Offering Advice on Investing

[LarryLaffer]

Hi Everyone,

This is not a request for advice but an offering of advice on investing to give back to the forum.

DISCLAIMER: Please note that I am not a finance professional. These are just my thoughts on investing. Don't act on this advice without asking a real finance professional. So don't sue me if this doesn't work!

I've spent considerable time thinking about how to invest my money and have come to the following conclusions:

1. The Efficient Market Hypothesis - which in layman's terms states "you get what you pay for" when it comes to investing is a good general rule but has a few important exceptions. There are 3 situations where mispricing can frequently occur. Those are:

a. Speculative Mania Overpricing - This is when excessive enthusiasm about an investment causes that investment to become wildly overpriced.

b. Hidden Problem Overpricing - I've noticed that sometimes, stocks or other investments can be overpriced even in the absence of a speculative mania because of a phenomenon I call "Hidden Problem Overpricing". This is when some market participants fail to realize that a stock or other investment has a hidden problem and therefore continue to trade it at above its intrinsic value even in the absence of excess enthusiasm.

c. Collectibles and Thinly Traded Investments - These investments can sometimes be inefficiently priced simply because very few people may be aware of them. A publicly traded large capitalization stock will usually be efficiently priced in the absence of a mania or a hidden problem. But if you became an expert at investing in a particular type of collectible then you might be able to realize high returns because these investments might be under-priced.

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In college, I took some finance classes and the professors all seemed to believe that stocks, bonds, and other investments were always efficiently priced. I was taught that the most sensible way to invest would simply be to buy index funds and trade as little as possible to avoid incurring transaction costs. For several years, I believe this to be the case. However, I have come to realize that my professors were incorrect in the 3 cases I mentioned above. I have been trying to develop ways to handle the three types of mispricing.


a. Speculative Mania Overpricing - I think that it is clear from simply looking at the historical record that speculative manias can cause overpricing. Clearly, extreme enthusiasm can cause the prices of certain investments to become wildly overpriced.

Japan in the late 1980's had a speculative mania. Read about it here:

http://en.wikipedia.org/wiki/Japanese_a ... ice_bubble

There was a time in the 1600's in the Netherlands when people were paying 10 times the average income for a tulip bulb:

http://en.wikipedia.org/wiki/Tulip_mania

In the US just about 10 years ago there was a speculative mania in internet stocks:

http://en.wikipedia.org/wiki/Dot-com_bubble

So clearly, professors who tell you investments are always efficiently priced are wrong. Speculative manias are an important exception to this rule. The question is, how do you deal with a speculative mania? Most people would say to avoid them entirely. I have a different view on the situation.

Speculative manias can follow different patterns. Some can be minor bubbles. When crude oil went over $140 a barrel this was a comparatively minor bubble. The price of oil was somewhat less than double what it probably should have been. Now it’s trading at about $85 per barrel. The Japanese asset bubble was a very large mania. The average, normalized PE ratio of publicly traded stocks in a developed country is about 15. The Japanese stock market had a PE ratio of over 100 at the peak of the bubble. See:

http://www.economist.com/node/9370662

Now I would argue that while you should not buy into a mania, if you already own stocks or stocks in a stock market that is undergoing a mania the best thing to do would actually be to hold onto the investments until they are 2 times what their intrinsic value would be. The reasons for this are as follows:

1. During the up phase of a mania, the investment will give you very good returns. You may be selling to greater fools but you are realizing very high returns by doing so.

2. It seems to me that most speculative bubbles will cause the value of the investment to exceed its intrinsic value by at least double. There are some minor manias where the bubble is smaller. But in these cases your loss is also smaller. You might lose some money by failing to sell out before it crashes. However, I believe that if you follow the rule of selling at the point where the investment is twice its intrinsic value will cause the expected value of your return to be higher than it would be if you simply sold the investment the moment it became overpriced.

3. If you were to set a threshold of more than 2 times the intrinsic value, you would probably be taking on too much risk. No one can reliably predict when the bubble is going to burst. If you try to ride the bubble higher there is a good chance you would realize huge losses as the bubble can pop very quickly. Sure you might miss out on some gains but the risk/reward seems to flip when the bubble has raised the price to twice what it should be.

So how do you determine intrinsic value? For a stock, it is the present value of all the future dividend payments. Now this isn't something that can be measured precisely as one cannot predict the future and the discount rate to be used is uncertain as well. However there is a good way to get a good estimate of the intrinsic value of a stock market. Generally, mature stock markets in developed countries have normalized PE ratios of between 10 and 25. It is important to use normalized PE ratios (that is, use historical profit margins) to adjust for the fact that in recessions cyclical companies often lose money and PE ratios may appear high. My rule is that if the normalized PE ratio of a developed countries stock market is above 30 or so it is a good time to sell as it is likely that the market is wildly overpriced. Now, of course, one should consider the countries growth rate and in some cases the normalized PE ratio that one should sell out at might be higher. However, if one were to have used this rule, and were to have bought index funds in a countries stock market and held onto them only to get out when the PE ratio went above 30, one would have realized above average returns with a lower level of risk. The PE ratio of the S&P 500 was around 35 before the market crashed in the early 2000's. One could have ridden the market up most of the way then avoided the crash.

b. Hidden Problem Overpricing - This is a less commonly known type of overpricing but probably even more commonly occurring than the speculative mania. This is when an investment continues to trade above its intrinsic value not because of excess optimism but simply because some market participants fail to realize some problem that it has. One of the flaws in the Efficient Market Hypothesis is that it assumes that all investors are rational and intelligent. While many participants, especially those who control most of the money, are highly rational, there are some participants that are irrational or ignorant. It only takes a few dumb market participants to cause an investment to be overpriced. Just two stupid investors, if they controlled enough money, could bid against each other and cause and investment to be overpriced. This is a serious flaw in the EMH. The leveraged buyout of RJR Nabisco is a good example of this. Read this:
http://en.wikipedia.org/wiki/RJR_Nabisco

An example of Hidden Market Overpricing would be the fact that GM shares continued to trade even after declaring bankruptcy. Read about it here:

http://www.nytimes.com/2009/07/11/busin ... hares.html

As you can see, if you aren't careful, you can be ripped off. The EMH is correct in that competition between investors usually prevents an investment from being UNDERPRICED. However, it doesn't prevent investments from being overpriced.

So what do you do about Hidden Problem Overpricing? You have to be very careful. If a stock or a market appears to be underpriced you are usually wrong. You are probably missing the fact that the stock or the market has some kind of hidden problem. You should attempt to value the stocks you buy NOT for the purpose of finding underpriced stocks, because competition between investors almost always prevents this from happening, but to make sure that the stock isn't OVERPRICED.

In other words, I feel that most liquid, publicly traded investments are either EFFICIENTLY PRICED or OVERPRICED. I do believe the EMH inasmuch as it almost always prevents UNDERPRICING. So don't try to find underpriced stocks because if you find a stock you think is underpriced odds are it has some kind of hidden problem. You should research stocks to make sure that they don't have hidden problems that haven't been realized by the market.

Think about it this way. What would happen if just 10% of the participants in a market knew and understood that there were major financial problems that would cause stocks to crash? They would pull out of the market. This might cause stocks to drop but if the other 90% were unaware of the problem then the stocks would continue to trade above their intrinsic value. Someone who believes in the Efficient Market Hypothesis would stay invested and would be hurt as a result when the other investors finally woke up and realized what the problem was. I think that this is basically what happened in 2008. Some investors realized that there were major financial problems and they got out in 2008. People who believe in the EMH and didn't pull out got hurt. It is always a good idea to periodically evaluate the condition of the country, the economy, and of the companies that you are invested in because, if something is terribly wrong, it might not yet be reflected in the stock price but it probably soon will be. Efficient Markets prevent you from getting a bargain but they DO NOT prevent you from being ripped off.

c. Collectibles and Thinly Traded Investments - I don't think that the EMH applies to collectibles because most investors don't have a chance to evaluate an individual collectible. Stocks are usually efficiently priced because there are so many investors researching each one and there is so much easy to find information about each one. However, if you become an expert at investing in some category of collectible you can realize above average returns. However, as most people know, it is a good idea to stay diversified so don't put all your money into collectibles.

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So to recap:

1. The Efficient Market Hypothesis is correct in that competition between investors almost always prevents UNDERPRICING. So, in other words, when you buy a stock you are either getting a fair deal or you are being ripped off. Your goal should simply be to avoid being ripped off. Attempting to beat the market by finding underpriced stocks will probably backfire. There are thousands of brilliant market participants who control billions of dollars. It is foolish to think that you can outsmart them.

2. If you already own stocks in a market that is undergoing a mania, don't sell right away. Ride the mania part of the way up. When the investment is more than double what any reasonable estimate of its intrinsic value is, sell it.

3. If you become an expert at investing in something that isn't publicly traded, like a collectible, you may be able to realize above average returns.

4. By simply following the previous three steps I believe you CAN get returns that are at least somewhat better than the advice most finance professors will give you, which is to just buy index funds and hold on forever. Furthermore, you can do this at a much reduced level of risk.