In this summary, you will learn
Why passive investing beats active stock picking;
What value and growth measures you can use to assess the value of stocks; and
Why emotion frequently gets in the way of logical investing.
The stock market isn’t random. It systematically punishes or rewards stocks with certain characteristics.
Passive investing, such as index funds, routinely beats active stock picking.
You need 25 years of data to determine whether an investment strategy is profitable.
Even a poor strategy, followed consistently, beats helter-skelter buying and selling.
You can beat the market by applying value measures such as price-to-earnings and price-to-sales ratios.
You can beat the market even more soundly by combining factors such as PE or price-to-sales ratios with relative price strength.
Consider risk. Buying stocks with high one-year appreciation is profitable, but too risky for most investors.
To reduce risk, pick a few strategies, including a mix of growth and value approaches.
Growth-measure strategies are riskier than those based on value measures.
The most profitable strategy from 1951 through 1996 used a combination of price-to-sales ratio with stock price appreciation.
The Power of Passivity
Want to beat the stock market? Don’t bother chasing tips or trying to outguess the competition. In fact, don’t even bother to actively manage your money. Passive management beats the market with less risk than is incurred with actively managed portfolios. Investing in companies based on traditional value measures will make money. Combining measures such as price-to-book or price-to-sales with strong price appreciation yields even better results.
Stock investors can be passive or active. Passive investors rely on index funds that represent the market, such as the Standard & Poor’s 500. Active investors try to beat the market by picking stocks. They follow one of two strategies. Growth investors seek a company with potential and hope its stock will rise. Value investors look for undervalued stocks.
However, active investors rarely beat the market. During the ten years ending in 1994, only a quarter of actively managed mutual funds beat the S&P 500. Fewer than half of those funds outpaced the index by more than 2%. Therefore, passive investing has gained popularity. Index funds have boomed from $10 billion in 1980 to $250 billion in 1990.
“The price of a stock is still determined by people. And as long as people let fear, greed, hope and ignorance cloud their judgment, they will continue to mis-price stocks and provide opportunities to those who rigorously use simple, time-tested strategies to pick stocks.”
The Case for a Rigid Model
Purists say that active investing lags behind the market because markets are efficient and stock prices reflect all available information. That theory ignores the fact that people determine stock prices, and people let emotions cloud their decision making. The true culprit for the failure of active investing is human folly. Investors are susceptible to sexy stories, second-guessing, and other unreliable patterns. Emotion overwhelms their best intentions.
By contrast, a model such as an index fund doesn’t vary. It automatically buys shares in indexed firms. Successful investing and human nature are polar opposites. Human nature leads investors to follow crowds, fall for stories and invest on tips.
“No one wants to buy Union Carbide after Bhopal or Exxon after the Valdez oil spill, yet it is precisely these times that offer the best buys.”
A rigorous investing model has several reliable characteristics:
Explicit rules - There is no ambiguity or room for interpretation.
Public guidelines - Anyone could reproduce the results.
Reliable rules - Steady rules let results remain consistent.
Objective guidelines - Researchers use standard criteria.
Reliable data - The results have credibility.
Following an investment model requires the discipline to ignore negative headlines. For instance, a strategy of buying the 10 highest-yielding Dow components would require an investor to ignore misgivings about Exxon after an oil spill.
“The past 45 years show that rather than careening about like a drunken monkey, the stock market methodically rewards certain types of stocks while punishing others.”
A study of stocks over 45 years yields intriguing results. Until risk comes into play, small stocks (market caps between $25 million and $100 million) outperformed the market. Midcap stocks (market caps between $500 million and $1 billion) and large caps essentially performed the same. Both lagged all stocks and small stocks. Market leaders - large companies that dominate their sectors - performed nearly as well as small stocks and with less risk. Many stock market models are flawed because they include results from microcap stocks, or issues with market caps below $25 million. Because such shares trade thinly, it’s impossible to make a large order without influencing the price.
Here’s how an investment of $10,000, made in 1951 and rebalanced annually, stacks up over 45 years. Keep in mind that $10,000 invested in all stocks would turn into $2.7 million over that time.
“The approach of traditional, actively managed funds makes perfect sense until you review the record. The majority does”To make money requires the ability to consistently, patiently, and slavishly stick with a strategy, even when it’s performing poorly relative to other methods.” not beat the S&P 500.”
PE Ratios - This measure proves more important for large stocks than for small issues. Of all stocks, the 50 companies with the lowest price-to-earnings ratios grew to $2.1 million, a compound rate of return of 12.65%. This return lagged all stocks and large stocks. But an investment in the 50 large stocks with the lowest PE ratios grew to $3.8 million, a return of 14.1% a year. Conversely, stocks with high PE ratios perform poorly. An investment in the 50 companies with the highest PE ratios grew to $558,000, or 9.35% a year. The 50 large companies with the highest PE ratios grew to $647,000. One caveat: The lowest 10% of stocks under-performed the second-lowest ten, perhaps because those stocks with the lowest PE ratios have serious problems.
“Buying high PE stocks, regardless of their market capitalization, is a dangerous endeavor. You shouldn’t let the flash of the latest glamour stock draw you in to paying ridiculous prices for earnings.”
Price-to-Book Ratios - Divide the current stock price by the stock’s book value. If you want to make money, buy stocks with low price-to-book ratios and avoid issues with high price-to-book valuations. A $10,000 investment in the 50 stocks with the lowest price-to-book ratios grew to $5.5 million, a return of 15% a year, compared to $2.7 million for all stocks. Among all stocks with low price-to-book ratios, large stocks are less risky.
Price-to-Cash Flow Ratios - Find cash flow by adding income to depreciation and amortization. Then, divide the market value of the stock by cash flow. A 45-year, $10,000 investment in stocks with low price-to-cash flow ratios yields $4.5 million. Large stocks perform better and are less risky than all stocks with low price-to-cash flow ratios. On the other hand, the 50 stocks with the highest price-to-cash flow ratios grew to only $335,000 after 45 years. Large stocks with high price-to-cash flow fared better; the 50 large stocks with the highest ratios on this measure grew to $719,000.
“Over the long term, the market rewards stocks with low price-to-book ratios and punishes those with high ones.”
Price-to-Sales Ratios - This measure calculates a company’s price based on revenue rather than profits. Stocks with low price-to-sales ratios performed spectacularly over 45 years, growing to $8.3 million, compared to $2.7 million for all stocks. Large stocks with low price-to-sales ratios grew to $3.9 million. Conversely, stocks with high price-to-sales ratios performed disastrously. An investment in the 50 stocks with the highest price-to-sales ratios grew to just $92,000 over 45 years. Large stocks with high ratios grew to $637,000.
Dividend Yields - Dividing a stock’s annual dividend rate by its current price brings varied results. Excluding utility stocks, an investment from all stocks with the highest dividend yields underperformed the market, growing to $1.6 million. But large stocks with high dividend yields outperformed the market, increasing to $2.9 million.
“A strategy won’t help if you can’t stick with it, so you must look for consistency over time.”
One-Year Earnings-Per-Share Growth - While this strategy occasionally works, more often it underperforms. A $10,000 investment in the top one-year earnings gainers grew to only $1.3 million over 45 years. Large stocks with the highest one-year earnings growth fared even worse, climbing to $567,000. Buying stocks with the lowest earnings growth isn’t any better. An investment in the 50 companies with lowest earnings growth turned into $1.5 million after 45 years.
Five-Year Earnings-Per-Share Growth - This strategy doesn’t produce winners, either. A 1954 $10,000 investment in the 50 stocks with highest five-year earnings growth grew to $535,000 by 1996, compared to $1.6 million for all stocks over the same period. Large stocks with high five-year earnings growth also lagged the overall market.
Net Profit Margin - Find income after expenses, but before provisions for dividends. Then, divide that number by net sales. A $10,000 investment in the 50 stocks with the highest net profit margins grew to $1.1 million over 45 years. Large stocks performed slightly better.
“The reason traditional management doesn’t work well is that human decision making is systematically flawed and unreliable.”
Return on Equity (ROE) - Divide common stock equity into income after expenses, but before provisions for dividends. An investment in high-ROE stocks goes to $2.5 million, less than $2.7 million for all stocks. High ROE stocks are riskier than all stocks. Meanwhile, the 50 highest, large company ROE stocks performed worse, climbing to $1.1 million.
Relative Price Strength - This refers to a stock’s price performance over a period of time. Buying stocks with the highest one-year appreciation proves profitable, if quite risky. An investment in the 50 best price performers turned into $4.1 million over 45 years. Large stocks did better, growing to $4.4 million. However, the significant volatility that accompanies this measure makes this strategy difficult for most investors. Conversely, buying the 50 weakest stocks gave horrible returns. An investment in the 50 stocks with the worst one-year performance was worth only $43,000 after 45 years. Among large stocks in this universe, the 50 worst performers grew to $605,000 after 45 years.
“While we may understand what we should do, we usually are overwhelmed by our nature, allowing the intensely emotional present to overpower our better judgment.”
Combining Value and Growth
To boost returns, investors can combine value and growth measures, an approach known as multi-factor modeling. This is especially profitable for small stocks. For instance, take the 50 stocks from all stocks with the best price growth the previous year and with PE ratios below 20. An investment of $10,000 grew to $22.7 million over 45 years. The same model applied to large stocks yielded $5.8 million. An investment in the 50 stocks with highest one-year price growth and price-to-book ratios below one grew to $18.6 million. Among stocks with price-to-sales ratios below one, the 50 stocks from all stocks with highest relative price strength grew to $23.3 million. The same model applied to large stocks grew to $5.2 million.
Ranking the Strategies
You can identify the best and worst strategies. This ranking rates overall growth of $10,000 based on 66 different strategies from 1954 through 1996. First place goes to price-to-sales ratio less than one, high relative strength, for a earning of $13 million. In second place, at $12.6 million earnings, are stocks where the earnings yield is higher than five, with high relative strength. All stocks (ranked 47th) grew to $1.6 million. S&P’s 500 made $972,000. And, at the bottom, are high price-to-sales ratio (65th place, $64,000) and low relative strength (66th place, $30,000).
Putting the Findings to Work
According to these 45-year patterns, how can you make money?
Invest on strategies, not emotion - Stocks with great stories lure many investors. But hot stocks have high PE, price-to-sales and price-to-book ratios, making them quite dangerous. Either follow disciplined strategies, or buy an index fund and call it a day.
Use strategies that really work - You need 25 years of data to determine whether a strategy is profitable.
Be consistent - Even a mediocre strategy, followed consistently, beats the pell-mell approach favored by most investors.
Avoid risky strategies - For instance, buying only stocks with the highest one-year appreciation is profitable but too risky for most investors.
Diversify among strategies - Pick a few strategies, including a mix of growth and value approaches. This guards your portfolio against the vagaries of the market.
Combine strategies - Multi-factor models, combining factors such as PE or price-to-sales ratios with relative price strength, outperform single-factor strategies.