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The Speculator

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The Speculator
A good news/bad news book for optimists
A study of 101 years of investment returns declares that the optimists -- those who bought stocks -- have won big. But it also predicts diminishing returns in the future.
By Victor Niederhoffer and Laurel Kenner

If there was one inspirational, instructional, inventive book on investing that Vic would recommend to his six daughters, one book that Laurel would recommend to her mother and former husbands, and one book that we’d recommend to readers of this column, it would be “Triumph of the Optimists: 101 Years of Global Investment Return” by Elroy Dimson, Paul Marsh and Mike Staunton.
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This great book tabulates 101 years of yearly returns for markets in 16 countries, with stock-by-stock returns in England and the United States. It compares these returns to Treasury bill rates, Treasury bond rates, inflation and currency exchange rates. The returns that are due to dividends, equity risk premiums and size effects are broken out.

With this as a base, the authors touch on every investment topic under the sun, including value vs. growth, small vs. big, seasonality, cost of capital, correlations between countries, earnings and dividend growth, benefits from diversification, the relevance of valuation models and likely returns for the future.

The book admirably blends the ability and specialized knowledge of three University of London Business School professors. Dimson, the ringleader, is a professor of finance, Marsh is Esmee Fairbairn professor of finance, and Staunton is director of the London Share Price Database.

Insight done right
Unlike most books written by academics, these professors know the pitfalls of hasty generalization and a biased sampling procedure. They rightfully fault all other studies based on arbitrary selection of starting and stopping points, the tendency to include the good and exclude the bad, and the collection of just one small slice of the global picture. Their work is a model of how investor research should be carried out and a guideline or control for the numerous biases and gaps they point out in previous studies. However it’s not cheap, retailing for $100.

Like most great books, “Triumph” has us saying “Wow!” and “Unbelievable!” with startling regularity. Here are 12 important, surprising and well-supported conclusions drawn from hundreds.
  • The dominant sector of the economy in 1899 was the railroads. Yet those who invested in them fared much worse that those who invested in industrials.
  • The 100-year returns for the English and U.S. markets were approximately equal at 10% a year. Inflation adjustments bring the returns down to 6.5% and 6.0% respectively. The inflation-adjusted returns for all 16 countries were remarkably similar, ranging from 2.0% for Belgium to 7.5% for Sweden and Austria.
  • Several countries had vibrant stock markets in 1900 that fizzled. For example, Russia in 1899 had the third largest, representing 10% of total world capitalization, about equal to England and half the size of the United States.
  • Realized inflation-adjusted returns per year were 6.5% for stocks, 1.5% for bonds, and 1.0% for T-bills.
  • The total capitalization of the U.S. bond market is slightly greater than the U.S. equity markets at $31 trillion, but for the world markets, the totals are equal.
  • After experiencing a high inflation rate in the first half of the 20th century, Germany enjoyed the lowest rate in the second half. There was a comparable reversal of fortunes for most of the 16 countries included.
  • U.S. corporate bonds yielded some 0.5% a year more than U.S. government bonds.
  • Purchasing power parity held in the long run for foreign exchange movements between countries with rates moving to equalize the cost of living adjusted for inflation.
  • The correlation between markets over recent years has risen, but investors in most countries would have been better off by investing worldwide.
  • Real dividends in the United States have grown by just 0.5% a year during the 100-year period.
  • It was discovered in 1981 that small stocks had performed better than large stocks, but since the discovery, U.S. small stocks have underperformed.
  • Value stocks performed better than growth stocks for most countries before 1990. Since then, the performances of value and growth stocks have not shown any significant differences.
It is amazing how often great books arise from humble circumstances. Shakespeare was an actor, an entrepreneur trying mightily to improve old stories so that his company could make a buck. Cervantes tried to repay his debts by painting a parody of the mania for reading books of knight errantry. Rabelais wrote humor to help cure the pain of his sick patients.

Data are a powerful tool
Dimson told us that “Triumph” was designed “to be a labor of love with just a small contribution that could lead to a paperback meant for light reading on planes.” The authors believe they have succeeded, but as Dimson said, “not without losing (their) humility as to the Herculean task to be accomplished. Our families would be less kind about our fixation.”

Mike Staunton, who collected the data, enjoys gathering statistics from original sources at specialized libraries. He wrote his doctoral thesis on airline prices. His favorite and most useful library in England is Guildhall, which houses all London stock market data. He prefers to collect all this data by himself rather than delegate.

The history of science is replete with examples of monumental collections of data that serve as the spark for revolutions in knowledge. Careful and extensive astronomical calculations with innovative telescopes led to the development of Kepler’s laws on planetary motion and Newton’s laws of motion. The database collected by Linnaeus in the early 18th century sparked the discoveries and explanations of the groupings of Darwin. The painstaking exactness and detailed measurements that Cavendish and Lavoisier made on the various chemical elements led to the discovery of the periodic table by Mendeleyev. After more than 130 years, the periodic table is still on the wall of most laboratories around the world, facilitating future discoveries and understanding. The formulation of a standard well-tempered keyboard sparked the profusion of compositions and instrumentation in the 18th century heyday of classical music. “Triumph” will play a similar role in the world of investment knowledge and research.

The authors have kindly provided a series of 100 years of U.S. returns for stocks, bonds, and treasury bill rates for readers of this column; send requests to us at gbuch@bloomberg.net. We have analyzed this data ourselves in an attempt to add to knowledge and return using our favored technique of stepwise regression analysis, and have uncovered several relations that were significant from both a practical and statistical standpoint. We will report on these in detail in a follow up article, but as a preview here are some of our conclusions.
  • There is a strong non-random element to the series of yearly returns with evidence of a two year cycle.
  • Bond returns lead and predict stock returns -- with above-average returns in bonds in one year leading to above average returns in stocks the next year.

Alas, we disagree
By far the most controversial finding in the book, and one that has and will be received with glee by all those who despise business and stock market investments, is the conclusion that future returns to stock market investments are likely to be considerably lower than past ones. They reach this conclusion by stringing together numerous disparate strands of evidence regarding dividend growth, dividend yield, risk preference and the pleasantness of surprises on free trade and liquidity.

Putting it all together, they state, “There is no doubting that the last century, especially the second half of the 20th century, was kind to investors in developed economies. Over that period corporations prospered and share prices went up. Part of that increase reflects what (with hindsight) we now know to be expectations a century ago of low profits and high required returns.”

It is a mark of this book’s power that even though we disagree with the conclusions and reasoning on this subject and on almost everything they say about behavioral finance studies, the value and importance of this book is not affected by one iota.

It is natural for the authors of a monumental work to reflect on the lessons that it holds for investors. “Those who bought common stocks were the optimists," Dimson said. "They triumphed over the past. Will they triumph on in the future or merely receive a ‘fair’ reward for risk? We don’t know.” While the authors provide persuasive evidence that cash flows and stock returns were better in many respects in the past five decades than investors had expected, they are not extremely pessimistic – suggesting only that the next 50 years might provide inflation-adjusted returns of 4% to 5% per year rather than the 6.5% realized in the 20th Century.

Next, we queried as to what effect he felt the book would have in the world of investments. “The death of high equity risk-premium forecasts, a refocusing on global stock market histories, and the Japanese experience of the 1990s might be revisited by other counties in the 2000s, but which countries, we don’t know -- so it’s necessary to diversify across assets and across national markets,” he said.

Finally, we asked what kinds of readers would benefit from the book. “Readers who wish to decide for themselves about asset allocation, about expected equity premium that is so modest that fees plus turnover need careful control, about how to make active managers take risk for their compensation, about the likelihood of mechanical strategies (small-cap/seasonality/value/etc.) winning over the long haul, about the cost of capital, etc," he said. "They will have more data than that which underpins the opinions of most experts.”

This is a book that belongs on every investor’s bookshelf.

A final note
Vic’s demanding mentor always used to ask, “What have you done for me today?” When we come up with a meal for a lifetime like the best investment book ever, we always expect our editors to demand a few things that the readers can do right now to make a buck.

As it happens, we have located three biotech companies that have recent insider buying that we plan to buy for our own account. They are ATS Medical (ATSI, news, msgs), Avant Immunotherapeutics (AVAN, news, msgs) and Allscripts Healthcare Solutions (MDRX, news, msgs).

Each of these is down some 50% or more over the last few months. We are willing to speculate that the insider buying in these companies is not designed to lure weak fish like us into following them, but is instead a legitimate expression of the insiders’ views concerning the likely performance of their companies. Thus, we plan to add these three companies to the 12 companies we indicated that we had bought in our column of March 14 (“Why earnings optimism is bad news.”)

While we have no idea what these companies do at all, our enthusiasm for purchasing them is increased by an analysis we performed of 1,500 similar companies over the previous six years that showed a superior performance of some 25% a year.

At the time of publication, Victor Niederhoffer and Laurel Kenner owned or controlled shares of the following equities mentioned in this column: Avant Immunotherapeutics.




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