A Simple Investment Principle
Posted December 5, 2010on:
Just like two sides of a coin, the capital market is made up of capital demanders (businesses) and capital suppliers (investors). What for businesses are costs of acquiring capital are for investors rewards of supplying it. It is a simple truth that
Costs of Capital = Expected Returns
Looking through this lens, many capital market phenomena can be explained.
Why small stocks tend to have higher returns than large stocks?
It is harder for small businesses to obtain capital than for larger businesses. They have to pay higher costs of capital than larger businesses ex ante. That’s why small stocks also have higher expected returns.
Why value stocks tend to have higher returns than growth stocks?
It is easier for growing businesses to obtain capital than for those that are not growing. Therefore, their costs of capital are lower ex ante. It follows that growth stocks have lower expected returns.
Expected returns are not actually returns. In actual historical returns, small stocks outperformed large stocks about 55% of the time; the rest of the time they underperformed. Value stocks did a little better: they outperformed growth stocks 65% of the time. However, over the long run, actual returns do converge to expected returns.
Take home lesson: don’t chase hot stocks or sectors
If a stock (or sector) is the darling of investors, its costs of capital must be very low. The expected returns must also be very low. Though you may get lucky once or twice, if you play this game often enough, actual returns will converge to expected returns.
The simple principle in action – MZ Capital 40/60 portfolio
This MZ Capital model portfolio invests only 40% in equity. It fell only half as much as the S&P 500 during 2008 and the early part of 2009, but it rallied at about the same rate as the S&P 500 after March 2009. Why? The portfolio has a strong tilt toward small cap value, the part of the market where costs of capital are the highest.
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