour. And it can very easily lead to some substantial losses if poor decisions are made. I’ve certainly made plenty of mistakes over the years and will likely continue to make more in the future.
So, what makes a good stock pick?
In my experience, some of my top performers that have beaten the FTSE 100 share some similar traits, despite being completely unrelated enterprises. The most prominent of them is an economic moat. This represents all the factors that give a company an edge over its competitors.
For example, a business with a reputation for high-quality products can charge customers more for its goods, even when there are cheaper alternatives. This is called pricing power.
Another competitive advantage that can be even more powerful is the creation of switching costs. This is when a service or product becomes so heavily integrated into a client’s operations that switching to a cheaper competitor is either financially unviable or so challenging that it’s an unappealing prospect.
There are plenty more traits to look for, from network effects to high entry barriers. But the point is, the more advantages a business has, the more likely it will thrive in the future. And since shares represent a tiny piece of an underlying company, if its profits start climbing, so should the share price. At least, that’s what I think.
I have to take into account the risk that individual stocks may underperform, of course. But I can minimise this risk by diversifying across companies and sectors.