The Devil's Dictionary

Jason Zweig has a fantastic new website that include's a "Devil's Financial Dictionary," you have to check it out. 

Zweig's dictionary was (I think) inspired by one of the most fun little volumes every written, Ambrose Bierce's "Devil's Dictionary." Here are a few of my favorite definitions from the original:

CONSERVATIVE, n. A statesman who is enamored of existing evils, as distinguished from the Liberal, who wishes to replace them with others.

CRITIC, n. A person who boasts himself hard to please because nobody tries to please him.

DESTINY, n. A tyrant's authority for crime and fool's excuse for failure.

EDUCATION, n. That which discloses to the wise and disguises from the foolish their lack of understanding.

EXISTENCE, n. A transient, horrible, fantastic dream, Wherein is nothing yet all things do seem: From which we're wakened by a friendly nudge Of our bedfellow Death, and cry: "O fudge!"

FAITH, n. Belief without evidence in what is told by one who speaks without knowledge, of things without parallel.

FUTURE, n. That period of time in which our affairs prosper, our friends are true and our happiness is assured.

HABIT, n. A shackle for the free.

HAPPINESS, n. An agreeable sensation arising from contemplating the misery of another.

LAWYER, n. One skilled in circumvention of the law.

LECTURER, n. One with his hand in your pocket, his tongue in your ear and his faith in your patience.

LIFE, n. A spiritual pickle preserving the body from decay. We live in daily apprehension of its loss; yet when lost it is not missed. The question, "Is life worth living?" has been much discussed; particularly by those who think it is not, many of whom have written at great length in support of their view and by careful observance of the laws of health enjoyed for long terms of years the honors of successful controversy.

OCEAN, n. A body of water occupying about two-thirds of a world made for man—who has no gills.

PAST, n. That part of Eternity with some small fraction of which we have a slight and regrettable acquaintance. A moving line called the Present parts it from an imaginary period known as the Future. These two grand divisions of Eternity, of which the one is continually effacing the other, are entirely unlike. The one is dark with sorrow and disappointment, the other bright with prosperity and joy. The Past is the region of sobs, the Future is the realm of song. In the one crouches Memory, clad in sackcloth and ashes, mumbling penitential prayer; in the sunshine of the other Hope flies with a free wing, beckoning to temples of success and bowers of ease. Yet the Past is the Future of yesterday, the Future is the Past of to-morrow. They are one—the knowledge and the dream.

PHILOSOPHY, n. A route of many roads leading from nowhere to nothing.

POLITICIAN, n. An eel in the fundamental mud upon which the superstructure of organized society is reared. When we wriggles he mistakes the agitation of his tail for the trembling of the edifice. As compared with the statesman, he suffers the disadvantage of being alive.

PRAY, v. To ask that the laws of the universe be annulled in behalf of a single petitioner confessedly unworthy.

PRESIDENCY, n. The greased pig in the field game of American politics.

RATIONAL, adj. Devoid of all delusions save those of observation, experience and reflection.

REALITY, n. The dream of a mad philosopher. That which would remain in the cupel if one should assay a phantom. The nucleus of a vacuum.

RELIGION, n. A daughter of Hope and Fear, explaining to Ignorance the nature of the Unknowable.

WEATHER, n. The climate of the hour. A permanent topic of conversation among persons whom it does not interest, but who have inherited the tendency to chatter about it from naked arboreal ancestors whom it keenly concerned.


Searching for Deep Value Stocks

Deep value investing is a powerful way to beat the market, but deep value stocks are an endangered species in the U.S.

I was recently talking with Tobias Carlisle, author of Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, about what constitutes a deep value stock. To find these stocks, Tobias prefers to use the “takeover” multiple. One version of the takeover multiple is the ratio of EBITDA (earnings before interest, taxes, depreciation and amortization) to enterprise value (market value of equity plus book value of debt minus cash).

This is a great multiple for stock selection. Like the price-to-earnings ratio, it helps you find unloved companies, but it also penalizes stocks for having too much debt (more debt = worse ratio, ceteris paribus). If all you did was buy the 10% of stocks with the cheapest EBITDA/EV ratios on an annual basis, you’d have outperformed the market by more than 5% annually over the past five decades.

I asked Tobias what he considers a very cheap multiple EV/EBITDA multiple, and we agreed that somewhere below 5x indicates a cheap stock, while a multiple of less than 3x indicates very deep value. So here is the problem: today, we face what is perhaps the most difficult environment for deep value investing in history.  Just 3.2% of non-financial, U.S. companies with a market cap of at least $200MM trade at an EV/EBITDA multiple below 5x.  That is just off June’s all-time low of 2.9%.

There are just 65 stocks today with deep value multiples. Most are small. While a few big energy stocks make the cut (COP, HES, MRO), the median market cap of these 65 stocks is just $1B. If we limit ourselves to EV/EBITDA multiples below 3x, then I see just 7 stocks available. The largest has a market cap less than $2B.

So what is a deep value investor to do? Two options are to go smaller (into the micro-cap market) and go international. I’ll explore these options in a future post. Going smaller isn’t feasible for big institutional asset managers, but is possible for the little guy. Going international is great, but hard to execute as a small individual investor.

As I’ve written before, this bull market has left us with a very homogenous market where valuations are clustered around the mean. The sad fact is that in 2014, it’s hard out there for a deep value investor.

For much more on the topic, go read Tobias’s book. You’ll notice that the book is expensive, but trust me—it is worth every penny. 



These Stocks Are Much Cheaper than Usual

Apple's stock is far cheaper today than it has been over the last decade. The transformation of Apple's valuation looks so remarkable, it made me wonder if other large U.S. companies have undergone a similar transfromation.  I found some very interesting companies pop up...

To identify stocks whose relative valuation (compared to all other stocks) has changed the most, I first calculated each large companies average valuation percentile (where 100 is most expensive) over the past 10 years. To measure cheapness, I use measures like price-to-earnings, price-to-sales, EBITDA/EV, free cash flow/EV, and total yield.  As a reminder, here is how Apple's valuation has changed. 

As it turns out, there are other companies that appear far cheaper today than they have been over the past decade, but Apple still leads the charge. Notice that some of the names, especially Whole Foods, aren't especially cheap today...but they are still much cheaper than in years past. 

Here are three other examples: Corning, Coach, and NetApp. 

Most valuation measures are used to compare companies across a market or industry at one point in time. But it is also interesting to compare valuations for individual companies against themselves through time.

The reason that value works is that it is a proxy for expectations. Cheap valuations = lower expectations for the future--but these bleak forecasts often turn out to be too grim. This alternative way of looking at value can help investors identify stocks that are both cheap today, but also have had falling expectations over time.  To paraphrase Templeton, the key isn't to find stocks for whom the outlook is good, but to find stocks for whom the outlook it is miserable. 

A Complete Investor Curriculum & More--The Millennial Money Pre-Order Offer

I am very excited to see my first book, Millennial Money, hit shelves on October 14th. I think you’ll love the book, but I also want to provide you with more. I have put together a package of extra content—designed to help you be a better investor—that will be available only to those who pre-order the book.

The Offer

If you pre-order the book, I will send you the following four pieces of exclusive extra content:

  • A Complete Investor Curriculum: I’ve read, watched, and listened to thousands of books, articles, and interviews on investing, and distilled them down to just the best. You get a complete investor curriculum, which represents the culmination of a decade of research.  It includes books, videos, interviews, articles, and websites covering all aspects of investing.
  • Millennial Money Strategy Preview: if you could only know five things about a stock, what would they be? The strategy in Millennial Money identifies the five things that have mattered most for selecting stocks through history -- and combines them into one strategy. You get this advance preview.
  • Millennial Money Research list: all of the sources (>100) used in the book. You get all the books, academic papers, articles, and websites.
  • Free Strategy Screen: I’m often asked which stock screener is the best. You get a paper that highlights a value-based screen that you can run for free. It links to the exact screen online, explains how to manage the strategy in real time, and reveals the historical results of the strategy since 1970.

All you have to do pre-order a copy of the book on AmazonBarnes & Noble, or Indie Bound and send the order receipt to with the subject line “millennial money pre-order.” I will then send you the collection of extra content—pretty simple!

You can see more info on the book at Amazon.

The offer will be available up until October 13th, the day before publication.

If you know any millennials who may benefit from this book, forward this offer their way. With your support, we can make this a successful book that helps a lot of people build a brighter financial future.

All my best,


P.S. Here are some early reviews for the book and a visual preview of the extras:

Reviews on Amazon
Review on

“O’Shaughnessy provides sound advice that will give millennials the advantages they need to improve their financial future.”-- Publishers Weekly

"Patrick has done something very unique: he's written a highly readable book that speaks up—not down—to young investors, while keeping things sophisticated enough so that even veteran investors will find indispensable insights within."—Joshua M. Brown, author of Clash of the Financial Pundits and on-air contributor to CNBC

“If someone had given me this book when I was in my 20s, I’d be a billionaire today.  Buy this book for someone you love who is in their 20s. They will think kindly of you when they are in their 60s.”—Barry L. Ritholtz, Chief Investment Officer, Ritholtz Wealth Management

“Patrick has got it right. The sooner you start investing, the more you make.  Patrick’s recommendation to invest broadly in international stocks is also spot on for young investors. This book is a must read for anyone from their 20’s to 40’s.”—Tim McCarthy, Former President, Charles Schwab and author of The Safe Investor

“Most young investors I know have abandoned stocks, and that's a big mistake.  O’Shaughnessy lays out a clear path for building wealth over a lifetime with a key message: start now, invest globally, and master your own behavior.”—Meb Faber, CIO, Cambria Investment Management, and author of The Ivy Portfolio

"Patrick O'Shaughnessy has written an accessible, thought-provoking guide to helping Millennials make the right financial decisions." —Kevin Roose, Bestselling author of Young Money

“Patrick’s book is a must read for my generation, and anyone who cares about building a more secure life for themselves and their loved ones. His message is clear: the time to act is now and the future is ours to take!” —Bryce Dallas Howard, Actress

For Apple, the iPhone 6 Doesn't Matter. Valuation Does.

Should you invest in Apple? As the market eagerly awaits the September 9th launch of a suite of new Apple products, this question occupies the airwaves. Back in April, I wrote that Apple looked attractive despite negativity about the company. Below is an updated objective look at Apple based on two key criteria for evaluating a stock: valuation and shareholder orientation. These two variables are more helpful for predicting future performance than prognostications about products and forecasts of earnings growth rates (which is where all the Apple attention seems focused).

The iPhone 6 and iWatch sound great, but they don’t matter nearly as much as valuation or shareholder yield. Let’s look at how Apple stacks up by these factors versus the rest of the market (hint: pretty damn good).


Apple went from a very expensive market darling focused on growth, to a very cheap market laggard with significant dividend and share repurchase programs.

Between 2010 and 2012, perception was that Apple was the greatest company in the world. In 2010, Apple was more expensive than 75% of the market based on a combination of simple measures like price-to-earnings, price-to-sales, and price-to-cash flow. Now, in 2014, it is cheaper than 90% of companies, based on those same measures. Look how quickly the change happened. Market perception can turn on a dime.

Valuation has been a powerful factor for predicting future returns throughout history. In fact, the cheapest 10% of stocks, on average, have outperformed the market by nearly 6% per year since 1963. Today, Apple sits in this cheapest valuation bucket.

Shareholder Orientation

The other key change in Apple (from the investor’s perspective) is its orientation towards its shareholders. For years, it issued new shares, diluting existing shareholders (shown as negative shareholder yield in the figure below) and paid no dividends. They’ve since pulled a 180, buying back a huge number of shares and paying a regular dividend. Again the change happened fast.

Shareholder yield, just like valuation, has also been a powerful predictor of future returns. Companies that pay impressive dividends and buyback significant amounts of their share have outperformed the market by roughly 4% per year since 1963. Again, Apple sits in the best group by shareholder yield today.

Apple Inc. vs. $AAPL

The consensus earlier this year was that Apple, the company, has less potential than it did a few years ago, but history suggests that its stock has much more potential than it did a few years ago. 

Apple Inc., the company, has taken its licks since it first peaked at $700 in 2012—but has come roaring back. $AAPL, the stock, has transformed in ways that should make investors take notice.  Investors should always buy cheaper companies that reward their shareholders rather than expensive stocks dilute them.  Of course Apple itself may flounder and underperform the market, but the odds are that a large basket of stocks with similar characteristics (cheap valuations, high shareholder yields) will do very well over the long term. In anticipation of September 9th, remember that products and earnings growth rates may be exciting, but value matters more.




Four Books For New Investors

Investing can be a daunting subject. I’ve always felt it should be a part of the high school curriculum, because we leave high school and college woefully underprepared to save and invest our money (8 years of French, though?!). Reading is the antidote to this problem. Below are four books which serve as a great introduction to smart investing. I am always the most intimidated by a subject (and therefore least likely to start learning) when I know nothing about it. As such, I’ve chosen books that are accessible, fun, and easy reads.

Simple Wealth, Inevitable Wealth by Nick Murray.  If a loved one needed to learn about investing, and I could only give them one book, this would be it. This book takes nothing for granted. Murray explains the basics of saving and investing in well written, plain English, and gives new investors most everything they need to know to work towards a comfortable and prosperous retirement.  As Murray says, “no matter how much money you have, if you’re still worried, you aren’t wealthy.”

The Little Book of Common Sense Investing by Jack Bogle. Jack Bogle and his company Vanguard have done more good for investors than anyone else. They’ve made it easy and incredibly cheap to access the entire stock market in a way that was impossible just a few decades ago. Bogle has written several books, but this one—which is short and sweet—is the best for new investors.

The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money by Carl Richards. If you want to be a successful investor, then controlling your own behavior is more important than your actual investment strategy. We are our own worst enemy when it comes to investing. This great book explains how to avoid getting in your own way and instead make smart decisions with your money.

The Richest Man in Babylon by George Clason. I don’t know about you, but I love when things are explained in narrative form, with heavy use of metaphor and analogy. This book is designed to explain the basics of saving and investing using a fun story. What you’ll see is that personal finance isn’t complicated at all, you just need to get off on the right foot.

There are many great books on investing, but these four will serve as a solid foundation on which to build. If you want more suggestions, I send out 3-4 each month. To receive those suggestions, you can sign up here.

The Putrid Portfolio

Just like it would be any investor's dream to have perfect foresight, it would be any short-seller's dream to know which stocks were going to fall by the highest percentages every year. In an earlier post, we saw that identifying a “perfect portfolio” ahead of time using valuation and other measures was basically impossible. But today we will see that finding the worst stocks, “the putrid portfolio,” may be much easier.

The putrid portfolio is formed by using perfect foresight to select the 25 stocks from a large cap universe that will perform the worst over the next 12 months. Think of this portfolio as Jim Chanos’s dream. Its historical return (since 1963): negative 50% per year!

Wouldn’t it be great if these stocks could be identified ahead of time, so that you could avoid them or short the hell out of them? Turns out valuation is a good starting point for finding these putrid stocks ahead of time.

As a reminder, valuation was not a great guide for finding the best performers. Here is the historical distribution by STARTING valuation for the stocks in the perfect portfolio over the past 50 years. Pretty random. Some started expensive, others cheap.

But here it is for the “putrid portfolio.” There is a clear and strong relationship between valuation and putridity. Nearly a third of the worst performers each year started their terrible run trading at very expensive multiples.

Here are the two charts together.

Why does this happen? Remember that valuations are a proxy for expectations. Higher price multiples (of earnings, cash flow, sales, etc) mean that the market is expecting big things from these expensive stocks. Often they have great prospects and great stories which seduce investors. Turns out, investors are often overly optimistic about these companies.

This phenomenon lines up neatly with the historical excess returns by valuation decile among larger stocks, shown below. Cheap stocks outperform by a nice margin (nearly 5%). But more interesting is the fact that the most expensive stocks underperform by an even wider margin (7%).

I’ve reached this conclusion in many different posts, but it bears repeating here. Some stocks priced at huge multiples (think $TWTR) will deliver outstanding returns. But as a group, expensive stocks have always delivered terrible returns relative to the market, and you would be smart to avoid them entirely rather than trying to pick the few diamonds in the market rough. You’ll miss out on the most fun stories, but your portfolio will be healthier for it.

Your Help With Millennial Money

My first book, Millennial Money, will be on shelves October 14th, and I need your help.

The book covers the why and the how of investing for millennials.  It explains all the key ingredients for long-term investing success, and highlights the tremendous opportunity that exists for the youngest generation of investors.

Investing isn't a topic in high school, but it should be. Learning the right investing lessons early on in life can make a world of difference to someone's lifelong financial well-being.  My hope is to provide a piece of that education for as many young people as possible. To do so, I would love if you could take a few minutes to fill out this brief form below. 

My goal is to understand what motivates you to buy a book, other than the obvious things like good reviews, a catchy title & cover, press coverage, and so on.  I'll use your responses to tailor the exclusive items offered in my pre-order campaign (in late August/early September), and to tailor my efforts come launch day. I deeply appreciate any help you can offer!

Are there sources (blogs, podcasts, websites, or anything else) that influence your book buying decisions? If so, I'd love to hear about them. I want to reach as wide an audience as possible and am willing to try just about any tactic, Any and all ideas are welcome.
Pre-Order Offer: what would most interest you? *
I am going to offer several exclusive items for those that pre-order the book. Which of the following items would you be interested in? Please check all that you'd find interesting
Are there other extras that would interest you that are not listed above? If so, please enter any ideas below.

Finally, if you run a website, podcast, or newsletter, and would like an advance review copy of the book, email me at with your website/podcast details and approximate audience size and I'll work on getting you an early copy of the book.

Many thanks to all, with your help I think this launch will be a huge success!


America, Inc.

American business is a beast. Here is its income statement, as of June 30, 2014[i]:

$12 trillion in sales, over the last year. The costs of doing business remain high, but even at an aggregate profit margin of 6.9%, American enterprise is generating $835B in profits[ii].

We can think of each economic sector as a subsidiary of America, Inc. Here is how they stack up.

Consumer stocks alone make up $4.2T of total sales, but margins are lower at 5.4%. Energy continues to dominate, as offshoots of Rockefeller’s original Standard Oil—Exxon and Chevron—continue to produce massive profits 155 years after the first “rock oil” was discovered in Pennsylvania.

America, Inc. continues to lead in technology, where its companies are earning an aggregate profit margin of 12.7%. Telecom and Utility stocks are much smaller “subsidiaries,” with combined sales of less than $700B, but both sport healthy margins.

America, Inc. is a quite the business: diversified, innovative, and massively profitable. This begs a question for millennials: would you rather sit in cash, or buy a slice of America Inc. ($SPY) with the click of a button[iii]?


[i] I’ve excluded financials for this post, because they don’t fit cleanly into traditional income statements. With financials included, total sales would be roughly $14T and net income would top $1T.

[ii] To be included in this calculation, a company has to be domiciled in the U.S., ADRs and other foreign stocks listing on a U.S. exchange are NOT included. I've excluded micro caps, but they don't add up to much. Private companies are NOT included in these calculations

[iii] I know I always argue against home bias, and indeed I think $ACWI is a better option for total global exposure, but I am just having some fun here.

The Perfect Portfolio


The best investing super-power would be perfect foresight. Imagine if every year you knew which 25 stocks (from a large, liquid universe just to keep things reasonable[i]) would be the best performers over the next year? This foresight would translate into outrageous annual returns over the past 50 years of 80% per year[ii]! Wouldn’t it be great if you could know about these stocks ahead of time? Even just one or two?

Last year’s “perfect portfolio” would have included Facebook, Tesla, Delta Airlines, Netflix, Orange (formerly France Telecom), and Alcoa. These companies came from all different corners of the market, and many would have doubled your money in just one year.

As exciting as these returns are, the important thing about these companies is that there is no rhyme or reason to how they look at the beginning of their run.  I ran a profile of all “perfect portfolio” stocks since 1963, hoping to find traits or factors which these stocks had in common. Maybe they were often super-cheap to start the year, or had huge recent price momentum, or were stocks of outstanding quality. But none of these hopes proved true.

Let’s look at their starting valuations, for example. It is well established that cheap stocks outperform expensive stocks over time. But perfect portfolio stocks came from across the valuation spectrum. They were almost evenly distributed across starting valuation percentiles (where percentiles were calculated based on simple measures like price-to-earnings and price-to-sales).

The same story was true for momentum and quality (two other proven ways to select outperformers): there were no common traits among the best performing stocks.

The sad fact is that headline-making high flying stocks are impossible to identify ahead of time with any degree of consistency. Of course, investors will never stop trying to find this market equivalent of the Holy Grail.  Sadly for investors, this grail quest will result in high costs and frustration, not 80% returns.


[i] Large defined as any stock with a market cap larger than the entire universe’s average market cap. Today would have a market cap floor of $7.3 billion

[ii] Of course, these returns are impossible in the real world. If you started with $1,000,000 and earned 80% annual returns, you’d own the entire global stock market (all $70 trillion of it) by your 27th year.  You’d also end up owning entire companies early on and be unable to trade and earn the 80% returns for long.


Black Gold (Energy Part I)

My great-grandfather, Ignatius Aloysius (“I.A.”) O’Shaughnessy, was born in 1885, exactly 100 years before I was born. From very humble roots in Stillwater, Minnesota, he built one of the country’s most successful private oil companies: Globe Oil. Once honored as the “king of the wildcats,” I.A. built a huge fortune and then slowly gave it all away (mostly in support of education and ecumenicalism, click below to check out the letter from the pope to I.A.s wife after he died).

It is the ultimate irony, given my profession, that I.A. distrusted stocks. According to his son (my grandfather) “[I.A.] didn’t like those people on Wall Street. He thought that what was going on economically in his companies shouldn’t be determined by Wall Street and its fluctuating stock prices…he tended to invest directly in companies that made money, not in the market. He didn’t play the market…he relied on his own business to create companies that were prosperous in finding oil and refining it.”

For his entrepreneurship and philanthropy, I.A. is one of my idols…but I have to disagree with him on the stock market! Building an oil business requires hard work and lots of luck, but investing in energy stocks is much easier. Given that oil (and gas) are the lifeblood of modern society, it is a fascinating sector to explore. This will be the first of two parts on the energy sector, laid out in a format similar to the two-part series on Consumers staples (Part I here and Part II here).

Sector Overview

Given oil’s ubiquity in our lives, it is amazing that the industry is only about 150 years old. The U.S. oil industry started when “rock oil”—so called to distinguish it from whale and vegetable oils—was first discovered in Pennsylvania and proved to be an excellent “illuminant” for lamps. The oil industry became massive providing only lamp oil, but ballooned once cars and planes started using gasoline as fuel.  By World War II, both Japan’s attack on Pearl Harbor and Hitler’s invasion of the Soviet Union were driven in large part by the desire for oil[ii]. Today, behemoths like Exxon, Royal Dutch Shell, Petro China, and Chevron sit in the top 15 companies in the world by market capitalization.

The energy business has the same objective today as it did in Pennsylvania in the 1850’s: find oil (and gas), get it out of the ground, transport it, and sell it. Most modern energy companies still fall into one or all of these categories. We can group energy stocks into sub-industries using the global industry classification standard (GICS), which breaks out the energy industry as follows:

At the industry level, oil & gas dominate over energy equipment & services, here is the number of stocks in each industry and their total market cap through history.

Within oil & gas, there are three primary lines of business called upstream, midstream, and downstream. Upstream (also called exploration and production, or E&P) involves finding oil and getting it out of the ground. Midstream involves processing and transporting oil. Downstream involves refining oil & gas into consumable fuel for end consumers.  Some companies focus on just one element, but the largest energy companies—like Exxon—are categorized as “integrated” because they participate in all three stages.  

Here is a look at the historical breakout between these three stages of the oil business. You’ll notice interruptions in the “midstream” companies, because at various points they were classified as utilities. This is inconvenient for this analysis, but they represent a fairly small part of the overall energy market.

Integrated oil and gas stocks, along with upstream E&P stocks, dominate the market.

Competition and Concentration

In its early years, the energy industry was dominated by Rockefeller's Standard Oil, which had up to 90%  market share. Today, the energy industry is much more competitive, despite a few top companies like Exxon and Chevron controlling large chunks. One convenient way to measure concentration is the “four firm concentration ratio,” which simply adds up the market share (% of total sector sales) of the top four firms in the energy industry group. 

Of the 24 industry groups in the entire stock market, energy stocks are the 12th most concentrated industry.

Historical Returns

The returns for energy stocks have been strong relative to the nine other economic sectors, but with an annual standard deviation of 24.1%, they have also been the second most volatile (trailing only technology stocks)[iii].  Note that in this chart, the results are slightly different than in Part I of consumer staples, because here I have included ADRs in the universe to capture the large global energy stocks that are an essential part of the energy market.

The returns for the energy sector as a whole are quite volatile, but this is especially true of companies that focus on upstream, E&P operations. Exploration and Production companies have by far the worst risk-adjusted return (Sharpe ratio) of the major sub-industries within the energy sector.  I don’t have complete data for midstream companies at this point, but relative to E&P stocks, returns are better for refining companies and significantly better for the vertically integrated oil & gas companies. This latter group represents a small sample size (only around 20 integrated companies today), but they have delivered very impressive historical returns.

Oil & Energy Returns

Oil is almost like money
— Robert O. Anderson

The price of oil has an obvious relationship with the success of energy stocks. To price oil, I use two primary benchmarks: Brent Crude, and West Texas Intermediate.  Data for Brent goes back to 1957, and today Brent Crude is used to price two thirds of crude oil globally. Here is the real price of oil (adjusted for inflation, shown in terms of today’s dollars).

When you compare the price of Brent crude to the energy index I’ve created, you see a clear relationship, especially in the 1975-1985 period and in 2008.

A Hyper Cyclical Sector

Some energy stocks have delivered outstanding long term returns, but the sector as a whole is very volatile. The previously explored consumer staples sector has had very stable returns on equity (ROE); but the energy sector is much more cyclical. Below are the historical ROE for the sector at large, and for the key individual industries.

The sector has huge swings relative to the market, but things get very interesting at the sub-industry level. The giant integrated oil & gas stocks drive the sector’s ROE, and are (relatively) more stable. By contrast, refiners and E&P stocks are much more cyclical. Early wildcatters, like my great grandfather, were not faint of heart. Not much has changed. Energy in general, and upstream E&P specifically, remains a tough business for entrepreneurs and investors alike--but those that have succeeded have earned huge returns. 



Notes: I have only just begun to explore this sector, and am contemplating a much more comprehensive (~50-100 pages) e-book. If you have any interesting resources (books, articles, white papers, anything really) on the sector please send them my way at

For the custom “indexes” I’ve created in this post, I constitute each index in December and include all stocks with a market cap > $200MM adjusted for inflation and equal weight them (this gives a fair representation of the opportunity set). The indexes are then rebalanced and reconstituted each December. I use GICS codes to determine industries.


[ii] The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin (THIS BOOK IS PHENOMENAL)

[iii] These returns differ somewhat from the first post on consumer staples because I am including ADRs

Humans: Hertz Machines In A Megahertz World

Most debates in investing focus on strategy: active or passive; hedge funds or private equity; gold or inflation protected bonds.  But while these debates are important (and fun), the most important element of investing success is your behavior. Trouble is, culture (e.g. markets) evolve quickly, but human beings evolve very slowly. We are left with bodies and brains that are optimized for a world that doesn’t exist anymore. The famous psychologist Phil Zimbardo wrote a very interesting book called The Time Paradox, from which I’ve pulled two of my favorite quotes:

YOU ARE A LIVING ANACHRONISM Because of the rapid change in the world around us since our birth, we humans are living anachronisms. Our world has changed dramatically in the past 150 years. Human physiology, in contrast, took millions of years to create and has not changed much in 150,000 years. Your body—even if it is in mint condition—is designed for success in the past. It is an antique biological machine that evolved in response to a world that no longer exists. Although we live in a world in which computer processing speed doubles roughly every twenty-four months, human information processing has not expanded substantially over the past 150,000 years. Our physiology is clearly behind the times.

As markets and technology get more sophisticated, we are being left in the dust.

We are hertz machines in a megahertz world. For an average human, simple reaction time is about 250 milliseconds. Simple reaction time is the time that it takes to react to a stimulus, such as a light going on when a button is pushed. Therefore, each “cycle” of light input and button depression response takes a quarter second. Four complete cycles can take place each second. Thus, a typical human has a processing speed of about four hertz. In comparison, modern desktop computers have central processing unit (the brain of a computer) clock speeds of over three gigahertz; they are roughly 750,000,000 times faster than we are. This relatively slow processing speed has two important implications. First, it means that all of us live more than 250 milliseconds in the past.

What this means for you, the investor, is that your body/brain will push you to make foolish decisions because your brain reacts to market threats and opportunities just like it did hundreds of thousands of years ago in the savannah.

My suggestion is to remove yourself from the equation as much as possible by making your investment plan automatic. Instead of trying to time the market, you should instead contribute automatically to your 401(k) and other investment accounts with every paycheck—even if the amounts are small. Instead of trying to rotate between asset classes, pick an allocation and stick to it with scheduled rebalances. These simply tactics cut out the main investing obstacle: you!

Boring Is Good

I’ve always liked investing rules, because they impose discipline. Here is one rule I find useful: boring investments are good investments. The more boring the investment, index, or asset class, the better it will probably be for your portfolio. This has been true throughout market history, and the rule manifests everywhere:

·         Trading less often isn’t as fun, but it leads to lower costs (trading and taxes) and therefore higher long term returns.  

·         Index funds are plain and dull, but they outperform a significant majority of active managers over the long run.

·         The best performing U.S. sector for the past 50 years is consumer staples, which includes companies that sell simple, boring products which rarely change.

No matter where you look, dull trumps exciting.  Consider, for example, two very different industries at opposite ends of the dull/exciting spectrum: food, beverage & tobacco (Coca-Cola, Altria, Kraft Foods--BORING) and technology hardware & equipment (Apple, Qualcomm, Cisco—EXCITING).

The technology sector is almost always the most exciting part of the stock market, because technology companies offer new and exciting products and services. The market is rabidly speculating about every detail of the upcoming iPhone 6, but no one gives a crap about (or expects) some revolutionary new flavor of Coca-Cola.

So here is the remarkable fact: since 1963, the boring stocks (food, beverage & tobacco) have had a return of 13.6% per year (or 69,402% total), while the exciting stocks (technology hardware & equipment) have had a return of just 9.2% per year (or just 8,464% total).  

You often hear that earning higher returns requires taking higher risk, but the opposite has been true for these two industries. Food, beverage & tobacco stocks have been HALF as volatile as technology hardware stocks (14.2% annual volatility versus 29.5%).  You can see the difference, here is the rolling five-year return for each industry for the past 50 years.

Technology is an incredibly competitive industry with a very high rate of change. It is impossible to predict what technologies will emerge in the future, and equally impossible to predict what companies will profit from those new technologies. 3-D printing may be revolutionary, but we have no clue what company will emerge from what will be an extremely competitive playing field.

And yet, even with such an unpredictable future, investors have almost always paid a premium for technology stocks, because they excite and inspire.  Here is the historical valuation percentile (higher = more expensive) for the two industries in question.

This means that, historically, investors have paid more for stocks in one of the most competitive industries, where it has been the hardest to succeed and stay on top.  

Change generates excitement, but as Warren Buffett has said, “We see change as the enemy of we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.”  

Your smartphone has more power than the first super computers; hardware has evolved at an unbelievable rate.  Over that same time frame, here is what has happened at Coca-Cola.

Stick with boring, and you’ll win. 



Calculation notes: The industry returns are based on an "equal weighted" custom index, which includes all stocks in the industry with a market cap > 200MM, inflation adjusted. The index is rebalanced/reconstituted annually in December 

Reading List July 2014

A few books for the Summer, to receive these lists every month, sign up here 


Creativity, Inc.: Overcoming the Unseen Forces That Stand in the Way of True Inspiration by Ed Catmull, Amy Wallace

This book was launched with tons of buzz, and deservedly so. It’s one of the most entertaining and useful business books I’ve ever read. The story behind Pixar is fascinating, but so are the management tactics used to keep the company edgy and creative. I found many ideas applicable to my job and my business. For those that follow asset management companies, there are many similarities between Pixar and Bridgewater. The emphasis on constant candor, honesty, and feedback are essential cultural elements at both firms. I particularly enjoyed the discussion of randomness.

Here are a few teaser quotes:

What is the nature of honesty? If everyone agrees about its importance, why do we find it hard to be frank? How do we think about our own failures and fears?

This principle eludes most people, but it is critical: You are not your idea, and if you identify too closely with your ideas, you will take offense when they are challenged. To set up a healthy feedback system, you must remove power dynamics from the equation—you must enable yourself, in other words, to focus on the problem, not the person.

When I mention authenticity, I am referring to the way that managers level with their people. In many organizations, managers tend to err on the side of secrecy, of keeping things hidden from employees. I believe this is the wrong instinct. A manager’s default mode should not be secrecy. What is needed is a thoughtful consideration of the cost of secrecy weighed against the risks. When you instantly resort to secrecy, you are telling people they can’t be trusted. When you are candid, you are telling people that you trust them and that there is nothing to fear.

Rational Expectations: Asset Allocation for Investing Adults (Investing for Adults Book 4) by William Bernstein

I’ve really enjoyed William Bernstein’s e-book series, especially this latest one. In typical Bernstein fashion, it’s very straightforward and informative. A few choice passages:

Oh, yes, and one more thing. Make sure, absolutely sure, that you have enough riskless assets to tide you over during the bad times, when you are the most likely to see your income fall or even lose your job. Preferably, you should have yet more than this, so as to take advantage of that high exchange rate when it shows up, as it inevitably does. Even more simply: you must have patience, cash, and courage—and in that order. All else, as Hillel said, is commentary.

This is no small point: how much liquidity you have when blood runs in the streets is likely the most important determinant of how successful you’ll be in the long run, since this is the time you’re most likely to lose your job, need cash to purchase stocks on the cheap, or buy the corner lot you covet from your impecunious neighbor.

Beware! Financial systems are not airfoils or electrical circuits that respond identically, each and every time, to given inputs. Stock, bonds, and portfolios are different animals, and can behave unpredictably.

Shadow Divers: The True Adventure of Two Americans Who Risked Everything to Solve One of the Last Mysteries of World War II by Robert Kurson

This book has nothing to do with investing; I include more as a riveting summer read. Two divers discover a U-Boat sunk off of the New Jersey coast which cannot be identified, and then go to amazing lengths to explore and ultimately identify the boat. I could not put this book down.  Kurson is a gifted storyteller.  One good lesson for investors is to never trust official documents or data.  We tend to believe that data is fact, but it is created/reported by fallible people. If a particular datum matters to you, you should always double check for accuracy. Data gets fudged all the time.

As One Is: To Free the Mind from All Condition by Jiddu Krishnamurti

This book is only for those interested in philosophy. Krishnamurti always challenges his listeners to think for themselves, to never be “second hand people.” In keeping with this month’s theme, he also has a lot to say about creativity: “creativity is something that comes into being only when the mind is in a state of no effort.” Here are a few passages:

Self-knowledge is the beginning of wisdom. Self-knowledge is not according to some psychologist, book, or philosopher but it is to know oneself as one is from moment to moment. Do you understand? To know oneself is to observe what one thinks, how one feels, not just superficially, but to be deeply aware of what is without condemnation, without judgment, without evaluation or comparison. Try it and you will see how extraordinarily difficult it is for a mind that has been trained for centuries to compare, to condemn, to judge, to evaluate, to stop that whole process and simply to observe what is; but unless this takes place, not only at the superficial level, but right through the whole content of consciousness, there can be no delving into the profundity of the mind.

[You] must have immense patience to find out what is true. Most of us are impatient to get on, to find a result, to achieve a success, a goal, a certain state of happiness, or to experience something to which the mind can cling. But what is needed, I think, is a patience and a perseverance to seek without an end. Most of us are seeking; that is why we are here, but in our search we want to find something, a result, a goal, a state of being in which we can be happy, peaceful; so our search is already determined, is it not? When we seek, we are seeking something which we want, so our search is already established, predetermined, and therefore it is no longer a search. I think it is very important to understand this. When the mind seeks a particular state, a solution to a problem, when it seeks God, truth, or desires a certain experience, whether mystical or any other kind, it has already conceived what it wants; and because it has already conceived, formulated, what it is seeking, its search is infinitely futile. And it is one of the most difficult things to free the mind from this desire to find a result.

So, can I, who have vast education, knowledge, who have had innumerable experiences, struggles, loves, hates—can that ‘I’ come to an end? The ‘I’ is the recorded memory of all that, and can that ‘I’ come to an end? Without being brought to an end by an accident, by a disease, can you and I while sitting here know that end? Then you will find that you will no longer ask foolish questions about death and continuity—whether there is a world hereafter. Then you will know the answer for yourself because that which is unknowable will have come into being. Then you will put aside the whole rigmarole of reincarnation, and the many fears—the fear of living and the fear of dying, the fear of growing old and inflicting on others the trouble of looking after you, the fear of loneliness and dependency—will all have come to an end. These are not vain words. It is only when the mind ceases to think in terms of its own continuity that the unknowable comes into being.


Consumer Staples, Part II

 “We see change as the enemy of we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.” Warren Buffett

In Consumer Staples, Part I, I explored the unique nature of consumer staples stocks and their impressive historical returns. In this part, I’ll explore how to find the best individual consumer staples stocks.

Some aspects of security analysis require a heavy touch. For example, evaluating the value of a brand, or the sustainability of a “business moat” requires hands on work and deep knowledge of each company. My approach is, instead, quantitative.  In this sector series, I’ll highlight “factors” that can be quickly calculated and compared across a wide universe of stocks. I’ll cluster these stock selection factors into several key categories: valuation, profitability, momentum, and quality.  I’ll also include some factors that do not add value historically, despite their appeal.

As we will see, the secret to success in the consumer staples sector is similar to the secret to success in the broad market: focus on high quality, cheap stocks. Value has been the most successful factor for choosing consumer staples stocks, but the value strategy can be enhanced by insisting on strong profitability and a shareholder orientation.

What Matters for Stock Selection

There aren’t that many consumer staples stocks. Today, there are just 108 U.S. stocks in the sector with a market cap greater than $200MM. If you include international stocks listed on a U.S. exchange (usually as an American depository receipt (ADR)), there are 161 stocks.

Because there are so few, my analysis of factors separates the universe into quintiles (buckets that represent 20% of the market sorted by a factor, or roughly 32 stocks each today) rather than deciles (which I normally use in a bigger universe). I’ve tried to include as many factors as possible that are available at free screening services like, but I’ve also included some factors that are not available from the free screening services.


Given that consumer staples stocks have had such high returns on their equity for so long, it is curious that they are have been, on average, the second cheapest sector after utilities over the past 50 years[i]. And their valuations have been steady. Look at the thick black line in the chart below. Measured against all stocks, consumer staples are almost always cheaper (i.e. their average valuation percentile is less than 50).  In this chart, 1 means cheapest and 100 means most expensive.

The sector is often cheap, but investing only in the cheapest stocks within the sector has yielded even more impressive results. The panel below breaks the universe of consumer staples stocks into quintiles based on different valuation factors. The analysis is run since 1963, and the quintiles are rebalanced on a rolling annual basis (so if you were to run a similar strategy, you’d want to hold positions for 12 months—this holds true for all other factors referenced below).

Clearly, buying cheaper stocks works. All four value factors can point you to sector-beating stocks, but EBITDA/EV and Earnings/Price work best.  Where do these factors point you within the staples sector? Here is the historical valuation percentile (similar to the one above) for the three industry groups within the staples sector.

Food & Beverage companies have tended to be cheaper while Household & Personal Product companies have tended to be more expensive. Take Altria Group (formerly known as Philip Morris) for example. It is the single best performing stock since 1963, but has spent a lot of time as one of the cheapest stocks in the entire market! Pretty amazing. Bottom line: buying the cheaper staples stocks leads to superior results.


The term ‘quality,’ like the term ‘smart beta,’ can mean a lot of different things. I’ve included a number of different factors here that I think are applicable to the staples sector.

Several lessons stand out.

·         High ROE is the defining feature of the Staples sector: the sector as a whole has earned market-beating returns on equity for 50 years. But buying the stocks with the highest individual ROEs has not been a winning strategy. Return on invested capital has been a better measure of profitability and a better way to select stocks.

·         I remember thinking the cash conversion cycle was very compelling during my CFA days, but it is not a helpful selection factor in this study.

·          A focus on strong free cash flow can help you find the best staples stocks. By avoiding stocks with low free cash flow/ sales and avoiding stocks with low free cash flow / short term debt, you can sidestep stocks that have tended to underperform the broad sector.

·         A focus on earnings quality (change in net operating assets[ii], and total accruals to total assets) can also give you an edge.


Two measurements of yield are very effective in the consumer staples sector: dividend yield and shareholder yield[iii]. I’ve only included the top 25 stock portfolio for dividend yield[iv].

Buying stocks with higher yields has been a very effective strategy. Companies paying regular dividend (whose yield is high because the stock is out of favor) have been reliable investments, and companies buying back shares have done well.


Buying stocks with strong momentum has worked well in the broad market, but hasn't added much value in the staples sector. This could be a coincidence of history, and I cannot think of a reason why it hasn't worked that well in this sector, but it is interesting nonetheless. 

Combining Factors for Superior Results

So what happens when you rank stocks on a combination of the best factors? Below are the results of a strategy that combines EBITDA/EV, shareholder yield, change in operating assets (earnings quality), and free cash flow/short term debt (financial strength).  Each stock is given a rank 1 to x and the 25 stocks with the highest average ranking are selected by the model.  The annualized return is similar to some of the factor portfolios above, but the Sharpe ratios are significantly improved. The annualized return is 17.5%--slightly better than the 17.3% for the cheapest stocks by EBITDA/EV listed above. But the volatility is just 14.6% for the four-factor strategy, versus 16% for EBITDA/EV.  That means the four-factor strategy has a Sharpe ratio of 0.85, a big improvement over the 0.76 Sharpe ratio for EBITDA/EV.


In my research, I found one final factor very interesting: Research & Development expenses divided by market value. I didn’t include it above because not all companies have R&D, so you cannot compare all companies to each other. But among those that do spend on R&D, it is a very effective factor. It is part value factor, part earnings quality factor. It measures value because the denominator is price, but also measures earnings quality because of an accounting quirk.

R&D is an investment meant to provide a long term benefit, but it must be “expensed,” meaning subtracted from earnings during the period that the spending takes place. This stands in contrast to other investments like property, plant and equipment which can be “capitalized.” Capitalizing just means that you only count a fraction of the cost—of say a machine—against current earnings. If a machine is going to last 10 years, you only subtract 1/10 of the cost of the machine in the first year. Capitalizing makes sense and smoothens earnings. You can argue that like a machine, R&D spending will have an impact over the course of many years, so the fact that companies have to expense R&D costs can make earnings look weaker than they are and lead to nice future earnings surprises and therefore nice future returns. Here is the factor, split out by quintile.

As always, let me know your thoughts by commenting below or emailing me at

IMPORTANT DISCLOSURE! These backtests do not include any costs whatsoever and so should be taken with a grain of salt.  While a once-per-year trading strategy is fairly easy to trade these days, the costs can still be significant when trading in small cap names. These test also have a fairly small sample size. With just about 150 stocks at any given time, the staples sector is small. The good news is that the factors that work in the staples sector work in the other nine sectors too, as we will see over the course of this series, and also work in international and emerging markets (which are nice out of sample tests).

Calculation Notes: everything, as always, is rebalanced on a rolling annual basis to avoid seasonality in the results. Only stocks with an inflation adjusted market cap above $200MM are included in the sample. Going smaller can improve results, but leads to trading and liquidity concerns.  Due to several comments about excluding international stocks in part I, I’ve included non-U.S. stocks that have a U.S. listing in this study. Results are similar if the universe is U.S. stocks only, but are improved for the most part with a larger (global) universe. The inclusion of ADRs is the reason the consumer staples overall sector return is slightly different from my first post.

[i] Cheapness measured using a composite of value factors: p/sales, p/earnings, ebitda/ev, etc.

[ii] Net Operating Assets = non cash assets minus non debt liabilities. A large positive percentage change is bad: it means things like accounts receivable, inventories, and property plant and equipment are growing at a rapid pace, which has historically boded poorly for future returns.

[iii] Shareholder yield = dividends yield plus buyback yield (% change in shares outstanding in prior year, negative better)

[iv] Dividend yield doesn’t “quintile” cleanly because of a group of stocks with zero yield.

What Drives the Market's Return on Equity?

Earning a high return on equity is one of the primary reasons to do business. Managers of (and investors in) companies want to earn the highest return on their equity as possible, and sustain this high rate of return over as long a period as possible. Some sectors of the market, like consumer staples, have had remarkably high returns over the very long-term, while others, like automobiles, have had extremely cyclically returns on equity.

The market as a whole is cyclical too, sitting somewhere between these two extremes over the past fifty years. In this piece I’ll break the market-level return on equity into its components (profit margin, asset turnover, and financial leverage) and try to identify where we are in the current cycle.

Three Components

High return on equity is almost always a good thing, but the source of return can come from three different areas.

1.       Profit Margin—calculated as net income (earnings) divided by sales (revenue), this simple measure shows how much of a company’s (or the market’s) sales are converted to bottom line earnings after all ordinary or extraordinary expenses. Higher margin = higher return on equity.

2.       Asset Turnover—calculated as sales divided by average assets, this measure shows how “productive” assets are. Imagine two companies that both use similar machines (which each cost $10,000) to make widgets. Company A uses its machine to produce $10,000 in widget sales per year while company B uses its machine to produce $20,000 in sales. Company A has an asset turnover of 1.0 while company B has an asset turnover of 2.0. Company B is using its assets more effectively. Higher asset turnover = higher return on equity.

3.       Financial Leverage—calculated as average total assets divided by total common (owner’s) equity, this measures how much the company has borrowed to earn its way. Leverage is always a tricky beast. Some leverage often makes sense and is an easy way to boost returns and profits; but too much leverage can spell doom. Higher financial leverage = higher return on equity.

With these three components, we can calculate return on equity as:

Profit margin * asset turnover * financial leverage = ROE

So where do we stand on these three measures? The figure below shows the rolling history of each—alongside the market’s total return on equity[i]

Several interesting trends emerge. While the market’s ROE itself has been very cyclical and mean reverting, the components have had more secular trends. Asset turnover has been in steady decline for several decades, falling from 1.23x in 1981 to 0.81x today. Financial leverage has also had a fairly steady decline from its all-time high of 3.4x in 1994 to 2.7x today. In fact, if you just multiply asset turnover times financial leverage, the resulting trend line looks very different from ROE.


That means that profit margins are the driving force (mathematically anyway) behind the market ROE’s cyclicality. Net profit margins can, in turn, be broken down into components just like ROE, and again there are three key variables:

1.       Operating Margin—operating profits (earnings before interest and taxes) divided by sales

2.       Interest Factor[ii]—Earnings after interest divided by operating earnings

3.       Tax Factor[iii]— Net income divided by Pretax income (earnings after interest) 

Just like with ROE, net margin is calculated as:

Operating margin * interest burden * tax burden = net margin

Here is the history of each component:

The two most recent spikes down in margin (and therefore in market-wide ROE) are due in large part to spikes down in the tax and interest factors. Think about interest, for example. During these two rough markets in 2000-2002 and 2007-2009, earnings fell off a cliff but fixed payments on interest remain fairly steady, so a much higher percentage of earnings are going towards interest payments.

Here is the combined effect of taxes and interest over time.

What’s Next?

I am no good at predicting anything, but it’s clear that each of these components can have a large influence on the return the overall market’s ROE. While the combination of asset turnover and financial leverage appear to be in the midst of a secular decline, margins are near all-time highs. Can margins stay here much longer? Operating margins have moved off of their recent all-time high, while the combination of taxes and interest is reducing operating profits by less than is typical throughout history (meaning that the combination of low effective tax rates and cheap debt are allowing companies to “keep” more of their operating profits).  

Interest rates will rise at some point (right?) and operating margins have been fairly cyclical in the past. My guess is that, like most things in the market, things will be cyclical and ROEs will decline. Hopefully this causes everyone to freak out so that we can buy stocks at cheaper multiples than we can today.

NOTE: I’d love to hear your thoughts on this piece. I am swimming in new macro/top-down waters here, because my investment philosophy/process is purely bottom up and ROE is not an important component in stock selection.  I mainly write to learn, so these posts are me reporting data and learning on the fly, so I may be getting aspects wrong. Email me with any thoughts.

Calculation Note: Prior to 1976 I have to use annual data (as opposed to quarterly) due to availability issues.

[i] This entire analysis excludes financial stocks, where return on assets are often a better measure of returns. If people are interested I may do another post specifically on financials because they are such a large part of the market.

[ii] Normally these are called interest “burden” and tax “burden,” but I hate that name because a higher “burden” sounds bad but you want these numbers to be higher (because a higher number keeps the total margin higher).

[iii] Other items sit between Pretax income and net income and would be bundled in this calculation: noncontrolling interest income, extraordinary items, and discontinued operations