Shownotes
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 07: The Value of Security Analysis.
LEARNING: Smart investors, like smart businesspeople, care about results, not efforts.
“Smart investors, like smart businesspeople, care about results, not efforts. That is why “smart money” invests in “passively managed,” structured portfolios that invest systematically in a transparent and replicable manner.”
Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over the 30 years to help investors as the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 07: The Value of Security Analysis.
Chapter 07: The Value of Security Analysis
In this chapter, Larry explains how to test the efficiency of the market by looking at how good security analysts are at predicting the future. If they can outsmart the markets, then the markets are not efficient.
Do investors who follow security analysts's recommendations outperform the market?
In business, results are what matters— not effort. The same is true in investing because we cannot spend efforts, only results. The basic premise of active management is that, through their efforts, security analysts can identify and recommend undervalued stocks and avoid overvalued ones. As a result, investors who follow their recommendations will outperform the market. Is this premise myth or reality?
To answer this question, Larry relies on the robust findings of academic research in the paper Analysts and Anomalies. The authors meticulously examined the recommendations of U.S. security analysts over the period 1994 through 2017. Their findings debunk the myth of analysts' infallibility and shed light on the surprising ways analysts' predictions conflict with well-documented anomalies. They also found that buy recommendations did not predict returns, though sell recommendations did predict lower returns. Another intriguing finding was that among the group of "market" anomalies (such as momentum and idiosyncratic risk), which are based only on stock returns, price, and volume data, analysts produce more favorable recommendations and forecast higher returns among the stocks that are stronger buys according to market anomalies. This is perhaps surprising, as analysts are supposed to be experts in firms' fundamentals. Yet, they performed best with anomalies not based on accounting data.
The evidence in this academic paper suggests that analysts even contribute to mispricing, as their recommendations are systematically biased by favoring overvalued stocks according to anomaly-based composite mispricing scores. The authors concluded: "Analysts today are still overlooking a good deal of valuable, anomaly-related information."
Results are what matters not effort
In conclusion, Larry states that if corporate insiders (e.g., boards of directors), with access to far more information than any security analyst is likely to have, have such great difficulty in determining a "correct" valuation, then it is easy to understand why the results of active management are poor and inconsistent.
While security analysts and active portfolio managers make great efforts to beat the market, historical evidence shows that those efforts have proven counterproductive most of the time. And savvy investors, like smart businesspeople, care about results, not efforts. That is why "smart money" invests in "passively managed," structured portfolios that invest systematically in a transparent and replicable manner.
Further reading
- Joseph Engelberg, David McLean and Jeffrey Pontiff, “Analysts and Anomalies,” Journal of Accounting and Finance (February 2020).
Did you miss out on the previous chapters? Check them out:
- Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
- Enrich Your Future 02: How Markets Set Prices
- Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
- Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
- Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
- Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Transcripts
Andrew Stotz:
Low Risk takers, this is your worst podcast hose Andrew Stotz, from a Stotz Academy, continuing my discussion with Larry swedroe, who, for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry is unique because he understands the academic research world, as well as the practical world of investing. Today, we're going to discuss Chapter Seven from his recent book enrich your future, the keys to successful investing. And that chapter is titled, the value of security analysis. Larry, take it away.
Larry Swedroe:
Yeah. So I think one of the things of way to test the efficiency of the market would be to look at the security analysts and see how good they are at predicting the future. And if they can outsmart the market, in the markets not really efficient, you can generate alpha. So it's an interesting question how good security analysts Well, we have a hint that by looking at the performance of actively managed mutual funds, right, because they rely on analysts forecast, right, and then seeing if they think stocks are cheap or not. And we've discussed many times, that evidence is very weak. Actually, the funds tend to generate a little bit of Alpha on a gross basis, because they're able to exploit naive retail investors. But after the expenses, the effort, they end up with significantly negative alpha. So that's really what matters is not whether the price is right or not, necessarily, but can you exploit any inefficiency, then, in order to claim the mock that was inefficient. So a great experiment was done, I thought, and that's why I put it in my book by UCLA professor named Brad Cornell. And this was in May of 1999. And Cornell presented this study. And here's the case study. So the Intel is the company, and the board of directors is sitting with a big cash load of $10 billion. And they want to know what to do with it. So there are choices, of course, one of them could be to pay a big dividend, right? If we can earn our return on capital, which would return it to our shareholders. Another option, if the stock is overpriced, based on what the board thinks the earnings outlook, etc, would be right? Then you will want to issue a ton of stock, take advantage of it and get cheap capital. And if you think, right, that the stock is undervalued, and it's trading below, then you want to use that cash to buy the stock. So those are your three options, really, that you could exercise it. So Cornell said, All right, how do we value a company? We take the earnings forecast or stream of earnings, right? And then we discount it at some rate. And the discount rate we use is the risk free rate plus a risk premium. So what whereas premium do we use? It's an interesting question. Because even with the stock market overall, it's very time varying, right and bear markets, the risk premium goes up because people perceive risk go up, and therefore you get higher expected returns. And in bull markets, the reverse is true over the long term, on a compound basis, the risk premium has been in the US about 7% got 10% Return on stocks, about 3% on T bills. Okay? So Cornell says, well, let's see what discount rate we use. Now the market was at a much higher prices at that time, right? This is maybe 99. And Intel was trading at 120 per share. So he says, Well, let's take the analysts forecasts that's publicly available and determined, should we buy the stock enough? Well, you got to ask what this carry and Cornell's showed that if you applied say a 5% rate, the stock would be about fair value. 120. But if you apply that 3% discount rate, then the stock is great is worth 200 And something if that's true, you ought to issue as many shares as you possibly. You know, sorry, you should buy up as many shares as possible at 120. Because it's really worth 205. Okay? And if but what if you applied the historical rate to seven? Well, now the stock is worth 82. And you better sell as many shares at 120. And raise more capital, right? Well, what we do know is what happened. And what happened is over the next 10 months or so, Intel stock soared, right, the market peaked in March of 2000. But it was the stock then collapse, I think I got as low as about 10. It didn't cross get back to where it was until 2014. And today, I think it's still trading at roughly the same price or below, it's certainly well below the high. So here you are the board of directors, you have all this insight to what the earnings you think are going to be. But how do you know what to do when you don't know what the discount rate is? Because first of all, it's time varying, you could put your best guess on it. But even for the overall market, let alone for Intel. And that's why it's such a tough decision. How does the board know what to do? How to analysts know what to do? Your best assumption is to let the collective wisdom of the market make that decision and say, Intel is the right price. Now, last thing we want to just cover here is there was a study done called analysts and anomalies, and they looked at the analysts recommend in favor of stocks that have the positive attributes of these anomalies, or that they recommend the other side, right? So for example, momentum, are they recommending stocks with positive momentum? Are they recommending value stocks or highly profitable stocks. So interesting, they found that the analysts on average tended to invest on the wrong side of anomalies, which really surprised me when I saw that, especially given that we know that even mutual funds do outperform by a little bit before their expenses. So that's the bottom line here. People think they can outsmart the market, they're basically saying, I can predict one the earnings better than everybody else. But then I can also predict the equity risk premium. And there's nobody really, that I know, that can predict it. Well, in fact, the greatest investor, maybe ever, Warren Buffett said, You should never try to time the market. But if you do buy when everyone else is panic selling, that's when the discount rate is high, and you have a high expected return, plus the risk didn't show up, and stocks could crash a lot further, you don't know, it's just the market's best guess. And when stock prices are high, like there were in March of 2000, then the only thing you know is that expected returns a low, but stock prices are high in 90 567, and eight, nine, and the market kept going up. So they're trying to time the market is not likely to be a winners game. And
Andrew Stotz:
I'm gonna work backwards from what you ended up with, which was how it was a little bit baffling that that analysts were coming up opposite of the anomalies versus the evidence that fund managers have, you know, without the fees or other things that you can see they have some skill, possibly, and but the point is, is that analysts are under very different pressures from fund managers, fund managers, you know, their net asset value is published every single day. And in a way analysts are, you know, trying to make noise and make, you know, extreme calls at times. And so I could see that, you know, analysts are kind of disconnected from the actual recommendation performance of what they're doing. Yeah, well,
Larry Swedroe:
we know that certainly what happened in the.com? Bubble?
Andrew Stotz:
Exactly. Now, I want to talk about this intel story a little bit, because there's two things I want to go through. One is, you know, what discount rate should a person use now, for instance, one of the things that I've seen is that you have recency bias, interest rates were really low and people came to me and said, Andrew, how do you value a company when the risk free rate is zero? And what you know, it's a part of what I'm trying to tell them is that when you're valuing a comp New evaluates cash flow for a lifetime of that cash flow. And you're going to discount it at different rates, you know, 12 months from now, it's going to be a different rate. And you're going to tell me, what do I value? Now I valued at 1%, or interest rates went up to five. And you see so much volatility and variability in the discount rate. In the Intel example, would it be better to just have said, Well, 10% is a long term average for stocks and on average, and therefore that's what we should have used? Or
Larry Swedroe:
there's no good answer, really, to that question, I'll give you my, whatever insights I think I can provide in this way. As countries evolve, like the US has, over the last 200 years, it's become much safer to be an investor, right? First of all, we didn't have an SEC, until 1930s, we didn't have a Federal Reserve to dampen economic activity, and help us avoid recessions and depressions. There was no Federal Reserve until 1913, I think it was. And we have accounting standards kept getting better, right. And then we get regulatory rules being passed and bills, you know, that force more disclosure, and forcing you to announce, you know, shareholder purchases, and stock hedge funds have to report all this stuff. And so that is made it you know, safer to invest. And on top of that, what's happened to the cost of investing? And all this has been driven down, way down, right? So if you're getting to keep more of the returns on your investment, starting from the gross, right, if you're paying 5% To buy a mutual fund or trade a stock, right, you're gonna demand a bigger discount rate. To make up for that, then if you would, if you could pay, you know, you know, two cents bid offer spread, and no commission, right, and that the expense ratio on mutual funds comes down. So now you can buy, you know, a Schwab ETF of the total market for one or two, you know, basis points a year. So, I would argue those things alone have driven the equity risk premium down. And then we know also that as countries become wealthier, what do you think should happen to the equity risk premium?
Andrew Stotz:
In theory, I guess it would come down, that stocks become less risky and more
Larry Swedroe:
reliable, that stocks become less risky. Think about where capital is more available in Kazakhstan, or France, or England or the US. Right? Right. When you have a shortage of capital, because you're very poor, or people are afraid to invest because of lawlessness. And those things, well, then capital is going to be very expensive. You think about what the borrowing rates were, you know, in the Middle Ages, they're a higher than they are today. So as countries have become wealthier, the equity risk premium comes down. And we have evidence of that as well. So my own view is, so is you could think about it this way, that cape tan, the long term average of PS been about 16. But it's been creeping up over the last 50 years. In the last 40 years, I think it's average in the low 20s. So what's the right number, the nav roughly 17, long term average was the last 40 years of 22. Now invert 22. And you get qualite, four and a half percent equity risk premium. To me, that likely seems more logical, and then COVID hits and prices collapse, and no one knows if you're ever gonna get out of this or a half the world they'll die and the risk premium jumps. So risk premiums are time varying. But I think we at least have some evidence to think about, you know, when they get excessively high, and excessively low, but I do think the risk premiums have come down, and we should not expect to get the same historical return unless prices go way down again. And because if you look at the 7%, real return to stocks, take that 16 or 17k 10, flip it around to get an earnings yield, then there's your six or 7% equity risk premium. So that's not a coincidence, right. So if we get prices much lower, again, because of a recession or a war, or geopolitical risks or whatever, then I would say the equities premium, again is higher. But today, US stocks broad, I think it would be much safer to assume that the equity risk premium is more in the four to 5% range, maybe, overall, small value stocks are trading at about their historical averages. So they may be still trading with another maybe five or 6% premium on top of that instead of the historical 3% premium. On top of that.
Andrew Stotz:
It's such a quagmire when you go into, because I've read through the books on equity risk premium, I've seen the different events, seminars and all kinds of stuff to go through it. And it's just such a quagmire that I've kind of stayed out of it. And I tried to think about just what's the discount rate I noticed today, two days ago, Ashwath, disordering, famous in the world of you know, I read pretty much every book, he wrote about valuing companies. And he puts out an equity risk premium thing every year. And he and I'm kind of surprised at how, you know, people really rely on this. And let me just look at what it says for us. He says, US equity risk premium 4.11%. And
Larry Swedroe:
all There you go. That's roughly in line with what I have said, now. But look, today, if you look at the s&p 500, I think you're talking a PE in the low 20s, which would correlate to his, you know, 4.1 or two, but look at small value stocks, you look at the font that I own Avantis is us small, I think the PE is about 10. Well, that's probably below the historical average, which I think is about 12. So maybe, you know, people obviously think that small value companies today are riskier than the big growth stocks. Everyone's infatuated with AI and stuff. And, you know, so those stocks have higher expected returns, whether you actually earn them or not, we won't know for another 10 or 20 years, whether the rest shows up or not.
Andrew Stotz:
It's an interesting point, I'm just when I went to the website there Avantis. For that fun, I'm just looking for the PE but I know, the PE in in the US in small caps is, you know, let's say outside of the top 10 or 20 stocks is is really, you know, half the level of let's say s&p 500 Or yeah, the
Larry Swedroe:
top 10 pe might still be in the mid 30s or something. If you clicked on if you're on Morningstar, it can click on the portfolio tab that says okay,
Andrew Stotz:
and they'll find it.
Larry Swedroe:
If you read the bar across the top one, there's a performance tab. And then there's a portfolio Yep, the Portfolio tab will get you the the P E and the price, take a look at the price the cash flows, which I think is a better measure of you know, because you can manipulate earnings, you can't manipulate cash flow. Right, right. Yeah,
Andrew Stotz:
I don't actually I don't get all that on Morningstar, because it's asking me to subscribe. So I have to think about that.
Larry Swedroe:
I'll pull it up while you make a comment or two.
Andrew Stotz:
So the the thing that I've come up with with equity risk premium is, first thing is that if it's so if there's so much volatility, because also you got to factor in when you're discounting a company, you got to factor in the risk free rate, the equity risk premium, and then the beta or the riskiness of that stock, let's just say if you use the cap M as a framework. Now I don't I basically tell my students forget about the cap M framework, just try to understand what the discount rate is that you're using. It's a little bit like Yogi Berra was saying about, you know, how many slices is that pizza? And they say, it's six slices. And he says, Well, just make it four. I could need six slices. I'm not that hungry. It doesn't matter how you slice it, what matters is you get the right discount rate. Well,
Larry Swedroe:
the first thing I would say is the cap M is dead. Dead for 30 years. Yeah, so you have to look at not only the market beta premium, but then look at size and value. You know, as well and considering that there and in this case, the Vontaze small value ETF as a current P E of about 10, eight and a price to cash flow of about four seven. These are cheap stocks, you know today, but that's very different than you know what the s&p 500 is Give me a second, I'll tell you what the date is
Andrew Stotz:
incredible cheap, incredibly cheap.
Larry Swedroe:
In fact, well, you know, that's not that's probably, you know, economy. Not in a severe recession. But it's not a depression type you when you get like in Oh, wait, you might see p is in the six to eight, right? So the market the The s&p 500 is showing at 21.6 and a price the cash flow of 14.40?
Andrew Stotz:
Well, certainly relative, it's, it's cheap. One of the interesting things too, I've seen a chart recently that shows that it's about 20, or 30% of small or mid cap companies are losing money in the US.
Larry Swedroe:
It's more than that. I think it's 40%. It's incredible. Yeah. Yeah, by the way, the Vanguard growth ETF is trading at 31 times earnings. And their price to cash flow is over 19. So
Andrew Stotz:
where does that small cap? You know, small cap value are those you know, there's different ways in the back of the book, you have a lot of great examples of funds and ETFs that can give you different exposures. How, how aggressive should someone be at trying to say, Okay, I know I can't predict the future. But I would say that that gap between the top companies and the bottom are mid size, you know, good companies, I'd say value quality type of companies is massive. What should I do? That's
Larry Swedroe:
a good question. For some people, the answer, I think, should be nothing. And for others, who are bolder, and have a strong belief system, you should back up the truck, as they would say. So. And the reason is this. We have very strong evidence. And this is logical, exactly the same thing happens with stocks, as it does with say the value premium. Okay, so what do I mean by that, when the P E ratio has averaged about 1617, stocks have gotten about 10%. When the PE is averaged about 20, stocks have gotten much lower returns. And when the P e is average, less than 10, stocks have gotten much higher returns. So valuations clearly matter. But here's the important message. When the P e is over, it's a 20, you still could have the next 10 years have high returns, it's just that the distribution of returns that can happen has now shifted entirely to the left. So the median has come down from say, of risk premium of seven down to five, the best returns have come down from say plus 15 to plus 10. And the worst returns have come from like losing 3% a year to losing 6% a year, the whole curve has shifted. Well, the same thing is true with the value premium. When it's averaged about let's say three and a half or 4%, something like that. Right. But when the spread is wider like it is now and it was in 90s. In the late 90s. The value of freemium was much larger, from 2000 oh eight, the value bring was double the historical average. Something like that, maybe even more than that it was the largest premium ever. But right the last three years, growth stocks have just gotten more and more expensive. So if you're gonna panic and abandon that, because you've had three years it doesn't work and you think three years a long time, then don't try. But the expectation should be today. The expected return to small value stocks, at least those that are profitable. So you want to screen out the junk stocks. That's the stocks that the average typical naive retail investor tends to load up on an institution's avoid and the retail investors leave that to be overpriced. Okay, and DFA and Avantis and Bridgeway and BlackRock and others have been screening out those stocks for decades have we talked about because the research shows you should avoid those thoughts. So if you're a believer like me and can stay the course. So for example, I was a The value investor about two thirds value by 1/3. Market in 95 698 game. This is now two years after Greenspan said the market was irrationally exuberant. And I said valuations again, to me Wait, too, I know it could get worse. But now the odds are much more in my favor. And that's all you could do split odds in your favor. So I went 100% value. And I was dead wrong for two years, a lot of people would panic and sell and get out, eventually, I was proved right. And value dramatically outperformed venture, I went all to small value. And I did even better because the small stocks, you know, even further outperform, and that held right up through around 2016 or so. And at the end of 2016, or early 20, the thing reversed. And now we've had growth outperforming, and you got to be able to stay the course because if you try to time it, you're gonna get it wrong. And you'll end up selling low after periods of poor performance and buying high after periods. And that's a recipe for failure.
Andrew Stotz:
The one last thing I just wanted to highlight briefly was about the choices that accompany faces like Intel in the story. And it just thinking about the framework and the constraints. So when your stock is really overvalued, where you feel you've calculated, you think that your stock is really overvalued, that means people are willing to pay a very high price for your business much higher than what you think that business is actually worth. At that point, you want to raise capital, because you can sell a lesser amount of shares and get a higher amount of money, you miss the capital is lower. Yep. And so by, but there is a constraint, if you went out and flooded the market, with shares in the issuance of shares, you're going to all you could cause people to get nervous, or you could cause them to worry about dilution, or their future earnings and all that. So there's a constraint on that side. Of course, on the other side, if you keep the money in the firm, and you keep investing in it, there's also the constraint that you could run out of, you know, highly profitable opportunities. And if the marginal investment was having a lesser return, then the existing assets that could cause the value of your business to fall. So that's the
Larry Swedroe:
empire building problem of big corporations, the CEO wants to justify higher pay, go out and make acquisitions, which on average, tend to do poorly, that we know the evidence is clear, this empire building is a problem.
Andrew Stotz:
And then the third one is the idea of well, I think that we've done an internal calculation, we think our business is worth about 100. And we see it trading in the market at 50. So what are we going to do, we're going to buy, we're going to take some of our excess cash, and we're going to buy back shares and retire them. Now, that so, of course, that has, you know, that has its own constraints. But the thing that's interesting about that, too, is you're also taking a portion of your money, your cash on your balance sheet and saying, we're not going to invest that in future growth opportunities. You could
Larry Swedroe:
even go another step as some companies do, and go out and lever up and take on debt to buy back the stock as some companies have done. And, you know, I think the key here is you have to have a belief that the market is under estimating the earnings. Right, as opposed to, you know, the cost of capital, the risk premium better than the market. That's you bris I think, but if you know, things that maybe the market doesn't, you're about to sign a big contract with the government, and it's going to generate, you know, all this revenue that nobody else knows about, well, why not buy the stock? Cheap, then that's a different story. Yeah,
Andrew Stotz:
in fact, in Asia, we have a lot of families that own businesses, and let's just take out the insider trading aspect. Let's just say for a moment that, you know, they've been through 3040 50 years of market cycles, and they see that the market is just absolutely crashed and their share price is just down. And so what these guys will do is they'll go to the bank and say, hey, you know, personally, some of them will actually get money from the bank, buy back shares announced it, you know, according to the SEC regulations, put those shares as collateral, you know, down for that loan. And then as soon as the share price starts to rise, they sell a portion of those shares and pay back that loan. And now, they've increased their ownership of the company from let's say, 40% to 45%, as an example. And then when they see the opposite happening when the markets super high, they're like, Look, I've been through this for 4050 years. And I feel like my business is going to be here for the next 40 or 50 years, and therefore I'm comfortable making those decisions. That is a very common thing that you see going on, you know, in Asia, for sure.
Larry Swedroe:
You see it all over the world. Yeah. Yep. I mean, executives are not dumb, and they see if they have a low cost of capital. That's just when you want to issue a lot of equity.
Andrew Stotz:
Well, Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth. And I look forward to the next chapter. Ladies and gentlemen, the next chapter is chapter eight. Be careful what you ask for. And it starts off with the Midas touch story, which actually, I had never heard the full story. So I'm looking forward to going through it. I've read it already, but I'm looking forward to it. So for listeners out there who want to keep up with all that Larry's doing, find him on Twitter at Larry swedroe. And also you can find him on LinkedIn. This is your worst podcast host Andrew Stotz saying, I'll see you on the upside.