Prices are Fair

Friday, July 26, 2013 6,397 views

Mark Hebner: Hi, I'm Mark Hebner, President of Index Fund Advisors. Welcome to, where we replace speculation with an education. And boy, you're about to get a good education today and over the next couple of weeks, as we complete a three-part series from Weston Wellington of Dimensional Fund Advisors.

Weston is a Vice President over at Dimensional and a member of Dimensional's in-house research team, and he is known around the world for being one of the foremost educators on how capital markets work and how to invest your money.

So Weston is going to start his three-part segment with a program on why prices are fair.

Weston Wellington: So today we're going to discuss this idea that prices for publicly traded securities on average are fair. Now let's start the discussion by exploring some things we can presumably all agree on. Securities markets are very competitive all around the world.

In the U.S. for example, today there are roughly two thousand companies listed on the New York Stock Exchange. But we have far more investors than we have stocks to invest in. There are two thousand companies on the New York Stock Exchange. There are hundreds of thousands, millions of investors – all flipping through that list of two thousand companies trying to find the most appealing opportunities when constructing their portfolios. This competition among market participants tends to drive prices toward fair value – just like the prices of an art work at an auction attended by hundreds or thousands of eager art buyers...prices for any particular work - a master painting, an unknown painting quickly converge on fair value.

What else can we say for sure about public securities markets? Every share, every company is owned by somebody. Now we know that there are some companies that are much better positioned, more profitable, faster growing, better managed than others. It's not hard to understand why people might want to own shares in a thriving enterprise, but we also know that some companies are less attractive. Maybe the management is a bit weak, maybe the finances are shaky, maybe the product line is uncompetitive. Who's going to own shares in those companies?

This is where the pricing mechanism comes into play. Investors study these companies, and on average, they are willing to pay higher prices for companies with more attractive prospects. They insist on lower prices to induce them to own shares of less appealing enterprises. But just like water seeks its own level in the bathtub, all this activity balances out. So at the end of every day, at least in theory, everybody is happy to own what they own; otherwise, they would have done more trading during the day.

And so in this world of equilibrium and competitive pricing, business enterprises come to the market place with prospects for the future – some better than others. Investors come to the market place with capital to invest, seeking the best return on that capital. Investors compete with each other to establish the proper value for all of these business enterprises. In this competitive process, which goes on every day the stock exchanges are open, serves to protect investors by providing a fair price for all securities.

Let's try to illustrate this idea of fair pricing with a particular example. Let's take two companies in the restaurant industry: the world's largest coffee shop chain [Multinational Coffee] and the third or fourth largest hamburger chain [National Hamburgers] in the U.S.

Let's ask two questions: First Question: Which of these two companies is clearly the superior company, at least from a financial standpoint? Let's put aside your menu preferences for the moment. If we look at reported company profits, for example, for a relatively recent 5-year period [ending December 2004], profits for the coffee chain [$610 Million] are much higher than the hamburger chain [$227 Million] – roughly triple the level of profits.

Perhaps more importantly for the 5-year period ending 2004 in this example, the profits for the coffee chain have grown at a very impressive rate: 289%. What about our hamburger chain? Not so impressive. Down about 19%, they are going the wrong way. Now we can use almost any fundamental measure of financial strengths: sales per square foot, return on assets – whatever -  and we can come to a similar conclusion. The coffee shop in effect is running rings around the hamburger chain. From a financial standpoint, what do we really want to know as investors? We want to know which of these two shares has the higher expected investment return.

Now the intuition on the part of many investors is: If I can be confident I can identify the superior company, I can be equally confident I found a stock with a higher expected investment return. That's where the intuition breaks down. This is where this idea of fair pricing, equilibrium takes over.  What's the price tag on the world's largest coffee shop chain? What do we have to pay if we want to become an owner of this wonderful business? We'll call it the finest coffee chain in the world. In this particular example, we add up all the shares outstanding, multiply it by the current share price, and the answer is $24.9 billion dollars [example: as of December 31, 2004].

So if you really like coffee, think it has bright prospects for the future, you can call your broker and say, "I want to buy every share of this coffee chain. What's it going to cost me?" $24.9 billion. And you can decide where the next coffee shop opens up.

If that's the right price to pay for this terrific coffee chain operation, what would you pay to own the hamburger business? Now we've all agreed presumably the hamburger business is less attractive - not as prosperous, not as profitable - but it's still a big company. They've got hundreds of locations, millions of dollars in profits, just not as many millions as the coffee business. It's got to be something worth more than zero, but something less than $24.9 billion. What's the right price? The same day investors decided the coffee chain was worth $24.9 billion, they said, in effect, the hamburger chain is worth $4.5 billion. This is equilibrium.

These two stocks are competing for your attention every day on the stock exchange. Who would buy shares in the hamburger chain if the price were the same as the coffee shop chain? My best guess is nobody would. So the stock exchange is asking every day, how much cheaper do we have to make the hamburger chain shares to persuade you to buy them when you really want to own the coffee shop instead?

Here's the answer – on this day at least – roughly a 20 billion dollar discount. At this point investors are now indifferent regarding the expected investment returns on these two shares, even though they can still agree the coffee shop is the superior company.

What happened the following year in this example? What happened to the shares for investors of the world's best coffee shop? They lost about 3.7%. Not so good. What about our hamburger chain, the underachiever? The investment return that year – over 42%.

Am I suggesting I found some clever way to pick winning stocks? I always pick the underdog or something? Absolutely not! All we are seeing is that once the price mechanism has equalized, adjusted for these obvious fundamental differences - now we can't say with any certainty who the investment winner is going to be.

Could be the hamburger chain, could be the coffee shop…we don't know which. What do we do as investors with this puzzle? We want to diversify. We want to own both of these companies in our portfolio – the clearly superior company [and] the clearly inferior company in the absence of a reliable way to pick the future winner. 

But this is a simplified two stock example. We aren't suggesting you own two stocks in your portfolio. But this is part of the logic of owning a broadly diversified portfolio of securities that includes the obviously superior companies and the obviously not so superior companies.

Can the experts working at all the major firms help us out on this? Can they supply the expertise to identify who will be the winners? If security prices are fair, it ought to be a difficult challenge – even for the experts.

A few years, ago the Wall Street Journal assembled a panel of expert security analysts – the folks who come to work all day, every day, study these companies, talk to the chief executives…and they asked these analysts [to] take all 500 companies in the S&P 500 index, and tell us just the 10 companies out of all 500 with the very best expected profit outlook for the year ahead. And they said [to] take the same 500 companies and tell us the 10 very worst companies by that same evaluation measure. What if we had invested our money based on those assessments: 10 best company strategy, 10 worst company strategy?

How did our 10 best stocks do the following year? Pretty good! On average, the return for the 10 stocks was about 13%. That's pretty good, because the average stock in the S&P that same year had a return of about 9%. 13% is a nice premium over 9%. It looks like the analysts are doing what they're supposed to be doing – identifying the above average performers. So far so good.

What about our 10 worst companies? How did they do? A lot better. 19% on average. And the single best performing company in the entire S&P index that year was a big oil refining outfit. Their shares are up over 128% just that year, but this oil refining company was among the 10 stocks the expert analysts told us ahead of time were going to have the very worst profit comparisons.

What's going on here? Did the Wall Street Journal find the wrong analysts? A more plausible interpretation is that this is exactly the outcome we would expect to see if security prices are fair. It doesn't matter how smart the analysts are. It doesn't matter how hard they work. Why? Because the analysts are competing with hundreds, thousands of other market participants, and they're all looking at the same information. When the analysts make these estimates at any point in time, they're looking at information that they have and other people have. These are public companies. By definition the information is public, and everybody can see it. And so the information used in making these estimates is probably already reflected in current prices. What the analysts don't have and what they can't have in any truly reliable sense is knowledge of future events that will arrive throughout any time period in unpredictable fashion, pushing prices for some companies higher, some companies lower, in ways we can't anticipate.

What's the message here for investors? We want to diversify, we want to own in effect the best positioned companies and the worst positioned companies in our portfolio.

What does this mean for the industry of money management – which claims to be able to identify the best stocks by doing careful research? We now have several decades of research by financial economists studying the performance of professional money managers doing intensive research and comparing them to simple, naïve, no-research diversified alternatives. Just buy and hold a large group of stocks.

One study by Professor Jim Davis, formerly teaching finance at Kansas State University, and now with us at Dimensional in our research department. He examined over 4,600 professional fund managers [4,686 U.S. Equity funds from 1965-1998] for a period in excess of three decades, and he found that he was unable to identify funds generating positive abnormal returns. What do we mean by that kind of qualifying language?

Let's take 4,600 professional fund managers. We'll put them in a football stadium and we'll have a stock picking contest. Each manager picks his or her very favorite 20 stocks. We're going to come back in a year and see how they've done. If we have 4,600 managers picking stocks, what are we going to find? Some number of the 4,600 will have picked 20 stocks and do terrifically well, made a lot of money. Some number will have picked 20 stocks that didn't work out so well, maybe lost a lot of money. And we'll probably find that a preponderance of the managers picked 20 stocks give us a return similar to the broad market average for that year.

Then we take 4,600 chimpanzees, put them in the other end of the stadium, give them darts to throw at the Wall Street Journal, and let them pick stocks. What are we going to find? If we have 4,600 chimps all throwing darts at the Wall Street Journal stock tables, some number by pure dumb luck are going to pick 20 great stocks. Some number are going to get unlucky, have poor results, and so on. Now in effect, what studies like this from Professor Davis and many others have found in the U.S. market, and markets all around the world, is that there are more chimps picking winning stocks than there are professional money managers picking winning stocks.  Now I want to emphasize that doesn't mean I can point to any single manager and say I can prove it – Bonzo was a better stock picker than you are. I can't say that.

All I can say is that when we have a large group of money managers and a large group of dart throwers – humans or chimps – we're going to expect a certain number of people or chimps to be successful just by dumb luck.

Now the advocates of conventional stock picking always like to point out how some of them do really well, and there are always some who do very, very well. The problem is we expect a certain number to do well just by getting lucky. And if there really is all this skill among the professional money managers, we ought to see even more money managers have great results because of that skill. But in study after study after study, we don't find them. There are more chimps getting lucky picking stocks than professional managers. Now the message here is not to hire a chimp to manage your pension fund. The message is you should be very skeptical about paying big fees to hire some investment professional who claims to be able to predict the future and pick the right stocks.

In wrapping up here, this idea of equilibrium of fair security pricing has powerful implications for investors. It's as if the New York Stock Exchange is like a gigantic discount store, where prices are competitively arrived at through the efforts of literally millions of shoppers who insist on getting shampoo or band-aids or dog food at the most attractive price. Investors go to the stock exchange to purchase securities in this competition. This idea of fair pricing protects them. It doesn't mean that it eliminates the risk of investing. It means the prices they pay are fair, and as a result, a broadly diversified low-cost portfolio is likely to be the most appealing investment solution for the overwhelming majority of investors.

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