The New Finance

1. The New Finance The Case Against Efficient Markets Second Edition byRobert A. HaugenPrentice Hall, 1999 visit our web-site haugensystems.com

2. THE FAMA & FRENCH STUDY* • Accepted theories of Modern Finance predict that differences in expected stock returns should be related only to differences in risk . • Fama & French find beta is unimportant • Instead, book-to-price appears as the most important. *(E. Fama and K. French, 1992, “The Cross-section of Expected Stock Returns,” Journal of Finance)

3. Book to Market as a Predictor of Return 25% 20% 15% Annualized Rate of Return 10% 5% 0% 1 2 3 4 5 6 7 8 9 10 High Book/Market Low Book/Market Value Growth

4. Diamond Head & Diamond Bar The difference between the returns to value and growth found by Fama & French is incredibly large.

5. The Roads to Diamond Bar and Diamond Head Cumulative Wealth $2,000,000 $1,500,000 $1,000,000 2.47% Return 15.18% Return $500,000 $0 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64

6. Moreover, Fama & French also find that value stocks actually have lower betas.

7. 1 0.9 0.8 Book to Market Equity 0.7 0.6 0.5 0.6 0.8 1 1.2 1.4 1.6 1.8 Beta Book to Market Equity of Portfolios Ranked by Beta

8. The Finance Profession Splits into Three Camps • Differences in expected returns are expected risk premiums. • CAPM out Efficient Markets still in (Fama & French). • Differences in expected returns are a surprise to investors. • CAPM and Efficient Markets are both out (Haugen). • Fama & French results are are an artifact of survival bias. • (Kothari, Shanken & Sloan).

9. Survival Bias The Compustat data base (used by Fama & French) was greatly expanded to cover 6000 companies in 1978. The histories of these companies were back-filled, but no companies were added that failed to survive through 1978.

10. The Three Foundations of Modern Finance • Portfolio Theory • The Tool • Invented in 1952 by Markowitz.

11. Expected Return 10% Risk Lowest Risk Portfolio With a 10% Return individual stocks

12. Expected Return Risk The Bullet The Efficient Set (Bullet)

13. The Three Foundations of Modern Finance • Portfolio Theory • The Tool • Invented in 1952 by Markowitz. • CAPM • The Theory • Invented in early ‘60s by Sharpe, Lintner, & Mossin.

14. Expected Return Us Risk Us on the Skin of The Bullet 10%

15. Market Index Expected Return Risk We all Make the Market Index

16. The Three Foundations of Modern Finance • Portfolio Theory • The Tool • Invented in 1952 by Markowitz. • CAPM • The Theory • Invented in early ‘60s by Sharpe, Lintner, & Mossin. • The Efficient Market Hypothesis • The Fantasy • Invented by Fama, also in the early ‘60s.

17. The Short and The Long Run • In theshort run: • All factors of production are fixed, including the amount of capital invested in a line of business. • Firms may earn positive or negative abnormal profits.

18. The Short and The Long Run • In the long run: • All factors are variable, including the amounts of capital invested by firms. • After competitive entry and exit, all firms in a competitive line of business earn normal profits. • Mean-reversion in firm profitability.

19. HowLongis the Short Run? • First clue offered by Jegadeesh & Titman’s* study of earnings surprises. • They rank stocks by performance in previous six months, and observe pattern of earnings surprises in subsequent months. *N. Jegadeesh & S. Titman, 1993, “Returns to Buying Winners and Selling Losers: Implications for Market Efficiency,” Journal of Finance

20. 1.0% 0.5% 0.0% Loser Portfolios 33 35 31 25 1 3 5 7 9 11 21 23 27 13 15 17 19 29 -0.5% -1.0% -1.5% Months Following 6 Month Performance Period Monthly Difference Between Winner and Loser Portfolios at Announcement Dates Monthly Difference Between Winner and

21. 5% 4% 3% 2% 1% Cumulative Difference Between Winner and Loser Portfolios 0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 -1% -2% -3% -4% -5% Cumulative Difference Between Winner and Loser Portfolios at Announcement Dates Months Following 6 Month Performance Period

22. Results are Confirmed by Return Volatility Estimates Measured Over Different Return Intervals • If returns are random, the variance of 5-day returns should be 5-times larger than the variance of 1-day returns. • With inertia patterns, variance more than 5-times larger.

23. Stock Value Inertia Wide Possible Range Inertia 0 1 2 Period Range of Possible Outcomes with Inertia and Reversal Patterns

24. 170% 160% 150% 140% Relative Volatility 130% 120% 110% Small 100% Medium 2 Firm 4 Large Size 8 16 Number of Weeks Used to Calculate Return Volatility Relative to a Series with no Reversals or Inertia

25. 5% 4% 3% 2% 1% Cumulative Difference Between Winner and Loser Portfolios 0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 -1% -2% -3% -4% -5% Cumulative Difference Between Winner and Loser Portfolios at Announcement Dates Months Following 6 Month Performance Period

26. Resultsare Confirmed by Return Volatility Estimates Measured Over Different Return Intervals • With reversal patterns, variance less than 5-times larger. • If returns are random, the variance of 5-day returns should be 5-times larger than the variance of 1-day returns. • With inertia patterns, variance more than 5-times larger.

27. Stock Value Inertia Reversal Wide Possible Range Reversal Inertia 0 1 2 Period Range of Possible Outcomes with Inertia and Reversal Patterns Narrow

28. 110% 105% 100% 95% Relative Volatility 90% 85% Japan Canada 80% U.K. 75% France 2 3 U.S. 4 5 Volatility Relative to a Series with no Reversals or Inertia Number of Years Used to Calculate Return

29. 5% 4% 3% 2% 1% Cumulative Difference Between Winner and Loser Portfolios 0% 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 -1% -2% -3% -4% -5% Cumulative Difference Between Winner and Loser Portfolios at Announcement Dates Months Following 6 Month Performance Period

30. Changing Investor Opinion as to the Length of the Short Run • Prior to 1924 • Stock valuation based on current normalized earnings.

31. Wall Street Journal February 26, 1924 “We cannot advise as to stocks which will appreciate in value, since it is contrary to our policy to give speculative advice.”

32. Changing Investor Opinion as to the Length of the Short Run • Prior to 1924 • Stock valuation based on current normalized earnings. • 1925 • E. L. Smith advises stock valuation based on future growth - New Era Theory.

33. Wall Street JournalJune 15, 1929 “It’s not so much what a company is earning now as what average earnings will be in years to come.”

34. Wall Street JournalMarch 8, 1929 “The younger minds are not troubled with past performance. They are looking into the future. We are looking into the past. We made a mistake and will have to admit it, as Mr. Schwab has done.”

35. Wall Street JournalAugust 7, 1929 “This change (in how stocks are valued) has brought common stocks into high favor with special emphasis on companies which have possibilities of continuous expansion over an indefinite period.”

36. Changing Investor Opinion as to the Length of the Short Run • Prior to 1924 • Stock valuation based on current normalized earnings. • 1925 • E. L. Smith advises stock valuation based on future growth - New Era Theory. • 1934 • Graham and Dodd dispute New Era Theory’s views on growth and valuation.

37. Security Analysis1934, p. 422 “The analyst’s philosophy must still compel him to base his investment valuation on an assumed earning power no larger than the company has already achieved in some year of normal business. Investment value can only be related to demonstrated performance.”

38. Changing Investor Opinion as to the Length of the Short Run • Prior to 1924 • Stock valuation based on current normalized earnings. • 1925 • E. L. Smith advises stock valuation based on future growth - New Era Theory. • 1934 • Graham and Dodd dispute New Era Theory’s views on growth and valuation. • 1960’s • Growth stock investing makes comeback.

39. M. Gordon, The Investment, Financing, and Valuation of the Corporation, 1962 “In our stock price model a future dividend expectation is what an investor buts. However, he is not considered so naïve as to assume that every future dividend is equal to the current dividend. He is interested in both the current dividend and its rate of growth.”

40. Changing Investor Opinion as to the Length of the Short Run • Prior to 1924 • Stock valuation based on current normalized earnings. • 1925 • E. L. Smith advises stock valuation based on future growth - New Era Theory. • 1934 • Graham and Dodd dispute New Era Theory’s views on growth and valuation. • 1960’s • Growth stock investing makes comeback. • 1962 • I.M.D. Little’s studies of “higgledly piggledly growth” casts doubt on New Era Theory.

41. I.M.D. Little, “Higgledly Piggledly Growth” 1962, p. 391 “My impression is that many stockholders, financial journalists, economists and investors believe that past growth behavior is some sort of guide to future growth. This belief seems to have developed especially in the past few years.”

42. How Long is the Short Run? • Do the earnings of fast growing firms continue to grow fast? • And for how long?

43. 250 1952 = 100 225 200 Fastest 175 150 125 Fast Average Earning Per Share by Quartile (1952=100) 100 Slow 75 50 Slowest 25 1956 1957 1958 1959 1952 = 100 Earnings Behavior For Fastest, Fast, Slow, and Slowest Growing Firms* *(1952-56)

44. 0-4 0-2 0-3 0-5 0-6 0-8 0-9 1-0 0 0-1 0-7 1-0 1-0 0-9 0-9 0-8 0-8 0-7 0-7 0-6 0-6 Industry Rank in the First Half of the 1950’s 0-5 0-5 0-4 0-4 0-3 0-3 0-2 0-2 0-1 0-1 0 0 0-4 0-2 0-3 0-5 0-6 0-8 0-9 1-0 0 0-1 0-7 Industry Rank in the Second Half of the 1950’s Consistency of Growth Relative to Other Firms in the Industry Source: Rayner, & Little, Higgledy Piggledy Growth Again, Basil Blackwell, Oxford, 1966.

45. Higgledy Piggledy Growth in America* • Do U.S. firms that have faster earnings growth in one 5-year period tend to grow faster in the next? • Earnings growth is measured based on the continuously compounded trend in earnings-per-share. *Lintner & Glauber

46. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 1.70% 0.21% 0% 0% 1951-55 with 1956-60 1956-60 with 1961-65 1946-50 with 1951-55 Period Percentage of Differential Earnings Growth in One 5-Year Period Associated with Earnings Growth in the Next Period Period Associated with Relative Growth in the First Percentage of Relative Growth in Second

47. Successive Years of Above or Below Average Earnings Growth* • Rank U.S. firms based on annual earnings growth. • Look for number of years in succession (runs) that a firm is above or below average. • Compare number of runs that actually appear with the number you would expect to see if being above or below average was merely a matter of chance. *Brealey, 1969

48. 1400 1200 1000 800 600 400 200 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Length of Run Actual Number of Runs of Good Years vs. 50-50 Odds 50-50 Odds Good Years Number of Runs Observed

49. 1400 1200 1000 800 600 400 200 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Length of Run Actual Number of Runs of Bad Years vs. 50-50 Odds 50-50 Odds Bad Years Number of Runs Observed

50. Do Stock Market Prices Accurately Reflect Prospects for Future Growth? • Rank roughly the 1000 largest U.S. stocks by earnings-to-price and form quintiles. • What is the earnings growth for each quintile (relative to quintile 3) in each of the eight years following the ranking? • Each quintile is formed to have the same industry composition. *Fuller, Huberts, & Levinson, 1993