Why putting the investment odds in your favour is so hard

R. B. Matthews

Norman Rothery’s ranking this past weekend of the 250 largest stocks on the TSX pointed out the advantages of tilting the odds of investment success in your favour by focusing on company-specific financial measures (called factors). Mr. Rothery focused on both value factors, such as a low ratio of share price to earnings per share (the P/E ratio), and share-price momentum. As was pointed out in the article, combining value and momentum improves the chances of investment success.

Other factors that have been proven to improve long-term returns include size of the company and shareholder yield. The largest 20 per cent of companies in any stock market tend to underperform. And companies that pay healthy dividends and/or buy back their own shares are more likely to outperform.

Yes, of course there are exceptions to these general rules. In each case, this is only true on average when looking at a large sample size over time. But that is exactly how you determine probabilities.

When using factors, you are taking an outside view. Instead of looking at a particular business and forecasting its future, you are looking at a very broad range of companies and looking for connections between their financial characteristics and future increases in their stock price. Because there is a strong long-term correlation, as well as a logical causation, between certain factors and future investment returns, it is reasonable to conclude that by following this approach, you are increasing the probability of outperforming the stock market average.

The ability to think probabilistically is crucial. This is how Warren Buffett’s partner, Charlie Munger, has graphically described its importance: “If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.”

As you would expect, combining several factors has been proven to further improve returns.

Focusing purely on factor investing for both buying and selling stock has proven successful for tax-sheltered entities such as pension funds and insurance companies. If you pay taxes, however, the resulting high portfolio turnover (frequent buying and selling of stocks) would increase your average tax rate.

To avoid this, taxable investors can elect to use factors only to define which companies they will consider investing in – and not be in a rush to sell the companies they purchase. You might, by way of illustration only, say, “I will only consider buying companies that are trading at a P/E ratio of less than 20, that have a history of buybacks or dividends providing a shareholder yield of at least 2 per cent per year, have a market capitalization of less than $50-billion, and have a return on equity (ROE) of greater than 16 per cent.” Once the field has been narrowed to companies that are more likely to outperform, you can consider other characteristics, such as debt levels, historical growth in revenue and profits, and your view of the competence of management, before deciding whether to buy.

This approach will not result in outperformance every single year, but over time it has, and likely will in the future. Most importantly, in every given year, and for every given purchase, it tilts the odds in your favour.

Unfortunately, investing in this manner runs counter to human nature. People find it easier to think about a single example than about a large sample. A quote often attributed to Stalin identifies this, perhaps inadvertently: “One death is a tragedy. A million deaths is a statistic.”

Many people believe they can predict a company’s future, and often confuse anecdotes with evidence. “If we followed those rules, we would never have bought Amalgamated Consolidated Widgets, which was a winner!” Correct. But that doesn’t change the fact that following the rules would have produced a better long-term result for the portfolio. Or that buying Amalgamated Consolidated was somewhat like winning at the roulette table in Las Vegas. The odds were against you and the happy outcome was based on luck, not skill. Over time, anyone operating with the odds against them will be disappointed.

Just to hammer home how difficult thinking this way is for most people, let’s take another example from everyday life. Your friend Frank buys a lottery ticket. You point out that the purchase was a mistake because the odds were dramatically against him. He replies that either he’ll win or he won’t. And once he knows whether he won, the odds will be irrelevant. Perhaps you instinctively agree with Frank’s view. Most people see no reason why a sample size of one is not sufficient to draw a conclusion. However, if you don’t adjust your thinking about future outcomes to focus on the probable, rather than the actual, result, you will never enjoy the benefit of going through a long life with the odds in your favour.

All of us are hard-wired to think short-term. Most people who do adopt an objective approach and know rationally that the strategy will succeed over time will abandon it if it does not produce the desired result in the first year or two.

Identifying the correct evidence-based approach is important. What is harder is having the discipline to execute that approach and stick with it through hard times.