"The Investor's Manifesto:" Chapter 2 (Part 3 of 3) -- Stocks

Here I continue my review of "The Investor's Manifesto" by Bernstein with my notes from Chapter 2. In Part 3 of my notes, we cover estimating returns on stocks, and a good deal more about choosing stocks and other investments. There's some math here, but also a good deal of good non-math information. Stick it out, please, Dear Reader.

Estimating a Value for Stocks

You should value stocks based on the payments you get from them each year. These payments are called dividends. The stock price goes up or down each day based on how investors feel about the company, how they feel about the economy in general, and whether or not the investor is in a good mood. The dividends go up or down based on how well the company is performing, so they're much more stable than the price.

If this seems strange, think about how we value other assets. An asset is valuable based on the money you get from it on an ongoing basis. A house you buy to rent out is valued based on the rent you get paid. A bond you purchase is valued based on the interest payments you receive. It should be the same for stocks.

We start with the annual dividend the stock pays, and add the historical growth rate of the dividend. The current annual dividend is a fact. The historical growth rate is also a fact, but we're guessing that it will apply in the future. If we take the average of a great many years of dividend data, we're likely to get a result that will also apply over a long period.

This formula -- adding the dividend yield and dividend growth rate -- is called the Gordon Equation. And here, thankfully, mercifully, wonderfully, we have some actual data -- an Excel spreadsheet Bernstein links to provided by Yale professor Robert J. Shiller. You can find the spreadsheet here. It covers The S&P 500 from 1871 to the present day (including 2013, which we're only a bit into) with inflation-adjusted numbers.

Bernstein states that the S&P 500 yielded a 3% dividend in 2009. (2.67% by my calculation.) From 1871 to 2009, inflation-adjusted dividends increased at 1.32% each year. This gives you an inflation-adjusted return of 3.99%.

The current expected return is similar. The 2012 dividend was 2.08%, so adding 1.32% dividend increase we get an expected real money return of 3.4% on the S&P 500.

Here's the actual formula: \\(latex r=\\frac{D}{P}+g &s=2\\) where:

  • r is the expected return
  • D is last-year's dividend
  • P is the price of the stock
  • g is the historical dividend growth rate

We can also work that equation backward if we want to specify our own rate of return (in the case of a riskier asset) and derive the appropriate price of the equity. (If the derived price is higher than the actual price, we'd buy the equity.) Here's the formula: \\(latex P = \\frac{D}{r-g}&s=2\\)

Next Bernstein touches on a vital point -- a growing economy does not necessarily equal a good investment environment.  China's economy grew at 9% annually for more than 20 years. (A spectacular result!) But Bernstein says between 1992 and 2008, investors lost 3.3% annually in Chinese stocks. Indonesia, Korea, Malaysia, Singapore, Taiwan, and Thailand were equally underwhelming. Often the best countries to invest in are the staid, stolid ones people are least excited about.

Now we're done with the math for this chapter. Relieved? Actually, that wasn't too bad.

Different Buckets for Stocks

All stocks can be divided along two axes: size and quality. Companies can be small or large, depending on whether the total value of their outstanding shares is above or below that of the average US publicly-traded company (about \$1 billion). Along the quality axis, companies can be divided into growth, mid, or value. Growth stocks are "glamorous, rapidly growing, 'good' companies—think Wal-Mart, Amgen, Cisco, or, until recently at least, Starbucks—while the latter group tends to consist of doggy, poorly growing, 'bad' companies—think Ford, Sears, or Caterpillar. The 'mid' category contains those companies that fall in between growth and value." Small stocks give higher returns than large stocks, and value stocks give higher returns than growth stocks. Small value stocks give the highest returns of all. Why? It's simply our old friend "risk premium."

How do value ('bad') companies tend to outperform growth ('good') companies in the stock exchange, when they manifestly do not in the consumer marketplace? Very simply, because they have to. Think about it: If Ford had the same expected return as Toyota, who in their right mind would buy Ford? In order to attract buyers for its far riskier stock, Ford must offer investors a higher expected return than Toyota. Although Ford may not survive, if it does, its shares will skyrocket. The company’s stock somewhat resembles a dollar lottery ticket with a 1- in- 10 probability of a \$20 payoff. While you might not want to put a large amount of your net worth into a single company, the law of averages dictates that owning a large number of 'lottery-ticket' companies should produce enough winners to make up for the majority of eventual deadsters.


Bernstein advises against having all your money in stocks because of the risk; what if your entire portfolio declines by more than half, as occurred in 1929-1932. While in theory going all-in on stocks would yield the highest long-term return, the risk is too great for most people to bear. Bernstein advises having a large chunk of your funds in bonds. Per my earlier post, I think I would advise having a large chunk of your funds in something safe, but not necessarily bonds.

This gets to the heart of the investing process: The goal is not to maximize the chances of getting rich, but rather to simultaneously allow for a comfortable retirement and to minimize the odds of dying poor.

Don't Buy Individual Stocks

Bernstein reinforces what I said about not purchasing individual stocks:

I know what you are thinking: 'Humbug on those low returns you’ve calculated! I can do better by carefully selecting the best-performing stocks myself, and if I cannot do that, I can find a mutual fund manager who can. Failing that, there are plenty of folks on TV, radio, and the Internet who seem to know where the market is headed. Surely I will be able to sell before the market crashes again.' Well, none of these strategies work. The reason why 90 percent of investors and fund managers cannot pick stocks is simple: Whenever you buy or sell a stock or bond, there is someone on the other side of that trade, and that someone most likely has a name like Goldman Sachs, PIMCO, or Warren Buffett. There is even something worse than trading with Buffett, and that is trading with a top executive of the company whose stock you are buying or selling, and who likely knows more about its condition and prospects than even the smartest and best- informed security analyst. Trading individual stocks is like playing tennis against an invisible opponent; what you don’t realize is that you are volleying with the Williams sisters.

Bernstein also talks about Technical Analysis. This is the idea that you can judge future stock patterns by looking at past stock patterns. Since we've already seen that you can't use historical prices to predict future prices, it's clear that Technical Analysis is a crock. The only people consistently making money through technical analysis are people selling technical analysis newsletters and tools.

The implications of the EMH for the investor could not be clearer: Do not try to time the market, and do not try to pick stocks or fund managers.

The most spectacular example of luck masquerading as skill was the case of William Miller, skipper of the Legg Mason Value Trust. Between 1991 and 2005, he beat the S&P 500 each and every year. Such a performance could not have occurred by chance—it must only be the result of superhuman skill, right? Investors would have to be crazy not to invest with this genius, would they not? It turned out that not investing with Mr. Miller was perfectly rational, after all. Between 2006 and 2008, he did so badly that he almost completely wiped out the previous 15 years’ worth of outstanding performance.

The Efficient Market Hypothesis

Now we need to talk about an important concept in finance called the Efficient Market Hypothesis, or EMH. This states that, "all known information about a security has already been factored into its price."

This has two implications for investors: First, stock picking is futile, to say nothing of expensive, and second, stock prices move only in response to new information—that is, surprises. Since surprises are by definition unexpected, stocks, and the stock market overall, move in a purely random pattern...

There are actually three forms of the EMH: the strong form, which posits that all information, public and private, has already been impounded into the price; the semi-strong form, which posits that only public, but not private, information has been impounded into price; and the weak form, which posits only that past price action does not predict future price moves.

Jack Bogle and the Birth of the Index Fund

Next Bernstein treats us to the story of John C. "Jack" Bogle, the founder of Vanguard. Bogle created Vanguard so that the Vanguard mutual funds would own all of Vanguard -- in essence, Vanguard's customers owned Vanguard. "Bogle had essentially turned the company into a nonprofit organization, run exclusively for the benefit of its customers."

Bogle then created the world's first index fund.

Bogle, noted that the largest mutual funds charged about 1.5 percent in management fees. The efficient market hypothesis predicted that none of these funds could beat the market for very long individually and further, in the aggregate, active managers must of necessity lag the market by their expenses and fees, since they were the market. He then calculated by hand their average return and found that it was ... 1.5 percent less than the market: 'Voilà! Practice confirmed by theory,' he noted. Vanguard would start the world’s first index mutual fund. Initially derided by the investment industry as 'Bogle’s Folly,' the Vanguard 500 Index Fund eventually became the world’s largest mutual fund.

There are two types of this new type of fund -- index funds and passively-managed funds. The Index Fund buys every stock in an index, such as the S&P 500. Once a year, a Standard & Poor's committee replaces some of the companies in the S&P 500. Any fund indexed to the S&P 500 must do so as well. Since all funds following the S&P 500 must do this at the same time, it's a messy and expensive rush that drives up the cost to purchase these stocks.

A passively-managed fund creates its own private index, specifically designed to keep turnover to a bare minimum.

In either case, the costs of a passively-managed fund or an index fund are so much lower than an actively-managed funds that actively-managed funds simply can't compete.

There is one legitimate criticism of index and passive funds -- you won't hit a home run. This is absolutely true. Index funds will get you good results over time, especially compared with actively managed funds. But putting your entire net worth in Google stock in 2004 would get you amazingly spectacular results. The important thing to note is that investing in Google is only a sure thing in retrospect -- it would have been an incredibly risky move, and there's plenty of stocks that were around at the same time and looked about as good at the time that are doing nothing now.

The advantage of index funds becomes even more clear when you're looking at bonds. "One portfolio of Treasury, municipal, and high-grade corporate bonds performs pretty much the same as the next; here the advantage of low fees rapidly becomes insurmountable. Over the 10-year period ending December 2008, the Vanguard Short-, Intermediate-, and Long-Term Bond Index Funds beat 99, 96, and 92 percent, respectively, of their actively managed peers."

A Home is Not an Investment, it's a Place to Live

Bernstein emphasizes that a home is not an investment, it's a place to live. Historical data shows that real (inflation-adjusted) home prices in the United States did not rise at all between 1890 and 1990. In Norway after 1819, prices rose by 1.3% a year.

Amazingly, economists have even assembled a series of house prices along Amsterdam’s tony Herengracht Canal going all the way back to the early seventeenth century. These show absolutely no increase in their after-inflation (real) prices for over almost four centuries—and in one of the world’s best neighborhoods to boot.

Bernstein talks about the mathematics of renting vs owning a home. If you own, you're tying up capital that you could invest anywhere, but you're saving the rent you'd have to pay otherwise. If you rent, you've got the capital, and you're out the monthly rent expenditure. A rule of thumb Bernstein advocates is to never pay more than 15 years of fair market rent for any home.

Here Bernstein has a wonderful footnote I'll reproduce in its entirety:

The figure I keep in mind when house shopping is 150: the number of months in 12.5 years. After hearing a realtor’s spiel, I will ask, “So, what would this house reasonably rent for?” If the number seems right, multiply it by 150; this will give you an excellent idea of the home’s fair market value, above which you are better off renting. I have found that this is one of the fastest ways known to man of darkening a realtor’s face.