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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.





Beta Risk   |   Small-Cap   |   Indexing   |   Valid Anomalies   |   Perish

"They're Pros at Pulling Off Cons"
by Jay Robert Nash
The Wall Street Journal, 23 July 1999, A14

"It's not what you say or do, or even what you are--it's what the sucker thinks you are that will be the foundation of a successful scam."

Many investment fads are based on market-generated data, especially share price, as opposed to company produced external accounting data in financial reports. Most common are market timing, market beta, dividend yield and other market price ratios.

Advocates for oscillators, waves, cycles, time series, asset allocation, sector rotation, quantitative analysis, momentum investing, growth investing, small-cap stocks, high-tech stocks (how to define?), emerging markets, indexing, modern portfolio theory and other investment strategies du jour sometimes prompt an investor to ask, Who can an investor trust?

These fads are not explored here in detail. Suffice it say that they do not conform with first principles. For example, oscillators, waves, cycles, and time series are concepts of physical science, not social science such as economics. They are not regular, pattern, or law but rather metaphors applied to variations and sequences as a way to organize historical data. Thus, they are not predictive.

Stock market expertise abounds in Wall Street, the financial press, and academia, but the experts contradict themselves and one another when advocating investment strategies. The objectives of these experts differ from that of investors, thereby creating potential conflicts of interest. Popular stock investment strategies are often fads based on either theoretical fallacies or ex post empirical analysis known as data snooping as opposed to ex ante empirical analysis which can be scientifically valid. No investor, even with financial advisors, can escape the ultimate responsibility to find what works for her or him.

Beta Risk. An alleged measure of investment risk. Beta is the slope coefficient of the econometric capital asset pricing model (CAPM). It is unacceptable for four reasons. First, stock prices and returns are not independent, but rather move with groupthink and herd mentality. Thus the normal (Gaussian) probability distribution is incorrect. Second, beta is estimated by a model with historical data that is selected arbitrarily. Third, correlation is not the same as causation. The univariate CAPM includes a grab-bag composite error term for "all other factors" that influence returns. The multivariate CAPM explains a small portion of total variation in total return, and the multiple factors interact with each other in time-varying and unknown ways. Forth, the volatility statistic measures both over performance and underperformance. Yet investors do not fear over performance, but rather are primarily concerned about extremes of underperformance. See the entry for Beta in the Glossary.

Small-Cap Stocks. One fallacy is the so-called "size effect." Size is the market value of the common stock equity capitalization of a firm. Specifying size as a risk factor in a pricing model reduces it in form to either a logically circular mathematical identity or an econometric autoregression. Mathematical identities are tautologies; they are biased, indeterminate and meaningless. Autoregressions of certain types can be inverted mathematically into equivalent moving averages. Various time-lengths of moving averages of either stock prices or market indexes are popular indicators used by technical analysts or chartists.

Although autoregression is a valid statistical technique, autoregressions of market-generated prices are fallacious because they lack any theoretical rationale and thus violate basic methodological principles in the game of science. Instead of judging the market price by established standards of value, these autoregressive models base their standards of value upon the market price.

The tautologous identities and data-instigated autoregressions are usually not obvious. They often are embedded either in theoretical asset pricing models, in the associated empirical estimating equations, or in the usage of data. The small-cap fad, based on the fallacious size effect, has grown since its inception in 1981 to more than 100 billion dollars in aggregate net asset value in the first quarter of 1996. Many investors have a small-cap component in their portfolios. Some growth increases value, but other growth decreases value.

The so-called size effect brings to mind Martin Heidegger (An Introduction to Metaphysics, 1961, Garden City, NY: Anchor Books, Doubleday & Company). Metaphysically speaking, the Easter bunny exists, but it is not real. Likewise, the size effect exists, but it is not real in the sense of independently explaining returns.

Indexing. Another fallacy concerns passive investing in a market index such as the S&P 500. Index investing entails the opportunity cost of not outperforming the average market return. In addition, indexing is predicated on two dubious assumptions: a single representative investor or homogeneous information, and risk-neutral behavior for all investors. Individuals and institutions each hold about half of all shares outstanding, but individuals have less information and are more risk averse than institutional investors.

Even though the size effect is fallacious and indexing is narrowly based on oversimplified assumptions, firm size and a market index can be used as practical benchmarks for measuring the relative explanatory power of valid risk factors in an asset pricing model of return. This risk-adjusted return is averaged across a number of stocks because nothing can be said with confidence about a single stock if statistical models are used. Valid factors include firm-reported external accounting data and other established standards of value such as consumer price levels, interest rates, and exchange rates.

Valid Anomalies. In a post-Cold War world of increasing global economic competitiveness and rapidly advancing technological change, a prominent risk factor in capital asset pricing process is the research and development (R&D) of private industrial enterprises. R&D is not necessarily the same as so-called "high-tech," an ambiguous term that is arbitrary in the companies it describes. An interesting and important question is whether R&D companies achieve so-called market efficiency in the pricing of their common stocks, or whether there are potentially profitable arbitrage opportunities in the shares of R&D companies. Theoretically, in an efficient market, prices fully reflect all available information.

Whereas security analysis of individual companies as going concerns is required for stock selection, capital asset pricing models are appropriate for studies of the stock market pricing process across stocks and holding periods. A
new study of the capital asset pricing process for the market as a whole has found several R&D-related pricing anomalies as indicated by statistically significant persistent average risk premia. The three major anomalies are: an R&D effect, a proprietary-R&D effect, and an R&D-group effect. Proprietary R&D is paid for by the firm, whereas contract R&D is paid for by a client. R&D group is a category of companies in the same industry that have sustained R&D programs for a decade or longer.

Surprisingly, in this study each tested measure of R&D was found to dominate the lower benchmark, lexical order of firm name, in the explanation of the variation in return. Firm name performs as expected like a randomly-selected passive market index. More surprisingly, R&D group was found to dominate the upper benchmark, firm size.

Conclusion. Many investors rely on research reports from Wall Street and academia. Yet these investment experts can be "trusted" primarily to respond to career and peer pressures, i.e. seek money and advancement over facts and truth. Whereas profit-seeking is the societal role of business, it is a departure for academia. In both cases, this can lead to biased findings that are deleterious to the choices of investors and thus inimical to the societal well-being in terms of optimal allocation of risk-bearing and investment resources, as pointed out by Fred Schwed in Where Are the Customers Yachts? See the citation in the Special Books. In the din of touts for small-cap, indexing, and high-tech, each investor is rewarded by trusting himself to look after his interests. These conflicts of interests or institutional dynamics were recognized as "idols of the mind" by Francis Bacon in his Novum Organum. See the citation in the General Books. It is useful to look at these financial fads as contagions as discussed by Aaron Lynch in Thought Contagion. See the citation in the General Books.

Perish -- the Thought

Publish or Perish. Academicians are compelled to attempt theoretical and practical explanations of the price and or value of every common stock and other marketable security. The academic agenda, publish or perish, is primarily and in some cases exclusively to get published and thereby receive bigger prizes, tenure, higher salary, more perquisites, and thus advance academic careers. There is a sociology to science as well as a logical method. Truth and valid scientific findings are generally secondary to academic social norms in the short run. The tyranny of political correctness and societal norms in U.S. institutions of higher education can be a major obstacle to the discovery and presentation of useful investment knowledge. In academia, institutional survival is more important than investor well-being. The academic agenda is addressed in Devil Take the Hindmost by Edward Chancellor (see the citation in Special Books).

Profit or perish. Likewise, Wall Street professionals, such as securities analysts and portfolio managers, are compelled to estimate a price and or value for every marketable security at every trading moment. Wall Street refers to the worldwide finance industry in general. The commercial agenda, profit or perish, is primarily if not exclusively the maximization of profits, return on equity, or other measure of shareholder value. The time horizon for business profits is short-term, typically ranging from one month to one quarter and rarely beyond one year. There is an unavoidable inherent conflict of interest between stock brokers and their customers. The major indicator of increased profits for the securities industry is increased transactions volume to insure that the broker and dealer organizations survive and thrive in competition against their rivals. In business, organizational survival is more important that investor well-being. See License to Steal : The Secret World of Wall Street Brokers and the Systematic Plundering of the American Investor in the general books section.

The symbiotic alliance between academe and Wall Street puts de facto mortal locks on individual investors who do not think for themselves. The asserted market pricing effects or anomalies published by academe are all too often misguided intellectual speculations at best and hoaxes at worst. These academic alleged effects symbiotically can serve as cover for the misbegotten investment strategies of Wall Street which are foolish financial fads that generate new sources of trading volume and associated broker commissions and fees.

Probe or perish. In contrast, individual investors can choose to be free of institutional and organizational dynamics. Investors are not compelled either to publish investment-related tracts or to increase trading volume. The investment agenda, probe or perish, i.e., investigate before you invest, is to find stocks that will maximize return on equity subject to any other investor-specific higher-priority restrictions on the universe of stocks. For intrinsic value investors, this means to circumscribe his or her circle of competence and to estimate the intrinsic economic value of only those companies and their common stocks within this perimeter. The time horizon for value investing is long-term, typically not less than five years. Many individual investors seek to postpone personal spending during their more-productive employment years in order to accumulate an even greater amount of purchasing power that will be available to them in their less-productive retirement years, and their investments are intended to serve this purpose. Maximum long-term total inflation-adjusted return on investment is one measure of investor economic well-being.

Summary. In Boolean set theoretic terms, the intersection of the academic, commercial, and investment agendas is all too frequently the null set.

Imagine an institution of society where the careers of the members are advanced if they lie, cheat and steal, and where their careers are not impaired if they are caught in the act of lying, cheating and stealing. What behaviors would be rational for the most ambitious and unscrupulous members of such an institution where the stakes too often are considered so great?

Robert A. Heinlein in Time Enough for Love, New York: Ace Books, 1988, page 349, writes: "The profession of shaman has many advantages. It offers high status with a safe livelihood free of work in the dreary, sweaty sense. It most societies it offers legal privileges and immunities not granted to other men. But it is hard to see how a man who has been given a mandate from on High to spread the word of joy to all mankind can be seriously interested in taking up a collection to pay his salary; it causes one to suspect that the shaman is on the moral level of any other con man. ... But it’s lovely work if you can stomach it. ... A whore should be judged by the same criteria as other professionals offering services for pay—such as dentists, lawyers, hairdressers, physicians, plumbers, etc. Is she [he] professionally competent? Does she [he] give good measure? Is she [he] honest with her [his] clients? ... It is possible that the percentage of honest and competent whores is higher than that of plumbers and much higher than that of lawyers. And enormously higher than that of professors."

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