Keys to Investment Success

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Keys to Investment Success

  1. 1. Keys to Investment Success Lowell D. Pratt Jr., CFA President, The Burney Company
  2. 2. Jack Burney <ul><li>Founded The Burney Company in 1974 </li></ul><ul><ul><li>West Point Class of ’46, retired General officer </li></ul></ul><ul><ul><li>Developed Proprietary, Quantitative Analytical Process in 1950s </li></ul></ul><ul><ul><ul><li>West Point issued slide-rule was the state-of-the-art computing device for several decades </li></ul></ul></ul><ul><li>17.9% average annualized rate of return since inception </li></ul>
  3. 3. $133 v. $42 after 30 years…
  4. 4. How Were Returns Created? <ul><li>By Consistently Playing Winning Bets </li></ul><ul><li>Asset Allocation </li></ul><ul><ul><li>Stocks v. Bonds </li></ul></ul><ul><li>Size and Style Allocation </li></ul><ul><ul><li>Historically, Small-Cap and Value </li></ul></ul><ul><li>Stock Selection </li></ul><ul><ul><li>More opportunity than many believe </li></ul></ul>
  5. 5. Stock Return Advantage vs. Bonds <ul><li>From 1950 to 2002, stocks have nearly twice the return (11.8% vs. 6.2%) </li></ul><ul><ul><li>Higher stock returns compensate for greater Short-Term Risk </li></ul></ul><ul><ul><ul><li>Defined as either Volatility or Worst-Case Return </li></ul></ul></ul><ul><ul><li>But, Stocks are not necessarily Riskier </li></ul></ul><ul><ul><ul><li>Depends upon Investment Time Horizon </li></ul></ul></ul>
  6. 6. Stock and Bond “Risk” v. Time <ul><li>Volatility is conventional definition of “Risk”, but Worst-Case Return is arguably better </li></ul><ul><ul><ul><li>Stocks clearly riskier than Bonds in short run </li></ul></ul></ul><ul><ul><ul><li>Stock/Bond risk fairly comparable in the mid run </li></ul></ul></ul><ul><ul><ul><li>Stocks less risky than Bonds in the long run </li></ul></ul></ul>
  7. 7. What’s a Share of Stock Worth? <ul><li>Two “Right” answers </li></ul><ul><ul><li>What someone else will pay </li></ul></ul><ul><ul><ul><li>Dominant during Bubbles </li></ul></ul></ul><ul><ul><ul><li>Less popular during subsequent Bubble-Bursts </li></ul></ul></ul><ul><ul><li>The value of an anticipated earnings stream discounted to the present </li></ul></ul><ul><ul><ul><li>Discount rate determined by prevailing interest rates plus an equity risk premium (ERP) </li></ul></ul></ul>
  8. 8. Valuation Math <ul><li>What Investors really “Buy” </li></ul>
  9. 9. Why do Stocks Return 12%? <ul><li>Long-Term Equity Returns Predetermined by Market’s Equity Discount Rate </li></ul><ul><ul><li>Composed of two parts: </li></ul></ul><ul><ul><ul><li>Long-term Treasury rate </li></ul></ul></ul><ul><ul><ul><li>Plus Equity Risk Premium (ERP) </li></ul></ul></ul><ul><li>Historically, Discount Rate averages about 12% </li></ul><ul><ul><li>Currently 11.7% </li></ul></ul><ul><ul><li>Use this to forecast future equity returns </li></ul></ul>
  10. 10. Price vs. Fundamental Worth
  11. 11. Fundamental’s Importance <ul><li>Observed price largely fundamentally determined </li></ul><ul><ul><li>S&P 500 P/V range past 10 years </li></ul></ul><ul><ul><ul><li>Low 0.62 (Sep02) </li></ul></ul></ul><ul><ul><ul><li>High 1.32 (Mar98) </li></ul></ul></ul><ul><ul><ul><li>Average 1.01 </li></ul></ul></ul><ul><li>Price Change v. Fundamental Worth Change </li></ul><ul><ul><li>R-Square </li></ul></ul><ul><ul><ul><li>1-mo 1% </li></ul></ul></ul><ul><ul><ul><li>3-mo 8% </li></ul></ul></ul><ul><ul><ul><li>12-mo 45% </li></ul></ul></ul><ul><ul><ul><li>36-mo 87% </li></ul></ul></ul>
  12. 12. Enduring Insight <ul><li>&quot;In the short run, the stock market is a voting machine. In the long run, the stock market is a weighing machine.&quot; </li></ul><ul><li>- Benjamin Graham </li></ul><ul><li>Circa 1930s </li></ul>
  13. 13. “ Is Now a Good Time to Invest in Stocks?” <ul><li>Answer ALWAYS the same: </li></ul><ul><ul><li>Long-term Investors – Yes </li></ul></ul><ul><ul><li>Short-term Investors – No </li></ul></ul><ul><ul><li>Market Timers – ABSOLUTELY NOT! </li></ul></ul><ul><li>Market Timing is Ultimate Losers Game </li></ul><ul><ul><li>Invest consistently in stocks, or not at all </li></ul></ul>
  14. 14. “The Market” Doesn’t Exist <ul><li>Stock Market Highly Segmented </li></ul><ul><ul><li>Big v. Small </li></ul></ul><ul><ul><li>Value v. Growth </li></ul></ul><ul><ul><li>Sector: Tech v. Financial </li></ul></ul><ul><ul><li>Industry: Computer Software v. Hardware </li></ul></ul><ul><li>EVERY index is biased, so no good single market gauge exists </li></ul>
  15. 15. Importance of Size and Style <ul><li>William F. Sharpe </li></ul><ul><ul><li>“ Asset Allocation: Management Style and Performance Measurements”, Journal of Portfolio Management , Winter ’92 </li></ul></ul><ul><ul><li>Size and Style, assuming broad Sector/Industry diversification, explain 85-90% of portfolio returns </li></ul></ul><ul><li>Sector diversification is a key assumption and therefore a 3 rd critical determinant of return </li></ul>
  16. 16. Size Relative Returns - Monthly
  17. 17. Size Relative Returns – 3-Year
  18. 18. Style Relative Returns - Monthly
  19. 19. Style Relative Returns – 12-month
  20. 20. The Power of Size and Style
  21. 21. Stock Selection’s Role <ul><li>NEVER FORGET : </li></ul><ul><ul><li>Size, Style and Sector account for 90% of equity return, so only 10% is leftover </li></ul></ul><ul><li>Objective is Marginal Return Enhancement </li></ul><ul><ul><li>Always treat Stock Selection as the minor variable of return that it is </li></ul></ul>
  22. 22. Burney Stock Selection Process <ul><li>Periodically “correlate” a factor library numbering over 1,000 (constantly growing) </li></ul><ul><ul><li>Proprietary process addresses the question: “Which factors best separate strong and poor performing stocks within like industry groups?” </li></ul></ul><ul><ul><li>Models built with 50 most meaningful, most dissimilar factors </li></ul></ul>
  23. 23. Stock Selection “Finds” <ul><li>Factor composites often better than the parts </li></ul><ul><ul><ul><li>GARP – Growth at a Reasonable Price </li></ul></ul></ul><ul><ul><ul><li>PARP – Profitability at a Reasonable Price </li></ul></ul></ul><ul><ul><ul><li>SARP – Safety at a Reasonable Price </li></ul></ul></ul><ul><li>Stock Risk not priced “efficiently” </li></ul><ul><ul><ul><li>Defined as poor profitability or financial weakness </li></ul></ul></ul><ul><ul><ul><li>Greater Risk should provide excess return, but delivers the opposite instead </li></ul></ul></ul>
  24. 24. Stock Selection “Chaos”
  25. 25. “Chaos” to Portfolio Order
  26. 26. Stock Selection “Don’ts” <ul><li>View each stock separately </li></ul><ul><ul><ul><li>Complementary parts of a portfolio </li></ul></ul></ul><ul><li>Chase Speculative Stocks </li></ul><ul><ul><ul><li>Poor quality and/or earnings </li></ul></ul></ul><ul><li>Inadvertently make Size or Style bets </li></ul><ul><ul><ul><li>Make them knowingly </li></ul></ul></ul><ul><li>Invest casually </li></ul><ul><ul><ul><li>A cutthroat business, requires vigilance </li></ul></ul></ul>
  27. 27. Summary <ul><li>Stocks Rule and Bonds Drool! </li></ul><ul><ul><li>Stocks are NOT riskier than bonds in the long run, just higher returning </li></ul></ul><ul><li>Emotion dominates stock-pricing in the short run </li></ul><ul><ul><li>ERP gauge of market’s emotional state </li></ul></ul><ul><li>Fundamentals dominate long-term stock-pricing </li></ul><ul><ul><li>Equity Discount Rate predetermines rate of return </li></ul></ul><ul><li>Size and Style are the key performance drivers </li></ul><ul><ul><li>90% variables of equity return </li></ul></ul>
  28. 28. The Possibilities…

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