I recently dusted off the Moto Guzzi and took a little ride to Alpharetta, Georgia. It was a perfect day for a motorcycle ride, at least for me. It was 60 degrees, sunny, and the wind was to my back. Covered from head to toe in full protective gear that my family calls the “power ranger suit,” I was neither cold nor hot. I was in a state of pure enjoyment.
As I neared Alpharetta the urge to keep heading west all the way to California was so strong I almost gave in, but I reminded myself I had an obligation to the CFA Societies of South Carolina, Georgia, and Alabama. Of course I did the right thing and stopped to fulfill my commitment.
As I had done in years past, I was attending the Southern Classic Research Challenge, the local edition of the CFA Institute’s Research Challenge. It’s a competition between university-sponsored teams composed of both undergrad and graduate students from finance and MBA programs. The teams each research a designated publicly traded company, write up a research report on it which is scored, and then present their findings to a panel of judges. There are three different levels to the competition: Local, Regional, and Global. Teams progress through these three levels until a Champion is declared the ultimate winner of the Global competition.
This year, the Southern Classic had twelve participating teams. Each team’s written report is scored prior to the presentations. On the day of the Southern Classic, the teams present and defend their recommendation to buy, sell, or hold common shares of the designated company to a panel of experts. Three teams with the highest combined score are named as finalists. My job was to judge the finalists and pick the winning team. Of course, I had some help. There were four other experts chosen to judge the finals. I find that most experts have gained a large portion of their expertise by making mistakes. It would be a big disappointment to the students if they were judged by a single expert who could easily make a bad decision unrelated to the presentation. With multiple experts, a single judge’s mistake can be corrected by the others. The good news is, when we tallied our scores, all of us had chosen the same team as the Champion. This is one time I can say that great minds think alike!
I will be taking a little longer ride in April as I head to Chicago to judge the Regional Competition. The Local Competition winners, from universities whose home bases are located in Canada, the US, Central and South America, will be competing for the title of Regional Champion. The following day, the Global Competition finals will also be held in Chicago, so I plan on sticking around to join the celebration.
I enjoy attending these events. The students are exceptional. The majority are the top business or finance students in their class. Without yet accumulating too much baggage of life, they are excited and optimistic about their future. It is good for me to see the excitement in their presentations. Their actions assure me that the future they envision has a higher probability of becoming reality than that of the nay-sayers calling for the doom of the following generations.
It is also a learning experience for me. I find out what they are being taught about finance, business and the capital markets. They are indeed experts of the quantitative requirements of good financial analysis. However, this skill is just the minimum needed in a professional setting. Great analysts and portfolio managers know that relying only on quantitative skills will never produce superior returns. We mentioned the benefit of having multiple judges where the average score produces a more reliable outcome than a single judge. Yet to produce superior portfolio returns, following the crowd, or relying on the average, will not do the job.
It is pretty easy for all of us to obtain average returns. There are many index fund options that will produce the average return of an index minus a small amount for the fee paid to maintain the fund. Even with the use of index funds, if you combine more than one, your results will be the average results of the combined portfolio. If you are wrong on the amount invested in each index, happen to choose an index fund that produces negative returns, or make any other of the multiple mistakes possible when choosing any investment, it could result in poor returns. This same problem occurs whether you use index funds or actively managed funds. What we do know, from studies such as the Dalbar analysis, is that individual investors, with or without the help of a traditional financial advisor, have a very poor track record of earning and keeping even the average returns.
From experience we find that most of the shortfall is caused by human nature. We react to our fear by selling low. We react to our greed by buying high. We invest our money on the belief that certain individuals have discovered a new way to make us rich. We invest our money on the belief that a finance or economics researcher who studied market history can use that knowledge to accurately predict the future.
While our reactions to fear, greed, and an unwarranted belief in gurus are up to each individual to address, we do what we can to help. When it comes to fear and greed, we encourage you to think clearly, remind you that you will never lose all your money, and explain that if it was so easy to make huge returns in a short period of time, everyone would be rich and no one would ever have to work again. When it comes to the belief that one individual has come up with a secret method to earn you a great rate of return, we can remind you that all Ponzi schemes began and prospered because of this belief.
When it comes to professional research we face a very difficult problem. By default, we know that most of the research studies completed and published in respected journals have been tested once, twice, or more with multiple reviews by competent and qualified individuals. The problem is not the quality of the research, but rather determining what research is capable of helping you reach your financial goals.
Although a few of you may enjoy sitting down in the evening and reading a twenty page academic research paper on investing, I would venture that the majority of you would rather have a tooth pulled. However, you deserve to know that we do review many papers. Some of these are good and some are not. Good research, in my opinion, is research that will help minimize your mistakes and make you better off financially. Bad research, in my opinion, is research that encourages you to take short-cuts in hopes of earning superior returns.
I am sorry to say that most of the research published I would consider the “bad stuff.” It is easy to understand why. There is so much money to be made if only you could find some magic formula. Because the payoff could make you rich, and everyone wants it now, not later, a huge effort takes place to find short-cuts to riches. In almost all of these papers, one has to believe that you can find the magic elixir before anyone else, and you have to believe that it will provide the same results tomorrow as it did yesterday.
The Efficient Market Hypothesis
We mentioned earlier that you can obtain average returns using index funds. Index funds were created because of research based on the belief that the markets are efficient. Burton Malkiel, the author of A Random Walk Down Wall Street, now in its 12th edition, is one of the world’s leading authorities on the efficient market hypothesis. Malkiel believes individuals should use index funds when investing in risk assets. The efficient market hypothesis contends that the current market prices of publicly traded common stocks reflect all publicly available information. Because of this, Malkiel contends “even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.” In other words, don’t waste your time trying to make better than average returns. Trying to time the market, pick stocks, or forecast is a waste of time.
In 2003, shortly after the great technology bubble burst, the efficient market hypothesis lost its luster and came under extreme scrutiny by professional investors and academic researchers. Following all major declines in prices, attempts are made to mine the data and find something that would have protected investors and even profited instead of taking huge losses. Dr. Malkiel defended the efficient market hypothesis against other strategies in a paper published in the Journal of Economic Perspectives entitled The Efficient Market Hypothesis and Its Critics. In this short paper he used statistical findings and behavioral underpinnings to discount many of the strategies being promoted. At the time, most of these strategies could be categorized under ten major headings which he addressed. What I find interesting is that you could take most of what I consider “bad research” and just file them under one of these same ten major headings that he mentions in his paper:
- Short-Term Momentum, Including Underreaction to New Information
- Long-Run Return Reversals
- Seasonal and Day-of-the-Week Patterns
- Predictable Patterns Based on Valuation Parameters
- Predicting Future Returns from Initial Dividend Yield
- Predicting Market Returns from Initial Price-Earnings Multiples
- Other Predictable Time Series Patterns
- The Size Effect
- Value Stocks
- The Equity Risk Premium Puzzle
You may be wondering if I have changed my entire outlook on investing and fallen into the efficient market camp. I assure you I have not. Those that do promote efficient markets are not telling you that superior returns are impossible. What they do contend is that the odds of doing better are so low and the cost so high that you should not even try. This is how Dr. Malkiel explains it:
What I do not argue is that the market pricing is always perfect. After the fact, we know that markets have egregious mistakes, as I think occurred during the recent internet “bubble.” Nor do I deny that psychological factors influence securities prices…
…Before the fact, there is no way in which investors can reliably exploit any anomalies or patterns that might exist. I am skeptical that any of the “predictable patterns” that have been documented in the literature were ever sufficiently robust so as to have created profitable investment opportunities, and after they have been discovered and publicized, they will certainly not allow investors to earn excess returns.
In the world of academic research a return in excess of your requirements has little to no meaning when discussing superior returns. The common method used to measure superior returns is to compare a portfolio return with that of a single non-managed index of securities or a strategic combination of non-managed indices. Performance is also measured over multiple short-term periods of time, linking the results and compounding over longer periods of time. However, we should all understand that the returns we have earned in the past have limited predictive qualities. They simply show what we have accomplished, not what we will accomplish.
True Value Wins in the End
What we can claim is that we will continue to use our skill to build and maintain portfolios the best we possibly can. Dr. Malkiel may advise most individuals to own index funds, but he also knows the key to superior investment results. In the very same paper written to defend the efficient market hypothesis, Dr. Malkiel shares this:
But I am convinced that Benjamin Graham was correct in suggesting that while the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism. True Value will win out in the end.
That’s when the guess work begins. If we accept that true value will win in the end, any investment made without some method to estimate future value will have a difficult if not impossible ability to meet your requirements, let alone superior returns.
Mutual funds, variable annuities, and prepackaged alternatives seem to be the preferred method of investing by individuals. This could be because people are comfortable with these, or it could be because they are the most recommended by financial advisors. With a little common sense you can easily see that these packaged products have no method of estimating value. The reason is that one has almost zero knowledge of what securities the funds hold. Without knowing what is owned, how can you determine a value?
Most mutual funds and other products that are classified as “value” funds buy stocks whose price to book value or price to earnings value are below the average of the entire market. This is a quantitative method of determination, yet every great value manager I know does not rely on just these academic measures of a “value” stock. Since value is in the eye of the beholder each successful manager will differ from others. Our approach will be different from others. Because of that we will use next month’s letter to share with you in more detail our approach to building and maintaining a value portfolio of common stocks.
Until next time,
Kendall J. Anderson, CFA