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Issue IX

September 1996


Sharp Investing


Beating the Market (Part II)

In Part I we looked at understanding and controlling human nature in order to beat the stock market. In Part II we turn our attention to understanding the way the market works in the short run and the long run, and finish with a discussion on minimizing investment expenses.

Short term market movements


Many econometric studies have shown that the stock market is almost completely random in the short run. Prices in the short run (less than a year) are determined by supply and demand that fluctuate throughout a trading day, based on assimilation of new information filtered through the perceptions of millions of investors. As information steadily flows into the markets, large events trigger large responses and smaller events combine to form smaller fluctuations in prices. Most of this new information is completely unpredictable in the short run and causes prices to move unpredictably. However, different stocks will consistently react more or less dependent on how investors perceive that the new information affects the growth prospects of the stock.

Stocks that react more violently to new information are said to have a high Beta risk. Beta is a measure of past reaction to new information for a particular stock. The whole stock market has a Beta of 1 by definition, so a stock with a Beta of 1.5 would be expected to have a larger price movement, positive or negative, than a stock with a Beta = .75 in reaction to the same piece of information.

There are two ways to take advantage of this phenomenon. The first method is to not buy stocks at the price currently being offered (market price). Based on short term randomness, an investor can reasonably expect to purchase the stock below the current market value if they are willing to wait for a month or so before making the purchase. What I am referring to is using limit orders to buy stocks rather than market orders.

A limit order is an order to buy a stock only if it reaches a certain price. Do you buy a house at the offered price? A car? If you are the buyer, why not take advantage of the fact that the stock you are interested in will most likely randomly fluctuate to a lower price in the near future? My studies have indicated that properly set limit orders can add 4% to portfolio returns. However, an investor does need a basic understanding of statistics in order to properly set the limit order based on the individual securities past volatility (Beta).

The second way that short term randomness can be exploited is through dollar cost averaging. Dollar cost averaging buys more shares at lower prices and less at higher prices. Take the


case where an investor has $90,000 to invest in a single stock. If bought at today's market price (say $10 per share), the investor ends up with 9000 shares. Assume this stock fluctuates between 9 and 11 dollars per share over the next three months. If the investor buys $30,000 per month for three consecutive months, they would purchase 3333 shares at $9 per share, 2727 shares at $11 and 3000 shares at $10 per share. The investor ends up with 9060 shares even though the stock has averaged $10 per share over the 3 months. The key is to spread the buys across time in equal dollar amounts, not equal share purchases. In the above example .67% was added to the return by dollar cost averaging. Extra returns from dollar cost averaging will be higher with more volatile stocks, and less with less volatile stocks. Combining both limit orders and dollar cost averaging should add about 5% to total portfolio returns for stocks of average volatility.

Don't swim against the tide! The trend of the market is up. Stocks are unlimited on the upside and limited to zero on the downside. If you are "long" in a stock you are swimming with the tide. If you are "short" in a stock you are swimming against the tide. Shorting a stock means borrowing shares from the broker and selling them into the market even though you don't own them. You eventually have to buy them back at some point to close out your short position. The hope is that the stock goes down and the investor buys the stock back for less than he/she sold it for in the first place. The most an investor can hope to make by a short sale is 100% return if the stock goes all the way down to zero. Conversely, the investor holding a short position can lose an infinite amount of money as the stock can go up and up and up. This is why shorting a stock gives about the same odds of success as gambling, less than a 50% chance of success.

Sometimes it can be very compelling to short a stock that seems ridiculously priced (currently, internet stocks come to mind) but resist the temptation to take on negative odds. Mispriced stocks can exist in their current condition for years, and can even move further up temporarily, which will induce margin calls, nightmares and stomach ulcers in the process. There is nothing like holding a short (a potentially infinite obligation) on a rising stock to sour an investor on the stock market. The only way an investor can win on a short is by luck which, the last time I checked, is not something very easy to duplicate.

The only prudent short for an investor to hold is known as shorting against the box. This is where an investor will short a stock they already own "long". It is a tax strategy designed to lock in unrealized capital gains until the investor wishes to realize the capital gains. Shorting without holding a long position is known as a naked short, which is not to be attempted unless the investor is willing to lose their shirt!

Long term market movements


Supply/demand factors for stocks have been linked to short term market movements rather than driving long term values. Current popular theory among the "things are different this time" crowd goes like this - Many baby boomers investing for retirement means more demand for stock, which means the market will continue to produce above average returns for the next 20 years. Reality is a bit different. Supply/demand is a popularity or voting issue. It is, has been, and always will be on a short term cycle. It has been proven to be a short term driver of stock prices for 400 years. Don't you think there were population bulges among various countries and societies over the last 400 years? Wouldn't one assume that more baby boomers means more companies, more stock issued, and rising supply to meet the rising demand? It is ridiculous to assume that more people will increase only demand and not supply. Basic economic theory disputes the possibility of long term disequilibrium between supply and demand.

Conversely, the indisputable driver of long term market value is the economy. Profits and interest rates. Fundamental value rather than popularity. Popularity (or lack thereof) is the lagged result of strong economic conditions (or lack thereof). That is, strong economic factors drive up stock prices, which are then driven higher still by popularity even as the economic conditions usually have started on the down cycle. Mathematically, this results in an overshoot condition in the stock market late in an economic expansion and an undershoot condition at the tail end of a recession.


"The stock market is a voting machine in the short run and a weighing machine in the long run."
- Benjamin Graham


While short term market movement is largely dictated by unpredictable supply and demand factors, longer term market movement is much more predictable. The market goes through cycles but the up cycles are bigger than the down cycles. Mathematically, this is known as a mean-reverting process with upward drift. The long term upward drift is explained by economists as continual improvements in technology which constantly increase productivity. Mathematicians point out that the owners of stocks have limited liability, meaning that stocks can go up forever, but can never be worth less than zero. This induces a positive bias in the process (known as geometric compounding or a log-normal distribution) that causes equity ownership to be lucrative in the long run.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
Sharp Investments, at:

13160 SW Butner Road
Beaverton, OR 97005
Phone 503-520-5000

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Daniel R. Sharp
Registered Investment Advisor




www.sharpinvestments.com

Market cycles are closely tied to the economy - bear markets precede recession, bull markets precede economic expansion. This is almost always true in the long run, although it can be obscured in the short run by temporary supply/demand factors. Through most of U.S. history, a complete economic cycle (expansion and recession) has averaged about 5 years, almost exactly the same time the average stock market cycle (bull and bear) lasts! The problem is, the stock market always reacts to the coming economic cycle before most economists have any idea of what is happening to the economy.

For example, we have had two very long economic expansions in recent history (1982 to 1990 and 1990 to the present) and not coincidentally the market has returned 50% higher than long term averages over this same time frame (15% annually). There is a very strong relationship
between the number of months the economy spent in expansion in any decade and stock market returns. Both the economic cycle and market returns cycle have spent a long period above the mean over the last 15 years. Eventually the means will revert towards recession and a bear market but the bear market will happen first as it almost always does. There have been 10 bear markets and 10 recessions since W.W.II, one of each every 5 years. Coincidence? I don't think so. Why do I go into such detail on this process? Because there are ways to profit from this knowledge.

Long term market timing: Many financial gurus advise against ever trying to time the market. This is great advice if your goal is to meet the market, not beat the market. The best advice for those attempting to beat the market is to never try and time the supply/demand cycles (short term) of the market because of their unpredictability. The longer term economic cycles are much more predictable. Everyone is aware of when the economy stinks or when it is going great guns. A strong economy increases corporate profits which should increase stock prices. A weak economy decreases profits and stock prices.

Stock prices reflect beliefs about future economic news. If investors are extremely optimistic about the future more than 4 years into an expansion - beware. Mean reversion (down) is more likely than continuing the up cycle. Likewise, if investors are extremely pessimistic more than 18 months into a recession, bet the farm. Again, mean reversion (up) is more likely than continuing the down cycle. In the long run, following this method has always eventually proven right, although frenzied supply/demand issues (such as we have currently) can temporarily cause a market to be mispriced in relation to current economic conditions. Patience is definitely a virtue when employing long term market timing techniques.

Missing out on the best 10 months of the last sixty years of the stock market knocks long term returns from 10% to 5%. This is a popular statistic used against attempting any market timing. What is not pointed out is that 9 of these 10 best months came out of the bottom of a bear market. Using the long term timing methods indicated above would have only resulted in missing one of these months. A less well known statistic: missing the 10 worst months of the last 60 years would have increased returns from 10% to 18%. Markets move down much swifter than they move up. Again, using the methods above, an investor would have missed 8

of these 10 worst months. Long term market timing works - if applied correctly and patiently.

Value Investing: The areas covered up to this point have been strategies to use in dealing with the stock market as a whole. Picking individual stocks within the market has been shown to be an almost fruitless task. With millions of investors studying the same publicly available information, the competition is fierce to exploit any known inefficiencies, which is why dartboards pick as many winners as Wall Street pros. However, there is a group of stocks that have consistently outperformed the averages. Picking randomly within this group has provided much higher returns than picking randomly within the market in general. This is backed up by over 50 academic studies covering many different time periods and different stock markets. I am referring to investing in value stocks.

Value investing is buying stocks selling for less than their fundamental value, meaning the stocks are relatively unpopular with investors. The value investor buys, holds, and waits for the next market cycle to bring the stock back to a fair value. The opposite approach is growth investing, which seeks to invest in stocks rising on popularity issues due to temporary demand. Growth stocks are those that have recently had the highest returns, which then attracts investors hoping that the stock stays hot. Growth investing relies on the unpredictable short term supply/demand cycles. Value investing relies on the more predictable long term economic cycles. Growth investing is a much more popular investment style because it is such an easy sell to investors, but value investing, which requires patience, has always been a much more lucrative investment style.

The same argument used for long term market timing holds for value investing. The market as a whole cycles between an undervalued condition (value) and an overvalued condition (growth) due to cyclical changes in the economy. Within this framework many individual stocks move from growth to value or value to growth depending on economic conditions and supply/demand conditions. This can be easily verified by looking at a Value Line sheet for any company. Value Line gives the high and low price-to- earnings ratios (P/E) for each year making it simple to see 4 to 5 year cycles of most stocks moving from value (low relative P/E) up to growth (high relative P/E) and back down to value again. It is a mean reverting

process that works the same as the overall stock market.

There are many ways to judge value - P/E, book/market, price/cashflow, growth rate of sales, etc. Guess what? They all work! Buying value stocks randomly has historically earned investors 18% return, versus 10% for the market and 7% for growth stocks. Makes sense, doesn't it? Buying value now generally means owning growth later, while buying growth now generally means owning value later. Buy low, wait a few years, sell high. It doesn't get any simpler than that.

There is one other powerful aspect of value investing that rarely is discussed. While growth investing requires a rising stock market to make money, value investing does very well even when the market doesn't do much of anything. Value stocks still turn into growth stocks and growth into value over 3 to 5 year cycles even when the market is essentially flat. Conversely, growth stocks only do well as long as the market in general does well. For example, the stock market made little progress in the 1970's. There were ups and downs, of course, but it took 15 years for the highs of the late 1960's to be surpassed. While many professional investors invested in growth issues suffered through this period, value investors continued to outperform the market. My two favorite examples, Robert Sharp and Warren Buffet, both earned their historical 30% annual returns during this period despite the dismal overall conditions.

This last point may be of significance in the years to come. Since the market has enjoyed 15 years of above average performance, we may see the pendulum swing the other way in the future. The long term outcome hinges on economic conditions of the future, which may or may not be as rosy as the last 15 years. Since value outperforms in all economic environments, value investors don't have to worry about predicting the economy.

Minimizing expenses


Lowering expenses adds to overall returns and increases the odds of beating the market. Here's how:

Unnecessary trading - Portfolio turnover should be less than 20% annually except for years at the very bottom (major buying program) or very top (major selling program) of the market cycle. Trading any more than this does two things. It puts


investors in a 50/50 game because the long term bias of the market is not allowed enough time to work. Second, it piles up commission costs, which on average, will cause an investor to lose money on investments, lowering the 50/50 odds by the cost of the commissions. Commissions can easily reduce portfolio returns by 2-4% return for an actively traded account.

Diversification - In a previous issue of Sharp Investing (Optimal Diversification, Issue II) it was shown that there are diminishing returns to holding more than 10 properly diversified securities. Over 98% of the diversifiable risk is removed by the first 10 stocks. The next 1000 securities in a portfolio reduce risk only another 2%. Anything after 10 is superfluous, unnecessarily complicates portfolios, and adds to expenses.

Mutual funds over-diversify because of government regulatory requirements and also because they want to own a piece of every "hot" stock out there which attracts investors to their fund. It's a sales strategy and a compliance issue, not an investment strategy. Buying and selling more companies requires working with smaller amounts of money per stock, which drastically increases commissions. Holding many securities also detracts from an investor's ability to adequately follow and research portfolio holdings. Most business owners do not buy hundreds of businesses to diversify risk away from their primary business. Equity investors are minority business owners, and holding more than 10 businesses is inappropriate under almost all conditions.

Financial Middlemen - The financial services industry has been created to provide a conduit between the investor and the companies wishing to raise capital. The more direct the conduit, the less the toll. The financial services industry has a vested interest in making the conduit as indirect and costly as possible. The more time I spend in this industry, the more I am amazed at how everyone seems to be selling someone else's investment service or product. Even though I have probably met 100 people in my industry, I have run into only two (besides myself) that actually make direct investment decisions. The industry is characterized by nine resellers for every one actual service provider. Everything is repackaged and sold, with accountability for the actual investing buried deep, three or four layers away in some distant location far from the investor.
Mutual funds, for example, are sold by everyone from financial planners to banks to insurance agents. Clients pay 2% for a money manager to invest them in mutual funds which charge another 2% and end up paying 4% annually for their double-layered investment advice. Most Registered Investment Advisors charge a fee and also purchase mutual funds for clients, doubling the cost to the client and removing themselves from the investment decisions. There are now even mutual funds made up of other funds (called a fund of funds) that are bought for clients by advisors. That's three sets of fees! Add commissions and any sales loads or penalties on top and one can see that it is possible for financial services to eat up most of the investment returns. It's even worse for business pension plans, which have another layer of administrative fees and custodial fees on top of the investing fees. Perhaps that's why pension plans have only returned 4.2% historically.

Here are the best strategies to minimize financial fees:

1. Commissions - Full service brokers charge 3 to 5% for a buy/sell trade for the average account. Discount brokers charge .25 to .75% for the same service. Presumably, the premium paid to the full service broker is for superior investment advice. Of course, this advice is coming from a broker who is not accountable for his/her performance record, who makes money from commissions - not from making you money, and who is likely an expert salesperson, not an expert investor. Some brokers may know how to invest, but they are a rare exception.

Increase portfolio returns by 3% by using a discount broker.

2. Loads and penalties - Steer clear of these red flags. The basic rule of thumb is that any investment that costs you more than a reasonable commission to get into or out of is an investment to be avoided. This includes mutual funds with sales loads or back end loads, insurance annuities with penalties for withdrawal, and anything else that takes an unnecessary chunk of your principal. Don't buy the theory that you have to pay these loads to obtain a superior investment. Studies have shown that loaded investments perform worse, on average, than no-load investments.

Increase portfolio returns by 3 to 5% by steering clear of loads and penalties.

3. Advisor fees - Many investors incorrectly assume that buying a no-load mutual fund does not cost them any more than buying a stock. Wrong. Mutual funds charge both an annual expense fee and many charge a 12b-1 fee. The 12b-1 particularly irks me because it's basically a smaller load fee hidden in a different category so that the fund can still claim it is "no-load". The annual expense fee is for the professional management of the fund. Added together, most mutual fund fee expenses range from 1 to 3%, with 1.5% being about average.

Here's a shocker for those of you that buy mutual funds. If you have $50,000 or more in mutual funds you could hire the services of a private money manager (such as Sharp Investments) for the same price or less of a mutual fund. For the same cost, your portfolio can be managed according to your risks, goals, and tax situations. Mutual funds don't do any of those things. Mutual funds were originally meant as a way for the really small investor to put $50 a month into the market in a diversified way. However, since selling mutual funds is much more lucrative than selling stocks, they have been pushed by investment product salespeople in a variety of inappropriate ways.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

If you are a do-it-yourself type because you enjoy picking and watching the investments, pick stocks instead of mutual funds. Studies have shown a group of randomly selected stocks outperforms a group of randomly selected mutual funds and at an annual average savings of 1.5% to your portfolio. If you want to hire a pro, go with a money manager that invests directly in common stock to get the most for your money. However, if you want a pro but don't have enough cash to meet a money manager's minimums, mutual funds are your best bet. I would recommend index mutual funds, which charge a fraction of the costs of actively managed mutual funds. Since 90% of mutual funds underperform the market and index funds always provide exact market returns, it is a better bet to stick with index funds in smaller sized portfolios.

Combining the strategies discussed in the last two issues of Sharp Investing will greatly increase the odds of beating the stock market over the long haul. Taking advantage of market inefficiencies, controlling emotions, and minimizing expenses are the keys to creating wealth in the stock market
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