New Principles of Equity Investment

Les Coleman

• Publisher: Emerald Publishing Limited
• Year: 2019
• ISBN:
  9781789730654
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

The modern finance paradigm is incomplete. Obvious gaps include poor performance of professional investors, puzzles enough in equity markets to support a sub-discipline of behavioural finance that patches over irrational biases and mispricings, and chronic, but inexplicable, financial crises. As with so many other disciplines, existing finance theory explains less than a tenth of what we see in markets and investment. A new paradigm of investment is needed.
New Principles of Equity Investment brings together robust scientific methodology with empirical evidence to propose a new paradigm of equity investment. It begins with a wide-ranging review of investor practices using mainly US and European research and surveys, and then outlines the nature of investment risk, the links between equity returns and institutional factors, and the structure of equity markets. The result is a sophisticated description of what we know is true about investment, and a frank assessment of the limitations to investment expertise. The author then presents a coherent, workable theory of equity prices that can be applied in practice by equity investors, and explains logical investor behaviours that have been thought of as biases.
Written by an academic with many years of practical investment experience, this book will provide new insights for equity investors who are looking for new perspectives and a better understanding of today's complex markets.

1

What this Book is About

I am to speak of what all People are busie about, but not one in Forty understands.

Daniel Defoe (1710) An Essay upon Public Credit

Money has a power above the stars and fate to manage love.

Samuel Butler (1684) The Lady’s Answer to the Knight

This book comes with reader advisories. First, it does not merely repackage the contemporary investment paradigm, but develops a new perspective that follows a rigorous research philosophy and is based on field evidence. The investment principles here comprise a descriptive theory that explains observed equity prices and investor decisions, and which captures practices and concepts that have proven their effectiveness through wide application. The two main innovations are to treat equities as contracts that have extensive properties, and are best described by a price model with multiple components; and to limit valuation horizon to a reasonably foreseeable next year. A further distinctive feature of this book is to focus on the central objectives of equity investment, namely: valuation of individual equities, managing exposure to losses, diversification of holdings through an appropriate portfolio and timing buy–sell transactions. This investment paradigm cobbles together well-recognised ideas, and most of its building blocks will be familiar to readers.

The book aligns the best of established theory, empirical evidence and industry practice to operationalise equity investment and match it to practices in the real world. In medicine – which is another archetypal practitioner-driven discipline – this process is termed ‘knowledge translation’ because it captures real-world evidence from field research and impounds it in theory, which enriches both and ensures that neither stagnates (Straus, Tetroe, & Graham, 2009). The book also meets a major goal for any new paradigm which is to explain puzzles in the existing paradigm, in this case anomalies that are captured in the behavioural finance (BF) literature.

An improved equity investment paradigm is required because most theories of finance and investment cannot be empirically validated, and this has steadily made them irrelevant. Gaps in understanding of real-world investment are so large as to precipitate regular equity market crashes that usher in global recessions. The direct loss to savers is huge, and there is also significant opportunity cost from loss of investor confidence (Brown, 2013). Optimised investment is a clear and important task, but theoretical gaps and regular crises distort outcomes. Sadly this deficiency in finance has remained true for centuries as shown by Daniel Defoe’s comment above in relation to ‘trade’, or what we term ‘finance’ today.

This book intuits three shortcomings in the current equity investment paradigm. The first is that its foundations were borrowed from classical economics that was developed for tangible commodities and manufactures with utility; however, equities’ market behaviour, however, is quite different. Second is that current finance assumptions are largely based on normative intuitions and lack robust empirical and theoretical support: there is no reason to retain them ahead of more plausible alternatives. Third, the finance world is a lot more complex than we acknowledge: research needs to better comprehend the structure of equities, especially by matching methods of analysis and reasoning to the nature of markets and investors.

The solution offered in this book is pitched to practitioners and researchers with a good grasp of investment, and who seek a coherent strategy and practical framework that they can apply. The book is also suitable as a text for an advanced course in equity investment.

Summary of New Principles of Equity Investment

Both the dictionary and common finance parlance see investment as employing money to generate a profit. The last is typically judged against the money’s opportunity cost, which is the best return available from an alternative investment of comparable risk. Principles here also take their dictionary meaning as ideas or rules that explain how something happens.

The new principles of equity investment in this book are summarised in the first box. These are based on a variety of precepts established by multiple disciplines and include the following:

1. Nature and substance of equities. Equities are qualitatively different to goods sold in traditional markets such as commodities and manufactures. The latter have intensive properties (where each part is identical or they form a single, unified system), whereas equity prices are extensive variables which are the aggregate of complex sub-systems. In addition, goods in traditional markets are tangible products that are exchanged to clear supply and demand. By contrast, equities invest in companies’ liabilities or obligations in order to make a series of payoffs. They are promises without any inherent cost, utility or worth, so their prices are of-the-moment and have no endpoint. Equities are unique products, and pricing theory developed for traditional markets is not relevant.
2. Social aspects of equity prices. Although equity markets are decentralised and most trading decisions are made in private, investors monitor other investors’ behaviour so that markets are extensively socialised. Thus equity prices incorporate expectations about firms, their market, and exogenous influences, which introduces feedbacks that are typical of closed loop and human-based systems, and so equity prices are crowdsourced.
3. Intuitions about investing in equities. Investment is intertemporal because it requires decisions now whose consequences lie in the future and are contingent on the then unpredictable state of world. In the meantime, return depends on performance of agents and counterparties. Moreover, outperformance requires economically meaningful prediction of price-relevant influences which is not practical beyond a year.
4. Investors. Dominant equity investors are financial institutions, which operate as a global oligopoly. They have a business model based on building funds under management; run mostly long-only portfolios with sticky, investor-determined flows; and invest through risk-neutral employees whose compensation is only weakly linked to performance. Their motivations differ from individual investors who are atomised, loss-averse optimisers of returns.
5. Investor behaviour. Flows of investor funds and price-sensitive data are subject to human control, and are frequently involuntary, seasonal and serially correlated which sets up exploitable patterns in liquidity and share prices. Investors interpret data through their own paradigm (or knowledge base and rules they believe govern market behaviour) which explains heterogeneous responses to identical facts. Price expectations are conditional on lagged data (including prices) and so relationships are time-varying and formed in light of recent data.
6. Equity investment is an archetypal practitioner–driven process involving complex decision making with Knightian uncertainty. Investors are not passive conduits of random data, but are active, socialised contributors to equity market behaviours; so techniques followed by today’s leading investors have evolved towards an optimum. Any theory must be investor-centric.
7. Equity price models. Studies of predictive capability across financial economics and other disciplines show that the most reliable forecasting technique is naïve extrapolation of recent data. Equity prices have multiple, time-varying determinants and are highly volatile; they are a closed loop system which has feedback from investor reactions. Thus predictive models need to be dynamic and conditional on current data. Also, equities are extensive variables which aggregate complex sub-systems; these are common in many fields and are typically modelled with multiple components related to unique features or sub-systems.
8. No more than about 10 percent of future equity returns can be predicted. Data from the real or goods economy has no predictive capability because it is all historical, whereas asset markets – equities, debt securities, commodities and exchange rates – are forward-looking and linked by common endogenous features (such as interest rates and investment) and exogenous features (especially inflation): they co-move.
9. Firm accounts report less than half of firms’ market value. Even so, accounts are one of only two objectively reliable datasets about equities, and can partially predict returns. Transactions-based data are the second reliable equity dataset; these, too, can partially predict returns.
10. Since formulation of the current equity investment paradigm by the 1970s, financial institutions have grown to dominate markets and important features of equity markets have assumed greater significance. These include changes in patterns of returns; and incentive problems between shareholders and the many agents in markets and firms, including information asymmetry and moral hazard (Allen & Gale, 2000).

This book links a variety of facts and hypotheses from multiple disciplines to develop an investment paradigm with five central features. First, equities sell in markets driven by socialised expectations and are quite different to tangible goods and services that have immediate, obvious payoff or utility. Equities’ intrinsic or fundamental value is a relatively small portion of price, and requires additional explanators which suggests four price components: intrinsic, fundamental value that is derived from firms’ ongoing operations; costs and benefits for investors from specific features of particular transactions; real option value from strategic opportunities and hazard liabilities that are contingent on unexpected conditions in the firm’s operations and environment; and extrinsic value related to socialisation of equity investors and feedback from market transactions. These are proxied by observable firm-specific value-determining variables, plus indications of strategic opportunities and hazard liabilities that may reshape firm payoffs and price data.

Second, dominant investors run equity-only portfolios whose management is quite separate to the infrequent task of asset allocation. Moreover, their buy–sell decisions are involuntary responses to client cash flows, so investment decisions are based on ranking of equities rather than their absolute value. Third, investors have a constrained holding period of about a year which is imposed by the limit of predictability of firm payoffs and market conditions. This implies that later payoffs are indistinguishable between firms.

Fourth, transaction data – particularly equity prices – have persistent structural features that are related to human and systematic influences on data flows and liquidity. Resulting patterns indicate sentiment and show past valuation extremes, which sets up short-term predictability that is useful in timing transactions. The fifth feature of equity investment is that risk is seen as the possibility of loss. It is managed over the one-year holding period through eliminating risky prospects, and at portfolio level during the decades-long investment horizon.

The proposed paradigm reshapes the objective of investment so it becomes ranking of equities’ value. This is less ambitious than intertwining asset allocation and stock selection, and less ambitious than calculating absolute standalone value. The short horizon adds further simplicity by limiting the relevance of discounting and statistical uncertainty. The net is to streamline a task that is too often made overly complex.

The following sections discuss central features of the proposed new paradigm of equity investment.

Why the Basis of Equity Pricing is Unique

The contemporary investment paradigm treats equities as typical of the goods envisaged in classical economic theory as set out in the writings of Marshall (1890), Walras (1900) and others. Their most important dictum for financial economics is:

when a trader or manufacturer buys anything to be used in production or to be sold again, his demand is based on his anticipation of the profits which he can derive from it. (Marshall, 1890, p. 78)

Thus the workhorses of contemporary equity valuation – especially discounted cash flow analysis, residual income valuation (RIV) and valuation ratios – are based on investors’ judgements about future payoffs.

A second dictum of classical economics that is central to modern investment theory is declining marginal utility: ‘the only universal law as to a person’s desire for a commodity is that it diminishes, other things being equal, with every increase in his supply of that commodity’ (Marshall, 1890, p. 80). This inverse relationship between price and individuals’ consumption leads axiomatically to a downward sloping demand curve, whose importance was stressed by Thaler (1989, p. 186) in describing an upward sloping demand curve as ‘heresy’. Linking the downward sloping demand curve to an upward sloping supply curve forms the law of supply and demand whereby price converges to the curves’ point of intersection, and achieves an equilibrium price that matches investors’ valuations of anticipated payoffs.

Empirical evidence is clear, though, that equity prices simply do not follow these traditional assumptions. Prices are not only unstable but also more volatile than can be explained by theory (see: Shiller (1992) and related writings). Also, equity demand is procyclical: as prices rise, so does investor support, and this is reflected by momentum in returns.

Atheoretical behaviour by equity prices can be traced to their unique features. First, equities do not satisfy a conventional need or want, but are state-dependent claims on cash flows or wealth. Thus they are information based. In particular, equities lack utility that is related to use or consumption and which can be built up from relatively transparent, tangible factors such ...