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7-Footers In A Sea Of Pygmies

Feb. 11, 2014 9:34 AM ETSPDR® S&P 500 ETF Trust (SPY) ETF10 Comments
Jacob L. Taylor profile picture
Jacob L. Taylor

7-Footers in a Sea of Pygmies

Why concentrating on just the averages obscures true market insights.

"If you're a basketball coach, you're probably not going to arbitrarily hire a 5'6″ player. You know there may be exceptions, but in general, you're looking for a 7-footer."

-- Warren E. Buffett

The average male human is 5'8" tall; most people fall somewhere close to that average. The average NBA player is 6'7" tall, which is obviously a quite rare height for a human.

During an average year, with average market prices, a typical company will sell for 15 times last year's earnings. So a 15x multiple equates to 5'8" on this normal distribution. Benjamin Graham, the father of value investing and a mentor to Warren Buffett, preferred to only buy stocks that were selling for a P/E of 8x or less, almost half as cheap as the normal price businesses typically trade for. He was a real bargain shopper.

Just like being tall usually conveys some advantages on the basketball court, research shows definitively that buying stocks when they're cheap will provide better returns than buying them when they are expensive. There's no bigger driver of investment success than the price that is paid: valuation is king. Paying less for something sounds like a no-brainer good idea, but for some reason people develop feelings of euphoria from higher prices, and panicked dismay from lower prices when it comes to their purchase of partial ownership of publicly traded companies.

Whether you're an NBA GM hunting for tall people or a fund manager looking for attractive investments, it's important to understand the statistical makeup of the population you're exploring. Imagine that you visit a tribe where for some reason, everyone was clustered around the same height of 5'2". Everyone is short-- would you expect to find a lot of

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Comments (10)

Mike McCoy profile picture
Waiting around with cash today might be more emotionally painful than buying stocks was in late 2008/early 2009. Excellent article.
AlbyVA profile picture
Buy the SPY. Reinvest the dividends. And go to sleep. You will beat 85% of everybody else out there who is picking stocks. I would love to be the 15% who beat the market, but reality says most will be the 85% who don't beat the market.

So just buy the SPY and suck it up that most of you will never be a Buffett.
The_Hammer profile picture
You nailed it. Old economy stocks were shunned like Philip Morris were yielding near 10% back in 2000. KO WMT and AXP great growth names were bubbles at 40+ p/e's. Most boats have floated higher today. when the tide goes out a number of biotech going to be slaughtered. a few sectors have gotten beaten and more beating would help for purchase.
rubicon59 profile picture
Thanks for another nice article!

What about other markets worldwide?
teidelma profile picture
Great article. There may be some 7 footers in Korea and Russia.
Byrleytf profile picture
I am an unhappy Monetary Economist and Chair of Department of Economics and Finance at SUNY Buffalo State. With respect to the article, I found it interesting and plan to have a student look more at the argument.
Mr. Bear profile picture
"One of the top 5 most dangerous markets of all-time". Yes, it is a dangerous market. And my agreement isn't based entirely on today's overvalued market. Its dangerous because the market has (once again) become ground-zero for unreasonably high expectations which invariably leads to horrific market corrections. Enjoyed reading your intelligent and well-written article, many thanks.
Brian Bobbitt profile picture
I say, simply, if a stock is falling in price, either short it, or leave it alone.
I also say, Look for a stock rising in price, and follow it. When it stops rising, sell, stop it, or short it.
In the meantime, you have been doing your due diligence and are ready for changes when they are needed.
But to buy a falling stock, (unless you have some pretty hard evidence it is in a corrective phase) just stand clear.
Capt. Brian
The Lost Navigator
PS ALL the while you own a stock, you should be selling calls against it for a little safety margin.
Qniform profile picture
Excellent article. The real problem is the supposed ability to properly time market entry and exits. When the opportunities appeared very limited in the late 90s and mid 2000s, going to cash would have been very costly in terms of lost opportunities. This is not accounted for in the back test presented. So, given the vital strategic principle that avoiding big losses is paramount to investment success, a tactical approach for those (like me) who are asset allocators with no inclination to attempt any kind of market timing would be to use downside hedges in higher risk environments like that described in the article.
The hardest part of investing is waiting.
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