Investing's Holy Grail: More Return, Less Risk

(Warning: All EMT believers should avert their eyes - pure blasphemy follows!)

EMT stands for Efficient Market Theory, which basically states that stock prices at any given time accurately reflect all relevant information and hence market pricing is efficient. It is impossible to "beat the market" because the market is always right, and the only way to get more return is to take on more risk.

Thus it is the equivalent of EMT blasphemy to suggest that it is possible to get more return with less risk. If anyone out there is well versed in incentive-cause biases, they should be saying to themselves, "Of course anybody who makes a living managing money and accordingly trying to beat the market has a strong incentive to disbelieve the EMT". Very true; if the EMT is correct there is no reason for active money managers to exist (some may argue this regardless of their EMT views!).

The only way to settle such arguments is via scientifically rigorous examinations of past stock market data. Or, we could listen to the views of Mr. Buffett:

"What you really want a course on investing to be is how to value a business? And that just isn't taught. And the reason why it isn't taught is because there aren't teachers around who know how to teach it. And since they don't, they teach that nobody knows anything - which is the efficient market theory." - Buffett

"It's like teaching a class on the efficient market theory. You walk into class on the first day and say, "Everything's priced right." Then what? What else do you need to say?" - Buffett

Clearly The Oracle is skeptical. So was his mentor, Ben Graham, who created the infamous, manic depressive "Mr. Market" to explain the market's daily price fluctuations, long before the EMT was spawned.

Joel Greenblat, a modern day investing legend writes in his book, The Little Book That Beats the Market about the discrepancy between price fluctuations and business values. Whereas stock prices invariably fluctuate wildly in any given year, does anyone reasonably believe that the values of the underlying businesses fluctuate as rapidly? EMT believers must answer "yes". For the rest of us, can we explain why prices fluctuate so much when business values don't? Greenblat writes:

"it's such a good question that professors have developed whole fields of economic, mathematical, and social study to try to explain it. Even more incredible, most of this academic work has involved coming up with theories as to why something that clearly makes no sense, actually makes sense. You have to be really smart to do that."

So back to the Grail. It is in fact possible to get more return with less risk, and thus the EMT is pure bunk. James Montier of Societe Generale published some great observations on this in his "Mind Matters" newsletter. The basic findings: value stocks are less risky but outperform more-risky growth stocks. Many folks reading this will probably respond with a resounding "No duh!", but remember that in doing so you are blaspheming an entire school of academic belief - a major subject in business schools and even the CFA curriculum. Hence we should at least glance at Mr. Montier's data.

Montier defined value stocks as the 20% of the market having the lowest price to cash flow ratios, whereas growth stocks were those 20% with the highest ratios. From 1950-2007, the value stocks outperformed growth by something like 7% per year. EMTers would respond that value stocks must be more risky. So Montier looked at several gauges of risk to see if this was so.

Standard deviation of returns: a "classic" definition of risk (and a silly one too I might add). Survey says.... BRRRRT! Growth stocks were more risky: strike one for EMT.

Beta (volatility of returns versus the market): another silly definition of risk, and once again, value exhibited lower "risk". Strike two for EMT.

Beta during bad times: Now we are stretching it, but team EMT is getting desperate. So Montier examined whether value stocks had higher betas and hence "risk" during "bad" markets. Strike two and a half!

Stock performance during recessions: "Ha!" say EMTers, "what about during recessions - value must perform worse than growth then!" Er... not so much. Strike three!

So the investing "Grail" is nothing more than value stocks - those stocks valued at low multiples to cash flow. Better return, less risk. And wouldn't you know it, Mr. Greenblat found pretty much the same thing: that buying stocks with low price to operating earnings ratios and high returns on capital crushed the market over a 17-year period. He even created a website, magicformulainvesting.com, to help folks pick their own portfolios of these stocks.

It all goes back to Ben Graham's "margin of safety". If you can buy a decent business at a cheap price, eventually good things will happen. That basically is my investment strategy - it just makes too much sense for it not to be.

Comments

[jswede]

Reminds me of John Dorfman's Robot Portfolio:

1) In Jan, buy the 10 lowest P/E (perhaps subs. lowest P/FCF here) US companies with >$500mm mrkt cap, pos earnings, equity-debt > 0.

2) Forget about them.

3) Revisit in 1yr.

Though the Robot Portfolio trailed the S&P by 3% in 2007, it beat it the previous 7yrs it was run --to the tune of 34% annual return, vs the S&Ps 4.6%.

[wyobenjamin]

Author discounts the measures of risk used in the study as not being the best - so what is the best measure of risk for an investment?

[tkenyon]

The best measure of risk is the probability of permanent loss of capital. The other measures are a function of stock price fluctuation, so that a stock that appreciates 100% but has a volatile stock price could be "riskier" by these measures than a stock that declines slowly and permanently. Or, a very cheap stock that has a volatile price could be "riskier" than a very expensive stock with a less volatile price - which of course is the opposite of reality. Assuming we are truly investors and not short term speculators, we need to try and evaluate the probability that we might permanently lose capital if we purchase the stock at a given price.

[kotika98]

I cant believe they are defining growth stock as the one with the higher P/E or P/FCF !? That the definition of the most overvalued. You should be comparing the low P/E stocks with the highest growth stocks. And anyway, in practice one should look for cheap stock with high growth, and no that is not an oxymoron logically, you just have to look harder.