Thursday, March 29, 2007

Are Growth Stock Prices Reflecting a Cheery Consensus?

In one of his chairman's letters, Warren Buffett once stated that ...

"The future is never clear, you pay a very high price in the stock market for a cheery consensus."

I just looked at the 10 year returns of the Russell 1000 Value Index, and the Russell 1000 Growth Index.

Frightening, the cost of a cheery consensus, particularly those orienting towards the growth side of the equation.

Sidebar note: If you're on a blog aggregator, you can visit The Confused Capitalist here for additional articles and exclusive content!

The difference in the current valuation metrics on the two indices are significant, scary, and points to, may I suggest, more of the same looking forward.


The Confused Capitalist

Thursday, March 22, 2007

A superior index arises: just a better mousetrap

This can either be read as a stand-alone posting relating to why fundamental indexing is a better way to go than tracking a conventional index, or it can also be read as part two of two of a book review of "The Little Book of Common Sense Investing", by John Bogle.

As relayed in part one of my review, I found the evidence presented by Mr. Bogle to be almost overwhelming that investing in a low-cost index fund was virtually the only way for the average equity investor to outperform the broad market, like the S&P 500, over time. A very good method as the book clearly details.

However, in the book (chapters 12, 14, 15 and 16), Mr. Bogle suggests that some of the new fundamental indices (e.g. FTSE RAFI) aren't going to stand up to the test of time, as market capitalization-weighted indices (such as the S&P 500) have. He intimates that, having seen various "better mousetraps" come and go, so too will fundamental indexing (which back-testing shows has outperformed a cap-weighted by nearly 2% annually, a huge margin). This is essentially, he claims, just another method to part the foolish from their prospect of future returns.

He denigrates the back-testing of these fundamental indices as if that was somehow undesirable. I personally fail to see the difference between the back-testing done there, and Mr. Bogle's own back-testing that led him to the conclusion that low-cost index investing was going to beat the then conventional mutual fund of the day (an advantage that has continued to hold up to this day).

Mr. Bogle fairly asks the question of why these fundamental factors (fundamental factors are centered on accounting items, like book value, dividends paid [or dividend growth rates], earnings, revenues, etc.) have not been properly exploited by stock markets in the past? While there have been tons of academic studies pointing out that a stock-picking method using virtually any of the aforementioned factors as a major stock-picking factor would have outperformed the broader market, that still doesn't really answer the question.

The question is best answered by examining behavioural research. In other words, it has to do with the emotional nature of people, something that even mutual fund managers are subject to, as clearly evidenced by the typical 100% turnover on the conventional mutual fund. Certainly, they also appear to be "taken in" by a "good story", as much as anyone. For more insight on this issue, see the following (warning: large pdf file) commentary, Seven Sins of Fund Management. In short, the problem is, my dear Mr. Bogle, interference from human beings.

Just as Mr. Bogle was then a pioneer of the day, by exploiting something seemingly obvious and mundane (i.e. 1. costs matter and 2. don't get trapped by "the story") it seems hard to believe that no one can build a method for a relatively sustainable advantage over a conventional index. In the future, the building of these fundamental indices today will probably be seen as something that should have occurred much earlier, given their obvious superiority.

But getting back to the business at hand, if, as alleged by Mr. Bogle early in the book, that long-term investment returns more or less parallel the returns of the stock market of the underlying businesses, doesn't it make sense to construct an index which actually gives weighting to those factors, as opposed to the more temporary and whimsical valuations imposed by market activity?

Doesn't it make sense to try and limit or exclude the "speculative" return (positive and negative) he discusses, which is, essentially, the contribution (deduction) to (from) short-term returns from stocks becoming over (under) priced? Fundamental indices attempt to do that: exclude the most-egregiously over-priced stocks, by fundamentally examining the books of each company. Conversely, these indices also include more of the relatively undervalued companies. That these indices might succeed over the longer-term would be due to the rules-based inclusion of companies into the index. A fairly simple, but effective, way of eliminating or minimizing poor investment decisions: rules!

After a time, I think Vanguard, Bogle, and other indexers will recognize that these are superior indices. Then, more index funds will be created to track them. Because the basis of inclusion into these indices are the actual economic activity of the companies themselves, rather than the more capricious valuations assigned by the market activity of the moment, they can finally answer a question Bogle poses in the book: How to know which companies are over-valued in a conventional index? Effectively, the books of the companies themselves answer that question.

In the end, an index that examines the fundamentals of companies in some manner simply has to be better than one which only considers the temporary selling prices of their stocks. Vanguard and others will finally realize this, and bring the same ruthlessness to cutting costs that they did to tracking the S&P 500, for instance.

Whether these indices will continue to significantly outperform conventional capitalization-weighted indices starting twenty years from now, the answer is "probably far less" than current back-testing has shown was available. As the "rise of the machine" eliminates emotional interference (1, 2) from making "on mass" good investing decisions, these market inefficiencies will be exploited such that they will disappear over time. And while the costs are currently slightly higher for these ETFs (about 0.5% annually) than an extreme low-cost conventional index-tracker (about 0.19%), the cost/benefit equation seems to be worth it (i.e. you pay an extra 0.3% or so, to get about 2% more).

In the interim though, as these inefficiencies are finally properly captured over the next decade or two, it's possible that excess returns will even exceed that shown in back-testing. And any advantage that is likely to persist over ten to twenty years isn't something to be ignored, in my view.

Anyone with a broadband connection and who wants to really understand the multitude of reasons why these are superior indexes, are suggested to go to these two (one, two) video presentations, by Rob Arnett of Research Affiliates.


The Confused Capitalist

Monday, March 19, 2007

Editorial: Why a Responsible Fed Won't Lower Rates Anytime Soon.

Notwithstanding the perceived subprime "crisis", a responsible Fed can't lower rates anytime soon. Why?

Because the consumer is finally being told, in no uncertain terms, to smarten up, stop spending more money than you have, and save a little bit. With this message, (and a puncturing of the home-ATM cash-machine) inflation will finally begin to get tamed.

Any loosening of the money supply at this point, while mitigating the short-term damage that will soon become evident in bloated housing markets, will only move that day of reckoning into the future. A future time which which would then have bleaker, more uncertain and more unstable fundamentals, from which to try making essentially the same maneuver.

No, dear readers, this is the medicine that great-great-grandmother used to force down great-grandmother's throat: a nasty-smelling, foul-tasting, herbal concoction that nearly gagged the dear girl. But medicine that helped the patient recover sooner, and more robustly.

To lower interest rates at this time is the equivalent of turning up the heat in the house, so that the feverish patient may feel comfortable. Foolish. Understandable to some, with the child whining so loudly but, all the same, foolish.

And a responsible Fed just won't do that.


The Confused Capitalist

Saturday, March 17, 2007

S&P 500 Future Returns

Readers may wish to take the investment poll located on the right hand side of the blog which asks what you expect the S&P 500 rate of return to be over the next 10 years.

Thanks to Geoff Gannon of Gannon on Investing for providing this poll.

The Confused Capitalist

The Little Book of Common Sense Investing - Book Review

Subtitled: The Only Way to Guarantee Your Fair Share of Stock Market Returns.

For those equity investors that read the compelling message provided by this book and follow author John Bogle's advice, the book might have several other compelling subtitles, such as "Relentless arithmetic proves it's almost impossible to outperform a low-cost index fund", or "Equity investors: find a less expensive/more profitable hobby! Like investing in a low-cost index fund!", or, more simply, "Most mutual funds suck!".

This book, by the father of the index-investing movement and founder and former head of the Vanguard Group uses "relentless arithmetic" to prove exactly why individual investors will, as an average, dramatically underperform the market averages (about 9.5% annually over long periods of time, according to the book). Bogle has been a persistent critic of traditional mutual funds, which have an excessive average cost of 2.5% annually, compared, for instance, to the Vanguard index fund cost of just 0.19%. Bogle has been a critic because, despite the high cost of a conventional mutual fund, it doesn't, on average, outperform a low-cost index fund.

Just considering the mutual fund cost portion of the drag (about 2.5% annually), this book shows that, compared to investing in the index, after 30 years, the typical mutual fund equity investor will only get about 50% of the market advance. After 50 years, this will decline even further, to only 31% of the total advance.

These dismal averages don't even consider the propensity of investors to trade in and out various funds, ETFs, or stocks (transactional costs), nor the further drag of picking the wrong funds. These are significant sources of further underperformance.

Bogle punctuates this message by regularly providing quotes from famous value investors and business school professors, to further support low-cost index investing. In some ways, I felt like the book was a form of Chinese water torture: at the end, it was all but impossible to dismiss its message. And that message is that low-cost index-fund investing is the "only way" to get your fair share of market returns. As the book puts it, "by aiming for the average, you can beat the average".

In summary, the book shows the three sources of underperformance - which are very significant in their totality - which is likely for average equity investors:
  1. Excessive costs of conventional mutual funds;
  2. Transactional or trading costs as investors trade in and out of various funds/stocks etc. and;
  3. The costs of picking the wrong funds (investor pile into funds which have risen lately, and history shows most of these are poised for a period of underperformance; and visa-versa).
Overall, this is a great book with a fabulous message for most investors, and most investors couldn't do wrong by following the approach espoused here.

In a separate future posting, I am, however, going to take on one of Mr. Bogle's final messages: that some of the new products and new market indices aren't likely to provide superior returns any better than tracking conventional market capitalization-weighted indices (S&P 500 is one such index, and most widely-quoted indices are of this type). I believe this to be false, and hope to explain why I think so, using mostly Mr. Bogle's own words to explain why.

No matter this relatively small dispute, I recommend that all investors unfamiliar with the huge advantages of low-cost index investing buy and read this book.


The Confused Capitalist

Sunday, March 11, 2007

Profit from "U"

I recently received two books: review copies from the well-known and respected John Wiley and Sons, publishers of many, many, business and investment titles. These two books are entitled, "Profit from China" and, "Profit from Uranium" and are printed under Wily's imprint "Investment U". Each is priced at $29.95 ($US) or $35.99 ($Cdn).

These "books" are total less than 50 pages in length and are written in the style of a friend-to-friend informal report. The actual number of pages discussing the topic at hand is less than 25 pages. That's right, the books are effectively priced at more than a $1 per page.

Each of these books provides a little bit of background around each investment theme and then suggests four stocks or ETFs that could benefit from continued investment into each respective theme.

I have to say that I agree with the review of these books given by portfolio manager and fellow blogger Roger Nusbaum.

While the "books" have some utility I have to say that I'm left with the impression that Wiley is viewing these as a potential "profit center" - meaning they view you, dear reader, as their profit center in this case. I think that Wiley can do a lot better than titles like these - or alternatively, reduce the price to something commensurate with the effort ($3.99?) or effective utility ($5.99?). I think the unfortunate result of publications like these will be to cheapen the name and reputation of Wiley as a publisher of quality business titles.

But that's just my opinion. You are, of course, free to form your own. For only $29.95.


The Confused Capitalist

Monday, March 05, 2007

Thinking About ETFs

As many readers here are aware, I'm a pretty big fan of ETFs, particularly as a solid foundation for a portfolio. However, I think that you have to drill down into the particular ETFs to consider what their chances of outperformance are.

Obviously, buying ETFs that have constituent companies with a high return on capital (or equity) and a low price (as in a low PE ratio), are likely to return greater capital to your wallet over the long term. That's why I try to drill down into these ETFs before I personally buy them.

One research firm that does this for you is AIR AltaVista Independent Research Inc. Its' methodology was recently highlighted in an interview with AltaVista Research President Mr. Michael Krause, by fellow blogger (here) James Picerno.

One thing that definitely caught my attention was ... statement in the later part of the interview relating to fundamentally-indexed ETFs ...
I am quite a fan of fundamental indexing. We’re getting new flavors and gimmicks in indexing all the time, but I think fundamental indexing is one of the most genuine and promising developments in a long time.

I have blown this horn fairly often in the past ... they appear to simply be a better way to invest. But whether you choose these fundamentally-indexed ETFs, or one of the many ETF allocations which still aren't fundamentally indexed, then researching your choices in relation to price and value measures is almost certain to improve your investing outcomes.


The Confused Capitalist