Yesterday three American professors, Eugene Fama, Robert Shiller and Lars Peter Hansen, won the 2013 Nobel Prize in economics for their research on asset price movement.
The three don’t work together—to the contrary, they’ve actually developed some competing theories. One economist commented that the Nobel Prize committee’s decision to recognize all three in the same year was like “giving a prize to the Yankees and the Red Sox.” But all three have contributed to our understanding of how prices are determined for assets including houses and stocks.
Robert Shiller is one half of the namesake for the Case-Shiller Home Price Index. His work has chipped away at the efficient market hypothesis, arguing instead that asset prices are often irrational, and that this irrationality causes bubbles to develop.
Eugene Fama also contributed to a more nuanced understanding of the efficient market hypothesis. His work argues that stock prices are relatively unpredictable in the short term, and that value stocks and small-cap stocks are the best investments. His research data is often cited by Digest contributor John Buckingham of The Prudent Speculator.
The Prudent Speculator, which was founded by Al Frank, “follows an approach to investing that focuses on broadly diversified investments in undervalued stocks for their long-term appreciation potential.”
They hold 50 or more stocks, usually, explaining in their latest issue: “This expansive diversification, we find, potentially serves us well in two ways: we can further minimize the risk of individual stock ownership, while maximizing the likelihood of finding the truly big winners among the undervalued masses.”
Last year, I interviewed John Buckingham, editor of The Prudent Speculator and chief investment officer at Al Frank Asset Management, about their approach to value investing and stock selection. I thought now might be a good time to revisit the interview, given the influence Professor Fama has had on their system.
Here’s my interview with John Buckingham, from March 2012:
Chloe Lutts Jensen: Al Frank founded The Prudent Speculator in 1977—when did you join the team?
John Buckingham: I started part-time in February 1987 when I was a senior in college at the University of Southern California. After graduation a couple of months later, I came on board full time in May 1987. Over the next three years, I was able to work my way up the proverbial totem pole (Al Frank was a computer “geek” and I was a computer science major with knowledge of spreadsheets and databases, so we hit it off right away), eventually becoming Director of Research in 1989 and Chief Portfolio Manager in 1990.
CLJ: What has changed about The Prudent Speculator over the past 35 years? What has stayed the same?
JB: As I learned at the foot of one of America’s greatest value investors, much remains the same—I very much believe that a long-term-focused strategy based on planting and patiently harvesting a broadly diversified portfolio of undervalued stocks is the key to success in the equity markets. Sure, technology has allowed us to be more disciplined in our objective reviews of what constitutes a “value” stock, but the core premise that stocks that trade for inexpensive multiples of sales, earnings and book value will deliver the best long-term returns remains intact.
That said, since Al Frank’s passing in 2002, we have augmented our analytics by explicitly including dividends and the income they generate into our decision-making process. Market history shows that anywhere from 25% to 40% of total return has been derived from dividends, so we think that there is strong evidence to support their inclusion in the analytical framework.
Also, as many may be aware, Al Frank was a heavy user of margin leverage through the years. While this augmented his gains in the favorable periods, it smacked overall returns in 1987, 1990, 1998 and 2002. While I believe that a judicious use of margin (my upper bound is generally in the 25% range, meaning that a $100K equity portfolio might control $125K in stocks) is O.K. for some folks, and I have personally used a modest amount of leverage in years past in my own Buckingham Portfolio, we presently use no leverage in our newsletter portfolios, including Al Frank’s TPS Portfolio, which I still manage, and only a handful of our managed account clients choose to utilize the tool.
CLJ: Can you give us a brief explanation of the newsletter’s investing system or philosophy? How do you pick the stocks you recommend?
JB: As value investors, we seek to buy stocks that are on sale, similar to what most folks do in their everyday lives.
Whether it is a box of cereal, a washing machine or a new car, most of us prefer to pay as little as possible and we generally walk away if we think the price is too rich. On the other hand, the stock market, as the old adage goes, is the only place where they hold a sale and few people show up.
Though we find this puzzling, given that history shows value stocks outperform growth stocks, we are grateful that investors often overly punish companies for short-term transgressions while they drive ‘hot’ stocks to unreasonably high levels. It is this dynamic that allows us to implement our strategy as we are able to make a reasonable assessment of fair value based on a variety of historical valuation “norms” for each company, its sector and the overall market. When a stock is priced at a significant discount to that determination of fair value, we buy. When it approaches fair value or when we find another stock with much better reward to risk potential, we sell.
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CLJ: What’s one important piece of advice you think more investors need to know?
JB: I think investors would do well to understand the time horizon for each component of their investment portfolio, as that will allow them to use the proper measuring stick. Money that is needed to pay the bills, send Junior to college in the fall or even provide a one-or-more-year emergency “cash” cushion should be invested very conservatively, though yields on available instruments are microscopic today.
Assets earmarked for retirement or with at least a three-to-five-year time horizon can be invested, in my view, in more volatile instruments including the stock market.
Unfortunately, the 24/7 media coverage of the equity markets and smart phone access to tick-by-tick portfolio valuations make it difficult to focus on the long term, which often leads to a much more conservative stance too early in life. Consider that depending on the “lens” used, 2011 was either an extremely volatile market year (there were 7% daily moves up and down in August, for crying out loud), or one of the least volatile years (the S&P 500 was virtually flat for the full year).
Remember that retirement funds may need to last 20 years or longer, so what happens in a day, week or even month in the stock market, should not cause one to deviate from a long-term investment plan.
CLJ: What do you see as the biggest challenge in the market right now?
JB: Fickle investor psychology is probably the biggest risk to stocks. We’ve seen markets suffer significant (though temporary) declines in recent years as “group-think” has never been more prevalent and risk-mitigation has become the most important tenet for many investment professionals. This has exaggerated moves to the downside, though it has created fantastic entry points!
CLJ: Let us get to know you better–what else do you like to do besides investing?
JB: I am truly fortunate to be able to say that my occupation is my avocation, but I enjoy playing basketball, travelling and spending time with my family, in addition to following the exploits of my beloved Minnesota Twins baseball team.
CLJ: Thanks to John Buckingham for taking the time to talk to us today!
I’m a firm believer in finding the investing system that’s right for you. I don’t think any one system has a monopoly on making money. But I do like Buckingham’s system for its firm grounding in research, including Eugene Fama’s data on the long-term performance of different types of stocks. If long-term, well-diversified value investing is your cup of tea, it’s a very well thought out system. (If you don’t know what kind of investor you are, there’s a quick quiz on the Cabot website that can help you figure it out.)
Wishing you success in your investing and beyond,
Chloe Lutts Jensen
Editor of Investment of the Week
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