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How to Think About the Stock Market

Even so, mistakes are likely. Buffett, for example, underestimated the problems of USAir’s relatively high operating costs when he invested in the airline in 1989. As a result, its cash flows, and hence its value, were well below the amount he had expected and he essentially gave up on the investment. Although the airline and the investment have recovered spectacularly in the last few years, he considers his record in making the investment “unblemished by success. I was wrong in originally purchasing the stock, and I was wrong later, in repeatedly trying to unload our holdings at fifty cents on the dollar.”

Overall, he and his investors have prospered because he appreciated the lasting value of both strong franchises—e.g., the dominance of The Washington Post in Washington, D.C.—and good managers in companies such as the Washington Post Company, Coca-Cola, Gillette, and GEICO, and was willing to bet heavily on them when he could buy their shares at prices well below their “intrinsic values.” Unlike most economists and other investors, Buffett believes that a concentrated portfolio acquired at bargain prices is inherently less risky than a diversified one bought with little “margin of safety,” i.e., with unrealistically high prices relative to earnings or other measures of value that will badly endanger the stock’s price if the company does not meet these lofty expectations or if market conditions change. Maintaining a “margin of safety” is the standard Graham used to distinguish “investing” from “speculating.” Remarkably, as we shall see, even crude applications of the value approach outperform the market averages and are less risky.9

During the last fifteen years, research by academics and investors has contested the idea of automatic stock market efficiency favored by econ-omists such as Burton Malkiel of Princeton University, one of its leading popular exponents. Since 1973, when his book A Random Walk Down Wall Street was first published, he has argued that stock prices are so efficiently determined by the millions of individual decisions by investors—and thus are so unpredictable—that it is only a slight exaggeration to say that “a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts.”

Those opposing this view have conducted much research to try to show that there are patterns in stock prices suggesting that some trading strategies work much better than others. Some of the important research papers from the 1980s and early 1990s are collected in the volume edited by Richard Thaler, Advances in Behavioral Finance. Many of the successful strategies are based on, and confirm, the principles of value investing laid out in the 1930s by Benjamin Graham and David Dodd in Security Analysis, and carried forward by Buffett and other disciples. In What Works on Wall Street, James O’Shaughnessy, a financial writer and investment adviser, presents evidence on the returns and risks of more than fifty investment strategies over the forty-five-year period between 1951 and 1996. Among his findings are the following:

  • Between 1951 and 1996 you could have done four times as well as the S&P 500 by concentrating on large, well-known stocks with high dividend yields (i.e., with low prices relative to dividends).

  • Buying Wall Street’s current favorites with the highest price/earnings ratio is one of the worst things you can do.10

When investments are made by following rules such as these, the strategies sacrifice subtlety and nuanced judgment in favor of simplicity and system. But O’Shaughnessy and many others show statistically that so long as they are used systematically, even crude measures of value can identify stocks that will yield uncommon returns. For example, one important study showed that, between 1968 and 1990, portfolios of “value” stocks—defined simply as stocks whose prices are low relative to very rough measures of their worth such as book value, earnings, or cash flow—that were held for five years outperformed portfolios of “glamour” stocks by about eight to ten percent a year. “Glamour” stocks, as defined in this study and others like it, are polar opposites of value stocks. They are fashionable, have been bid up, and thus sell at prices that are high relative to variables like book value, earnings, or cash flow. (Portfolios of value stocks were defined, for example, as the 10 percent of all stocks in the sample with the lowest price/earnings ratios, while glamour stocks were the 10 percent with the highest price/earnings ratio.)11

The particular danger of glamour stocks is that they leave little margin for error when they don’t meet expectations. Oxford Health Plans, one of the fastest-growing HMOs, is a recent example. Oxford provides health care coverage to almost two million people, mostly in the Northeast, where it has a large roster of doctors and hospitals. On October 24, 1997, its shares were trading at about $70, roughly 250 times its earnings during the preceding twelve months, and more than ten times higher than typical price/earnings ratios at that time. Investors apparently thought that the rising demand for managed health care and Oxford’s attractive program would support the company’s growth and earnings. But the company’s price/earnings ratio, relatively high in any case, should have been cautionary. Managed care companies were at the time under pressure to improve service and not scrimp on medical care, which could well have meant lower profits. Oxford shares fell more than 60 percent during the market’s break the following Monday, October 27, when the company announced that its revenues and earnings would be lower than expected because it had wrongly estimated its costs and receipts. A share of Oxford stock is now less than $18.

Internet stocks like Amazon.com, the on-line bookseller, are currently very hot. The Amazon company went public last year at a price of $18 a share. It still has no earnings, yet its share price is about $82 (down from a high of $200), giving the company a total market value of approximately $2 billion. And although its revenues have grown sharply, from $511,000 in 1995, its first year of operations, to $147 million last year, its losses have risen from $303,000 to $27.6 million. Amazon, moreover, will be facing increased on-line competition from book chains such as Barnes and Noble and publishers such as Bertelsmann.

Amazon and Oxford are part of the Nasdaq, or over-the-counter market, in which apparently inflated valuations such as theirs are quite common. The Nasdaq market includes about 5,400 companies, including Microsoft, Intel, and Cisco Systems, as well as a great number of small, unproven ones. As a group, the Nasdaq companies have a P/E ratio of about seventy, almost three times that of the S&P 500. But suppose we exclude from that group Microsoft, Intel, and Cisco, which account for about 25 percent of the market value of all Nasdaq companies and for nearly 60 percent of their total earnings. These three stocks currently trade at P/E ratios of about fifty-five, eighteen, and fifty-two, respectively. Without them, the P/E ratio for the remaining companies jumps to more than ninety.12

The statistical studies of value investing suggest that just as popular stocks like Oxford frequently cannot live up to investors’ inflated hopes, out-of-favor stocks like the Washington Post Company in 1973 tend to rebound from excessively depressed levels. Equally important, value stocks seem to be no more risky than glamour stocks, whether risk is measured by the variability of their returns (as it most commonly is) or, more appropriately, by how well the returns hold up in bad times such as recessions or falling stock markets. This conclusion crucially undermines the conventional wisdom of economists. True believers in stock market efficiency tend, tautologically, to attribute the success of any strategies that beat the market to their presumed riskiness.

According to Peter Bernstein’s Against the Gods, risk became identified with the variability of investment returns in part because volatility can be measured relatively easily.13 But despite this advantage, volatility may not be the best measure of risk if shares are undervalued and if investors are willing to be patient. Warren Buffett, for example, prefers the dictionary definition of risk, “the possibility of loss or injury,” which is often unrelated to volatility. If, he points out, the stock of the Washington Post Company in 1973 had suddenly fallen even further, then its volatility would have been greater. By this measure, Buffett wrote, “the cheaper price would make it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it is riskier to buy $400 million worth of properties for $40 million than $80 million.”

Why do such opportunities for value investors continue to exist? Keynes hinted at the reasons in the General Theory. First, he observed, many investors do not look for long-term values, but try simply “‘to beat the gun,’…to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow,” much like “a game of Snap, of Old Maid, of Musical Chairs.” As a result, the stock market can be

likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.14

This way of thinking creates discrepancies between value and glamour stocks. Because it may also cause undervalued shares to become even more undervalued in the short term, value investors must be able to withstand losses.15 For example, throughout 1973 shares of the Washington Post Company sold in the stock market at a small fraction of the company’s value. But the shares were twice as cheap at the end of the year as at the beginning. Although Buffett acquired his stake in the company near the low end of the range, he still had unrealized losses that year and at times during the following year.

Second, because it involves betting against popular opinion, value investing requires greater conviction than simply following the crowd. If these factors, financial and social, limit the willingness of investors to take advantage of market prices that can be far out of line, they can also explain the persistence of stock market bargains. “An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and…will in practice come in for most criticism,” Keynes wrote. “For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.”

American experience during the last fifteen years makes it easy to forget that stock prices have not always gone up and that investing in the stock market is risky. During the 1970s, for example, investors in both stocks and bonds lost money after adjusting the values of their holdings for inflation. In the first volume of Securities Markets in the 1980s, Barrie Wigmore, a limited partner of Goldman Sachs, describes in detail the abrupt transformation in financial markets that took place in the early 1980s. Between 1979 and 1984, returns on the S&P 500 averaged almost 10 percent a year after inflation compared to losses of 1.5 percent annually during the preceding decade. At the same time, the markets for junk bonds, mergers and acquisitions, mortgage securities, and government bond futures began to grow dynamically. They have hardly paused.16

Unless we are now in a “new era” of permanent prosperity, a view that also was popular during the late 1920s and seems equally unlikely today,17 then the economy eventually will worsen and share prices will adjust, perhaps excessively, if only because hopes, and thus prices, are currently so high. For example, a recent survey of mutual fund investors found that they expected returns of 34 percent a year for the next ten years. That should be a warning sign.18 But because attempting to predict when the market will fall is such a poor gamble, and the rewards and risks of sound stock investments so attractive, investors who can afford it would be better off maintaining a relatively steady presence in the stock market. The extent of their stock investments should depend on how long they expect to hold their investments and on how much money they would be prepared to lose in the short term. J.P. Morgan suggested one way to estimate how much money to commit to stocks when he reputedly advised a friend who was losing sleep over his shareholdings, “Sell down to the sleeping point.”19

By this standard Americans seem, at least for the moment, to be sound sleepers. Over the last ten years they have increasingly invested in the stock market, largely through mutual funds, which now have assets of about $2.7 trillion and hold approximately 16 percent of all corporate shares compared to roughly 5 percent in the mid-1980s. Despite the success of Buffett and other value investors, mutual funds do not appear to have followed their lead. Neither the Investment Company Institute nor Lipper Analytical Services has a “value” category for their surveys of mutual funds because the label is used in such different ways by fund managers. Instead, the most popular mutual funds are “growth funds,” which tend to buy stocks with relatively high price/earnings ratios. Such funds account for more than 50 percent of all mutual fund assets.20

This helps to explain why even in these exceptional times, mutual funds have not matched market averages. For example, between 1984 and 1994 the average mutual fund returned about 12 percent a year compared to about 14 percent for the S&P 500. During that ten-year period, some 26 percent of all actively managed mutual funds beat the S&P, more than in any other ten-year span that ended in the 1990s. During the last ten years, however, only 14 percent did so. Because of results like these, and because those funds that beat the market averages do not do so consistently, “index” funds, whose portfolios simply mimic a broad stock market index such as the S&P 500, have better results than most active investment strategies.

The assets of funds based on the S&P 500 and other indexes have grown even more rapidly than mutual funds generally, increasing from about 1 percent of the assets of all equity funds in 1985 to 7 percent today; but they remain relatively small. The small size of index and value funds, combined with the popularity of growth funds, is yet another indication of the optimism of stock market investors and the attraction of fashionable investment strategies. If index and value funds were to account for a much more significant proportion of all shares, then the market would more closely resemble the economists’ efficient ideal—there would be far fewer undervalued or overvalued stocks. But the S&P 500 is after all merely an index: one can buy a fund that mimics it but, unlike most other Wall Street investments, the index cannot be promoted as benefiting from the expertise of stock analysts and money managers; and those who invest in it have no choice over the stocks that make it up. Passively investing in a market index is just not as exciting as investing in a growth fund or in the stocks that many are talking about.

Worldly wisdom,” Keynes wrote, “teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” For this reason, there will always be overlooked value stocks, and we will never know for certain if the market’s exuberance is rational or irrational. Experience suggests, moreover, that economic and stock market growth cannot be sustained indefinitely. If the unemployment rate continues to fall, for example, wages are likely to rise more rapidly, increasing inflationary pressures and making higher interest rates more probable. If this happens, (and it may not), the economy and the stock market can be expected to falter, and those who have chased fashion will suffer most.—May 26, 1998

  1. 9

    All of the unattributed quotations here are from writings by Warren Buffett. Most are from his appendix to Graham’s The Intelligent Investor. This essay also includes his early investment record and those of six other investors who share the same general approach (and have also done substantially better than the market). The quotations about “intrinsic value” are from the 1996 Annual Report of Berkshire Hathaway Inc., the publicly traded holding company through which Buffet has been investing since 1969, when he closed his investment partnership. USAir is discussed in the 1994, 1996, and 1997 Annual Reports. See also Jeff Madrick, “How to Succeed in Business,” The New York Review, April 18, 1996, p. 24, and, on the growing importance of intangible assets, Lowell L. Bryan, “Stocks Overvalued? Not in the New Economy,” Wall Street Journal, November 3, 1997.

  2. 10

    O’Shaughnessy, What Works on Wall Street, p. xvii. There are two opposite sources of bias in such statistical results. First, if a given body of data is “mined” intensively enough, some patterns—whether of market success or failure—will show up even if the data are truly random. On the other hand, many potentially profitable findings undoubtedly have not been made public. Some of the new research discussed below explains why inefficiencies might persist even if they are well known.

  3. 11

    Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny, “Contrarian Investment, Extrapolation, and Risk,” The Journal of Finance, December 1994, pp. 1541-1578. Price-book value ratios and other value measures were also used. Book value is a company’s net worth, the value of its assets less its liabilities as shown on its books. Its limitations are well known: not only are intangible assets vastly understated in corporate accounts, but even “hard” assets—property, plant, and equipment—are carried at their original cost less estimated depreciation and not at their current market value or the cost of replacing them. The portfolios were also adjusted for company size because there is some evidence that shares of small companies outperform those of larger ones.

  4. 12

    Alan Abelson, “Up and Down Wall Street,” Barron’s, April 27, 1998.

  5. 13

    Against the Gods, pp. 247-261. Bernstein explains that Harry Markowitz, who won the Nobel Prize in Economics in 1990, was the first to systematically identify risk with the variability of investment returns but did not actually use the word “risk.” “He simply identifies variance of return as the ‘undesirable thing’ that investors try to minimize.” Volatility is also critical to the formula for valuing options for which Myron Scholes and Robert Merton were awarded the 1997 Nobel Prize in Economics. (Fischer Black, who undoubtedly would have shared the prize—the option-pricing formula is known as “Black/Scholes”—died in 1995.) An option is the right to buy (or sell) an asset at a specified price for a period of time. The right to prepay a mortgage without penalty, for example, is an option. Its value becomes greater the more likely it is that interest rates will fall. See Bernstein, pp. 310-316.

  6. 14

    John Maynard Keynes, The General Theory of Employment, Interest, and Money (Harcourt Brace, 1936), pp. 152-156.

  7. 15

    See J. Bradford De Long, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann, “Noise Trader Risk in Financial Markets,” reprinted in Richard Thaler, editor, Advances in Behavioral Finance, pp. 23-58; and Andrei Shleifer and Robert W. Vishny, “The Limits of Arbitrage,” manuscript, March 1996.

  8. 16

    I have written about the junk bond and merger markets in the 1980s in “The Golden Age of Junk Bonds,” The New York Review, May 24, 1995, pp. 28-34.

  9. 17

    See Martin S. Fridson, It Was a Very Good Year, Chapters Three (1927) and Four (1928).

  10. 18

    David Barboza, “Bull Market’s Glitter May Be Blinding Investors,” The New York Times, October 22, 1997. It is possible, however, that some of the respondents gave their expected cumulative (rather than annual) returns. See Robert McGough, “Was Investor Survey a Rush to Judgment?” Wall Street Journal, October 27, 1997.

  11. 19

    Quoted in Malkiel, A Random Walk Down Wall Street, p. 321.

  12. 20

    In a series of papers on the money management industry, Josef Lakonishok, Andrei Shleifer, and Robert Vishny have shown that pension funds, which hold about 25 percent of all shares, tend also to buy popular stocks with above-average P/E ratios, rather than out-of-favor value shares. See “What Do Money Managers Do?” manuscript, February 1997, and “The Structure and Performance of the Money Management Industry,” Brookings Papers on Economic Activity (1992), pp. 339-391.

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