Archive for December, 2005
Happy New Year 2006
Dear Visitors,
I wish all of you a Happy New Year & Happy Emotionless Investing!
Crazy Market Is Tough to Beat
by Jonathan Clements in Wall Street Journal
It’s one of the great investment contradictions. Yes, stock investors do all kinds of goofy things. No, beating the market isn’t easy. On the face of it, this seems absurd. If some folks behave irrationally, others should be able to make money at their expense. Yet, as is patently clear from the long-run market-lagging performance of most stock-mutual funds, it is awfully difficult to beat the market. This isn’t just an issue of how to manage money. It is also a raging debate among finance professors. For years, the prevailing academic wisdom was that the stock market was highly efficient, with prices set by rational investors.
But lately, that notion has come under assault from behavioralists, who argue that market movements aren’t adequately explained by traditional economic models. No doubt about it, irrationality is on display everywhere.
Why do investors trade so much? All that buying and selling can’t be rationally justified. Why do companies bother splitting their stocks, say, two for one? All it means is that shareholders now have twice as many shares, each with a 50% smaller claim on the company’s earnings. Why do companies pay dividends? From the standpoint of taxes, it makes far more sense to buy back stock. Yet shares often rise after a company announces a dividend increase.
“It doesn’t look to me like markets behave as if investors are rational,” says Richard Thaler, an economics professor at the University of Chicago. “Everybody agrees that there are some irrational investors out there,” Mr. Thaler says. “The controversial question is whether they set prices. The behavioralist line is that they do some of the time. The efficient-market line is that prices are set by rational traders.” Not all behavioral quirks hurt market efficiency. Many investors, for instance, are excessively self-confident. This shows up in investors’ ill-advised tendency to trade too much and to bet heavily on a limited number of stocks. But it also manifests itself in the huge effort made to find undervalued stocks, says Mark Rubinstein. “I concede that investors are overconfident,” Mr. Rubinstein says. “But what this means is that active managers spend too much on research. It makes the markets too efficient. It’s like a gold mine where most of the gold has already been taken out.
Occasionally, you’ll find some, which will egg you on. But it’s just not cost-effective to keep mining.” Mr. Thaler says the validity of behavioral economics doesn’t hinge on being able to beat the market. “It could be that stock prices were wildly irrational, but unpredictable,” he says. “If so, it wouldn’t be possible to make money.” Indeed, even if you buy the behavioralist argument that the markets aren’t entirely efficient — and the evidence is compelling — that doesn’t mean you should try to beat the market. No matter where investors stand on the academic debate, they “should behave as if markets are efficient,” argues William Sharpe, a finance professor at Stanford University and a 1990 winner of the Nobel Memorial Prize in Economic Science.
Consider the 1987 stock-market crash, when the Dow Jones Industrial Average plunged 22.6% in a single day. It stands out as a glaring example of irrational behavior on a grand scale. But that doesn’t mean you can predict the next bear market, says Meir Statman, a finance professor at Santa Clara University. “The market may be crazy,” he says. “But that doesn’t mean you can beat it.” After all, if the overall market is a tad screwy, the blame lies with us, the market’s participants. “Individuals make mistakes,” says Hersh Shefrin, also a finance professor at Santa Clara University. “Markets aggregate those mistakes. But in the aggregation, the errors become smaller than those made by individuals. As a result, if you set out to try to beat the market, you’re more likely to fail than to succeed,” after figuring in investment costs.
Even Mr. Thaler, who has turned his hand to money management, readily concedes that beating the market isn’t easy. “The academic dispute doesn’t translate into very big differences in advice for individual investors,” he says. “The efficient-market guy says it’s impossible for the individual investor to make money. The behavioralist will look at the data and say most individual investors don’t make money. So they would both give the same advice, which is to buy and hold.”
The bottom line? The behavioralists may offer some slim hope to the market’s stock jockeys. But in the end, it still makes a ton of sense to settle for average market results, by purchasing index funds.
It’s one of the great investment contradictions. Yes, stock investors do all kinds of goofy things. No, beating the market isn’t easy. On the face of it, this seems absurd. If some folks behave irrationally, others should be able to make money at their expense. Yet, as is patently clear from the long-run market-lagging performance of most stock-mutual funds, it is awfully difficult to beat the market. This isn’t just an issue of how to manage money. It is also a raging debate among finance professors. For years, the prevailing academic wisdom was that the stock market was highly efficient, with prices set by rational investors.
But lately, that notion has come under assault from behavioralists, who argue that market movements aren’t adequately explained by traditional economic models. No doubt about it, irrationality is on display everywhere.
Why do investors trade so much? All that buying and selling can’t be rationally justified. Why do companies bother splitting their stocks, say, two for one? All it means is that shareholders now have twice as many shares, each with a 50% smaller claim on the company’s earnings. Why do companies pay dividends? From the standpoint of taxes, it makes far more sense to buy back stock. Yet shares often rise after a company announces a dividend increase.
“It doesn’t look to me like markets behave as if investors are rational,” says Richard Thaler, an economics professor at the University of Chicago. “Everybody agrees that there are some irrational investors out there,” Mr. Thaler says. “The controversial question is whether they set prices. The behavioralist line is that they do some of the time. The efficient-market line is that prices are set by rational traders.” Not all behavioral quirks hurt market efficiency. Many investors, for instance, are excessively self-confident. This shows up in investors’ ill-advised tendency to trade too much and to bet heavily on a limited number of stocks. But it also manifests itself in the huge effort made to find undervalued stocks, says Mark Rubinstein. “I concede that investors are overconfident,” Mr. Rubinstein says. “But what this means is that active managers spend too much on research. It makes the markets too efficient. It’s like a gold mine where most of the gold has already been taken out.
Occasionally, you’ll find some, which will egg you on. But it’s just not cost-effective to keep mining.” Mr. Thaler says the validity of behavioral economics doesn’t hinge on being able to beat the market. “It could be that stock prices were wildly irrational, but unpredictable,” he says. “If so, it wouldn’t be possible to make money.” Indeed, even if you buy the behavioralist argument that the markets aren’t entirely efficient — and the evidence is compelling — that doesn’t mean you should try to beat the market. No matter where investors stand on the academic debate, they “should behave as if markets are efficient,” argues William Sharpe, a finance professor at Stanford University and a 1990 winner of the Nobel Memorial Prize in Economic Science.
Consider the 1987 stock-market crash, when the Dow Jones Industrial Average plunged 22.6% in a single day. It stands out as a glaring example of irrational behavior on a grand scale. But that doesn’t mean you can predict the next bear market, says Meir Statman, a finance professor at Santa Clara University. “The market may be crazy,” he says. “But that doesn’t mean you can beat it.” After all, if the overall market is a tad screwy, the blame lies with us, the market’s participants. “Individuals make mistakes,” says Hersh Shefrin, also a finance professor at Santa Clara University. “Markets aggregate those mistakes. But in the aggregation, the errors become smaller than those made by individuals. As a result, if you set out to try to beat the market, you’re more likely to fail than to succeed,” after figuring in investment costs.
Even Mr. Thaler, who has turned his hand to money management, readily concedes that beating the market isn’t easy. “The academic dispute doesn’t translate into very big differences in advice for individual investors,” he says. “The efficient-market guy says it’s impossible for the individual investor to make money. The behavioralist will look at the data and say most individual investors don’t make money. So they would both give the same advice, which is to buy and hold.”
The bottom line? The behavioralists may offer some slim hope to the market’s stock jockeys. But in the end, it still makes a ton of sense to settle for average market results, by purchasing index funds.
Random Readings
Click on the link to read the full story
“You need discipline, patience, and courage. You must have a willingness to lose, but a strong desire to win.” – Gary Biefeldt
Stephen Roach on India’s future
“I think it is premature to crack out the champagne and celebrate the dawn of the new Asian century,” says Morgan Stanley, MD, Stephen Roach. But at the same time he explains, “India is a market, a story, a country, an economy and they (investors) need to take it seriously.”
Click here for the whole story
Random Readings
Click on the link to read the full story
‘Buy’ on Infotech Ent: ICICI Sec
‘Neutral’ on Arvind: SSKI
Foreign investments spur growth of stock market
SAIL favours mega merger of steel PSUs — `A single entity is the need of the hour’
Analysts` corner: Timex Watches
Stock watch: K M Sugar Mills
Banks 2005: Benchmarking global standards…
Market valuations stretched: Gryffon Investment Advisors
Open offer season
It’s the capital gain, not dividend, stupid!
Of wealth creators & markets - must read!
‘Neutral’ on Arvind: SSKI
Foreign investments spur growth of stock market
SAIL favours mega merger of steel PSUs — `A single entity is the need of the hour’
Analysts` corner: Timex Watches
Stock watch: K M Sugar Mills
Banks 2005: Benchmarking global standards…
Market valuations stretched: Gryffon Investment Advisors
Open offer season
It’s the capital gain, not dividend, stupid!
Of wealth creators & markets - must read!
“In horse racing, people generally don’t like to bet on a great horse at short odds. Instead they under-bet the best horse and over-bet the worst. The same is true for the stock market.” – William Ziemba
Long Term Investing = Contrarian Investing?
Economists muse about just why it is that stock markets around the world are subject to fits of “irrational exuberance” and “excessive pessimism.” Why don’t rational and informed investors take more steps to bet heavily on fundamentals and against the enthusiasms of the uninformed crowd? The past decade gives us two reasons. First–if we had correctly identified long-run fundamentals a decade ago–betting on fundamentals for the long term is overwhelmingly risky: lots of good news can happen over a decade, enough to bankrupt an even slightly leveraged bear when stocks look high; and lots of bad news can happen over a decade enough to bankrupt an even slightly leveraged bull when stocks look low. Thus even in extreme situations–like the peak of the dot-com bubble in late 1999 and early 2000–it is very difficult for even those who believe they know what fundamentals are to make large long-run bets on them. And it is even more difficult for those who claim they know what long-run fundamental values are and want to make large long-run contrarian bets to convince others to trust them with their money.
As J.P. Morgan said when asked to predict what stocks would do: “They will fluctuate.”
Perhaps this is how it should be: if it were easy to pierce the veils of time and ignorance and to assess long-run fundamental values with a high degree of confidence, it would be easy and safe to make large contrarian long-run bets on fundamentals. In this case the smart money would smooth out the enthusiasms–positive and negative–of the overenthusiastic crowd. And stocks would fluctuate less. And there wouldn’t be teasing evidence at the edge of statistical significance of large-scale deviations of stock market prices from fundamental values.
Source: Bigpicture blog
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Random Readings
Click on the link to read the full story
Markets: The writing is on the wall!
End of bull run or long-term bet?
Analysts` corner: Hero Honda
Stock watch: Mahindra Ugine
Vivek Paul set to ink deal with Sharekhan
Momentum in auto ancillaries: Morgan Stanley
Brics initiates buy on Petronet
Indian equities expensive: ML
Country funds hot now: Durham
For Finance St, 2005 has been a year to remember
Operators run rings round the Sensex
Reliance demerger: You ain’t seen anything yet - a good read!
How GDP is estimated in India
The incredible power of compounding - a good read too!
“In the short run, the market is a voting machine but in the long run it is a weighing machine.” – Benjamin Graham
The Little Essay That Beats the Market
By Joel Greenblatt
I love movies. I hate reading movie reviews. That’s because I don’t like people telling me what to think, plus most reviews merely summarize the plot and give away the ending. That kind of ruins things for me.
Nevertheless, my plan is to ruin things for you. Luckily, we’re not talking about a movie. We’re talking about stock market investing. I’m going to tell you what to think, summarize the basic idea and end with a “magic formula” that can make you a better stock market investor.
So, what should you think? If you want to be a successful stock market investor, you should think about buying pieces of “good” businesses at “bargain” prices. Yes, that sounds simple, but if you actually could find a good business at a bargain price, wouldn’t it make sense to buy it? Doesn’t that sound like an investment strategy that should work!
The only problem is figuring out what’s a “good” business? Well, a “good” business is a business that can earn a high return on capital. What’s that? It’s a pretty simple concept really.
Say you own a store. In my recent book, The Little Book That Beats the Market, we used the example of a gum store (yes, a store that sells only gum–don’t ask!). Anyway, say that store costs $400,000 to build (including inventory, store displays, etc) and last year that store earned $200,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build, sounds like a pretty good business.
But what if we compared that to another kind of store, say a store that sells only Broccoli (we called that store, Just Broccoli, for obvious reasons). What if it also costs $400,000 to open a Just Broccoli store? But what if that store only earned $10,000 last year? Earning $10,000 a year from a store that costs $400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.
So here’s the tough question. Which sounds better–a business that earns a 50% return on capital or one that earns a 2.5% return on capital? Of course, the answer is obvious. You would rather own a business that earns a high return on capital than one that earns a low return on capital.
So, now we know what “good” is–a business that earns a high return on capital. But what’s cheap? In the book, we defined cheap as a business with a high earnings yield. What’s that? Take two businesses, one earned $300,000 last year, one earned $100,000. Both are for sale for $1 million. If we buy the first, we get an earnings yield of 30% ($300,000 in earnings divided by the $1 million purchase price). The second has an earnings yield of 10% ($100,000 in earnings divided by the $1 million purchase price).
Which is cheaper? All other things being equal, the company that earns more relative to the price we’re paying is cheaper than the one that earns less. In other words, getting a 30% earnings yield is better than a 10% earnings yield–a high earnings yield is better than a low one.
And that’s it. Now you know the “magic formula”! What do I mean? Well, in the book we show that if you just stick to buying “good” companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market’s average annual return. And you can do it with very low risk.
Having trouble believing that it’s that easy? Well, how about this? A study we conducted over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period (see Table 1).
Note: The “market average” return is an equally weighted index of our 3500 stock universe. Each stock in the index contributes equally to the return. The S&P 500 index is a market weighted index of 500 large stocks. Larger stocks (those with the highest market capitalizations) are counted more heavily than smaller stocks. Over 17 years, earning 30% a year means $11,000 would have turned into over $1 million! Not bad.
But what if we made it even easier for people to follow the magic formula? What if we created a free website–magicformulainvesting.com–that made finding “magic formula” stocks completely automatic? Would that convince you to try it yourself?
Actually, maybe not. With me being such a blabbermouth, if everyone “knows” the “magic formula” maybe it will stop working? After all, how can any strategy keep working if everyone follows it?
Well, here’s the answer. The great thing about the “magic formula” is that it isn’t that great! It doesn’t work all the time. That’s right. Over long periods of time, it’s true, the results are amazing. But…there are still 1, 2 and even 3 years periods when the formula doesn’t work at all! Most people just don’t have the patience or the discipline to stick it out during those tough periods. After a year or two of following a strategy that underperforms the market, most people simply give up!
That means for the “magic formula” to work for you, you must “believe” that the formula makes sense and that it will continue to work over the long term–even if it hasn’t worked for months or even years. For that, you’ll have to understand why the magic formula makes sense. You’ll have to continue to believe that it still makes sense even when friends, experts, the news media, and Mr. Market indicate otherwise. That’s tough to do! Unfortunately, to really “believe”, I mean really, truly “believe”, you’ll have to be convinced that buying above average companies at below average prices actually makes sense. I believe it does. I hope you “believe” too.
If you do, I know you’ll become a more successful investor. But darn if I didn’t just give away the ending.
Source: John Mauldin Newsletter
