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Valuations Are 80% Of The Stock Investing Story

By Rob Bennett I often make the claim that it is a terrible mistake for buy-and-holders not to take valuations into consideration when setting their stock allocations, because the peer-reviewed research in this field shows that valuations are the most important factor bearing on whether an investor achieves long-term investing success. I say that if you get valuations right, you are almost certain to do well in the long run even if your understanding of all other issues is poor, and that if you get them wrong, you are almost certain to do poorly in the long run even if your understanding of all other issues is strong. I sum up the point by stating that the valuations issue comprises roughly 80 percent of the stock investing story. It’s an informed estimate. I don’t believe that there is any way to say precisely how big an impact understanding valuations will have on an investor’s long-term success. But the evidence that I have seen has persuaded me that the valuations factor is of far more importance than most people realize, that it may well be 80 percent of the stock investing story or perhaps even a bit more than that. How much would you say that price matters when buying a car? It’s certainly not the only factor. You need to be sure that a car is well made. A poorly designed car is not a good deal even at a low price. And you need to be sure that the car you buy is one well suited to your needs. Someone who desires a sports car will not be happy with even a well-designed family van. And there are lots of personal considerations that need to be taken into account. Some people like red cars. Some people like black cars. Getting the color right can add a good bit to your enjoyment of the car you buy. Still, I think it can be said that researching prices and negotiating a good deal on price is 80 percent of what makes one a successful car buyer. Getting the color right is easy – you just need to be willing to drive to a second dealer if the first one you visit does not have the right color in stock. And it doesn’t take too much effort to identify the best style of car to satisfy your particular needs. We all know what is out there. You might need to check out a few vehicles to decide which particular sports car or which particular family van is right for you. But it is not difficult to get that aspect of the car buying experience settled in your favor. Nor does it take much research to learn which cars have a reputation for being built well. Getting the price right is harder. If you accept the dealer’s price, you are almost certainly going to overpay by hundreds of dollars, and quite possibly by several thousand dollars. If you do enough research to enter the dealer’s lot with confidence that you know the fair market value of the vehicle that you intend to purchase, and are willing to invest the time and energy needed to negotiate a good deal, you are going to enjoy a huge dollar return for the hours invested. You can improve your car deal by thousands of dollars by working the price aspect of the matter, potentially turning a very bad deal into a very good deal by focusing on this all-important issue. There is now 34 years of peer-reviewed research telling us that it works precisely the same way when buying stocks rather than cars. The safe withdrawal rate in 2000 was 1.6 percent real. The safe withdrawal rate in 1982 was 9 percent real. This means that a retiree with a $1 million portfolio who began her retirement in 1982 could live the life available on a $90,000 budget for her remaining years, while a retiree with a $1 million portfolio who began her retirement in 2000 could only live the life available on a $16,000 budget for her remaining years. That’s a big difference! It is critical to take valuations into consideration when planning a retirement. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the retirement planning story. The story is the same for investors who are in the stage of life where they are accumulating assets, rather than living off the earnings from them. A regression analysis of the 145 years of historical data available to us shows that the most likely 10-year annualized return for stocks purchased in 1982 was 15 percent real. The most likely 10-year annualized return for stocks purchased in 2000 was a negative 1 percent real. That’s a difference of 16 percentage points of return! For 10 years running! Knowing about that difference and taking advantage of the knowledge by going with a higher stock allocation when going-forward returns are likely to be good than you go with when going-forward returns are likely to be poor turns the magic of compounding returns very much in your favor. I think it would be fair to say the numbers show that valuations are roughly 80 percent of the asset allocation story too. Lots of non-valuation factors matter. Interest rates matter. Unemployment rates matter. Consumer confidence levels matter. Inflation rates matter. And on and on. But those factors are all factored into the price that is available to the individual investor considering a stock purchase. So, while these other factors play a role in the investing game, we as individual investors need not pay attention to them. There is only one decision in our control – what percentage of our portfolio will be comprised of stocks. If we buy at good prices, we always do well in the long term. There has never once in the history of the market been an exception to this rule. And if we buy at bad prices, we always do poorly in the long run. Again, there has never been an exception. Most investors accept that valuations matter. But few realize how big a factor the valuations factor is (I can’t help but wonder if the reason might be that there is so much money to be made on the selling side by persuading investors that valuations are not a big deal). The reality is that the stock market is like every other market known to humankind – price is by far the dominant factor in the determination of whether market participants are able to achieve a good deal or not. Disclosure: None.

Short-Selling: What Are You Optimizing?

Summary What separates investing from gambling? Positive expected value. Short-selling has a negative expected value – more negative than some casino games. What are you optimizing? In theory investing is about optimizing return, but many investors’ behavior suggests they are optimizing/minimizing something else. For some heavy short-sellers, it’s intellectual stimulation. I don’t think short selling is right for me or most investors, but this is just my still-evolving opinion. Full disclosure: I’ve never shorted a stock in my life. As such, I’m probably terribly biased and not credible. Short selling is betting that a stock or security will go down. Instead of buying low and selling high, you first sell high and then buy low. You do so by borrowing someone else’s shares when you initially sell and then replacing those shares later on by buying them. For reasons I will explain in this article, I don’t think most investors, including myself, should engage in short selling. Some should, but even for those for whom short selling (“shorting”) is appropriate, it probably should not be used as a primary strategy. This argument has been hashed out many times. I could repeat what’s been discussed many times. For example, when you engage in shorting your upside is limited and downside unlimited – the unfavorable reverse of going long. Instead, I will focus on what I see as the most important points for me and perhaps where I’ve added some original thought. When you short-sell a stock, the odds are against you What separates investing from gambling? Sure, investing isn’t done in a casino, it’s much more calculated, there’s far more money in it, etc. The biggest difference though, is that when you gamble, there is a negative expected value – the odds are against you. The casino takes a cut. When you invest, there is no golden rule saying it has to be a favorable bet, but equities in the US have been increasing rather consistently for over 150 years (see Jeremy Siegel’s excellent book Stocks for the Long Run ). Studies of “rules-based” systematic investing styles like buying the lowest 10% of the market by EV/EBIT and rebalancing annually will often include the returns of the opposite decile (the highest 10% of the market by EV/EBIT in our example). The idea is that the larger the gap in returns between the two poles, the more predictive value the metric has. So what’s the point? Well when you look at these studies, it’s surprisingly hard to find one where the worst decile is actually delivering negative returns. This is significant because it means that stocks don’t only appreciate substantially on average, it’s also hard to find some that will go down at all. For myself and presumably many other investors, this odds-against-you fact is a total deal breaker. I remember in high school, I would print out the Las Vegas odds of each weeks NFL games and offer to do straight bets with anyone on any game so long as I had the favorite. I was okay with this activity because by picking the favorite without paying for it, I had a positive expected value – even though I didn’t know that term at the time. Several months ago, I was viewing the Ultimate Fighting Championship with family and someone suggested we bet on the fights. We would pool money and bet on who would win the fight and what round (or decision) they would win in The gamble was, on the surface zero-sum. No one was taking a cut of the bets. And I did research. I immediately pulled out my smartphone and looked up the favorite in each fight. I then looked up what percentage of UFC fights end by knockout versus decision. (click to enlarge) 41% of fights go to decision. Assuming a three round fight (most fights are 3 rounds, championship fights are 5), that 41% is significantly higher than the 25% it would be if each outcome were equally likely. So in each fight, I picked the favorite by decision with some confidence that I had a positive expected value. I won three out of the four fights we bet on. My approach to these situations where the game is explicitly zero or positive sum is in stark contrast to negative expected value situations. Casinos take a cut of all bets by structuring games such that odds are slightly in their favor. The lottery usually has a very negative expected value because: the winnings are taxed at the highest federal income rate and by your state as well municipalities take a huge cut (it’s a significant source of revenue for them) the advertised prize is not a present value, it’s usually a long-term annuity – taking the cash up front means getting far less there could be multiple winners that split the winnings, and the probability of this increases when the pot is large and many tickets are sold, offsetting the EV benefit of the higher pot. I’ve never engaged in these sorts of activities and would have a lot of trouble forcing myself to. It is counter to the investor mindset. But short sellers do just this. On average, they will lose money. The expected value is negative. The idea, though, is that by doing deep enough research and being opportunistic enough, they can make the expected value positive. This is tough for me to accept. First, the odds are dramatically against them on the surface. If stocks appreciate 9.5-10% a year in nominal terms, those odds are far worse for the short seller than some casino games. For example, in blackjack, the odds of you winning versus the dealer are 48%. Roulette is something like 47.4%. If stocks are appreciating 9.5-10% that’s the equivalent of ~45%. And that’s just the direct costs. Then there’s taxes, dividends you must pay on the shares you short, borrowing costs on hard to borrow stocks (unfortunately, many of the stocks with the best short cases have the highest borrowing costs because everyone wants to short them). This is somewhat offset by the fact that you can (I believe) use some of the cash you receive from the sale upfront for other things in the interim. I believe this depends on your creditworthiness as perceived by your broker, the size of the short sale relative to your assets, etc. Some brokers may require you to keep the margin in cash, which eliminates this benefit. The bottom-line: short selling is a negative expected value activity, so why do it? What are you optimizing? Value Investors Club is a great site. The quality of research is very high and there are some smart people on it – some of the smartest people in the investment industry, in fact. That’s why it confounds me that some of these investors are so short-focused. Some of these investors have written 25 articles and like 23 of them are shorts. Some of the smartest investors with the highest profiles are also heavy shorters. David Einhorn and Bill Ackman come to mind. Ackman now describes his firm as primarily long but opportunistically short, which may be the case, but historically he’s done a lot of shorting. I have a theory that these investors are attracted to shorting precisely because the expected value is worse than going long. It’s harder. It requires deeper research. It’s intellectually stimulating. It’s exhilarating. These things probably really appeal to smart people with a chip on their shoulders for some reason. But what is investing about? Is the goal of investing to optimize return or optimize intellectual stimulation? Most investors agree verbally that it’s all about return, but most don’t behave that way – and there are other examples. Obsessions over volatility, dividends, minimizing taxes, etc. are all examples of other things I’ve found many investors trying to optimize through their behavior. Buffett has said a few insightful things on this topic: “You don’t get points for difficulty” The mono-linked chain metaphor The one-foot hurdle metaphor It is certainly understandable that for investors capable of analyzing and understanding very difficult situations, it is challenging to focus on easy ones. Conclusions I have some other thoughts like the idea of specialization – maybe an investor, for some reason like a deep skeptical streak, is much better at shorting than going long – but they will have to wait for another post. This article is just me putting my thoughts to paper. At this point, I’m comfortable recommending that most investors (including myself) focus on positive expected value situations to optimize return and that means avoiding short selling.

Is There A Holy Grail To Investment Success?

It is possible to beat the market averages, otherwise managers like Warren Buffett and George Soros would not have done so consistently for many years. Investors should maximize the geometric mean of their outcomes instead of the arithmetic mean. Leverage destroys the geometric mean of returns over time, which is why it should never be used. The efficient market hypothesis only applies to equity exclusive investors and equity fund managers. Investors who manage concentrated stock portfolios and multiple asset classes can beat the averages. As Dr. Edward Thorp discovered the secret to beating the game of blackjack, investors can use probability to beat the stock market by skewing the odds in their favor. The Holy Grail is described in mythology as the cup that Christ drank from during the Last Supper, and is described as having mystical and miraculous powers. It is the stuff of medieval and Arthurian legend. It is also metaphorically described as something magical and elusive that may or may not exist. For investment professionals, the Holy Grail would be a formula for trading the financial markets that generates superior results. But to determine whether the Holy Grail exists or not we first have to define our terms. What results would classify a trading or investment formula as the Holy Grail? Would it be a strategy that simply beats the stock market averages or beats it by a lot? Some theorists believe there is no investment Holy Grail, just as some believe there is no secret to financial success. But throughout human history there have always been people who succeeded financially and those who did not. Is there a key that separates the successful from the unsuccessful? There must be otherwise it would not be happening, the same way it has happened for thousands of years. The proponents of the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) would have you believe that it is not possible to beat the market averages and that everyone should just buy an index fund and be done with it. But if that were true there wouldn’t be managers such as Warren Buffett and George Soros and numerous others who have beaten the averages consistently for many years. If the odds were against them, then they would have lost money or their results would have mirrored the averages. It is obvious they are doing something different from the norm. The question is, what is it? Proponents of EMH argue the averages cannot be bested because they take the performance results of the equity mutual fund industry as a whole and compare it to the market averages. The problem with this reasoning is they fail to make the connection that equity mutual funds as a whole are the market. Of course, their results will not significantly differ from the averages. That is like saying someone who bets on every horse in a race cannot lose. Of course they can’t. After years of experience and extensive research, I’ve come to the conclusion that the Efficient Market Hypothesis, while valid, only applies to equity exclusive investors with broadly diversified stock portfolios. In other words, it applies to individual investors who only buy stocks, as well as equity fund managers. For example, if you are a stock fund manager with a required minimum of 100 stocks in your portfolio, then you will be at a disadvantage. Over time, your results will not significantly differ from the averages, and transaction costs will leave your results below that of the averages. Mathematically speaking, there are two ways to beat the stock market averages: Have a concentrated equity portfolio Own multiple asset classes Leveraging a portfolio will not beat the market averages, as I will explain later. For example, let’s say we have a DeLorean and went back in time to the year 1990. For argument’s sake, let’s say you wanted to invest in equities, but could only buy 5 stocks. You decided to buy Microsoft (NASDAQ: MSFT ), Intel (NASDAQ: INTC ), Apple (NASDAQ: AAPL ), Starbucks (NASDAQ: SBUX ), and Wal-Mart (NYSE: WMT ). How would your portfolio have fared? We all know the answer to that. A portfolio of these winners would have left the market averages in the dust. Of course, hindsight is always 20/20, but this example demonstrates the power of a concentrated portfolio with superior performers. The trouble is, no one could have predicted that result let alone had the wherewithal to stay with those positions. The other way to beat the averages is to own multiple asset classes. Different asset classes, such as bonds, precious metals, real estate, and cash, can not only reduce the overall risk of your portfolio, but also make it more profitable. By holding different asset classes and rebalancing them regularly, investors will be profiting from market fluctuations. This differs from the margin speculator who is betting on the direction of the market. He will always lose in the long run to the balanced investor. The purely mathematical reason for this is because big losses hurt you more than big gains help you. Let’s say you start with $1000 and enter an investment that combines a 9 percent gain with a 9 percent loss. You would end up with $992. In contrast, let’s say a speculator entered the same position, but instead used 10 times the leverage. He would end up with $190 at the end. Roughly an 80 percent net loss! This is astonishing when you think about it, especially given the number of traders out there who are holding naked margin positions. When you ask most speculators about the potential risks of their trading systems, they think simplistically that a 90 percent gain combined with a 90 percent loss will be a wash with no net gain. This is incorrect because they aren’t grasping the concept of the arithmetic versus the geometric mean. With the arithmetic mean or simple average, you add up all the outcomes and divide by the number of outcomes. Whereas, the geometric mean multiplies the outcomes and takes the root of the number of outcomes. For example, let’s take 3 numbers: 1, 7, and 13. The arithmetic mean or simple average would be 7, whereas the geometric mean would be 4.5. (1 + 7 + 13) / 3 = 7 Simple Average ³√ (1 * 7 * 13) = 4.5 Geometric Average The geometric mean is calculated by multiplying the three numbers and taking the cube root of the product. Compound return is geometric average, not simple average. Leverage always lowers the geometric mean of outcomes over time because once again, big losses hurt you more than big gains help you. Every consistently winning manager emphasizes and follows this rule. Large losses destroy a portfolio, and reducing or eliminating leverage is the first step to increasing absolute return. Investors should always choose the game with the highest geometric mean of returns. This is the Holy Grail. However, if you define the Holy Grail as an investment system with all gains and zero losses, not even in the short term, then I would agree there is no Holy Grail. But a system that significantly beats the market averages over time could be classified as such. In 1962, a mathematician by the name of Edward O. Thorp published the book, Beat The Dealer, which presented the first popular mathematical system for beating the game of blackjack. The card counter was born. Contrary to popular opinion, the card counter was not immune to losses. He could lose half his bankroll during a losing streak. But if the counter kept playing, he would beat the casino significantly. It was just a matter of time. The odds were on his side. Dr. Thorp discovered the Holy Grail of beating the game of blackjack. It was a probability puzzle and he figured out how to skew the odds in his favor. The financial markets are nothing more than one giant probability puzzle. If others have beaten it, it is entirely possible that you can too. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.