Friday, July 14, 2006

Stock Market Investing

There are five investment techniques, or styles, that I can count. One is risible, one is gambling, one is speculating, and two are worth careful examination. The risible technique is charting. Now don’t get me wrong, I think there really are things like levels of resistance and support, but taking it much beyond that is silly, and not worth further discussion.

Gambling is fine if that is what you do, and if you don’t mind losing money more often than you make it. Gambling includes buying stocks on hot tips, ‘momentum’ investing (buying a rising share just because its rising, and hoping you get out before it crashes), buying shares because you like the company’s name or because the stock code is your first girlfriend’s initials, etc etc.

Then there is speculating. I think speculating is an important pursuit that generally gets a bad press. I put it in a different class to gambling. Speculating is taking a calculated, and usually very high, risk. Often on the basis of imperfect information. You do it in return for a very high reward, and only with money you are prepared to lose. Only one major speculation every few years needs to come off, to make it all worthwhile. That is assuming your pockets are deep enough to survive that long. But speculating is critical to our entrepreneurial system – someone needs to support the start-ups, the big ideas, the early-stage companies that need a bit of faith.

The other two styles, the two that are worth investigating from the point of view of someone who fundamentally does not want to lose money, are ‘value investing’ and ‘portfolio investing’. These terms raise extraordinary passions among their supporters. In their pure form they are perfect opposites, both at a deep theoretical level and at the level of practical application.

Value investing means looking very hard at individual businesses, getting to know them, understanding the business, their cashflows, their market, their prospects. It means evaluating companies on the cash they generate, not on their future growth prospects. Once you like what you see, it is then fundamental that you buy when it is really cheap. That is to say, when the share price is at a level at which your fundamental analysis is saying: this company is a bargain. Then you buy, and you buy big, and you hold it till doomsday, ignoring daily, monthly or yearly price fluctuations.

Portfolio investing (it has lots of other names) is the reverse. It says you can’t pick stocks. No matter how hard you try you will never get it consistently right. Instead you buy a portfolio of companies, the more the better, theoretically and preferably the whole market. It is a statistical approach. Portfolios of different compositions will produce different returns. Portfolio investing is big on risk, which it defines as price volatility. “Efficient” portfolios are composed so as to deliver the maximum possible return associated with any given level of risk. The higher the risk (as defined) the higher the return. Again, once you have bought, you simply hold.

Interestingly, the proponents of both styles come down very heavily against the typical managed fund (or unit trust). This is interesting because I suspect that an actual majority of the world’s savings are in managed funds of one sort or another. The problem is the fees, the churning of shares (raising transaction costs), the evident inability of fund managers to consistently beat the market.

The fundamental theoretical belief behind value investing relates to price and value. Value investors state, passionately, that price does not equal value. “Price is what you give, value is what you receive” in the words of the founder of this approach. This means that it is possible to find an undervalued company. If it were not possible, then value investing would not be possible. Value investors distrust the noise from the “Market”, and all the commentary about cycles and ups and downs etc etc. Value investors don’t try to pick cycles, or time the economy or the market. They look for undervalued companies with strong, growing cashflows, and when they find them they buy them and hold them for the long term. They are not too fussed about price fluctuations of companies they have bought. But they believe that, in the long run, “value will out”.

These investors value companies in the most fundamental way – by looking at the actual cash a company will generate, in earnings or in dividends. They like to see strong, growing earnings, earnings that will pay back the outlay on the share within a few years (certainly less than ten). Value investors do not buy “growth companies” on PE ratios of 20 or more. Value investors don’t go in over-much for diversification. You can’t deeply analyse too many companies, and anyway, if you are buying the right ones in the first place it is not necessary. So a typical portfolio may be as little as ten, and probably no more than twenty, companies.

The fundamental theory behind the portfolio approach is comprehensively worked out and has a strong academic underpinning. That is not to say it is right, just that this approach is more amenable to a lot of mathematics and statistics. The foundation doctrine is the efficient market theory, from which springs the modern portfolio theory. The efficient markets theory says that at any given time all information about a certain stock is already built into the share price. All market participants have the same information, and any new information is reflected instantaneously in the share price.

Therefore there are no undervalued companies (or over-valued ones). Value is the same as price. It is useless to try to pick stocks. Taking this further, the theory says that most of a company’s price performance is dictated by the general performance of the market – whether the market is rising or falling and the rate at which it is doing so. This is systematic risk. Most of the rest of a company’s performance is dictated by ‘unsystematic risk’ – risks specific to that company, whether related directly to the company (such as bad management decisions) or to outside events (such as wars or market changes) that specifically affect that company. These are considered unpredictable and essentially random. The final determinant of a company’s performance is simply its size. These three things explain all of a company’s performance. Risk is the company’s price volatility relative to the overall market.

The correlation of risk and reward is fundamental to portfolio theory. The next step is to draw a graph with risk (price volatility) on one axis and return on the other. An “efficient” portfolio is one that delivers the maximum return for a given level of risk, and it will plot along the 45 degree line bisecting the two axes. An inefficient portfolio will lie off this line, and will deliver a higher level of risk than is necessary for a given level of reward. One can construct high risk/high reward portfolios, or low risk/low reward portfolios, and provided they are efficient, they will deliver exactly the maximum level of reward that can possibly be achieved for the chosen level of risk. It is important to understand that the most efficient portfolio, under this theory, is of course the whole market. Index funds are, unsurprisingly, among the strongest proponents of the portfolio theory, as they are designed to deliver the index return, neither more nor less, and hence should be perfectly “efficient”.

So how do these two approaches stack up? Is one right and the other wrong? One takes a focused approach, looking closely at individual businesses, and the other takes a broad statistical approach, looking at the whole market and ignoring individual companies.

At the theoretical level they both can’t be right. This is because of the value/price conflict – one theory says that price and value are different, the other says they are exactly the same.

In my view the value investors have it right on this one. It is patently obvious that price and value can differ. I have nearly a decade of experience in running listed companies, and I know very well that the market can get it wrong. Also that they market will usually eventually get it right. The boom was a powerful and painful demonstration of how wrong the market can get it. On the other hand, stripping value investing down to its essence can make it look rather facile – that is, if you can find and buy severely undervalued assets, you will make money out of them.

Nevertheless there is something very convincing about the portfolio approach, if not the theory. We all know that shares outperform other asset classes over time. If one could guarantee the market return over the long term for one’s hard-earned cash, most of us would take it. That is really what the portfolio approach promises. At bottom it is essentially empirical, buttressed round with a lot of statistics and theory. But historical data shows that the market as a whole delivers a certain return, that bad companies do worse (en masse) than good companies, that small companies (en masse) grow faster but in a more volatile fashion than big companies.

So while I don’t agree with the efficient markets theory, I do think that there is a lot of bald empirical fact supporting the portfolio approach to investing.

Consider value investing. There are two problems with its practical application. Firstly, how do you find undervalued companies? Because while the market can clearly get things wrong, I think it usually gets them pretty right. That means that it can be very hard for a value investor to find something to invest in, and for that reason they need the discipline to sit on cash for extended periods. The second problem is, once you have found an undervalued company, how do you find out whether it is undervalued, or really is a dog that will be dead in 6 months? Essentially this is contrarian investing, so you better make sure that there is not something out there that you don’t know, that is causing the market to give a PE ratio of 4 to your carefully selected “great” company. Practically speaking, it is hard for a private individual to find the time and resources to look at companies in this level of detail.

On the other hand there is something deeply real and satisfying about investing in an actual business, rather than buying a statistical entity representing a market index. Indeed, for those with real wealth, there is almost a moral responsibility to use it to invest in and support good businesses. You cannot do that if you invest in indices.

It would be nice to unify these two approaches on a theoretical level. Someone should work on that. Companies are not random number generators, even though the market on a daily basis acts in a random fashion. But real people work very hard to build good companies, and they need informed and active investors to support the business and through that the economy and the whole free market system.

But the reality is that most people simply don’t have the time or the skills to pick ten or fifteen companies to put their life savings into.

However I do think most people can value companies, especially if they stick with businesses they know well. Over time opportunities do come up. So the reality for the private investor who does not want to lose money, but who wants to be in the market in order to make a reasonable return on hard-earned cash, is probably an unexciting mixture of the two. I would avoid managed funds, because the fees are too high and erode returns, and the responsibility of getting someone else to invest your money is too great. Most fund managers don’t, in fact, beat the market.

So a reasonable approach for an investor with a sum of money that he wants exposed to the stock market would be to choose a few index funds and invest some proportion of the cash in them. The rest of the money can go, over time, into good, familiar companies that have solid earnings but low(ish) PE ratios (good luck finding them). Don’t act hastily, buy over time, or bide your time. The ratio of index investments to company investments is up to you, and depends on your skills, resources and appetite for risk. Good luck.


Post a Comment

<< Home