Good Businesses at Good Prices

There isn’t a more commonly recited investment strategy than “buy good businesses at good prices.” This simple strategy sums up much of Warren Buffett’s success, and countless investors have attempted to mimic his style. Indeed, when I asked those on twitter what their favorite investing ‘factor’ was, the most common response was price-to-book (P/B) divided by return on equity (ROE).  The idea behind the simple ratio is to find good businesses (high ROE) at good prices (low P/B). This factor is similar to another similar two-factor comparison, Joel Greenblatt’s “magic formula,” which also combines a measure of good businesses (high return on invested capital) and good prices (cheap earnings-before-interest-and-taxes to enterprise value).

I rebuilt the factor since 1963, ranking all stocks by P/B-to-ROE and sorting them into deciles[i].  Since each decile represents several hundred stocks (and is therefore unrealistic for individual investors to manage) I’ve also included a concentrated, 25 stock strategy which selects the best stocks in the market by this measure. So does this simple measure help you find stocks that will outperform the market? The answer is a qualified yes. The top 20% of the market by the P/B-to-ROE measure does tend to outperform by a decent margin…but the concentrated portfolio isn’t as impressive.

Results

Here are the results for the 10 deciles—and the 25-stock strategy—versus the market. Both of the top two deciles outperform the market, but the second decile provides the highest Sharpe ratio.

More curious is that the concentrated version doesn’t do all that well. While it does beat the market over the very long term, it is not at all consistent. In rolling 10-year periods, it only beats the all stock universe 26% of the time—before costs. If transaction costs and taxes were factored in, it wouldn't be worth it.  As for the top decile, you'd have to be very patient to win with this strategy. There has been a 1-in-5 chance, historically, that the best decile underperforms the market in a 5-year period--and again, that is before costs. 

I should note that price-to-book is the least impressive value factor I’ve tested, and ROE is the least impressive measure of quality/profitability. EBITDA/EV, for example, yields much better results than P/B, and ROIC yields much better results than ROE. Is this just historical coincidence, a small bit of data mining? It is impossible to say, but there are compelling reasons for using factors other than P/B and ROE—but that’s a topic for another post.

Let me know if you have other ideas for testing, email me at Patrick.w.oshaughnessy@gmail.com

[i] Deciles are rebalanced on a rolling annual basis, and companies with negative earning and/or negative equity are excluded.

We Are All Factor Investors

Smart beta, indexing, Fama/French, margin of safety, Graham (deep) value, growth, momentum, GARP. Each of these terms represent very different styles of investing, but they all have one thing in common: they are all predicated on the fact that certain factors have, and will continue to, drive stock returns.

·         Smart Beta: fundamental-weighting, low volatility

·         Indexing: market cap (larger better), costs (lower better)

·         Fama/French: book/price (higher better), market cap (smaller better)

·         Margin of safety: business moats, cheap valuations

·         Graham Value: very cheap valuations

·         Growth: earnings growth

·         Momentum: strong price trends

·         GARP: strong earnings growth and reasonable valuations

If you think about the stock selection process, you’ll see that everyone makes decisions based on some factor(s).

How we make investing decisions

If you are an “active” manager, trying to select stocks that will outperform the market, the process is always the same, and it looks like this:

Both traditional and quantitative managers follow this same process: they collect data they believe to be relevant, process/evaluate that data, and reach conclusions. They buy certain stocks based on certain factor inputs.

Each approach has one major weakness (and many other small ones).

Quantitative Weakness: The quantitative approach is reliant on data that tends to be fairly raw. This means that its weakness lies in its lack of nuance. Raw reported data will sometimes be wrong or hide important realities (think off balance sheet items on bank balance sheets in 2008).  I don’t mean to plant the axiom that traditional managers all do pick up on these inaccuracies/nuances, but some do and have been successful as a result.

Traditional Weakness: Any good strategy only works if it is consistently applied over long periods in the market, but human beings are extremely inconsistent thinkers. This means that relative to quantitative managers, it is very hard for traditional managers to measure and apply their preferred factors across a large universe of stocks, and to do so consistently through time.

One of the reasons that indexing works is that it is so consistent. Its strategy (buy big stocks, the bigger the better) is mediocre, but it never veers off course. Most humans are extremely inconsistent in their decision making and processing of information. Losing $100, for example, has twice the emotional impact on the average human than does gaining the same $100 dollars: we are wired to be especially sensitive to losses.

You can see this tendency in the following chart of all U.S. stock market bull/bear markets. The bulls tend to be slow & plodding, often lasting many years. The bears, by contrast, tend to be sharp, quick and painful.  They are fueled by panic: our oversensitivity to losses.

View fullsize

Humans are a lollapalooza of behavioral biases, and these biases precipitate bad decisions.  Because we aren’t well wired to make smart and consistent investing decisions, I believe that the quantitative approach is superior despite its weaknesses; it removes emotional influences from the investing process. If you believe in factor investing over index investing, then the quantitative approach is more reliable.

Factor Investing in the Future

The funny thing about factors is that just like individual stocks themselves, a factor’s short term success will likely be inversely related to its popularity among investors (which will, of course, wax and wane). Measuring a stocks popularity is pretty easy: lofty valuations, large returns over the past few years, and very high share turnover can all help you identify the most popular stocks (and as I’ve written here and here, they tend to perform terribly). But identifying popular factors is more difficult.  We can look at factor spreads (e.g. how much cheaper are the cheapest stocks than the most expensive stocks) and conclude that the narrower the spread—and therefore the more similar stocks look—the more popular the factor. We can also look, more subjectively, at how often certain factors are mentioned and what sort of fund flows they are garnering (think of the large inflows into dividend yield in 2012, which went on to underperform in 2013). These are imperfect, though, so timing factors will be difficult.

Investing is an incredibly complex endeavor, so it is impossible to sum it up…but J.M. Keynes came close when he said, "It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them." So long as people (compelled by human nature) are responsible for pricing stocks, one edge will likely persist: that which is out of favor—be it a stock, industry, country, or a factor—will likely outperform.  It is psychologically difficult to do, but if you want to beat the global market index funds, you’ll have to position yourself in parts of the market that others disdain. Picking factors in the short term will be as difficult as picking stocks in the short term. I think the key is to instead focus on the longer term: do your own investigating, find what factors make sense to you, and stick with them through thick and thin. 

Overdiversification

Who doesn’t like to be diversified? It’s one of the easiest words to throw around when pitching an investment product or process because the word has an almost perfectly positive connotation. I am guilty of overusing the term because it’s just so easy to throw around.

But diversification isn’t all peaches and cream. There is such a thing as being overdiversified. Take an index fund. It owns tons of stocks that will stink over the next year. Apple last year is a great example. It was the biggest stock in the S&P 500 (and therefore most impactful on returns), and had a relatively weak year.

Owning everything means you will always own certain types of stocks that tend to perform poorly. Let’s look at four such types, and then see how an index would perform if it first stripped out the worst stocks by these measures. Because market indexes are weighted by capitalization, I’ll focus on large stocks here.

Value

Expensive stocks—those trading at high multiples of their sales, earnings, and cash flows—have been very poor performers historically. These are usually exciting companies, but the market expects too much of them, and when reality sets in, the stocks underperform. The most expensive stocks in the large stock universe (the worst 10%, rebalanced annually) have underperformed by 6.8% annually since 1963.

Momentum

Same story for the falling knives out there. Stocks whose recent returns have been among the worst in the market tend to continue to lose over the next year. Stocks with the worst momentum have underperformed by 4.5% annually since 1963.

Quality

Stocks with suspicious earnings quality—which tend to have very high accruals and weak cash flows—have also gotten beaten up over the years. Stocks with the worst earnings quality have underperformed by 3.4% annually since 1963.

Shareholder Yield (Dividends + Buybacks)

Stocks with the worst shareholder yield (meaning they are issuing shares and typically not paying a dividend) have also underperformed, by 5.3% annually.

An Index without the Crap

So what would happen if we just refused to invest in expensive stocks, low quality stocks, stocks with poor price momentum, or stocks issuing shares? The results below illuminate what I mean by overdiversification. An equal weighted basket of all large stocks (junk included) has grown at an annual rate of 10.3% with an annual standard deviation of 15.9%, since 1963.  If, instead, you stripped out stocks (annually) in the worst 20% of the market by value, momentum and quality, and also stripped out any stocks that were net issuers of shares (issuance – buybacks > 0), then you’d have achieved a much better result. This modified index would have grown at a 13.1% annual rate and done so with less volatility, with a standard deviation of 14.6%. You’d still own several hundred stocks, and be very diversified, but you’d have a smarter portfolio. Here is the historical growth of the two strategies. Diversification is good…to a point. But owning everything—even the junk—can be a drag on returns over the long term.

Skin in the Game

They say you should put your money where your mouth is. With that in mind, I really liked the spirit of Meb Faber’s recent post about having “skin in the game,” and so here I copy his idea (and hope others follow suit).

To reiterate something Meb said, my situation is unique and my investment allocation isn’t relevant for other investors with different preferences, risk tolerances, and time horizons. None of this is investing advice.

I have 100% of my invested assets in quantitative, long only strategies. The vast majority (90%+) is invested in strategies run by O’Shaughnessy Asset Management (“OSAM”). The only reason that it is not 100% is that I cannot access OSAM’s emerging markets strategy in my retirement account, so I have to get my EM exposure through another option (DFA, in this case—although whenever the OSAM EM strategy becomes available I will switch 100% of my EM exposure to that strategy. I also have a small amount in Meb Faber’s Global Value strategy).

Some key points about my allocations.

• I’m 29, have a high tolerance for equity volatility (in fact I’d welcome it for the chance to buy more at better prices), and have a very long time horizon.
• I believe that automatic allocations are one of the keys to investing success because, like quant strategies, automatic allocations take most of the emotion out of investing. I contribute to my 401(k) automatically, and I also contribute automatically to other investment accounts.  

Some key points about the strategies I use to invest.

• I believe investing should be completely rules-based/systematic/quantitative
• Every strategy I use to invest is predicated on four key factors: valuation, yield (dividends, buybacks, debt paydown), quality, and momentum. I have a roughly equal exposure to these key factors.
•  I use a number of different strategies and allocate across them using a contrarian approach. I add to strategies that have 1) better current valuations (i.e. lower expectations) and 2) negative recent results (absolute and relative).  For example, for the past year or so I’ve been adding mostly to our global, yield driven strategy because 1) international and emerging markets are cheaper than the U.S. market and 2) the strategy has underperformed. Like the strategies that I use themselves, my allocations across strategies are rules based.
•  I have a very global portfolio, and am underweight the U.S. market. This is because 1) the U.S. is more expensive than almost all global markets and 2) my career and earnings are concentrated in U.S. dollars and U.S. markets, so I like the diversification.  
• To give you a flavor for where these strategies are pointing right now, I own a lot of international energy and telecom companies, and “old world” tech stocks in the U.S.

Because of the nature of value investing, it’s usually easier to tell a scary story about many of the stocks that I own than a rosy, growth story. If I wasn’t comfortable with that, I’d just buy index funds.  

For Great Returns, Follow the Cash

Earnings get all the attention on Wall Street. While earnings are of course important (and measures like P/E are very useful in stock selection), they aren’t everything.  Less discussed, but equally important, is the cash that is flowing into and out of a company. Hidden in the statement of cash flows is an extremely useful tool for identifying great investments.

When a company releases its three financial statements, the income statement (led by bottom line earnings) dominates, the balance sheet comes second, and the statement of cash flows generally comes third. You’ll see a lot of “breaking earnings reports” on CNBC, but you’ll never see a “breaking cash flow report.”

This may be in part because the statement of cash flows has only been around since 1987, whereas income statements and balance sheets have been around forever. In the cash flow statement, cash flows are grouped into operating, investing and financing categories. Operating cash flows dominate—these are inflows and outflows resulting from normal business operations. Investing cash flows matter too, because they reveal how much a company is investing in things like machines, office buildings, and the like. But financing cash flows are the most useful for investors.

Financing cash flows are pretty straightforward. Positive numbers (cash coming into the company) result when a company raises cash from outside stakeholders (through debt or equity offerings). Negative numbers (cash leaving the company) result when a company sends cash back to stakeholders by repaying debt, paying dividends, or buying back shares.

It turns out that companies with the most negative flows, relative to their market value, perform considerably better than those with the most positive flows and perform better than the overall market. The factor (financing cash flows divided by market value) is sometimes called “shareholder yield,” but I prefer “stakeholder yield” because it doesn’t belittle the creditors who are not technically equity shareholders. Here are the annualized results, since 1987, for stocks broken into decile groups by stakeholder yield.

The bottom line is that following financing cash flows has been extremely useful in the past, and you ignore them at your own peril.

NOTE: This factor has received attention (notably in Jim O’Shaughnessy’s What Works on Wall Street, in Meb Faber’s Shareholder Yield, and in academic papers), but still remains fairly under the radar. In this example, I only run the numbers since the statement of cash flows was first reported in 1987 and only use data directly from the cash flow statement (although the factor can be extended to 1970 using other data, as I did in a previous piece).

Two Ways To Improve The Momentum Strategy

Momentum investing worked very well in 2013, but it’s been awful in 2014. The momentum reversal has been one of the major headlines in an otherwise flat and quiet market year because the high-flying stocks from 2013, especially popular tech names like Tesla, have been crushed in recent months. Momentum investing works great over the long term but can suffer from short term reversals that are painful to live through.  Luckily, there are ways to significantly improve the momentum trading strategy—which would have side-stepped the momentum carnage of 2014 completely.

Momentum Works On Its Own

Momentum investing is popular because it has worked well across market history. I’ll define momentum in simple terms: total return over the past 6 months. Since 1963, a strategy that buys the top group (best 10% of the market) of stocks by 6-month total return, has delivered a 14.4% annual return, which is roughly 4.5% better than the S&P 500. But, to earn this excess return you have to live through a roller coaster ride. The annualized volatility of this strategy is 24.4%—almost 10% more than the market’s 15% annual volatility.

The weakness of a raw momentum strategy is that it will sometimes piles you into very expensive and/or low quality stocks. At the end of 2013, companies in the top 10% of the market by trailing 6 month return (which included lots of social media stocks, biotechs, and power companies) had valuations which were, on average, more expensive than 67% of the market[i]. Some of the most talked about names like Plug Power and Twitter were literally the most expensive stocks in the market. The best way to mitigate this issue is by insisting on valuation and quality—if you never buy the expensive, junk stocks, then the momentum strategy gets much better.

Improving the Momentum Strategy with Value

You may think that value and momentum are polar opposites, but they work remarkably well together. Think of the combination as cheap stocks that the market is just beginning to notice.  The combination of the two factors yields results more impressive than either of the two investing styles on their own. (Note: for value, I’ll use the simplest measure possible to make the point: price/earnings)

The cheapest 10% of stocks by P/E have historically delivered 16.3% per year, and the top momentum stocks have delivered 14.4%, but a combination of the two has yielded 18.5% per year (bottom right corner of the table below). What’s more, the volatility of this combined strategy comes way down: from 24.4% for raw momentum to 18.9% for value + momentum.

The table below breaks all stocks into a 5x5 panel by value and momentum (6m return and price/earnings). Stocks in the upper left have terrible value and terrible momentum. Stocks in the lower right have great momentum and great valuations. The combination of these concepts has been very powerful.

Annualized returns, 1963-2013

Quality Works Too

A second way to improve the momentum strategy is to focus on companies with higher quality earnings. The simplest way to define quality earnings is by looking at non-cash earnings. The fewer non-cash earnings (which come from accruals like accounts receivable), the better[ii].  Here is a similar 5x5 panel by quality and momentum. The effect is similar to value, but quality is a different factor and so a different take on qualifying the stocks you are willing to buy.

Annualized returns, 1963-2013

Don’t Fight the Tape, Unless...

Momentum investing works on its own—but there are ways to improve the strategy by following some trends and ignoring others. If you are trading momentum stocks, remember that the momentum effect has worked better amongst the cheapest and the highest quality names out there.  If value was a part of your momentum strategy, you’d wouldn’t have owned any of the stocks making headlines for the wrong reasons so far in 2014.

Some people are buying the dip, but most of these stocks remain very expensive. Investing based on factors like momentum is like all other investing: diversification improves and smoothens your returns.

[i] Value based on a combined measure of p/sales, p/earnings, ebitda/ev, yield

[ii] Earnings Quality defined as percentage change in total accruals  

Talk Is Cheap: Why CEOs' Actions Speak Louder Than Their Words

When you think of any famous CEO, you probably think of the great products or services that they’ve championed. CEOs that build great businesses become very famous, and justifiably so. But building a business that generates tons of cash flow is just step one. The less interesting—but equally crucial—job of any CEO is allocating their capital. Capital allocation is not glamorous, but capital allocation choices have had a huge impact on stock returns historically. The bottom line is that disciplined, shareholder-oriented capital allocation plans produce great results—for both companies and investors…but reckless spending, acquisitions, and cash-raising lead to weak results.

How to Use Capital

When it comes to allocating (or raising) capital, CEOs have a fairly limited toolkit.  As William Thorndike, author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, summarizes in his book:

CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options. Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Let’s look at each option and how they affect stock returns, on average.

Investing In Operations

“CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated by those operations.”

— William Thorndike

The first group is companies that have lots of new capital expenditures. I consider the 10% of companies every year[i] that are growing their capital expenditures by the greatest percentage year over year. These are the big spenders. How has this group done historically? They’ve delivered an annual return of 5.4%[ii]. That is roughly half the return of the market’s 10% return over the same period. Rapid growth may sound good, but these results indicate otherwise. Overzealous expansion has led to weak stock returns. These stocks are also more volatile than the market (22% annual standard deviation vs. 15.5% for the market).

Acquiring Other Businesses

The easiest way to find acquisitive companies is to look for those companies whose “goodwill” has grown by the greatest percentage in the past year. Goodwill is a balance sheet account that grows when one company buys another, but pays more than the book value of the company they are acquiring (the difference is added as an asset called “goodwill,” which ostensibly measures the value of things like brand name, patents, etc.).  There have been a number of studies which show that big acquisitions tend not to work out for shareholders.  The evidence from companies with the largest growth in goodwill supports these findings.  This group has delivered an annual return of 6.5% (18% volatility), again significantly lower than the market’s 9.1% (14.8% volatility) return over the same period[iii].

Issuing Debt and Raising Capital

A third group is companies raising lots of cash through debt or equity issuance. These companies have been a disaster historically. The best way to measure this option is using financing cash flows.  Financing cash flows come in different flavors, and are basically the “capital allocation” options listed above.  Positive financing cash flows (money coming into the company) result when a company raises cash through new debt or equity offerings. Negative cash flows (money leaving the company) result when a company pays back creditors, pays dividends, or repurchases shares. This group is the 10% of companies that have the largest positive financing cash flows relative to their market cap (meaning they are raising cash). The stocks of these companies have grown at just 5.71% (21% volatility)--which is a little more than half the market’s 10% return (15% volatility) over the same period[iv].

Dividends, Share Buybacks & Paying Down Debt

The last category—and the one that delivers great outperformance versus the market—is the 10% of companies that have the most negative financing cash flows. These companies are sending cash back to stakeholders by paying dividends, repurchasing shares, or paying down debt. Their historical returns have been 15.4% per year (17.6% volatility), which is 5.4% better than the market’s 10% return (15% volatility)[v].  Sometimes these companies are referred to as having high “shareholder yields.” Owning these companies has worked great in the past.

The data from these four groups shows that you can do very well as an investor by following a CEOs actions. If they are spending like crazy, or raising tons of cash—look out. If, instead, they are sending cash back to stakeholders, then you should take notice.

Discipline Is Key

Back to The Outsiders. The author distills the lessons he’s learned down to 10 rules, the 8th of which is very important:

8. Retain capital in the business only if you have confidence you can generate returns over time that are above your hurdle rate [hurdle rate being some minimal acceptable return on investment, say 20%].

The discipline implied by this eighth rule is rare. CEOs awash in cash often spend overzealously on projects with lower than acceptable rates of return or on projects/acquisitions that are simply too risky. The successful CEOs described in The Outsiders had a disciplined process for spending on new projects. If there are no projects available that can earn a high rate of return, the best CEOs instead pay dividends, repurchase shares, or pay down debt.

Just like with investing, disciple is key for CEOs to be successful—and true discipline is rare. As Thorndike points out,

This outsider approach, whether in a local business or a large corporate boardroom, doesn’t seem that complicated; so why don’t more people follow it? The answer is that it’s harder than it looks. It’s not easy to diverge from your peers, to ignore the institutional imperative, and in many ways the business world is like a high school cafeteria clouded by peer pressure. Particularly during times of crisis, the natural, instinctive reaction is to engage in what behaviorists call social proof and do what your peers are doing. In today’s world of social media, instant messaging, and cacophonous cable shows, it’s increasingly hard to cut through the noise, to step back and engage Kahneman’s system 2 [thinking with your head instead of with your gut], which is where a tool that’s been much in the news lately can come in handy.

One example is with share buybacks. In general, they’ve led to solid returns for investors. But you’ll often read stories that buybacks are mistimed and stupid uses of cash. This is partly true. Look at the below table, which takes the 20% of stocks in the market that are buying back the most shares.  It then splits this group out into give groups by valuation. You can see that when CEOs and their companies buyback shares at cheap prices[vi], their stocks tend to do very well in the next year, beating the market by 5% on average. But when they buyback stock while valuations are expensive, they get killed by the market, losing by 5% on average. The key lesson is that the best CEOs buyback shares when it’s smart to do so, not just because all the other kids are doing it.

1963-2013

Ultimately, choosing what to do with a company’s cash (or how to raise it) is one of a CEO’s most important decisions.  By avoiding the big spenders, and buying cheap companies that are disciplined with their cash and rewarding their shareholders, you can outperform the market over the long-term.

[i] Rolling annual rebalance

[ii] 1963-2013

[iii] 1989-2013

[iv] 1972-2013

[v] 1972-2013

[vi] Cheapness measured by p/e, p/sales, ebitda/ev, etc

Portfolio Patriotism, and Why You Should Avoid It

The U.S. equity market is expensive.  The median stock is about as pricey as it’s been in 50 years, and valuations are all clustered: there are far fewer bargains than in years past. I am not an index investor, so I generally pay less attention to market-level valuation measures like the Shiller P/E or Tobin’s Q—but both show the U.S. market as expensive. These valuation tools are more strategic than timing tools, but both signals advise caution.

What’s strange, then, is how little attention global equities get.  The debate is all about the U.S. market, which represents less than half of the global stock market.  But today, non-U.S. equities are cheaper than U.S. equities, with more bargains to be had. One simple example: among companies with a market cap greater than $200MM, there are about 100 companies in the U.S. that still have a price-to-earnings multiple below 10; there are more than 550 Non-U.S. stocks with a P/E below 10.

American investors need to diversify globally, because having all one’s risk tied up in one market doesn’t make sense—especially when that market is the most expensive developed market in the world.  It’s not just because valuations are better abroad, but because history teaches us again and again that individual country markets can have long, tumultuous periods of negative returns. Luckily, the global market portfolio usually holds up well.

Portfolio Patriotism

The preference to own companies in one’s home country is one of the most pervasive and persistent biases in investing.  We prefer familiar companies that offer products or services that we use and know. Lots of U.S. investors own Coke, but very few own Suntory (a Japanese drinks company).  The overweight to home countries is often extreme. In 2010, the U.S. market was roughly 43% of the global stock market, but U.S. investors had 72% of their portfolios allocated to U.S. stocks. It’s much worse in smaller countries like Canada and the U.K. In 2010, Canadian stocks were roughly 5% of the global market, but Canadian investors had a 65% allocation to their domestic market (the U.K. was very similar: 8% of the global market, but U.K. investors had a 50% allocation)[i].

If you believe in index investing, then a “neutral” or “passive” portfolio would be the MSCI All-Country World Index or some similar benchmark, but few portfolios look like the ACWI. Even though the U.S. has been the dominant stock market for more than 100 years, there are compelling reasons to own a more global portfolio.

Using the incredible long-term global equity market data built by Dimson, Marsh, and Staunton, we can review the history of individual country equity markets to make the case that you should not bundle all your risk into one country.  There have been many examples of disaster within one market, so to think that similar disasters won’t happen in the future is naïve.  Throughout it all, the global equity portfolio has held up remarkably well. 

Triumph of the Optimists                     

based on annual data from Dimson, Marsh & Staunton

Dimson, Marsh and Staunton’s book Triumph of the Optimists is a must-read for many reasons, but the core message (hinted at in the title) is that equity markets across the 20 major countries that the authors studied have performed well since 1900 —19 have delivered positive returns after inflation. At the right is a table of the annualized returns for these 20 countries between 1900 and 2012 (note: 2013 data not yet available, so these numbers would all get better, sometimes much better). The U.S. market has been one of the top performing markets over the past 113 years.  It lagged Australia and South Africa, but because it was many times the size of those smaller markets, its performance has been amazing. It is interesting to note that the top markets are very rich in natural resources.

Worst Case Scenarios

While the long term record has been strong for equities, nobody has a 113 year time horizon (well, unless you are Ray Kurzweil). Investors are still jittery today and worried about the risk in stocks, so I ran the worst-case scenarios for all 20 equity markets over a variety of different holding periods, which are listed in the table below (these returns are in US dollars, so they represent the returns that a U.S. investor would earn rather than a local investor in each respective market—the local returns are quite similar).

based on annual data from Dimson, Marsh & Staunton

While the U.S. has never had a negative 20-year period of returns, most markets have. Other than the U.S., only the Canadian and Australian markets have provided positive returns in all 20-year periods. Because the U.S. has such a dominant weight in the World portfolio, I’ve also included an equal weight portfolio here, which does very well (equal weight to each of the 20 countries, rebalanced annually).

Here is the cumulative growth of the three best markets alongside the three worst and the world portfolio since 1900.  

based on annual data from Dimson, Marsh & Staunton

World War II

You’ll notice in the table above that many of the countries that have had very bad 40+ year worst-case scenarios were in the thick of things during World War II. Along with the Great Depression, World War II was the most disruptive influence on stock market returns. Below are the results for the U.S. and Axis powers in and around the war.  As always, to the victor go the spoils. Germany’s stock market was essentially “reset” after the wind down of its three major banks (that had sympathized with the Nazis) in 1948, so German investors were wiped out.

based on annual data from Dimson, Marsh & Staunton

The worst case scenario for us in the future would be some similar dislocation that crushed the U.S. equity market. It is interesting to note how the world portfolio performed (because it included both the winners and the losers--again this is in US Dollars but local version is similar).  Of course, it would have been very hard (or impossible) to own a global portfolio in the 1940’s, but today it’s easy.

Go Global

Overcoming portfolio patriotism is important if you want to reduce long-term risk in your portfolio.  The U.S. market has indeed had a remarkable multi-century run, and some of that success may be because America is “exceptional” in some key ways (then again, the insane American demographic explosion didn’t hurt, but that effect has stabilized—with a fertility rate of 1.9 we aren’t quite replacing our population). Still, other great countries have faltered in the past.

It just so happens that today, international country stock markets offer many of the best opportunities. As has been exhaustively demonstrated by many valuation experts (Grantham, Shiller, Meb Faber, and so on), the U.S. market is more expensive on an absolute and relative basis that most other major countries throughout the world. This isn’t a death sentence for the U.S. market, as there have been many examples where the market did quite well even from an expensive starting point. But it would be foolish, given how easy and cheap it is to buy global stocks, to keep your equity risk concentrated in your home country. This final chart is the Triumph of the Optimists writ large: it tracks the long term growth of $1 in the world equity portfolio (weighted by market cap) and an equal weighted version of the world portfolio. These returns include two World Wars, the Great Depression, countless recessions, crises, and market collapses. If you are an investor with a long time horizon, the global stock market should be the central part of your portfolio.

based on annual data from Dimson, Marsh & Staunton

[i] https://advisors.vanguard.com/iwe/pdf/ICRRHB.pdf?cbdForceDomain=true

The Death of Money Portfolio

I finished James Rickards’s latest book Death of Money this weekend, which I found provocative, informative, and scary, but ultimately lacking in terms of investment advice.  Rickards knows his stuff, and I recommend the book for all the great information it contains and because it will get you thinking. I plead ignorance on most of the books topics, save the final one: how you should position your portfolio to defend against what Rickards thinks is an inevitable global financial meltdown. His suggested portfolio has some serious flaws.

The Death of Money Portfolio

At the very end of the book, Rickards recommends the following portfolio allocation: 20% gold, 30% cash, 20% alternatives (long/short equity, resource funds, etc.), 10% fine art, and 20% undeveloped land. Rickards suggests that this portfolio will protect against all of the scary potential outcomes: deflation, hyperinflation, the return to a gold standard, and even social unrest.

His basic rationale is as follows. Gold, land, and art should hold their value and protect against inflation/hyperinflation. Cash protects against severe deflation and gives you optionality to move into whichever other asset makes the most sense depending on how the collapse plays out. Alternatives (he specifies resource based funds, or long/short equity) should do well in any environment. A few thoughts on this portfolio:

It is incredibly unproductive. Aside from whatever yield you’d earn from the alternative category, this portfolio is dead weight that produces no income (and, because he recommends physical gold and undeveloped land, it also has significant carrying costs).

It is all but impossible for a typical investor to build. Unless you’ve got a multi-million dollar portfolio, how the hell could you invest in museum quality fine art, hedge funds, and undeveloped land? Even the part of the portfolio for which I have the most sympathy (alternatives) is easier said than done: finding the right hedge fund managers is very hard to do—and the best ones are often closed to new investors.

It should hedge against the severe outcomes he foresees. Rickards is clear that he can’t predict how the international monetary system will melt down, only that it will. This portfolio—which emphasizes hard assets—would hold up well in a severe deflationary scenario, hyperinflation, and maybe even during social unrest. In discussing the importance of hard assets, Rickards makes an interesting observation on Warren Buffet’s acquisition of Burlington Northern:

Buffett described this purchase as a “bet on the country.” Maybe. A railroad is the ultimate hard asset. Railroads consist of a basket of hard assets, such as rights of way, adjacent mining rights, tracks, switches, signals, yards, and rolling stock. Railroads make money by transporting other hard assets, such as wheat, steel, ore, and cattle. Railroads are hard assets that move hard assets. By acquiring 100 percent of the stock, Buffett effectively turned the railroad from an exchange-traded public equity into private equity. This means that if stock exchanges were closed in a financial panic, there would be no impact on Buffett’s holdings because he is not seeking liquidity. While others might be shocked by the sudden illiquidity of their holdings, Buffett would just sit tight. Buffett’s acquisition is best understood as getting out of paper money and into hard assets, while immunizing those assets from a stock exchange closure. It may be a “bet on the country”—but it is also a hedge against inflation and financial panic. The small investor who cannot acquire an entire railroad can make the same bet by buying gold. Buffett has been known to disparage gold, but he is the king of hard asset investing, and when it comes to the megarich, it is better to focus on their actions than on their words.

The invocation of Buffett brings me to my next point…

No global equities?! Rickards has a 0% allocation to history’s most successful and remunerative asset class.  As he himself explains many times in the book, forecasting outcomes in complex adaptive systems like the global financial/monetary system is very hard to do. It is odd, then, that his portfolio assumes a 0% chance that some global markets will weather the coming storm. A global equity portfolio has stood up remarkably well since 1900 through a wide variety of calamitous events. In my book, I have a chapter on the importance of “going global,” because while a German equity investor between 1900 and 1948 (or a Japanese investor between 1990 and the present) would have realized awful returns in their home country equity markets, they would have done just fine in a global portfolio. Of course, there were no cheap, global ETFs in 1900 so the German investor would probably have still been screwed, but things are different today. Even if the U.S. were to collapse or significantly falter, a global portfolio should provide some protection.

Rickards believes that anything that is a derivative or an electronic claim on an asset is dangerous and should be avoided. But if we are going to be in a situation where stocks markets are all shut down and our stock holdings are worthless, then the best investment might be a go bag! Rickards even suggests keeping your gold somewhere other than a bank safety deposit box, which brings me to my final huge concern…

Gold. One of my main issues with owning gold is the fact that I don’t command an army. Most people forget that FDR—one of our most respected and popular presidents—confiscated the country’s gold in 1933 through Executive Order 6102. Americans had to turn over their gold in exchange for $20.67 an ounce. If they didn’t, would have had to pay a fine and might have been sent to jail for 10 years.  With the confiscated gold secure in vaults at the newly built Fort Knox, FDR re-priced gold at $35 an ounce, giving the U.S. extra dollars to fight off the Great Depression. Americans weren’t allowed to own gold again in significant quantities until the 1970’s.  If Rickards is right, then why in the world couldn’t (or wouldn’t) a similar confiscation happen again?? Maybe we’d get a somewhat fair price for our gold, but if things were as bad as Rickards suspects they may be in the future, the government might just flex its muscles and take it all. They’ve got an army with guns. Individuals would be bringing knives to a gun fight.

The bottom line is that the Death of Money portfolio is not really an investment portfolio, but a big hedge against the Chicken Little, sky-is-falling, scenario. Zero equity exposure makes no sense to me. Owning some hard assets is a reasonable suggestion (I buy some gold jewelry for my wife!), but in the event that the world weathers the coming storm, and global stock markets don’t cease to function, you should have a large allocation to global equities. Sometime soon, I will write a more data driven post on the importance of global equities—which are very important given current valuations in the U.S. In the meantime, check out Meb Faber’s latest book Global Value. 

Popular Stocks Stink

Why does value investing work?  One of the reasons is that value factors like price-to-cash flow or price-to-earnings identify companies with very low market expectations. They tend to be boring companies, have negative news, poor outlooks, and so on. Value works because the market leaves these stocks too cheap, and when perception is ultimately adjusted to reality, value stocks outperform the broad market.  

But there is a second reason that value investing works. Some of the outperformance of the value strategy comes because you don’t own the really expensive, popular stuff which tends to do terribly in the market. Sometimes, what you don’t own is as important as what you own. Take Apple 18 months ago.  As I noted in a recent piece, Apple was very expensive, and value strategies would have avoided it. Not owning Apple was a huge boon to any strategy being compared to the S&P 500 in 2013, because Apple’s relatively weak year was a large drag on market returns for the year.  Regardless of what you owned in 2013, your relative performance would have been boosted by not owning Apple.

I was amused when I came across this story posted by Business Insider, saying they were hiring someone to cover exciting stocks like “Tesla, Netflix, Facebook, Twitter, and the biotechs.” Can you imagine seeing a similar position posted to cover “potentially great investments like DirecTV, Marathon Petroleum, and Northrop Grumman.” I can’t see people lining up for that job.

Measuring Popularity

Tesla, Netflix, and Twitter are all very popular stocks. They are also expensive: they are in the 99th, 89th, and 95th percentile by value, respectively. Valuation is just one way of measuring popularity, but it is a bit indirect. One more direct way is to look at something called share turnover, which measures what percentage of a company’s total shares are trading hands every day. The higher the share turnover, the more action there is in the stock. Sometimes this is because of really bad news, but more often it’s because the stock is exciting.

Among the larger stocks in the U.S., Netflix and Tesla have by far the highest share turnovers today. On average over the past month, about 7% of the shares of each stock has changed hands every day. With that in mind, check out this figure below.  These are the historical results of a strategy that buys the top 25 stocks in the market based on their share turnover (with a rolling annual rebalance).  This group of the most highly traded stocks has delivered an annual return of -3.1% since 1984. That is putrid compared to the equal weighted basket of all stocks, which has delivered an 11.4% return in the same period.

Today’s portfolio of highest share turnover stocks would include Netflix, Tesla, Plug Power and Yelp, among others. (Note: don’t just take my word on share turnover, Roger Ibbotson has a great paper—and firm—devoted to this factor.  His findings mirror mine: high share turnover stocks lag, and less loved & low share turnover stocks outperform).

I think share turnover is a nice alternative to value to identify extremely popular stocks that you may want to avoid.  The success of value strategies and the lack of success for high share turnover stocks teach us that investing success is as much in the avoiding as it is in the choosing. 

Forget Passive vs. Active--Here's How To Evaluate Any Investment Strategy

Burton Malkiel has a new piece up on Wealthfront’s website calling smart beta strategies into question. It’s a very interesting and hot debate at the moment, and Malkiel’s perspective is worth a read—many of his points are important to consider.    

The problem with this debate is that it is impossible to evaluate “smart beta” as an entire category relative to cap-weighted indexes, because smart beta strategies can be very different from one another. For example, a low volatility smart beta strategy will provide very different returns than a high momentum strategy. Any comparison between cap-weighted indexes and smart beta should be made on a strategy by strategy basis.

I think smart beta strategies should be assessed just like any strategy, and here I’ll lay out the criteria by which I think investment strategies should be evaluated. Hopefully you can use these criteria when making a decision between a smart beta strategy—or a traditional active strategy—and a traditional cap-weighted index.

Passive Investing—Misnamed, Misunderstood, and Flawed

First off, the debate between “passive” and “active” is misleading. As Cullen Roche recently pointed out in a post, everyone is active to some extent.  Every strategy is an active bet that certain stock selection and weighting criteria are better than others.

Cap-weighting is itself a strategy that says “buy big stocks, the bigger the better.”  Cap-weighted indexes are hard to beat because they are so cheap (and the fee differential between index funds and other strategies compounds over time) and the fact that rules-based cap-weighted indexes are inherently disciplined…they never deviate from their strategy.  The goal of Smart Beta indexes/ETFs is to use the same discipline, but build indexes with better rules. 

Malkiel’s best point is that costs (higher fees, taxes, and turnover) make some smart beta strategies inferior. But the piece, which denounces smart beta as a marketing tactic, is pretty light on empirical evidence. In a bit of cherry picking, Malkiel invokes the example of RAFI indexes taking on more risk in 2009 by overweighting bank stocks (which worked for RAFI), but leaves out the similar risky bets taken by cap-weighted indexes, like the massive weight to tech stocks in 2000 (which didn’t work for the S&P 500). Oh, and RAFI would have worked in the tech wreck, too, because fundamental indexes would have been very underweight the tech stocks that were producing very little sales/earnings/cash flows/dividends.

Evaluating Any Investment Strategy

Given that any investment strategy is active to some extent, I think there is a small list of important criteria when choosing where to put your money—whether it is indexing, smart beta/indexing, or traditional active. There are four main criteria worth considering.

#1 – Strategy consistency

Is the strategy rules based (and therefore consistent) or not? Consistency is very important for long-term success. Indexes—and Smart Beta—have this in their favor.  The S&P 500 “strategy” has never changed, so it has consistency baked in. Non-index managers are less consistent. According to this recent SPIVA report, over the past five years, just 46% of funds stayed consistent to their style. Switching strategies/styles at the right time is very hard to do. 

Bottom line: consistent approaches are better.

#2 – Selection Criteria

Rules-based is good, but the rules themselves are very important too. 

I spend a few chapters on this topic in my book, but the bottom line is that market cap is a convenient but sub-par weighting/selection criteria. Indexing is the right strategy for a lot of people and is a great basic way to own equities, but I also believe that the right kind of “smart” strategy will deliver superior results. Here’s one example why.

Imagine breaking up all of the investable stocks[i] in the U.S. market up into 10 equal groups (deciles) based on their market capitalizations. Decile 1 would have the 10% of companies with the biggest market caps, and decile 10 those with the smallest. Today, there are around 300 companies in each decile, and 3,000 investable stocks total. Then imagine doing the same thing every year back in time for the past 50 years.

The figure below illustrates how each size decile has performed relative to the equal weighted opportunity set. Not much information in the 8 smallest deciles, but the largest stocks have significantly lagged the equal-weighted market. In particular, the biggest group of stocks has lagged the equal weighted opportunity set by almost 2% per year. Here’s the problem: 78% of the weight of the S&P 500 is in this largest decile today.  The top 50 stocks by market cap have done even worse historically.

1963-2013

In contrast to market cap, there are a host of other rules that have worked for selecting stocks. A brief list includes: value, momentum, low volatility, quality (earnings quality, profitability), and small cap.  The effectiveness of these factors varies. Below is the value example I’ve used before: value is much more powerful than small cap.

Malkiel is right that these factors (on their own) can have long periods of underperformance: momentum did poorly in the 2000’s because of the ’09 momentum reversal. But typically, as the holding period lengthens, the “risk” of losing to the market fades. Here is the percentage of time that cheap large stocks (using earning/price) outperform all large stocks over the past 50 years. These factors (and any smart beta strategies using them) only work if you stick with them.

1963-2013

Smarter selection criteria have been proven to work over very long periods of time, arguably because these factors identify stocks that are systematically mispriced by the market; and the market is comprised of people who make systematic behavioral errors.  Value and Momentum are the two that work the best. We’ve known about each “anomaly” for a long, long time, and yet they’ve continued to deliver outsized returns.  

Bottom line: there are smarter ways than market cap to build a portfolio (before costs, we’ll get to those in a moment).

#3—Concentration

I loved Howard Mark’s latest shareholder letter, which is essentially an ode to “active share.” If your goal is to beat cap-weighted indexes, then your odds go up if you are very different from the index that you are trying to beat. There’s really no reason to be an “active” investor if you are just going to hug/slightly tilt an index.

Of course being different, or “daring to be great” as Mark’s calls it, brings the highest odds of ruin, too. There are smart ways to be different and dumb ways. The very long-term historical success of certain factors suggest that cheap stocks with good momentum is a smart way, and building a unique portfolio using value and momentum is the best way to “dare to be great.”

One of the main arguments against “active management” is that the average active manager loses to index funds—but this is like saying the Pope is Catholic or bears crap in the woods. Because of fees charged, active management is a negative sum game.  The entire group of investors will earn the market rate of return, and the average will be negatively offset by active management fees that are higher than index fund fees. As this paper on active share demonstrated, the group of funds with the most unique holdings (highest active share) has historically beat market-cap weighted indexes by 1.1% after costs/fees. It has paid to be different than the market.

Bottom line: if you don’t buy an index, you’ll want to focus on strategies that have unique holdings and high active share.

#4—Implementation Costs (Trading (Turnover), Taxes, and Fees)          

Turnover and taxes are hard to evaluate. Broadly speaking, the best strategies will have holding periods long enough that most gains are taxed as long-term capital gains. Trading/turnover get a bad rap, but turnover (and the taxes it brings) is really just the flexibility to move into more attractive opportunities. No turnover means you never adapt to changing market opportunities.  I think the best strategies balance trading costs and turnover with the need to buy newly attractive stocks (e.g. undervalued, good momentum) and sell stocks that look less attractive (e.g. overvalued, bad momentum).

Fees are most straightforward category. Lower is better, and here indexes have a massive advantage. But it will thin out in the years to come. Smart beta fees (and traditional active fees) will keep coming down. Lots of smart beta strategies are in the 0.50% range right now, which is a disadvantage versus the 0.07%-0.09% range for index funds, but many smart beta strategies have historically delivered much more than 0.41% outperformance.

Bottom line: any strategies edge (its potential outperformance) needs to be greater than the total cost differential versus a cap-weighted index. The best deciles of value and momentum stocks have outperformed the market by between 4%-6% annualized since the early 1960s[ii]. That is more than enough to overcome cost differentials. Will these excess return number persist over the next 10-20 years? Of course it is impossible to say.  But these factors (and others) sync nicely with the latest research in the behavioral economics field, have long and proven track records, and have continued to work despite widespread awareness of their existence and effectiveness.

Summing It Up

The funny thing about smart beta is that it’s gone by the name “quantitative investing” for two decades. Big names like Josef Lakonishok and Cliff Asness were writing papers about value and momentum in the early 90’s, and the first edition of What Works on Wall Street (which chronicles many “smart beta” factors) came out in 1996.

There are many successful quant firms that have posted consistent, market-beating results net of costs. Many of these firms are very well known, have great strategies, and manage taxes and turnover as best they can.

Cap weighted indexes do have big advantages.  A consistent strategy, low taxes, low trading costs, and low fees is a great combination. When looking for strategies other than cap-weighted indexes, look for ones that are rules based (consistent), use rules/factors that have worked well over long periods of history (like value and momentum), are different from the market, balance taxes and turnover with expected outperformance, and charge reasonable fees.

If you are investing in the stock market for long term success, then smart beta strategies with the right strategies can be a great alternative to cap-weighted benchmarks, but each should be evaluated on its own. So far, the leaders in the online financial advisory space (especially Wealthfront) have avoided smart beta. I will be very curious to see if it lasts. 

[i] Market Cap above $200MM, then inflation adjusted back in time

[ii] Complete stats for these any many other factors available in the latest edition of What Works on Wall Street

1,000% Returns - Hitting the Stock Market Lottery

Hope springs eternal in the human breast. – Alexander Pope

People love huge, lottery like gains. Fast gains get attention, which is why I titled this post “1,000% Returns” instead of “Earn 1,000% Over 30 years.” In pursuit of quick riches, we sometimes turn to lottery-like stocks: companies that trade at outrageous valuations, have exciting stories, and have the potential to be wildly successful. Lottery stocks are expensive because they have such exciting prospects for the future. Their stock prices don’t reflect what they have accomplished, but what they might accomplish.

We love these stocks because we love innovation, new technologies, and revolutionary companies. Many of the best companies in the world today were once revolutionary upstarts themselves, and investors want to find the next big thing and ride it to the top.  Also, because they are usually smaller, younger companies, lottery stocks give us the chance to get rich very quickly. IBM isn’t going to grow 10-fold in one year, but a small biotech company with a drug that fights cancer might.

Lottery Stocks Defined

I define lotto stocks as the most expensive stocks in the market: the 10% of stocks with the highest prices relative to their sales, earnings, cash flows--which means they are the stocks for which the market has the highest expectations. On average, about 40% of these stocks come from just three of the twenty-four major industries: Pharmaceuticals & Biotechnology, Technology Hardware & Equipment, and Software & Services. Here’s the sobering picture of how lotto stocks have done historically:

1962-2012

Of course, some lottery tickets pay off—as the Powerball slogan says, “Hey, you never know.” Google and Apple have both fallen into the “lottery stock” category at times. But on average these stocks are dangerous, and today’s lotto stocks—including biotechnology companies, some internet stocks, battery companies, and so on—should be avoided at all costs. Contrary to the Powerball slogan, for the most part you do know what will happen to these stocks. They’ll kill your portfolio.

We play regular lotteries like Powerball because of what is possible, not because of what is probable. Everyone knows the odds are terrible, but the prospect of great fortune has always been, and will always be, very seductive.  

Lottery Brain

Our brains suck at processing odds in general, but our handicap gets worse when dealing with large potential rewards.  We tend to significantly overestimate the probably of an outcome if that outcome means a big reward.  Take horse or dog racing.  We prefer to bet on the long shots—despite their terrible odds—because of the huge potential payoff.

There is a great chapter in my favorite behavioral finance book (Inside the Investor’s Brain) on probabilities. Author Richard Peterson explains:

As the size of a potential monetary gain increases, so too does reward system activation (specifically the nucleus accumbens).  Potential reward size is more emotionally arousing than proportional changes in probability…When an outcome is possible but not probable, people tend to overestimate its chance of occurring. This is called the possibility effect. When an outcome is likely, people tend to underestimate its odds. This bias has been named the certainty effect. Events of probability less than 40 percent are susceptible to the possibility effect. Outcomes with greater than 40 percent probability are in the realm of the certainty effect.

If there is a chance that we might earn a big reward, our brains push us towards going for it, even if the odds stink. Here is a visual representation of how we should evaluate odds versus how we actually do. The straight diagonal lines is how we should assess them: if something has a 10% probability then we should give it give it a 10% chance when weighing our odds. The curved line is how we actually do assess them.  We make huge mistakes, especially for very improbable events. As the figure shows, we might think something has a 15% chance of happening when it in fact has a 1% chance.

Modified from original in Inside the Investor's Brain, by Richard L. Peterson

Peterson lists conditions under which we are likely to screw up our assessment of the probabilities, including:

• Vivid or easily imagined results
• Minimal awareness about the event’s likely outcomes
• Event is represented as a novel/unique phenomenon
• Wanting the outcome to occur
• Feeling a personal or emotional stake in the outcome, or feeling excited about the outcome

The biotechnology industry fits these definitions. These stocks have usually not produced big earnings, but have huge potential if a drug comes through. Here is how biotech stocks have stacked up to the rest of the market in terms of value (cheap or expensive) and momentum (popularity) since 1980.  Their popularity ebbs and flows as the prospect of great fortune waxes and wanes, but they are always expensive.

Lottery Stock Results

Using my definition of lottery stocks (the most expensive 10% of the market), let’s first look at the exciting possibilities of these stocks. Here are some examples of winning lotto tickets, so to speak, from the last 10 years:

Like usual, these stocks enticed investors because they represented new technologies and innovations that had the potential to lead to massive success (and earnings) if their new car/energy/medical technologies panned out. Like the regular lotto, every so often you will hit it big.

But it is stories like these that keep the fire burning for future lottery stocks (“I know it’s a long-shot, but this might be the next Tesla!”). The chance, however small, that one might catch lightning in a bottle is seductive enough to get investors buying.

But there is a big difference between what is probable and what is possible. Since 1963, the most expensive 10% of the market has underperformed by 8.5% annually. If, since 1963, you bought every lotto stock in the market every year, 60% of those buys would have lost money in the next 12 months (and they’d have been down an average of -41%). Even though the remaining 40% made money, the entire group of lottery stocks has grown at a tiny 1.5% annual rate since 1963—that’s worse than inflation, and significantly worse than the S&P 500 which grew at roughly 10% per year over the same period. The historical record is clear: it doesn’t pay to play the stock market lottery.

Don’t Play the Stock Market Lottery

So what does it mean for stocks today? Some stocks in the typical industries—technology, biotech, cutting edge energy—are once again priced at insane levels. There will always be companies like Apple and Google that work out. But picking those winners ahead of time from a crowded field of competition is extremely difficult to do. You are much better offer buying the overall market or buying cheap stocks (which will be the subject of another post soon).

History teaches us that we should avoid lottery stocks like the plague.  Just like the actual lottery, the probabilities of a big payoff are just too low.  When you buy a lottery stock, you are paying for the excitement that your ticket might pay off--a decision that is emotional not rational.  A good rule of thumb for lottery stocks and investing in general: if it feels good or excites you, it is probably a bad idea. 

"Sell in May" and Election Cycle Years

As May approaches, I figured it'd be a good time to summarize the historical evidence for/against "selling in may and going away" and the evidence for investing more or less during certain years of the election cycle.  Here is a quick summary, using S&P 500 return data from 1926-2014.

S&P data from Roger Ibbotson (nominal returns)

Stocks have performed better in the months of Jan, Feb, Mar, Apr...Nov, Dec.  They have done worse (but still delivered solid returns) in the months of May, Jun, Jul, Aug, Sep, Oct. 

If, since 1926, you'd sat on the sidelines between May and October every year, your returns would have been considerably worse (6.91%) than a simple buy and hold approach (10%)--to say nothing of the increased taxes and turnover such a strategy would require.

Because you always want the odds in your favor, its also important to note that the S&P 500 has delivered a positive return in 65% of the May-October periods since 1926.

Election cycle years also have different annualized returns. Year 3 is by far the best and Year 2 (also referred to as a mid-term election year, where we are today) is the worst.

Combining "sell in May" and election cycle years, here are the average May-Oct returns broken out by election cycle year. No clear reason for caution in year 2 of the cycle.

Here are the year by year results: 

S&P data from Roger Ibbotson (nominal returns)

While mostly positive, there are some very negative observations--one of which (2008) helped drive the popularity of the "sell in May" strategy.

But implementing a timing strategy is very psychologically difficult. Imagine selling in May of 2008.  You'd have felt like a genius come November, but do you really think that you'd have stuck to the strategy and bought back into the market in November of 2008? That would have taken extreme discipline.

The bottom line is that selling in May and returning to the market in November has been an inconsistent strategy and one that would require perfect discipline to implement (not a typical investor forte). If you are a long-term investor, you'll inevitably have to ride out tough periods of performance. I say keep your eye on the long term prize.  Even if this turns out to be a bad year, over the long term its better to stay put.