Dollar Cost Averaging Stock Strategy

Stock Strategies
Dollar Cost Averaging Stock Strategy
by InvestorGuide Staff


Investors have three major concerns when buying stocks:

• making a profit on their investment,
• minimizing risk, and
• the actual rate of return they will receive (including any dividend income).

Ideally, there would be windfall profits in record time with no risk.

In the real world, investors must use stock strategies that match both their resources and skill level. The dollar cost averaging stock strategy is a great approach for people new to stock investing that minimizes risk and trends towards sound profitability - especially the longer it is used.

Basics of Dollar Cost Averaging

The dollar cost averaging stock strategy minimizes risk because it reduces the difference between the initial investment and the current market value over a long enough timeline. This is accomplished by making fixed investment amounts at predetermined times. Now this investment could be in a specific stock or perhaps even an index fund. The point is to remain committed to this investment for years and not to allow fluctuations in price to affect your buying strategy.

Knee jerk responses are common with stock investments, especially for beginners. One bad earnings report can send stock prices tumbling and cause investors to panic. This causes a sell-off that further lowers prices. But; if a person were to keep their stock and still continue buying at regular intervals, the average price of the stock should continually approach the current market value at the time of purchase at each interval. Temporary fluctuations in pricing should even out. While the stock price may be lower than the initial investment value, the ability to acquire more shares at a lower price means that the short-term decrease in average stock price should be balanced out when the share price increases. However, never confuse dollar price averaging with simple averaging.

For instance, let's say an investor purchased 1,000 shares of Microsoft stock at $40 per share at the first interval and another 1,000 shares of stock at the next for $25 a share. That would make the total investment $65,000 and the average stock price $32.50. However, this is not dollar cost averaging - it is simple averaging.

The average cost of the stock will not trend towards the current market value if you do not remain consistent in your investment strategy. Using dollar cost averaging, a person would invest a fixed amount - say $33,000 per interval. Thus, when buying the same Microsoft stock at the first interval, a person would end up with 825 shares of stock at $40/share and 1320 shares at $25 each. This adds up to 2,145 shares and an average cost of $30.75 - closer to the current market value of $25 than the simple averaging strategy.

From the example above, the one drawback to the dollar cost averaging strategy is revealed:

• while it reduces risk and lowers the difference between the average stock price and the current market value, it will not eliminate the possibility of a loss if the average price does not move fast enough.
• In fact, if an investor were to pick a stock that was on its way down and continued investing in regular intervals as advised by the dollar cost averaging strategy, the losses could add up rapidly.

While the investor may be buying more shares at each interval due to lower prices, having more shares of continually declining stock simply adds insult to injury. For this reason, an investor must have a cutoff point at which he/she ceases purchasing the stock at regular intervals. Fluctuations in market price can be absorbed and an investor can still make a healthy profit using the dollar cost averaging stock strategy but a declining stock is just a loser. Unfortunately, the dollar cost averaging strategy is most profitable on stocks that were underperforming at the time the investment plan was initiated. Therefore, the best stocks to make the most profits on are also the ones that are more likely to recover and continue trending upwards in share price. Prudent research is necessary before initiating any dollar averaging stock strategy.

Implementing a Dollar Cost Averaging Strategy

The very first step in planning to use this strategy is determining how much you can realistically afford to invest over an extended period of time. This is very important because the strategy will not reduce risk of loss effectively unless the investment amount is consistent. You will not insulate yourself against losses as effectively when a large initial investment is made and then followed by increasingly smaller amounts. In such a scenario, the gap between the average stock price and current market value will be larger and the risk for loss greater.

The next step in this or any other stock strategy should be to choose your investment carefully. Remember, you need to stay with this investment for many years for the strategy to be effective. An investor will get killed if they purchase an underperforming stock that does not recover. For this reason, combining the benefits of dollar cost averaging strategy with the diversification and reduced risk of an index fund is a prudent approach when choosing an investment.

An index fund is like a mutual fund in that it is designed to mimic the returns of prominent benchmarks such as the Dow Jones Industrial Average or the S&P 500. Investors own a fraction of each stock that makes up the index. The principle difference and benefit to investors in an index fund is that their management fees are a fraction of those charged for actively managed mutual funds. This is because index funds are passively managed. By combining the dollar cost averaging strategy with the increased diversification and reduced management/transaction fees of an index fund, an investor can maximize the profit potential and minimize risk.

Finally, pick an interval that you can be consistent with for years into the future. A weekly interval will work but it is probably best to make it monthly or even quarterly. Longer intervals are better because they reduce the expense of multiple transaction fees and also allow you to buy larger numbers of stock with each purchase.

Dollar cost averaging

Dollar cost averaging

From Wikipedia, the free encyclopedia


Dollar cost averaging is a timing strategy of investing equal dollar amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio.

• By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high.
• The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.

In dollar cost averaging, the investor decides on three parameters:

• the fixed amount of money invested each time, and
• investment frequency, and
• the time horizon over which all of the investments are made.

With a shorter time horizon, the strategy behaves more like lump sum investing.

One study has found that the best time horizons when investing in the stock market in terms of balancing return and risk have been 6 or 12 months.


Criticism of DCA Risk Reduction Theory

Pro: While some financial advisors such as Suze Orman claim that DCA reduces exposure to certain forms of Financial risk associated with making a single large purchase.
Con: Others such as Timothy Middleton claim DCA is nothing more than a marketing gimmick and not a sound investment strategy.

Pro: Others supporting the strategy suggest the aim of DCA is to invest a set amount; the same amount you would have had you invested a lump sum.
Con: Middleton claims that DCA is a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once.

Studies of real market performance, models, and theoretical analysis of the strategy have shown that:

• DCA is associated with lower overall returns, and,
• DCA does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy.

(Buffett does not believe in dollar cost averaging. Why buy stocks when the prices are high? Buy when the stocks are offered at a bargain.. and always!)

Post-mortem on your actions during the 2007 - 2009 severe bear market

What were you doing during the 2007-2009 severe bear market?

Let us look at the many possible actions one may have taken.

Sold totally at the beginning of the bear market.

Sold partially at the beginning of the bear market.

Sold totally at the middle of the bear market.

Sold partially at the middle of the bear market.

Sold totally during the Lehman crash in Oct. 2008

Sold partially during the Lehman crash in Oct. 2008

Sold totally after the Lehman crash.

Sold partially after the Lehman crash.

Bought more at beginning of the bear market.

Bought more in the middle of the bear market.

Bought more during the Lehman crash.

Bought more after the Lehman crash.

Kept you existing portfolio and ignored the market.

Went for a long vacation (2 years!).

Stop monitoring your stock prices.

Continuously monitoring your stock prices.

Stop monitoring the fundamentals of your stocks.

Continuously monitoring the news for fundamentals of your stocks.

Continuously relating the falling price to the returns of your stock (Wow, so cheap and getting cheaper).

Rebalancing your stock at regular intervals.

Continuously following Bloomberg and CNBC for developing news.

Ignoring Bloomberg and CNBC.

Following the gurus' opinions in investing: Marc Faber, Nouriemi, Soros, Buffett, Teng Boo, etc.

Ignoring the gurus.

Following the various blogs: "Ze Moola", "Fusion", "Samgoss", "Same gang" etc.

Ignoring the various blogs.

How were you emotionally?

• Were you fearful when the prices tumbled?


• Were you indifferent when the prices tumbled?


• Were you happy when the prices tumbled?

What were your thoughts driving the above emotions?

• Were these thoughts based on objective facts?


• Were these thoughts emotionally driven?

Etc., etc.


There are many more specific actions you may recall. Anyway, which of these are most productive and which of these are totally non-productive and perhaps even destructive?

The recent 2007 - 2009 severe bear market offered a wonderful opportunity for you to review your actions during that period and reappraise your investing philosophy and strategy. Lessons learned will be of benefit for a lifetime. Well worth doing a post-mortem on what you did the last 2 years in your investing.

Cheers.

How can you improve your investment returns in stocks?

The adage, "Buy low and Sell high" and pocket the profit, is well known. I like to also remember it this way: "Never buy high and Never sell low".

The subsequent discussion applies to investing in high quality good stocks bought at a bargain only.

How can the average investor improves his investment returns in stocks? More specifically how can an average investor improves his return to 10% annually? Even better, to above 15% annually and consistently? Let us examine some factors affecting investment returns.


1. Stock selection

This is important. You wish to have a stock that gives you a good total sustainable return over many years. You will need to invest in those stocks with a high ROE of at least 15% or more. Also, these stocks should have good earnings growth (EPS growth) that is consistent and sustainable. Such companies run businesses with a huge competitive advantage over their competitors with a large moat.


2. Buy when the selected stock is selling at a low price.

This is the better way to get superior return - the potential return is higher with concomitant lower risk. Invest in "value stocks". A good portfolio should always have cash available to benefit from a bear market or a correction or panic sell in a bull market/or a specific stock.

Here is a recent illustration from icap. to emphasize this point:

"This pleasant result is due to the “Intelligently Eclectic” value investing style that Capital Dynamics has adopted for the last 21 years. What does it mean in practical terms ? A stock that the i Capital Global Fund invested in plunged around 85% during the 2007-2009 bear market. However, instead of selling as it dropped, we bought so much more of this stock that the cost price plunged around 80% too. By now, the i Capital Global Fund is sitting on a gain of 175% on this particular stock. The reason why ICGF bought so much more was because if it was attractive at higher prices, it is even more attractive at depressed prices since the business fundamentals of the company have not changed. "


3. Taking profit

Profit should be realised from sales of stocks in the following situations:
(I) when the stock is obviously overpriced, or
(II) when the sale of the stock frees the capital to be reinvested into another stock with potentially better return.

Not taking profit in the above situations can harm your portfolio and compromise its returns. In other circumstances, let the winners run.

Underperforming stocks should also be sold early. Hanging onto underperforming stocks is costly too. There is the opportunity cost that the capital can be better employed for higher return. Also, hanging onto these lack-lustre stocks reduces the overall return of your portfolio.


4. Reducing serious loss

When the fundamentals of a stock have deteriorated, sell to protect your portfolio. This decision should be make quickly based on the facts and situations, in order to keep your losses small.


5. Diversify, but not overdoing it

According to Buffett, adding the 7th stock to the portfolio reduces the return without reducing the overall non-systemic risk. of the portfolio. Select the best 6 stocks. If you need to add money to your portfolio, buy more of these preexisting stocks when they are offered at a good or bargain price. If you identify a better stock to invest, perhaps, this should replace one of the preexisting stocks in the portfolio.


6. Asset allocate according to your risk taking ability

It is perplexing to know of investors whose days are affected by the swings in the market. You should not bet your total networth into the stock market. Allocate the amount that you are willing to risk.

Many long-term investors are always riding on a significant amount of gains. This means that they will only lose their capital in very unlikely extreme situations.

Here is an example to illustrate this point.

"After investing more than £2 bln in Barclays Plc, two years ago, Temasek, the well-known investment arm of Singapore, recently sold its stake in the British bank at a big loss."

Sometimes you made a serious mistake, or events turned against you, and there is no way to redeem this without taking a big loss. The only protection here is you have allocated your allocate asset appropriately such that this "black swan" phenomenon won't harm you irreparably. Hopefully this will not 'stopped out' in your investing.


7. So far so good. The hardest part: getting wired like Buffett and Teng Boo!

To invest like what Teng Boo did in ICGF, you need to be knowledgeable and able to execute 'coldly' (or cooly) without being affected by emotions. These are among the harder skills to master. Have you wondered what drives this blogger to write on investing? Through writing, rather than lurking, you can focus on the facts and solidify your knowledge, philosophy and strategy.

Admittedly, there is no single philosophy or strategy; but you should have one to guide your investing. It prevents you from over-reacting to emotions and circumstances, that may harm your portfolio and investing returns. As this discussion assumes the portfolio contains only good quality stocks, it prevents you from "Buying high and Selling low" due to falling prices in the market. It may allow you to benefit hugely from the volatilities and follies of the market; making volality your friend.

Understanding and mastering this field of behavioural finance is yet another challenge to higher investment returns for me.

Review of potential past KLSE market returns

In 1997, this KLCI touched the low of 300 points briefly. Today, the KLCI is about 1,100. From 1997 to 2009, the KLCI has compounded at 11.4% per year over the 12 year period. To achieve this 11.4% return. The KLCI was a low of 850 at end of 2008; giving a CAGR of 9.93% over the last 12 years. To achieve these returns, you would have to have invested a lump sum at the trough of the market in 1997.


What of the performance of the average investors?

This is the average guy. He is the guy who invests regularly whenever his savings allow him. He is not among those who achieved the 11.4% compound annual return.

Let us make this assumption to facilitate some calculations. His dollar cost averaging over 12 years approximates to a lump sum investment in the market from KLCI 700 to KLCI 1100 over 6 years. His gain is the equivalent of compounding annually at 7.82% over 12 years. When the market was at its low at end of 2008 (KLCI of 850), his CAGR over 12 years was 3.29%. (KLCI 700 is chosen as it is the average of the trough KLCI of 300 in 1997 and present KLCI of 1100.)

How can this average investor improves on his investment returns? More specifically how can he improves this return to 10% annually? Or, to above 15% annually and consistently?


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Return Rate (Discount Rate / CAGR) Calculator
http://www.moneychimp.com/calculator/discount_rate_calculator.htm


Total return from a stock
= (Capital appreciation + Dividend + Profit from Sale of Stock)/Amount Invested
= (Capital appreciation + Dividend + Profit from Sale of Stock)/(Value of Stock + Cash)


Total return from a portfolio
= (Capital appreciation + Dividend + Profit from Sale of Stocks)/Amount Invested
= (Capital appreciation + Dividend + Profit from Sale of Stocks)/(Total Value of Portfolio + Cash)

Lessons from the recent severe bear market

Reviewing my investing of the last 1 year.

What I did right.

1. Investing in good quality stocks. These stocks were down in the bear market, but the majority have rebounded, some higher than before.

2. Investing when the price is low. Using PE, average PE and the PE range as a guide, and buying when the PE is at a discount to the average PE.

3. Keeping my investments to those businesses that I can understand, that is within my circle of competence.

4. Buying when the market is low.

5. Buying when a particular stock is sold down for various reasons other than to deteriorating fundamentals.

6. Not buying lousy companies. (Best avoided, short term gain, long term pain)

7. Not buying good quality stocks that are trading at high prices.

8. Selling certain stocks in certain sectors where the business will be challenging in a recession.

9. Selling certain stocks in certain sectors that were fairly or highly priced to reduce the amount of money at risk in the portfolio when the downturn was clearly established.

10. By not selling stocks that were priced at below 'fair value' during the severe downturn, despite the continuing falling price.

11. Not timing the market. Holding onto good quality stocks bought at bargain for the long-term in my portfolio even during the severe downturn. The biggest return has already occurred in the recent upturn of stock prices.

12. By averaging up or down in my purchases of good quality stocks. Both these actions are safe. By always buying more shares in the stocks at lower prices, and buying less shares when the stocks were at higher prices.

13. By investing big in a good quality stock that I am confident of its value when it was offered at a bargain.

14. By always buying at a bargain, or at a fair price. Never, never, never and never at high price.

15. Believing in myself and my valuation.

16. Ignoring the noises in the market.

17. Having a sum of cash for investing opportunities.




What I did wrong.

1. Looking at the price of a stock, rather than the business and the financial statements of the stocks.

2. Reacting emotionally to falling prices. (Not easy, but can be overcomed if I focus on the fundamentals of the company).

3. Not selling some stocks early in the downturn. (But then this would be market timing which I feel is an impossible strategy for one to profit from consistently.)

4. Selling some good quality stocks when the major fall in prices had occurred. (This action has the effect of reducing the amount of money in the portfolio at risk in a down market, but then also harmed the return of the portfolio in a up market. Most gains in a portfolio are derived by buying or holding stocks in a down market before the change in trend than by selling stocks in a high market before the change in trend. Moreover, the prices of these good quality stocks had since rebounded. It would have been better to hold or add.)

5. Not buying more stocks in March. (To do so, I will need to focus less on the prices of the shares and more on the fundamentals of the business.)




What I hope to do the next 12 months

1. Do the same

2. Reinvest the dividends, just as before.

3. Allocate more capital on a regular basis to increase the portfolio, just as before.

4. Continue to rebalance the portfolio at regular intervals, just as before.

5. Continue to maintain a focussed portfolio with little diversification. Eight (8) stocks in this portfolio will account for 80% of the total value of the portfolio, just as before.

6. Continue to invest a meaningful sum with Tan Teng Boo's managed funds, just as before.

7. Always keep enough cash for opportunistic investing when the occasions arise, just as before.

8. ...

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.)

Value Stocks and Superior Returns

Stocks that exhibit low P/B and low PE ratios are often called value stocks.

Those with high PE and P/B ratios are called growth stocks.

Prior to the 1980s, value stocks often were called cyclic stocks because low PE stocks often were found in industries whose profits were tied closely to the business cycle. With the growth of style investing, equity managers who specialised in these stocks were uncomfortable with the cyclic moniker and greatly preferred the term value.

• Value stocks are concentrated in oil, motor, finance and most utilities.
  
• Growth stocks are concentrated in the high-technology industries such as drugs, telecommunications, and computers.
  
• Of the 10 largest U.S. based corporations at the end of 2001, 7 can be regarded as growth stocks (GE, Microsoft, Pfizer, Wal-Mart, Intel, IBM, and Johnson & Johnson), whereas only 2 (Exxon Mobil and Citigroup) are value stocks; AIG can go either way depending on the criteria used for selection.

A study summarising the compound annual returns on stocks from 1963 through 2000 ranked on the basis of both capitalization and book-to-market ratios appear to confirm Graham and Dodd's emphasis on value-based investing.

• Historical returns on value stocks have surpassed those of growth stocks, and this outperformance is especially true among smaller stocks.
• The smallest value stocks returned 23.26% per year, the highest of any of the 25 categories analysed, whereas the smallest growth stocks returned only 6.41%, the lowest of any category.
• As firms become larger, the difference between the returns on value and growth stocks becomes much smaller.
• The largest value stocks returned 13.59% per year, whereas the largest growth stocks returned about 10.28%.

One theory about why growth stocks have underperformed value stocks is behavioural: Investors get overexcited about the growth prospects of firms with rapidly rising earnings and bid them up excessively. "Story book stocks" such as Intel or Microsoft, which in the past provided fantastic returns, capture the fancy of investors, whereas firms providing solid earnings with unexciting growth rates are neglected.

Another more economically based reason is that value stocks have higher dividends, and dividends are taxed at a higher rate than capital gains. As a result, value stocks must have higher returns to compensate for their higher taxability. However, tax factors cannot explain the wide spreads between small value and growth stocks.

The differences in the return between large growth and large value stocks appears to wax and wane over long cycles.

• Growth stocks gained in the late 1960s and peaked in December 1972, when the "nifty fifty" hit their highs.
• When investors dumped the nifty fifty, growth stocks went into a long bear market relative to value stocks. One of the reasons for this was the surge in oil stocks, which are classified as value stocks, when OPEC caused petroleum prices to soar.
• From 1982 onward, growth stocks gained relative to value stocks, soaring in the technology boom of 1990-2000, only to fall again when the euphoria subsided.
• In fact, large growth stocks have outperformed large value stocks in about half the years since 1963.

BARRA, Inc., a California-based stock research firm, has divided the firms in the S&P 500 Stock Index into two groups of growth and value stocks with equal value on the basis of the firm's market-to-book ratio. Using the ratio of the cumulative return on these two large capitalization growth and value indexes since Dec 31, 1974, when the indexes were first formulated:

• On the basis of capital appreciation alone, growth stocks, with a 11.06% annual return, beat value stocks by 0.31% over this 37-year period.
• However, these value stocks have dividend yields that are about 2 % above that of growth stocks. When dividend yields are included to find total cumulative returns, value stocks' return of 15.6% per year outperformed growth stocks by about 1.9%.
• However, for taxable investors, the difference between the cumulative returns on S&P growth and value stocks has been very slight over the past 27 years, a difference of only 0.69%.

Furthermore, the unprecedented volatility of growth stocks relative to value stocks in recent years has played havoc with historical data.

• For someone who began investing in 1975, the technology bubble of the late 1990s sent after-tax growth returns higher than after-tax value returns from September 1999 through September 2000.
• Once the bubble popped, however, growth stock returns fell back below those of value stocks very quickly.

It should be noted that beginning the growth and value series in 1975 is very favourable for value stocks.

• Large value stocks crushed large growth stocks from 1975 through 1977, when soaring oil prices sent the price of oil and resource firms (which are always ranked as value stocks) skyrocketing.
• Since August 1982, when the great bull market began, cumulative returns for growth and value investors have been almost identiacal, even after the growth stock collapse of 2000-2001.

Also read:

Nature of Growth and Value Stocks

Nature of Growth and Value Stocks

These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.

The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.

Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.

In fact, over time, many stocks go through value and growth designations as their market price fluctuates.

The literature often showed value stocks beating growth stocks. What does this mean?

• As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value.
• It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.

There is no question that investors always should be concerned with valuation, no matter which stocks they buy.

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

Stock Prices and Future Stock Returns

The PE ratio can be a very misleading indicator of future stock returns in the short run, in the long run, the PE ratio is a very useful predictor.


Current yield of a bond = interest received / price paid
(Current yield of a bond is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.)


Earnings yield of a stock = EPS / price


Since the underlying assets of a firm are real, earnings yield is a REAL, or inflation-adjusted return. Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

This contrasts with the NOMINAL return earned from fixed-income assets (like bonds), where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns. The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%. This earning yield exactly matches the 6.8% real return on equities from 1871.

There are limitations to using the PE ratio to predict future short-term stock returns.

• For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
• And in the short run, there are many other sources of market movement, such as changes in interest rates or the risk premium demanded by stockholders.

Stocks for the long run - buy the dips

Most investors claim to retain their faith in stocks as the best long-term investments. Experience showed that market sell-offs were indeed ideal times for investors to commit more to the market. The mantra of the common investor in the 1990s was "Buy the dips."

Despite the steadfast faith in the market, the bear market of 2000 - 2001 has raised doubts in many minds about the desirability of holding the overwhelming proportion of a portfolio in stocks.

• Has the continued popularity of the stock market planted seeds of its own destruction?
• Have investors sent equity prices so high that they cannot in the future possibly match their superior historical returns?

The answer to these questions must come from an understanding of how stock prices influence their future returns.

An important lesson from the October 1987 crash

A comparison of the DJIA from 1922 - 1929 and 1980 - 1987 showed an uncanny similarity between these two bull markets. On October 19, 1987, we witnesse d the greatest 1-day drop in the stock market history, exceeding the great crash of October 29, 1929. In fact, the market in 1987 continued to trade like 1929 for the remainder of the year. Many forecasters, citing the similarities between the two periods, were certain that disaster loomed and advised their clients to sell everything.

However, the similarity between 1929 and 1987 ended at year's end. The stock market recovered from its October 1987 crash and by August of 1989, hit new high ground. In contrast, 2 years after the October 1929 crash, the Dow, in the throes of the greatest bear market in U.S. history, had lost more than two-thirds of its value and was about to lose two-thirds more.

What was different? Why did the eerie similarities between these two events finally diverge so dramatically?

The simple answer is that in 1987 the central bank had the power to control the ultimate source of liquidity in the economy - the supply of money - and, in contrast to 1929, did not hesitate to use it. Heeding the painful lessons of the early 1930s, the Federal Reserve temporarily flooded the economy with money and pledged to stand by all bank deposits to ensure that all aspects of the financial system would function properly.

The public was reassured. There were no runs on banks, no contraction of the money supply, and no deflation in commodity and asset values. Indeed, the economy itself moved upwards despite the market collapse. The October 1987 stock market crash taught investors an important lesson - that a crisis can be an opportunity for profit, not a time to panic.

Volatility is the friend of the value investor

Although most investors express a strong distaste for market fluctuations, volatility must be accepted to reap the superior returns offered by stocks. Risk and volatility are the essense of above-average returns: Investors cannot make any more than the risk-free rate of return unless there is some possibility that they can make less.

While the volatility of the stock market deters many investors, it fascinates others. The ability to monitor a position on a minute-by-minute basis fulfills the need of many people to know quickly whether their judgement, which affects not only money but also ego, has been validated. For many people, the stock market is truly the world's greatest gambling casino.

Yet this ability to know exactly how much one is worth at any given moment also can provoke anxiety. Many investors do not like the instantaneous verdict of the financial market. Some retreat into investments such as real estate, for which daily quotations are not available. They believe that not knowing the current price makes an investment somehow less risky.!

As Keynes stated over 50 years ago about the investing attitudes of the endowment committee at Cambridge University:

"Some Bursars will buy without a tremor unquoted and unmarketable investment in real estate which, if they had a selling quotation for immediate cash available at each audit, would turn their hair gray. The fact that you do not know how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one."

How high is high and how low is low.

Buying when the VIX is high and selling when it is low have proved profitable in recent years. However, so has buying during market spills and selling during market peaks.

The real question is how high is high and how low is low.

For instance, an investor may have been tempted to buy into the market on Friday, October 16, 1987, when the VIX reached 40. Yet such a purchase would have proved disastrous given the record 1-day collapse that followed on Monday.