To cut to the chase, Gary N. Smith became an independently wealthy multimillionaire by investing in stocks. In his new book, the Pomona College finance professor reveals how smart value investing made that happen.
Key to his strategy is the underlying idea: How much would you pay to own a stock that generates cash every few months for years to come? The answer: the equity’s intrinsic value. The cash? Its dividends.
In an interview with ThinkAdvisor, economics scholar Smith, whose new, often humorous, book is “Money Machine: The Surprisingly Simple Power of Value Investing” (AMA), discusses his stock-screening process, stocks he likes, why he’s not a fan of Amazon.com and the blunders security analysts make, among other investing matters that advisors — and their clients — should know about.
A specialist in writing about statistical pitfalls, Smith, 71, received his Ph.D. in economics from Yale, where he taught for seven years. He has authored numerous papers, including “Do Statistics Test Scores Regress Toward the Mean?” (1997) and “Would a Stock by Any Other Ticker Smell as Sweet?” (2009).
Among the several books he has written is “Standard Deviations: Flawed Assumptions, Tortured Data and Other Ways to Lie with Statistics” (2014), which Nobel Prize-winning economist Robert J. Shiller called “a very entertaining book about a very serious problem.”
“Money Machine” features analyses and applications of the stock-picking models of John Bogle, Shiller and John Burr Williams.
Smith is now at work on a new book, “Artificial Unintelligence,” all about algorithmic trading.
ThinkAdvisor recently chatted with the prolific professor, who was on the phone from Claremont, California. The debated existence of a current market bubble is one issue on which he opined. Here are excerpts from our interview:
You write that the two main drivers of the stock market are companies’ profits and the interest rate used to discount profits. That makes it sound so easy: Just keep track of those two.
It is easy. It’s not rocket science. One of the problems is that we have human emotions — fears, hopes, greed.
How do those enter the investing picture?
Because of those emotions, the things we do aren’t completely rational, and that’s what makes us trade too much. When a stock price is going up, people want to buy it, which, of course, is the wrong time to buy. In the 2009 crash, prices were way down, and people said, “I’ve got to get out of the market before I lose more.”
But not if you’re a value investor.
Right. If prices go down, that’s the time to be buying.
Is that why you’re a value investor?
It’s very hard to predict short-term price movement because it’s hard to predict surprises. Most of the people who try that do poorly; the ones that do well are mostly just lucky. So it’s not a sound investment strategy.
You’ve written books about how to invest, and you’re a professor of finance. With all that expertise in investing, why aren’t you independently wealthy?
I am! I started with nothing and now have literally millions of dollars. The only reason I keep working is because I have a fun job.
You write that human emotions and animal spirits create potentially profitable opportunities for value investing and that that’s “the essence of value investing.”
Yes. When people base their investment decisions on human emotions, it’s probably not going to turn out very well. Don’t let your decisions be ruled by greed and animal spirits. Just think of stocks as a money machine: What’s going to give me money year after year, and what would I pay to get it? Stop trying to predict the price for tomorrow and the next day. Instead, think: “I’m buying this stock for the long haul, and I’m going to be happy with the dividend it’s paying.” It’s as simple as that.
You recognized the dot-com bubble early on. Is there a market bubble now?
Not at all. A bubble occurs when prices are going up because people believe they’re going to keep going up. If prices are going up because stocks have good earnings and good dividends, like now, that’s not a bubble. That’s a rational reaction to good economic news.
You say that the true benchmark for gauging investment ideas is “how tomorrow will differ from what others expect.” Please elaborate.
When you’re considering announced earnings, don’t think: Are earnings higher than they were last year? Think: Are earnings higher than analysts expect them to be? It’s earnings surprises that cause stocks to jump up and down.
You say that Warren Buffett views stocks somewhat as “disguised bonds.” And you agree.
If you look at a bond as: Here’s a bond that pays a dollar coupon every quarter for 30 years. What would I pay to get that dollar coupon? In the same way, you can think: “What would I pay to get this stock that pays a dollar dividend every quarter — and dividends also go up over time. What the stock is really worth is what the cash flow is worth. What would you pay for that amazing money machine that gives you money year after year? You don’t have to try to predict price fluctuation. That’s good because you can’t predict short-term price fluctuations.
Various personality types perceive things differently from one another, you point out. How does that relate to investing?
When an event occurs, some people will react one way and others will react a different way. So getting a handle on who you are is often the key to making better financial decisions. If you’re trying to save for your retirement, say, knowing your own personality type is the first step because if you haven’t realized how hard it is for you to save, you shouldn’t set a rule to save $100 a month — since you’re not going to do it.
As a value investor, what are your criteria for picking a stock?