Monday, May 02, 2005


The Greater Fool

I found this little blurb at the bottom of a recent Motley Fool article rather amusing:

Since he launched his Motley Fool Hidden Gems newsletter service in July 2003, Tom's picks have returned 28% -- a mind-blowing 23 percentage points above the S&P 500. If you like those odds, Tom is offering a no-obligation, 30-day free trial to Hidden Gems, full privileges included -- simply click right here to learn more.

Now, I ain't no math genius, but by my calculation, the S&P 500 equal weight portfolio has returned roughly 40 percent since July 2003. As I've argued before, an equal weight portfolio is the intellectually correct benchmark against which one ought to measure returns. So by my score, Mr. Gardner has underperformed the market and owes his subscribers an explanation. Now, I don't want to push this point too far because I realize that almost everyone compares their returns to the S&P 500 value weight index (including me, by the way). Still, if people knew better, do you really think Mr. Gardner would be bragging about his results?

As for the essence of the article, what can I say? The facts are sort of right but the interpretation isn't. Yes, it's true that value stocks have historically outperformed growth stocks. This does not mean, however, that the efficient market hypothesis is wrong. Look at it this way: consider two companies that are identical in every way except that company A is "riskier" than company B. In an efficient market, the price of company A would be lower, and the expected return to holding company A's stock would be higher (to compensate investors for the extra risk of holding company A's stock). This implies that company A's price to earnings ratio and price to book ratio would be lower than company B's. Anyone looking at the data would then observe that "value" with low P/E and P/B ratios tend to outperform growth companies.

Thus, the fact that value outperforms growth is not an indictment of the efficient market hypothesis. The real mystery, as Fama and French note, is that value stocks do not have higher market betas than growth stocks. Hence, they are not "riskier" in in the way standard finance theory dictates. However, as Fama and French also note (and very few people seem to appreciate this point), this does not imply that that the efficient market hypothesis is wrong either. The reason is that value stocks and growth stocks tend to move together like flocks of birds. Sometimes value does better (like in the past 4 years), and sometimes growth does better (as in the late 1990's). If it were the case that a simple strategy of going short growth stocks and using the proceeds to go long value stocks generated risk-free excess profits, then the efficient market hypothesis would be wrong. But it's not.

Where does that leave me? Despite what you may think by looking at my portfolio, I'm neither a value investor nor a growth investor. I'm an opportunist (in the good sense of the word!). If this were 1999, you'd see lots of internet stocks in my portfolio because that was clearly where the profits were. In today's environment, I believe that value stocks are the better choice, and I'll continue to invest in them until I am proven otherwise.

I have written about 60 articles for TMF, but I am done now. Working with them was not at all like I expected it to be. One day I'll write about the experience. Good for you for calling them on this sort of thing.
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