Investors’ Insights: Market Valuations And Stock Returns – Conclusion

Investors’ Insights: Market Valuations And Stock Returns – Conclusion
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Investors’ Insights: Market Valuations And Stock Returns – Conclusion by Steven De Klerck

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Having three contributions, we are perfectly able to summarize both the connecting thread and the most important lesson for investors regarding valuations: in the long run ‘cheap’ performs significantly better than ‘expensive’, moreover the degree of cheapness can easily be quantified by price in relation to realized fundamentals (e.g. book value, revenues, earnings, …). It is understood that diversification is a necessity – an issue which often is neglected. For an elementary study about the performance of various valuation measures for US stocks over a forty-year period, refer to here. Please notice that the value effect is weakening as the market capitalization increases. Most investors do not have billions of euros under management and hence there is no problem at all for them to invest in a combination of small, mid and large cap value stocks. Please keep in mind that individual investors in Belgium are confronted with transaction costs and high taxes on transactions and dividends – issues that easily put pressure on the portfolio return with 2 percent on an annual basis.

In the previous three sections, I have emphasized the quantifiability of an investment strategy. The importance of this issue has already been stressed many times by Benjamin Graham (1934, 1949), and that was done in a period when investors did not yet dispose of extensive databases in order to examine the robustness of investment strategies.

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By contrast, the investor’s concept of the margin of safety – as developed earlier in this chapter – rests upon simple and definite arithmetical reasoning from statistical data.

Benjamin Graham, 1949

We know of practically no published investment studies which show the actual results of following a given theory, or technique, or plan of selection over a fairly long period of time. … No doubt, more and better data of this kind will gradually emerge out of the research activities of the graduate schools of business and finance.

Benjamin Graham, 1949

Recently Jim O’Shaughnessy, value investor, also emphasized the importance of quantifiability over an as long as possible period, being a part of the five most important recommendations for investors based on his experience over the past thirty years.

Finally, I would like to pose two additional questions. The first question is about the returns to valuation metrics taking into account analysts’ future earnings forecasts. For an answer, I refer to the aforementioned study by Gray and Vogel (2012). In their study, they introduce the price-to-earnings ratio where analysts’ forecasted earnings are used. Return of a basic price-to-book strategy: 13.6 percent on an annual basis over the 1982-2010 period; return of the valuation method with forecasts: 8.6 percent return on an annual basis over the 1982-2010 period. Secondly, there is the question how the surplus value of comprehensive analyses of the financial statements relates to simple valuation metrics such as price-to-book and price-to-earnings ratios. I will answer this question at length in the near future.

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  1. Benjamin Graham – also known as The Dean of Wall Street and The Father of Value Investing – was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

    Graham’s first recommended strategy – for casual investors – was to invest in Index stocks.
    For more serious investors, Graham recommended three different categories of stocks – Defensive, Enterprising and NCAV – and 17 qualitative and quantitative rules for identifying them.
    For advanced investors, Graham described various special situations or “workouts”.

    The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
    The last requires more than the average level of ability and experience. Such stocks are also not amenable to impartial algorithmic analysis, and require a case-specific approach.

    But Defensive, Enterprising and NCAV stocks can be reliably detected by today’s data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

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