Investment Strategies

10) The tenth tenet of Valuation-Informed Indexing is that a revolution is needed in our understanding of what sorts of investing strategies are most likely to lead to long-term investing success.

John Templeton warned us about “It’s different this time.”

People twist his words.

John Templeton is a value investor. He cautions us to look at valuations. Others twist his words to fit their own message. Suddenly, the caution against “it’s different this time” becomes an assertion that you should buy all-stocks, always, regardless of valuations, regardless of circumstances. After all, stocks have always been the top performers in the long-term. Or should I say, in the long-enough-term?

Here is another point.

Very often, people refer to the Efficient Market Hypothesis. David Dreman destroyed such notions to the uttermost in Contrarian Investment Strategies: The Next Generation. The result is that I keep seeing are new definitions of the Efficient Market Hypothesis. Every time that I see it discussed, I see an assertion, followed by a proof of fallacy, then a new definition with an updated assertion, followed by another proof of fallacy, then a new definition and on and on and on.

The market reacts rapidly. It does not always react intelligently.

James O’Shaughnessy wrote What Works on Wall Street. One of his findings was that Book Value is the least reliable indicator of Value. The other traditional measures of Value are better: price-to-earnings ratio (buy when low) and dividend yield (buy when high). So is the price-to-sales ratio (buy when low).

Book Value failed throughout the decade of the sixties. Its choice as an indicator of value is based on concerns about accounting and the ability to distort earnings. Even so, when looking at stocks in general, the price-to-earnings ratio is better.

As a practical matter, most Value Investors include several indicators of Value.

Those following Benjamin Graham’s advice smooth earnings over several years instead of relying on a single year’s price-to-earnings ratio.

Our findings with Safe Withdrawal Rate research favor Benjamin Graham’s advice. Professor Robert Shiller’s P/E10, which uses the average of ten years of earnings, is a better predictor of Historical Surviving Withdrawal Rates than Tobin’s Q.

In fact, its reciprocal, the percentage earnings yield 100E10/P, is a better predictor than dividend yields or a combination of the percentage earnings yield and dividend yields. Smoothed earnings make better inputs to the Gordon Equation (and other versions of the Dividend Discount Model) than current year dividend amounts.

Dividends can be cut abruptly. Smoothed earnings ensure the reliability of dividends. In addition, smoothing earnings over several years eliminates many accounting distortions.

The assumptions behind rebalancing are flawed.

The key assumption behind rebalancing is that there is no meaningful measure of value. There are great difficulties in exploiting short-term market fluctuations. That is the element of truth. But there are meaningful, straightforward ways to measure value for use in the medium-term.

We have found that rebalancing helps a little bit when valuations are high. It hurts when valuations are normal. It hurts a lot when valuations are low.

Fads are expensive, but not always wrong.

The Dogs of the DOW strategy was elevated into a fad. It was implemented badly. Fees were high. Front running was easy. [It was widely broadcast which stocks would be bought and sold and exactly when.]

After a few years, people abandoned the Dogs of the DOW strategy. They declared the Dogs of the DOW to be a dead strategy.

Guess what? It’s working again. Investors hide their plans. They spread their purchases throughout the year. They keep their turnover rates low, being careful about expenses and taxes.

The idea was good. The implementation was bad.

There are many more lessons for us to learn. For example, Lowell Miller reported the truth about Utility stocks in The Single Best Investment. People had assumed that Utilities, with their high dividend yields, produced below average total returns. They had not looked at the data. They were wrong.

There are many more lessons for us to learn.

Have fun.

John Walter Russell
November 13, 2005