Get Schooled in Academic Research

 | Jan 12, 2012 | 1:00 PM EST  | Comments
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After having dinner with Real Money contributor Jonathan Moreland the other night, I spent time thinking about the challenges of beating the market and earning a decent return over time.

As we have learned in the past decade, there are extended periods when matching the market's rate of return is not enough to build wealth. Investing in index funds when the tide is rising, as in the 1980s and 1990s, can be wonderful, but much less so in periods like we have seen since 2000.

To build wealth, you have to find an investing approach that is different from what everyone else does, even when the stock market does not cooperate.

One of the topics Moreland and I discussed was the value of academic research. Academics have found some of the most important market anomalies and theories that investors can use to earn above-average returns. I try to stay up to date on the latest studies and data relating to the financial markets, and I've found that the information is useful and makes me a better investor over time.

But there are two major problems with using academic data and conclusions as an investor.

First, let's look at stocks trading below book value. It is well documented that these stocks outperform the market. Most of the studies break the universe of stocks into deciles and rank performance. Stocks that have the lowest price-to-book ratios, lowest price-to-earnings ratios and highest dividends outperform the broader market, as well as higher-priced but lower-yielding stocks. This is valuable information, but it doesn't relate to real returns unless you have an enormous amount of capital to work with.

The bottom deciles of stocks with a given characteristic are going to require the purchase of more than 500 individual stocks. The deciles are also going to contain many smaller companies, so an equally weighted portfolio would involve buying some of the companies in their entirety. Most of us are not in a position to buy that many stocks or engage in merchant banking to construct a portfolio.

The other problem with using the market-beating theories of academics is one I wrote about a few months ago. When looking at groups of stocks with certain characteristics that have beaten the market over time, the outperformance is contained to a small subset of the sample. When the Brandes Institute looked at stocks that had fallen 60% or more, they found this group of stocks beat the market by a wide margin. They also found that a large percentage of the group filed for bankruptcy. This was replicated in a study by Professor Edward Altman of New York University's Stern School of Business of companies emerging from bankruptcy. As a group, they beat the market by an impressive margin. A very high percentage of them re-entered bankruptcy and were liquidated. The outperformance was the result of a few spectacular stocks in both cases.

The trick for individual investors is to find those potentially spectacular stocks. One way is to use credit and financial scoring systems. Using measures such as University of Chicago Professor Joseph Piotroski's F score and the Altman Z score can help isolate companies that are likely to survive and improve when considering stocks with value anomalies. Investors Louis Navellier, Richard Driehaus and others have done great work identifying persistence in some of the momentum-based outperforming anomalies (all the strategies that I found offering substantial outperformance are either momentum or value based. Everything else seems to be a form of indexing). Using further screening information to narrow the pool of stocks to a manageable number can helps isolate the core stocks that help to grow wealth over time.

Another way to narrow the pool of potential winning stocks is to combine characteristics. When I look for stocks currently trading below book value, I get a list of 1609 stocks. That's too many. If I screen that pool for companies with less than a 0.3 debt-to-equity ratio, I get it down to 738. Better, but still too many. If I add Jonathan Moreland's favorite criteria and look for companies below book with reasonable debt and have insiders buying shares in the past six months, the list falls to just 126 names. That's a number I can work with.

The key to long-term success in the markets is never to stop learning. Stay on top of the current research and new ideas and apply them to your approach to investing to see if they add to your efforts.

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