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.

stockval is interesting but after a brief trial, I’m not sure it adds much to Morningstar/huntley. Thanks for the link though! Valuecruncher, although less user friendly is free.

For $300, Morningstar/ Huntley is great value for money. Try out the trial if you haven’t.
http://www.morningstar.com.au/ [I'll give it a trial during my mid year break.]

Eureka report is ok for a read but I’ve made very little money on any of the ideas or information from it. I like Alan Kohler though, he’s entertaining.

About the only thing I find worth reading in AFR is Bassanese. I pretty much buy the weekend AFR, read his column and throw the rest out. I found out he has a site on investing/trading ETF’s :  http://www.pennywiseinvestment.com.au/webpages/1_home.php

Which is basically my philosophy except that I trade a bit more. I’ve signed on for the trial subscription but I’m not sure it’s worth the $300 per year.

Out of the sites I’d rate (out of 10):

• Morningstar/Huntly 9/10
• Your site 8/10 (love your site, keep it up!)
• Bassanese 7/10
• Eureka/business speculator report 6/10
• AFR 5/10

Since being taken over by Morningstar, huntley doesn’t do small companies as much.

I must buy Sean a beer someday to thank him for the encouraging feedback and worthwhile comments.

I have subscribed to dozens of investment newsletters and sites over the years and used to read newspapers. What follows are my opinions based on past experience, the publications mentioned may have changed since I subscribed.

Traditional Media

• Newspapers 1/10. I gave up reading newspaper about fifteen years ago. Mind numbing garbage written by journalists can not provide an edge. As Sean said there are some good journalists, but I don’t wish to waste time sorting the wheat from the chaff. Journalists are paid to comments on the noise. I prefer to concentrate on the bigger picture, the signals. Consume for entertainment purposes only.
• Television news and finance shows 1/10. A worse time waster than papers. The talking heads may occasionally be entertaining but they’ll rot your brain and blunt any edge you may have. Avoid.

Before I go on I should point out I’m like an empty vessel filled by those around me. Hence why I avoid newspapers and television news. If you have stronger filters than me and plenty of time to waste consuming noise, then suck up as much as you want.

Newsletters

I’ve subscribed to a score or more over the years. I always considered newsletters to be like employing cheap analysts and treated them as a source of good ideas. For me the best newsletters are the ones which teach their subscribers along the way.

• The hands down winner based on that criteria are The Motley Fool newsletters. Unfortunately, over recent years, the Brothers Gardner have eviscerated their value by upping the price of their newer services and spreading themselves to thin. However, there remains great value in many of their newsletters and the associated forums are excellent adjuncts. 9/10 for TMF newsletters under $300.
  

• Eureka Report. I enjoyed a two month free of the eureka report last year. They were the first site I offered free advertising is exchange for a subscription. Alan Kohler said no. I particularly enjoyed reading Roger Montgomery’s articles. If you’re a resources investor then Eureka’s resource columnist, David Haselhurst, has an excellent track record. 7/10 (gets two bonus points for a reasonable price.)

• Intelligent Investor. Good educational material. Reasonable ideas. Unfortunately they take too many savaging from too many dogs for my liking, ROC Oil and GTP TREES spring to mind. They need to focus more on Buffett’s rules one and two; Never Loose Money. A focus on quality not quantity would help them. Good content, but at $545 it’s overpriced. 5/10

• Complete Growth Investor. Excellent value, good ideas, very educational. Was 10/10 prior to Jeff Fischer defecting back to the TMF. 8/10

• ChangeWave. Fantastic idea to entice an army of coal face professionals to give their views on the state of their industries and then try and synthesis that into investment ideas. Unfortunately something is lost in translation. Toby and co talk up their successes and sweep their failures under the mat, sometimes even for the same stock, Sirius Radio is a great example of that. Many subscribers took a bath on Sirius, but all you ever hear from ChangeWave is how one of their calls on the stock worked out.  Low on education high on marketing hyperbole. 2/10

The main problem with newsletters is that only a lucky minority of subscribers ever outperform the newsletter. Newsletters influence market prices, some dramatically so; therefore, subscribers will on average buy higher and sell lower. Another influential factor is subscriber biases resulting in a pick ‘n’ mix approach by subscribers. Investment returns are often skewed by one or two excellent performers. Subscribers have poor odds of picking the winners amongst the dozens of suggestions.

That’s enough opinions from me for one day. I’d love to hear about your experiences with different newsletters and investment services.

I skimmed Sustainable Energy – Without The Hot Air. It the best take on sustainable energy I’ve read. You can download a free copy or buy a printed version.

Let’s hope scientists crack Deuterium-based fusion or our grandchildren are totally screwed.

A few points

• individuals consume 24 times more energy than their home use. i.e. whatever electricity you use is at home overall in your life you and others on your behalf consume 24 times more energy.  Expressed another way, putting solar panels on your roof to power your home takes care of 4% of your energy needs.
• alternative energy is not capable of replacing fossil energy. Our demand is too great.
• traditional nuclear is also not a realistic long term solution and is very wasteful of uranium, which is not as plentiful as I thought.
• conservation of energy is often focused on trivial areas, like phone chargers. Focus on what can significantly reduce your own energy consumption.
• those in influence and power prefer centralised solutions as big players need big projects.

My Investment themes

• electrification of transport – Nissan-Renault are one of the leaders there and have strong battery research. John Petersen is knowledge on batteries, he writes at Seeking Alpha and Alternative Energy Stocks.
• solar and wind – while they’re only ever be a part of the solution, their growth will continue. Vestas Wind is well known and there is a small Canadian company that may be of some interest, Catch the Wind. GE along with Suntech continue to be my two plays in greening.
• avoid hydrogen and biofuels

Grantham’s quarterly letter

was once again a must read; entertaining and insightful. Read it!

Just Deserts and Markets Being Silly Again
On a longer horizon of 2 to 10 years, I believe that resource limitations will also have a negative effect (see 2Q 2009 Quarterly Letter).  I argued that increasingly scarce resources will give us tougher times but that we are collectively in denial.  The response to this startling revelation, for the first time since I started writing, was nil.  It disappeared into an absolutely black hole.  No one even bothered to say it was idiotic, which they quite often do.  Given my thesis of a world in denial, though, I must say it’s a delicious irony.

[Jeremy, it may have been a startling revelation to you, but many people are already signed up members of the Resources are Finite Club. Eastern philosophy is one of finite resources which should be used wisely. Though you are right, we should have applauded louder at your revelation.
It's good having someone as intelligent and thoughtful as Jeremy Grantham getting the message out to a wider influential audience.]

So, back to timing.  It is hard for me to see what will stop the charge to risk-taking this year.  With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1100.  It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again.  I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels.  “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19).

…
In soccer terminology, for the last six months it is Voting Machine 10, Weighing Machine nil!
Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment.

Also see:
http://www.meti.go.jp/english/statistics/tyo/iip/index.html industrial production and http://www.meti.go.jp/english/statistics/tyo/iip/h2afdlde.html#data_ope

Security Analysis

It’s two months since I began my journey through Security Analysis. I’m not sure if I wish I had of read this book earlier or if I’m only now able to appreciate it. It’s a heavy book, full of wisdom. Graham and Dodd explain value and investing via an open minded appraisal of the options available. I’ve decided to read it through once, before re-reading and sharing my notes.

Right now, I’m enjoying Part IV, Theory of Common Stock Investment.

There are three general investment approaches; secular growth, individual growth and margin-of-safety. There are two techniques to achieve margin-of-safety, buy at times when the general market is low or discover undervalued individual common stocks.

Due to an obsession with growth the market discounts ” enterprises that are long established, well financed, important in their industries and presumably destined to stay in business and make profits indefinitely in the future, but have no speculative or growth appeal.”

Is it any wonder that low P/E stocks outperform? TMFRich at TMF has been doing some back testing and found a P/E range of 5-10 provides the best returns. Dreman and others have highlighted that point over the years.

Favourite thoughts for the Week

Two from among dozens of favourites in this weeks New Scientist.

• A cat has the ecological footprint of a VW Golf. A medium dog has a larger eco-footprint that an SUV. I wonder how many Prius drivers have pets? [They were talking post production ecological footprint.]
• Scientists made a black hole which sucked microwaves into the core of the ‘black hole’.  The device could lead to a new and more efficient way to gather sunlight to generate solar electricity.

and a brilliant one from MDC via Decision Point.

• it often makes sense to look at particular technical signals as information signals, not action signals.

What this all says to me is that investors are too hopeful. They look for the big wins and ignore smaller ways to make extra money. They swing for the fences and get an “out,” rather than blooping singles with some regularity. I like blooping singles with regularity.

via Merkel on Falkenstein’s ‘Finding Alpha: When Risk and Return Break Down’ — Seeking Alpha.

OK, I’ve never use the word blooping though I have often posted similar sentiments. I do like taking singles, but I love putting myself in a position for even greater returns with the same amount of risk. By risk I mean specific company and situational risk not some easily obtainable metric.

I look forward to checking out Falkenstein’s blog.

Merkel said “One core idea of the book is that risk is not rewarded on net. It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds). Junk underperforms investment grade bonds on average. Lower beta and standard deviation stocks overperform on average.”

Trying to formalise risk by any theory or metric is not something I have found useful, especially via basic metrics like beta and standard deviations. While there are common dangers in investments, risk is unique to each enterprise and each situation. No simple metric can capture that and thus are at best only useful as filters. I’m wonder if one filter is really a worthy of a core idea? Though in fairness Merkel covers eight of Falkenstein’s core idea is this excellent review.

On my first flick through to prepare my mind, as I prepare a garden bed prior to sowing seeds, I read the contents, the two prefaces, the introduction and this quote.

“Many shall be restored that now are fallen and many
Shall fall that are now in honor” Horace – Ars Poetica

I am sure the essence of that quote Graham and Dodd introduced their masterpiece with was not as clichéd then as it is now. Iterations of Horace’s wisdom are now common place in investors lexicon, perhaps most famously expressed with Buy Fear Sell Greed. Just yesterday I quoted Berkowitz’s most recent rendition, “Almost by definition we are running towards that which most people are running away from because how else are you gonna get a very reasonable, cheap price on a good company unless the marketplace believes something is terribly wrong?”

Though for all its clichéd use I see little evidence of true understanding from investors. The very nature of markets and individual stocks over-extensions in both direction is testament to the lack of true understanding by the majority. If you haven’t guessed already I’m arrogant enough to say I not only get it, but practice it. I’m not sure whether it was my upbringing by a  coupon clipping mother and scavenging father, my love of sales or my strong desire for rebellion and differentiation, but what ever the reason I find trolling among the fallen a comfortable part of my investing philosophy. Almost all investors could benefit from finding their inner coupon clipper.

Security Analysis was first published in 1934, my skinny wrists are getting tired holding up the 1940 second edition. Here are my notes from my first flick through.

Preface to First Edition

p.X “fixed value investments can be soundly chosen only if they are approached – in the Spinozan phrase – “from the viewpoint of calamity“.”

guard “against overemphasis upon the superficial and the temporary” … “this overemphasis is at once the delusion and the nemesis of the world of finance”

Focus on the downside and let the upside take care of itself. Despite Never lose money being Buffett’s first two rules, many investors seem to only focus on the most optimistic of outcomes.

Contents

I’ll be reading the book slightly out of order, preferring to read Part II Fixed Value Investment last.

Introduction

The authors, hence forth referred to as Graham, highlight the growing instability of markets even in ‘normal times’. If I can find the data I’d like to look at current comparison to their data, though I’m confident the trend has not reversed. Instability should be viewed as an asset, a friendly storm who dashes fools against the rocks and lets you plunder their treasures.

p.4 “the times would seem to call for caution in embracing any theory as to the future and for flexible open-minded investment philosophies“. Like all I’ve read so far those words remain as true now as they were 70 years ago.

“Two serious depressions in the past twenty years, and the collapse of an enormous volume of railroad issues once thought safe beyond question” That was then, but with a few word substitutions it is now. Two serious bubbles and collapses in the past ten years and the collapse of an enormous volume of financial institutions once thought safe beyond question.

p.5 Future of interest rates and bond prices. “Rates stayed low longer than anticipated and even in the face of considerable business expansion in 1936 – 37“. Is this groundhog day or what? Will rates now stay low longer than anticipated? As I noted a few weeks back David Rosenberg commented:

Long-term investors should note the time-worn rule that bear markets in Treasuries do not occur until two things happen — and these two things are highly correlated:
(i) the unemployment rate begins a descent from its peak, and
(ii) the Fed signals its intent to tighten monetary policy.

p.9 Abbott Labs is an example of a well financed enterprise believed to have especially attractive prospects of increased earnings. Ge is that and a leading company with satisfactory records. Graham has a swipe at the P/E ratio and its unrealistic use. He comments on the “unrealistic pricing of favored stocks” As a starting point investors could do worse than to short companies in industries and groups that are in favour and buy those out of favour.

p.15 delivered my favourite quote thus far. Strangely I have only ever heard the first part of the sentence stated as Graham’s belief, while to me the second part is clearly more important.

“It is our view that stock-market timing cannot be done, with general success, unless the time to buy is related to an attractive price level, as measured by analytical standard of value.”

I believe I’m going to enjoy this book and no longer find it daunting, I hope you enjoy riding along.

If you’re looking for finance books then this is the link I use. 

5 of my Favourites

• Baupost Fund Letters 1995 through to first half 2001. Great insights. Did you know the Baupost Fund underperformed the market for ten years during the nineties? 
• Damodaran on Valuation Anyone interested in Damodaran’s work will find a lot via a search on his name. However, Damodaran is very generous is sharing his work on his website, blog and via SSRN, so it’s probably a tad uncool to share his copyright material. Actually, it’s probably uncool to share any copyright material and I’m torn whether to publish this post. The only reason I am going to publish this post is that the authors and publishers can easily get their work removed. As it is left up, I kid myself that they must get be getting something out of the transaction, like publicity. I also think most people will use resources like Scribd to browse books to decide whether they want to buy it. Maybe I really am delusional, but I know I’m not about to print out 700 pages and I like books.
• 101 Options Trading Secrets by Kenneth Trester. This is a good book on options for big picture people who want an easy read. Worth reading by anyone interested in trading options. I disagree with some of Trester concepts, but still see value in this book.  
• Reminiscences of a Stock Operator by Edwin Lefevre (to Jesse Livermore) Fantastic book and unlike many of the other books on Scribd this one doesn’t infringe on copyright. 
• Steve Nison Japanese Candlesticks Charting Techniques I haven’t read this book yet, but have heard excellent things about it.
• One more for the road. I posted about this yesterday, but this fantastic Jason Zweig article, Lessons and Ideas from Benjamin Graham, deserves another mention. Lots of great incites in easily digestible format.

OK, two more for the road.

• Market Wizards: Interviews with Top Traders Study Notes. I highly recommend the actual book, but these notes are an excellent summary.
• Options,Future and Other Derivatives This book is currently $145 on Amazon and like all the copyright material here and on Scribd I hope you use it as an opportunity to browse to decide if you want to buy the book.

1. I’ve enjoyed Scribd for over a year and thought everyone one else was as well. To my surprise I recently discovered that it is not as well known as I thought. The Dividend Guy highlighted this fantastic Jason Zweig article, Lessons and Ideas from Benjamin Graham. I’ve been struggling though Security Analysis so this article was a timely pickup for me. It is full of great advice for all investors.

• “get out of stocks when they are overvalued and stay in cash or bonds until stock get cheap again” It doesn’t get much simpler than that, though the difficulty is all in the execution and even seasoned investors get swayed from the rational path.
• “Graham consistently beat the market by 250 bps [2.5%] a year for more than two decades…Graham was an extraordinary good investor.” Many investors aim way to high and fool themselves that they can outperform the market by 10% or more every year.
• “the importance of focusing not on what people ought to do to get optimal results but, rather, on what they can do. The best investing advice is not theoretically ideal but psychologically practical.” 
• “Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage” How many people are guilty of this over the last six months?
• “devote at least as much attention to a company once they own it as they did when they were considering buying it in the first place.” I can only do that with a concentrated portfolio of under twenty companies.

2. The Origin of Wealth: Evolution, Complexity and the Radical Remaking of Economics by Eric D. Beinhocker. I’ve only read the free download of Chapter One, but that is enough to convince me this is a must read book. I’ll order it soon from Amazon.

• Beinhocker explores how “complexity economics” provides provocative insights on issues ranging from creating adaptive organizations to the evolutionary workings of stock markets to new perspectives on government policies. A landmark book that shatters conventional economic theory, The Origin of Wealth will rewire our thinking about how we came to be here–and where we are going.

3. The Last Hurrah and Seven Lean Years Jeremy Grantham’s quarterly letter. [Free registration required]

• Absolutely brilliantly written and chock full of good advice. ” …have a simple battle plan of determining levels at which to reinvest and to stick to it absolutely” That advice was presented as an antidote to investors too terrified by the recent declines to deploy cash. I think that advice can be used more widely. A key takeaway for me from George Soros is investors should always have a battle plan for each position and their overall allocation. They should then monitor the positions against the plan and imperatively always react and continue to update the plan. The letter is a must read for all investors. A tip of the hat to MDC for highlighting this one.

4. Reinvesting when Terrified by Jeremy Grantham [Free registration required]

• “There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer.” Read the article it is only one page. I know I’ve repeated the above advice, that’s how important I think it is. 

The Best Twenty Dollars an Investor Could Spend

OK, perhaps not the best, but it is the next twenty I’ll be spending at Amazon.