Book Reviews, Trading, Value Investing

Book Review of Navigate the Noise by Richard Bernstein

The full title of this book is Navigate the Noise: Investing in the New Age of Media and Hype by Richard Bernstein (2001).

Richard Bernstein was Chief U.S. Strategist at Merrill Lynch. I got to know about this book after I saw some of the old pieces from Bernstein while he was at Merrill, and googled to find out more about him.

The book is a pretty smooth read, coming in at ~230 pages. The key points from the book, for me, are

  1. Don’t get caught up by noise.
  2. Adopt a long-term, well-diversified, disciplined approach to investing.
  3. Timing the market by switching strategies is very difficult, stick to your strategy if it is working as expected.
  4. Both growth and value investing works, however there are cycles between the two styles due to profit cycles and interest rate cycles.
  5. Know what your edge is.

The book does not present any specific investment strategy. It highlights a number of good points such as sticking with a good strategy and not jumping from one seemingly failed strategy to the next, and gave interesting observations with regards to economic conditions that favor growth over value strategies and vice versa.

On growth stock investing, Bernstein pointed out that growth investing works best when interest rates are going lower, and profits are decelerating. That is interesting to me because I have always associated growth investing with a stock market bull run like the dot-com boom and the real estate boom prior to the subprime crisis. In those cases, profits are accelerating and rates are going higher. Bernstein highlighted that the relationships with profit cycles and interest rates don’t hold in a speculative bull market. That I think is the difficulty of trying to switch styles base on market forecast. Even if you get the market forecast correctly (i.e. accelerating profits and higher rates), the style chosen might still be wrong! That’s why it really might be best to stick with a particular style of investing and sticking with it through its good and bad times.


More Timely Information Isn’t Necessarily Better Information

  • I have a stock selection model, called the EPS Surprise Model, that is based on analysts’ earnings estimates. The model has outperformed its benchmark during 11 of the past 14 years.
  • Despite the outstanding performance, the data used within the model is updated only monthly. The model uses month-end earnings estimates, and we do not incorporate intra-month estimate revisions.
  • An investor once quite effectively incorporated this particular model into his investment strategy, and rebuilt our model to incorporate the latest available earnings data on a real-time basis. He ended up losing a lot of money for two reasons
    • His trading costs began to escalate because the increased flow of information made it difficult for him to determine what was noise and what was true investment information. As a result, he traded much more frequently and haphazardly.
    • He now had a larger number of decisions to make, and the simple probability of making poor decisions began to rise.
  • He turned a successful and disciplined investment strategy based on well-measured forecasted information into an unsuccessful, random, high-turnover trading strategy that reacted to noise.

More Information Can Be Harmful

  • There is an opportunity cost to decipher all the information for which you now pay. If you subscribe to a lot of data or information providers and believe that all of them provide insight and are invaluable because you are learning from all of those sources, I suggest that you leave your investing up to someone who might know more about investing than you do.
  • The more you attempt to keep up and be aware of everything that is going on, the more susceptible you are to trading on noise. I would rather willingly admit that there are short-term topics in the stock market about which I am unaware, than not to understand more fully the major events in the market.

Don’t Assume Providers of Information Have the Same Goal as You

  • Most providers of information aim to keep information users glued to the information to sell more advertising time, not to provide accurate and straight reporting.
  • Many investor relations departments attempt to put a positive spin on every company event.
  • Riskier assets attract noise and attention. The media does not focus on assets with little risk.


Beware of Data Mining

  • Investment how-to books tend to look backward rather than forward. Investors should be skeptical of claims of finding a superior strategy, especially when there is no economic theory presented to support why and when strategy outperformed and will outperform.
  • James O’Shaughnessy’s What Works on Wall Street advocated low price-to-sales ratios as the best strategy to follow, it significantly underperformed the market after the book came out.
  • David and Tom Gardner’s The Motley Fool Investment Guide advocated low P/E-to-growth rate strategy, it underperformed the market after the book came out.
  • If the books’ popularity caused their underperformance, why did the authors write the books in the first place?

Attempting to Time Different Strategies Is Very Difficult

  • Few strategies outperform all the time, and you should thoroughly understand why and when underperformance is most likely to occur.
  • Value-oriented strategies tend to perform poorly during economic recessions.
  • The first step when a strategy fails is to compare the economic environments in which the strategy failed in the past, and to determine if the current environment is similar.
  • When historical economic precedent can indeed explain the performance of a strategy, then the investor should probably continue using the strategy despite poor short-term performance because attempting to time different strategies can be a very difficult task. Short-term performance is typically very misleading, so the probability is reasonably high that you might give up on a strategy just before it begins to work again.
  • If the economic environment is not one in which the strategy has historically fared poorly, then the next step is to be somewhat introspective. Is it I, the investor, or the strategy that is failing? Simply monitor the performance of the strategy’s entire portfolio versus that of the stocks selected by the investor. If the performance of the stocks is inferior to that of the entire portfolio, then the investor detracted from the strategy’s basic performance.

Don’t Look for the Next Microsoft

  • I believe the attempt to find the next Microsoft is a futile effort. Despite what most investors believe regarding their stock selection prowess, the only way most will find such a stock is by luck.
  • Even if you were lucky enough to find a stock that appreciated 10-fold during the next 10 years, you might have to have a substantial initial investment in the stock in order to pay for college in 10 years.
  • Investing in only one company implies no diversification. Would you be able to sleep at night knowing that your child’s future college education relies on the success of only one company?
  • And if you had a stock that appreciated 10-fold early on, would you sell the stock and lock in your gains?


Increase Your Time Horizon

  • The probability of losing money when investing the S&P 500 was about 38% during any random month, but it was only about 17% in any given year.
  • You can reduce the probability of a negative return by increasing your time horizon and increase it by decreasing your time horizon.
  • Day traders are looking at minutes and hours, their probability of success if extremely low.

Review Strategies By Time and Not By Event

  • One of the best investors I know rebalances his portfolio only twice per year.
  • Reviewing a long-term strategy according to time creates discipline and helps to prevent three things: propensity to trade because of noise, placing emphasis on events that seem important but will probably be forgotten, and being encouraged to switch strategies during periods of underperformance.


Earnings Expectations Life Cycle (Clock)

  • 6: Unattractive stocks with low earnings expectations
  • 7: Positive earnings surprises
  • 8: Stock picking models pick up stocks with positive earnings surprise
  • 9: Analysts raise earnings estimates
  • 10: Earnings and estimates continue to improve and gain momentum
  • 12: Stock is termed a growth stock
  • 1: Earnings disappointment occur
  • 2: Stock picking models highlight stocks with negative earnings surprise
  • 3: Analysts lower earnings estimates
  • 4: Negative rumors abound and shunned by investors
  • 5: Research coverage dissipates.

Investors and the Earnings Expectations Life Cycle

  • Good investors hold from 6 to 12
  • Bad investors hold from 12 to 6
  • Growth investors hold from 9 to 3
    • Growth investors hold too long because they are encouraged by all the good news.
    • Growth investors need to ignore overwhelming positive news.
  • Value investors hold from 3 to 9
    • Value investors buy too early because of the abundance of bad news.
    • The time to buy stocks as a contrarian is not when the news is overwhelmingly negative but rather when there is no news at all.

Look for Good Stocks, Not Good Companies

  • It appears that bad companies actually make better stocks than do good companies over the long term.
  • The number of good companies are small, and their market capitalization is usually quite large. They tend to perform similarly to the overall market over the long term because they are known as good companies.
  • Bad companies tend to make good stocks over the long term. However, there are periods when these stocks performed very poorly, so investors must be willing to hang on through good and bad times to reap the long-term performance these stocks offer.
  • Secularly rising profits in the United States may be one reason that lower quality stocks have outperformed over the long term.

Reported Earnings Give More Investment Information Than Operating Earnings

  • Reported earnings include all expenses even if they are non-recurring.
  • The important information is that the reported earnings of a company that takes one-time charges will not be as stable as the company that does not take charges. The variability in earnings can be attributed to the economic cycle or to one-time charges. Anything that disrupts the stability of earnings lowers the predictability of earnings and the quality of the company.
  • A study uncovered that strategies that employed operating earnings tended to underperform identical strategies that used reported earnings. The study found that the conclusion held for both growth and value strategies.


Growth vs. Value Investing Performance

  • Over the long term (30 years), the performances of the two styles are remarkably similar (13.33% vs. 13.14%)
  • There are distinct cycles of style investing within those long-term statistics, where growth outperformed value and vice versa. On average, the periods of outperformance last about 3 to 5 years.

Factors Influencing Style Performance

  • Profits Cycle
    • Growth outperforms value when the profits cycle decelerates. When the profits cycle accelerates, value outperforms growth. Periods in which this relationship does not hold are when the stock market exhibited speculative bubbles (e.g. Nifty Fifty period in early 1970s and technology bubble in late 1990s).
    • When the profits cycle decelerates, earnings growth becomes increasingly scarce, and investors react by bidding up the price of that scarce resource, i.e. they expand the P/E multiples on the stocks that can maintain their earnings growth.
    • When the profits cycle accelerates, growth becomes increasingly abundant. Investors become comparison shoppers for growth.
    • Growth investors essentially believe that only a few companies will significantly growth their earnings, so they must find those few stocks and pay whatever price is necessary to hold them.
    • Value investors believe everything will grow, so they comparison shop among all these healthy companies for the cheapest one.
  • Long-term Interest Rates
    • Growth stocks resemble long duration bonds. High P/Es mean investors are discounting earnings very far into the future. Low dividend yields mean that is little or no interim income payments.
    • Value stocks resemble short duration bonds. Low P/Es mean earnings are discounted for a short time periods. Higher dividend yields mean a higher level of interim payments.
    • When interest rates fall, growth tends to outperform value. When interest rates rise, value tends to outperform growth.

Choosing Between Growth and Value

  • Profits cycle
    • If profits cycle is accelerating, you have many choices of growth companies, so go for a value-oriented approach.
    • If decelerating, there are fewer companies with earnings growth, so go for a growth strategy.
  • Interest rates
    • If rates are expected to raise, look for current rather than future profitability, and favor value over growth.
    • If rates are expected to fall, look for future profitability and favor growth over value.
  • Bad news on the economy is generally good news for growth stock investors. A profits recession (i.e. two consecutive quarters in which S&P 500 earnings growth is negative), or economic recession (i.e. two consecutive quarters in which real GDP growth is negative) means slower profits growth, which means a scarcity of earnings, lower long-term interest rates, and a great environment to be a growth investor.


Questions to Answer Before Making an Investment Decision

  • Why is this investment better than any other investment right now?
  • What do you know that everyone else does not?
  • Are you holding a well-diversified portfolio with a long-term time horizon or are you day trading in the latest hot sector?
    • Day traders who focused on minutes and hours are generally bound to lose money.
  • What led you to the investment?
    • Is the source credible?
  • Is it a hot investment?
    • Cold investments might soon be frozen solid, and frozen investments probably need time to thaw. Lukewarm might be best.
  • Where is the investment on the earnings expectations life cycle?
    • Attempt to buy at 7 o’clock on the life cycle.
  • How does the investment fit in with your existing portfolio in terms of diversification?
  • Do you think the investment is risky?
    • Don’t feel compelled to invest in risk assets.
  • How do you know the investment is risky or safe?
    • Based on mere perception or actual numeric risk characteristics?
  • Good company or good stock?
  • Is this a high or low quality company?
  • Is it time for high or low quality companies?
    • Make a judgment as to whether economic and profit conditions will be better or worse one year from now.
    • If better, then typically lower quality stocks are preferable. If worse, then higher quality stocks are preferable. Don’t get caught up in the minutiae of economic forecasts (i.e. GDP growth, inflation, productivity, etc.)



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