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Markets: Outsized Returns
New York: September 26, 2005
By John R. Stephenson

Just what are the guideposts to successful investing? What do the experts know that you don't? Do certain sectors outperform others over the long haul? Or is it just a crapshoot where the luck of the draw determines your outcomes as much as anything else. If you listen to the academics in their ivory towers they will tell you that stock prices are efficient, meaning that all known information about a company is already priced in. In others words, why bother trying to game the system because sharper minds than your own have already figured out the true value of the stock — so what's the use in trying? If you can't beat the market then why not go out for a walk and plop your hard-earned dough in an index fund and forget about it. While that may be the path of least resistance, is it the path of greatest returns? Maybe.

But should you even buy stocks? Yes. Every academic study conducted on financial markets has shown that over any given twenty-year period — the stock market and most particularly high-quality dividend paying stocks, have outperformed the returns from real estate, bonds, gold and cash. If stocks outperform other assets that you could hold in your portfolio as a broad index, is it possible to improve upon the performance of the broad (S&P 500 etc.) averages?

Perhaps. New academic research has established that profitable trends do exist in the stock market that astute investors can capture. In fact, much of the past analytical work that assumed that markets were efficient was limited to some of the largest 1,000 stocks or so and made the erroneous assumption that the return distributions of various stocks were normally distributed. The truth? Returns have fat tails — in other words, profitable trends exist in the marketplace that can be exploited.

Not only do profitable trends exist, but also, research has shown that value investing outperforms growth investing. But what exactly is value investing? Value investing is an investment approach that seeks to find out of favor, neglected and downright cheap investments. This was first highlighted academically in a 1992 study released by Fama and French entitled,"The Cross Section of Expected Stock Returns." These researchers hypothesized that certain stocks become undervalued for a variety of reasons, such as an overall market decline or a specific industry falling out of favor. The result? The stocks in these companies or industries are cheap (low P/E ratio) relative to that of the broader market. While these value stocks have higher risk associated with them since they are under-followed by the broad market, the researchers concluded that they also offer higher expected investment returns.

These findings were further supported by a 1987 study entitled In Search of Excellence: The Investor's Viewpoint, where two types of companies were studied: Excellent (high profile growth companies) and Unexcellent Companies (value stocks). While the value companies were deemed riskier investments (greater volatility) they also produced higher investment returns.

Not only do investment returns tend to be stronger with value stocks, but Fama and French also discovered that investors can outperform the broader market (at least over long periods of time) by selecting a basket of small capitalization stocks. Again, risk and return figures prominently. Smaller, less widely followed companies that trade at a discount can offer investors substantial outsized returns — because ultimately some of them will become large well-followed companies. While the risks are higher to investors who invest in smaller less widely followed companies, the returns can be huge and can help to propel your portfolio beyond those of the broader stock market.

Of course, when investing in out of favor or smaller company universes it is always important to diversify. In fact, diversification is one of the bedrocks of investing. It makes no sense to throw your hard earned money away on a couple of stocks no matter how well chosen — the risks are just too great. The solution? Buy one of the many exchange traded funds ("ETFs") that provide a basket of either large capitalization (price times number of shares outstanding) value or small cap value stocks. Not only will you be well diversified, but by using ETFs, you will substantially lower your costs. The idea behind diversification — don't put all of your eggs in one basket.

While investing is simple to describe, it is hard to do in practice. The reason? We have to fight the urge to buy when everyone else is jumping on the bandwagon and sell while others are piling in. The secrets of the pros? Do your homework, diversify, look for trends to invest in before the herd and think about tilting your portfolio to include some value and some small cap value stocks.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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