This book is not what I expected. The title proclaims “New” and continues: “Applying Behavioural Finance to Stock Valuation Techniques”, and I anticipated something radical and possibly, for dinosaurs like me, incomprehensible. Instead, Mr Howard’s book is rather traditional; based on ideas expounded by economists and professional investors, notably Ben Graham and Warren Buffett, for decades.
At its heart are two propositions. First: “The market is a human institution, susceptible to human emotions.” (p26). Howard uses this insight to deny the “efficiency” of the market, arguing instead that emotions mean prices of stocks are sometimes “inefficient” in a way that presents opportunities for less emotional investors. Next he asserts: “On average, low-price (P/E) stocks outperform high-price ratio stocks.” (p26). Putting the two together, what is advocated is a patient policy of buying neglected, low P/E shares and waiting for other investors to see the error of their ways and rerate them.
This is not new. Mr Graham wrote of exploiting the manic-depressive mood swings of “Mr Market” and advised buying unloved, cheap stocks in his book Intelligent Investor. But Mr Howard writes with clarity and his book is well-organised. What is more, along the way he offers some useful insights. For instance, I was persuaded by his recommendation that a successful equity portfolio needs no more than 10-20 holdings to be “properly diversified” (p8). This is far fewer than most investors find comfortable. Elsewhere, although unsubstantiated, I love this punchy claim: “The market generates a positive return 55 per cent of the days, 65 per cent of the months, and 75 per cent of the years. I like these odds.” (p59). We like these odds too and they underpin our bullish disposition.
If there is one idea in the book I baulk at, it is this: “Over the long run the most important force behind the market is the economy.”(p55). Actually, the market is not so beholden to the economy, as even Mr Howard admits when he points out that long-term GDP growth is 3 per cent a year real, while long-term market returns are 7.0 per cent real (p56). This outperformance needs explanation and we think it is because the market is not just the place where units of GDP are measured – possibly low value-added units; much more important, it is where innovation is tested and capitalised. For us it is new ideas – technology in the broadest sense – and not the economy, that are the big drivers of stock prices.
Nick Train is investment manager of the Finsbury Growth and Income Trust