Bad Timing

Here’s an article I found a long time ago, entitled “When Index Funds Go Bad [registration required: may I suggest].” It has been sitting in a draft post for a long time and just today my last post inspired me to publish it. The title doesn’t accurately describe what the article is about. What she talks about applies to all investments, not just stocks. Here’s the main thesis:

Indeed, investors of all stripes are notorious for their poor timing: They often purchase investments after periods of strong performance and sell them belatedly after periods of weak performance. Those timing decisions thus have a major–and negative–impact on the returns shareholders actually pocket.

She then looks at “dollar-weighted returns to gain a better understanding of how investors have really fared, because dollar-weighted returns account for cash flows in and out of a fund.” The results, in my opinion, are quite staggering:

The results indicated that, as with most active funds, investors’ timing decisions were costly when it came to index funds. The dollar-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of the third quarter 2005. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. That’s not chump change.

There is a chart given which gives the dollar-weighted returns and the official returns for many index funds. Over a 10-year period the gap between the two returns ranges from -0.8% to -6.18%. The whole article is excellent and I highly recommend reading it. I will just provide the last paragraph as I think it sums things up pretty well:

Clearly, index investors aren’t immune from the behavioral biases that can produce bad results from good funds. Although many of indexing’s most vocal proponents (Burton Malkiel and Jack Bogle, for example) also preach the importance of disciplined, long-term investing, it appears that many investors didn’t heed that advice. True, investors were challenged by one of the most precipitous bubbles in stock market history, and I take some comfort from the fact that asset flows into index funds have smoothed out over the past few years. But many still have a propensity to pile into the hottest funds at just the wrong time. Witness the recent strong inflows many energy funds have experienced this year. I mistakenly assumed that index funds were less likely to invite such behavior, but this study proved me wrong. I still think index funds provide investors a great way to get low-cost, no-fuss exposure to the stock market, but they are good investments only if shareholders use them wisely and maintain the long-term orientation that’s necessary to benefit from all they have to offer.

Investors are always being told to pay attention to MERs. To look at low-cost ETFs as an alternative to index mutual funds or actively-managed mutual funds. Some people take this to the extreme, recommending ETFs (with MERs of around 0.25-0.5%) instead of index mutual funds (with MERs of around 0.5-1%). To save a few percent on your annual return? As this study shows, a much more important factor affecting your portfolio’s performance has to do with keeping your head. This is something that is easier said than done. As Benjamin Graham said on page 8 of The Intelligent Investor,

We shall say quite a bit about the psychology of investors. For indeed, the investor’s chief problem–and even his worst enemy–is likely to be himself.

This is what investing intelligently is all about. This kind of intelligence, explains Graham, “is a trait more of the character than of the brain.”

Investors May Let Emotions Drive Decisions

I found this excellent article, “Investors May Let Emotions Drive Decisions” on The Mess That Greenspan Made.

Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case,” Tilson wrote in a paper called “Psychology & Behavioral Finance.”

One problem: We’re too emotional. A study published in “Psychological Science” co-authored by professors at Stanford University, Carnegie Mellon University and University of Iowa pitted people with normal brains against people whose limbic systems, the brain’s emotional center, were impaired.

The paper asks whether a neural systems dysfunction that curbs emotion can lead, in some circumstances, to more advantageous decisions. The answer, in terms of investing, was yes.

In the study, people were given $20 in play money and could invest it $1 at at time. Winning or losing was decided by a coin toss, the winners would win $2.50, more than tripling their initial investment. The losers would lose the dollar they invested. The odds were clearly in the investors favour. Yet the people with normal brains became more conservative after losing. The people with impaired limbic systems did not.

“Medical study confirms brain impairment HELPS improve investment returns,” Ajay Singh Kapur, chief global equity strategist at Citigroup, wrote in a summary of the study.

He uses the study as an argument for fighting instinct and getting into the market when investment sentiment is most negative and exiting when investor sentiment is high.

Benjamin Graham talks a lot about NOT thinking too hard when it comes to investing (unless you make it your full-time job like him) and keeping a simple, conservative approach: “It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.” As well, there is the quote I gave at the bottom of this article.

This is one of the key aspects of the Intelligent Investor, “harnessing your emotions.” In the commentary for the Introduction, Jason Zweig writes:

What exactly does Graham mean by an “intelligent” investor? Back in the first edition of this book, Graham defines the term–and he makes it clear that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself.”

2 tips from Graham

The has an excellent little summary of two of the key concepts from the Intelligent Investor: 1) Buying stocks makes you an owner and 2) Always buy with a margin of safety.

The author expands on 1), saying that as an owner of a stock you have a right to get answers from management about their performance and to demand better. Doing this kind of thing is not out of the reach of people like Buffett or Bill Ackman who own significant portions in common stocks. But I think it is important to think about buying stocks as ownership in a company and not just a randomly fluctuating ticker symbol. It’s helpful to ask, as Graham often does, if this business were a private business, would you buy it at the current market price? 2) Always buy with a margin of safety, is extremely important. The article says,

Graham details just how to buy with a margin of safety, which he calls the “central concept” of investing. Put simply, the “margin of safety” is the difference between the intrinsic value and the price at which a stock trades. For example, a security worth $50 per share but trading at $25 per share enjoys a massive 100% margin of safety. Buying in that situation heavily stacks the odds in favour of the investor.

The margin of safety concept is very important. The term “safety” reminds me that buying low not only improves the odds of a greater return in the future, but ensures greater “safety” against a significant loss, compared to a stock which is trading at a high price. After all, this is the main purpose of investing, as Graham defines it at the beginning of Chapter 1 of the Intelligent Investor, where Graham quotes himself, from the 1934 edition of Security Analysis: “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” How can one ensure a margin of safety? Graham hints at this early on, in the Introduction, entitled, What This Book Expects to Accomplish: “we shall suggest as one of our chief requirements here that our readers limit themselves to issues selling not far above their tangible-asset value [book-value, or net-asset value] . . . The ultimate result of such a conservative policy is likely to work out better than exciting adventures into the glamorous and dangerous fields of anticipated growth.”

Clearly, Graham was not about speculation, and he favoured a conservative and boring approach to investing. In the Appendixes, written by Buffet, he tells about a man named Walter Schloss. Walter never went to college but took one course taught by Ben Graham at Columbia and later worked at Graham-Newman. His strategy? Buffett recalls Adam Smith wrote about him in Supermoney,

He has no connection or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it. . . Money is real to him and stocks are real–and from this flows an attraction to the “margin of safety” principle.

Buffet continues,

Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. . . He simply says, if a business is worth a dollar land I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. [italics his]

Looking at Walter Schloss’s returns in the Appendixes show some pretty amazing returns. From 1956 to 1984, WJS Limited Partners had a 16.1% annual compound return and WJS Partnership had a 21.3% annual compound return. That compares to an 8.4% return for the S&P500 over the same period. Pretty impressive returns for what sounds like a very simple approach to investing, on the surface. We cannot forget of course that Walter J. Schloss probably spent his entire day pouring over annual reports for many companies, which is no small chore.

Finally, the author of the Fool article offers a glowing recommendation for the Intelligently Investor:

I’ve read and re-read my copy of The Intelligent Investor. It is lined with yellow highlighter ink. Reading that book was one of the most important steps I took toward developing a lucid investment strategy. And I believe Buffett was right when he called it the “best book on investing ever written.”

I second his comments, and that reading this book was one of the best investments I ever made, after getting a university education. I am just now going through it for the second time, only now I am covering it in yellow highlighter ink as well. I’ve had to take a short break this week as I need to buy a new highlighter already, after just the first two chapters!

Diversify, or Quit Your Day Job

Saw this article, “To Diversify or Not to Diversify” on the Canadian Capitalist’s blog and at Consumerism Commentary. Kiyosaki seems to recommend not diversifying (for “any investor who wants to be a rich investor”) yet he keeps reminding us that “to become a professional investor, the price of entry is focused dedication, time, and study” and that finding the best investments (focusing) means “sifting through hundreds of offers, studying, analyzing, and determining the pros and cons of each.” He is correct. For me to not diversify my portfolio, I would have to devote my entire day (and life) to investing.

And finally he says one of the reasons “the rich get richer is because they are focusing, while the middle class is diversifying.” He fails to mention the possibility that the rich are getting richer because they have access to far better (and more costly) financial advice than the rest of us, and access to far more capital which gives them access to far more investment and speculation opportunities. And he fails to mention getting better financial advice as an alternative to diversifying. Instead, he tells us blindly focus our investments rather than diversifying, because after all “people like Warren Buffett, Oprah Winfrey, or Lance Armstrong, they have all focused intensely in order to win.” He also fails to mention that some of the rich have probably become poorer because they are focusing.

So what’s the point of the article? I think it’s that you should quit your day job, and start “focusing on finding the best investments” so that you can be the next Warren Buffett. Or “if you choose to remain an amateur — a passive investor — then, by all means, diversify.” Well folks there’s no shame in being an amateur or a passive, defensive investor. In fact you will probably have far better success if you pursue this path. Benjamin Graham explained the dangers of trying too hard so well in the first chapter of the Intelligent Investor:

A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom. If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.

Since anyone–by just buying and holding a representative list–can equal the performance of the market averages, it would seem a comparatively simple matter to “beat the averages”; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market. [italics his]

Google shares reach $400, still a good value?

Today, Google’s shares reached $400. It seems unlikely that any true value investor would consider Google (GOOG) to be a good “value.” Renowned fund manager Bill Miller seem to think it is. His Value Trust fund (a fund that I am considered for my US portfolio) has a good portion (4.3%) of it’s assets invested in Google. Bill Miller “follows a value discipline in selecting securities” according to Value Trust fund’s Investment Strategies statement.

Just for fun, I wanted to see if Google meets any of Graham’s basic criteria for defensive investors (or rather, how badly it fails):

  • Google’s price/book ratio from the most-recent quarter is 12.64. Graham probably wouldn’t touch Google unless it’s P/B Ratio was less than 1.5, meaning Google would have to trade in the $50 range.
  • Google does have a positive book value, which Graham considered a must.
  • Google’s current ratio from the most recent quarter is 15. Graham looked for a current ratio of at least 2.
  • Google’s growth rate has been phenomenal. About 400% from 2003 to 2004, and on pace to grow earnings about 350-400% in 2005. Graham looked for earnings growth of 33% over 10 years. Google hasn’t even been around for 10 years yet and Graham would probably classify it as a “new issue” and would stay clear of it.
  • Google has never paid a dividend. Graham looked for stocks with uninterrupted dividends over 20 years.
  • Google has not made money in each of the last 10 years. Graham liked businesses which had some earnings in each of the past 10 years. Since Google was a start-up not too long ago, there was a time within the last 10 years when it did not make money. Basically Google fails this test because it is just too new.
  • Google’s revenue was $3 billion in 2004, on pace for more than that in 2005. Graham recommends investments with annual revenue of more than $500 million (in today’s dollars).
  • GOOG’s valuation is now $119 billion. This meets Graham’s criteria of being a large-cap stock. Although if Google were valued at its book value of $9 billion it doesn’t look so big.
  • P/E ratio on trailing 12-month earnings is about 89. This is well above Graham’s recommended 15.

Google fails several of these basic criteria by such a huge margin that it makes me feel good about not owning Google, and somewhat worried about buying Bill Miller’s Fund. Apparently, in retrospect, Google’s IPO price of around $100 was a good value, and so was $200 3 months later. And it was still a good value earlier this year when it traded at $300. Google has certainly paid off for Bill Miller who apparently bought it at $85. I’m just not sure if he’s skilled or lucky. Some of his other tech stocks have not fared as well, such as Amazon and eBay, both among his top 10 holdings, and he is at risk of ending his 15 year beat-the-S&P500 streak. Miller’s Value Trust fund has only gained 1.82% this year so far, compared to 3.06% for the S&P 500.

Out of curiosity, I checked ABC Funds American Value Fund, a true value fund (no tech stocks here), and is up 6.34% year-to-date as of October 31, 2005. I am a bit more comfortable with ABC Funds’ true value investing approach, but the minimum required investment is just too high for me right now.

Growth vs. Cash

Investors (actually “288 investment professionals” according to MSNBC and “290 mutual fund managers” according to the Globe & Mail) are apparently preferring growth to cash (dividends):

About 49 per cent of the 288 investment professionals quizzed by Merrill in November said they wanted to see companies increase capital expenditure, the highest response since this question was first asked in September 2002, 11 points higher than the corresponding figure three months earlier.

I am not sure what fundamentally changed in the average business to cause this increase in three months. Here’s what Benjamin Graham had to say about this in 1949:

A company’s management may run the business well and yet not give the outside stockholders the right results for them, because its efficiency is confined to operations and does not extend to the best use of the capital. The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell. Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest. This is a question in which management, as such, has little interest. Actually, it almost always wants as much capital from the owners as it can possibly get, in order to minimize its own financial problems. Thus the typical management will operate with more capital than necessary, if the stockholders permit it-which they often do. [italics theirs]

Jason Zweig, in his commentary in Chapter 19 of the Intelligent Investor Revised Edition, notes two interesting pieces of research: “Surprise! Higher Dividends=Higher Earnings Growth” (Arnott and Asness) and “Dividend Changes and Future Profitability” (Nissim and Ziv). However there has been some contradictory research as well: “Dividend Changes do not signal future Profitability.” Without pouring over these papers in detail it’s impossible for me to judge who is right. Zweig does say that “even researchers who disagree with Arnnott-Asness and Nissim-Ziv agree that dividend increases lead to higher future stock returns.” Either way, I think this comment by Zweig sums it up nicely:

Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away. [italics his]

ABC Funds

I think I’ve found my dream mutual fund company: ABC Funds. From the introduction:

The most distinguishing characteristic of the ABC Funds is our firm adherence to true value investing. The funds use a “bottom up,” Graham and Dodd style in selecting securities. This style commands thorough, proprietary research on fundamentally undervalued Canadian and American securities and strong investor discipline. All three ABC Funds use this investment approach.

Before you go on and read about it, you should know that they require a minimum initial investment of $150,000 per fund (I assume that’s CAD). The MER is 2% on all their funds and they seem to have an excellent track record at beating the indexes. Some years they do worse than the indexes, but that shouldn’t worry the long-term investor.

Do not shy away from clicking on the “client area” link on the main page. It looks like everything there is publicly accessible.

It seems easy to find good active value management in Canada if you have lots of money. Another company that comes to mind is Strategic Advisors Corp (affiliated with Ross Healy).

Value Investing and the Death of Efficient Market Theory

This article by Joseph Nocera about the recent annual Graham and Dodd breakfast at Columbia University brought up a few interesting things that I hadn’t read too much about before, mostly concerning the theory behind how 95% of the world invests today. Apparently most business schools across the United States teach Modern Portfolio Theory as a way to minimize risk in a portfolio. It (MPT) holds that because the market is efficient (an assumption), it cannot be beaten, and therefore the only way to minimize risks and maximize returns is through diversification. This is essentially the theory from which banks and other financial managers from all over will tell you things like “Experts agree that the asset mix of your investments – safety, income and growth, account for more than 80% of your portfolio’s return.” This statement doesn’t even make sense to me, although I have sort of accepted it gospel for a long time, since it was posted on TD Canada Trust’s website, and of course the big banks know everything.

Bruce Greenwald, who runs a value investing course at Columbia, like Benjamin Graham and Robert Heilbrunn before him, says that “efficient market theory is basically dead.” Warren Buffet says modern portfolio theory is akin to the theory that the “world is flat.” Well that was enough for me… I guess modern portfolio theory is just a theory and the efficient market hypothesis is just a hypothesis.

There is also talk in the article about why value investing is so unpopular, even with the success of Buffett and Graham and many others and the fact that studies that have been published which show that “a portfolio of value stocks generally outperformed the market.” There are many reasons given. Jason Zweig (who wrote the updated in comments in Graham’s latest Intelligent Investor), says that value investing is “just plain hard,” (ie. takes a long time pouring over statements) and others say that there simply aren’t as many value stocks out there these days (could be true, if you look at the long term trend in P/E ratios). But Jean-Marie Eveillard, a successful value mutual fund manager said what Joseph Nocera thought was the best answer, that “It goes against human nature . . . You have to be very patient. You’re not running with the herd — and it’s much warmer inside the herd.”

Welcome to Investing Intelligently

This blog (and blog title) is inspired by the late, great Benjamin Graham, author of the Intelligent Investor. He was a pioneer the value investing approach, perhaps even the founder of value investing as a “method of investing,” even though many people probably practiced the technique much earlier. His value investing techniques can be applied to other investment instruments as well, such as bonds, real estate, and mutual funds. More than just value investing, Graham’s book made me look at investments using plain old common sense.

This blog is not just about value investing, however, particularly because I do not do a lot of individual stock investing myself. This blog will deal with common sense investing as well as personal finance. It will have a mostly Canadian slant, with of course some US content as well.

I really hope I can generate some interest with this blog. I find there are a lot of misconceptions out there about investing and personal finance. There are a lot of good books and a lot of bad books, and lot of bad financial advisors and some good ones, and some good investments and some which are downright bad. There are also a lot of people out there in the media and in the general public who have no idea what they are talking about that will try to give you free advice. That advice will more often than not be bad advice. The goal of this blog is not to give out advice. It is to educate people on the facts about investing and personal finance so they can make intelligent decisions themselves.