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HEY! DID YOU KNOW…

 

  • The median age in the U.S. is 36.8
  • The median income in the U.S. is $51,939
  • The average 401k match is $1 for $1 up to 6%

A 36.8 year old investing 10% of their $51,939 income with a $3,116.34 match:
With just average stock market returns of 10% would have $1,114,479.31 by retirement.

Join 7,200+ other readers who have learned how anyone, even beginners, can easily make this desire a reality. Download the free ebook: 7 Steps to Understanding the Stock Market.

The Concerning Trend Towards Return on Capital and Away from Graham

Investors have a myriad of options available when it comes to analyzing a business. The return on capital ratio is one fantastic way to do this. It’s an especially strong metric when it comes to identifying companies with a good growth track record or prospects.

return on capital

But I’m concerned there’s a growing popularity with the return on capital ratio and too much reliance among many other fund managers who have been successful thus far. It could lead to lower performance in the coming years, especially in the case of a bear market.

First, let’s define return on capital.

There are many flavors of the actual return on capital formula. Check out the successful value investor and my friend Ken Faulkenberry’s article if you’d like to see 5 variations of this important calculation.

Since I personally come from a very value investor based school of thought, and much of my website teaches value-based principles, I’m going to focus on Joel Greenblatt’s definition of return on capital. This is likely the formula many successful fund managers are using as self-proclaimed value investors themselves.

The Magic Formula (Joel Greenblatt) return on capital equation is:

Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

Instead of examining this with an example, let’s look at this at a higher level. Testing the validity of equations through a logical examination is better than blindly following a widely used process.

EBIT is simply earnings before interest and taxes. It’s basically a measure of a company’s operating earnings, which gives you good insight on how well the core business model is performing.

An obvious advantage of this is it gives a sense of how much demand there is for the company’s products or services and exposes companies that consume a lot of cash in order in relation to their sales—creating smaller profit margins and indicating possible higher risk.

Net Fixed Assets is another way to describe net tangible assets. The “net” portion refers to tangible assets minus liabilities. This number is commonly negative or positive depending on the business model.

For example, a company with a strong brand may have negative net tangible assets because it doesn’t need much capital to create profits, the popularity of its brand name already creates very high demand. In the fundamental analysis camp of the stock market, a company like this would be called a low capital intensive business.

I’ve covered the debate whether tangible or intangible assets should be preferred before. For the sake of brevity, I’m going to assume you’ve read the article and have insight on these implications. [click to continue…]

Debunking Flawed Efficient Market Hypothesis Assumptions

efficient market hypothesis assumptions

The efficient market hypothesis is one of the hottest debated topics in the investing world. In today’s session, we are going to discuss some of the many ways this theory is flawed. We will talk about many of the efficient market hypothesis assumptions and how they may or many not have gotten it wrong. Pricing is one of the main hot buttons in this theory and we will show why the efficient market hypothesis assumptions are incorrect.

 

  • The efficient market hypothesis states the market can’t be beat
  • All stock prices have all relevant information included in them
  • Only way to beat the market is with passive investing
  • Warren Buffet debunks this with his famous speech
  • Value investing has beaten the market over the last thirty years
  • The efficient market hypothesis is based on people being rational, which we all know we are not.
  • The market can be beaten and there are lots of tools to help.
  • If you don’t want to be an individual investor than index funds are the way to go.

 

Andrew: Well, two weeks ago we took out our weapons and fired them into the financial services industry and probably pissed off a few people.

Today we are going direct it against some other group. Probably make some people mad. Basically talking about the academic types in their ivory tower. There is a theory called the efficient market hypothesis, really based off a lot of the professors at the University of Chicago.

If you pursue an education in relation to investing or the stock market, economics you will get exposed to the efficient market hypothesis.

It is something that there has been a lot of studies on. Ph.D. thesis was done on it. It is also a very hotly debated theory among investors, particularly value investors.

You have the value investor side. Guys who have made billions like Warren Buffett, Seth Klarman, Peter Lynch, Joel Greenblatt, Monish Pabrai, and on, and on.

It’s kind of like them through their performance that has proved the efficient market hypothesis hasn’t held true for them. So, there’s that camp. And there’s the other camp that says the other investors should not try to beat the market because the markets are efficient.

So that’s something we kind of want to address and give our own takes on it to see.

Our audience is a lot of beginners and if there are academic studies saying we shouldn’t try to beat the market. Or is it something we should try to follow, or is it something we should look further into and see if there is a way to mitigate that.

That’s what I hope to do with this episode.

Dave: Why don’t you tell us a little bit about the efficient market hypothesis. Where it originated and who started it, and what your thoughts are on it.

Andrew: It’s been around for a while. Most recently is has been popularized by Jack Bogle and author Burton Malkiel, who wrote a Random Walk Down Wall Street. Where he brought his own inputs into it and gave some conclusions about why the markets are really efficient.

[click to continue…]

Analyzing Greenblatt’s Magic Formula Strategy without Backtesting

It seems that every argument supporting Joel Greenblatt’s magic formula examines some flavor of a backtest to prove its effectiveness. The problem with backtests is that the results don’t tell the complete picture. Backtests are fundamentally flawed, so we should find other ways to validate or disprove the magic formula strategy.

Backtests are dangerous indicators of success for two reasons.

  • Time periods can be easily cherry picked
  • Survivorship bias can skewer results significantly

When it comes to backtests… the shorter the time period examined, the more important timing is. This should be obvious, as results can fluctuate greatly even in short 1-3 year periods.

But results also fluctuate over the very long term. For example, examining the performance of buy and hold during 1999 would show it greatly outperforming market timing. That same study after the 2000 crash would show buy and hold as a sub-optimal strategy. The media loves to place significance to these performance numbers as they make for sensational headlines.

magic formula

On a related note, out performance between value stocks, growth stocks, and momentum trading also fluctuates depending on the starting and ending time period. Small caps and large caps performance naturally fluctuates. Various asset classes are better investments at different times.

So you can see, performance numbers even on a CAGR basis greatly differ due to the natural cycling of investments and asset classes. And even though the impact reduces over a long enough time frame, there’s still a significant difference especially at market extremes.

Take this obvious example.

An examination over 20 years would see the S&P 500 returning roughly 6.6% a year from 1989 – 2009. A cherry picked time period just slightly shifted from 1991 – 2011 of the same index would be 14.8%.

The strong diversity of strategies by various fund managers shows their performance to fluctuate depending on the time period as well. Guys like Buffett had staunch under performance to the market average during the late 90’s bubble. Yet it only took a couple years to reverse that performance data.

So while Greenblatt achieved a CAGR of 40 – 50% over a 10 year period, this alone isn’t enough evidence to prove a strategy’s validity partly due to the weakness of backtests.

Of course, along with the inherent problems with backtests and past performance data are the many stock screeners which cherry pick stocks from the past and further skew the resulting data. The further back a strategy looks back, the harder it is to obtain financial data—especially before the internet.

As far as looking for SEC financial figures online, finding any data before 1992 – 1994 is impossible if you’re strictly using their own website, sec.gov. You’d likely have to go to a library to get easy and free access.

So the limited availability before 1992 either constrains the number of people able to publish relevant backtests or constrains the backtest to the last 25 year time period.

As we’ve seen previously, even a longer time period like 20 – 25 years can be greatly misinterpreted based on current market prices and how they fall in the bear or bull market cycle.

Don’t also discount the significant effect of companies that either fell off a major index or went completely bankrupt. Many backtests simply don’t include such companies. There’s no use in providing this data for many financial websites.

Stock screeners and backtests both tend to use stocks that are still currently trading. Screeners must sift through data already there, and many stocks that fell off aren’t included in past databases, especially the farther back you go. It makes a compounding effect in skewing the results.

Let’s be clear, I’m not completely discounting the value of a backtest.

It provides a good starting point but isn’t the end-all be-all for proving or disproving a strategy. I believe a strategy like the magic formula should be valid on a logical level.

If the reasons why the magic formula works does make sense on a fundamental business level, then coupling this evidence with past performance track records of Joel Greenblatt will suffice.

It’s no different than studying Graham or Buffett and understanding what the numbers mean, why they work like they do, and how such a mindset can be implemented by the average investor. As I’ve written before, blinding following a margin of safety formula can be both difficult and disastrous, as can blindly accepting the results of a backtest.

What is the Magic Formula exactly?

Joel Greenblatt wrote a bestselling book outlining his strategy called The Little Book that Beats the Market. The magic formula ranked stocks based on these 2 metrics.

  1. Earnings yield
  2. Return on capital

Following the magic formula investing strategy also comes with these conditions:

  • A stock should have at least $50 million in market cap
  • Financial, utility and international stocks are prohibited
  • Buy the top ranked 5-7 stocks every 2 to 3 months
  • Sell each stock after holding for a year (1 week beforehand if the stock is a loser for a short term capital loss deduction, 1 week afterwards for a winning stock for a long term capital gain)

With a few disclaimers:

  • Your portfolio will be fully diversified in about 10 months
  • Outperformance should take effect in about 3-10 years

Now, let’s simply look at the formulas for earnings yield and return on capital to deduce what they mean on simple terms and if they make sense for finding solid stocks that are likely to outperform. [click to continue…]

IFB07: Creating Portfolio Income with Ben Reynolds from Sure Dividend

portfolio income

Creating portfolio income is one of the main reasons we all invest. There are many ways to create that income. One of the best ways is utilizing dividends. These payouts from your investments are one of the leading ways to create portfolio income for your retirement or hopefully, before that.

Tonight we have the extreme pleasure to have a conversation with Ben Reynolds of Sure Dividend. Ben is one Andrew’s and I’s favorite writers and his work is a must-read for anyone even remotely interested in dividend investing. The writing is very easy to read and he provides tremendous value with each analysis that he does. Ben focuses on companies that pay dividends and his real passion is helping investors create portfolio income through these dividend payers.

  • Having a long-term horizon
  • Discovering the important ratios of dividend investing
  • the importance of dividend aristocrats
  • A new take on dividend reinvestment
  • ETFs or individual stocks 
  • How to start dividend investing
  • 8 rules for dividend investing

He has two newsletters that he writes that focuses on different aspects of the dividend investing world. Sure Dividend is for his subscribers that have a longer time horizon and the Sure Retirement that is for those who are looking for higher yields. We will discuss these in much more detail in our interview.

This was a treat for me as I was able to be the moderator and ask the questions. Then just sit back and listen to Ben and Andrew go back and forth.

Here is our interview with Ben.

Enjoy.

 

Dave: How did you get interested in dividend investing?

Ben: I have been interested in investing, since basically when I finished college. I have always been interested in finance from a very early age. I got interested in dividend investing in particular when I started researching market anomalies. You probably have heard of some of them. Like the value investing effect or low price to earnings stocks. Or the low-volatility effect where low-volatility stocks have outperformed high-volatility stocks.  

[click to continue…]

What Malkiel’s Random Walk Got Wrong about Pricing Efficiency

There’s many different trains of thought when it comes to the stock market. Among those is the idea by Burton Malkiel that you can’t beat the market—because prices move around like a random walk and that stocks are already efficiently priced.

Malkiel’s work has been both praised and criticized by many. He is a big proponent of the efficient market hypothesis (EMH), which states that the market is efficient and stocks are always correctly priced based on the information available.

random walk

EMH is without a doubt a hotly debated topic in economics. On the one side you have very highly educated people who support EMH. Academics, many who are from the University of Chicago, who are recognized for their studies, research, and dissertations and hold many prestigious awards and positions.

On the other side is the group who opposes EMH. It comprises of individual stock investors, many who run their own funds or invest with other people’s money. A special group of these investors, clustered from the Columbia School of Business, have public track records of handily beating the market for decades. Many investors from this school of thought are both respected as businessmen and extremely wealthy—to the tune of billions.

This special group, dubbed the SuperInvestors of Graham and Dodd by Warren Buffett, are known as value investors and they believe that the market creates inefficiencies—causing stocks to trade in ranges outside of their real value. Emotions such as optimism and pessimism influence stocks one way or the other, creating opportunities in stocks that are undervalued.

Malkiel claims that there’s no way for the average investor to reliably gain an information edge in today’s age, and that stocks efficiently move up or down as new information on business results comes out.

He also claims you can’t beat the market and that past track records of successful managers are just outliers. Malkiel uses the following analogy to explain why.

A large group of monkeys all flip a coin. Heads is a winner, tails is a loser. As the coin flip results move around in a random walk, there’s a likely probability that some monkeys will flip consecutive winners as this experiment plays out. As this luck continues, other monkeys seek advice and try to emulate the winning monkeys—much like we see on Wall Street today.

Warren Buffett arguably disproved this analogy in his SuperInvestors speech. He said something along the lines of… if every winning monkey comes from the same business school (The Columbia School of Business), you should start to question the idea that it’s a random walk and maybe investigate what kind of coin they are using.

Interestingly, Malkiel glossed over this valid critique and refused to address it.

I’m not here to throw dirt on Burton Malkiel and his work. In fact I respect much of his contributions to the world of economics, and it turns out we agree on several things.

1) A reason Malkiel advises investing in index ETF funds over mutual funds is because of the high expense ratio that is attached to almost all mutual funds. There are different fee structures for various types of funds, but those who are actively managed by a person are all but certain to be more expensive to the investor than one passively managed.

A mutual fund can charge 1 or 2% in fees to the investor just at the onset. This might not seem like much, but when you are talking about the life or career of an investor that percentage point compounds to a make a serious difference. If you’re going to invest in a fund, just the aspect of fees makes an index ETF far more attractive than a mutual fund.

2) Malkiel takes this a step further with research about the average mutual fund manager underperforming the market. If the professionals can’t do it, his logic is that the average investor can’t do it either. So he takes these findings to conclude that EMH is valid and you can’t beat the market.

Of course, I’m not going to disagree with facts. The data and studies about underperforming mutual fund managers are there. If you put a gun to my head and forced me to choose between only a mutual fund or an index fund, I’d choose the index fund because of these two distinct advantages. No question.

But…

I take exception to the idea that since a majority of mutual fund managers can’t beat the market, that markets are efficient and can’t be beat. It’s not that there aren’t exceptions to the rule—and Malkiel never argued that. After all, some “monkeys” are going to get better results. However, he concludes that these institutional investors—who have vastly more informational resources and capital than the individual investor—all underperform on average, so the average stock picker should expect the same.

He doesn’t consider or acknowledge the real reason why these institutional investors underperform (and there’s several). Let’s start with the most basic factor.  [click to continue…]