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5 Ways To Beat The Market: Part II Revisited

In a series of articles in December 2014, I highlighted five buy-and-hold strategies that have historically outperformed the S&P 500 (SPY). Stock ownership by U.S. households is low and falling even as the barriers to entering the market have been greatly reduced. Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals. The second of five strategies I will revisit in this series of articles is the “value factor” that has seen stocks with these characteristics outperform the broader market. In a series of articles in December 2014, I demonstrated five buy-and-hold strategies – size, value, low volatility, dividend growth, and equal weighting, that have historically outperformed the S&P 500 (NYSEARCA: SPY ). I covered an update to the size factor published on Wednesday. In that series, I demonstrated that while technological barriers and costs to market access have been falling, the number of households that own stocks in non-retirement accounts has been falling as well. Less that 14% of U.S. households directly own stocks, which is less than half of the amount of households that own dogs or cats , and less than half of the proportion of households that own guns . The percentage of households that directly own stocks is even less than the percentage of households that have Netflix or Hulu . The strategies I discussed in this series are low cost ways of getting broadly diversified domestic equity exposure with factor tilts that have generated long-run structural alpha. I want to keep these investor topics in front of the Seeking Alpha readership, so I will re-visit these principles with a discussion of the first half returns of these strategies in a series of five articles over the next five days. Reprisals of these articles will allow me to continually update the long-run returns of these strategies for the readership. Value In the first article in this series, I described the “size factor”, or why small-cap stocks tend to outperform large-cap stocks over long time intervals. The size factor is captured in the Fama-French Three Factor Model that helped earn Eugene Fama the Nobel Prize in Economics in 2013. Another of these factors is the “value factor.” The researchers noted that low market-to-book stocks tended to outperform high market-book stocks. Adding the “size factor” and value factor” to the Capital Asset Pricing Model better describes the stock market performance than beta alone. Since we are trying to beat the general market, it makes intuitive sense that alpha would be found in a value factor that was used as a supplement to better describe overall returns. Our second way to beat the market, as proxied by the S&P 500, is then to simply buy value stocks. Below I have tabled the average returns of the S&P 500 Pure Value Index, and show the returns of this index graphed against the S&P 500. For more information on this style-concentrated index, please see the linked microsite . This index is replicated through the Guggenheim S&P 500 Pure Value ETF (NYSEARCA: RPV ) with an expense ratio of 0.35%. The S&P 500 Pure Value Index identifies constituents by measures of high levels of book value, earnings, and sales to the share price. In the five strategies I am detailing to “beat the market”, I will be using trailing 20 years of data, which is the longest time interval that encapsulated all of the relevant indices used in the analysis. (click to enlarge) Source: Bloomberg; Standard and Poor’s Source: Bloomberg; Standard and Poor’s Why has value investing worked historically? Why has the S&P 500 Pure Value Index outperformed over this long sample period? Value investing has been extolled since the days of Benjamin Graham, and put into most visible practice by his pupil, Warren Buffett. Value investing necessitates understanding the difference between a stock that is valued too low by the market, and a stock that is a “value trap” because changes in the business or its industry have created a structural headwind. Value investors then need to have the fortitude to hold their investment when investor sentiment runs counter to their investment themes. On average, individual investors do not have these attributes. In data from “How America Saves”, the fund giant Vanguard has published a wealth of data on defined contribution plans under its management. The table below shows participant contributions in Vanguard’s defined contribution plans over the trailing ten years. Investors should on average be taking a long-term view towards their retirement assets; however, investors owned their lowest percentage of equities in 2009 as markets rebounded from the 2008 downturn, missing a 26.5% total return for the S&P 500 and a tremendous 55.2% return for the S&P 500 Pure Value Index. Source: Vanguard – an updated version of their analysis is linked . In the four years that the S&P 500 produced a negative return in our twenty-year dataset, the value index produced a higher return in the following year. In the Vanguard data, retirement plan participants, who should be taking a long-term view towards their investments, were less likely to own equities after 2008. Value investing is a discipline, and the average investor is not suited to follow this approach, which may be why a low-cost, rules-based exchange-traded fund with a value bent like may be a good solution for some investors. While a value-based strategy has historically outperformed, you can see from the data table below that the value-based index lagged in the first half of 2015. Source: Bloomberg, Standard and Poor’s This 249bp first half underperformance relative to the S&P 500 was the last first half underperformance since 2012. In that year, value stocks rebounded by generating a nearly 18% return in the second half versus a 6% return for the broader market. Value stocks have only produced negative returns over the first six months of four calendar years in the dataset, 1994, 2000, 2008, and 2015. Two of those periods (2000 and 2008) preceded economic recessions and one year 1994 – featured sharply higher interest rates. As I wrote in my 10 Themes Shaping Markets in the Back Half of 2015 , with stock prices near all-time highs and bond prices still elevated from low interest rates despite the first half sell-off, forward returns in asset markets will continue to be subnormal. For long-term investors with a buy-and-hold approach, the value factor has generated alpha over long-time intervals. I will be publishing updated results for three additional proven buy-and-hold strategies that can be replicated through low cost indices over the next three days. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Beta: The World’s #1 Passive Fund

Summary I own Vanguard’s Total Stock Market Portfolio in their 529. Here is why I own it and why everyone should consider it. You can make a tax-advantaged contribution at a significant scale. #1 Passive Fund in the World I have always mixed active investing ideas with some amount of passive market exposure. Passive exposure is cheap, simple, and tax-efficient. It also provides me with a little insurance against the results of my active ideas. My #1 favorite place to get market exposure with these benefits is Vanguard’s Total Stock Market Portfolio (MUTF: VTSMX ) within Vanguard’s 529. It has done well since inception: It is up over 50% since I discussed it as a long idea: Management Vanguard claims that, We hire top investment professionals with the experience and expertise you’d expect from Vanguard. But this is an unmanaged fund, so as long as they can keep the books straight, they could also, hire psychotic crack fiends with the experience and expertise I’d expect from San Quentin. for all that I would care. Service Their service is fine. You get 25 free trades per year if you keep over $1 million and you get 500 free trades per year if you keep over $10 million at Vanguard. They are quite generous about this status as they count the entire family’s balance towards the requisite total. In addition to the free trades, they also give you the name and phone number of a competent representative who typically can solve problems associated with such accounts. 529s A 529 savings plan is an investment account intended for college and other higher-education costs. They are sponsored by individual states and offer various tax benefits. Earnings are deferred from federal taxes. Withdrawals for qualified higher-education expenses are also tax-free. You can make up to five years’ worth of contributions at one time without triggering gift tax. The uses are pretty generous – you can use the money for tuition, room and board, books, and other expenses. Why Nevada? Nevada is one of the few remaining states without any income tax. If you have flexibility as to where you live, these are probably states worth considering. Of the bunch, Wyoming is my favorite. If one lives in Wyoming close enough to Montana to shop there, you can pay Wyoming’s zero percent income tax and Montana’s zero percent sales tax. As for Nevada, since they lack a state income tax, they cannot lure Nevadans to their 529 with promises of avoiding state income tax. Instead, they have offered every other type of inducement. Their contribution limit of $370,000 is high. Funds are removed from your estate and are exempt from creditors’ claims. They are lenient about any requirement to withdraw funds. Why Vanguard? Compared to the alternative in Nevada, Vanguard’s 529 allows you to invest in Vanguard funds. The alternative fund costs from 0.29-0.89%, while the expense ratio on my favorite Vanguard fund is 0.21%. Vanguard’s minimum initial contribution is $3,000 instead of $250, but the whole idea with this investment is to make a large investment and to hold it for a very long time. There are no enrollment fees for either Vanguard or the one alternative to Vanguard in Nevada. Why the Total Stock Market Portfolio? While this fund is highly correlated with the S&P 500 (NYSEARCA: SPY ), it is somewhat more diversified. It includes smaller capitalization companies. In doing so, it avoids some of the turnover associated with companies entering and exiting the S&P 500. That reconstitution generates trading fees and taxes. Companies included in the S&P 500 trade at a premium, which one has to pay every time one buys an S&P 500 index fund or ETF. Owning a broader based fund avoids such expenses. But whether or not you agree with my rationale, the difference is trivial: Scale This is a tax-advantaged fund 67x your IRA contribution limit. For 2015, the IRA contribution limit is $5,500 ($6,500 for people 50 or older). One might as well fund it, but the scale is small. The 529 limit is $370,000. If you are married, you can each invest $370,000 with oneself as the owner and beneficiary. At that scale, this investment has already been worth over $1.1 million since inception and over $391,000 since I last discussed it. This is an ideal vehicle for long-term tax-free compounding. Withdrawals This investment idea works well regardless of your intention for the proceeds. It works best when invested for at least a generation or longer. However, regardless of your time-horizon, it is more flexible than it first appears. There are at least five great ways to use the proceeds. 1) College for your kids and grandkids First, one can use it for its intended purpose: college, presumably for your kids or grandkids. It is easy to transfer money from one beneficiary to another. You can transfer assets in increments of $70,000 once every five years without any gift tax. Higher education is expensive and getting more expensive. It should be no surprise that we suffer under the highest inflation where there are the most third party payers. The government enters the bid side of a market with no price-sensitivity and it… increases prices: Is the expense more worrisome or is the fact that politicians fail to see the connection between their behavior and prices? In any event, it is likely that you will have higher education bills in your future. 2) College for yourself Secondly, you can spend the money on yourself. Whether or not you have kids or grandkids (or have any inclination to subsidize said kids/grandkids), you can still save the money in a 529 and spend it on… your own bad self. Courses in wine tasting and golf in an idyllic college town would not be terrible. 3) College as philanthropy Thirdly, you can give the money away. Even if you do not want to spend it on either your progeny or yourself, this would make a perfect foundation for your philanthropic educational efforts. Whether or not you will have college bills to pay, someone certainly will. You will be able to help them. 4) Future expanded usage Fourth, it is reasonably likely that the hodgepodge of tax-advantaged accounts will be simplified and consolidated in the future. If this one is consolidated with others intended for retirement or healthcare, then the limitations on usage will have effectively disappeared. Over the next fifty years, this is highly likely. 5) Just pay the penalty… you will still come out ahead Fifth and finally, you can simply pay the penalty. But here is where this idea gets really interesting, in fact dominant as a strategy: the penalty is too small . Federal law imposes a 10% penalty on earnings for non-qualified distributions. While I never plan to pay this penalty, the value of 10% of the earnings on the back end will probably be far less than the value of compounding tax-free in the interim decades. Even if you intend to spend the money on wine, women, and song (and fail to find an anthropology course “Wine, Women & Song 101”), then you can compound tax-free, pay the penalty, and still end up ahead. Scholarship Encouragement If your kids fully expect that you will pay for college, it can be harder to encourage them to find scholarships. There are piles of scholarship dollars everywhere for almost every type of kid. The key is for them to be motivated to find it and get it. If they receive a scholarship, then the penalty for withdrawing money from a 529 is waived. My hope is that my kids attend military academies (also that my daughter elopes). If the plan succeeds, then there are decades ahead of tax-free compounding without any restriction on some withdrawals. In order to interest them, I am offering each kid half of whatever they earn in scholarship money. Conclusion If you max out your 529 contribution and then wait for a long time, you will benefit from tax-free compounding at a significant scale. At the same time, the cost of the limitations on withdrawals is manageable. With that base of passive market exposure, one can turn to active ideas. My best ones are here . Disclosure: I am/we are long VTSMX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

The Drop In How Many U.S. Stocks Equaled 1 Greek Economy?

The article shows that the capitalization change of a small number of large-cap U.S. stocks equaled the entire annual output of the Greek economy. This effort is in part to frame the impact Greek turmoil is having on U.S. assets. A qualitative discussion of whether this capitalization change is warranted is included. The title of this article asks readers to guess the number of U.S. stocks whose reduction in market capitalization on Monday was equivalent to the size of annual Greek economic output. The answer: 86 To come up with the figure, I compared the gross domestic product of the Greek economy from the World Bank to the capitalization change of the largest components of the S&P 500 (NYSEARCA: SPY ) by market capitalization until the change in value equated to the Greek GDP of $242B. I had some notable takeaways from this data that I wanted to share with readers. The question for market participants is whether these moves are justified. If the value of an asset is its future cash flows discounted back to the present, then the reduction in domestic equity prices on Monday was either a function of an expectation of lower future cash flows and/or a higher discount rate. The former, lower future cash flows, seems unlikely to have had a large impact given the limited trade between the U.S. and Greece and the fact that the Greek economy is roughly the size of the Minneapolis-area economy. The negative translation effect of broader global cash flows earned by these U.S. companies from a strengthening U.S. dollar would have had a proportionately larger impact. That means that the re-pricing of risky assets is more likely a function of a higher discount rate. The interest rate component of the discount rate fell on Monday as U.S. rates rallied on a flight-to-quality bid signaling that an “equity risk premium” applied to U.S. equities increased to move the discount rate higher. While the outcomes from a potential “Grexit” remain uncertain and difficult to analyze, the transmission mechanism for broader global contagion seems equally uncertain. The potential financial sector link, which roiled equity markets in 2012 given the amount of Greek debt held by European banks at the time, appears to have been muted by a rotation of Greek debt from bank balance sheets to official creditors, enhanced stability mechanisms, European quantitative easing, and much lower yields in the periphery. While the odds of a disorderly outcome in Europe are certainly rising, investors must handicap how much of a risk premium on global assets is justified. While we are likely to continue to see heightened volatility in the near term, if the Greek drama was responsible for the entirety of the move on these 86 companies, I believe that the impact has been overstated already. Disclaimer : My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.