What is the best investment? Part Six: Value

The Value premium: companies in low demand are better than companies in high demand

If a product is in high demand it has a high price as compared to the same product in a low demand scenario. Conversely, if a product is in low demand, the price is lower than if that same product was in high demand. Got it?

Investing is similar.

Stocks are priced based on supply and demand. Stocks that tend to be in high demand are priced accordingly. Companies like this have a strong record of dividends, job creation, high earnings, and catchy brand messaging that accompanies good products or services.

Other stocks are in low demand and are priced accordingly. Why? Because the company is in distress. Earnings have come in below expectations for three years in a row. Their debt/earnings ratio is high. They have had layoffs. They have stopped innovating.

Ironically, over the past 92 years it is the second group, the distressed stocks, that have outperformed their stronger partners. This is probably due to the incessant human need to survive, coupled with a capitalist economy and our American obsession with buying things. That distressed company hires a better CEO and starts innovating again. Consumers buy their things. Their share price rises, and the prudent investor profits from having owned some of those shares through the distressed period.

This is one of the Three Factors, the Value Premium.

Ugly truth: you cannot claim the value premium if you are buying individual value stocks: not everyone innovates, and you are forgetting Prudence. (Remember Kodak?)

Beautiful truth: it is not complicated to employ the value premium—it just takes coaching.

Simon Joshua is a licensed investment advisor representative at Cornerstone Wealth Partners in Michigan. He has structured his practice around investor coaching and committed himself to leading communities in establishing a legacy of fulfillment.

What is the best investment? Part Five: Size

The Size premium: small companies are better than large companies.

All else being equal, smaller things move faster, farther, and more efficiently. Even when falling. Given two burdens, one larger and heavier than the other, which would you choose to carry?

Remarkably, investing is similar.

There is a mentality in investing that says you should invest in companies that you recognize, believe in, that have a long record of dependability. [There is some prudence here: one should not invest retirement savings in companies that are less than five years old or that have been publicly traded for less than one year.]

Think of Apple, Microsoft, Amazon, Facebook, Google (traded as Alphabet, Inc.), Berkshire Hathaway, or others like them. These companies trade at several times their book value, and each has a market capitalization of many hundreds of billions of dollars. They are the biggest of the big.

In contrast, think about companies like Toll Brothers, Arrow Electronics, Tetra Tech, Horizon Therapeutics and others like them. How about Sul America or Spar Group? These companies are small.

The risk that these companies will fail is far higher than the risk from the large companies listed above. Yet, your brain should be singing a song right now: more prudent risk, more reward.

Small size brings high risk. When we prudently diversify into smaller asset classes, we can reasonably expect higher returns over the long term (i.e. greater than ten years). In our Three Factor Model, this Factor is called the size premium.

Ugly Truth: the last thing you want more of is US large growth companies (the ones you can recognize and depend on).

Beautiful Truth: prudent diversification makes investing dependable, no matter how risky the underlying equities.

What is the best investment? Part Four: Market

The Market premium: stocks are better than bonds.

So far in our series, we know that taking more prudent risk will yield higher long-term returns than taking less prudent risk. Applying that to the Market premium, when you invest in bonds, you are lending, which is less risky than owning.

When a company is founded, there are two groups of people taking risk, each in two different ways. First, the founders (think: CEO) will take risk to generate cash by selling off pieces of the company to other people or by borrowing money from other people. The investors (think: you) will take risk to receive returns by buying ownership in the company or lending to it.

Each pair of risks involves both the founders and the investors. One pair of risks is based on ownership and the other is based on debt.

If the company goes bankrupt, there is a good chance that the owners will not make a single dime of return while the lenders will get their portion of whatever the company is sold for.

Here is the catch: if the company succeeds, the owners will enjoy an increase in the value of the company, but the lenders will only ever receive interest payments.

Ugly truth: you cannot make long-term stock market returns with anything else: not bonds, not real estate, not gold, not cryptocurrency.

Beautiful truth: you can easily own thousands of stocks, eliminating the risk of losing everything: remember Prudence?

What is the best investment? Part Three: Factors

Diego was beginning to think that his streaming subscription was as much a waste of his money as his time. Ever since he finished all seven seasons of his favorite TV show last month, for the second time, he has not been able to find a show that caught his attention. That is probably because all hit TV shows are a creative variation of a tested formula.

Investing is similar.

Of the 630,000 stocks available on the global market, some are blatantly unwise investments, and others, by virtue of their class of the stock market, are mediocre. Academic investing is about carving off every unwise and mediocre choice from the portfolio, while leaving in everything else.

A bit like TV shows, all good portfolios are a creative variation of a tested formula. Stocks that are neither bad nor mediocre can be identified by applying at least three qualifications, called factors. They comprise the Three Factor Model.

Market: stocks are better than bonds.

Capitalization: small companies are better than large companies.

Value: companies in low demand are better than companies in high demand.

Of course, you already knew, from Part One, why all of those are true. In fact, you can explain them yourself: each of those factors denotes an increase in risk.

Ugly truth: unlike TV shows, you cannot have dependable success by falling in love with one, two, or even five stocks. See Part Two.

Beautiful truth: this is not an ad for a day-trading app. You do not need to decide which stocks are best in order to invest prudently. What you need is coaching.

What is the best investment? Part Two: Prudence

Prudence is a wise little girl. She takes just enough. She gives as much as she can, but only as much as she can. She courageously does many things, but only what can be done. She is cautiously daring.

Prudence is a necessity in investing. It has to do with Part One, which was all about introducing risk into the portfolio. Risk is good, but only so long as it is prudent. Imprudent risk has no reward.

Ecclesiastes chapter 11 tells you that when you chop down a tree you do not know which way it will fall, and that when you sow you do not know which seeds will be fruitful and which will not. We are then commanded to commit a portion to several causes because we cannot predict the future.

There are two kinds of risk that we could be exposed to in investing: risk of volatility and risk of losing everything. Volatility looks like your account going down in one period of time and back up in the next. Losing everything looks like…well, losing everything. We have all been told to stay invested: if you jump off the rollercoaster you will get hurt! Yes, this is true when we are riding a well-built rollercoaster. But if your portfolio is foolishly invested in only one stock, or five, fifty, or five-hundred you cannot be reasonably assured of success over the long term.

Another biblical principle to apply here is fidelity, in counterbalance to diversification. Once a prudent investing philosophy can be determined, we must be utterly committed to that philosophy, to the exclusion of all others.

Ugly truth: we know which stock made the best return last year, but we had no idea which stock that would be at the beginning of last year.

Beautiful truth: you do not need to know which stock will do the best in any year. You need coaching.

What is the best investment? Part One: Risk

My three-year-old brain knew it had to be safe, but I was scared of the water.

“Come on, jump. I’ll catch you.”

My dad’s friend, who I completely trusted otherwise, was urging me to jump into a pool. I was scared because I could not swim, and it seemed like a long way between me and him. Risk.

In the end, what I needed was a push, which my brother provided. After the scream, the firm but gentle catch, and the lukewarm embrace of pool water in July, I felt my first adrenaline rush. Reward.

Investing is similar.

Cost of Capital

When you lend, you are letting someone else use your money for a while. Risk. In return, they have to pay you rent for the use of your money, called interest. Reward.

Cost of Capital describes the idea that the cost will be high (you will charge high interest rates) if the borrower is risky. More risk—more reward.

It is a conclusion of empirical science that the higher the cost of capital associated with an asset class, the higher the expected return associated with that asset class (Fama*). Yes, the risks and rewards of owning a company are related to the risks and rewards of lending to it.

Ugly truth: the buying of well-positioned, reliable, dividend-issuing stocks is the worst performing stock investment practice in history. Low risk—low reward.

Bonus ugly truth: buying any single stock, risky or safe, exposes you to the risk of losing everything. More risk—more risk!

Beautiful truth: you do not need to go buy riskier stocks. You need coaching.

*Fama, Eugene. “Random Walks in Stock Market Prices”. Financial Analysts Journal, September/October 1965.

What are the chances?

We were all 12 and group games were our default. In this particular game, one of us was blindfolded in the middle of the room. The rest of us had ten seconds to pick a corner of the room to stand in, but we had to move quietly. The kid in the middle would then point to a corner. Anyone in that corner was out. That was one round. We would repeat until only one kid was left standing. That kid got to go in the middle and get blindfolded.

The boy starting in the middle on one occasion, Nat, had been a good friend of mine. I happened to survive the first three rounds. Everyone in the room, including myself, concluded that I knew the best corner to stand in, owing to my friendship with Nat. In the fourth round, everyone left standing piled into my corner.

Nat pointed straight at me.

What did I learn? Kids make noise.

What can you learn? The chances that an action which repeats itself will keep on happening are dependent on the chances that the action occurs once. If that is anything but 100%, the chances of the activity continuing gets smaller as it is repeated. Let me illustrate and prove that.

Hypothetically, we will assume the probability of a portfolio manager beating the market average in any given year is 0.5 or 50%. It is lower in reality. What are the chances that a portfolio manager beats the market two years in a row? Multiply the chances of doing it in a single year by itself for each year: 0.5 x 0.5 = 0.25 or 25%. How about three years in a row? 12.5%. Fifteen years? 0.098% or one chance out of 1,000 managers. Now you just have to find that one.

Here is an ugly truth: if it so happens that any manager will beat the market over the next ten years, you have no idea who they are.

Here is a beautiful truth: you do not need an advisor or a manager with a record of beating the market in order to succeed at investing. You need coaching.

What is the meaning of it all?

This morning, along with others across the nation, I stopped to reflect in silence for those lost in the terrorist attacks of 9/11/2001. I thought of those four moments in New York City: the first plane strike, the second plane strike, the first tower collapse, the second tower collapse. All the aftermath plays over again.

Following moments like that one, all the world seems to come into hyperreal focus: my daily routines, frustrations, and concerns, the friends near me, a family that loves me, my friends and family who have passed on. I have to ask the right questions in order to put all of this into perspective.

How did we get here?

“The word of the Lord came to me: I chose you before I formed you in the womb; I set you apart before you were born.” Jeremiah 1:4, 5

What is the purpose of our lives?

“Dear friends, we are God’s children now, and what we will be has not yet been revealed. We know that when he appears, we will be like him because we will see him as he is.” I John 3:2

“At the name of Jesus, every knee will bow” Philippians 2:10

How do we know what is good?

“Taste and see that the Lord is good. How happy is the person who takes refuge in Him!” Psalms 34:8

Where will we all end up?

“All the nations will be gathered before Him, and He will separate them one from another, just as a shepherd separates the sheep from the goats … And [the wicked] will go away into eternal punishment, but the righteous into eternal life.” Matthew 25:32, 46

The remaining question is tough, but I would not love you if I refused to ask it.

Which side will you be on?

“Let the one who is thirsty come. Let the one who desires take the water of life freely. ” Revelation 22:17

Email, call, text. I’m here.

What is the right price?

It seems like restaurant food costs too much. It seems like too many people pay too much for not enough. In Ann Arbor, one bowl of chili can cost more than a week of chili would cost if I made it myself every day. That is too expensive, right?

Stock pickers tell us that some stocks cost too much. They tell us that too many people are irrationally buying up what they should leave alone. Just check your news feed. They have to know what they are talking about, right?

In the stock market, shares of companies are being bought and sold every day. If one person thinks the price of a stock is too high, they will sell it. And if someone else thinks it will cost more in the future, they will buy it. This exchange of ownership goes back and forth millions of times every second of every trading day. Hundreds of thousands of professionals worldwide search for new information about every publicly traded company and buy or sell it based on their judgement. Each buy or sell order from every trader incorporates all the knowledge that individual has about that company, as well as their instincts, emotions, and perceptions.

How does the restaurant market work? Each patron decides every time they go out whether to pay the price for the meal they want and whether to return next week. The price of restaurant food incorporates every past patron’s experiences, tastes, and desires. We can make the claim that as consumers with good taste, we are qualified to make judgments about restaurant food.

But are you (or is anyone) smarter and faster than all other traders currently examining a stock? The stock pickers say they are. The data says no one is. The truth is that stock prices move randomly, and that the best guess as to the value of a stock is its current trading price. The price incorporates all available information. This principle is called the Efficient Market Hypothesis.

Here is an ugly truth: no one can tell you whether the trading price of a stock is higher or lower than its real value; the current price of a stock is its current value.

Here is a beautiful truth: you do not need to know the price or forecast of any stocks in order to invest for the future. You need coaching.

A quick tip: never buy an initial public offering: zero trading history is incorporated into the price. This can be counter-intuitive when it comes to restaurants: once upon a time, some friends of mine went to a restaurant grand opening together and got free food. They told me later how good it was. Thanks, guys.

What will happen next?

Meteorologists have the job of interpreting weather data and telling us what we can expect the weather to do the rest of the week. Usually we need to know whether to take an umbrella to work, but sometimes we need to know whether to pack up what we can carry and leave our home. When it comes to the weather, we need to know the future. As a direct result of this need, we tend to believe what the meteorologists tell us, despite our frequent dashes through the rain.

Market chartists have the job of interpreting trading data and telling us what we can expect the markets to do over the next few months. They tell us that we need their market predictions in order to have proper involvement with our portfolios. We also tend to believe what they tell us.

In both weather and investing, we need informative and motivational communication: people need to evacuate disaster-prone areas in time, and investors need to know how to behave based on how the market really works. In investing, unlike in weather, we do not really need predictions. So why do market experts try to tell us what the market is about to do? Because the more we indulge our desire for predictions, the more experts will try to feed them to us.

Here is an ugly truth: no one knows the future; our want of a prediction can never be truly satisfied.

Here is a beautiful truth: you do not need market predictions in order to have dependable investing success. What you need is coaching.