Loyal reader Kenneth MacDonald writes to ask for advice on investment books. I’m a fan of A Random Walk Down Wall Street, but the bottom line there is pretty simple–diversify, buy and hold, and avoid high fees. Ken is looking for “a more focused book on how to research stocks,” something that explains P/E ratios and other fundamentals that can be used to look for value. So to answer Ken I turned to two more knowledgeable investors:
Felix Salmon is also more of an index fund guy but for those willing to bear the risks he recommends the classics:
- The Intelligent Investor by Graham, Zweig and Buffett.
- Value Investing by Greenwald (frequent Stiglitz co-author) et al.
Bartley J. Madden has a wealth of experience in investing and is unusually analytical. He developed the cash-flow-return-on-investment valuation model which is widely used around the world today. His recommendations are:
- Equity Valuation edited by Viebig (“…an excellent overview of valuation models used by institutional
investors. The section written by David Holland and Tom Larsen is a
particularly useful and up-to-date technical explanation of the CFROI
model.”) - Driven: Business Strategy, Human Actions and the Creation of Wealth by Litman and Frigo (“…a very good job of linking business strategy to long-term levels and changes in stock prices.)
For an advanced treatment of the CFROI model I’d also recommend Bart’s own book Maximizing
Shareholder Value And The Greater Good (free download here). Readers?
Winning the Loser’s Game followed by The Intelligent Investor, followed by The Little Book that Beats the Market followed by re-reading them.
The key is to get excited about investing, then have the Efficient Marketers beat that emotion out of you rather than the almost efficient market beating it out of you.
“diversify, buy and hold, and avoid high fees”
Right…and for the last 10 (ten) years if you had been in a no-load mutual fund tracking the S&P 500 you would have earned…say, -3.5%? All while losing half of your money twice (00-02 and current market), yes that’s a great strategy.
It absolutely boggles the mind the obsession people have with picking stocks, no matter how intelligent and value oriented they are (a la Graham/Dodd/Buffet). You can *not* beat the market, you can only hope to profit from black swans or lose *less* than the next guy in downward trending markets.
The better path is (I believe) one of two ways: 90% in TIPS and 10% in wildly OTM options (a la Taleb) or spend some real time doing research on allocation research, where returns are really derived (ok, gosh, I know its the vol’ of returns that are mostly explained by asset allocation research, but c’mon).
Stephen Penman’s Financial Statement Analysis book explains an earnings, rather than cash flow, based approach to valuation (Full disclosure – he was my accounting teacher at UC Berkeley)
Chapter 20 of John Cochrane’s “Asset Pricing” is worth reading to shed some light on market efficiency.
Agree with Andrew, read anything by Joel Greenblatt.
For one that hasn’t been mentioned yet (at least as of when I type this), I would add Jeremy Siegel’s Stocks for the Long Run to the list – aside from the basic premise, it provides a really good survey of a lot of different investing theories, which gets better with every edition.
Dhando Investor
Anything by Greenwald or Greenblatt, any Green really
One up on Wall Street
i agree with a_c.
i advise to skim through random walk, buy your index funds, and get back to enjoying life.
To the sophisticated indexer, investing in equities is not about sticking your money into an S&P500 fund and forgetting about it.
Over the last ten years, while the S&P500 index saw a negative return of -3.2%, other segments of the equity market were showing a positive return. An index for emerging markets returned a bit more than 7% over the last ten years. REITS? 3.1%. Did your portfolio hold a little gold by owning a precious metals and mining fund? About 13%. Commodities like energy? 14%. Did you take advantage of the French/Fama research showing a risk premium in small-cap value funds? 3.2%.
And since these asset classes were often uncorrelated, or even negatively correlated, with the overall U.S. equity market, there would have been a small additional benefit by holding them together in a portfolio which was rebalanced annually.
An asset allocation that was 60/40, equity to U.S. government bonds, and which diversified the equity portion of the portfolio into international (including emerging markets), REITS, value stocks, as well as a small portion put into gold or commodities, would have done okay. Not great, mind you, but okay. You would have almost certainly at least kept up with inflation.
Authors who follow this approach (more or less) include Larry Swedroe, Rick Ferri, and William Bernstein.
Gotta put a good word in for Fred Schwed’s great book from long ago “Where Are The Customer’s Yachts?.” This should be basic reading for all. If only those Bernie Madoff clients had read this…
“Buy and hold” is more risky than buy and sell, and random walk is a counsel of despair.
The best for learning to read a balance sheet and cash flow statement:
Learn to Earn, Peter Lynch
Best on reading charts:
How Charts Can Help You in the Stock Market, William Jiler
Best on investing:
How To Invest Like a Shark, Rev Deporre
bjk,
“‘Buy and hold’ is more risky than buy and sell, and random walk is a counsel of despair.”
Wrong on both counts.
“Buy and hold” is a recognition by the investor that the market will go up over the long run and that market timing is a fool’s game.
Don’t believe me? Listen to Peter Lynch, the man whose book you recommend: “[Most investors] should buy, hold, and when the market goes down, add to it.”
Buy and hold of stocks at bubble peaks is a terrible investment — you can determine times to sell by looking at trailing P/E ratios and when they are excessively high shift to high quality bonds (or cash if you like). Wall Street should be tarred and feathered for the nonsense of buy-and-hold after the past 18 months — this will be especially clear when the S&P resumes its plunge and sets some more new lows later this year or early the next.
As for the “random walk” / efficient market hypothesis, I refute it thus.
Margin of Safety by Seth Klarman. It’s a framework for value investing. Exceedingly hard to find, but worth it as he makes unbelievable amounts of sense from simple observations (i.e., index funds are overvalued by nature – if a stock is added to an index, index funds have to buy it, thus driving the price above it’s fundamental value…leaving you with a portfolio of overvalued stocks).
I would counter “A Random Walk Down Wall Street” with “A Non-Random Walk Down Wall Street“, by Lo and MacKinlay.
bjk,
“The market will go up over the long term due to dividends, compounding, and inflation. Gold will go up over the long term too, I wouldn’t buy and hold gold. Stocks are an asset class just like gold.”
Gold is not an asset class like stocks. It is a commodity, and holding commodities will provide no real return over the long run. (See here. Over the last two hundred years, gold has barely beat inflation, while the value of stocks rocketed.) Gold should only be held as portfolio insurance for times like this, and even then I would suggest a more balanced commodity fund rather than just holding gold.
Pincher Martin,
No, I have plenty of evidence. I just didn’t give you any.
Warren Buffett offers plenty of evidence. His “Superinvestors of Graham and Doddsville” is fine. It in no way contradicts the idea that most people aren’t investors at all and should simply buy index funds and diversify.
You need to learn the difference between possible and probable.
“The fact that beating the market is a zero sum game.”
That means there are winners and losers. So, if half the people win, half lose, hey that’s 50/50. Sounds like chance to me. Good enough for an academic paper that goes along with current dogma. Nevermind that there might actually be better bettors and lesser bettors. Nevermind that stock trading is not necessarily even a zero sum game as commodity trading is.
Andrew,
“Warren Buffett offers plenty of evidence. His “Superinvestors of Graham and Doddsville” is fine. It in no way contradicts the idea that most people aren’t investors at all and should simply buy index funds and diversify.”
Buffett did not offer plenty of evidence. He offered nine funds in 1984. Buffett’s conceit is that the outliers consistently follow a value-based approach to investing that he also follows.
Buffett could not appreciate at the time he first made his speech (and wrote his subsequent article) the Fama-French research which would find a value and size premiums in the equity markets that outperformed the overall market, but which is also riskier than the overall market.
So the proper comparison for value investors is not with the returns of the total market, but with the risk-adjusted returns given the value and size premiums in their portfolios.
It’s ironic, given the name of Buffett’s article, that just before Benjamin Graham died, he had also come to believe that it wasn’t worthwhile trying to beat the market: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.”
*****
“You need to learn the difference between possible and probable.”
I’m well aware of the difference. What you don’t appear capable of understanding is that the probabilities have already been worked out, and responsible investors should take heed by indexing rather than chasing after the gold at the end of value rainbows.
Indexing is probably more active than Buffett and Buffett is more active than most. And inactivity isn’t the only blessing.
As for risk, that is the main thing Buffett debunks. Just because Fama and French added a fudge factor to their model to accommodate value out-performance doesn’t prove their original model. And just because you say that value stocks should be judged against value stocks because value stocks outperform based on simple metrics doesn’t impress.
Why do stocks outperform other assets? It is not because of risk. It is because of superior value creation. It is however because of risk that they aren’t already bid to the parity point. Same thing for individual stocks.
“The better path is (I believe) one of two ways: 90% in TIPS and 10% in wildly OTM options (a la Taleb) or spend some real time doing research on allocation research, where returns are really derived (ok, gosh, I know its the vol’ of returns that are mostly explained by asset allocation research, but c’mon).”
You have got to be kidding. Assuming 1yr options, this strategy will just lose you 10% of your money every single year. You’ll be bankrupt in no time. Wildly OTM options will simply expire every time out of the money. BTW, Taleb is a fucking pretentious idiot.
And you think stock-picking is bad. Ya…I mean Warren Buffet is only the 2nd richest man in the world.
I meant Buffett is more active than many if not most value investors. I believe what Buffett says about value investing, it is redundant.
You can’t say that value performance must be benchmarked against value on the upside, but must be benchmarked against all other active traders on the downside. I’m not talking about mutual funds here.
Buffett owns about 60 companies. I just have to buy Berkshire once. Sure, I just have to buy an index fund once, and there is little turnover there, but depending on the index fund there is reinvesting of dividends, adding and subtracting companies, etc. Inactivity is achieved in index funds by following the market swings, not always a virtue.
Perhaps my theory is just a theory, but I think the problem can exist today BECAUSE there are so many non-value-oriented traders and BECAUSE there are fundamental analysts who just value on earnings and dividends. It is possible to be a successful active trader BECAUSE you haven’t convinced all the others to be passive.
Intelligent Investor – Chapters 8 & 20
Margin of Safety by Seth Klarman – excellent philosophical framework
Value Investing by Bruce Greenwald – offers some technical fundamentals
Still amazed by the depth of “comments”…the investment boggles the mind….all I have to offer is that the width of a chariots wheels can still be seen in modern railroad track width.
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