Morningstar Ratings Update
Last week, I posted on this blog an article from my newsletter criticizing Morningstar ratings. Surprisingly, the VP of Research at Morningstar found it and responded in the comments the very next morning, so we went back and forth a little.
If you’ve ever wondered what it would be like if two investing nerds got together to talk about their views, here’s your chance to see for yourself.
Are Morningstar Ratings Useful?
From the August 2010 newsletter:
The financial industry certainly places more emphasis on style than substance. So when their work is actually evaluated, it tends to be disappointing. Wall Street’s earnings forecasts? They suck. Performance of mutual fund managers? Quite embarrassing. Do Morningstar ratings also belong in the same category? You probably see them all the time; mutual fund companies love using Morningstar ratings in their marketing materials. But is there any value in a 5-star rating?
Luckily for us, researchers recently looked into these ratings and published their results. They compared Morningstar ratings vs. fund expense ratios as a predictor of future performance. The expense ratio is one of my favorite metrics. If you assume that mutual fund managers have no value, which I find to be a very good approximation, you would expect lower costs to predict better performance. The report found just that:
Wall Street’s Earnings Forecasts
Forecasting company earnings is a critical first step in Wall Street’s favorite pastime–predicting stock market returns. As an investor, you are most likely exposed to forecasted earnings when looking at a version of the P/E ratio that uses future earnings. This ratio uses future earnings subjectively forecasted by Wall Street research analysts, instead of using past earnings that have been objectively aggregated.
The appeal of using future earning is obvious. Which sounds more interesting to you: past earnings, or estimated future earnings incorporating all available information including past earnings? Surely, research analysts employed and trained by Wall Street firms are able to do a decent job in forecasting earnings. Well, let’s look at the evidence.
The P/E Ratio
From the March 2010 newsletter:
Last time we discussed Q, which seemed to predict future 10yr returns decently well for the US stock market. This time, I introduce a valuation metric that many of you are probably familiar with, the P/E ratio. It is typically defined as price divided by earnings over the prior 12 months. The biggest problem with this definition is that earnings over one year are highly volatile, making this version of the P/E ratio not very useful.
One way to make the P/E ratio more meaningful is to use earnings over a much longer period of time. Using 10 years or more of earnings is ideal. The chart below shows the P/E ratio (using 40 years of earnings!) vs Q and the following 10-year return of the S&P 500 index. It looks like this P/E ratio does a good job of predicting future 10-year returns. In fact, it’s even slightly better than Q (r-squared of 0.83 vs 0.69).
Valuing the Market With Q
From the February 2010 newsletter:
Today, I introduce you to a stock market valuation metric called Q popularized recently by economist Andrew Smithers. Q is defined as the ratio between the value of companies according to the stock market and their net worth measured at replacement cost. Extremely high values for Q indicates that the stock market is too high relative to its replacement cost, leading to lower future returns as the market corrects. A low value for Q indicates a stock market that is too low relative to its replacement cost, leading to higher future returns.
Well, this sounds great in theory, but how has Q performed as a predictor of returns? What follows is a chart of Q for the US stock market vs the following 10-year return of the S&P 500 index starting from 1946.
Trying to Beat the Market
The NY Times recently highlighted an academic study that estimates the proportion of mutual fund managers that can truly outperform the market. These types of studies have been conducted countless times, and all show that beating the market is very difficult. The results of this study using data from 1975 to 2006 are:
The researchers’ tests found that, on a pre-expense basis, 9.6 percent of mutual fund managers in 2006 showed genuine market-beating ability — far higher than the 0.6 percent after expenses were taken into account. This suggests that one in 10 managers may still have market-beating ability. It’s just that they can’t come out ahead after all their funds’ fees and expenses are paid.
Why Indexing Is So Hard
The most counter-intuitive part of indexing is the avoidance of action, especially in an effort to beat the market. We generally associate hard work and hours of effort with success, however in investing it turns out to be exactly the opposite. All those costs incurred by action (commissions, bid-ask spreads, and realized capital gains) make beating the market that much harder.
This “action bias” to do something has recently been documented in the decision making of goalkeepers during penalty kicks. Although data shows that they could be more successful by staying in the middle (no action), they still jump to either side (action) over 90% of the time.
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