Friday, January 30, 2015

Short Takes: International ETF Tracking Error, Core-and-Explore, and more

Here are my posts for this week:

Debating What Income Level is Safe in Retirement

The Stock Picker’s Checklist

Here are some short takes and some weekend reading:

Canadian Couch Potato explains some of the sources of tracking error in international ETFs.

Boomer and Echo explain the problems with running a core-and-explore portfolio. Spoiler: most investors can expect lower returns if they add an explore part of their portfolio.

The Blunt Bean Counter explains some of the capital gains rules that apply at your death. The main catch is that your can end up owing capital gains taxes even if nothing is sold.

Andrew Hallam reviews Larry Swedroe’s latest book, The Incredible Shrinking Alpha.

InsureEye has a very interesting list of 16 factors that affect your home insurance costs. The table layout of the factors makes it easy to digest the information. One that caught my eye was whether you run a business out of your home. I know several people who do this but don’t tell their insurance company. This can lead to not being covered after a fire or other calamity. My own experience with telling my home insurance company about the business I ran from home was very negative. Even though all I used was a computer and never had clients in my home, they dropped me, and I couldn’t find any other insurance company to cover me.

Preet Banerjee has been working on a rent vs. buy calculator. He still considers it to be a beta version that may have problems, and he’s looking for expert feedback.

My Own Advisor made a start at listing his spending needs in retirement. He certainly drew a lot of comments.

Big Cajun Man is running a TurboTax giveaway.

Wednesday, January 28, 2015

The Stock-Picker’s Checklist

I was a stock-picker for about 12 years. In the early years my habits were very effective for protecting my ego and maintaining my confidence. However, as time passed I began to slip. Reality invaded my thoughts. I was no longer blind to my real skill level. Eventually, I couldn’t pick stocks any more. I’ve turned my cautionary tale into a checklist for those who want to feel good about their stock picking.

1. Don’t calculate your returns.

In my first few years of stock picking, I never calculated my return on any stock investment. I just had the vague warm feeling that I’d made some good picks. This was helped greatly by some extremely good early luck in 1998 and 1999.

2. If you must calculate returns, do it separately for each stock.

When I first made the mistake of examining my returns, I looked at each stock separately. I also managed to not calculate the returns for picks that worked out badly. This had the advantage of allowing me to focus on my wins and not think about the losses. I felt great about my abilities.

3. If you must calculate portfolio returns, exclude anomalies.

When I started to calculate overall portfolio returns, I didn’t quite include all the stocks my wife and I picked. I tended to group only a subset of my accounts together. The fact that our worst picks were in the accounts I excluded was just a coincidence. It’s amazing how great your results look when you drop out a couple of real stinkers.

4. If you must calculate complete portfolio returns, shop for a good time period.

As I began using spreadsheets to calculate overall portfolio returns, it became more difficult to justify excluding a few bad results. But it was easy to choose a favourable time period. Because my initial results were so strong, I always looked at my total returns from the beginning. This way, a few recent bad results still left me with good overall returns. This method of always starting the clock before a period of strong returns is very helpful for the ego.

5. If you must calculate annual complete portfolio returns, don’t compare them to benchmarks.

As I began computing my annual portfolio returns, it became harder to ignore poor years. But I found solace in knowing that things could have been worse. There were stocks I passed on that would have made my annual return even lower. At least I was doing better than some of my friends who picked some real dogs.

6. If you must compare your annual returns to a benchmark, shop for a low benchmark.

It’s amazing how much flexibility there can be in choosing a benchmark. If you own stocks in Canada and the U.S., you can use just an index of Canadian stocks, or you can use a blend of Canadian and U.S. indexes. There are a number of U.S. stock indexes to choose from, and you can choose whether to factor in currency exchange rates or not. By choosing the method that gives the lowest benchmark return and rationalizing why this method makes sense for the current year, you can make your own results look good. The key is to choose your benchmark at the end of the year rather than in advance.

7. If you must compare your annual returns to an appropriate benchmark chosen in advance, just give up stock picking and invest in broad indexes.

When I finally removed the last remaining wiggle room from comparing my returns to a sensible benchmark, I had to face my poor investing record from the year 2000 on. I’ve been steadily shifting to investing in low-cost broad index ETFs since about 2010. The process is nearly complete today.

No doubt readers have figured out by now that I’m not serious about this advice. I don’t advocate deluding yourself into feeling good about failed attempts to beat the market through stock picking. If you’re one of the extremely rare people who actually compare your annual returns to an appropriate benchmark chosen in advance, and you show positive alpha over many years, then good for you. However, others should seriously consider giving up stock picking.

Monday, January 26, 2015

Debating What Income Level is Safe in Retirement

How much we can safely spend each month from our savings during retirement can be an emotional subject. People want more income, but they also want to know that they won’t run out of money. The truth on this subject can be very unwelcome. Financial advisors seem to feel this pressure from their clients because advisors often seek ways to argue that higher withdrawal rates are possible. I give a couple of examples here.

Most people whose lifestyles are not fully covered by CPP and OAS payments have not saved enough to cover the difference over a long retirement. Either their lifestyles must become less expensive or they will drain their savings too fast. These people don’t want to hear that their withdrawal rates are unsustainable.

People seek reasons to believe that they can exceed the well-known 4% rule when the reality is that this rule is overly optimistic because it is based on zero investment fees. In truth, a 3% rule is closer to the mark for a long retirement.

Among reasonable people I discuss finances with, one of the most unwelcome observations I make is that the 4% spending rule in retirement is often too aggressive. In a world where so many people would like to quit working but have less saved than they’d need, there is a strong emotional need to believe it’s possible to generate a high income from savings.

Financial planner Wes Moss uses a 5% rule that he justifies by investing in stocks with high dividend yields and then hoping they produce the same capital gains as other stocks with lower dividends. This shouldn’t be very persuasive, but consider it from the point of view of someone who hasn’t saved enough. Suppose you’re retired at 60 and desperately want to spend $5000 per month, but the 4% rule gives you only $3000 per month. Moss says you can have $3750 and I say that only $2250 is safe. I’m pretty sure most people would listen to Moss and push me out the door.

Even David Toyne, Director of Business Development at the very client-friendly firm Steadyhand isn’t immune to the pressure to allow higher income. In an otherwise useful and informative video interview, Toyne said the following at about the 11-minute mark:
“In retirement you can withdraw 4% of your portfolio and that’s a sustainable withdrawal rate—in other words you won’t run out of money—remember that 4% could be 5% if you trim your fee by 1%.” I’m all for cutting fees, but the 4% rule is based on zero fees. Cutting fees might boost your safe withdrawal rate from 3% to 3.5%, but it won’t get you to 5%.

A justification I hear for higher spending levels is that people tend to spend less as they age. This is almost certainly true, but it is largely because people spend less as they see they’re running out of money. A study examining this question produced data supporting this conclusion. People begin to reduce spending, even in their 60s, if their spending is high relative to their savings. But people whose spending is in line with their savings don’t spend less as they age.

I’m not a lone voice on this point. Jeff Brown makes a case for something closer to a 3% rule, and William Bernstein is quoted as saying “Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you're eating Alpo in your old age.”

Because their clients want to hear they can safely spend more, even some good advisors want to believe that higher withdrawal rates are safe.

Friday, January 23, 2015

Short Takes: Lowering Interest Rates, Closed Stock Markets, and more

Here are my posts for this week:

Alternative Canadian Indexes

The Average Investor

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand called for higher interest rates in Canada. However, Rob Carrick reported that the Bank of Canada just lowered interest rates. Then Tom Bradley followed up with comments on the interest rate decrease concluding that the Bank of Canada is more concerned about the short term than the long term. However this all plays out, the cheap debt party can’t last forever.

Canadian Couch Potato found that it’s not a good idea to trade a Canadian ETF that holds U.S. stocks on a day when the U.S. stock market is closed.

LSM Insurance explains why paying your life insurance premiums yearly instead of monthly can save you a bundle.

The Blunt Bean Counter clarifies which self-employed Ontarians will be eligible for the Ontario Retirement Pension Plan (ORPP).

Big Cajun Man has more trouble taking money out of a TD RESP. Anything that takes multiple visits to a branch to sort out doesn’t sound very pleasant.

My Own Advisor says he’s still discouraged about retirement even though Malcolm Hamilton says “Canadians are unduly and irrationally discouraged about their [retirement] prospects.”

Wednesday, January 21, 2015

The Average Investor

Few of us like to admit we are merely average in some respect. You’ll hear commentators say that anyone who is just an average investor would be better off owning low-cost index funds. Curiously, it is both indexing proponents and detractors who say this. Digging deeper into the meaning of “average investor” gives some insight the value of index investing.

We often hear proponents of active stock-picking or market timing say things like “indexing is fine if you’re just average,” or “why would you want only average returns?” On the other side of this debate, Dave Nadig wrote “you have to accept that you, the investor, are not a special flower. You have to accept that you, the investor, are average.”

I see little hope of convincing overconfident stock pickers and market timers that they are merely average until we define “average investor.” After all, I’ve met many of my neighbours. I’m willing to bet that I can comb through companies’ financial statements better than most of them can. Doesn’t this make me above average?

An important thing to understand about the competition among stock pickers is that the average is dollar-weighted. This means that if you have more money than someone else, you contribute more to the average skill level in the stock market.

If I have a $100,000 portfolio, then someone with $200,000 contributes twice as much to the average as I do, and someone with $50,000 contributes only half as much. This may offend our sense of democracy, but it is the reality of competition among stock pickers.

What about a mutual fund controlling $10 billion? They count as much as 100,000 people with $100,000 each to the average of all stock pickers. When your neighbour hands his money over to a mutual fund, his stock-picking skill no longer counts in the average; his money just makes the fund’s managers count for slightly more in the average.

When your other neighbour sticks to index investing, he has taken himself out of the average as well. People only count in the average skill level of stock pickers to the extent that they are actually picking their own stocks.

So, your competition isn’t really your neighbours. As an active investor, you’re really competing against an army of professional investor dollars and a lesser number of individual investor dollars. To a first approximation, the average investor is a professional money manager.

You don’t have to admit that you’re merely an average investor among your friends and acquaintances to embrace index investing. You just have to admit that you’re not better than investment professionals. And even if you are better than the pros, you have to be better by enough to make up for the higher costs of active investing.

Monday, January 19, 2015

Alternative Canadian Indexes

A reader, J.H., asked the following thoughtful question about non-market-weighted indexes in Canada (edited for length):
“I wonder if it’s wise to not buy a Canadian Index ETF because these funds are so over-weighted in financials and energy equity (as high as 65% in November in some indexes).

“I note a more equally-weighted fund, ZLB has beaten the index since its inception, and is doing better than the Canadian index during these unsettled times. It's designed to defend against volatility, but its composition of generally equal-weighted stocks also offers more diversity than a Canadian Index ETF. Index funds seem to be better investments when they have greater diversification, like those mirroring the US market. At least that's the hunch of this investor who is still learning the ropes.

“If ZLB is not for some, they could try a strategy of setting up their own Canadian portfolio of equally-weighted stocks.”
A great virtue of market weighted indexes is that when a stock’s price changes, it remains market-weighted. No trading is needed to rebalance as stock prices fluctuate. However, with equal market weighting or anything other than market-weighting, price changes put the allocation out of balance and ETFs must make trades to get back into balance.

This means that market-weighted indexes will tend to offer the lowest cost way to invest. Any other weighting method must outperform a market-weighted index by enough to cover the extra trading costs (and in taxable accounts income tax costs).

These higher costs may not be large, but I’ve cast my lot on the assumption that ETFs based on alternative weighting methods will not give better results after costs than market-weighted ETFs. I don’t know for certain whether I’m right or wrong about this, but that’s the choice I’ve made.

As for the concern about the concentration of financials and energy in Canadian stocks, I deal with this by only having 30% of my stock investments in Canada. The rest are in the U.S. and international index ETFs.

I can’t resist commenting on “during these unsettled times.” The present is always unsettled, and the future is unknown. The past seems more settled because we know the outcomes and they can’t change. The human tendency of hindsight bias makes us believe we knew the past would unfold as it did even though the truth is we didn’t know what was going to happen.

It’s true that over short periods of time some non-market-weighted indexes have outperformed market indexes. I’ve decided to bet this won’t persist. The bigger the gap in total costs between a non-market-weighted ETF and a market-weighted ETF, the more skeptical I am that the outperformance will persist. Others may see things differently.

Friday, January 16, 2015

Short Takes: Switching to Index Investing, Capital Gains on Investment Real Estate, and more

Here are my posts for this week:

Crashing a 2014 stock-picking contest

When would you offer more than the asking price?

Here are some short takes and some weekend reading:

Robb Engen at Boomer and Echo gives a thoughtful discussion of his 2014 portfolio return and his decision to switch to simple ETF-based index investing.

Preet Banerjee explains how your capital gains on investment real estate can be much less than simply the sale price minus the purchase price.

Canadian Couch Potato has made some extensive changes to his model portfolios.  I like the changes.  Hes sticking to the major asset classes instead of including REITs and other assets.  Simplicity is important.  Its amazing how complicated things can get as you try to manage several types of accounts in a single portfolio.  For the ETF-based portfolios, hes focusing on Vanguard's ETFs.  This makes sense to me because they're a great company.

Canadian Portfolio Manager analyzes 4 actively-managed funds that appear to offer market-beating returns, but after accounting for value tilts and small-cap tilts the shine comes off. I’m of two minds about these factor regressions. On one hand they show that outperformance is often just overweighting in value and small-cap stocks. On the other hand, what if a fund manager had the skill to know whether such stocks would outperform over a given period of time? Factor regression will deny the existence of such skill by definition. Taken to the extreme, if we add enough factors so that every stock is in its own category, then buy-and-hold outperformance is impossible by definition. All that said, I think 3-factor regressions are likely a useful way to examine outperformance.

Big Cajun Man pays homage to the humble Mason jar as a versatile source of frugality.

My Own Advisor is musing about transitioning out of the work force. Sounds like someone who doesn’t feel like going to work today. That probably applies to many of us.

Wednesday, January 14, 2015

When Would You Offer More than the Asking Price?

You sit down to begin negotiating with the car guy. But you have an edge. You know that the last customer paid $19,000 for the same car you’re planning to buy. The car guy knows you know this. So, the first thing you say is “the most I’ll pay for this car is $20,000.”

What!?

Why would you say that? The answer, of course, is that you wouldn’t say that. But in the world of limit orders for stock trading, this is perfectly reasonable behaviour as I’ll explain.

A sensible strategy for limit orders was explained clearly by Canadian Couch Potato. However, I’ve run into two people now who say they’ve read this article but say they just use market orders because they don’t want to dicker over small price differences. This comment makes it clear they’ve missed the point.

The point is to offer to pay more than the asking price for your shares. Yep, that’s right. Offer more. I assume that this point gets missed because it seems counterintuitive and readers get baffled by a jumble of numbers.

We all know that stock prices move around. Usually, they don’t move too much from minute to minute. So, if you see your stock with an asking price of $25 and you place a market order for 1000 shares, you’ll most likely get them for something very close to $25 each.

But sometimes stock prices swing wildly. What if the price suddenly jumps to $50 just after you place your order? You could end up paying $50,000 when you expected to pay about $25,000. This certainly won’t happen often, but even once is too often. How can you protect yourself against this?

Enter the limit order. Suppose you offer to buy your 1000 shares with a price limit of, say, $25.10 each. Does this mean you’ll pay an extra ten cents per share? In most cases the answer is no. If the asking price is below your limit, you’ll get the asking price. This means that in most cases your limit order with a price limit above the current asking price will work exactly the same as a market order.

So, why bother with limit orders? They protect you against wild market swings. When your price limit is initially above the asking price of a stock, it will only stop your trade if the stock price jumps sharply on you the instant after you enter your trade. If you’ve set a limit at the maximum price you’re willing to pay, then this works out perfectly. Either you get the shares for the best price available below your limit, or you don’t get them at all.

For selling shares, you can get the same effect by setting a limit below the current bid price for your stock.

It’s certainly true that you can use limit orders to dicker and try to save a few pennies per share by offering slightly less than the current asking price. But this doesn’t work well in the long run. Sometimes you’ll save a little, and other times your stock’s price will rise and you’ll have to pay more later. What we’re talking about here is choosing a limit price above the current ask price to protect yourself against wild markets.

So, it does make sense to offer more than the asking price when you’re buying stocks, but I don’t recommend it when buying a car. I seriously doubt that the car guy would listen to your bid and say, “That’s too high. I’ll give you the same price as the last customer.”

Monday, January 12, 2015

Crashing a 2014 Stock-Picking Contest

It’s that time of year again where I compare the return of my real-money portfolio against those of the entries in a stock-picking contest held at Financial Uproar. Because my portfolio is almost completely indexed, I tend to end up somewhere near the middle. The important question is whether I’m above or below the middle.

Back in 2012, my return was trounced, but I made a partial comeback in 2013. Now for 2014 ... drum-roll, please ... I beat the average by 4.6%. I would have placed fourth out of 11 participants. If we look at the three-year results among the stock-pickers who participated in 2012, 2013, and 2014, none beat my portfolio.

What’s the lesson here? It’s certainly not that I’m a great investor. Anyone capable of ignoring the market’s ups and downs can be an index investor. The real lesson is that it’s hard to beat the index over the long term by picking your own stocks. There appear to be some investors, like Warren Buffett, who can do it, but these investors are very rare.

Friday, January 9, 2015

Short Takes: Useless Forecasts, Stock Picking Risk, and more

Here are my posts for this week:

Security Analysis

My Investment Record to 2014

The Dumbest Argument for Dividend Paying Stocks

Here are some short takes and some weekend reading:

Canadian Couch Potato explains just how useless and dangerous financial forecasters are. Amusingly, I saw the following ad above the article: “Gold Price Forecast: Where We Are and Where We Are Going.” This happens on my blog as well sometimes.

Larry Swedroe explains why individual stocks are riskier than they appear.

Morningstar reports on a new fund in Canada that is exempted from U.S. dividend withholding taxes. I wonder if an ETF could ever do the same thing. If possible, this would pave the way for an index ETF of U.S. stocks that could only be held in an RRSP or RRIF and could be denominated in Canadian dollars.

Celebrating Financial Freedom has a message for people with balances on their credit cards: the 7 huge credit card lies we tell ourselves.

My Own Advisor lists his personal financial goals for 2015. I found it interesting that he chose not to list RRSP contributions because they are on auto-pilot. This speaks to how painless saving can be when it comes off the top of your pay automatically.

Big Cajun Man made me laugh with his interpretation of the Chinese year of the Ram, but the picture of a computer’s RAM seemed to be only in the version of this article in his feed. He’s no fan of New Year’s resolutions, but he’s got a few financial matters you should be thinking about for the New Year.

Boomer and Echo suggest some ideas for saving more money including the mind game of saving $52 the first week of the year, then $51 the second week, and so on until you only have to save $1 in the last week. I used to use this for exercises I didn’t like: a set of 10, then 9, 8, and on down to 1.

Thursday, January 8, 2015

The Dumbest Argument for Dividend Paying Stocks

This article’s title is a play on the title of a recent article by Dividend Growth Investor, “The dumbest argument against dividend paying stocks.” In it the writer uses a straw man argument to misrepresent criticisms of dividend investors who ignore past “solid dividend-paying stocks” that subsequently performed poorly or went bankrupt.

I won’t repeat DGI’s points here, but will point out two mistakes that many (but not all) dividend investors make when they ignore the existence of past solid dividend-paying stocks that faltered.

1. Too many dividend investors own far too few stocks.

In Canada, many people who consider themselves dividend investors own nothing but a few of the big bank stocks. This worked well in the past, but is risky for the future. The failure of just one of their holdings would be very harmful to their portfolios.

One of the problems here is the stories we hear occasionally about an elderly person who became rich holding onto just one stock. Concentrated portfolios will always give both the best and worst results. We rarely hear stories of the many investors who hold a single stock for decades and eventually lose most of their money. It’s the rare few who happened to hold a long-time winner that make better stories.

2. Many dividend investors look at the past long-term track record of their current holdings and conclude that their investing approach is superior to other forms of investing.

This is an extreme case of survivorship bias. By looking only at companies with no blemishes for decades, you’re necessarily excluding those companies that faltered. When we screen for good dividend stocks today and imagine having held them since the distant past, we are using recent information that wasn’t available back at the time we imagine having invested the money. This creates unrealistic expectations for future returns.

If we were to go back 50 years and create a dividend portfolio based on only the information available back then, many of the stocks we selected would have had problems in later years. Of course, all other strategies will pick some losers as well. All this doesn’t make dividend investing bad; it just means that dividend investing is not superior to other forms of investing such as index investing.

It’s certainly possible to get acceptable results from dividend investing. The key is to be adequately diversified and to not to have unreasonably high expectations. If all dividend stocks continued their exceptional performance indefinitely, then a dividend-based portfolio would certainly outperform. But investors can’t count on this. The reality is that some of their beloved stocks will falter. The likelihood of outperforming the market over the long-term is very small.

Wednesday, January 7, 2015

My Investment Record to 2014

Each year I calculate my portfolio’s overall investment return. This used to be more important when I was actively picking individual stocks because it’s easy to delude yourself into thinking you’re doing well when you aren’t. Now that my portfolio is almost completely indexed, I continue measuring my returns. This forces me to review my less-than-stellar stock-picking record.

My 2014 return using the internal rate of return method was 14.12%. This includes index ETFs as well as a block of Berkshire Hathaway stock my wife still holds because we don’t want to realize the capital gain. Berkshire had a very good year. If my wife had held Vanguard’s large-cap value ETF (VTV) instead, our portfolio’s overall return would have been 12.67%. I consider this return to be our benchmark for 2014.

Sharp-eyed readers may find both of these return numbers strangely high considering that Canadian, U.S., and international indexes didn’t do this well. I measure my returns in Canadian dollars. With the Canadian dollar dropping significantly relative to the U.S. dollar, my returns on U.S.-listed ETFs got a significant boost. This currency boost was far more than enough to overcome a modest drag from unlucky timing of adding new money to my portfolio when markets happened to be up.

The cumulative 20-year growth of $100 in my portfolio compared to benchmark index returns each year is shown below. The returns have inflation subtracted out which makes these real returns. This shows us how buying power has changed over the years. I used a logarithmic vertical axis so that the distance between curves shows how well I did compared to the benchmark.


The first thing that jumps out is that I had a spectacularly high return in 1999. My roughly 12 years of active stock-picking began in mid-1998. I took insane chances during 1999 that worked out phenomenally well.

After 1999, the stock market was less cooperative. The benchmark didn’t make it back to 1999 levels until 2006. But my portfolio was well below 1999 levels in 2006. Things were even worse in 2007 and 2008. My stock-picking record from 2000 to 2008 could be charitably called sub-par. Other words that come to mind are ‘pitiful,’ and ‘why are you still picking your own stocks?’

It was around 2008 that I started thinking about indexing more. Luckily I didn’t make the switch until about mid-2010 because I had a very good year in 2009. Since mid-2010 my returns have been quite close to the benchmark returns because my portfolio has been mostly indexed.

Overall, my stock-picking record only looks good because of my 1999 luck. After that, I lost to the index badly. So, now I’m a happy indexer with some extra time on my hands that used to be taken up reading annual reports.

Monday, January 5, 2015

Security Analysis

Even among stock pickers, few investors will read Benjamin Graham and David L. Dodd’s book Security Analysis cover to cover. It contains many useful insights into investing but is not an easy read. Originally written in 1934, this classic is now in its sixth edition that adds modern introductions to each section including a Foreword by Warren Buffett. My main goal in reading it is to see if it re-sparks my passion for stock picking.

Security Analysis is like a bible for value investors. It contains many lessons backed up with numerous examples of real stocks and bonds to illustrate the points. Even value investors who have never read the book speak of it reverently. However, Benjamin Graham himself said the following in 1976:
“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
This intense competition among stock analysts has only intensified over the years since 1976. As I slowly came to understand how difficult it is to beat the market over the long term, I sold my individual stocks and switched to index investing. I picked stocks for about 12 years and had a good record solely because of one enormously lucky year.

In deciding to read Security Analysis in its entirety, I was interested to see if could tempt me to get back into the search for undervalued stocks. Before getting to the answer, let’s look at some parts of the book that caught my attention. There are far too many good lessons in this book to hope to cover more than a small fraction of them.

Modern Value Investing

In his preface to the sixth edition, Seth A. Klarman offers two reasons why value investing is still alive and well. One is that many investors are very short-term oriented making it easier for those with a longer-term focus. The other is that there are so many more securities today than there were back in 1934 that there are more opportunities to find something undervalued. These two points are certainly true. The question is whether they make much difference in the face of much greater competition from other value investors.

Definition of investment

Graham and Dodd distinguish investment from speculation or gambling as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” Does index investing satisfy this definition? The book does not address this question. I’d say that index investing over short time periods does not offer safety of principal. However, judging by long-term historical returns, indexing over a decade or more has preserved principal well and has given at least satisfactory returns.

Advice from investment counsel

“The chief disadvantage is the cost of the service, which averages about [0.5%] per annum on the principal involved. ... This charge would amount to about [one-seventh] or [one-eighth] of the annual income, which must be considered substantial.” I have to assume the authors would choke on mutual fund fees of 2% or more.

Projections

“There are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. ... There is the law of diminishing returns and of increasing competition which must finally flatten out any upward curve of growth. There is also the ebb and flow of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback.”

Misleading accounting

“The overwhelming majority of managements are honest, [but] loose or ‘purposive’ accounting is a highly contagious disease.” The authors go on to devote a large part of the book to showing how accounting practices mask the real financial results of companies. They also show how to undo these effects to get at the real results and examine the adjusted earnings record.

Dishonest Management

“You cannot make a quantitative deduction to allow for an unscrupulous management; the only way to deal with such situations is to avoid them.” An interesting accounting trick they describe goes as follows. A parent company gives cash to one of its operating companies and then takes some of it back as a dividend. Then the parent company treats the cash donation as a one-time event that doesn’t count against earnings but counts the dividend as income.

P/E limit

The authors say that paying more than 20 times average earnings is speculative and therefore not worthy of being called an investment. I wonder what they’d say about the generally higher P/E ratios that exist today.

Why most buyers of low-priced shares lose money

“The public buys issues that are sold to it, and the sales effort is put forward to benefit the seller and not the buyer.” The idea is that sellers push the bad low-priced stocks and not the good ones. In modern times, this applies to mutual funds. The most expensive funds are the most heavily pushed.

Apathetic Stockholders

“The typical American stockholder is the most docile and apathetic animal in captivity. He does what the board of directors tell him to do and rarely thinks of asserting his rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as ‘the management.’” I’m not sure things are much better today.

Mergers and segregations

On the excitement generated when companies merge or a company splits into parts, the authors say “Wall Street becomes equally enthusiastic over mergers and just as ebullient over segregations, which are the exact opposite. Putting two and two together frequently produces five in the stock market, and this five may later be split up into three and three.”

Technical analysis or “charting”

“Chart reading cannot possibly be a science.” Any dependability of charting predictions “will cause human actions that will invalidate it. Hence thoughtful chartists admit that continued success is dependent upon keeping the successful method known to only a few people.”

The other side of trades

“In the typical case the [stock an analyst] elects to buy is not sold by someone who has made an equally painstaking analysis of its value.” This has certainly changed since this book was written. Today, stock market trading is dominated by professionals. When an individual investor makes a trade, odds are high that it is a pro on the other side of the trade.

Conclusion

I still find Graham’s 1976 remarks about the difficulty of succeeding at stock picking persuasive. I’ll admit to some nostalgia for my stock analysis days, but not much. I believe I will end up with more money after all costs by indexing rather than by picking stocks. Even if I had enough skill to beat the index, I estimate I’d have to beat it by about an average of 2% per year to justify the time required. However, a far more likely outcome would be trailing the index by an average of 2% per year, thereby effectively paying myself a negative wage. I’m still an indexer. However, even indexers will learn some lessons from this book if they have the patience for its length and extensive use of the passive voice.