Playing the long game: Turning traders into investors

At the end of The Little Book that Beats the Market value investor Joel Greenblatt makes a deal with readers.

If they earn enough money from the investment formula he describes and are grateful for their good fortune, they should find a way of giving back through philanthropy.

Many people, he says, believe liquidity, in other words the huge volume of buying and selling on the stockmarket, is useful. By participating in an active marketplace, investors give companies the opportunity to raise money for investment. Some trading is necessary, Greenblatt says. But he also argues: "Ninety-five per cent of the trading back and forth each day is probably unnecessary. The market would still be fine without almost all of it. The market would certainly be fine without your contribution."

That observation has troubled me over the years. When companies invest money well, they innovate, create products and jobs and improve people's lives but when individuals trade shares on the stockmarket they don't provide money to companies for investment. They buy ownership of investment that has already been made. By trading shares I may make myself richer, and by writing about successes and failures I may help other people become richer, but that can't be it, surely.

Professor John Kay's report for the UK government last year shows how buying shares in the stockmarket might promote the common good, an activity I distinguish from the trading Greenblatt describes by calling it "investment".

The Kay report conducted an investigation into whether the UK stockmarket helps sustain competitive businesses that will earn the necessary return on investment to fund our pensions and other long-term financial goals.

Short-termism

Kay concluded it doesn't. Short-termism is endemic and erodes the competitiveness of business.

Kay blames this short-termism on the internationalisation of share ownership, which has created fewer powerful shareholders, and an explosion of "intermediation", the army of brokers, advisers, platforms, fund managers and trustees, all with their own interests, that sit between companies and the people that ultimately own them.

He also criticises the glut of information from those that stoke speculation about what companies are going to report next and the effect on the share price.

Kay confirms Greenblatt's earlier observation: "While some trading is necessary to assist the provision of liquidity to investors, current levels of trading activity exceed those necessary to support the core purposes of equity markets."

But he goes further. Trading is a zero-sum game of winners and losers, but that doesn't benefit savers as a whole. In fact it harms them because it harms the long-term prospects of businesses listed on the stockmarket.

The traders that dominate the market sell when companies disappoint, so company directors strive to meet their short-term expectations. Too often they achieve those expectations through under-investment, rabid restructuring, financial engineering, and mergers and acquisitions.

If traders behaved more like investors and analysed businesses instead of predicting share prices, companies would take decisions with the confidence that would improve those businesses. Investors would ensure remuneration rewarded stewardship, instead of waving through incentive plans that blatantly reward short-termism.

Thankfully there are investors and companies like this, but short-termism is pervasive and ending it, Kay's objective, means turning traders into investors. The report mainly targets asset managers, the professionals who run funds, because they are responsible for most stockmarket activity, but I've been thinking about the implications for private investors, and one particular private investor, namely me.

Obviously I could be a better investor by Kay's standards but before I explain how, here's a quote from Benjamin Graham. Graham is the father of value investing lauded by many in the subsequent generations of value investors, such as Greenblatt and Warren Buffett. The quote comes from Security Analysis, a textbook still in print nearly 80 years after its first edition, and nearly 40 years after Graham died.

It may be the most quoted definition of investment. Graham said: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Although I'm an admirer of Graham, I don't like his definition. It could apply to a system for winning at poker or any gambling activity in which skill is a factor. Its indefiniteness was intentional because Graham wanted to include trading where the risks and rewards could be calculated with confidence.

The Nifty Thrifty

The Nifty Thrifty is a mechanical investment strategy published in Money Observer every quarter. It uses a computer algorithm to select good companies at cheap prices. It's based on a combination of two statistics: the Magic Formula, invented by Greenblatt, and the F_Score, invented by academic Joseph Piotroski.

Both statistics have been tested independently and together by academics, investment banks, and rather rudimentarily by me. They ape the value investing systems invented by Graham and validated by academia. Upon thorough analysis, the Nifty Thrifty promises safety of principal and a satisfactory return. It's the kind of investment operation Graham had in mind.

But the Nifty Thrifty violates many of the distinctions between investors and traders itemised in Kay's report. Traders are anonymous. Investors are committed to companies and encourage long-term strategies. Traders own large portfolios of companies they know little about while investors own more concentrated portfolios they understand. Traders focus on predicting short-term company performance and share prices. Investors focus on business fundamentals and the potential for profit over many years.

The Nifty Thrifty algorithm generates quite a large portfolio picked by an anonymous computer and trades them every year, similar to the average trade-happy fund manager.

The system resembles arbitrage, a term for buying and selling the same security simultaneously in different markets to take advantage of a difference in price. Strictly, an arbitrageur realises the difference in value between the cheaper security he buys and the more expensive one he sells instantly, without risk.

With the Nifty Thrifty, markets are separated by time. The arbitrageur buys shares cheaply but has to wait a year for his profit, and it's not risk free. In some years, the algorithm will do poorly. But, over many years, value is realised and the probability of losing to the market reduces as time passes.

Systems like the Nifty Thrifty are codifications of old-school value investing: buying shares on low price/earnings ratios, for example. Fifty years ago an investor such as Graham would have had to do the work without a computer but the result would have been much the same: a large group of potentially undervalued shares, many of which would do badly. The winners, though, would do well enough over long periods of time for the group as a whole to beat the market.

Value investing

This realisation of value sets old-school value investing apart from trading. It focuses on companies that are cheap relative to proxies for business fundamentals, usually profit or book value. This investing does not punish companies that do badly in the short term but may be investing for the long term; instead it rewards them.

But the old-school value investor is not calculating that the business is especially good, he's calculating it's especially cheap and the return comes not from the gradual realisation of profits but a rising share price when the sentiment of other traders changes. That is a benign form of trading and some of my handpicked Share Sleuth portfolio members also fall in this category.

I humbly propose tightening up Graham's definition of investment along lines Buffett and Greenblatt might approve of, so that it only incorporates a subset of the activity he embraced: "An investment is ownership of a share in a business that, after thorough analysis, promises safety of principal and, through its operation over many years, satisfactory returns."

To invest is to evaluate a business, its finances, its management and its strategy and encourage those businesses that have the qualities to prosper by engaging with management and holding the shares for as long as the business justifies it. Even the best businesses can be poor investments if you pay too much for them, but price by itself cannot define an investment. Where price is the dominant factor it's arbitrage, or arbitrage's destructive twin, speculation. Both are forms of trading.

Engagement is an intimidating prospect for some private investors. But simply by reading annual reports we engage with a company. By holding or buying shares in good businesses when others sell, we send a positive signal. Private investors increasingly share research in discussion forums, on blogs, and with companies. Individually, and together, private investors talk to company directors. Such activity has little influence on the biggest companies, those that are most actively traded, which means smaller companies are perhaps the more natural preserve of private investors.

When investors engage companies with our long-term perspective we improve them and so investing not only makes us richer, it makes us all richer.