I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

• Beta is not a stable parameter; also, it does not measure risk well.
• Company-specific risk is significant, and varies a great deal.  The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?  They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.  If less scientific, it was probably more accurate than MPT.  Science is often ill-applied to what may be an art.  Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems.  They are true in fair weather, but not in foul weather.  The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.  The cost of financing assets goes up dramatically when a company needs financing in bad times.

Read the full post here

Eugene Fama said that in order to test whether markets were efficient in this sense you needed an economic theory of how prices were determined. He chose the Capital Asset Pricing Model, devised a few years before by Jack Treynor, Bill Sharpe and John Lintner. It said risky stocks would outperform less-risky ones, with the risk that mattered being something called beta—the correlation of a stock’s movements to those of the overall market.

Roll started pointing out issues with CAPM in the 1970s, and Fama and French concluded in 1992 that the conjunction of CAPM and the EMH simply didn’t match the data. They chose to jettison CAPM, not the EMH (Fischer Black made more or less the opposite choice). But without an economic theory of how stock prices should move, there’s no way of testing the claim that markets are efficient in the “price is right” sense. Pricing models like the arbitrage pricing theory or the Fama-French factor models simply assume that prices are right, then extrapolate from that what the relevant risk factors must be that determine prices. But this assumption that prices are right is now based on no empirical evidence at all. In fact, both Fama and Roll have said that there’s just no way to tell whether prices are right or not.

That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects. But if “we can’t tell where the markets are going” was all the finance professors had to offer, they wouldn’t have had much influence.

The price-is-right combo of EMH and CAPM allowed finance professors to say much more than “we dunno.” They may not have known exactly where a stock’s price was headed, but thanks to CAPM they could confidently predict the bounds within which it would move. Thus armed they went on to conquer the world, eventually transforming MBA curricula, legal thinking, corporate governance, financial regulation and many aspects of investment practice. It’s admirable that finance scholars—especially Fama, since it was his theory in the first place—kept sniffing around and eventually concluded that the EMH/CAPM combo didn’t match the evidence. It’s not so great that some of them now pretend that the price-is-right version of the efficient market hypothesis never existed, and fail to fully confront what its demise means for a lot of the other things taught in finance and investment classes.

Read the full post here

As anyone who has taken Finance 101 knows, there are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Yet although efficient market theory is not true, it may nevertheless be illuminating. The absurdities of rational expectations come from the physics envy of many economists, who mistake occasional insights for universal truths. Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

…The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Yet if reality were shaped by beliefs about the world, not only would we need to investigate how beliefs are formed and influenced – something economists do not want to do – but models and predictions would be contingent on these beliefs. Of course, models and predictions are so contingent, and an understanding of how beliefs form is indispensable. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies. The future of investing – and economics – lies in that more eclectic vision.

Read the full article here

Further reading: Culture and Prosperity: Why Some Nations Are Rich but Most Remain Poor

One of the tenets of modern portfolio management most damaged due to the financial crisis has been asset allocation.  We have discussed how during a bear market correlations tend to one, the myth of the all-weather portfolio and how investors may need a more dynamic approach to asset allocation.  It seems we are not alone in our opinion(s).

Noted finance professor Andrew Lo of MIT has a piece in the Financial Times discussing how the practice of portfolio management has been upturned in part due to the financial crisis – asset allocation included.  While we recommend you read the entire piece, the bottom line is that the investment world is now much more complicated post-crisis.  Lo writes:

Diversification is still a good idea, but it has become much harder to achieve. Thanks to the increasing competition for additional yield, every type of investment vehicle and strategy has experienced substantial growth in assets under management.

The asset classes (and dynamic) strategies that have been touted as portfolio diversifiers have seen an influx of capital and managers.  Lo cites the case of the “carry trade” that has become popular enough to have spawned an ETF that follows the strategy.

Read the full post here

For quite some time now financial advisers of all stripes have been in search of the elusive “all-weather portfolio.”  That is, an asset allocation that serves to protect investors in bad times (bear markets) and performs well in good times (bull markets).  Does an all-weather portfolio really exist?

Prior to the economic crisis many would have answered in the affirmative and would have pointed to the large university endowment funds as examples of investors who had achieved this goal.  However the aftermath of the credit crisis and ensuing bear market indicate these funds have failed to achieve this goal.

Maybe it isn’t that case that asset allocation models are broken.  It may simply be the case that we are asking too much of asset allocation as a discipline.  In what other investing endeavor do we expect to have the best of all possible worlds?

Read the full article here

Broker stock picks can help investors outperform most mutual funds, research by one of the largest hedge funds has suggested.

While most asset managers have long dismissed analysts’ recommendations as anything but reliable, traders and academics at GLG – the $21.5bn London hedge fund manager – have found otherwise.

Based on a database of the daily recommendations it received from European brokers for the past four years, the hedge fund found that a portfolio following analysts’ tips, and holding them for three months, would outperform 75 per cent of mutual funds.

Such a portfolio delivered annualised returns of between 2.8 per cent and 6.4 per cent above benchmarks and after fees in each of those four years.

GLG said the research was some of the first to be conducted into the value of equity analysts’ calls since the scandals and subsequent reforms that rocked brokerages after the telecoms and tech bubble.

“When you look at the returns the average active manager tries to beat benchmarks by, we think the outperformance of recommendations is reasonably good,” said Sandy Rattray, an asset manager at the fund.

GLG’s findings were based on all the recommendations from salespeople at a range of European brokerages it had received since 2005, based on a single daily “pick” given to the fund from each.

Read the full story here

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

Over the next few pages we’re going to take you on a journey through the academic battles that have brought us to this point. This is FORTUNE’s annual Investor Guide, not The Chronicle of Higher Education, so we wouldn’t tell this story if we didn’t think it had relevance for investors battered by the experience of the past few years. The message that the behavioral finance guys have for investors is that yes, you can beat the market, but–for reasons that are essential to the whole behavioralist case–you almost certainly won’t. As a result, they end up offering much of the same investment advice that the efficient markets folks do. Only this time we might actually listen.

Gene Fama, it must be said, doesn’t buy any of this. It’s a cold, gray mid-autumn day in Chicago, but Fama is wearing a loud shirt with too-short sleeves that prove him to be probably the buffest 63-year-old finance professor on the planet. With the hint of a Boston accent that remains after two-thirds of a lifetime in Chicago, he’s talking the academic version of trash. “I don’t know that it’s progressed much beyond the level of curiosity items,” Fama says of the research done by the behavioralists. “They’ve got lots of interesting curiosity items.”

For years Fama was more than tolerant of this search for “curiosity items.” Unlike his longtime Chicago colleague Merton Miller, who saw the behavioralists’ work as an ideological assault on free markets (Miller died in 2000), Fama always encouraged empirical research, even research that revealed seemingly inefficient market behavior. In a 1991 sequel to his famous “Efficient Capital Markets” paper of 1969, he acknowledged that reality had in fact turned out a lot messier than he and other efficient-markets theorists had envisioned–although not so messy that the theories couldn’t accommodate it.

In 1997, though, Fama wrote still another paper, one that argued that a lot of the purported market anomalies discovered by the behavioralists were due to bad statistical work, and that the behavioralists’ attempts at building a theoretical alternative to the efficient-markets hypothesis had so far been “embarrassing.” The paper was something of a sensation–until interest in the D.C.-area sniper sent a piece called “Multiple-Victim Public Shootings” to the top of the charts in October, it was the most downloaded work in the almost six-year history of the Social Science Research Network, a leading academic website. Fama had no problem with behavioral finance as a critique of efficient-markets theory. But he thinks it’s a disaster as a replacement. “I don’t know what asset pricing would look like in a world that really took behavioral finance seriously,” he says. “If you really think prices are incorrect, what are you going to tell me about the cost of capital?”

We’ll get back to that question. But first let us document the behavioralists’ triumph. Half of this year’s economics Nobel went to their patron saint, Princeton psychologist Daniel Kahneman (the other half went to Vernon Smith of George Mason, whose economic experiments have also shot holes in efficient-markets dogma). Then there’s the John Bates Clark Medal, awarded by the American Economic Association every two years to the most important U.S. economist under 40: The 1999 and 2001 editions both went to behavioralists. On the pop-culture front, Yale efficient-markets skeptic Robert Shiller’s 2000 bestseller Irrational Exuberance was the most talked-about book by an economist in years.

The most dramatic development of all, though, may be that the office directly below Fama’s at Chicago’s Graduate School of Business now belongs to behavioralist pioneer Richard Thaler, 57. A magazine profile last year characterized Thaler, to the undying amusement of his students, as “thick-set,” but that’s not quite fair. He is not the jock that his upstairs neighbor is–Fama beats him at tennis. But Thaler, who arrived in Chicago in 1995 after years in the relative academic wilderness of Cornell University, appears to have eclipsed Fama as the most influential faculty member at the business school that has had more influence on the study of finance than any other.

For decades the University of Chicago was the temple for those who believed that markets always got things right. Thaler’s intellectual journey, in fact, began in the early 1970s on a campus that followed Chicago’s example to almost absurd lengths: the University of Rochester. “I can remember my professors yelling, ‘The price is right! The price is right!’” recalls Dartmouth finance professor Kenneth French, who arrived at Rochester just after Thaler left. “It was like a bad game show.”

Rochester was an extreme version of the direction the entire economics profession–not just its finance offshoot–had taken. The idea that economic activity can be explained as rational individuals trying to maximize their wealth goes back at least to 18th-century Scotsman Adam Smith, and the thought that all this was best expressed mathematically occurred to economists as long ago as the 1870s. But the approach didn’t really take off until the 1947 publication of MIT professor Paul Samuelson’s Foundations of Economic Analyses, which recast the principles of economics in the language of Newtonian calculus. The mathematization of economics that followed swept all before it. While academic economics had previously allowed room for multiple streams of thought, it took just a couple of decades before mathematical models built on the assumption of rationality were the only game on campus.

One of the most compelling of those models, and the one that seemed most closely to fit real-world data, was the efficient-markets hypothesis. It had its roots in empirical research that appeared to show stocks moving in a random walk–albeit with an upward trajectory determined by rising corporate earnings. The theoretical explanation, first proffered by Samuelson in 1965 and soon elaborated by Fama (who got his Ph.D. at Chicago in 1964) and others, was that stock prices fluctuate randomly because all knowable information about the value of a stock is already discounted in the price. That is, prices change only in reaction to news, which is by definition unpredictable.

For this view of price movements to work, the market has to behave rationally. That doesn’t mean every last investor has to be rational; it’s enough to assume that the hordes of irrational investors are irrational in different ways, thus canceling each other out. Or failing that–and here the theory begins to wobble–rational investors would be able to take advantage of the market’s temporary insanity to make a killing and push prices to where they belong.

That brings us back to Thaler, who was working on a Ph.D. in economics at Rochester in the early 1970s. His dissertation was an attempt to put a value on human life by looking at how much more people were paid to work in risky fields like mining and logging. He was working on the assumption, of course, that people rationally weighed the risk of death in their decision to accept a job.

Along the way Thaler decided to ask a few friends how much they’d be willing to pay to eliminate a one-in-1,000 chance of immediate death and how much they would have to be paid to willingly accept an extra one-in-1,000 chance of immediate death. What he found was that they wouldn’t pay much for the extra margin of safety but demanded huge sums to accept added risk–which isn’t, strictly speaking, rational. “I came to two conclusions about these answers,” Thaler wrote years later. “(1) I had better get back to running regressions if I want to graduate, and (2) the disparity between buying and selling prices was very interesting.”

Thaler did discuss his subversive thoughts with a few trusted colleagues and people from other disciplines. One of those people happened to be a newly minted psychology Ph.D., who sent Thaler a copy of a 1974 article by Israeli psychology professors Amos Tversky and Daniel Kahneman. (Tversky died in 1996; if he were still around, he surely would have shared in this year’s Nobel.) The article argued that in making decisions involving probability and risk, people rely on mental shortcuts that “are highly economical and usually effective but … lead to systematic and predictable errors.”

It was that last part that was so significant. That people make judgment errors wasn’t news, but if those errors were “systematic and predictable,” well, that was something an equation-wielding economist could get up and run with. (And making decisions involving probability and risk is what investing is all about, although Thaler wasn’t really thinking about that at the time.) Thaler wangled a short-term research gig at Stanford University when Tversky and Kahneman were visiting professors there in 1978 and ended up staying for 15 months. Then he played a key role in unleashing Tversky and Kahneman’s ideas on the economics profession.

The profession did not immediately respond with great enthusiasm. But over the years Thaler began to collect a few allies. Some were economists who shared his fascination with psychology. Others were number-crunching finance professors who had stumbled across seemingly irrational market phenomena–from short-lived ones like the “January effect” of rising stock prices in the first weeks of the year, which disappeared not long after people started writing about it, to the persistent tendency of “value” stocks with low price-to-book ratios to outperform the market. Throughout the 1980s the ranks of the doubters grew, but they remained a fringe element.

The efficient-markets guys, meanwhile, not only had come to occupy the academic mainstream but also had moved in on Wall Street. Not surprisingly, their initial relations with the Street had been hostile. What the professors were saying, after all, was that highly paid fund managers and analysts were not worth a dime. Some of the professors clearly reveled in that: In one famous mid-1960s exchange, a money manager asked MIT’s Paul Cootner, “If you’re so smart, why aren’t you rich?” To which Cootner replied, “If you’re so rich, why aren’t you smart?”

The answer to that second question was that people on Wall Street didn’t have to be smart to get rich, since they could make money off fees and brokerage commissions even when their market calls stank. But the devastating bear market of the 1970s caused some investors to question whether the people with whom they’d entrusted their money really were worth the expense. One logical result of such thinking was the index fund, which instead of trying to outsmart the market simply tried to imitate it while charging much lower fees than actively managed funds do. The first index fund for institutional investors was started in 1971 by Wells Fargo Investment Advisors (now Barclays Global Investors) in San Francisco. The first such fund for retail investors–the Vanguard Index Trust–was launched five years later.

Meanwhile a few finance scholars of a more diplomatic bent than Cootner began spreading their ideas of risk and return in the real world. Princeton economist Burton Malkiel’s A Random Walk Down Wall Street, published in 1973, probably played the biggest role in bringing efficient-markets thinking to the retail investing masses. But on Wall Street itself, the most important messenger was William Sharpe.

Sharpe, now 68, grew up in Southern California and learned his economics at UCLA. He was of the efficient-markets school, but his work (for which he won the economics Nobel in 1990) appealed even to those who still hoped to beat the market. In an efficient market the only way to outperform the market is to take on more risk. Sharpe devised a simple measure of risk based on past volatility, called “beta,” that could be used to build balanced portfolios–and to measure whether active money managers were actually beating the market or just taking on extra risk.

Sharpe wasn’t content to make his point merely in academic journals. He wrote textbooks on investments and finance and did so much consulting for Wall Street firms and pension funds that he gave up full-time teaching at Stanford in the mid-1980s. In 1996 he even launched a dot-com, Financial Engines, to make his advice available to small investors. So while Sharpe believes in efficient markets, he has also spent much of his career helping investors make choices. That, it turns out, makes him a big fan of behavioral finance. “As a practical matter, I still think it’s prudent to assume that the market is pretty close to efficient in terms of pricing and risk and return and all that,” Sharpe says. “On the other hand, we’ve certainly learned from cognitive psychology that ordinary human beings need to have alternatives framed in ways that can help them make right decisions rather than wrong decisions.”

Most of the wrong decisions investors make, behavioral research has shown, stem from overconfidence. That is, we think we know more than we do. We trade too much, we don’t diversify enough, and we extrapolate from the recent past to make assumptions about what will happen next.

As a result, much of what the behavioralists have to offer in terms of advice has to do with protecting retail investors from themselves. That’s why Thaler spends a lot of his time thinking about how best to design 401(k) plans. It’s why Sharpe incorporates behavioralist research into the advice Financial Engines doles out. And it’s almost certainly why Daniel Kahneman, when asked by a CNBC anchorman the day after his Nobel was announced in October what investment tips he had for viewers, responded, “Buy and hold.”

When I recount Kahneman’s words a few weeks later to Fama, he reacts with glee. “That means I won!” he shouts. It is, on one level, an absurd claim. The behavioralists are now clearly the dominant stream in academic finance, having made the leap from outsider status during the 1990s as a new generation of professors rose to positions of prominence. But the real-world phenomenon that cemented the behavioralists’ victory also illustrates why, when it comes to actual investing advice, they sound so much like Fama and Sharpe.

That real-world phenomenon was the stock market bubble of the late 1990s. According to strict efficient-markets thinking, there must be a rational explanation for what happened. Fama describes those sky-high Internet stock valuations as a risky but not crazy bet that one or two of those money-losing Net companies would end up as big as Microsoft. But he’s almost all alone on this one. “We have just lived through the biggest bubble of all time,” says Malkiel, who now calls himself a “random walker with a crutch.” Fama’s favorite collaborator, Dartmouth’s French, is on the verge of using the b-word as well when he stops himself. “I work very closely with Gene,” he says. “He would be very upset if I used that word in print.”

Yale economist Robert Shiller has no such compunctions about ticking off Gene Fama. In 1984 he declared that the logical leap from observing that stock price movements were unpredictable to concluding that the prices are in fact right “represents one of the most remarkable errors in the history of economic thought.” That was Shiller’s first brush with fame. He got more popular attention after the 1987 stock market crash, which the efficient-markets professors had trouble explaining. (“It’s weird,” Sharpe told a reporter at the time. Later his mother called to berate him: “Fifteen years of education, three advanced degrees, and all you can say is, ‘It’s weird’?”)

Shiller is 56 and did his economics training under Samuelson at MIT. He and Thaler have long been allies, but Shiller seems less interested than many of the other behavioralists in assembling the cognitive-psychology building blocks of a market bubble (which would involve that persistent flaw of extrapolating from the recent past to make assumptions about what will happen next). Instead he’s perfectly willing to accept at face value the conventional wisdom that markets are sometimes taken over by fads and mass hysterias. By the mid-1990s Shiller had become convinced that we were entering into one of those mass hysterias. His evidence was straightforward: Price/earn-ings ratios were really high. He began sounding the alarm wherever he could, including the offices of the Federal Reserve Board. Then he wrote Irrational Exuberance, which hit bookstores in March 2000, just as the market peaked.

The book’s perfect timing was dumb luck, Shiller himself says. And while he took most of his own money out of the stock market in the 1990s, his advice to investors now is to “diversify completely” and not try to beat the market. This happens to be what Sharpe would tell you. Or Fama. Or Thaler. The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile. In answer to Fama’s question of how they plan to calculate the cost of capital in a world where prices are incorrect, the behavioralists say that for the purposes of such calculations, they’ll just assume that prices are right.

But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market’s inefficiency to spend their careers trying to beat it. Behavioralist theory, of course, has no problem accommodating the belief that some investors can beat the market. In fact, several behavioralist professors, Thaler included, have money-management firms that try to take advantage of the anomalies they discover in their research.

But there’s a limit to the riches that can be dredged from market anomalies. That’s because “markets can remain irrational longer than you can remain solvent.” This aphorism is usually attributed to economist and speculator John Maynard Keynes, and there are those who contend that the whole of the behavioralist case is contained in chapter 12 of Keynes’s 1936 General Theory, with its wonderful depiction of investing as a game of musical chairs. But the argument of modern behavioralists includes a crucial observation that wasn’t in Keynes–that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market. If they do, as was the case with a lot of value-oriented mutual funds in the late 1990s, they can soon find themselves without any customers’ money to invest.

That gets us to a world in which an investor with enough staying power and contrarian gumption can beat the market, but the vast majority of mutual funds and hedge funds don’t. In other words, the behavioralists have reconciled the success of a Warren Buffett (which efficient-markets purists have absurdly termed dumb luck) with the overwhelmingly empirical evidence that most professional money managers fail to beat the market.

This is, we posit, a major intellectual accomplishment. What does it mean for you? That’s easy: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible.

“Thinking, good thinking that is, is a lonely sport.  This may explain why so many of us do it so poorly.  Good thinking is also an inefficient process.  It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace.  Particularly, as Seldon so accurately noted in 1912, ‘Most coming events cast their shadow before, and it is on that intelligent speculation must be based.’

At the heart of the thinking process is the need to anticipate change correctly, and on a timely basis.  Investment thinkers must develop for themselves a model, or systematic perception, as to how markets really work.  Those believing strongly in the efficient market hypothesis are, of course, relieved of such undertakings.  However, as is becoming increasingly clear, portfolio theory does not fully explain security price movements, either here or abroad, or tell us too much about how to achieve better-than-average performance.  Most practitioners of active money management need to improve their thinking procedures.”

“The consensus view is usually wrong because it’s based on a more-or-less simple extrapolation of past trends and events and does not effectively incorporate change into expectations.  Theory tells us that value-changing events occur in a random fashion and cannot be predicted with any accuracy or consistency.  This is not so.  There is a flow to the news because there is a flow to the events that make the news.  Stock prices begin reflecting new developments before it is generally recognized that these developments have taken place.”

For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.

In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.

Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.

Score one for the stuffy “efficiency theorists.”

But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…

Forget “Market Efficiency”… Here’s the Best Way to Beat the Market

The study simply categorized companies by market capitalization (shares outstanding times share price). The 10 divisions ranged from small to large – and research proved that small firms consistently outperformed their larger cousins for many decades.

And it’s now widely accepted that this “small firm effect” is arguably the best way for investors to beat the market.

And the logic in seeking out small firms is sound. After all, Microsoft (Nasdaq: MSFT), Wal-Mart (NYSE: WMT) and hundreds of other mega-companies all started as small firms.

It’s what we like to call the “white cap” effect…

The Five Common Characteristics of the Perfect “White Cap” Stock

The beauty of “white cap” stocks is that they feature a powerful, earnings-boosting blend of three “market efficiency” anomalies – momentum, value and IPOs.

~ White Cap Factor #1: Products That Satisfy Unmet Market Need
One of the key traits of a good momentum stock is that the company has an exciting new product(s) that fulfills an unmet consumer need.

Take Apple (Nasdaq: AAPL), for example. With consumers across the world clamoring for Apple products, the stock has refuted the “market efficiency” approach and delivered outstanding returns for investors.

The White Cap Report remit: Target very small firms with products that supply an unmet market worth at least $1 billion.

~ White Cap Factor #2: Company is a Stock Market Newcomer
Many investors shy away from Initial Public Offerings (IPOs) because they’re too unknown and unproven in the stock market.

But invest properly and the risk is certainly worth the reward. Plus, you can mitigate risk by only picking small firms that have received an upgrade from an over-the-counter (OTC) stock to a major exchange. It also ensures that you’re not buying into a penny stock, which really ratchets up the risk.

~ White Cap Factor #3: Low Debt
When people and institutions buy bonds from a publicly traded firm, that money has to be paid back plus interest.

This is why bondholders (debt) can sometimes hurt regular shareholders. Debt puts a drain on building assets like cash, and as debt rises, shareholder value drops.

~ White Cap Factor #4: Low Competition and High Barriers to Entry
Warren Buffett, the greatest stock investor in the world, looks for companies in industries with high-entry barriers and low-exit barriers. Why? Because it’s difficult for any serious competition to join the industry.

The wisdom behind this approach is that poorly managed, unprofitable firms can get out easily without resorting to desperate price gouging – something that would cause a consumer bidding war and damage the well-managed firm’s profitability.

White Cap Factor #5: No Analyst Coverage

Watch shows like “Mad Money” on CNBC and you get a sense that Wall Street’s attitude is, “If the public wants stocks, we’ll give ‘em stocks.”

Thing is, though, lots of companies aren’t recommended to make you wealthy… but to fatten up commissions for Wall Street firms.

In fact, there are numerous studies that show that Wall Street analysts are absolutely untrustworthy. For example…

• They’re perpetually bullish and are pressured by CEOs, fund managers and supervisors not to downgrade a stock. This means the public is almost never told when they should really sell a stock. The reality is that when there’s a fire in the house, Wall Street opens the exits for its “good ol’ boys” first and leaves you behind to get burned.
• They often recommend the same stock as other prominent analysts. So if he’s following her, and she’s following him, just who the heck is doing any meaningful “research” on Wall Street?!
• They’ve been caught “front-running” – i.e., recommending stocks that prominent investors, investment houses and employee option-vested Wall Street executives are trying to sell for an obscene profit. This was particularly true in 1999 and 2000, where the vast majority of top executives cashed out, even while analysts where overwhelmingly bullish across the board.

This is where The White Cap Report differs. The goal is to find firms that Wall Street has no clue about. It makes sure few if any analysts covers the stock. This way, the waters don’t get muddied and you’re able to get in before the market does, sending the price upward.

All five of these “white cap factors” are essential parts of the investment formula that The White Cap Report team follows in identifying the small-cap stocks packed with the most profit potential – a formula that has proved extremely successful.

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It all starts with education,

Dr. Scott Brown

So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50^th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the whole concept of correlation and assets. Correlations change.”

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19^th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we’ve wiped out a generation of retirement income. I could go on and on, but it’s nonsense.

We let the rating agencies become way too important. They were supposed to be the adults supervising the sandbox, and they weren’t. They started out perfectly acceptably, but then they decided they wanted to rate multiple-obligor securities like real estate mortgage bonds using the same ratings they used for corporate bonds. They sold their business souls and didn’t even realize it.

Remember, we trained a generation of people to think they could model this stuff. So they modeled what potential defaults would be, based on past performance, and not even past performance that looked like the assets in the investments they were rating. But it was scientific and looked like the models they learned in school.

Every time you get a letter from me, there is a page and a half down there at the bottom, full of disclosures. At least twice in those disclosures I say past performance is not indicative of future results. It’s like, “coffee is too hot, don’t spill it.” We don’t pay attention to it, but it’s the most important thing, because past performance has nothing to do with future history.

The future is going to look different, yet we think we can model it. The models are bullshit. (That’s a technical economics term that requires advanced degrees to use.) They just are. Now you can take some comfort from them, and you have to try and figure stuff out, and you look for correlations. That’s what I do, and we all do that. I confess I use models every day.

But you have to recognize that the model has a huge asterisk beside it. You just can’t bet the farm on it. And God, have I learned that the hard way. I’ve got bruises on my back from making assumptions. That’s why I don’t go around half-naked, because it would just look ugly.

We let the rating agencies use a corporate bond-rating system — AAA, AAB — for multi-obligor bonds that had nothing to do with reality, and they rated them up on the way up and now they are rating them down on the way down, and they are screwing us both ways. Because if you lose 1% on a triple-A bond, it immediately goes to junk. That means the banks have to write it off their capital and sell it for 50 cents on the dollar.

When did this problem start? July of 2007, when we introduced mark-to-market accounting. When did AIG have a problem? When they had to start writing their AAA’s down. Now we should never have let it get to that place to begin with, but now we have to deal with reality. You can’t just sit there and say, “Tsk, tsk, we need to let these guys go bankrupt.”

No, you can’t, not unless you want 25% unemployment again. We have “X” amount of pain to go through to get back to whatever the “new normal” will be. Think of this as a big tube of pain, OK? We can do it in one year or in seven or eight years. I vote for seven or eight. I don’t want 20-25% unemployment. I would rather have 10% unemployment for seven years. Now, that’s just me, because I know when my neighbor is unemployed, when my kid is unemployed, that it hurts.

The Trend Is Not Your Friend When It Ends

So, the establishment is now saying, “Let’s keep the system going.” Now, are we going to have problems when the Fed starts trying to pull the extra cash they are printing out of the economy? Yes. Is that going to create a different form of future history than we have experienced in the past? Yes. Therefore, trying to model the future based upon that past, will not work.

We believed the trend. The trend is not your friend when it ends. OK? It just isn’t. Now, I’m the guiltiest person in the world. I live on what one of my friends calls “psychic income.” That is the income you get when you take a current business model, the current business you are in, and you say, if I could grow these assets to “Y” I would make “Z”. That “Z” charges me up. I haven’t earned it yet and the train probably won’t go there, but it gets me up in the morning. That’s my psychic income. We all do that. But we rarely realize that it’s just psychic income; it’s not real income until the cash is there.

Given all that I have said, I still contend I am not a pessimist, at least not in the long term. Stocks go from high valuations to low valuations to high valuations. They’ve done it in US markets and world markets, and we are halfway through the trip in a secular bear market. We haven’t gotten to low valuations yet, I don’t care what they say. The P to E at the end of July was something like 289 on the S&P. You can go to the S&P website and you can see that. Now you smooth it with five-year curves and performance, and it goes to 20. 20 is not cheap. But it’s going to get cheap — at least that’s what history tells us.

Now maybe history is wrong, because past performance is not indicative of future results; and I could be wrong, but sometimes you just have to set an anchor and say this is what I’m believing. I think we are going to lower valuations, and when that happens we will have compressed price to earnings ratios just like we did in 1982. The world will be coming to an end and we’ll be moaning and groaning. We haven’t gotten as bad as we were in ’82 — whoever pointed that out is correct.

But what will happen? The stock market will be a coiled spring and we’ll have a bull market and we’ll get to have fun in the stock market again. Until then, be careful.