A Random Walk Down Wall Street: Chapter 14

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Once the investor has figured out what portion of his portfolio will be dedicated to equities (as per the last chapter), he is ready to consider the different ways in which he can go about investing in the equity asset class. In this final chapter of the book, Malkiel discusses the four main ways in which investors can participate in the equity market.

In the first edition of the book (back in 1973), Malkiel called for an index mutual fund that individual investors could buy into, as that product did not exist at the time. Now, however, investing in index funds has become the easiest way for investors to enjoy the market's return. Using this mechanism to invest, individuals will outperform most money managers after fees.

For those who must go it alone and invest in individual securities themselves, Malkiel has four rules of advice to help them beat the market:

1) Only buy companies that can grow earnings at an above-average pace for 5+ years

2) Don't pay more than the market's P/E ratio for a stock

3) Buy stocks with good stories on which other investors may jump

4) Minimize trading (subject to taxes, e.g. it is fine to sell losers at the end of the year to lower capital gains taxes)

Even following these rules, the investor is not guaranteed to outperform the index. But investing is fun, and for those who just have to play the game, these rules are designed to tilt the odds in the individual investor's favour.

The third manner by which the investor may enter the equity market is through a money manager. Malkiel does not believe investors can do well attempting this, as identifying the superior managers (of which there are few) appears only possible after the fact. Furthermore, in the studies Malkiel has conducted, good past performance does not persist into the future. Therefore, just because a manager's record is good does not seem to suggest that he will continue to be good. Malkiel does note that there are a few managers that are the exception to this, including Warren Buffett.

Finally, closed-end mutual funds that trade at large discounts to their net asset values are also considered good investments. Here, investors are offered the opportunity to buy shares in companies at a discount to the market. Sometimes, discounts can stretch as high as 40%, but the discounts do change over time. When the discount is above 25%, Malkiel suggests investing.

Malkiel ends the book with a discussion about how a great portion of one's returns from the stock market are due to luck, and that individuals wrongly attribute their returns, or lack thereof, to skill or a lack of skill.

A Random Walk Down Wall Street: Chapter 13

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

This chapter is targeted to those looking to determine what their ideal asset allocations should be. The author argues that higher risk leads to higher return, and therefore an investor's asset allocations should be based on his risk tolerance. Here, Malkiel divides risk into two components: willingness to take risk (i.e. how well can you sleep at night with volatile investments?) and ability to take risk (e.g. can your future employment income take care of any investment losses?).

Risk (as measured by volatility) drops based on the time horizon of the investment. For example, while in one particular year, stock market returns could be quite negative, over 25-year periods there is very little volatility in returns. As a result, investors with long time horizons can take on more short-term volatility of returns.

For investors who invest their employment income, Malkiel strongly recommends dollar-cost averaging, where the same dollar-investment is invested no matter what is going on in the market. The benefits of this strategy are that fewer (more) shares will be purchased when the market is high (low), leading to a cost-basis for the investor that is below the average market price.

Finally, Malkiel stresses that the investor's ideal asset allocation should be based on each individual's present situation, and will evolve over time. He presents some example situations where investors should hold different asset classes, and presents some asset allocations that might apply to certain groups of investors. An investor's risk tolerance is also key to choosing an asset allocation, and therefore Malkiel includes a questionnaire meant to ascertain an investor's risk profile.

A Random Walk Down Wall Street: Chapter 12

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, the reader is taken through the last several decades of stock and bond returns, and a method for predicting stock returns going forward is put forth.

Specifically, Malkiel divides the last 60 years into three periods, each of which contained a different set of circumstances that dictated the outcome of stock and bond returns. For example, periods with high unanticipated inflation would see poor bond returns, since bond prices would have to drop in order for bond buyers to receive a rate of return that was higher than inflation. While stock prices are believed to be rather neutral to inflation, history shows that stocks also performed poorly during bouts of high inflation.

The formula Malkiel uses to predict stock returns is as follows:

Stock return = Current Dividend Yield + Dividend Growth Rate + P/E change

The P/E change is the most difficult factor to predict. When the market is optimistic (pessimistic), market P/E's will rise (fall). Over the long-term, however, the effect of this valuation change reduces in significance; but over short periods, this factor can have a dominant effect. The current dividend yield is easily calculable, while the dividend growth rate can be approximated. (Malkiel appears to use recent history to estimate the dividend growth rate, but other methods also exist such as multiplying the market's aggregate return on equity by its retention ratio, the percentage of earnings that the market does not pay out in dividends.)

A Random Walk Down Wall Street: Chapter 11

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

The author discusses various investment options that individual investors have at their disposal. Insurance is discussed, and within this section, the various types of insurance in which individuals should "invest", depending on their situations. Bonds (both investment grade, and junk), money-market funds and real-estate (both as the investor's home, and in the form of Real Estate Investment Trusts) are discussed as asset classes in which investors should participate. Malkiel also discusses the various tax deferral and (legal) avoidance strategies that are available to US investors (IRAs, Roth IRAs, Keogh Plans, annuities).

Malkiel also discusses how investors can protect against inflation. While he believes common stocks and real estate are the best hedges against inflation, Malkiel does not buy into the idea that investors should buy "things" like art, commodities and other assets for this purpose. For one thing, relying on a greater fool (who will buy the "thing" back later) is risky, while common stocks and real estate offer a claim on real cash flow. At the same time, Malkiel advocates that gold constitutes a part of the investor's total portfolio as a diversification mechanism because of its tendency to have low correlation with the US market. Treasury Inflation-Protection Securities are also discussed as inflation hedges.

Malkiel finishes with a word on commissions. There are many methods to buy the various securities that are available to investors, and some will charge more than others. Searching around for the best commission can result in shaving several percentage points from the fees investors pay. The discount brokerage business, for example, is extremely competitive, and doing a bit of research can go a long way towards achieving strong returns.

A Random Walk Down Wall Street: Chapter 10

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, Malkiel responds to the claims that the market offers various opportunities for returns above the average. The following observations are discussed:

1) Several studies demonstrate that stock prices do exhibit momentum. For example, a stock price rise in one week signals a greater than normal chance of a stock price rise in the following week.

2) Stocks that have performed poorly for several years tend to outperform the market as well.

3) Stocks exhibit seasonal moodiness: prices tend to rise in January, and at the end of the week.

4) Smaller stocks tend to outperform the market

5) Stocks with low P/E, low P/B, and higher dividend yields outperform

While Malkiel recognizes that behavioural finance elements do play a part in market forces, the anomalies listed above don't cause him to waver in his belief of an efficient market. In each of the above cases, he lists reasons for why these anomalies can exist in an efficient market. Some of the reasons are as follows: some of the outperforming stocks are more risky, some of these anomalies no longer occur as they have been exploited, and some of the out-performance is so small that there is no excess profit after trading costs.

Malkiel ends the chapter with data showing that the performance of the average mutual fund manager does not outperform the market after fees. He uses this as evidence to demonstrate that even though the anomalies may exist in theory, after taking into account transaction costs the anomalies cannot be exploited in practice.

A Random Walk Down Wall Street: Chapter 9

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

This chapter contains further discussion of risk, as defined in the previous chapter. Risk is divided into two components: systematic risk (this is the volatility of the market as a whole, since stocks tend to move in concert to some extent) and unsystematic risk (this is the volatility of individual stocks unrelated to market factors).

The theory asserts that unsystematic risk can be diversified away, while systematic risk cannot. Therefore, investors will only be rewarded for the systematic risk they take (since unsystematic risk can be diversified away). As such, high importance is placed on systematic risk, which is measured using the Greek letter beta. A stock's beta is its volatility relative to the market. The higher the beta, the higher the risk, and therefore, the higher the reward, according to Modern Portfolio Theory.

In the second half of the chapter, Malkiel discusses beta's usefulness when taken out of the academic world and applied to the stock market. He quotes studies (including his own) that demonstrate that there is no relationship between a stock's beta and it's return! However, Malkiel still believes in volatility as a risk measure. But he attributes the apparent uselessness of applying beta with the fact that it is very difficult to measure.

Finally, Malkiel argues that since higher beta does not result in higher returns, beta is still useful in that it can allow investors to find low-beta stocks and generate similar returns to the market without the volatility.

A Random Walk Down Wall Street: Chapter 8

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Modern Portfolio Theory (MPT) is the focus of this chapter. While previous chapters discussed how firms approach investing (using either the castle-in-the-air or firm-foundation theories), MPT is the approach employed by academics.

MPT asserts that the only way to achieve higher returns than the market is by taking higher risks. Furthermore, risk is defined as volatility. In other words, if a security's price changes by a larger percentage than the market (even if that change is positive), it is considered to be a higher risk than the market. Though Malkiel acknowledges that it is downside risk that is important (not upside), he shows that for indexes such as the S&P 500, the distribution of volatility is normal (meaning upside volatility is similar to downside volatility).

If you accept this definition of risk which lies as the basis for MPT, then there are some important implications. By diversifying, investors can reduce their risk for a given level of return. This concept is illustrated by Malkiel by way of example. If there are two businesses in town, an umbrella manufacturer and a resort owner, both with equal expected returns and equal volatility of those returns, an investment in either one of them could result in a loss (due to the volatility of returns). But because the umbrella manufacturer will do well when the resort owner does poorly, and vice versa, by owning both firms, the investor can achieve the same expected (or average) returns but without the volatility.

This concept is then extended to broader markets. An investor owning both US and Japanese stocks can achieve similar returns but with far less volatility than another investor who owns only one country's stocks. The concept can also be extended to other asset classes which don't have perfect correlation with the investor's portfolio (e.g. real estate). A criticism of this concept, however, is that when volatility rises (e.g. times of fear), correlations between asset classes tends to rise, and so the benefits of diversification are lost at the time in which they are needed most.

Later in the book, Malkiel will use MPT to create ideal asset allocations for investors of different age groups.

A Random Walk Down Wall Street: Chapter 7

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

The author now turns his attention to discrediting fundamental analysis. The author discusses several academic studies (including some of his own work) that show how analysts add no value in predicting future earnings and how most mutual funds under perform the market.

Malkiel cites four reasons analysts can't get earnings growth predictions correct:

1) The influence of unpredictable events. Analysts can't forecast these, but analysts will believe strongly in their predictions anyway.

2) Creative accounting. Managements have a lot of leeway when it comes to producing their bottom-lines, making it difficult to predict the results in advance.

3) Incompetence. Malkiel cites several examples (including those which he has witnessed personally) where analysts simply do a poor job.

4) The promotion of the best analysts. Superior analysts don't stay at their jobs for too long.

While Malkiel recognizes that some fund managers do beat the averages consistently, he notes that these managers are so few that these incidences are not inconsistent with the laws of chance. He cites the example of a contest where 1000 people flip coins, where the "heads" move on to round 2 and the "tails" go home. After 5 flips, there will be approximately 30 people who flipped heads five times in a row, and their advice will be sought and their biographies will be written, despite the fact that they arrived at their rank by pure luck.

Despite the academic evidence that Malkiel cites throughout the chapter, he concludes by offering his personal opinion that the market is not completely efficient. He writes that "some gremlins are lurking about that harry the efficient-market theory and make it impossible for anyone to state that the theory is conclusively demonstrated." He vows to discuss these market anomalies in Chapter 10.

A Random Walk Down Wall Street: Chapter 6

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

In this chapter, Malkiel discusses whether or not technical analysis (as described in previous chapters) actually works. The answer is a resounding no.

Malkiel himself claims not to know a single chartist who has become rich because of his investing technique, but he knows many who have gone broke. On the other hand, he knows many who have done well, not because of their technique, but because they have managed to convince others to churn their portfolios and therefore generate brokerage fees.

Anecdotal evidence aside, Malkiel cites numerous studies that have shown that while technical analysis can work some of the time (as all stock market strategies do), they do not beat buy-and-hold strategies over time. He discusses some of the more popular and elaborate charting techniques including stock price momentum, The Filter System, Dow Theory, Relative-Strength Theory, and price-volume systems. In each case, computer simulations were able to refute the claims that these patterns were anything more than random occurrences with unpredictable future results that could not beat a buy-and-hold strategy.

Despite the evidence to the contrary, why do people continue to profess to be able to tell future stock prices using past stock prices? Malkiel's answer is that humans find it hard to accept randomness. They look for patterns, even when there aren't any. Furthermore, brokerages employ technical analysts because they help speed up the churn rate in client accounts: followers of technical analysis generate far higher commissions for their brokers than do buy-and-hold investors!

Finally, Malkiel discusses some of the famous technical analysts that have come and gone including Joseph Granville, Robert Prechter, and Elaine Garzelli. The familiar pattern to each of these stories, however, is that while a technical analyst can make a name for himself with a few correct calls in a row (also likely random, as with so many people trying, there will be some successes by chance), the successful predictions are never sustained.

A Random Walk Down Wall Street: Chapter 5

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Investment professionals base their decision-making process on one of the two methods discussed in the first few chapters: castle-in-the-air, or firm-foundation. Castle-in-the-air theorists use what is called 'technical analysis' while firm-foundation theorists use 'fundamental analysis'.

Technical analysts make predictions of future stock prices based on historical price charts. They look for trends in a stock's previous prices (is it going up or going down?) and resistance levels (does the stock get stuck repeatedly when it hits a certain price?). These analysts tend to be short-term traders, as opposed to long-term investors.

There are some reasons to believe why technical analysis could work on some levels. When prices go up, investors do tend to jump in and make a continuing upward trend a self-fulfilling prophecy (as discussed in the chapter on asset bubbles). There may also be unequal access to information that causes insiders to buy first, followed by friends/family of insiders, followed by institutions etc. such that it makes sense to jump on an upward trend even if there is no fundamental reason yet released.

Resistance areas may be created when investors who purchased at a certain price level are psychologically tied to that level. For example, if the price was at $50 for a while, several investors may have acquired the stock for that price, and if the price subsequently drops to $40, a great number of those investors may decide to sell when it returns to $50, in order to break even. In this way, a resistance level is created.

According to Malkiel, technical analysts are not well-regarded on Wall Street, but nevertheless they have a strong following. Some of the arguments against charting are the fact that sharp reversals in trend can occur, and some of the techniques are self-defeating (i.e. if all analysts buy on the same signals, the price will skyrocket to the point that no profit can be made).

Fundamental analysts, on the other hand, try to estimate the firm's future earnings and dividends. To do this, the analyst estimates sales levels, costs, taxes and other items that impact cash flow. The most common tools the analyst will use to do this are the company's past record, its income statements, balance sheets, and a visit and appraisal of the company's management. Furthermore, because the industry plays a large role in determining a company's prospects, analysts will often study a company's industry.

One of the arguments against fundamental analysis is the suggestion that the costs of acquiring the information gathered by analysts is larger than the benefit that is obtained, as it is very difficult to determine how much to weigh each piece of information gathered among the boatloads of information that can be obtained. Another argument is that even if the analyst makes predictions of the company's record that are superior to those of the market, his value estimate of the stock could still be faulty, since the market's willingness to pay certain multiples can change very quickly.

Finally, some analysts combine some elements of both approaches of investing. Such analysts look for good undiscovered growth stories that the market may come to like, but don't recommend purchases unless the price of the stock trades below their estimate of intrinsic value.

A Random Walk Down Wall Street: Chapter 4

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Having poked holes in the "Castle In The Air" approach to investing, Malkiel now discusses the Firm Foundation approach. (Both of these approaches were introduced in Chapter 1.) The author discusses what he considers to be the four key determinants used to value stocks using the intrinsic value approach:

1) The expected growth rate

2) The expected dividend payout

3) The degree of risk

4) Market interest rates

Malkiel references or shows evidence that each of these factors do play a role in determining prices. At the same time, however, the willingness of investors to pay for each of these factors can change drastically in relatively short periods of time. For example, while the market always pays more for "growth" stocks, during bouts of market optimism (pessimism) the market is willing to pay a high (low) premium relative to the broad market.

Part of the reason for this fluctuation is that items like the future growth rate cannot be known for certain, and so expectations fluctuate wildly based on the market's overall sentiment. From the words of an analyst who tried to determine the intrinsic value of IBM a few decades ago:

"I began by forecasting growth in earnings per share. This was a little under the average for the previous ten years...I forecast at 16% growth rate for 10 years, followed by indefinite growth at 2%...When I put all these numbers into the formula, I got an intrinsic value of $172.94, about half of the current market value. It doesn't really seem sensible to predict only 10 years of above average growth for IBM, so I extended my 16% growth forecast to 20 years."

Despite the tendency to fall prey to biases/sentiment and the fact that the inputs are to the model are so uncertain, analysts/investors treat their estimates as being certain, and rely on precise calculations in forming their decisions. Unfortunately, when the inputs are so uncertain, precision can hardly be expected in the results.

A Random Walk Down Wall Street: Chapter 3

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Considering the madness of crowds as described in the previous chapter, many investors believe it prudent to attempt to grow their savings and wealth using professional money managers. While professional/institutional money management has grown tremendously in the last few decades (in 1960, only half of all trades were from institutional managers, while today closer to 90% of trades are institutional), Malkiel attempts to show that such managers fall prey to the same vagaries as do individual investors.

Starting from when he first started working on Wall Street in 1959, Malkiel walks the reader through several crazes Wall Street went through over the years that cost investors dearly:

1) The "Tronics" Boom of the early 1960s

Investors were hungry for growth stocks, and the market provided them, as 1959-1962 saw more issues than at any other period. IPOs would trade at several multiples of their prices only weeks after the fact, and regular companies would add a "tronics" suffix to their names in order to boost their stock prices. In 1962, the party ended, with "growth" stocks suffering far more than the general market.

2) The Conglomerate Boom

Two plus two equals five for these acquirers of the mid-1960s. Companies in totally unrelated industries were merging and "creating value" for shareholders with back-end "synergies". Companies trading at high multiples would buy companies trading at lower multiples and thus show earnings per share growth. The combined company would then trade at the multiple of the acquiring company, thereby increasing value like magic! Not only did multiples not drop after such acquisitions, but they would actually rise, seemingly due to the earnings per share "growth" that was occurring. The bottom fell out in 1969 when multiples for conglomerates came crashing back down to earth.

3) Concept Stocks

In the late 1960s, a focus on near-term stock returns led to a boom in concept stocks. These were stocks of companies with little to no revenue, but with compelling stories. Fund managers did not even have to believe the stories, they just had to believe that other fund managers would believe, and that would be enough to buy in, with the hope of selling to a 'greater fool'. The pros lost a lot of money for their clients when the bear market of 1969-1971 destroyed the prices of these dream stocks.

4) The Nifty Fifty

With the silly fads that had taken place in the 60s, Wall Street pros began the 70s with an eye towards quality companies. These companies were big caps (and were thus "proven") and had great returns on capital, and therefore the thinking was that even if prices were temporarily high, the earnings would eventually catch up since the companies were so great. The P/E's of companies like Sony, Polaroid, McDonald's and International Flavors traded above 80, but they would all trade at fractions of this level some years later.

5) The Roaring 80s

A return of the appetite for "growth" companies saw investor demand for new issues once again overwhelm prices. Where electronics companies commanded ridiculous multiples in the 60s, it was biotechnology companies that were favoured by investors in the 80s. Malkiel discusses a few individual stocks to demonstrate how insane even the institutional investor can become.

6) The Nervy 90s

The 90s saw huge bubbles in both internet stocks and Japanese real estate. There was no doubt that the internet would be a game changer, but Wall Street's overzealous demand for internet securities led to ridiculous valuations where companies with no earnings could sell for 350 times their revenues!

While anomalies such as the ones described in this chapter do occur every once in a while, Malkiel takes care to note that in each case, even if it took years, the markets eventually corrected. Therefore, he argues that in the long-term markets are efficient.

A Random Walk Down Wall Street: Chapter 2

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

This chapter contains a discussion of asset price bubbles throughout history, and the psychology behind them. Malkiel discusses the Tulip Bulb Craze, The South Sea Bubble, The Florida Real Estate Craze (the one in the 1920s...the book's writing preceded the one last year!) and the crash on Wall Street of 1929.

Of interesting note is the fact that it is obviously very difficult to sit on the sidelines and see one's friends and neighbours profit from a bubble. Therefore, even though many of the participating "investors" recognize that prices are irrational, they are willing to part with their money anyway, hoping for a "greater fool" to sell to later.

Another commonality of these bubbles is the fact that there are always groups of people who can rationalize the price no matter how high a level is achieved. Even after the bubble pops, such people will maintain that the high prices were rational, only this time their opinions are considered foolish, whereas during the bubble they were considered reasonable.

Even Isaac Newton fell victim to one of the bubbles described in the book. He is quoted as grumbling, "I can calculate the motions of heavenly bodies, but not the madness of people."

While unsustainable prices can persist for years, eventually they succumb to gravity. The larger the bubble, the more dramatic the reversal and the longer the resulting hangover. Few of the builders of the "castles in the air" (a reference from Chapter 1) can anticipate the reversals in time to realize their paper profits. Malkiel concludes by arguing that it is not difficult to make money in the market, but one of the easiest ways to become a loser is to be constantly swept up in the latest bubble.

A Random Walk Down Wall Street: Chapter 1

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Malkiel starts the book off by arguing that individual investors can indeed outperform the so-called "experts" on Wall Street by following the principles of the book. The term "random walk" in the title refers to the fact that future steps or directions in the stock market cannot be predicted. Malkiel argues that earnings predictions and chart patterns are useless.

One of the largest threats to investor portfolios is inflation, and while it has been tame in recent decades, Malkiel warns that it may not continue to be so. As the economy continues to become more service-based, Malkiel believes that productivity improvements will be harder to come by, which will drive up prices.

In the rest of the chapter, Malkiel describes and discusses the two approaches used on Wall Street to value assets:

1) The Firm Foundation

Each investment has an intrinsic value. When the price of the investment falls below that value, a buying opportunity exist. Malkiel argues that the logic of this theory is respectable, but that in practice it is very difficult to correctly value a security, because the future is so uncertain.

2) The Castle-In-The-Air

With this method, investors attempt to determine which securities will be popular in the future, and thereby buy before the crowd does. Malkiel also calls this the "Greater Fool" theory, since it suggests that it's allright to pay three times what something is worth as long as later on you can find someone else to pay five times what its worth.