A Random Walk Down Wall Street - Part Three 3: The New Investment Technology

Chapter 11. Potshots at the Efficient-Market Theory and Why they Miss

Robert Shiller concluded from a longer history of stock market fluctuations that stock prices show far “too much variability” to be explained by an efficient-market theory of pricing and that one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market.

The author reviewed all the recent research proclaiming the demise of the efficient-market theory and purporting to show that market prices are, in fact, predictable. His conclusion is that such obituaries are greatly exaggerated and that the extent to which the stock market is usefully predictable has been vastly overstated. He shows that following the tenets of the efficient-market theory – that is, buying and holding a broad-based market index fund – is still the only game in town. Although market may not always be rational in the short run, it always is over the long haul.



I. What do we mean by saying markets are efficient?

1. Markets can be efficient even if they sometimes make egregious errors in valuation. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends.

2. Economists view markets as amazingly successful devices for reflecting new info rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above average returns without accepting above-average risks.

3. No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occasionally appear, there are quickly wiped out once they become known. No one person or institution has yet to produce a long-term, consistent record of finding money-making, risk-adjusted individual stock-trading opportunities, particularly if they pay taxes and incur transactions costs.




II. Potshots that completely miss the target

1. Dogs of the Dow: out-of-favor stocks eventually tend to reverse direction. The strategy entailed buying each year the ten stocks in the DJ that had the highest dividend yields. The idea was that these ten stocks were the most out of favor, so they typically had low price-earnings multiples and low price-to-book-value
ratios as well. This strategy consistently underperformed the overall market during the last half of the 1990s. “The strategy became too popular” and ultimately self-destructed.

2. January Effect: stock-market returns have tended to be especially high during the first two weeks of January. The effect appears to be particularly strong for smaller firms. One possible explanation for it is that tax effects are at work. Some investors may sell securities at the end of the calendar year to establish
short-term capital losses for income tax purposes. Although this effect could be applicable for all stocks. It would be larger for small firms because stocks of small companies are more volatile and less likely to be in the portfolios of taxexempt institutional investors and pension funds. However, the transaction costs of trading in the stocks of small companies are substantially higher than for larger companies (because of the higher bid-asked spreads) and there appears to be no way a commission-paying ordinary investor could exploit this anomaly.

3. Hot news response: some academics believe that stock prices underreact to news events and, therefore, purchasing (selling) stocks where good (bad) news comes out will produce abnormal returns. Fama found that apparent underreaction to info is about as common as overreaction, and post-event continuation of abnormal returns is as frequent as post-event reversal.

4. It is obvious that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct. Indeed, the January effect became undependable after it received considerable publicity.



III. Potshots that get close but still miss the target

1. Short-term momentum: Lo and Mackinlay found that for two decades broad portfolio stock returns for weekly and monthly holding periods showed positive serial correlation. Moreover, Lo and others have suggested that some of the stock-price pattern used by so-called technical analysis may actually have some
modest predictive power. Behavioral economists find such short-run momentum to be consistent with psychological feedback mechanisms. Individuals see a stock price rising and are drawn into the market in a kind of “bandwagon effect.”
However, two factors prevent us from believing markets are inefficient:
a. It is important to distinguish statistical significance from economic significance. The statistical dependencies giving rise to momentum, in fact, are extremely small and are not likely to permit investors to realize excess returns.
b. We should ask whether such patterns of serial correlation are consistent over time.

2. The dividend jackpot approach: Depending on the forecast horizon involved, as much as 40% of the variability in future market returns can be predicted on the basis of the initial dividend yield of the market as a whole. Investors have earned higher total rates of return from the stock market when the initial dividend yield of the market portfolio was relatively high. These findings are not necessarily inconsistent with efficiency. Dividend yields of stocks tend to be high (low) when interest rates are high (low). Consequently, the ability of initial yields to predict returns may simply reflect the adjustment of the stock market to general economic conditions. Moreover, the dividend behavior of US corporations may have changed over time. Companies in 21st century may be more likely to institute a share repurchase program rather than increase their dividends. Thus dividend yield may not be as meaningful as in the past. Finally, this phenomenon does not work consistently with individual stocks. Investors who simply purchase a portfolio of individual stocks with the highest dividend yields in the market will not earn a particularly high rate of return.

3. The Initial P/E predictor: Campbell and Shiller report that over 40% of the variability in long-horizon returns can be predicted on the basis of the initial market P/E.

4. Long-run return reversals: buying stocks that performed poorly during the past three years or so is likely to give you above-average returns over the next three years. However, return reversals over different time periods are often rooted in solid economic facts rather than psychological swings. The volatility of interest rates constitutes a prime economic influence on share prices. Because bonds – the front-line reflectors of interest-rate direction – compete with stocks for the investor’s dollars, one should logically expect systematic relationships between interest rates and stock prices. When interest rates go up, share prices should fall, other things being the same, so as to provide larger expected stock returns in the future. Only if this happens will stocks be competitive with higher yielding bonds. Similarly, when interest rates fall, stocks should tend to rise because they can promise a lower total return and still be competitive with lower yielding bonds.

5. The small firm effect: since 1926, small firms have produced returns over 1.5% points larger than the returns from large stocks. But, small stocks may be riskier than larger stocks and deserve to give investors a higher rate of return. Thus, even if this effect was to persist in the future, it’s not at all clear that such a finding would violate market efficiency. Moreover, this effect may due to “survivorship bias”. And in most world markets it was the larger cap stocks that produced larger rates of return.



IV. Why even close shots miss

1. Regarding to internet bubble, when we know ex post that major errors were made, there were certainly no clear ex ante arbitrage opportunities available to rational investors. And even when clear mispricing arbitrage opportunities seem to have existed, there was no way to exploit them.

2. To me, the most direct and most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. But the fact is that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. During the past 30 years, about two-thirds of the funds proved inferior to the market as a whole. The same result also holds for professional pension fund managers. There are some funds which beat index. But the problem for investors is that at the beginning of any period they can’t be sure which funds will be successful and survive.



V. A Summing Up

1. Market valuation rest on both logical and psychological factors.

2. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into market prices. Prices adjust so well to reflect all-important info that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts.

3. With respect to the evidence indicating that future returns are, in fact, somewhat predictable, there are several points to make.
a. There are considerable questions regarding the long-run dependability of these effects. Many could be the result of “data snooping”.
b. Even if there is a dependable predictable relationship, it may not be exploitable by investors (e.g. high transaction costs).



A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part Three 2: The New Investment Technology

Chapter 10. Reaping Reward by Increasing Risk

Diversification cannot eliminate all risk. Sharpe-Lintner-Black tried to determine what part of a security’s risk can be eliminated by diversification and what part cannot. The result is known as the Capital asset pricing model (CAPM). The basic logic is that there is no premium for bearing risks that can be diversified away. Thus, to get a higher average long-run rate of return in a portfolio, you need to increase the risk level of the portfolio that cannot be diversified away.


I. Beta and Systematic risk

1. Two kinds of risks: systematic risk and unsystematic risk. Systematic risk cannot be eliminated by diversification. It is because all stocks move more or less in tandem that even diversified stock portfolios are risky. Unsystematic risk is the variability in stock prices that results from factors peculiar to an individual company. The risk associated with such variability is precisely the kind that diversification can reduce.
2. The whole point of portfolio theory is that, to the extend that stocks don’t move in tandem all the time, variations in the returns from any one security tend to be washed away or smoothed out by complementary variation in the returns from other securities.
3. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole.  Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.
4. Risk-averse investors wouldn’t buy securities with extra risk without the expectation of extra reward. But not all of the risk of individual securities is relevant in determining the premium for bearing risk. The unsystematic part of the total risk is easily eliminated by adequate diversification. The only part of the total risk that investors will get paid for bearing is the systematic risk, the risk that diversification cannot help.



II. CAPM
1. Before the advent of CAPM, it was believed that the return on each security was related to the total risk inherent in that security.
2. The theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go. The beta is the measure of the systematic risk.
3. As the systematic risk (beta) of an individual stock (or portfolio) increases, so does the return an investor can expect.
4. If the realized return is larger than that predicted by the overall portfolio beta, the manager is said to have produced a positive alpha.


III. Look at the record
1. Fama and French found that the relationship between beta and return is essentially flat.
2. The author believes that “the unearthing of serious cracks in the CAPM will not lead to an abandonment of mathematical tools in financial analysis and a return to traditional security analysis. There are many reasons to avoid a rush to judgment of the death of beta:
a. The beta measure of relative volatility does capture at least some aspects of what we normally think of as risk.
b. It is very difficult to measure beta with any degree of precision. The S&P 500 Index is not “the market”. The total market contains many additional stocks in the US and thousands more in foreign countries. Moreover, the total market includes bonds, real estate, precious metals, and also human capital.
c. Investors should be aware that even if the long-run relationship between beta and return is flat, beta can still be a useful investment management tool.



IV. Arbitrage Pricing Theory

1. It is fair to conclude that risk is unlikely to be captured adequately by a single beta statistic. It appears that several other systematic risk measures affect the valuation of securities.
2. In addition, there is some evidence that security returns are related to size, and also to P/E multiples and price-book value ratios.
3. If one wanted for simplicity to select the one risk measure most closely related to expected returns, the best single risk proxy turned out to be the extent of disagreement among security analysts’ forecast for each individual company. Companies for which there is a broad consensus with respect to the growth of future earnings in dividends seem to be considered less risky than companies for which there is little agreement among security analysts.



To sum up, the stock market appears to be an efficient mechanism that adjusts quite quickly to new info. Neither technical analysis, nor fundamental analysis seems to yield consistent benefits. It appears that the only way to obtain higher long-run investment returns is to accept greater risks.

Unfortunately, a perfect risk measure does not exist. The actual relationship between beta and rate of return has not corresponded to the relationship predicted by the theory during long periods of the twentieth century. Moreover, betas for individual stocks are not stable over time, and they are very sensitive to the market proxy against which they are measured.

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part Three 1: The New Investment Technology

Chapter 9. A New Walking Shoe: Modern Portfolio Theory

Many academics agree: the method of beating the market is to assume greater risk. Risk and risk alone determines the degree to which returns will be above or below average, and thus decides the valuation of any stock relative to the market.


I. Defining Risk:

1. Financial risk has generally been defined as the variance or standard deviation of returns.
2. It is quite true that only the possibility of downward disappointments constitutes risk. Nevertheless, as a practical matter, as long as the distribution of returns is symmetric – that is, as long as the chances of extraordinary gain are roughly the same as the probabilities for disappointing returns and losses – a dispersion or variance measure will suffice as a risk measure.
3. Although the pattern of historical returns from individual securities has not usually been symmetric, the returns from well-diversified portfolios of stocks do seem to be distributed approximately symmetrically.


II. Documenting Risk: A long-run Study – stylized facts
1. On average, investors have received higher rates of return for bearing greater risk.
2. Stocks have tended to provide positive “real” rates of return, that is, returns after washing out the effects of inflation.


III. Reducing Risk: Modern Portfolio Theory (MPT)
1. Portfolio theory begins with the premise that all investors are risk-averse.
2. Harry Markowitz discovered that portfolios of risky stocks might be put together in such a way that the portfolio as a whole could be less risky than the individual stocks in it.
3. As long as there is some lack of parallelism in the fortunes of the individual companies in the economy, diversification will always reduce risk.


IV. Diversification in Practice
1. A portfolio of 50 equal-sized and well-diversified US stocks can reduce total risk by over 60%. As further increases in the number of holdings do not produce much additional risk reduction.
2. About 50 is also the golden number for global-minded investors. The international diversified portfolio tends to be less risky than the one of the corresponding size drawn purely from US stocks.
3. Investors may do even better by including stocks from emerging markets in their overall mix. Correlations between broad indexes of emerging market stocks and the US stock market are generally lower than those of the US stock market with developed foreign markets.
4. There are also compelling reasons to diversify a portfolio with other asset classes. Real estate investment trusts (REITs), enable investors to buy portfolios of commercial real estate properties. Real estate returns don’t move in tandem with other assets. For example, during periods of accelerating inflation, properties tend to do much better than other common stocks. Thus, adding real estate to a portfolio tends to reduce its overall volatility. Treasury inflation-protection securities do not mirror those of other assets and tend to provide relatively stable returns when held to maturity.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part Two 3: How the Pros Play the Biggest Game in Town

Chapter 8. How good is Fundamental analysis?

Two opposing views about the efficacy of fundamental analysis. Wall streeters feel that fundamental analysis is becoming more powerful and skillful at the time. People in the academic community have argued that fund managers and their fundamental analysts can do no better at picking stocks than a rank amateur.

1. Analysts can’t predict consistent long-run growth because it does not exist.

2. The careful estimates of security analysts do little better than those that would be obtained by simple extrapolation of past trends, which we have already seen are no help at all. Indeed, when compared with actual earnings growth rates, the five-year estimates of security analysts were actually worse than the predictions from several naïve forecasting models.

3. Of course, in each year some analysts did much better than average, but no consistency in their pattern of performance was found. Analysts who did better than average one year were no more likely than the others to make superior forecasts in the next year.

4. Five factors that help explain why security analysts have such difficulty in predicting the future:

a. The influence of random events.
b. The production of dubiously reported earnings through “creative” accounting procedures by companies.
c. The basic incompetence of many of the analysts themselves.
d. The loss of the best analysts to the sales desk or to portfolio managements
e. The conflicts of interest facing securities analysts at firms with large investment banking operations: to be sure, when an analyst says “buy” he may mean “hold”, and when he says “hold” he probably means this as a euphemism for “dump this piece of crap as soon as possible.”

Researchers found that stock recommendations of Wall Street firms without investment banking relationships did much better than the recommendations of brokerage firms that were involved in profitable investment banking relationships with the companies they covered.

5. Many at the funds are the best analysts and portfolio managers in the business. However, investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index.

6. There are many funds beating the averages – some by significant amounts. The problem is that there is no consistency to performances. Many of the top funds of the 1970s ranked close to the bottom over the next decade.  The ability of mutual fund managers to time the market has been egregiously poor. Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns.

8. The board (semi-strong and strong) forms of the efficient-market theory: The “narrow” (weak) form of the theory says that technical analysis – looking at past stock prices is useless. The “board” forms state that fundamental analysis is not helpful either. Fundamental analysis cannot produce investment recommendations that will enable an investor consistently to outperform a strategy of buying and holding an index fund. The efficient-market theory does not state that stock prices move aimlessly and erratically and are insensitive to changes in fundamental info. On the contrary, the reason prices move in a random walk is just the opposite: the market is so efficient – prices move so quickly when new info does arise – that no one can consistently buy or sell quickly enough to benefit. And real news develops randomly, that is, unpredictably.

9. The author’s view is between the pure academic view (pros cannot outperform randomly selected portfolios of stocks with equivalent risk characteristics) and the view of investment managers (professionals certainly outperform all amateur and casual investors in managing money). I believe that investors might reconsider their faith in professional advisers, but I am not ready to damn the entire field.

10. I worry about accepting all the tenets of the efficient-market theory, in part because the theory rests on several fragile assumptions. The first is that perfect pricing exists. We have seen ample evidence that stocks sometimes do not sell on the basis of anyone’s estimate of value – that purchasers are often swept up in waves of frenzy. Another fragile assumption is that news travels instantaneously. Finally, there is the enormous difficulty of translating known info about a stock into an estimate of true value.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part Two 2: How the Pros Play the Biggest Game in Town

Chapter 7. Technical analysis and the Random walk theory

1. I personally have never known a successful technician. Technical analysis is anathema to the academic world.

2. Chartists believe momentum exists in the market. The “technical rules” have been tested exhaustively. The results reveal that past movements in stock prices cannot be used reliably to foretell future movements. 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 overwhelm the substantial transactions costs involved in undertaking trend-following strategies.

3. For example, technical lore has it that if the price of a stock rose yesterday it is more likely to rise today. It turns out that the correlation of past price movements with present and future price movements is slightly positive but very close to zero.

4. Yes, history does tend to repeat itself in the stock market, but in an infinitely surprising variety of ways that confound any attempts to profit from a knowledge of past price patterns.

5. The market is not a perfect random walk. But any systematic relationships that exist are so small that they are not useful for an investor.

6. Not one has consistently outperformed the placebo of a buy-and-hold strategy. Technical methods cannot be used to make useful investment strategies. This is the fundamental conclusion of the random walk theory.

7. Chartists recommend trades – almost every technical system involves some degree of in-and-out trading. Trading generates commissions, and commissions are the lifeblood of the brokerage business. The technicians do not help produce yachts for the customers, but they do help generate the trading that provides yachts for the brokers.

8. Even if markets were dominated during certain periods by irrational crowd behavior, the stock market might still well be approximated by a random walk.

9. All that can be said is that the small amount of info contained in stock market pricing patterns has not been shown to be sufficient to overcome the transactions costs involved in acting on that info.

10. No technical scheme whatever could work for any length of time. Any regularity in the stock market that can be discovered and acted upon profitably is bound to destroy itself. This is the fundamental reason why I am convinced that no one will be successful in using technical methods to get above-average returns in the stock market.

11. Using technical analysis for market timing is especially dangerously. Because there is a long-term uptrend in the stock market, it can be very risky to be in cash. A study by Seybun found that 95% of the significant market gains over the 30 year period from the mid-1960s through the mid-1990s came on 90 of the roughly 7500 trading days. If you happened to miss those 90 days, just over 1 percent of the total, the generous long-run stock market returns of the period would have been wiped out. The point is that market timers risk missing the infrequent large sprints that are the big contributors to performance.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part Two 1: How the Pros Play the Biggest Game in Town

Chapter 6. Technical and Fundamental analysis

The efficient market theory (from academics) has three versions – the “weak,” the “semi-strong,” and the “strong.” All three forms espouse the general idea that except for long-run trends, future stock prices are difficult, if not impossible, to predict. The weak form attacks the underpinnings of technical analysis, and the semi-strong and strong forms argue against many of the beliefs held by those using fundamental analysis.


I. Technical versus fundamental analysis:

1. 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.

2. Technical analysis is essentially the making and interpreting of stock charts. Thus its practitioners are called chartists. Most chartists believe that the market is only 10% logical and 90% psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave. Charts tell only what the other players have been doing in the past. The chartist’s hope, however, is that a careful study of what the other players are doing will shed light on what the crowd is likely to do in the future.

3. Fundamental analysts believe the market is 90% logical and only 10% psychological. Fundamentalists believe that eventually the market will reflect accurately the security’s real worth. Perhaps 90% of the Wall Street security analysts consider themselves fundamentalists.


II. What Can Charts tell you?

1. The first principle of technical analysis is that all info about earnings, dividends and the future performance of a company are automatically reflected in the company’s past market prices.

2. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest.

3. As John Magee wrote in the bible of charting, Technical Analysis of Stock Trends, “Prices move in trends and trends tend to continue until something happens to change the supply-demand balance.”


III. The Rationale for the Charting Method

To me, the following explanations of technical analysis appear to be the most plausible.

1. Trends might tend to perpetuate themselves for either of two reasons. First, it has been argued that the crowd instinct of mass psychology makes it so. When investors see the prices of a speculative favorite going higher and higher, they want to jump on the bandwagon and join the rise.

2. Second, there may be unequal access to fundamental info about the firm. When some favorable piece of news occurs, it is alleged that the insiders are the first to know and they act, buying the stock and causing its price to rise. The insiders then tell their friends, who act next. Then the professionals find out the news and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs get the info and buy. This process is supposed to result in a rather gradual increase/decrease in the price of the stock when the news is good/bad.

3. Chartists are convinced that even if they do not have access to this inside info, observation of price movements alone enables them to pick up the scent of the ‘smart money’ and permits them to get in long before the general public.


IV. Why Might Charting Fail to Work?

1. First, the chartist buys in only after price trends have been established and sells only after they have been broken. Because sharp reversals in the market may occur quite suddenly, the chartist often misses the boat. By the time an uptrend is signaled, it may already have taken place.

2. Second, such techniques should ultimately be self-defeating. As more and more people use it, the value of any technique depreciates.


V. The Techniques of Fundamental analysis

1. The technician is interested only in the record of the stock’s price, whereas, the fundamentalist’s primary concern is with what a stock is really worth. His most important job is to estimate the firm’s future stream of earnings and dividends. To do this, he must estimate the firm’s sales level, operating costs, corporate tax rates, depreciation policies, and the sources and costs of its capital requirements. 

2. Because the general prospects of a company are strongly influenced by the economic position of its industry, the obvious starting point for the security analyst is a study of industry prospects. Indeed, in almost all professional investment firms, security analysts specialized in particular industry groups.

VI. Why Might Fundamental analysis fail to work?

1. There are three potential flaws in this type of analysis. First, the info and analysis may be incorrect.

2. Second, the security analyst’s estimate of “value may be faulty”.

3. Third, the market may not correct its “mistake” and the stock price might not converge to its value estimate.

4. To make matters even worse, the security analyst may be unable to translate correct facts into accurate estimates of earnings for several years into the future. Even if the security analyst’s estimates of growth are correct, this info may already be reflected accurately by the market, and any difference between a security’s price and value may result simply from an incorrect estimate of value.

5. The final problem is that even with correct info and value estimates, the stock you buy might still go down. Not only can the average multiple changes rapidly for stocks in general but the market can also dramatically change the premium assigned to growth. One should not take the success of fundamental analysis for granted.



VII. Using Fundamental and Technical analysis together

Many analysts use a combination of techniques to judge whether individual stocks are attractive for purchase.

1. 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 investment. The purchaser of a stock whose earnings begin to grow rapidly has a chance at a potential double benefit – both the earnings and the multiple may increase.

2. Rule 2: never pay more for a stock than its firm foundation of value. Generally, the earnings multiple for the market as a whole is a helpful benchmark. What is proposed is a strategy of buying unrecognized growth stocks whose earnings multiples are not at any substantial premium over the market. In sum, look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus – both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy – both earnings and the multiples drop.

3. Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air. The above rules seem sensible; the point is whether they really work? – Not really (However, the author uses these rules as advice for those investors who want to pick stocks by themselves, though he strongly recommends investors to buy index funds, please refer to Chapter 15)!


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 6: Stocks and Their Value

Chapter 5. The Firm-foundation Theory of Stock Prices

Firm-foundation theorists view the worth of any share as the present value of all dollar benefits the investor expects to receive from it. The starting point focuses on the stream of cash dividends the company pays. The worth of a share is taken to be the present or discounted value of all the future dividends the firm is expected to pay.

The price of a common stock is dependent on several factors:

I. Determinant 1: the expected growth rate: 

1. Dividend growth does not go on forever. Corporation and industries have life cycles similar to most living things. Furthermore, there is always the fact that it gets harder and harder to grow at the same percentage rate.
2. 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.
3. Corollary: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.


II. Determinant 2: The expected dividend payout. 

1. The higher the payout, other things being equal, the greater the value of the stock. The catch is “other things being equal.” Stocks that pay out a high percentage of earnings in dividends may be poor investments if their growth prospects are unfavorable. Conversely, many companies in their most dynamic growth phase often pay out little or none of their earnings in dividends.
2. Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out is cash dividends.

III. Determinant 3: 

Rule 3: A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

IV. Determinant 4: the level of market interest rates: 

Rule 4: A rational investor should be willing to pay a higher price for a share; other things being equal, the lower are interest rates.

V. Two Caveats 

Caveat 1: expectations about the future cannot be proven in the present. Predicting future earnings and dividends requires not only the knowledge and skill of an economist but also the acumen of a psychologist. And it is extremely difficult to be objective.
Caveat 2: Precise figures cannot be calculated from undetermined data. You can’t obtain precise figures by using indefinite factors.

VI. Testing the rules 

1. The 2002 data shows that high P/E ratios are associated with high expected growth rates.
2. Fundamental considerations do have a profound influence on market prices. P/E ratios are influenced by expected growth, dividend payouts, risk, and the rate of interest. Higher anticipations of earnings growth and higher dividend payouts tend to increase P/E. Higher risk and higher interest rates tend to pull them down. There is logic to the stock market, just as the firm foundationists assert.
3. It appears that there is a yardstick for value, but one that is a most flexible and undependable instrument. Stock prices are in a sense anchored to certain “fundamentals,” but the anchor is easily pulled up and then dropped in another place. The standards of value are the more flexible and fickle relationships that are consistent with a marketplace heavily influenced by mass psychology.
4. The most important fundamental influence on stock prices is the level and duration of the future growth of corporate earnings and dividends. But, future earnings growth is not easily estimated, even by market professionals.
5. Dreams of castles in the air may play an important role in determining actual stock prices. And even investors who believe in the firm-foundation theory might buy a security on the anticipation that eventually the average opinion would expect a larger growth rate for the stock in the future.
6. It seems that both views of security pricing tell us something about actual market behavior.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 5: Stocks and Their Value

Chapter 4. The Biggest Bubble of All: Surfing on the Internet

1. The NASDAQ Index, an index essentially representing high-tech New Economy companies, more than triples from late 1998 to March 2000. The P/E ratios of the stocks in the index that had earnings soared to over 100.

2. Amazon sold at prices that made its total market cap larger than the total market values of all the publicly owned booksellers such as Barnes & Noble. Priceline sold at a total market cap that exceeded the cap of the major carriers United, Delta, and American Airlines combined.

3. Cooper, Dimitrov and Rau found that 63 companies that changed their names to include some Web orientation enjoyed a 125% greater increase in price during 10 day period than that of their peers. In the post-bubble period, they found that stock prices benefited when dot-com was deleted from the firm’s name.

4. The relationship between profits and share price had been severed.

5. Security analysts $peak up:
a. Mary Meeker was dubbed by Barron’s the “Queen of the Net.” Henry Blodgett was known as “King Henry”. Henry flatly stated that traditional valuation metrics were not relevant in “the big-bang stage of an industry.” Meeker suggested that “this is a time to be rationally reckless.”
b. Traditionally, ten stocks are rated “buys” for each on that is rated “sell.” But during the bubble, the ratio of buys to sells reached close to 100 to 1.

6. The writers of the media: the bubble was aided and abetted by the media – which turned us into a nation of traders. Journalism is subject to the laws of supply and demand. Since investors wanted more information about Internet investing opportunities, the supply of magazines increased to fill the need.

7. The result was that turnover reached an all-time high. The average holding period for a typical stock was not measured in years but rather in days and hours. Redemption ratios of mutual funds soared and the volatility of individual stock prices exploded.

8. History tells us that eventually all excessively exuberant markets succumb to the laws of gravity. In the early days of automobile, we had close to 100 automobile companies, and most of them became roadkill. The key to investing is not how much industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.

9. The lesson here is not that markets occasionally can be irrational and, therefore, that we should abandon the firm foundation theory. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality – albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But eventually, true value is recognized by the market, and this is the main lesson investors must heed. 


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 4: Stocks and Their Value

Chapter 3. Stock Valuation from the sixties through the Nineties

By the 1990s, institutions accounted for more than 90% of the trading volume on the NYSE. And yet professional investors participated in several distinct speculative movements from the 1960s through the 1990s. In each case, professional institutions bid actively for stocks not because they felt such stocks were undervalued under the firm foundation principles, but because they anticipated that some greater fools would take the shares off their hands at even more inflated prices.

I. The Soaring Sixties

1. The New “New Era”: The growth-stock/New-issue craze:

a. Growth was the magic word in those days, taking on an almost mystical significance. More new issues were offered in the 1959-62 period than at any previous time in history. It was called the “tronics boom”, because the stock offering often included some garbled version of the word “electronics” in their title, even if the companies had nothing to do with the electronics industry.

b. Jack Dreyfus commented on the mania as follows: a shoelace making firm (P/E ratio is 6) changed the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners,” which no one understands. A word that no one understands entitles you to double your entire score. Therefore, after the name change, the new P/E ratio = (6 + 15)*2=42!

c. The SEC uncovered many evidence of fraudulence and market manipulation in this period. Many underwriters allocated large portions of hot issues to insiders of the firms such as partners, relatives, officers, and other securities dealers to whom a favor was owed. The tronics boom came back to earth in 1962.


2. Synergy Generates Energy: The conglomerate Boom.

a. Part of the genius of the financial market is that if a product is demanded, it is produced. The product that all investors desired was expected growth in earnings per share. By the mid-1960s, creative entrepreneurs had discovered that growth meant synergism, which is the quality of having 2 plus 2 equal 5.

b. In fact, the major impetus for the conglomerate wave of the 1960s was the acquisition process itself could be made to produce growth in earnings per share. The trick is the ability of the acquiring firm to swap its high-multiple stock for the stock of another firm with a lower multiple. The targeting firm can only “sell” its earnings at multiple of 10, say. But when these earnings are packaged with the acquiring firm, the total earnings could be sold at a multiple of 20.

c. As a result of such manipulations, corporations are now required to report their earnings on a “fully diluted” basis, to account for the new common shares that must be set aside for potential conversions. The music slowed drastically for the conglomerates on January 19, 1968. On that day, the granddaddy of the conglomerates, Litton Industries, announced that earnings for the second quarter of that year would be substantially less than had been forecast. In the selling wave that followed, conglomerate stocks declined by roughly 40% before a feeble recovery set in.

d. The aftermath of this speculative phase revealed two factors. First, conglomerates were mortal and were not always able to control their far-flung empires. Second, the government and the accounting profession expressed real concern about the pace of mergers and about possible abuses. Few mutual or pension funds were without large holdings of conglomerate stocks. They were hurt badly. During the 1980s and 1990s deconglomeration came into fashion. Many of the old conglomerates began to shed their unrelated, poor-performing acquisitions to boost their earnings.

3. Performance comes to the market: the Bubble in Concept stocks

a. With conglomerates shattering about them, the managers of investment funds found another magic word: performance in the late 1960s. The commandments for fund managers were simple: Concentrate your holdings in a relatively few stocks and don’t hesitate to switch the portfolio around if a more desirable investment appears. And because near-term performance was important it would be best to buy stocks with an exciting concept and a compelling and believable story. Hence, the birth of the so-called concept stock.

b. Cortess Randall was the founder of National Student Marketing (NSM). His concept was a youth company for the youth market. Blocks of NSM were bought by 21 institutional investors. Its highest price was 35.25. However, in 1970, its lowest price was 7/8.



II. The Sour Seventies

1. In the 1970s, Wall Street’s pros vowed to return to “sound principles.” Concepts were out and investing in blue-chip companies was in. They were called the “Nifty fifty”, also “one decision” stocks. You made a decision to buy them, once, and your portfolio management problems were over.

2. Hard as it is to believe, the institutions had started to speculate in blue chips. In 1972, P/E for Sony is 92, for Polaroid is 90, for McDonald’s is 83. Institutional managers blithely ignored the fact that no sizable company could ever grow fast enough to justify an earnings multiples of 80 or 90.

3. The end was inevitable. The Nifty fifty were taken out and shot one by one.


III. The Roaring Eighties

1. The Triumphant Return of New issues: the high-technology, new-issue boom of the first half of 1983 was an almost perfect replica of the 1960s episodes, with the names altered to include the new fields of biotechnology and microelectronics. The total value of new issuers in 1983 was greater than the cumulative total of new issues for the entire preceding decade.

2. Concepts Conquer Again: the Biotechnology Bubble: valuation levels of biotechnology stocks reached an absurd level. In 1980s, some biotech stocks sold at 50 times sales.

3. From the mid-1980s to the late 1980s, most biotechnology stocks lost three-quarters of their market value. What does it all mean? – Styles and fashions in investors’ evaluations of securities can and often do play a critical role in the pricing of securities. The stock market at times confirms well to the castle-in-the-air theory.


IV. The Nervy Nineties

1. One of the largest booms and busts of the late twentieth century involved the Japanese real estate and stock markets. From 1955 to 1990, the value of Japanese real estate increased more than 75 times. By 1990, Japan’s property was appraised to be worth 5 times as much as all American property.

2. Stock prices increased 100-fold from 1955 to 1990. At their peak in Dec 1989, Japanese stocks had a total market value of about $4 trillion, almost 1.5 times the value of all U.S. equities and close to 45% of the world’s equity market cap.  Stocks sold at more than 60 times earnings, almost 5 times book value, and more than 200 times dividends.

3. The financial laws of gravity know no geographic boundaries. The Nikkei index reached a high of almost 40,000 on the last trading day of the decade of the 1980s. By mid-August 192, the index had declined to 14,309, a drop of about 63%. In contrast, the DJIA fell 66% from Dec 1929 to its low in the summer of 1932.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 3: Stocks and Their Value

Chapter 2. The Madness of Crowds

The psychology of speculation is a veritable theater of the absurd. Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. Unsustainable prices may persist for years, but eventually they reverse themselves.

I. the Tulip-Bulb Craze

1. In the early 17th century, tulip became a popular but expensive item in Dutch gardens. Many flowers succumbed to a nonfatal virus known as mosaic. It was this mosaic that helped to trigger the wild speculation in tulip bulbs. The virus caused the tulip petals to develop contrasting colored stripes or “flames”. The Dutch valued highly these infected bulbs, called bizarres. In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it.

2. Slowly, tulipmania set in. At first, bulb merchants simply tried to predict the most popular variegated style for the coming year. Then they would buy an extra large stockpile to anticipate a rise in price. Tulip bulb prices began to rise wildly. The more expensive the bulbs became, the more people viewed them as smart investments.

3. People who said the prices could not possibly go higher watched with chagrin as their friends and relatives made enormous profits. The temptation to join them was hard to resist; few Dutchmen did. In the last years of the tulip spree, which lasted approximately from 1634 to early 1637, people started to barter their personal belongings, such as land, jewels, and furniture, to obtain the bulbs that would make them even wealthier. Bulb prices reached astronomical levels.

4. The tulip bulb prices during January of 1637 increased 20 fold. But they declined more than that in February. Apparently, as happens in all speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time at all panic reigned.


II. The South Sea Bubble

1. The South Sea Company had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU ( I owe you: debt) of almost 10 million pounds. As a reward, it was given a monopoly over all trade to the South Seas. The public believed immense riches were to be made in such trade, and regarded the stock with distinct favor.

2. In 1720, the directors decided to capitalize on their reputation by offering to fund the entire national debt, amounting to 31 million pounds. This was boldness indeed, and the public loved it. When a bill to that was introduced in Parliament, the stock promptly rose from ￡130 to ￡300. 3. On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at ￡300. The issue could be bought on the installment plan - ￡60 down and the rest in eight easy payments. Even the king could not resist; he subscribed for stock totaling ￡100,000. Fights broke out among other investors surging to buy. The price had to go up. It advanced to ￡340 within a few days. The ease the public appetite, the company announced another new issue – this one at ￡400. But the public was ravenous. Within a month the stock was ￡550, and it was still rising. Eventually, the price rose to ￡1,000.

4. Not even the South See was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for the next South Sea. As the days passed, new financing proposals ranged from ingenious to absurd. Like bubbles, they popped quickly. The public, it seemed, would buy anything.

5. In the “greater fool” theory, most investors considered their actions the height of rationality as, at least for a while; they could sell their shares at a premium in the “after market”, that is, the trading market in the shares after their initial issue.

6. Realizing that the price of the shares in the market bore no relationship to the real prospects of the company, directors and officers of the South Sea sold out in the summer. The news leaked and the stock fell. Soon the price of the shares collapsed and panic reigned. Big losers in the South Sea Bubble included Isaac Newton, who exclaimed, “I can calculate the motions of heavenly bodies, but no the madness of people.”

III. Wall street lays an egg

1. From early March 1928 through early September 1929, the market’s percentage increase equaled that of the entire period from 1923 through early 1928.

2. Price manipulation by “investment pools”: The pool manager accumulated a large block of stock through inconspicuous buying over a period of weeks. Next he tried to enlist the stock’s specialist on the exchange floor as an ally. Through “wash-sales” (buy-sell-buy-sell between manager’s allies), the manager created the impression that something big was afoot. Now, tip-sheet writers and market commentators under the control of the pool manager would tell of exciting developments in the offing. The pool manager also tried to ensure that the flow of news from the company’s management was increasingly favorable – assuming the company management was involved in the operation. The combination of tape activity and managed news would bring the public in. Once the public came in, the free-for-all started and it was time discreetly to “pull the plug”. Because the public was doing the buying, the pool did the selling. The pool manager began feeding stock into the market, first slowly and then in larger and larger blocks before the public could collect its senses. At the end of the roller-coaster ride the pool members had netted large profits and the public was left holding the suddenly deflated stock.

3. On September 3, 1929, the market averages reached a peak that was not to be surpassed for a quarter of a century. The “endless chain of prosperity” was soon to break. On Oct 24 (“Black Thursday”), the market volume reached almost 13 million shares. Prices sometimes fell $5 and $10 on each trade. Tuesday, Oct 29, 1929, was among the most catastrophic days in the history of the NYSE. More than 16.4 million shares were traded on that day. Prices fell almost perpendicularly.

4. History teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability.

5. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 2: Stocks and Their Value

Chapter 1. Firm Foundations and Castles in the Air

I. What is a random walk?

1. A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Investment advisory services earnings predictions, and complicated chart patterns are useless.

2. Market professionals arm themselves against the academic onslaught with one of two techniques, called fundamental analysis and technical analysis. Academics parry these tactics by obfuscating the RANDOM WALK theory with three versions (the “weak”, the “semi-strong,” and the “strong”).

II. Investing as a way of life today

1. 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.

2. Just to stay even, your investments have to produce a rate of return equal to inflation.

3. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money.

4. Most important of all is the fact that investing is fun. It’s fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets.


III. Investing in theory

1. All investment returns are dependent, to varying degrees, on future events. Investing is a gamble whose success depends on an ability to predict the future.

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.

2. The Firm-foundation theory: 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. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value the stock; thus, differences in growth rates are a major factor in stock valuation.

3. The castle-in-the-air theory: it concentrates on psychic values. John Maynard Keynes argued 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.

4. Keynes described the playing of the stock market in terms readily understandable: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence.

5. The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price.

6. The castle-in-the-air theory has many advocates, in both the financial and the academic communities. Robert Shiller, in his best-selling book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late 1990s can only be explained in terms of mass psychology.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 1: Stocks and Their Value

Preface

1. Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds.

2. The basic thesis of the book: the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts.

3. Through the past 30 years, more than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index.

4. One’s capacity for risk-bearing depends importantly upon ones’ age and ability to earn income from noninvestment sources. It is also the case that the risk involved in most investments decreases with the length of time the investment can be held. Thus, optimal investment strategies must be age-related. 


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

The great investors tend to focus on the process more than the actual outcome.

Over time, the great investors tend to focus on the process more than the actual outcome.

If you have a simple, proven, repeatable system with the relevant mental models, the results will ultimately take care of themselves.

Having a sound philosophy and method will allow you to focus on the components that matter most to an investor's success.

By following this long enough, you will develop everlasting habits and positive feedback loops as you compound on your knowledge of investing and the businesses around you.

The more you invest now and get to know the underlying businesses and the stock market, the better you will be at investing long term.

What determines the returns from stocks?

Very long-run returns from common stocks are driven by two critical factors:

1.  the dividend yield at the time of purchase, and,
2.  the future growth rate of earnings and dividends.

In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the "present" or "discounted" value of its stream of future dividends.

A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.

Even is a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to:

1.  a more rapidly growing stream of dividends in the future or
2.  alternatively to greater earnings that can be used by the company to buy back its stock.

The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula for the long-run total return for either an individual stock or the market as a whole:

LONG-RUN EQUITY RETURN
= INITIAL DIVIDEND YIELD + GROWTH RATE




From 1926 until 2010:

Common stocks provided an average annual rate of return of about 9.8%.
DY for the market as a whole on Jan 1, 1926 was 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
DY + Growth rate gives a close approximation of the actual rate of return.


Over shorter periods

Over shorter periods, such as a year or even several years, a third factor is critical in determining returns.
This factor is the change in valuation relationships, namely, the change in the price-dividend or price-earnings multiple.
[P/Div and P/E tend to move (increase or decrease) in the same direction.]


Ref: A Random Walk Down Wall Street

A Guided Tour of the Market 13

Utilities

[...] utilities that provide electric service dominate the ranks of the publicly traded companies in the utilities sector. The electric utility business can be divided into essentially three parts: generation, transmission, and distribution.

[...] regulation is perhaps the single most important factor shaping the utility sector.

Regulated utilities tend to have wide economic moats because they operate as monopolies, but it's important to keep in mind regulation does not allow these firms to parlay this advantage into excess returns. In addition, regulation can (and often does) change.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 12

Energy

Although energy can be harvested from myriad sources – coal, nuclear, hydroelectric, wind, solar – nothing can come close to challenging the dominance of oil and gas as a source of energy.

The profitability of the energy sector is highly dependent on commodity prices. Commodity prices are cyclical, as are the sector's profits. It's better to buy when prices are at a cyclical low than when they're high and hitting the headlines.

Keep an eye on reserves and reserve growth because these are the hard assets the company will mine for future revenue.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 11

Industrial Materials

The industrial materials sector includes a broad array of companies, which make everything from the fragrances used in soap to bulldozers and heat-seeking missiles. The general business model is simple: Industrial materials companies buy raw materials and facilities to produce the inputs and machinery that other firms use to meet their customers' expected demand for goods.

We divide industrial materials into two groups: (1) basic materials such as commodity steel, aluminium, and chemicals and (2) value-added goods such as electrical equipment, heavy machinery, and some specialty chemicals. The primary difference is that commodity producers have little or no influence on the price of the products they produce. Makers of value-added industrial materials, on the other hand, may be specialized enough or improve a customer's business enough for the manufacturer to share part of that benefit in the form of a premium price.

Although basic materials industries do have significant barriers to entry – the cost of constructing a new steel, aluminium, or paper processing plant is steep – stiff price competition makes for mediocre profits at best.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 10

Consumer Goods

The consumer goods sector is composed of industries such as food, beverages, household and personal products, and tobacco. Like anything large and old, it also moves slowly: Consumer goods markets typically grow no faster than the gross domestic product and sometimes even slower. Despite this slow growth, consumer goods stocks tend to be solidly profitable, fairly steady performers, which can make them excellent long-term holdings for your portfolio.

Consumer goods companies generate profits the old-fashioned way: They make products and sell them to customers, usually supermarkets, mass merchandisers, warehouse clubs, and convenience stores.

The handful of giant firms that dominate each consumer goods industry enjoy such massive economies of scale that it would be virtually impossible for a small new entrant to catch up.

The networks that manufacturers use to get their products on to shelves in the stores can be another competitive advantage that is very difficult for competitors to replicate.

Companies with brands that hold dominant market share are likely to stay in that position because shifts in share tend to be fairly small from year to year. Thus, whoever is number one right now is likely to remain in that position over the next several years.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 9

Telecom

The telecom sector is filled with the kinds of companies we love to hate: They earn mediocre (and declining) returns on capital, economic moats are nonexistent or deteriorating, their future depends on the whims of regulators, and they constantly spend boatloads of money just to stay in place. [...] Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 8

Media

Media companies generate cash by producing or delivering a message to the public. The message, or content, can take several shapes, including video, audio, or print.

Companies that rely on one-time user fees sometimes suffer volatile cash flows because they're heavily affected by the success of numerous individual products, such as newly released films or novels. While having a string of hits can result in a bonanza for the firm, the converse is also true: Several flops in a row can lead to disaster. This uncertainty can make it difficult to forecast future cash flows.

Subscription-based businesses are generally more attractive than one-time user fee businesses because subscription revenue tends to be predictable, which makes forecasting and planning easier and reduces the risk of the business. There is another advantage to subscriptions: Subscribers pay upfront for services that are delivered at a later date.

Companies with advertising-based models can enjoy decent profit margins, which are often enhanced by high operating leverage. The reason for the high operating leverage is that most of the cost in an advertising-based model is fixed. [...] However, advertising revenue streams can be somewhat volatile – advertising is one of the first costs that company executives cut when the economy turns south, which is why advertising revenue growth tends to move with the business cycle.

Media firms enjoy a number of competitive advantages that help them generate consistent free cash flows, with economies of scale, monopolies, and unique intangible assets being the most prevalent. Economies of scale are especially important in publishing and broadcasting, whereas monopolies come into play in the cable and newspaper industries. Unique intangible assets such as licenses, trademarks, copyrights, and brand names are important across the sector.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 7

Hardware

The environment in the hardware sector makes it fiendishly difficult to build a sustainable competitive advantage because technological advances and price competition mean that the lion's share of hardware's benefits are passed to consumers, not the company creating the products.

In the hardware industry, network effects can arise because hardware often needs (1) to operate with other hardware and (2) to be maintained by people. The more a certain product becomes prevalent, the more other hardware needs to take heed of the product's characteristics and the more people (and time) are invested in learning to operate the product.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 6

Software

Because technology buyers are inherently conservative and loath to buy products from a vendor that might go out of business and leave them stranded for basic service, companies are increasingly buying only from industry leaders.

Like database software, the ERP market isn't growing very fast because most large companies already have some type of ERP system installed.

Often, companies that dominate a smaller niche are more attractive investments than household names that serve larger markets.

License revenue is the best indication of current demand because it represents how much new software was sold during a given time. It's a very profitable source of revenue because software can be produced for almost nothing after it has been developed. Service revenue, which is the other major type of revenue that many software firms report, is less profitable because it's expensive to employ consultants to install software.

The low barriers to entry of the software industry contrast with high barriers to success – it's easy to start up a software firm, but it's much more difficult to create one that's still around after several years. Thus, look for software companies that have thrived during multiple business cycles and have solid results during both the peaks and valleys of IT spending.

The software industry is highly cyclical, with sales hinging on economic conditions and IT spending. The problem is that in good times software companies thrive, and in bad times they're some of the hardest hit. The primary reason for this cyclicality is that many corporations view software as a discretionary purchase that can be deferred in tough times. In other words, when the economy and business suffer, cutting IT spending is a quick way to buffer profit declines.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 5

Asset Management and Insurance

With huge margins and constant streams of fee income, asset managers are perennial profit machines. However, these companies are so tied to the markets that their stock prices often reflect oversized doses of the current optimism or pessimism prevailing in the economy, which means it pays off to take a contrarian approach when you're thinking about when to invest.

Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return. This is lucrative work and requires very little capital investment. The real assets of the firm are its investment managers, so typically compensation is the firm's main expense. Even better, it doesn't take twice as many people to run twice as much money, so economies of scale are excellent.

The single biggest metric to watch for any company in this industry is assets under management (AUM), the sum of all the money that customers have entrusted to the firm. Because an asset manager derives its revenue as a percentage of assets under management, AUM is a good indication of how well – or how badly – a firm is doing.

Investors should look for asset management companies that are able to consistently bring in new money and don't rely only on the market to increase their AUM. Look for new inflows (inflows higher than outflows) in a variety of market conditions. This is a signal that the asset manager is offering products that new investors want and that existing investors are happy with the products they have.

Given the commodity-like products of the life insurance industry, it is next to impossible for one insurer to successfully grow – without acquisitions – above the industry's long-term annual revenue growth rate.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 4

Banks

[...] the heart and soul of banking is centered on one thing: risk management. Banks accept three types of risk: (1) credit, (2) liquidity, and (3) interest rate, and they get paid to take on this risk.

One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up in investors' faces. To help avoid getting stuck with a bank that blows up, investors should pay close attention to charge-off rates and delinquency rates, which are seen as an indicator of future charge-offs.

Beware of super-fast growth. It's an axiom in the financial services industry that fast growth can lead to big troubles. Fast growth is not always bad – many of the best players have above-average growth rates – but any financial services company that's growing significantly faster than competitors should be eyed with skepticism.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

A Guided Tour of the Market 3

Business Services

Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at technology-based, people-based, and hard-asset-based subsectors.

Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the success of their company.

In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume – especially over fixed-cost networks – companies can lower unit costs and achieve greater profitability.

Size impacts the industry through branding as well. Often, brands play a major role in a business outsourcing purchase decision.

In general, technology-based businesses [...] require huge initial investments to set up an infrastructure that can be leveraged across many customers. These huge investments are a barrier to entry for new competitors.

Another desirable characteristic of technology-based businesses is the low ongoing capital investment required to maintain their systems. For firms already in the industry, the huge upfront technology investments have already taken place.

As a result of the high barriers to entry into technology-based businesses and long-term customer contracts, firms in this subsector tend to have wide, defensible moats.

The people-based subsector includes companies that rely heavily on people to deliver their services, such as consultants and professional advisors, temporary staffing companies, and advertising agencies. Investments can be attractive at the right price, but the model is generally less attractive than that of the technology-based subsector.

Brands, longstanding relationships with customers, and geographic scope can provide some advantages relative to competitors. But within most people-based industries, there are usually multiple competitors with similar strengths in these areas, and they tend to compete aggressively with one another.

Companies in the hard-asset-based subsector depend on big investments in fixed assets to grow their businesses.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/