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PART ONE
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continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory.
But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7%
return would have yielded nothing in the way of real income. -- Warren Buffett
Income tax paying investors would have seen 1.4 points of yield taken away by tax and a further 4.3 points in inflation.
As a result of these dismal figures, Buffett and Berkshire will only purchase currency-related securities if theres the
possibility of an unusual gain. The most common situations are credit asset mispricings or because rates rise to a level
that offers the possibility of realizing substantial capital gains when rates fall.
Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt:
Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.
-- Warren Buffett
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Assets that will never produce anything
The second category of assets, which seem to be safe investments at first glance but are in fact inherently risky, are,
according to Warren Buffett:
...assets that will never produce anything, but that are purchased in the buyers hope that
someone else -- who also knows that the assets will be forever unproductive -- will pay
more for them in the future. -- Warren Buffett
Tulips are of course the most famous of this asset class. Buffett continues:
This type of investment requires an expanding pool of buyers, who, in turn, are enticed
because they believe the buying pool will expand still further. Owners are not inspired by
what the asset itself can produce -- it will remain lifeless forever -- but rather by the belief
that others will desire it more avidly in the future. -- Warren Buffett
This is where Buffett begins to criticize gold as an investment. It is the favorite bastion of safety for investors who are
afraid to hold almost all other assets. However, golds most pressing shortcoming is the fact that it does not grow. If
you buy one ounce of gold and hold it for eternity, at the end, youll still be holding one ounce of gold.
In his article, Buffett goes so far as to state that gold was in a bubble, similar to the dot-com or housing bubbles, at the
time the article was written Feb 9, 2012, gold was trading around $1,750). The Oracle of Omaha then uses an example
to lay out why investors should avoid gold as an investment.
Today the worlds gold stock is about 170,000 metric tons. If all of this gold were melded
together, its...value would be about $9.6 trillion. Call this cube pile A.
Lets create a pile B costing an equal amount. For that, we could buy all U.S. cropland...
plus 16 ExxonMobils...After these purchases, we would have about $1 trillion left over
A century from now the 400 million acres of farmland will have produced staggering
amounts of corn, wheat, cotton, and other crops...ExxonMobil (s) will probably have delivered trillions of dollar in dividends to its owners and will also hold assets worth many
more trillions...The 170,000 tons of gold will be unchanged in size and still incapable of
producing anything. You can fondle the cube, but it will not respond.
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These figures are somewhat out of date, but you get the picture.
Productive assets
Buffetts third and final investment category is that of investments in productive assets, whether it be businesses,
farms or real estate. Buffett likes assets that can deliver an increase in real purchasing power over the long-term, while
requiring a minimum of new capital investment. Companies such as Coca-Cola, International Business Machines
Corp., and Sees Candy.
I believe that over any extended period of time this category of investing will prove to be the runaway winner among
the three weve examined. More important, it will be by far the safest.
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PART TWO
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book value stocks in the markets worst 25 months, and in the other 88 months when the market declined. And
concluded:
Overall, the value strategy [low price-to-book value] appears to do somewhat better than the
glamor strategy [high price-to-book value] in all states and significantly better in some states.
If anything, the superior performance of the value strategy is skewed toward negative return
months rather than positive return months. The evidence [in Table 9] thus shows that the value
strategy does not expose investors to greater downside risk.
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What has worked in investing: Investing with the inner circle: buying stocks where the insiders
(officers, directors or the company itself) are buying
Tweedy, Browne uses this section of the booklet to group together five different studies, all of which assess the
impact of insider accumulation of stock price performance. The five studies, Donald T. Rogoff, The Forecasting
Properties of Insider Transactions, Diss., Michigan State University, 1964; Gary S. Glass, Extensive Insider Accumulation as an Indicator of Near Term Stock Price Performance, Diss., Ohio State University, 1966; Charles W.
Devere, Jr., Relationship Between Insider Trading and Future Performance of NYSE Common Stocks 1960 - 1965,
Diss., Portland State College, 1968; Jeffrey F.Jaffe, Special Information and Insider Trading, Journal of Business,
July 1974; and Martin E. Zweig, Canny Insiders: Their Transactions Give a Clue to Market Performance, Barrons,
July 21, 1976, cover a period from 1958 to 1976 and show that the investment returns on the stocks of companies
purchased shortly after insiders purchases all surpassed the subsequent market performance.
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PART THREE
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Behavioral Investing
James Montier is the author of several books that have become staples for any investor, one of which is Behavioral
Investing: A Practitioners Guide to Applying Behavioral Finance. Within the pages of the book, James Montier summaries the topic of behavioral investing -- a broad topic with an enormous amount of research available. Additionally,
James Montier adds some insights of his own on the topic, making the book an indispensable resource for investors
on the subject of behavioral finance.
The Brandes Institute, the research arm of Brandes Investment Partners has put together a summary of James Montiers book, with some added insights. And its this summarized six-page booklet that Im looking at within this article.
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The first four key criteria relate to the central bias of self-deception. Two of these are overconfidence and overoptimism. More often than not, investors overestimate their ability and feel more confident than they should. Two other
self-deception factors are self-attribution and hindsight. Simply put, people credit their skill for good outcomes and
blame bad luck for bad outcomes.
On the central topic of simplification, once again there are four primary traits that hold investors back. Firstly, anchoring: People often grasp non-relevant information, often believing that are making better decisions. Secondly, representativeness: People judge by appearance rather than likelihood. People like a good story over hard facts. Thirdly,
framing: More often than not, investors will give different answers depending on the same, but differently framed,
questions. Fourth, loss aversion: People usually give more weight to losses than to corresponding gains.
On the two central topics of emotional and social interaction, James Montier notes that the two main traits holding
investors back are:
1.
Regret theory: The fear of being wrong outweighs the cost in objective economic
terms
2.
Herding: Neurologists have found that real pain and social pain are felt in the same part
of the brain. Contrarian strategies are the investment equivalent of seeking out social pain.
James Montier pulls together all 22 behavioral biases and four central topics to create a Seven Sins of money management:
1. Enormous evidence shows investors are hopeless at forecasting, yet it may be at the heart
of their investment process
2. Investors are obsessed with information, yet more information doesnt lead to better decisions, just overconfidence
3. Meetings with company management are overrated; management themselves are likely highly biased.
4. Investors typically think they can outsmart everyone else.
5. Investors are increasingly obsessed with short-term time horizons
6. People like good stories and often enhance them to suit their own biases, while ignoring the
boring facts.
7. The minds default tendency is to believe; innate skepticism is rare, yet advantageous in investing.
But behind almost all behavioral biases is group behavior. James Montier believes that the subject of group behavior
is one of the most important in behavioral finance. Psychologists have found that groups amplify rather than alleviate decision-making biases. They falsely lead members to increased confidence and are not good at uncovering new
information.
Groups can suffer cascades (in which individuals abandon their own views), polarization (in
which groups move to a more extreme version of original beliefs), and ultimately groupthink
(an extreme version of polarization).
Behaviorists distinguish between statistical groups, whose independent decisions actually add
up to pretty good decisions, and deliberative groups, who tend to amplify biases. Group biases include the main ones noted previously: representativeness, framing, overconfidence, and
anchoring. Montier notes that solutions to the problems of group decision making are just as
difficult as overcoming individual biases. Possible solutions include: secret ballots, devils advocates, and simply having respect for other group members.
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PART FOUR
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Company #10 is expected to earn $50,000 cumulatively over the next three years. Company #1 is only expected to
earn $19,000 over the same period, but the market is willing to pay 2.7x for the stock. Why? The market is willing to
pay a high premium for growth. Company #1s earnings are set to jump for $4,000 to $8,000 over three years, if this
growth continues, the company will earn an equivalent, if not greater level of earnings than company #10 at some
point in the future.
Investors are willing to pay more for glamour stocks. However, the Brandes Institute has found that the value/glamour
cycle has been surprisingly persistent and bordering on the predictable over the long-term:
We find a manifest chronology of overreaction, revision, sentiment shift, and multiple expansion in value stocks. In glamour stocks, a similar record of overoptimism,
revision, disappointment, and multiple contraction existed...the purchase of value
stocks tends to exploit, rather than succumb to, behavioral biases such as overoptimism, overreaction, and anchoring. These biases tend to push prices for securities
above or below their inherent worth. -- The Brandes Institute: The Role Of Expectations In Value And Glamour Stock Returns
The report notes that these biases, which push prices to extremes in the short-term, dissipate over the long-term, and
security prices revert away from extreme levels.
As prices make this reversion, we believe there are ample opportunities for profitminded investors who can remain rational and patient. -- The Brandes Institute:
The Role Of Expectations In Value And Glamour Stock Returns
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With growth stocks, it was found that overoptimism set expectations for growth at unattainably high levels -- required
to sustain already elevated stocks prices. Eventually, it then becomes increasingly difficult for a company to meet
growth targets. At some point in the future, eventually, growth expectations will be missed (typically by a wide margin), and expectations will be revised downwards. Investors then become rattled, and prices fall leading to multiple
contraction.
The numbers in the table below really do sum up the argument nicely.
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PART FIVE
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This chart is from Professor Santos post on value. The gray line shows the returns of ten portfolios over a five decade
period. On the left, the portfolio of stocks with the lowest price to book values. On the right, the portfolio of stocks
with the highest price to book values. The blue line is where the returns should be if beta were an accurate measure of
risk and the CAPM held true in all cases. As the chart shows, its not always necessary to take on more risk to achieve
higher returns.
...the point that it delivers is nevertheless striking: the CAPM cannot explain any of the
variation in returns associated with variation in book-to-market. In particular notice that the
CAPM says that value stocks should have much lower returns than what they have in the
data! The inability of the CAPM to explain the value premium is what academics call the
value premium puzzle
Experienced value investors should know the answer to this puzzle; Mr. Market is to blame.
So why do academics keep arguing over what perhaps many a practitioner considers an
obvious issue: that Mr. Market is prone to temporary periods of insanity, euphoria, and depression? Because the market is the fundamental allocation mechanism and if in some loose
sense the market is not efficient...well perhaps society should consider the appropriate public
interventions to improve on what otherwise would be a suboptimal allocation of capital. You
can see now why academics worry so much about this issue: The question is not academic
at all! It affects the organization of our economic life in ways that are sometimes not fully
appreciated by even the best-informed investors.
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PART SIX
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Data quality
The average company specific figures for US stocks used in the study were as follows. The average
book-to-market equity value for low book-to-market stocks used in the study was 0.4x. The average
book-to-market equity value for high book-to-market stocks used in the study was 1.6x. The average
company market cap. was $431 million and median size $42 million. Due to the size of the US and
Japanese markets, these two stock universes accounted for 75% of the studys results.
One thing to note about Fama and Frenchs study is the fact that they used the MSCI database to
calculate returns. MSCI is just a compilation of hard-copy issues of Morgan Stanleys Capital International Perspectives. It includes historical data for firms that disappear, but does not include historical
data for newly added firms, so there is no backfilling problem. As a result, the data is relatively free of
survivor bias, which makes the study more indicative of real-life trends than most.
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Study results
Results of the study showed that the difference between average returns on global portfolios of high
and low book-to-market equity stocks was 7.60% per year. Value stocks outperformed growth stocks
in 12 of 13 major markets during the 1975-1995 period. Whats more, similar return premiums were
also reported when sorting the stocks in order of earnings/price, cash flow/price, and dividend/
price.
It was found in many cases that the markets high expectations for growth stocks held back their
long-term performance. Specifically, the market often pegged a high valuation on growth stocks from
the very beginning, leaving them no choice but to grow into their valuation. After growing into lofty
valuations, growth tends to slow, and the valuation adjusts accordingly.
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...people think because these are good companies, their stock returns will be
high. But in fact, their prices are pegged so high by the market that their returns
actually tend to be low...The intuition is that value stocks have low prices relative
to their book value, so the market feels theyre relatively distressed...The intuition is the opposite for growth stocks. -- Eugene Fama
Fama and French put together Value Versus Growth: The International Evidence as part of their
findings in the process of examining the validity of the Capital Asset Pricing Model, which has
been used for decades as a means of describing the relationship between expected return and risk in
stocks. Fama and French found that CAPM couldnt possibly explain all the variation in expected returns. Further, by using the CAPM and relying on just one measure of risk (beta) Fama and Frenchs
research showed that those investors using CAPM tend to take on more risk than is optimal (something I covered in part five of this series).
CAPMs downfalls
After presenting evidence to display CAPMs downfalls, Fama and French went on to examine multifactor models that allow many different sources of risk to impact expected returns. They found that
to explain average stock returns, the most efficient strategy is to use three measures of risk. These
measures include sensitivity to the market return; a measure to distinguish the risks in small stocks
versus big stocks; and a measure to identify the risks in value stocks versus growth stocks.
Value Versus Growth: The International Evidence uses two measures of risk to explain the average
returns -- a market risk factor and a value-growth risk factor. The market risk factor is the return on
an international market portfolio of stocks, and the value-growth factor is the difference between the
return on an international portfolio of high book-to-market stocks and the return on an international
portfolio of low book-to-market stocks.
And the results do support the conclusion that CAPM gives too simplistic a view of the world. Additionally, the results present hard evidence, which supports the argument that, over time, value always
outperforms growth.
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PART SEVEN
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There is a lot of skill in markets and investors themselves are all very similarly
skillful this is reflected in prices. As a consequence, that leaves more to luck
and is the reason why short-term outcomes can mostly be put down to luck.
-- Michael Mauboussinsource.
The key to improving investment performance then is to define, refine and improve skill. Appreciating the difference
between skill and luck is the first step on this journey. Then you have to focus on the process. You need to ask yourself
if your investing process is any good? Has it worked in the past?
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PART EIGHT
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portfolio bucket generated an annualized return for the period of 19.2% versus 11.2% for the S&P 500. On the other
hand, the high dividend yield, high payout ratio bucket produced an annualized return of only 11.0%, underperforming the S&P 500.
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The Importance of Dividend Yields in Country Selection The High Dividend Yield Advantage
The second international study comes from OShaughnessy Asset Management and is entitled Stocks, Bonds, and the
Efficacy of Global Dividends. Using data from Morgan Stanley Capital International (MSCI) going back to 1970,
OShaughnessy Asset Management found that the top decile of dividend paying companies in that database produced
returns that were 5.7% better, on an annualized basis, than the returns of the broader database.
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PART NINE
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Seth Klarman notes that many investors are often pressured into investing prematurely; the cheapest security in an
overvalued market may still be overvalued. It is often the case that another opportunity to buy will come along soon,
offering a better return for your money.
Nevertheless, value alone is not sufficient; investors must choose only the best absolute values among those that are
currently available. Oddly, this is where Seth Klarman advocates increased trading or rebalancing.
... Value investors continually compare potential new investments with their current
holdings in order to ensure that they own only the most undervalued opportunities
available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings
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It is only fair to note that it is not easy to distinguish an investment fad from a real business trend. Indeed, many
investment fads originate in real business trends, which deserve to be reflected in stock prices. The fad become dangerous however, when share prices reach levels that are not supported by the conservatively appraised values of the
underlying business
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PART TEN
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As shown in the chart above, between 1995 and 2014 the average stock fund returned 9.1% annually, but the average
investor in stock funds earned only 5.2%. Why was this the case? The chart below offers an explanation.
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Investors are guided by their emotions. By trying to time the market, chasing hot investment and avoiding out-offavor areas they are holding back their performance. When building long-term wealth, maintaining an unemotional,
rational and disciplined mindset is critical. Making emotional decisions based on short-term market movements can
have disastrous consequences.
The chart compares the returns of 20-year returns of an investor who stayed the course over the entire period to those
who missed just the best 10, 30, 60, or 90 trading days. And as you can see, the investors that missed just the best 30
days during this 20 year period experienced an investment that remained flat. Being out of the market for a full 90
days would cost a 8.6% per annum.
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It is impossible to predict accurately the short-term direction of the market, and as a result, investors need to remember that when evaluating managers (or their own investment strategy), short-term performance is not a strong
indicator of long-term success.
Investors who recognize and prepare for the fact that short-term underperformance is inevitable may be less likely to
make unnecessary and often destructive changes to their investment plans.
Recognize That Historically, Periods of Low Returns for Stocks Have Been Followed by Periods of
Higher Returns
Historically, disappointing periods for the market have been followed by periods of
recovery. Why? Because disappointing periods provide long-term investors the opportunity to purchase good businesses at lower pricesand lower entry prices have helped
increase future returns. -- Chris Davis
Based on data spanning the past nine decades, history has shown that investors should feel optimistic about the longterm potential for stocks after a disappointing period.
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Long-term investors should always consider adding to their equity holdings following periods of poor returns. Trying
to time the market by getting out of the market after a period of poor performance may sabotage your ability to build
wealth.
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Stocks Historically Have Been the Best Way to Build Wealth, Despite Inevitable Periods of Uncertainty
There is always something to worry about and a hundred reasons not to invest. Those
who abandon stocks because of fear or uncertainty may pay a tremendous price. History has shown that a diversified portfolio of equities held for the long term has been
the best way to build real wealth. -- Shelby M.C. Davis
Below is a chart showing the cumulative inflation-adjusted returns from 1925 to 2013 for stocks, bonds, Treasury bills,
and the U.S. dollar. Over the period studied, there have been multiple wars, recessions, bear markets, financial crises
and market panics. Whats more, the Great Depression started in 1929, and Financial Crisis took place in 2009.
Nevertheless, despite all of these obstacles large-cap stocks have outperformed all other asset classes over the period.
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