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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.
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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