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February 24 - March 15, 2018
More than two-thirds of professional portfolio managers have been outperformed by unmanaged broad-based index funds.
it’s probably a good idea to explain what I mean by “investing” and how I distinguish this activity from “speculating.” I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term. It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. A speculator buys stocks hoping for a short-term gain over the next days or weeks. An investor buys stocks likely to produce a
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Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm-foundation theory or the castle-in-the-air theory.
The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something’s actual price with its firm foundation of value.
THE CASTLE-IN-THE-AIR THEORY
The castle-in-the-air theory of investing concentrates on psychic values.
It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.
Selling short is a way to make money if stock prices fall. It involves selling stock you do not currently own in the expectation of buying it back later at a lower price. It’s hoping to buy low and sell high, but in reverse order.
Remember that the major sellers of the stock of IPOs are the managers of the companies themselves. They try to time their sales to coincide with a peak in the prosperity of their companies or with the height of investor enthusiasm for some current fad.
Most bubbles have been associated with some new technology (as in the tronics and biotech booms) or with some new business opportunity (as when the opening of profitable new trade opportunities spawned the South Sea Bubble).
The promise of the Internet spawned the largest creation and largest destruction of stock market wealth of all time.
the NASDAQ Index, an index essentially representing high-tech New Economy companies,
The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. And history tells us that eventually all excessively exuberant markets succumb to the laws of gravity.
Credit boom bubbles are the ones that pose the greatest danger to real economic activity.
eventually, true value is recognized by the market, and this is the main lesson investors must heed.
Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors. In the final analysis, true value will win out.
There is no evidence that anyone can generate excess returns by making consistently correct bets against the collective wisdom of the market.
Stock investors can do no better than simply buying and holding an index fund that owns a portfolio consisting of all the stocks in the market.
Most, however, opt for one of two methods: technical or fundamental analysis.
Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks.
Perhaps 90 percent of the Wall Street security analysts consider themselves fundamentalists. Many would argue that chartists are lacking in dignity and professionalism.
As more and more people use it, the value of any technique depreciates.
Albert Einstein once described compound interest as the “greatest mathematical discovery of all time.”
Suppose you invest $100 this year and next year in an investment that produces a 10 percent annual return. How much have you made by the end of year two? If you answered 21 percent, then you deserve a gold star and a trip to the head of the class. The algebra is simple. Your $100 grows to $110 at the end of year one. Next year, you also earn 10 percent on the $110 you start with, so you have $121 at the end of year two. Thus, the total return over the two-year period is 21 percent.
Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money.
For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years).
this brings us to the first fundamental rule for evaluating securities: Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
It is the P/E multiple, not the price, that really tells you how a stock is valued in the market.
Determinant 2: The expected dividend payout.
Stocks that pay out a high percentage of earnings in dividends may be poor investments if their growth prospects are unfavorable.
Many companies tend to buy back their shares rather than increasing their dividends.
Rule 2: A rational investor should pay a higher price for a share, other things equal, the larger the proportion of a company’s earnings paid out in cash dividends or used to buy back stock.
Determinant 3: The degree of risk.
Rule 3: A rational (and risk-averse) investor should pay a higher price for a share, other things equal, the less risky the company’s stock.
Determinant 4: The level of market interest rates.
On the other hand, when interest rates are very low, fixed-interest securities provide very little competition for the stock market and stock prices tend to be relatively high.
Rule 4: A rational investor should pay a higher price for a share, other things equal, the lower the interest rates.
Caveat 1: Expectations about the future cannot be proven in the present.
Caveat 2: Precise figures cannot be calculated from undetermined data.
Caveat 3: What’s growth for the goose is not always growth for the gander.
WHY MIGHT FUNDAMENTAL ANALYSIS FAIL TO WORK? Despite its plausibility and scientific appearance, there are three potential flaws in this type of analysis. First, the information and analysis may be incorrect. Second, the security analyst’s estimate of “value” may be faulty. Third, the market may not correct its “mistake,” and the stock price may not converge to its value estimate.
Many analysts use a combination of techniques to judge whether individual stocks are attractive for purchase. One of the most sensible procedures can easily be summarized by the following three rules.
Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years. An extraordinary long-run earnings growth rate is the single most important element contributing to the success of most stock investments.
Rule 2: Never pay more for a stock than its firm foundation of value. While I have argued, and I hope persuasively, that you can never judge the exact intrinsic value of a stock, many analysts feel that you can roughly gauge when a stock seems to be reasonably priced. Generally, the earnings multiple for the market as a whole is a helpful benchmark.
Suppose, for example, you buy a stock earning $1 per share and selling at $7.50. If the earnings grow to $2 per share and if the price-earnings multiple increases from 7½ to 15 (in recognition that the company now can be considered a growth stock), you don’t just double your money—you quadruple it. That’s because your $7.50 stock will be worth $30 (15, the multiple, times $2, the earnings).
Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.
The stock market has little, if any, memory. While the market does exhibit some momentum from time to time, it does not occur dependably, and there is not enough persistence in stock prices to make trend-following strategies consistently profitable.
What are often called “persistent patterns” in the stock market occur no more frequently than the runs of luck in the fortunes of any gambler. This is what economists mean when they say that stock prices behave very much like a random walk.
I am not saying that technical strategies never make money. They very often do make profits. The point is rather that a simple buy-and-hold strategy (that is, buying a stock or group of stocks and holding on for a long period of time) typically makes as much or more money.
