The Evidence-Based Investor

Tag Archive: joachim klement

1. Another sign that market efficiency is increasing?

   December 1, 2020 6:30 am Comments Off on Another sign that market efficiency is increasing?

    

   By JOACHIM KLEMENT

    

   Much to the chagrin of value and contrarian investors everywhere, markets in the Western world have increasingly been dominated by momentum effect. It seems sometimes as if momentum investing is the only way to beat the market these days. One of the culprits that has often been blamed for this phenomenon is the rise of passive investing. Mindless investors buying stocks at any price just because it is part of an index eliminate the function of the market as a weighing machine of fundamentals and thus makes it less efficient.

   I don’t buy into this argument at all as I have explained here. But when I read a paper from Andy Chui and his colleagues, I thought there might be another reason why momentum has become the dominating factor in stock markets.

    

   Is it because market efficiency is increasing?

   What if markets become more momentum-driven not because they are becoming less efficient but because they are becoming more so?

   The research looked at momentum effects in Chinese A and B shares. The fun thing about these two markets is that the China A share market is almost exclusively accessible to Chinese investors while the China B share market is accessible to both domestic and international investors.

   There are plenty of stocks that trade both on the A share and B share market, so you can investigate the price dynamics of the same stock in an environment of mostly retail investors that trade a lot on noise and aren’t that sophisticated (A shares) and in an environment of more professional and knowledgeable investors like pension funds and asset managers (B shares). But because there is no direct arbitrage opportunity between A and B shares prices on the same stock can deviate due to different balances of supply and demand.

   The differences are striking. The chart below shows the profits of a traditional momentum strategy Shares that trade on both the A and B share market show strong momentum effects in the B share market but not on the A share market. There simply is so much more noise trading in the A share market due to the larger number of retail investors that they destroy momentum effects. In effect, the shares that trade on both the A and B share market look very much like the shares that trade only on the A share market.

    

   

    

   With the “professionalisation” of retail investing, more and more private investors in the West are no longer managing individual stocks themselves. Instead, they use funds and delegated mandates to have their assets professionally managed.

   That means that in the West, there are fewer and fewer noise traders as well while the share of informed investors rises. And that means that a bigger share of the market is driven by professional assessments of what a stock is worth. And while professional investors constantly disagree, they are much more in agreement with each other and much less likely to stray from the herd than retail investors. And as a result, herding in the stock market increases, and momentum effects become stronger.

    

   US stock market ownership over time (Source: Goldman Sachs)

    

   

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   How hard is it to find the next Amazon?

   Practitioners still pay too little attention to academia

   Stocks have lagged bonds since 1970. Why?

   No more room at the factor zoo

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

    

   PREVIOUSLY ON TEBI

   Here are some other recent posts you may have missed:

   Should investors be optimists or pessimists?

   The only way to be a buy-and-hold investor

   Why active will continue to underperform

   Why cap-weighting dominates

   Five ways to boost your financial resilience

   The patience of a saint

    

   FIND AN ADVISER

   Investors are far more likely to achieve their goals if they use a financial adviser. But really good advisers with an evidence-based investment philosophy are sadly in the minority.

   If you would like us to put you in touch with one in your area, just click here and send us your email address, and we’ll see if we can help.

    

    

    

2. Always confident but often wrong

   November 17, 2020 11:29 am Comments Off on Always confident but often wrong

    

   By JOACHIM KLEMENT

    

   Note: This post is the result of a conversation I had with Preston McSwain. We found it so interesting that we decided to work on a post together. We hope you enjoy it.

    

   “If you are a smart and experienced investor you know there it always a ‘but’ somewhere.”

   — Joachim Klement

   “You need to have a margin of certainty and understand your odds of being wrong. Paraphrasing Warren Buffett, an opportunity has to be both important and knowable to be actionable.”

   — Preston McSwain

    

   This was part of an exchange that the two of us had on a call. The candid conversation about our shared investing experiences from different parts of the world was actionable — it sparked this joint post.

   Knowledge has never been fixed and we now live in a world where knowledge, and the sharing of it, is growing exponentially.

   In the investment world, this makes markets more competitive than ever. Information is shared freely and globally — often literally in microseconds. To have an edge, you need to be certain that you have better information than hundreds of thousands of extremely well-educated and well-resourced investment professionals from around the globe. Your margin of certainty needs to be high and is only growing higher.

    

   There is always a “but”

   If you are a smart and experienced investor, you know that no matter what you do, there is always a “but” somewhere. Every time an investor buys a stock, publicly or privately, somebody else must sell it to you — it is literally like an auction. The “but” is that when you buy, you just paid more for it than someone else thought it was worth.

   A level of uncertainty will always exist and analysis paralysis is a problem. Decisions need to be made and mistakes will be made.

   Over our investment careers, which both span over 30 years, we’ve just experienced this spin on an old Wall Street saying all too often: “Always confident but often wrong.”

   When making changes or trades, decisive action is important. The trick is to not become overconfident.

   Human nature being what it is, we tend to become more certain of our decision once we have made it. As with many things, this can put a person in a corner when investing – investors get anchored and cognitive dissonance can kick in.

    

   Trapped in a corner

   History is filled with investors getting trapped in a corner. As an example, earlier this year many realized that COIVD is important. Because of this, it’s importance, some investors took action to sell stocks to avoid what they thought would be a long-lasting bear market. The problem was that the length of the bear market, which was largely already well developed by the time many sold, was not knowable.

   Without fully understanding all the issues surrounding COVID, all areas of the economy that would be impacted by it, and how various segments of the market would trade, and for how long, did many sell too much in an effort to be avoid “certain” losses?

   I wonder how many investors who sold got trapped in a corner and never got back into the market — missing out on one of the largest positive runs in market history?

    

   Never be too certain

   When it comes to investing, being overconfident and reaching for a big upside win or downside protection save can be costly.

   Investing involves risk and we aren’t suggesting that you don’t keep your eyes open for rewarding opportunities.

   Just make sure you are never too certain you are right.

   Ask yourself, what can happen if I am wrong?

   Understand your margin of certainty. Don’t put yourself into a corner that you cannot get out of.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   How hard is it to find the next Amazon?

   Practitioners still pay too little attention to academia

   Stocks have lagged bonds since 1970. Why?

   No more room at the factor zoo

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

    

   FIND AN ADVISER

   The evidence is clear that you are far more likely to achieve your financial goals if you use an adviser and have a financial plan.

   That’s why we’re now offering a service called Find an Adviser.

   Wherever they are in the world, we will put TEBI readers in contact with an adviser in their area (or at least in their country) whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help them. If we don’t know of anyone suitable we will say.

   We’re charging advisers a small fee for each successful referral, which will help to fund future content.

   Need help? Click here.

    

    

3. How hard is it to find the next Amazon?

   October 25, 2020 6:30 am Comments Off on How hard is it to find the next Amazon?

    

   By JOACHIM KLEMENT

    

   I recently wrote about the research of Henrik Bessembinder, who investigates the extreme outliers in the US stock market, i.e. the 200 best and worst stocks by 10-year performance. Obviously, we all would love to find the next Amazon before it becomes the next Amazon, but we all know that this is nigh impossible. Or is it?

   Bessembinder concludes his series of papers on extreme stock performers with an analysis of typical characteristics that future top performers have. Looking at the best 200 and worst 200 stocks by decade should at least give us some hints at what to look for.

    

   The top performers

   For the future top performers, Bessembinder finds that these companies should invest in the future and come out of a difficult period with lots of drawdowns. Top performing companies in a decade have:

   — Invested more in R&D in the previous decade to fuel future growth (R&D investments to total assets of 4.8% for top firms vs. 2.8% for the average firm).

   — Experienced much larger drawdowns in the previous decade than the average firm (81% vs. 70%)

   Additionally, the future top performers tended to be younger companies with lots of growth possibilities. In other words, they were growth companies with a shaky past that had to learn their lessons from past failures and disappointments and invested heavily in research and development to create a superior product or service.

    

   The worst performers

   Meanwhile, the worst 200 stocks have had some different characteristics:

   — They were already unprofitable in the previous decade with a much lower income to asset ratio than the average firm (-10.1% vs. 1.1% for the average firm)

   — They had higher growth of intangible and other non-traditional assets on their balance sheet (19.6% in the prior decade vs. 8.6% for the average firm)

   — They were more leveraged at the beginning of the decade (debt-to-asset ratio of 58% vs. 50% for the average company)

   — They had already issued a lot of new equity to investors in the prior decade (new equity issuance to assets of 26% vs. 9% for the average firm)

   In other words, the worst stocks were over-leveraged, haven’t been profitable in a long time, and had lots of dubious assets on their balance sheet such as goodwill and intangible assets that are vulnerable to accounting restatements.

   Sounds easy, doesn’t it?

    

   But there’s a problem

   The problem is that the Bessembinder also notes that the characteristics he investigated only explained about 2% of the cross-section of returns over the subsequent decade. 98% of the differences in returns remained unexplained. And that means that while the criteria above can give you an indication of which company will do well in the long run, they are by no means a sure thing.

   Other factors and sheer luck will still play an important role in any company that wants to become the next Amazon.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   Practitioners still pay too little attention to academia

   Stocks have lagged bonds since 1970. Why?

   No more room at the factor zoo

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

   Is there a link between intelligence and performance?

   Wall and Main are two different streets

    

   WHAT NEXT?

   Here are some other recent articles on TEBI we think you might enjoy:

   A higher intelligence

   Does carry trading work?

   An investment lesson from the US election

   No one consistently picks the winners in advance

   Unique insight or common knowledge?

   Making sense of gold

   Three reasons why the index advantage will persist

   What investors can learn from Moneyball

    

   NEED AN ADVISER?

   If you need a financial adviser, we may be able to help.

   Wherever you are in the world, we will try to put you in contact with an adviser in your area whom we know personally, who shares our evidence-based investment philosophy and who we feel is best able to help you. If we don’t know of anyone suitable we will tell you.

   We’re charging advisers a small fee for each successful referral, which will help to fund future content.

   For compliance reasons, this service is currently unavailable to readers in the US.

   Click here and let’s get started.

    

    

4. Don’t aim too high

   September 30, 2020 4:49 pm Comments Off on Don’t aim too high

    

   Something we observe again and again is that the rules that usually apply in middle-class society simply don’t work in investing. Try hard? You’d be better off not trying at all. Be smarter than the rest? Actually, acknowledging how ignorant you are would stand you in better stead.

   What about aiming high? Well, it might help you climb the career ladder. But, as JOACHIM KLEMENT explains, it probably won’t give you an edge as an investor. In fact new research suggests that the bigger the returns you aim for, the lower the returns you actually receive are likely to be.

    

   I have been on the receiving end of so many management goal-setting exercises, my eyes glaze over whenever I see another CEO tout aspirational targets for companies in their earnings calls. Don’t get me wrong, goals are important to have and they should be stretch goals. A goal that is easily achievable isn’t motivating. But a goal that is too much of a stretch or too audacious (have you ever been subject of the BHAG, the Big Hairy Audacious Goal?) is counterproductive and can destroy performance.

    

   How ambitious should investors be?

   Let’s take a look at the evidence from investors. Investors tend to have return goals that are way too high to be realistically achievable in the long run. A study from the Catholic University in Louvain, Belgium, looked at the trading accounts and stated return goals of more than 4,000 retail investors between 2008 and 2012.

   About one third of these investors had a target return of 8% or more above inflation. Assuming a 2% inflation rate, that amounts to more than 10% average nominal returns. Another 41% had target returns of 5% to 7% above inflation. Given that a realistic assumption for the equity risk premium above inflation is somewhere around 3% to 7%, this means that three out of four retail investors try to achieve returns that can only be achieved with pure equity portfolios or riskier propositions. And if you think that this is just a reflection of the heavy losses, investors occurred in 2008 at the beginning of the study, then know that a 2016 study by Natixis of investors from 22 countries came up with an average required return of 9.5% above inflation. On average!

    

   The higher they aimed, the worse they did

   What the research found was that investors with a higher target return did miss their targets by a wider margin than investors with average target returns. And they did worse in terms of total return achieved. The group with the highest return targets did worse from 2008 to 2012 than investors with more moderate return targets.

   In a backtest, the researchers also showed that in the bull market before the crisis from 2006 to 2007, the performance of the more ambitious retail investors lagged the performance of less ambitious investors even more.

    

   The danger of falling behind

   Another study amongst CEOs of companies shows why more ambitious goals may lead to lower performance. Looking at the performance incentives of CEOs of the 750 largest US companies from 1998 to 2017 they found that CEOs on average stand to earn c. $4.2m more per year if they end up in the top 10% of their peer group. Of course, everyone wants to be in the top 10%, so CEOs constantly are compared to their peers. It turns out that if CEOs fall behind their peers, they crank up the risk of their business and financing activities.

   Relative to the best performing CEO in the peer group the worst performing CEO increases financial leverage, R&D spending and restructure the business to such an extent that stock price volatility increases in the aftermath by 18 percentage points and ROA volatility increases by 31 percentage points. This effect gets even more pronounced the closer to a potential payout of stock options the CEO gets. Unfortunately, that higher risk doesn’t pay off in general, so investors are typically left with more volatile but lower performing companies as a result of CEOs trying to meet stretch goals.

   So, the next time, some management guru talks about the BHAG of your company, just call BS and throw them out of the room. Unless of course it is your CEO, in which case, smile, nod and ignore the CEO the moment you leave the room. Both you and your company will be better off for it.

    

   JOACHIM KLEMENT is a London-based investment strategist. This article was first published on his blog, Klement on Investing.

   Joachim is a regular contributor to TEBI. Here are some of his most recent articles: 

   Practitioners still pay too little attention to academia

   Stocks have lagged bonds since 1970. Why?

   No more room at the factor zoo

   Boohoo teaches ESG investors a lesson

   Stop admiring your successful trades

   Is there a link between intelligence and performance?

   Wall and Main are two different streets

    

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