Lucky Hand Investing and Index Benchmarking

By Tim Poulus
Tech & Telecom,

I have some unfinished business to attend to. In my first column, "What is Value?," I presented DCF (discounted cash flow) modeling as the best way to value assets. In the second, "DCF Valuation Improves Naive Value and Growth Strategies," I focused on multiples-based valuation (or other quantitative methods) as a tool for managers who are tracking a large set of stocks and simply have no time to do a DCF on each individual title. It is a suboptimal method that really makes no sense when you look at individual stocks. But from a statistical point of view, it could be a way to at least beat the average.

So now we can tie some loose ends together. When you work with multiples, your valuation will only make sense on an aggregated level, not on an individual level. So, to say that a stock is undervalued because its P/E is low, is just plain dumb. But maybe you have a method to link P/E values to performance, in which case the best you can hope for is to beat the average by selecting a portfolio using this method. And the average, as we all know, is... the relative index!

"And the average, as we all know, is… the relative index!"

My next observation is that, yes, it does make sense to benchmark, or track an index. This is at least true for investors who resort to using multiples instead of "decent" DCF models. If they feel they have some sound quantitative rule (linking a multiple to outperformance), they can expect to beat the index.

Unfortunately however, academics teach us that it is not possible to outperform the market (on a risk adjusted basis). So why benchmark? Well, first of all, this is an entrenched method. People have come to expect it from their managers. Above all however, statistics will allow individual investors to have a "lucky hand," and outperform the market for a number of years. There will even be some outliers who may be lucky for a very long time. And as they say: "In the long term, we're all dead," so who cares about mean reversion?

Finally, why doesn’t everybody do decent DCF models? To start with, as I stated before, people may not have the time or knowledge to do it, especially when they have to cover a large set of stocks. Secondly, they may believe that "traditional" investing works better for them, secretly hoping to be an "outlier" of sorts. And finally, if DCF is all there is to go by, how do you locate undervalued stocks among the thousands of stocks listed on dozens of exchanges worldwide?

Now that is a question that I will leave to our readers to think about.

Article interests AMEX: DIA, AMEX: DOG, AMEX: SPY, AMEX: SDS, Nasdaq: QQQQ, NYSE: NYX, AMEX: QLD, NYSE: DCF. Please see our disclosure at the Wall Street Greek website.