You Don’t Need Perfect Batting Average

You Don’t Need Perfect Batting Average: In order to significantly outperform the market, investors need not generate near perfect results. 


Hammering home the idea that a few good stocks a decade can make an investment career, Lynch had this to say about Buffett:


"Warren states that twelve investments decisions in his forty year career have made all the difference."


Related:

Lessons Learned From Investing Genius Peter Lynch

Benjamin Graham
"To achieve satisfactory investment results is easier than most people realise; to achieve superior results is harder than it looks."

Investment Strategy and Superior Returns

"Style investing," where money managers rotate between small and large, and value and growth stocks, is all rage on Wall Street.

Historical data seem to imply that:

• small stocks outperform large stocks and
• value stocks outperform growth stocks

Yet the historical returns on these investment styles may not represent their future returns at all.

• The superior performance of small stocks over large stocks depends crucially on whether the 1975-1983 period is included.
• Furthermore, the superior performance of value stocks over growth stocks may not be inherent to the industry they are in but merely reflect fluctuations in investor enthusiasm about certain sectors.

All these implies that the average investor will do best by diversifying into all stock sectors.

• Trying to catch styles as they move in and out of favor not only is difficult but also is quite risky and costly.
• Hot sectors or investment styles can lull investors into a trap.
• When a sector reaches an extreme valuation level, such as the technology issues did at the end of the technology bull market, reducing its allocation will improve your returns.

An investor can use the lessons of history to avoid getting caught in the next technology, stock or market bubble.

Also read:

Bubbles: Does history guide us?
Bubble lessons never go out of style

IPOs and Superior Returns

IPOs always have fascinated investors. New companies are launched with enthusiasm and hope that they can turn into the next Microsoft or Intel.

Historically,

• The large demand for IPOs means that most IPOs will "pop" in price after they are released into the secondary market, offering investors who bought the stock at the offering price immediate gains.
• For this reason, many investors seek to obtain as many shares in IPOs as possible, so underwriting firms ration the shares to brokerage firms and instituional investors.

A study by Forbes magazine of the long-term returns on IPOs from 1990 to 2000 showed that investing in IPOs at their OFFERING price beat the S&P 500 Index by 4% per year.

However, many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5000) that went public between 1970 and 1990.

• Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11%.
• Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14% annual return.
• And these data do not include the IPO price collapse in 2001.

High Dividend Yields and Superior Returns

Another favourite value-based criterion for choosing stocks is dividend yields.

More recent studies by James O'Shaughnessy have shown that from the period 1951-1996, the 50 highest dividend-yielding stocks had a 1.5% higher annual return among large capitalization stocks.

In another study, a strategy based on the highest yielding stocks in the DJIA outperformed the market.

The correlation between the dividend yield and return can be explained in part by taxes. Stocks with higher dividend yields must offer higher before-tax returns to compensate shareholders for the tax differences.

It should also be noted that most current studies, like O'Shaughnessy's, exclude utility stocks, which as a group have by far the highest dividend yield but have vastly underperformed the market over the past decade.

(Another point to note: for a stock that is paying fixed dividend, the high dividend yield reflects a lower price of the stock and a low dividend yield reflects a higher price of the stock. Therefore, dividend yield fluctuates along a range. Dividend yield can be usefully employed as another tool for valuing the stock.)

Price-to-book ratios and Superior Returns

PE ratios are not the only value-based criterion for buying stocks. A number of academic papers, begining with Dennis Stattman's in 1980 and culminating in the paper by Eugene Fama and Ken French in 1992, have suggested that price-to-book P/B ratios may be even more significant than PE ratios in predicting future cross-sectional stock returns.

Like PE ratios, Graham and Dodd considered book value to be an important factor in determining returns. More than 60 years ago, they wrote:

We suggest rather forcibly that the book value deserves at least a fleeting glance by the public before it buys or sells shares in a business undertaking..... Let the stock buyer, if he lays any claim to intelligence, at least be able to tell himself, first, how much he is actually paying for the business, and secondly, what he is actually getting for his money in terms of tangible resources.

Low PE stocks and Superior Returns

In the late 1970s, Sanjoy Basu, building on the work of S.F. Nicholson in 1960, discovered that stocks with low PE ratios have significantly higher returns than stocks with high PE ratios.

This would not have surprised Benjamin Graham and David Dodd, who in their clasic 1934 text, Security Analysis, argued that a necessary condition for investing in common stock was a reasonable ratio of market price to average earnings. They stated:

Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 16 times their averge earnings are likely to lose considerably money in the long run.

Yet even Benjamin Graham must have felt a need to be flexible on the issue of what constituted an excessive PE ratio. In their second edition, written in 1940, the same sentence appears with the number 20 substituted for 16 as the upper limit of a reasonable PE ratio.

What types of PE ratios are justified in today's economy?

Small Cap Stocks and Superior Returns

In 1981, Rolf Banz, a graduate student at the University of Chicago, investigated the returns on stocks using the database provided by the Center for Research in Security Prices (CRSP). He found that small stocks systematically outperformed large stocks, even after adjusting for risk as defined within the framework of the capital asset pricing model.

Some analysts maintain that the superior historical returns on small stocks are compensation for the higher transaction costs of acquiring or disposing of these securities. This means that there may be an extra return for illiquidity. Yet, for long-term investors who do not trade small stocks, transactions costs should not be of great importance. The reasons for the excessive returns to small stocks are difficult to explain from an efficient markets standpoint.

Although the historical return on small stocks has outpaced that of large stocks since 1926, the magnitude of the small stock premium has waxed and waned unpredictably over time.

Distressed Firms and Superior Returns

Despite the higher returns provided by value-based firms, there is one class of stocks, those of distressed firms, that has achieved some fo the highest returns of all.

Many distressed firms have negative earnings and zero or negative book value and pay no dividends.

Research has shown that as the ratio of book value/price or earnings/price declines, so does the return. However, when book value or earnings turn negative, the price of the stock becomes so depressed that the future returns soar.

This same discontinuity is also found with dividend yields. The higher the dividend yield, the higher is the subsequent return. However, firms that pay no dividend at all have among the highist subsequent returns.

Research revealed that most stocks that have negative earnings or negative book values have experienced very adverse financial developments and have become severely depressed. Many investors are quick to dump these stocks when the news get very bad. This often drives the price down below the value justified by future prospects. Few investors seem able to see the light at the end of the tunnel or cannot justify - to themselves or to their clients - the purchase of such stocks under such adverse circumstances.




(Note: Tongher)

What factors can investors use to choose individual stocks with superior returns?

What factors can investors use to choose individual stocks with superior returns?

Earnings
Dividends
Cash flows
Book values
Capitalization
Past performance

These, among others, have been suggested as important criteria to find stocks that will bear the market.


Security analysis cannot presume to lay down general rules as to the "proper value" of any given common stock.... The prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions.
Benjamin Graham and David Dodd