At a Berkshire Hathaway annual meeting, Warren Buffett was asked how he managed to be such a successful investor. He described his approach as nothing more than putting the odds in his favour.
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That’s what we are trying to do. It’s imperfect but that is what it is all about.”
This explanation concisely describes the only rational approach to investing. It zeros in on the necessity of estimating the odds.
Of course, this is not always possible. Some things are reasonably predictable and some are not. Most people have trouble distinguishing between the two.
We all overestimate our ability to predict what is going to happen. Why is this? As Nassim Nicholas Taleb pointed out in his book, Fooled by Randomness, it is largely because humans continually underestimate the role of chance. We look for patterns – even when they do not exist. Random factors affect every event in our lives. Nevertheless, after the fact, we often believe that we should have expected the event, and we invent causes.
People are not very good at recalling the way an uncertain situation appeared to them before they knew the results. Many independent studies confirm the presence of this hindsight bias. For example, after the tragic events of Sept. 11, 2001 (as unexpected an event as we can imagine), one in five members of the general public interviewed said they had fully expected something along those lines would occur.
Professionals are no better at near-term forecasting. A distressing number of them enjoy speculating on macroeconomic matters such as foreign exchange rates, commodity prices, future interest rate changes and impending recessions. However, numerous studies have shown that short-term forecasts in these areas are no better than would be achieved by chimps throwing darts. Likewise, we are bombarded with predictions of the short-term direction of the stock and bond markets. Yet study after study has shown that the timing of near-term market increases and decreases is entirely unpredictable.
You should think of these pundits not as seers, but rather as entertainers.
Returning to Mr. Buffett’s advice to calculate probabilities, a good starting point would be to avoid wasting time thinking about the type of unpredictable events described above. Eliminate all macroeconomic predictions and all attempts to guess the direction of the markets over the short run. You are then free to focus on those factors that can actually put the odds in your favour.
There is one area that is completely predictable. You know with certainty that your net investment return is increased if you can reduce your cost of investing.
For a taxable investor, the principal cost of investing is income tax. Your after-tax return varies inversely with the amount of tax you pay. How do you minimize your taxes? Begin by recognizing that deferring tax for the long run is the next best thing to eliminating it.
Capital gains tax is payable only if you sell your investment. (Even then it is payable at a low rate, applied to only part of your sale proceeds.) Reduce the turnover in your stock portfolio by owning only companies with strong balance sheets that operate profitable, growing and relatively predictable businesses – and plan to hold them for the very long run. Also, when possible, hold any dividend-paying stocks (particularly non-Canadian, dividend-paying stocks) in your RRSP or RRIF.
After tax, your next highest cost is investment management fees, commissions, etc. Mr. Buffett has said that 95 per cent of people should own only very low-fee index funds, and hold them for the long run. This sensible approach lowers your fees and, because of the low turnover in index products, also materially lowers the amount of tax you pay.
Moving from the certain to the highly probable, equities have proven to be one of the best asset classes in which to invest your capital over time. While short-term price movements are entirely unpredictable, the return from investing in publicly traded companies over a period of five or more years is likely to be highly satisfactory. Unless you have a short time horizon, there is a lot to be said for investing in stocks rather than bonds or other asset classes.
Also, numerous studies have shown that, for stock investors, value investing does work. Market multiples, such as the ratio of price a share to earnings per share (the P/E ratio) will, over time, revert to a long-term average. Investors who buy reasonably predictable businesses at historically low multiples of their normalized earnings can expect to outperform the stock market averages over time.
If you want to engage an active manager to invest your capital, find a value manager that charges reasonable fees for the amount invested, has relatively low turnover in their portfolio, and thinks about allocating your investments between your taxable and tax-sheltered accounts in a tax-efficient manner.
As the Oracle of Omaha says, it’s all about putting the odds in your favour.
What will 2016 bring for Canadian investors? Two obvious trends will be a higher percentage of our aging population living off their capital, and higher taxes for wealthy Canadians.
The Globe and Mail has run many insightful articles explaining the advantages of owning stocks that pay generous and growing dividends. There is much to support this view. The payment of dividends by a company shows management’s confidence in the future of the business. Also, as an investor, it is psychologically satisfying to know that, regardless of stock price volatility, you can, over time, count on receiving a growing income stream from your investments.
Dividends from Canadian (although not foreign) companies are taxed at a favourable rate relative to interest on bonds. Because of the mechanics of the dividend gross-up and tax credit, if an Ontario taxpayer has no taxable income other than their Canadian dividends, they can receive up to about $50,000 in dividends without paying tax.
For top marginal tax rate investors, however, the analysis is more complicated.
Let’s assume that you, a top marginal rate taxpayer, are about to retire. You have calculated that, in addition to a generous pension from your former employer, you will need, for living expenses in the first year of retirement, about $80,000 – and this amount will increase with inflation each year. Thanks in part to a recent inheritance, you have $5-million of capital that you wish to invest in a portfolio of Canadian stocks.
For purposes of illustration, assume that you have only two options – investing in a Canadian stock portfolio that pays a dividend yield of 4 per cent, or one that pays no dividend. Also assume that, each year, the total before-tax return (dividends plus capital gains) for the portfolios will be the same. Which portfolio should you choose?
If you are that non-existent being, an entirely rational person, you will recognize that you do not need income in the accounting sense. Instead you need cash flow, regardless of where that comes from. You will focus on maximizing your total after-tax return over time.
This would lead you to choose the non-dividend-paying portfolio. There are two reasons for this. First, capital gains are taxed at a lower rate (about 25 per cent) than Canadian dividends (about 34 per cent). Secondly, dividends are received – and tax is paid on those dividends – when the dividends are paid by the company, regardless of whether you need the money at the time.
If you had elected the dividend-paying portfolio, you would receive and pay tax on $200,000 of dividends in a year when you need only $80,000 after tax. Had you chosen the non-dividend-paying portfolio, you would simply sell enough shares in the first year to produce after-tax proceeds of $80,000. The portion of the proceeds representing what you paid for the shares would be received tax-free, as a return of capital, and the balance as a capital gain taxed at about 25 per cent.
The comparison between receiving dividends and harvesting capital gains for cash becomes more dramatic if we assume that you, like most high-net-worth Canadian investors, want to own both Canadian and U.S. stocks. Dividends from foreign (e.g. U.S.) companies are taxed not at the 34-per-cent rate applied to Canadian dividends, but at your top marginal rate. Consequently, the above analysis is doubly true if you own U.S. stocks.
None of us is, however, entirely rational. For evolutionary reasons, our brains are hard-wired to think short term, and to be very risk-averse. When contemplating a non-dividend-paying portfolio, most people would worry about having to sell shares to raise cash in a “down year” (ignoring the fact that this would be offset by also selling in more frequent “up years”). They would also not see liquid financial assets as being effectively interchangeable, preferring the time-honoured, if illogical, distinction between capital (which we must never sell) and income. And so most people would, for perfectly legitimate psychological reasons, choose the financially inferior option.
Now let’s consider what we should do, assuming we found ourselves in the fortunate financial circumstances described above, and we were not limited to just two choices. Most of us would be best off opting for a middle ground. We would invest in a combination of stable Canadian companies that pay a healthy dividend, and higher-quality U.S. companies, most of which would pay no dividend (examples of non-dividend-payers include Berkshire Hathaway Inc. and Alphabet Inc./Google Inc.). To add a new wrinkle, we would also put any dividend-paying U.S. stocks in our RRSP, in order to defer the payment of tax on the dividends.
Such a portfolio would provide a close to optimal solution from both a financial and a psychological point of view. It would allow us, each year, to receive a portion of our living expenses as dividends from the Canadian companies, and to sell non-dividend-paying U.S. stocks to make up the balance.
A high-dividend-yielding Canadian portfolio will work well for most Canadians. However, Canada’s top 1 per cent, for whom tax will have even more bite after the end of 2015, should take the time to consider the alternatives.
The Globe and Mail has published several insightful articles on how to invest successfully in stocks. However, most people would prefer to leave that to someone else. Which raises the question: Just how should you go about finding the best person or firm to invest your family’s money?
Let’s start by putting the question in context. Over any period of more than a year, most active investment managers will, after fees, underperform the broader market. This is true on a before-tax basis – and doubly true after tax. So finding that rare manager who can beat the market over time is not only an important task, but a difficult one.
To assist you in your quest, here are some suggestions.
Comfort and trust
It is, of course, crucial that you deal with someone with whom you feel comfortable talking about your financial affairs, and in whom you have complete trust. That person will focus on your circumstances and goals, not their product.
In addition to trusting your instincts as to whether the person or firm is truly putting your interest first, it is a good idea to inquire about their reputation. Ask to speak to an existing client of the firm about their experience.
The majority of Canadian investment management firms have high standards, but there are some dramatic exceptions.
Understandable investment approach
Naturally, you will inquire about the firm’s long-term investment returns. (The key here is “long term.”) The investment strategy should be proven to work over time, particularly in down markets. Equally important, the investment approach should be easily understood. This test eliminates a surprisingly large number of investment firms, including the large, diversified financial institutions that have lots of products on their shelf but no underlying philosophy.
You should also ask how decisions are made. Is it by an individual who could leave tomorrow, or does the firm have a disciplined and repeatable process implemented by a qualified team? You should, of course, know exactly which securities you own at all times. If the firm operates a “black box” into which you are not permitted to see, thank them for their time and move on.
A reasonably focused portfolio
Most investment accounts are overdiversified. To quote Warren Buffett, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Independent studies have shown that the more stocks in a managed portfolio, the less chance it will, after fees, outperform the broader market. Some diversification is a good thing, but 20 high-quality companies operating in at least five industries is sufficient.
Alignment
To ensure your manager is fully focused on maximizing your investment returns, and has the same risk profile as you, the manager should have most of their financial capital invested in the same portfolio as you do. Be sure to ask about this.
Reasonable fees
The firm should disclose exactly what fees they will charge, and those fees should be reasonable for the amount managed. It is stunning that the vast majority of clients have no idea what fees they are paying. This is crazy. All studies prove that, over time, investment returns vary inversely with the amount of fees charged. Some investment managers have been known to say, “You get what you pay for.” A more accurate statement would be, “We get what you pay for.”
The most egregious fees are so-called performance fees, which consist of the investment firm taking a percentage of the return in a given period above a hurdle rate. At first blush this seems quite reasonable, but typically the performance is measured over too short a period on which to judge – let alone reward – investment success. Very few people realize that, in most years, the stock market either rises more than 20 per cent or produces a negative return. Irrespective of your money manager, your return will be strongly correlated with the return of the broader stock market. If your manager charges a performance fee and your portfolio rises sharply with the broader market, you will be obliged to pay a hefty additional fee. If the market, along with your portfolio, tanks the following year, the manager will not return that fee.
A further problem with performance fees is that the investment firm has an incentive to take additional risk with your money. Rolling the dice results in a big payday for the firm if it works out, while you are left with the loss if it doesn’t.
Tax efficiency
Last, but not least, look for a firm that recognizes you live in an after-tax world. Like fees, taxes erode your capital over time. You pay capital gains tax only when an investment is sold. So there is a great advantage in finding a manager with low portfolio turnover. This allows your money to compound on a before-tax basis. One test of whether an adviser truly puts your interests first is whether they focus on, and talk to you about, your likely long-term after-tax returns.
Selecting the right investment manager will make a huge difference to your ability to retire comfortably. Your single best investment may be the time you spend making that selection.
Some investment managers also charge performance fees. These are incremental fees paid on top of a base fee when the manager performs better than a chosen benchmark. Those that charge them argue that performance fees better align them with the client by providing more incentive to perform, and that the client only pays in the event of outperformance (win-win).
However, performance fees are usually a one-way street – managers take them in good years, but don’t refund them to you in bad years. Given that, in most calendar years, stock markets either rise by more than 20 per cent or produce a negative return, performance fees can badly whipsaw clients.
Among investment firms, it is hedge funds that most commonly charge performance fees. Like other investment managers, most hedge funds underperform the broader market. This is highlighted by a bet Warren Buffett made in 2008. He challenged several hedge fund managers to pick a group of hedge funds that would outperform a low-fee index fund tracking the U.S. stock market (S&P 500 Index) over 10 years. By the end of 2013, the cumulative return of the index fund was 44 per cent, while the group of selected hedge funds, picked by industry experts, had returned only 13 per cent.
Today, stock markets appear fully valued and fixed-income yields are at historic lows. More than ever, the proper management of your investments is important. Some investment managers charge reasonable fees and some do not. Some will be worth the fees that they charge and others will not.
What are we looking for?
Growing companies with a history of high returns on invested capital (ROIC) that are also trading at relatively inexpensive valuations. Why? Because the increase in the economic value of a business depends on a combination of its ROIC and growth. We performed a similar screen for Canadian companies a couple of weeks ago. Today, we look at U.S.-based companies.
ROIC is a company’s earnings before interest and taxes (EBIT) divided by its invested capital (working capital plus fixed assets). It is a measure of a company’s efficiency in allocating its capital to profitable investments. We use EBIT rather than net income in our ROIC calculation, as it allows us to put companies with different levels of debt and tax regimes on equal footing.
The longer a business can sustain an ROIC greater than its cost of capital, and the greater the spread between the two percentages, the more value it will create. A consistently high ROIC is usually indicative of a sustainable competitive advantage, which is what Longview looks for in the companies it owns.
Twitter Inc.’s recent IPO has many people talking about how its business will evolve in coming years. The one thing most observers agree on is that its future is hard to predict.
Why does this matter? Because predictability is at the heart of successful investing.
The goal of stock market investing is to buy shares in a company and sell them for a higher price in the future. You can do this only if you have an idea of the true value of a company at the time you buy its shares. To estimate the value of a company, you must predict its future financial prospects.
There are many high-quality companies that you count on to grow at relatively predictable levels for several decades. Their long-term financial prospects can, therefore, be estimated reasonably accurately, making them easier to value.
Surprisingly, such companies are often undervalued by the stock market because most investors focus on what a company’s share price might do in the next year or so, rather than taking the long-term view.
Investors should remember that a business is worth only the money that you can take out of it over time. Consequently, the economic value of a business is simply the present value of the cash flow that it will produce during the rest of its existence.
Many people fail to recognize that most of a company’s economic value (usually more than 75 per cent) is based on cash flow that the company will produce more than five years from now. Investors who don’t look beyond the next five years are largely speculating about how a company’s share price will perform and will often undervalue the shares of predictable businesses with long-term potential.
Consider Warren Buffett’s company, Berkshire Hathaway Inc., in early 2000. At that time, it was valued at just over the cost of its underlying assets. This was despite a highly regarded management team and businesses with obvious long-term prospects.
Why? Because it was the height of the high-tech bubble and investors were speculating on the potential near-term returns from high-tech shares – somewhat like today. As a result, the shares of predictable but unexciting companies, like Berkshire Hathaway, were undervalued.
On March 10, 2000, the Nasdaq index (the bellwether for the U.S. tech market) peaked before crashing. That was the precise day that Berkshire Hathaway’s shares bottomed, at a price that they have not been close to since.
Investing is a probabilistic exercise in which you should be trying to tilt the odds in your favour. Investing in companies with relatively predictable growth profiles can help you do so.
Predictability not only increases your chances of estimating accurately the economic value of a company, it also leads you to companies that you can feel comfortable owning for many years. Owning shares for the long run has the benefit of deferring tax on capital gains. This allows your capital to compound tax free.
If you purchase a share for $10, it grows at 10 per cent each year and you own it for 20 years, at the end of 20 years it will be worth approximately $67 before tax and $54 after you sell it and pay capital gains tax. Alternatively, if, at the end of each year, you sell the share you own, pay the capital gains tax and then reinvest in another share that also grows at 10 per cent your investment will be worth only about $43 after tax at the end of 20 years. In this case, the advantage of buying and holding leads to 25 per cent more capital after tax.
To find predictable companies, steer away from sectors where there is a risk of obsolescence (e.g. high tech) or where performance depends on the price of a commodity (e.g. mining, oil and gas).
A good place to start is with companies that have relatively consistent historical growth and profitability as well as defensible competitive positions. For instance, the consumer staples sector includes some of the most predictable public companies in North America, such as Brown-Forman Corp., McCormick & Co. Inc. and Wal-Mart Stores Inc.
Short-sighted investors may always see such companies as fully valued, thereby missing out on attractive opportunities. But long-term investors who own these businesses will be sleeping soundly at night, dreaming of compounding returns, and knowing that the companies they own will likely still be growing many years down the road.
What are we looking for?
Growing Canadian companies with a history of high returns on invested capital (ROIC) that are also trading at relatively inexpensive valuations. Why? Because the increase in the economic value of a business depends on a combination of its ROIC and growth.
ROIC is a company’s earnings before interest and taxes (EBIT) divided by its invested capital (working capital plus fixed assets). It is a measure of a company’s efficiency in allocating its capital to profitable investments. We use EBIT rather than net income in our ROIC calculation, as it allows us to put companies with different levels of debt and tax regimes on an equal footing.
The longer a business can sustain a ROIC greater than its cost of capital, and the greater the spread between the two percentages, the more value it will create. A consistently high ROIC is usually indicative of a sustainable competitive advantage, which is what Longview looks for in the companies it owns.
Today’s media are full of advice for the retail investor. At least 99 per cent of that advice relates to before-tax investment returns. It ignores the fact that people live in an after-tax world.
In part, this happens because people find thinking about investing and tax planning at the same time to be much like patting their head and rubbing their stomach – surprisingly difficult.
When a tax issue is raised with an investment adviser, the ill-considered response is often, “Don’t let the tax tail wag the investment dog.” In fact, maximizing investment returns and minimizing taxes are, more often than not, entirely compatible goals.
Consider some simple examples. Over time, stocks are likely to produce a higher before-tax investment return than bonds, and the return from stocks (dividends and capital gains) is taxed at a lower rate than interest from bonds.
Also, low-fee index funds or ETFs beat 80 per cent of actively managed retail mutual funds over time. Because the lower turnover within the index products defers the payment of capital gains tax, these low-fee products are also more tax efficient.
But let’s assume that you, like most people, have elected to use an active investment manager, a financial planner or a traditional stock broker as your financial adviser. Your instructions are that the selection of securities is to be made with a view to maximizing your before-tax investment return. Should you also expect your adviser to minimize the tax that you pay on your investments? Absolutely you should.
A knowledgeable adviser who puts your interest first will take the time to allocate your securities among your accounts in the most tax-efficient fashion. This will have a material effect on the amount of capital you are able to live on in your retirement.
Imagine you have a total portfolio of $1-million, of which $490,000 is in an RRSP account, $490,000 is in a non-registered (i.e. taxable) account and $20,000 is in a Tax Free Savings Account (TFSA). Your portfolio consists of Canadian and U.S stocks, most of which pay a dividend.
Your U.S. stocks are paying you dividends that, if held in a taxable account, would be taxed at your highest marginal tax rate. To the extent possible, these stocks should be held in your RRSP. If you do this, not only are the U.S. dividends not currently taxable, but under the Canada-U.S. Tax Treaty there is no withholding tax levied by the U.S. government on the dividends.
Most of your Canadian stocks pay a dividend. On these Canadian dividends you get a dividend tax credit, which, if held in a taxable account, can result in anything from no tax to a tax rate well below your top marginal rate. So, to the extent possible, these stocks can be held in your non-registered account.
Your TFSA shelters from tax the income and capital gains relating to securities held in the TFSA. However, dividend-paying U.S. stocks should not be held in a TFSA account as one can never recapture in a TFSA the otherwise refundable withholding tax paid on U.S. dividends. High-dividend-paying Canadian stocks are a better choice.
And what about those shares of Berkshire Hathaway that you bought 10 years ago and expect to hold for the long run? Because Berkshire does not pay a dividend, and this will likely be a long-term hold, you can achieve a major tax deferral simply by holding your Berkshire shares in your taxable account. They should not be held in your RRSP account because that would have the effect, when you cash in your RRSP, of converting the low tax rate on the realization of a capital gain to your then top marginal tax rate.
Because you live in an after-tax world, your objective should be a high after-tax investment return. Accomplishing this objective involves both maximizing your before-tax return and minimizing the tax you pay on that return.
Several years ago I was discussing with a colleague the well-known strategy of buying companies with low price-to-earnings ratios. He disparaged this approach as “rear-view mirror” investing, because it looked only at history and did not allow him to bring any judgment to bear upon the likely prospects for the company.
His observation was, of course, correct. What is less obvious is that investment decisions are generally hurt, not helped, by incorporating your predictions about a company’s future.
Of all the mental biases that humans possess, overconfidence in our ability to predict the future may be the most harmful.
Several studies have shown that predictions are most likely to be accurate when they are founded on a statistical base case rather than on the all too human tendency to extrapolate from particular situations. Models beat human forecasters because models consistently apply criteria that have proved over time to be relevant. They focus on the signal, not the noise.
Models don’t favour human-interest stories over boring statistical data. People, on the other hand, look to a limited set of remembered experiences, and then generalize to create a rule of thumb. While this works reasonably well in many aspects of our life, it cripples our ability to make rational investment decisions.
Behavioural psychologists have illustrated this unhelpful bias by posing the following question to groups of people: Fred lives in a small Midwestern city. He wears glasses and enjoys reading. Is it more likely that Fred is a salesman or a librarian?
Most people guess librarian. In fact there are, in any city, at least 40 times as many salesmen as librarians, so the correct answer is salesman.
Another study examined the results of medical diagnoses based on a series of medical test results. The diagnosis was performed, in one case, by a computer and, in a second, by experienced doctors who were presented with the same information. By now you will have guessed that the computer was able to diagnose the disease more accurately than the doctors.
What is most surprising, however, is the results of a second test. This time the doctors were given the results produced by the computer before being asked to make a diagnosis. The doctors’ performance improved but they still did worse than the computer.
So what should an investor do? To beat the stock market averages over the long run you must do two things. The first is to find a strategy that has been proven to outperform over time. The second is to follow it consistently.
Finding a proven approach to beating the market over the long run is not difficult. A good starting point can be found courtesy of Tweedy Browne.
In broad terms, most approaches that have been proven to be successful rely upon the fact that the relationship between the market price of a company and its current fundamentals (earnings, revenue, book value etc.) will revert over time to a long-term average.
One dead simple investment strategy that has been proven to work reasonably well is to own only the companies in an index, such as the S&P 500, that fall in the lowest decile by price-to-sales ratio (current market capitalization divided by revenue over the past 12 months), and adjust annually.
Continue this for 10 years and your chances of beating the market over that period will be greater than 80 per cent. (If you choose instead to buy an equity mutual fund, actively managed by a professional investor, your chances of beating the market over the same period, after fees, will be less than 20 per cent.)
Now, here is the hard part. Once you have identified a strategy, you must stick to it. You must not let your overconfidence in your ability to predict the future and your other biases interfere. If the formula requires you to purchase a buggy whip manufacturer, you buy it. And if the formula doesn’t work for two or three years you don’t abandon it. The odds are in your favour and the law of large numbers will eventually skate you onside.
Sticking purely to a formula through thick and thin requires more discipline than most investors, including this writer, possess. However, to the extent that you can base your decisions only on known facts, and follow a proven strategy in a disciplined fashion, your investment returns will improve dramatically.
The Globe and Mail’s Strategy Lab, which pits growth, value and other stock-picking styles against one another, raises the essential question: What works in investing?
While there is never any shortage of opinions on this topic, scientific studies accessible to the general reader are few in number. A notable exception is James O’Shaughnessy’s book, What Works on Wall Street.
First published in 1996 to wide acclaim, this tome compares the returns, over the past several decades, resulting from about 20 of the best-known investment strategies, such as buying only companies with a low price-to-earnings ratio or high growth in earnings per share. Some of these strategies have worked well over time. Most have not. The fourth edition, which came out earlier this year, contains more data than previously and an improved format. All serious investors should read it.
Mr. O’Shaughnessy starts by laying out the framework for his thesis. He points out that, although investment results are unpredictable over the short run, it has been proven many times that, over longer periods of time, investing in companies based on the relationship of their market price to their economic fundamentals does pay off. Although most investment professionals underperform the market index, any disciplined investor who follows these strategies can far outperform the averages over time.
So why doesn’t everyone do this? Human nature gets in the way. We are hardwired to prefer listening to stories or following trends rather than studying numbers. And, even when we know intellectually that a strategy will do well over time, we will typically abandon it if it is not working in the short run. In fact, sticking with winning strategies through thick and thin is far harder than identifying those strategies in the first place.
And just what are those winning strategies? Essentially, all you have to do is buy companies that are trading at low multiples of certain economic values – and wait for those multiples to revert to their long-term mean.
For the cognoscenti, the five key ratios Mr. O’Shaughnessy’s studies have identified are: price to book value; price to earnings; price to sales; price to cash flow; and earnings before interest, tax, depreciation and amortization to enterprise value. Using a value composite of these ratios will yield much better results than will using just one ratio.
Long-term studies have also shown that even better results are obtained if you overlay on your value composite a screen for six-month price momentum. This last concept will be anathema to most value investors, who will choose to reject it, even while knowing that their rejection will likely result in lower returns.
Other parts of the book deal with the long-term returns investors have realized from investing in different business sectors, and which strategies are most appropriate for a particular sector.
Economics 101 teaches that when one business or sector produces above average returns, capital rushes in to finance competition for the outperforming businesses, which in turn reduces the profitability of those outperformers. That is not, however, what happens in practice.
Brands, patents and other factors provide to some companies an enduring competitive advantage, or economic moat, which allows them to outperform for many decades. Investing in these companies will result in higher investment returns. And not surprisingly, investors who restrict themselves to sectors such as consumer staples, where many of these companies are found, will generally outperform the broader market index.
Mr. O’Shaughnessy’s most interesting finding is not how to beat the market (although that is not without interest), but rather proving conclusively that the averages can easily be beaten.
His studies demonstrate that, over time, the movement of stock prices does not resemble a random walk. It is, in his phrase, more like a “purposeful stride.” Investors can do far better than the market average if they adopt and stick to time-tested strategies based on rational methods for selecting stocks.
But very few will.
Having trouble deciding whether you should worry more about the European banking crisis, the U.S. debt cliff or the slowdown in China? If so, you are not alone. But perhaps it is time to take a step back and consider how those worries are affecting your ability to think rationally.
The great expert on this question is the Nobel Prize winning psychologist, Daniel Kahneman. His best-selling book, Thinking, Fast and Slow, describes Mr. Kahneman’s intellectual journey in discovering how humans are hard-wired to make the wrong decisions much of the time.
Among the unhelpful mental biases that Mr. Kahneman discovered is our tendency to be overconfident about our ability to predict the future (or, for that matter, accurately explain the past). Our instinctive fear and greed, which were useful in a much earlier stage of evolution, now interfere with our ability to analyze. We tend to think primarily about short-term results. And we focus far too much on recent experience, which we assume will continue. This so-called “recency bias” means that investors (including the pros) are excessively risk averse when stock markets have fallen, and overly optimistic when markets have risen.
This partially explains why, over long periods of time, and after fees, only a statistically insignificant percentage of investment managers are able to beat the stock market index. Mr. Kahneman goes so far as to conclude that the investment industry is “built on an illusion of skill.”
This implies that the best approach to stock investing is to buy a low-fee index fund or ETF. A leading advocate of buying index funds is Jack Bogle, the founder of Vanguard Funds. In The Little Book of Common Sense Investing, Mr. Bogle cites a number of studies supporting the view that active investing is a loser’s game. Most other objective students of the stock market agree. Even Warren Buffett has often said that the best solution for most investors is a low-cost index fund.
And yet it is also true that a small percentage of investors do beat the market over time. To take a simple example, studies have shown that anyone can beat a traditional stock market index (where companies are weighted by their market capitalization) simply by buying all the companies in the index and weighting them equally. This is because overvalued stocks will always be overweighted in traditional indexes.
We also know that Mr. Buffett has beaten the market index each decade over the past 50 years. In his amusing essay “The Super Investors of Graham-and-Doddsville,” Mr. Buffett says that everyone who worked for his mentor, Ben Graham, in the 1950s, and went on to form an investment firm, has significantly beaten the market averages after fees. As Mr. Buffett points out, these firms all followed Mr. Graham’s value-based investment approach.
So how do we reconcile the rarity of those who beat the market with the evidence that at least some people have been able to consistently outperform?
I believe it is precisely because of the behavioural shortcomings that Mr. Kahneman has identified that stock market inefficiencies exist. And these mispricings can be utilized by the small minority of investors who understand, and are able to resist, most of our mental biases.
Mr. Kahneman has some tips on how we can improve our thought processes. He points out that, when it comes to avoiding investment errors, organizations can fare better than individuals. Debate between two or more people forces a more balanced view of risks and opportunities. And organizations can impose procedures that must be followed. So, when evaluating a company, use a checklist, and make a point of discussing your investment ideas with a knowledgeable friend.
The key is to be able to identify irrational behaviour by others while minimizing the chance that your own behaviour is subject to the same biases. So, take a long- term view. Wait patiently for waves of fear and greed to misprice stocks. If you can train yourself to be, in Mr. Buffett’s words, “fearful when others are greedy, and greedy when others are fearful,” you will indeed outperform the market over time.
A concise and highly insightful book on the crucial role of chance in investing, and in life – and on how we perceive and consistently underestimate it. Wonderfully irreverent. A great read.
This book describes how a highly disciplined investor is virtually certain to beat the market over time if he or she simply follows a few simple rules, and makes decisions based only on the known facts, without trying to predict the future.
This book points out that, after fees, less than 10% of active investment managers can beat the relevant stock market index over time — and that there is no meaningful correlation between those who have done it over a given period and those who will do it over the next period. This is a sobering reality check for those of us in the business of managing money!
This book explains why most investors (including the pros) underperform the index — i.e. how, when it comes to investing, human beings are hardwired to do the wrong thing. Fascinating reading.
The timeless classic on value investing. Read especially the Introduction and Chapters 8 and 20. The Appendix includes Buffett’s famous lecture on “The Superinvestors of Graham-and- Dodds Ville”.
Selected, arranged, and introduced by the publisher, Lawrence A. Cunningham. A well thought out compilation of Warren Buffett’s letters to shareholders. Chapter II outlines the framework within which Buffett makes investment decisions.
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