This is MoneyClub

Stocks for the Long Run
Part 2: Valuation, Style Investing, and Global Markets.

Chapter 9

Security Analysis cannot presume to lay down general rules as to the “proper value” of any given common stock… The prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. – Benjamin Graham and David Dodd, 1940

Stocks that Outperform the Market
-What criteria can investors use to choose stocks with superior returns? Earnings, dividends cash flows, book values, capitalization, and past performance have been put forward.
-Yet if markets are efficient, this information cannot improve returns. The CAPM shows the correct measure of a stock’s risk is the correlation of its return with the overall market, known as beta.
-Unfortunately, beta was not successful in explaining the differences in returns among individual stocks. a 1992 Journal of Finance article showed that the size of stocks and the valuation of stocks are fare more important in determining a stock’s return than its beta.

Small and Large-cap stocks
-Rolf Banz at UChicago found in 1981 that small stocks systematically outperformed large stocks, even after adjusting for risk as defined within the framework of the capital asset pricing model.
-Evidence: from 1926 to 2006, small stocks performed 6.27% above what would have been predicted by the CAPM.
-However this performance wasn’t a constant. Small stocks never overtook large stocks between 1926 to 1959. From 1960 to 1974, small stocks only averaged 0.5% more than large stocks. Between 1975 and 1983, small stocks averaged 35.3% while large stocks were at 15.7%. After 1983 til 1999, small stocks again underperformed. they then enjoyed 7.2% compared to large stocks <1% from 2000 to 2006.
-Causes: the Employee Retirement Income Security Act in 1975 made it easier for pension funds to diversify into small stocks. The 2000-06 bubble followed the collapse of large cap tech stocks.
-What ever the reasons, small cap stocks not in a big index like the S&P 500 makeup about 20% of total US market value. The caveat is that the small stock premium is not a constant.

VALUATION
-Value stocks offer higher returns than growth stocks
–Relating the price of a stock relative to some fundamental metric of the firm’s worth like dividends, cash flows, etc., stocks whose prices are low relative to these fundamentals are called value or cyclical stocks, while those with high prices are called growth stocks. Value stocks generally occur in industries like oil, motor, finance, and utilities. Growth stocks are generally tech, consumer, and healthcare names which are more resistant to the business cycle and have high profit growth.
-Dividend Yields
–Graham and Dodd stated in 1940 that a dollar of earnings is worth more to the stockholder if paid in dividends than when carried to surplus.
–Ramaswamy and Litzenberger in 1978 found that dividend yield and subsequent returns were significantly correlated.
–O’Shaughnessy in 2003 found that the 50 highest dividend yielding large caps stocks had a 1.7% higher return than the market from 1951 to 1994
–Siegel’s research confirms this and shows the highest dividend yielders also had a beta below unity. The lowest dividend yielding stocks not only had the lowest return (1.68% underperform) but also the highest beta.
-Other dividend Yield strategies
–A well known alternative strategy is “Dogs of the Dow” chosen from the high yielding stocks of the DJIA: one of the most successful strategies of all time. The strategy calls for investors to buy the 10 highest yielding stocks (typically out of favor) in the DJIA and to hold them for the subsequent year and then repeat the process each december. This returned 14.08% p.a. over the past 50 years. This could be extended to a Dogs of the S&P strategy which returned a 15.71%. each was between 3 and 4% above their respective benchmarks.
–The worst year for both strategies was 1999 when large cap tech stocks reached their bubble peak, underperforming the indices by 16-17%. During the later stages of a bull market, value based strategies will underperform cap weighted strategies as growth stocks catch the eye of investors. However the performance of these strategies during bear markets more than redeems them, even gaining in down markets.
-Price to earnings ratios
–Sanjoy Basu (70’s) and Nicholson (60’s) discovered stocks with low PE ratios have significantly higher returns than high PE’s, even after accounting for risk. A portfolio of the 20% highest PE stocks had a return of 8.9 percent and the the 20% lowest had a return of 14.3%
-Price to book ratios
–Research by Dennis Stattman, and then Fama and French supported this. However there are significant problems with this today. During 1987 thru 2006, book value underperformed either dividend yields, PE ratios, or cash flows in explaining returns. this is because firms increasingly have values in intellectual property.

COMBINING size and valuation criteria
– Analyzing data from 1958-2006, the smallest value stocks returned 19.59% per year while the smallest growth stocks returned 5.97%. This difference narrows with larger stocks, where value returned 13.17% vs growth’s 9.87%.
-Initial public offerings; the disappointing overall returns on new small-cap growth companies
– Some of the most hotly sought after small stocks are initial public offerings.
– Examining the buy and hold returns of the 8606 IPOs issued since 1968-2001. 79% of them were losers, 50% underperformed the market by more than 10% per year. The performance of the mostly technology IPOs issued in the late 1990s were disastrous.
-The nature of growth and value stocks
When choosing growth and value stocks, investors should keep in mind that these designations are not inherent in the product the firm produces or the industry that the firm is in. Over time many firms and even industries are alternately characterized as value or growth as their market price fluctuates.
-Explanations of size and valuation effects

– The noisy market hypothesis

Conclusion