Value Investing Studies

The Dangers of Quantitative Value Investing

In recent years, quantitative stock analysis has taken the investment world by storm while qualitative analysis has been given a back seat. Value investing however — as Benjamin Graham would remind us — is both an art and a science.

A new study in the CFA’s Financial Journal showed the underperformance / diminishing alpha of stocks chosen purely based on their quantitative value, and explains why value factors taken alone aren’t great indicators.

But first, a quick trip into the value investing time machine..

Quantitative Value Investing History

Benjamin Graham’s and David Dodd’s 1934 Security Analysis is the seminal book on value investing. Security Analysis offers investors a comprehensive guide to analyzing companies to find value stocks which are priced below their intrinsic value. Graham & Dodd advise a number of strategies to find value stocks, ranging from qualitative factors like identifying industry trends and a company’s management team to quantitative factors like book value, P/E ratio, and sales-to-price.

As Graham’s value investing ideas gained popularity in the investing community with disciples like Warren Buffet and Mario Gabelli, a ton of portfolio managers and private investors began mining his work to develop their own investment strategies.

With the advent of powerful computers, databases, and stock screeners it has become increasingly easy for investors to implement Graham’s quantitative strategies, while the qualitative study of companies remains nearly as time consuming and research intensive as it was in 1934. This imbalance of effort has generated a dangerous proliferation of quantitative investing without qualitatively studying stock fundamentals.

This view of intrinsic value was quite definitive, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by book value.
– Benjamin Graham, Security Analysis, pg. 17

Facts about Formulaic Value Investing

Recently U-Wen-Kok, CFA, Hason Ribando, CFA and Richard Sloan published a paper, Facts about Formulaic Value Investing which outlines the shortcomings of quantitative investing in the CFA’s Financial Analysts Journal.

Minimal Evidence of Fundamental-to-Price Ratios Outperforming

U-Wen-Kok, Ribando & Sloan back-tested six portfolios split using the Fama-French Value Factor Model, which simply divides up the stock market using two factors:

  1. Book-to-Market tiers – HIGH, MEDIUM and LOW. As a refresher, book-to-market is the total asset value on a company’s balance sheet divided by the company’s market cap, so the higher a companies book-to-market ratio, the better value the company offers by this metric. In this study the High portfolio is the top 30% of book-to-market companies, the Medium is the next 40% and the Low the remaining 30%.
  2. Market Cap Tiers – Large Cap (BIG) & SMALL Cap.

To look for a correlation between book value and stock returns, we will take a look at the study’s results for the HML, HML Big and HML Small alpha returns. The HML alpha returns for each period show the returns on stocks with the highest book-to-market values (top 30%) minus the returns of stocks with the lowest book-to-market values (bottom 30%). Comparing the returns between the highest and lowest value stocks gives us a good indicator of how strong a stock’s book value predicts it’s future returns.

A last note before we take a look at the study’s results, HML BIG is the large cap subset of the overall HML performance, and the HML SMALL is the small cap subset. The overall HML alpha return is equally weighted between HML BIG and HML SMALL.

Study Results: Annualized Alpha for High – Low Value Stocks

1926-1962 Alpha 1.32% 0.14% 2.50%
1963-1981 Alpha 6.47% 6.17% 6.76%
1982-2015 Alpha 5.21% 1.41% 9.15%
2002-2015 Alpha 0.50% -1.63% 2.68%
1926-2015 Alpha 3.52% 1.55% 5.53%

After reviewing the HML alpha for each period a few conclusions can be drawn.

Firstly, value offered significantly better returns from 1963 to 1981, both large and small cap high-value stocks produced a 6%+ alpha over low-value stocks.

Outside of the 1963-1981 period, value has been a weak factor to predict outperformance.

The second best HML period was 1982-2015, however the bulk of that performance was in HML SMALL (9.15%) while HML BIG only generated a meager 1.41% alpha. Despite the study equally weighting HML BIG and HML SMALL, in reality 90% of NYSE market cap is from HML BIG while only 10% is from HML SMALL.

Digging further into the outperformance of HML SMALL during this period, the study’s authors note that the HML alpha can be tied more to horrible performance by the low-value small cap stocks for the period instead of great performance by the high-value stocks.

Furthermore, value’s alpha falls to nearly flat for the 2002-2015 period.

So why did value only outperform in the 1963 to 1981 period?

The Nifty-Fifty craze of the 60s and 70s helps tell the story of value’s temporary outperformance. As investor confidence soared, a fad surfaced that there were about 50 well-known companies (IBM, McDonald’s, Pfizer, etc) which were labeled can’t miss investments that would continue to grow their dividend and offer healthy stock price appreciation.

The Nifty-Fifty stocks inflated to an average P/E of 42 while the S&P 500 P/E was 19. Extraordinary P/Es were given to names like Polaroid (91), McDonald’s (86) and Walt Disney (82). These growth stocks eventually reached their demise in the 1973-74 crash which dropped the Dow Jones 45% from it’s then all-time high. As the stock market bled and investors fled, the P/Es of the Nifty-Fifty contracted at a rapid pace. Value stocks during the same period were obviously severely hurt by the crisis but weathered the storm considerably better than the Nifty-Fifty growth stocks; helping to explain the value factors outperformance from 1963-1981.

Could FANG stocks — Facebook, Amazon, Netflix, and Google — be today’s version of the Nifty Fifty? I’d love to hear your thoughts in the comments!

Why do some stocks appear significantly undervalued?

Stocks that are significantly undervalued by quantitative measures often experience a reversion to the mean, their price eventually becomes more inline with their fundamental value. This reversion to the mean can occur one of two ways (or a combination of both!):

  1. Price Increase — the optimistic outlook of the quantitative value investor — that the stock’s valuation will reach a natural equilibrium by the stock’s price increasing more in line with the underlying value of the company.
  2. Fundamentals, book value, earnings deteriorate – the low price of the stock actually foretold the coming decrease in the underlying value of the company, and the lower earnings of the company reverts the firm’s P/E to a higher level.

To discover whether price increases or fundamental deterioration plays a larger role in stocks returning to a reasonable valuation, let’s examine an attribution graph pulled directly from U-Wen-Kok, Ribando & Sloan’s study.

These graphs show the change in book-to-market (graph A) and earnings-to-price (Graph B) for the highest value stocks from one year to the next. The “beginning spread” is the difference in valuation for these stocks vs the middle tier of value, and the “ending spread” is the difference in valuation after a year.

For instance, Stock A and Stock B both have earnings per share of $2 but Stock A’s price per share is $50 and Stock B’s is $100. In this case the beginning spread of Stock A and B is 100% as Stock A offers double the value of Stock B — an earnings-to-price ratio of 4% vs E/P of 2%. If we take it that Stock A was an exceptional value compared to the rest of the market, after a year we’d expect to see Stock A’s 4% E/P revert towards the mean of 2%, if it ended the year at 3% that would drop the “ending spread” to 50% from our beginning spread of 100%.

The “impact of book value changes” (Graph A) or “impact of trailing earnings changes” (Graph B) represent how much of the difference in valuation change came from the underlying value of the stock. So if in our example Stock A’s price stayed at $50 but it’s earnings per share dropped to $1.5 from 2, the impact of earnings changes was the sole contributor to closing the valuation spread.

Value Stock Mean Reversion Attribution Graph

As you can see from the chart, on average the impact of changes in the stock’s underlying fundamentals (e.x. book value or earnings changes) makes up more than 100% of the change in valuation spread! Price is actually contributing negatively to the reversion to the mean, so the price is actually DOWN slightly (increasing the value spread) while the fundamentals of the stock are dropping precipitously.

A Sports Analogy

Lebron James Quantitative Reversion Analogy

To help illustrate what’s happening when stocks which appear to be high value on paper revert to their mean valuations over time, consider betting on a basketball game.

The championship contending Cleveland Cavaliers are playing the — non-championship contending — Charlotte Hornets. You can use any data-driven analysis to conclude that the Cavaliers should be the favorite by perhaps 6-7 points. Yet you look at the betting line and somehow the Cavaliers are 4 point underdogs! Of all the games tonight, betting on the Cavaliers offers you the most favorable spread.

However, nowhere in your quantitative basketball gambling model is the fact that Lebron James sprained his ankle and he won’t play against the Hornets; and that’s the reason the spread seems to be out of whack.

Looking beyond the numbers is the core concept of the CFA journals’ study. If a stock appears to be cheap based on it’s financial statements, there is probably a qualitative reason for it’s current price level. This is of course not to say that value can’t be found, but value cannot be determined strictly by crunching numbers without assessing a company’s industry, management, growth prospects, and so on; to determine if and by how much a company is undervalued.

A Real World Investment Example

While the CFA study’s data alone is powerful, let’s use the video game retailer GameStop (GME) as a real world example of why seemingly high value stocks can be misleading.

Game Stop Logo

In January of 2015 GameStop traded at $32.50 per share on $3.30 EPS, giving it a PE ratio of 10. As of writing this article in June of 2017, GameStop’s PE ratio has dropped to 6, it’s EPS remains at $3.30 but it’s stock price is at an all-time low of $20. GameStop is now an extremely high value stock on paper. From a stock analysts perspective however, GameStop faces considerable headwinds:

  1. Internet speeds have increased so quickly that now almost all PC games are downloaded over the web, and in fact GameStop no longer sells PC games in their stores. Similarly, Playstation and Xbox are now offering the option for consumers to download their game directly from their consoles, so people can pick up games instantly without having to trudge down to their local GameStop.
  2. Online retailers — namely Amazon — are creating tremendous pressure on brick-and-mortar stores. Even beyond the direct competition these online stores offer, overall mall and shopping center foot traffic is falling quickly.
  3. Video game rental subscriptions are gaining popularity, with Microsoft’s Xbox now offering their own service for $9.99/mo to their most popular games on demand

Through the lens of the CFA study we reviewed, we can make a prediction that GameStop’s P/E will revert closer to it’s mean historical ratio of 10 in the coming years. Unfortunately for GameStop shareholders, it’s more likely that GameStop’s earnings will dry up — similar to BlockBuster after the advent of Netflix (NFLX) — than the company’s share price will rise.

Could GameStop defy gravity and maintain or grow it earnings in the coming years? Of course, there are exceptions to the rule; but I thought it would be fun to take an example stock in the moment today when the outcome is uncertain. It will be interesting to watch GameStop’s stock in the next few years!

In Conclusion

In conclusion, using financial ratios alone to assess a company’s value can be extremely misleading and seldom leads to portfolio outperformance. Sometimes there is great wisdom in the valuations of Mr. Market and active investors. However, to truly excel in investing, we need to learn the dance of art and science.

If you’d like to learn more about Facts about Formulaic Value Investing, here’s a CNBC interview with the study’s author U-Wen Kok.

Mr. Market Yelling Prices
Benjamin Graham's Value Investing Advice

Mr. Market: The Parable of Value Investing

Arguably the most important concept in value investing, Warren Buffet called the parable of Mr. Market his favorite chapter in The Intelligent Investor. Let’s explore a simple story to illuminate Benjamin Graham’s view of Mr. Market.

Imagine that you bought a Manhattan gas station last year for $1 million. The gas station is in a great location and it earns you $200,000 per year.

Across the street from you is an identical gas station owned by a man named Mr. Market. Every day Mr. Market stops by and offers you a price to buy your gas station or sell his gas station. On Monday he offers you $800k, on Tuesday $1.1 million, on Friday $900k. He does this EVERY DAY and he rarely offers you the same price. You begin to think this Mr. Market is a little crazy.

Mr. Market Allegory Gas Station

Mr. Market is a little crazy for our gas station.

Typically, if we buy a stock from Mr. Market for $100 and it goes down in successive weeks [5%, 2%, 3%], we begin to panic, we made a mistake, this stock is a loser! Or the stock has an amazing run up and we say wow we got lucky, lets sell this stock before gravity pulls it back! In reality, the signals market prices send are meaningless to the fundamentals of the underlying company, they benefit us only buy offering an opportunity to buy or sell at any given time.

The Mr. Market parable is the core concept of value investing. In its most basic form, value investing is simply developing a strategy for creating our own price for a stock based on the company’s financials, past performance, management, and future prospects. With our own intrinsic price of a stock we can then decide at what price we should buy it and when we should sell it. If we invest without having a system to analyze a company’s value and determine our own price, we are simply throwing darts at a dart board and spinning stories of our random successes and failures.

Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.”
Warren Buffet, 2013 Berkshire Hathaway Letter to Shareholders

Benjamin Graham's Value Investing Advice

The Enterprising Investor: How to Outperform the Market

Graham outlines 5 possible ways to outperform the market (but only recommends 2):

  1. Growth Stocks
  2. Relatively Unpopular Large Cap Stocks
  3. Market Timing
  4. Purchase Bargain Issues
  5. Secondary Stocks

1) The Growth Stock Approach

Every investor, myself included, has a respect for the Motley Fool. They do a great job identifying stocks and they are true investment professionals. They are also are exceptional marketers: “The hottest stocks this year!” “This stock could be like buying Amazon in 1997!”.

Graham concedes that buying growth stocks appears to be the easiest way to outperform the market. It is intuitive to believe that the fastest growing stocks will continue to sky rocket. So why not just get a list of the top 100 best performing stocks, pick out the 10-15 best companies, and let it ride?

There are three threats to the growth approach that Graham identifies:

  1. Stocks that have been successful and are believed to have bright futures already sell at high multiples. Even though an underlying company may have excellent growth prospects, if we overpay for the stock our eventual returns may be disappointing.
  2. At some point the growth curve flattens out, and the company’s slower earnings growth takes an axe to it’s optimistic P/E.
  3. Growth stocks are much more volatile, investors have to weather much larger price swings, and these expensive stocks carry considerably more risk

Graham defines growth stocks as companies with P/Es above 20, and he generally argues to ignore stocks with a P/E above 25 altogether.

But come on, what a buzz kill Graham is!! If only he was alive to see the Amazon, Netflix, and Teslas of the world; all the ten baggers, the hundred baggers he would have missed out on!

Well he did see similar growth stocks in his time and he offers a thoughtful caveat which you may have experienced if you’ve owned a soaring growth stock, When should I sell? After seeing the stock you’ve purchased double, triple, or more; your overall financial position grows in the stock, as well as the percentage of your portfolio in the position. The company you initially invested $10,000 in is now worth $75,000 and man are you checking it’s price everyday. It dips 3 or 5% and the dread sets in: the roller coaster ride is over; we freak out and we sell. Or we set arbitrary price ceilings on the stock, and we sell. While we know companies that have had exponential decade-long periods of growth, it’s a rare investor who was disciplined enough to hold those stocks from beginning to end against all temptations to sell.

I’ve done it myself. I purchased Facebook at $21.85 in 2012. As the price continued to rise it became like an insatiable itch to sell, I could picture the day when people would begin to finally lose interest in aimlessly perusing Facebook or Instagram and the stock would take a hit. Despite that, the earnings continued to rise, quarter after quarter FB returned amazing growth. As the stock surpassed $80, $90, and then $100 a share, I began to count down the days and hours to each earning call. Finally, I sold 65% of my position at $130 in Q1 2017 while Facebook continues to accelerate and is currently trading at $152.

Each decline – however temporary it proves in the sequel – will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a goodly profit, but one far less than the ultimate bonanza.
Benjamin Graham, The Intelligent Investor

2) Relatively Unpopular Large Cap Stocks

The Intelligent Investor may argue that if growth stocks attract a popularity that can overvalue them, then unattractive stocks become undervalued. Frequently these undervalued stocks are beset by temporary headwinds that create excellent investment opportunities.

While that explains Graham’s recommendation for unpopular stocks, why does he hone in on only large cap stocks? Large cap stocks offer two advantages over small and even mid-cap stocks:

  1. Large cap stocks have the finances, assets, and human capital to survive a downturn in their industry
  2. If an unpopular but well-known company begins to show an uptick in their earnings and future profitability, the market will reward the company and its shareholders with a nice bounce.

Today, the unpopular large cap strategy has become known as the Dogs of the Dow. The Dogs of the Dow strategy is to annually purchase the top 10 highest yielding dividend stocks on the Dow to identify the index’s most unpopular stocks. So how does this value strategy first developed by Graham in 1949 hold up in the modern “growth stock era”? AMAZINGLY well!

Here are the total returns (including reinvested dividends) for the Dogs of the Dow, entire Dow index, S&P 500, and the Vanguad Growth Fund ETF (VUG).

Strategy 2012 2013 2014 2015 2016
Dogs of the Dow 9.9% 34.9% 10.8% 2.6% 20.1%
Dow Jones 0.2% 29.7% 10.0% 0.2% 16.5%
S&P 500 16.0% 32.4% 13.7% 1.4% 12.0%
Vanguard Growth ETF 17.0% 32.5% 13.6% 3.3% 6.1%
5 Year Growth of $100,000 2012-2017
Dogs of the Dow, Dow Jones, S&P 500 and Vanguard Growth ETF

The Intelligent Investor Dogs of the Dow Strategy vs DJI vs S&P vs Growth

So at the end of the most recent 5 years the Dogs of the Dow strategy would have grown $100,000 into $202,413, $35.5k more than the Dow Jones, $4.1k more than the S&P, and $9.4k more than the Vanguard Growth ETF!

The best website I found to implement the Dogs of the Dow Strategy is, they show you the list of stocks each year and track the returns of the strategy at and I used their performance tracker for this post.

3) Market Timing

Conceptually, market timing is simple, buy during bear market lows and sell in bull market highs. In practice, as we have all experienced, market timing is much more difficult. Making matters worse, in a CFA Institute study, Professors Chua and Woodward found that for a market timing strategy to be successful, an investor would have to make accurate calls over 70% of the time.

Furthermore, I believe market timing can be the greatest detractor to our long-term returns whether we become overly pessimistic and sell into bear markets, catch the irrational exuberance bug and buy into the end of bull market rallies, or sell out too early in bull markets and miss some of the best years in the market. In sum, the stock market is way too unpredictable to employ a market timing strategy.

4) Purchase Bargain Issues

Graham defines Bargain Issues as companies whose value exceeds 50% of their stock price, by using one of two methods:

  1. Income Statement – Estimating a stock’s future earnings and dividends, and then using that information to appraise the firm’s true value. A potential formula you might use is the dividend discount model which we explained in an earlier post.
  2. Balance Sheet – Reviewing a firm’s net assets to derive the value of a company to a private owner; for example if the company was bought out.

Companies that become bargain issues have usually gone through a period of poor earnings and/or general unpopularity. Graham warns that only companies of a certain caliber should be considered for this strategy: 10+ years of strong earnings under their belt, with no negative annual earnings, and they must have cash to survive a continued downturn.

I’m not going to waste too much of your time on this strategy because Warren Buffet, the living Intelligent Investor, has tried and failed repeatedly to profit from bargain issues and since 1989 has publicly denounced what he nicknamed the “cigar-butt” strategy.

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
– Warren Buffet in his 1989 Berkshire Hathaway Shareholder Letter

5) Secondary Stocks

During every Olympic Games, we all want to know, “How many gold medals have we won?” Although the difference between gold and silver in the Olympics can be a split second, a single pound, or a few inches; we put the gold medalist on a much higher pedestal than the second place finisher.

The Intelligent Investor recognizes that a similar premium is awarded to each industry’s leader (gold), and a related discount is offered to secondary stocks (silver) in each industry; giving us tremendous value investing opportunities. While in the Olympics you either win it all or not; the stock market is constantly in flux and often times secondary stocks can deliver exceptional long-term profits.

Secondary Companies when silver investments are gold

Secondary stocks may deliver a higher total return for a combination of reasons:

  1. Better dividend yield – since secondary stocks trade at a discount compared to industry leaders, their dividend yield is often considerably higher.
  2. Reinvested dividends compound – reinvesting the higher dividends compound to dramatically increase the total return after 5 or 6 years.
  3. Lower P/Es stocks are exceptionally rewarded during bull market runs as investors become less picky in their investment choices and expand their investment horizons beyond best-in-class stocks (as an extreme example picture the low quality stocks which received crazy valuations in the dot-com bubble).
  4. More room for growth – because secondary stocks by definition have a smaller market share, a positive change in management and strategy (or hubris infecting the industry leader) gives secondary stocks a higher ceiling for growth.

A good example of the dividend yield disparity of secondary stocks are Exxon Mobile (XOM) vs. Shell (RDS.A). While Exxon has an industry leading market cap of $344 billion to Shell’s $227 billion, Shell offers a 6.98% yield compared to Exxon’s 3.78% yield. That’s a 3.2% higher annual dividend for Shell, a company with a very similar future outlook as Exxon. The premium/discount in price between both companies is also reflected in their P/E ratios – Exxon trades at a 34x multiple while Shell trades at 29x.

In Summary

In The Intelligent Investor, Benjamin Graham analyzes 5 ways an enterprising investor can outperform the market.

Recommended strategies to outperform the market:

  1. Relatively Unpopular Large Cap Stocks
  2. Secondary Stocks

Strategies less likely to outperform the market:

  1. Market Timing
  2. Growth Stocks
  3. Purchase Bargain Issues
Graham's Enterprising Investor Risks
Benjamin Graham's Value Investing AdviceSecurity AnalysisStock TipsValue Investing

The Enterprising Investor: The Risks

To continue our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll jump into part one of Graham’s enterprising investor: the risks.

Before we start, let’s take a moment to consider how Graham differentiates the defensive and enterprising investor. The defensive investor, which we wrote in our last post is a patient investor and an investor who doesn’t have the time, interest, or capital (think doctor, widow, or early 20s investors) to really analyze the stock market and pick out names which may outperform the overall market. The defensive investor is wise, they recognize that frequent trading negatively effects their portfolio returns, they commonly buy ETFs which will likely outperform their individual stock choices, or favor well-known blue chip stocks.

However, I’d take a bet that the majority of this blog’s followers are likely students of the market. We know we can buy an S&P and or other market-wide ETFs, leverage dollar cost averaging by adding more money to our portfolio regularly, and sleep comfortably with the reasonable expectation of tremendous long-term returns. But… there’s just something, well, boring about that strategy. Could we not invest a little more of our time to find high-quality stocks at good prices? Would we not be able to squeak out a few more percentage points of return most years by developing and managing our portfolios more closely? Of course we can, but before we cannon ball into the deep end, it’s worth taking a look at some of the risks and pitfalls Graham warns us that enterprising investors can fall for.

Those Who Do Not Remember the Past are Condemned to Repeat It

“Any well defined and protracted market situation of the past may return in the future.”
Benjamin Graham, The Intelligent Investor

There are a number of major stock market events we can all call to mind – the Great Depression, the run on banks, Black Monday, the Oil Embargo, the dot-com bubble, the 2007-2008 financial crisis; and the list goes on. Every investor knows the stock market is cyclical, yet prices don’t get driven to their all-time highs and bearish lows without a flock mentality. What objective, first-person signs can we look for to recognize over-valuations (feel free to add your ideas in the comments!)?

Here’s a short list of market signals I’ve seen personally:

  • In the midst of the dot-com bubble, my mom (who despite this story is actually a wise investor!) joined an all-women’s investment club of realtors and house wives. Please don’t misunderstand my point as a criticism of women (many studies have found that women are better investor’s then men), but the take away was that people who were never before interested in investing began to hear about how much people were making and flocked to the market.
  • In late 2011-2012, gold was breaking record highs every month, and it seemed every TV commercial break included a commercial for buying gold or trading in your old gold.
  • In the lead-up to the 2007-08 financial crisis, we heard endless stories of people flipping homes and new homes being built.
  • “Experts” talking about paradigm shifts in a particular market. In the dot-com bubble there were plenty of market analysts talking about how the internet has changed the game, earnings and P/E ratios no longer mattered nor did sound business plans. Similarly, in the darkness of the recent financial crisis, investors became overly-weary of the housing market and began to think there was a shift where long-term housing appreciation could be stalled or fall. We wrote in our December 2008 Real Estate Outlook (not to toot our own horn =)) that the fear was overblown.

Benjamin Graham’s Intelligent Investor Risks to Look Out For

My own experience is all well and good, but what risk factors does Ben Graham outline in the Intelligent Investor?

Bond Risks

We don’t discuss bonds often in this blog, mostly because interest rates are currently at artificial lows. However, Graham’s advice for bonds is extremely relevant today, he warns that when bond market yields are low, investors often look to steal an extra 1-2% in yield buy purchasing low grade bonds. In exchange for over-reaching for 1-2% yield, we can risk the entire loss of our principal.

IPOs: Graham’s Favorite Stock Market Factor

Graham counsels us that while investors generally prefer to invest in blue-chip companies, as bull markets rage investors become less selective and more aggressive. As a result, companies which investors would never have taken an interest in begin to receive more attention. A quantifiable response to investor’s becoming less selective are the number of private companies which become attracted to the high valuations the stock markets appetite may award them with, and the lower quality threshold the stock market demands for an Initial Public Offering (IPO).

Stock Market IPOs By Year, 1990-2016

IPOs By Year 1980-2016

I created the above chart of IPOs for 1990-2016 using Univerisity of Florida’s Jay R. Ritter’s data, Prof. Ritter uses a tight definition of IPOs which I believe is more helpful for getting a sense of where we are in the current bull cycle by excluding some noise, “follow-on offerings, oil & gas partnerships or unit trusts, ADRs (9 offerings), REITs”, etc.

The 74 IPOs in 2016 was the lowest IPO total since 2009! By Graham’s standards, this relatively low IPO output last year would indicate that the current bull market is far from over. At the same time, there has been some reporting in the last few years that private companies are shying away from the high-pressure and myopic stock market, as this Business Insider article details. Could this mean a paradigm shift is causing the slowdown of IPOs and Graham’s indicator is losing its value? With any paradigm shift, I’m doubtful, I believe greedy human nature, and genuine working capital advantages of going public will continue to make IPOs are useful indicator in the years to come.

If you are interested in tracking IPO data, the best available source I found on the web is Renaissance Capital’s IPO Stat Center. Please keep in mind they don’t have as tight a definition of IPO as Prof. Ritter, but they have more information on proceeds raised, filing activity, pricing activity, and a breakdown of IPOs by sector. Watch this space.

Defensive Investing - The Tortoise & The Hare
Benjamin Graham's Value Investing AdviceSecurity AnalysisValue Investing

Graham’s Stock Market Strategy for the Defensive Investor

To begin our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll start with Graham’s guidelines for the defensive investor.

I like to think of the defensive investment strategy along the lines of the The Tortoise and the Hare:

Hare ran down the road for a while and then and paused to rest. He looked back at Slow and Steady and cried out, “How do you expect to win this race when you are walking along at your slow, slow pace?”

Hare stretched himself out alongside the road and fell asleep, thinking, “There is plenty of time to relax.”

Slow and Steady walked and walked. He never, ever stopped until he came to the finish line.

The animals who were watching cheered so loudly for Tortoise, they woke up Hare.

Hare stretched and yawned and began to run again, but it was too late. Tortoise was over the line.
After that, Hare always reminded himself, “Don’t brag about your lightning pace, for Slow and Steady won the race!”

As silly as drawing investment advice from a children’s fable seems, there are a lot of parallels between the strengths of defensive investing and the tortoise’s winning strategy. Yes, the tortoise may not have a hot year where his portfolio is on fire; but he also won’t be subject to the same or greater downside risk. While the hare counts down the minutes to their latest hot stock’s earnings call, only to find out the value of the stock options they purchased have been crushed; the tortoise may be thinking up his dinner plans on the drive home from work, oblivious and unanxious at his blue chip’s stock’s earnings which just hit Wall Street expectations.

The tortoise will seldom have exciting stocks to brag about at dinner parties, but he will slowly but surely grow his investments while focusing on his main source of income – his career.

So what are the four rules for defensive stock picking?

  1. Reasonable Diversification – Graham recommends holding 10-30 names at any given time. Too few names, and the risk of any one stock plummeting can derail your portfolio, too many names and all the work you do in choosing quality stocks will become diluted.

    I would add that diversification requires a bit more thought than simply the number of stocks in your portfolio, having 20 gold stocks would still be a risky proposition. In a recent podcast interview with Howard Marks the founder of Oaktree Capital Management, Mark’s suggested a novel defensive investment strategy I – since none of us can consistently accurately predict the future, develop a portfolio which will do well in a range of outcomes we can imagine instead of betting the farm on one potential outcome. Mark’s noted that over the last 20 years, his flagship fund has never been above the 40th percentile in returns, but the fund has also never been below the 25th percentile in returns; and amazingly enough over the 20 years his cumulative return is above the 95th percentile.

    Returning to the topic over-diversification, while Graham didn’t have this intention when he first published TII in 1949, his warnings about over-diversification seem to dip into 21st century debate over active vs passive investing. Buying an S&P 500 ETF would give you a portfolio of 500 stocks, far more than the 10-30 names Graham recommended. Does this mean that Graham would be against index funds? The Motley Fool investigated the subject and concluded he would support index funds.

    We will revisit Graham’s views on index funds and passive investing in a future article. However, I do believe the new craze of passive investing deserves some reflection. Is it truly “passive”? An investor still decides the ETFs they want to purchase, sometimes by market – US, Global, Europe, Emerging, other times by sector – financial, technology, utilities, etc. Then the “passive” investor may still face the same challenges of active investors – they may interrupt or disrupt their returns by following the herd and pouring money into ETFs when they are most expensive; or they may sell in fear when the market takes a turn.

  2. Stock’s should be “large, prominent, and conservatively financed.” Graham defined large as a company with a market of at least $50 million, but because that number was established in his ‘72 edition, we’ll use Investopedia’s definition of a blue-chip stock as a market cap above $5 billion. A defensive stock is considered “prominent” if it is above the 65th percentile in it’s industry.

  3. A defensive stock should also have a long record of dividends. Graham recommends a stock having a dividend history of longer than 10 years, at which point a company has established a track record of consistent profits and returns for the company’s investors.

  4. Set a maximum Price-to-Earnings ratio that you are willing to pay for stocks. Graham recommends a maximum P/E of 20.

    Interesting, especially in a chapter outlining defensive investing strategy, Graham doesn’t rule out growth stocks, which he defines as stocks which are poised to double their earnings in 10 years (7.1% per year). Graham writes, “obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.” Using Graham’s open definition of defesinve stocks, I believe a case can be made for Facebook, the poster-child of growth stocks, based on today’s valuation. Even though Facebook has an incredible market cap of $441 billion and a P/E of 43 (as of April 28, 2017); their earnings growth over the last 3 years is an astronomical 90% per year, from $1.5 billion in 2015 to over $10 billion in 2016. While a 90% growth rate is unsustainable, even a 20% per year growth rate over the next ten years would lead Facebook’s earnings to be rise from $10 billion per year to $62 billion per year, which given a more conservative 20 P/E makes the stock a $1.2 trillion company. Although Graham might not have, I would exempt FB from Graham’s third requirement for dividends, as I believe Facebook’s return on investing moneyin their own business is higher than the return a shareholder would find with dividends. In sum, Is Facebook’s P/E high by traditional standards, yes; is it excessively priced based on its track record and prospects for growth? I don’t believe so.

Finally, Benjamin Graham closes his advice for the defensive investor by recommending an annual review of our portfolio. If we choose high-quality companies, at reasonable prices, we remove both the need and the risk over micromanaging and over-trading our portfolios. In a poignant (if not slightly depressing) paper by U.C. Berkley, “Do Investors Trade Too Much?” they wrote:

“This paper tests whether the trading profits of discount brokerage customers are sufficient to cover their trading costs. The surprising finding is that not only do the securities that these investors buy not outperform the securities they sell by enough to cover trading costs, but on average the securities they buy underperform those they sell.”

Benjamin Graham's Value Investing AdviceValue Investing

Value Investing vs. Speculative Investing

Benjamin Graham, Value Investing vs. SpeculationWhile you contemplate a major investment decision, you need to ask yourself if you will be making a value investment or a speculative investment. You can use Benjamin Graham’s extensive writing about the difference between value and speculative investments to categorize potential investments you are considering.

Speculative investors bet on the Yankees in a Vegas casino. When the Yankees are on a hot win winning streak, the speculator can double his investments after each victory, but when the Yankees’ bats turn cold, the speculative investor will be walking the streets hat in hand.

Value investors buy bonds for Yankee stadium’s construction.

Speculative investors buy a stock with a hunch that the price will go up or down quickly. Value investors buy a stock after determining the long-term value of the business.

Although value investors outperform speculative investors in the long-run, value investors do not expect to outperform the market. Value investors accept the reality that no one can predict market behavior; instead, value investors work to control their own investment behavior.

Benjamin Graham’s 3 Types of Value Investments

1) Well established investment funds – examples are 5-star Morningstar mutual funds, corporate bond funds, & municipal bond funds.

2) Common trust funds (separate accounts) – High net worth investors can hand their portfolio over to a commercial bank or investment firm that will responsibly manage their money on a one-to-one basis.

3) Dollar cost averaging – Deposit a consistent amount of money at specific intervals (monthly or quarterly) into your portfolio. The easiest way to dollar cost average is to buy a mutual or bond fund (from Vanguard for example) where you can setup automated deposits – this way you don’t have to pay trading fees for buying new stocks or bonds every investment cycle. Suze Orman offers a dollar cost averaging calculator on her website.

Benjamin Graham wasn’t alive to see the days of Exchange Traded Funds (ETFs) but I would add ETFs as a fourth value investing option:

4) ETFs – ETFs allow you to buy a stock index (i.e. SPDR S&P 500 ETF – SPY) or a weighted stock sector (i.e. Ultra Basic Materials – UYM). The advantage of ETFs, is that you can buy a diversified investment without having to pay the associate trading fees if you bought a number of stocks, and the ETF management fees are considerably lower than their mutual fund counterparts, about .1% vs. 1.5% respectively.

Benjamin Graham’s 3 Types of Speculative Investments

1) Trading in the market – Shorting stocks that have had a short-term run-up in price.

2) Short-term selectivity – Buying stocks with upcoming earning releases that the speculator believes will beat Wall Street estimates.

3) Long-term selectivity – Picking stocks with high returns in the past, or stocks with promising product releases like tech and drug companies. A risk of “long-term selectivity” is that the speculator may buy a company with an upcoming product that eventually undersells or never makes it to market. Or the speculator’s estimates were correct, and the firm’s upcoming product is a hit, but the previous market price already consider the product’s success. Or even though the speculator’s assessment was correct, he could suffer from the John Maynard Keynes’ proverb, “The market can stay irrational longer than you can stay solvent.”

Special Situations

In between value and speculative investing are “special situations.” A prime example is investing in merger & arbitrage opportunities. Companies announce mergers for shareholder approval far in advance of any formal agreements. The announcement includes a suggested buyout price, and there is usually a spread between the market price of the company being purchased and the suggested buyout price. Immediately in response to the announcement the spread between the market price and buyout price begins to close. However, up until the day that the deal is finalized (or canceled), the spread fluctuates based on investors’ assessment about the likelihood that the deal will be completed. A recent example of a successful M&A closing is 2008 purchase of Anheuser-Busch by inBev. As close as two months before the deal closed, the merger spread widened on credit concerns, causing Anheuser-Busch to sell at $64.86 a share, while the buyout offer stood at $70 a share.


Do you find that you are more of a value investor or a speculative investor?

I find that my natural inclination is to be a speculative investor. So before I make a trade I ask myself how easily I will be able to sleep at night, or as Benjamin Graham puts it, I ask myself if the trade promises “safety of principle and a satisfactory return.”

High Dividend StocksValue Investing

Dividend Discount Model Example

Stock AnalysisThe Dividend Discount Model (Gordon Equation) calculates the intrinsic value of a stock based on the present value of a company’s future dividends. The model is a powerful investing tool to evaluate if a stock is over or undervalued compared to the market price. Professional investors use the Dividend Discount Model (among others) to value a stock, but for some reason casual investors have a habit of looking at a stock’s price chart to determine if a stock is a good value. The ill-fated chart approach has caused many casual investors to lose a bundle, after all – how can you profitably drive your portfolio if you’re focused on the rear view mirror?

This post is divided into the following sections: Dividend Discount Model’s equation, a sample valuation using Microsoft, and problems with the model.

The Dividend Discount Model


D1 (Estimate of next year’s dividend) = Current annual dividend * (1 + g)
r (Required Rate of Return for the Stock) = Real Risk Free Rate + (Market Return – Real Risk Free Rate) * Beta of Stock
Real Risk Free Rate = 52-Week T-Bill Yield**
Market Return = Estimate for the stock market’s return in the next year
g (Dividend Growth Rate) = Estimate for the stock’s dividend growth rate (you may calculate g by using the growth of the dividend in the past)

** 52-Week T-Bill Yield – You can find the yield by going to the U.S. Treasury Direct website, selecting the most recent year under auction date > 52-week bills > PDF of the latest auction results.

Sample Valuation

Here’s a sample valuation of Microsoft (MSFT) using the Dividend Discount Model..

The Dividend Discount Model requires two major assumptions – the return on the stock market for the next year and the growth rate for the stock’s dividend. In this example I will use an optimistic 12% expected return for the stock market, and a 10% dividend growth rate for Microsoft, based off their 2008 dividend growth. When you run the equation you can change these values to high, medium and low numbers, so that you can see a range of strike prices based on differing 1 year outcomes for the stock market and Microsoft’s dividends.

g (growth rate) = 2008 dividend / 2007 dividend
= .44/.40
= 10%
D1 = Current Dividend * (1 + g)
= $.52 * (1 + .1)
= $.572
r (required rate of return) = risk free rate + (market rate – risk free rate) * MSFT’s beta
= .55% + (12% – .55%) * 1.01
= 12.12%
Dividend Discount Model = D1 / (r – g)
= $.572 / (.1212 – .1)
= $26.98

Microsoft closing price as of last Friday July 24, 2009 was $23.45, so with a $26.98 valuation from the Dividend Discount Model, Microsoft would be considered undervalued.

Problems With the Model

For high-growth stocks, the growth rate (g) may be higher than the required rate of return (r), in which case the suggested stock value would be a negative number.

It is important not to use the Dividend Growth Model by itself, but rather as one tool in the value investing toolbox we’re constantly building on this blog

Feel free to ask me any questions you may have in the comments section below..

Value Investing

10 Value Investing Rules to Remember

Merril Lynch’s David Rosenberg predicted the recession in January of 2008, when the downturn was in its infancy and the Dow Jones was only down about 10%. Rosenberg gave credit for his great insight to Merril Lynch’s former investment analyst Bob Farrell’s “10 Market Rules to Remember”.

Rules one through four, which include the belief that markets always return to long-run averages and excesses in one direction are invariably followed by excesses in the opposite direction, are applicable to this decade’s housing cycle, Rosenberg said.

Farrell’s rules “were a compass in terms of guiding me through the past three years,” said Rosenberg

– Bloomberg, “Merrill’s Rosenberg Inspired by Farrell in Foreseeing Crash” 

Farrell’s 10 Market Rules to Remember:

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras — excesses are never permanent.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5. The public buys the most at the top and the least at the bottom.

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.

8. Bear markets have three stages — sharp down — reflexive rebound —a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree – something else is going to happen.

10. Bull markets are more fun than bear markets

For a detailed analysis of the ten rules, check out this MarketWatch article.

Even with the stock market finding a pulse of late, the overwhelming investment sentiment is clearly pessimistic. I can’t stop thinking about October of 2007 when the Dow Jones was at 14,000. The investment community and average investors were unified in their optimism to equal levels that they are now pessimistic. I love Farrel’s ninth rule – when all the “experts” agree, something else is going to happen. I’m still firm in my belief that Mr. Market has given value investors a great opportunity to buy.

Any thoughts on Farrell’s ten rules?

Value Investing

How to Create a Medium Risk Portfolio

This post focuses on a technique to attain medium risk in your portfolio with a value investing approach. “Medium risk” seems to be an elusive term, which was well illustrated in the bear market of 2008. In Nassim Taleb’s book he shares his brilliant “barbell” investing strategy that comes as close to the essence of a medium risk and value investing portfolio as I have come across. He advises that we invest 80-90% of our portfolio’s in Treasury bills, the safest investment class on the planet. The remaining 10-20% should be invested in high risk bets like options.

Taleb’s strategy is unconventional, but lets take a closer look. In the past year we have seen overwhelming proof of investors and economists inability to speculate. Millions of shares of Bear Stearns were bought above $100 before their sale to J.P. Morgan for a couple of dollars and the majority of “sophisticated investors” were only mildly bearish in January 2008. By investing 80-90% of a portfolio in T-bills you create a safe nest-egg. The percent of your portfolio devoted to options gives you a floor on your possible exposure to massive losses in the equity market – you cannot lose more than 10-20% in any given year. At the same time, if your option bets are successful, you have a large upside.

Let us consider the medium risk math – the most recent 10 year treasury notes sold for about 4%  interest rate (which is near the historical low). Lets estimate that all your option investments have a wide range of 50% returns or 50% loses in a year. If 80% of your portfolio returns 4% that effects your portfolio with an overall increase of 3.2% (80 x 4%). The 20% dedicated to options with a +/- 50% return will deliver a 10% increase in your overall portfolio or a loss of 10%, at either end of the spectrum. So overall in a good year of 50% returns on options your overall portfolio will increase 13.2% (3.2% + 10%) and in a terrible year of 50% loss on options your overall portfolio will decrease 6.8% (3.2%-10%). By a show of hands how many people would be happy to have only been down 6.8% this year?

If you are considering treasury bills you can research rates and buy t-bills at the goverment website –

Taleb’s proposal is an interesting blend of very low and very high risk that appears to attain true medium risk. I am interested to hear what you think and if you would consider Taleb’s diversification method. The method came from his bestselling book, The Black Swan: The Impact of the Highly Improbable. Taleb is a sucessful hedge fund manager and professor who studies human’s poor ability to make predictions and the effect of “Black Swans” or random, unpredictable events. Taleb’s book is available on Amazon:

Happy Holidays!!

Financial News

What is a Ponzi Scheme?

Charles Ponzi

The Madoff scandal may have you asking: What exactly is a Ponzi scheme?

The essence of a Ponzi scheme is better known today as a pyramid scheme.

In 1920, a Boston investment broker named Charles Ponzi told investors that he could earn them 50% returns on a 45 day bond, from his mysterious investing technique. Within the 45 days, Ponzi would recruit larger investors, and use their investments to pay interest on the last round of investors. When word spread that Ponzi had been delivering on his high yield promises, huge lines of eager investors formed outside his office. In his own words:

“A huge line of investors, four abreast, stretched from the City Hall Annex . . . all the way to my office! . . . Hope and greed could be read in everybody’s countenance. Guessed from the wads of money nervously clutched and waved by thousands of outstretched fists! Madness, money madness, was reflected in everybody’s eyes! . . .To the crowd there assembled, I was the realization of their dreams . . . The ‘wizard’ who could turn a pauper into a millionaire overnight!”

– Charles Ponzi