What Pays Off and Why

I’ve never seen Robert Haugen’s 1999 book of the above name on anyone’s recommended reading list. I only came to be reading The Inefficient Stock Market – What Pays Off and Why as the title caught my eye while I was looking for another book. I’m glad it caught my eye as it deserves a place on my recommended reading list.

This is an insightful look at market inefficiencies and how investors can profit via expected return factor models. Written in an entertaining and easy to read style, Haugen outlines why the market is upside down, with the lowest risk stocks providing the highest returns. One of Haugen’s main points is financial models based on rational economic behavior are built on unsound foundations.

The book is primarily about factor models and how instead of using them to predict risk in a stock portfolio they should be used to predict returns. Haugen provides compelling evidence in the book that factor models are better at predicting returns than risk. Since writing the book Haugen has used his expected return factor model to outperform the market over the last ten years. The chart below from Haugen Custom Financial Systems is testament to the predictive powers of his models.

“In an expected-return model, you use factors that help explain and predict which stocks have tended to or will drift up or down in value relative to others. These factors tend to be individual stock characteristics, which differ in level from one stock to another.”

Another interesting discussion in the book is the length of the short run. Haugen explains how the market thinks the short run is longer than it actually is and thus why high P/E stocks are priced too high.

In the video below Haugen explains his stance of market inefficiency. Markets are highly inefficient and upside down. The riskiest of stocks provide the lowest returns while the least risky provide the highest returns. The highest expected return stocks comprise big companies with low risk, are profitable, improving profitability, cheap on fundamental indicators and improving momentum.

The Haugen model uses approximately 70 factors grouped into seven families:

• Risk
• Liquidity
• Stock price relative to several measures of corporate income and cash flow
• Profitability
• Stock return history
• Analysts estimates and
• Macro economic and sector influences

What I find attractive about Robert Haugen’s ideas is that they are intuitively sensible. Surprisingly that is refreshing in the world of finance. His ideas sit comfortably alongside those of skillful investment practitioners like David Dreman, whose books The New Contrarian Investment Strategy and Contrarian Investment Strategies: The Next Generation are amoung my all time favourite investment books.

I highly recommend The Inefficient Stock Market – What Pays Off and Why to anyone interesting in mechanical investing and encourage all market participants to track down a copy. Paperback versions are available at Amazon from $4. If you want to read more on Haugen’s ideas download Case Closed.

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