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.”

Proposed Changes to XIC, XGV, XSP, XIN

Barclay’s is having a special meeting of unitholders, to decide on proposed changes to iUnits ETFs: XIC, XGV, XSP, XIN [pdf]. The most significant proposed change is to have XIC track the S&P TSX Composite rather than the TSX 60 index. Reasons given are:

  1. More securities and more diversified exposure to large-cap, mid-cap and small-cap stocks improves diversification which helps reduce volatility risk.
  2. The Composite Index is the most widely used benchmark of Canadian equity performance, which improves investors’ ability to compare results to other Canadian equity funds.
  3. Offering funds which track the S&P/TSX 60 Index and the S&P TSX Composite Index provides investors in iUnits funds with more choice.
  4. The increased fee reflects the time, expertise and expense involved in managing a portfolio of over 200 securities versus 60 securities.

XIU, the non-capped S&P TSX60-tracking ETF will still exist, it is only the capped XIC which is being changed.

XGV is becoming more diversified, to include provincial, municipal, and corporate bonds, rather than just Government of Canada bonds. It will now be tracking the Scotia Capital Short Term Bond Index.

XSP (S&P 500 tracker) and XIN (MSCI EAFE International Index tracker) will now be unaffected by exchange fluctuations. I assume this was done because of what happened in the last couple years, where Canadian investors’ in the US indexes were hurt by the falling US dollar in relation to the Canadian dollar (and every other currency for that matter).

We will know on November 15 the outcome of the vote by unitholders on the proposed changes. More detailed information can be found in the information circular.

REITS vs. the Stock Market

Think that real estate is hands-down a better investment than the stock market? I found some data on REITs (Real-Estate Investment Trusts) compared to the stock market, and on first glance it looks as if the stock market outperformed the real estate market from 1975-1993 and also from 1990-1996. Be wary, especially now that we are in a real estate peak, of people telling you that real estate is the best investment out there. Be also wary of those who tell you that it was the “best investment they ever made.” As David Chilton says, for many of those people, “it’s usually the only investment that they’ve ever made.”

Stocks end lower, rattled by housing

It looks like the shit is starting to hit the fan in the housing market. It’s starting to spill into the stock market with this announcement from Toll Brothers Inc. and more and more into the mainstream (unfortunately it probably hasn’t caught on with the speculative condo owners yet). Weston Boone, vice president of listed trading at Legg Mason Wood Walker says:

A soft real-estate market is not good for the consumer. It is not going to bode well going forward. You have to take into consideration the rising interest-rate environment. There aren’t a lot of catalysts for positive sentiment in the market.

Hopefully by the time the market is in the bottom of it’s trough, I’ll have enough of a down payment saved up. Historically, the time from peak to trough has lasted at least 7 quarters (or 1.75 years) in Vancouver. So I am extremely content to not be invested in real estate at this time. Not only is my rent far below the mortgage payment I would pay for the same place, but we can pick up leave with a month’s notice at any time. No, rent is certainly NOT throwing your money away.

Berkshire Hathaway Undervalued?

This article, Berkshire’s a Bargain lays out a convincing argument to buy Berkshire Hathaway:

“Rather than the historical increases in book value of 22% or 19%, I assumed that Berkshire’s book value only grows by 15% per year for the next 10 years. At that rate, the book value per share would go from $57,010 today to $230,637 by 2015. I then assumed that in 2015, the stock would be trading at a historical low in terms of multiple of book value (1.35 times). That would mean that the shares would be priced at $311,360. On the basis of those assumptions, if I buy the shares today at $85,200, I would earn a 265% return on my initial investment or a compound annual rate of return of 13.8%. On a risk-adjusted basis, I have a hard time coming up with anything that comes close.”

He refers to this site, which calculates Berkshire Hathaway’s intrinsic value. The author quotes Buffet in 1995, when his stock was trading at 2.44 times book value (price/book value of 2.44) as saying “historically, Berkshire shares have sold modestly below intrinsic value. But recently, the discount has disappeared, and occasionally a modest premium has prevailed.” Then, in 2000 when “new hot issues” (as Graham would describe them) were at their peak, boring stocks like Buffett’s were trading at lows. Berkshire Hathaway was trading at 1.35 times book value. When this Fool article was published on November 2, Berkshire was trading at 1.5 times book ratio (which he says is still a bargain), and is today trading at 1.58 times book value.

The only assumption that I did not like at first was the fact that he assumes that Berkshire’s book value will increase just has it has in the past. However, Warren Buffett is seen as a value investor, and I am confident in the value investing approach and Warren Buffett’s track record to believe that he can achieve even the most conservative gain of 15% increase in book value over the next 10 years.

Although BRK.A is difficult to afford because the cost of one share is currently just over $90,000 USD, the B shares, BRK.B should be affordable for many, at just under $3,000 USD per share.

Why Invest in Stocks?

This article, Armchair Millionaire Community Bulletin: All the Wrong Reasons to Invest in the Stock Market, gives some good reasons to invest in the stock market. He says that “as you make your investing decisions, don’t be misled by clichés that insist that stocks are simply the ‘best’ investments out there. You’ll need to dig deeper to learn whether stocks are genuinely right for you.” This goes for any type of investment.

Another advantage of stocks is that they “give you an excellent hedge against inflation. So while inflation will eat away at your portfolio at the rate of 3 percent or so a year, stocks will out pace inflation to provide you with a positive net return over time.” This is discussed in Chapter 2 of the Intelligent Investor, where Jason Zweig says in his commentary “In 50 of those 64 five-year periods, stocks outpaced inflation.” In periods of very high inflation, companies and their stocks will suffer, however.

Finally the author, Lewis Schiff says: “Shares of stocks rise and fall–sometimes dramatically–but that does not mean that investing in stocks is gambling. There are no guarantees in gambling, but stock investing does give you one guarantee: By buying shares of a company’s stock, you will get a share of that company’s future earnings and growth. So on a very small scale, when you invest in the stock market, you get in on the growth of capital markets. And there is one thing that has been proven over time: Capital markets work.”

The article linked to in the first paragraph comes from, a site based around the book by the same name. It has some good points about saving and investing, similar to those in the Wealthy Barber: invest monthly into an RRSP (or US-equivalent), and contributing another 10% of your gross income to another fund. He emphasizes dollar-cost averaging and has a good conservative approach to investing in the stock market. He suggests investing in a mix of index funds, large-caps, small-caps, and an international fund.