The Investment Scientist

Ever since Fama and French published their seminal paper “The Cross-Section of Expected Stock Returns” in 1992, the world (at least the academic world) has come to understand that over the long run, small cap stocks outperform large cap stocks and value stocks outperform growth stocks.

This quest to understand stock returns has not stopped. In 2013, Robert Novy-Marx published “The Other Side of Value: The Gross Profitability Premium” in the Journal of Financial Economics. In the course of this research, he discovered that profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market in predicting the cross-section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having higher valuation ratios.

Almost concurrently, other researchers confirmed Novy-Marx’ discovery, notably Fama and French’s new paper “A Five Factor Asset Pricing Model” and Hou, Xue and Zhang’s “Digesting Anomalies: An Investment Approach.” Both papers were published in 2015.

Unlike the small cap premium and value premium, the profitability premium does not have a satisfactory risk-based explanation.

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Early on the morning of May 13, President Trump tweeted:

“President Xi of China, and I, are working together to give massive Chinese phone company, ZTE, a way to get back into business, fast. Too many jobs in China lost. Commerce Department has been instructed to get it done!”

What?!?!?! Trump wants to save Chinese jobs? To say that I am caught by surprise is an understatement.

Let me give you a little background just in case you don’t pay attention to the news (God Bless You!)

When ZTE was caught selling telecom equipment to Iran and North Korea in 2016, they entered into a plea agreement with the US commerce department (Obama administration) that included the following stipulations:

  1. They will pay a $1.19 billion fine, the largest fine ever paid by a company.
  2. They will fire the four executives involved.
  3. They will discipline the 35 employees involved.

Fast forward to May 2018, just before the US trade delegation headed over to Beijing for negotiations, the US commerce department announced a 7-year ban on component exports to ZTE because they did not carry out the third stipulation of the plea agreement. It turns out the 35 employees were not disciplined, they were given their 2016 year-end bonus!

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The following is the content of my June 2012 newsletter. It’s still very relevant today.

As I am writing this, the markets are falling like a rock. The Dow has entered negative territory for the first time this year; Nasdaq, which was up 20% a mere two months ago, is up only 5% for the year. The S&P 500 has lost close to 10% of its value since its April 1 peak.

I wrote the above paragraph using typical financial press lingo. This type of language has the tendency to cause amygdala hijack.

The amygdala is a part of our brain that processes threats. When we perceive a threat, the amygdala takes over the whole brain. fMRI scans show that blood supplies are Read the rest of this entry »


trade-deficit.jpgIn 1971, Nixon ended the gold standard and since then the US has been consistently running a trade deficit. The US has not gotten poorer but instead has benefited tremendously from trade deficits.

Prior to that time, foreign holders of dollars could  redeem the money in gold and ship it out of the country, resulting in the loss of national wealth. That’s why prior to 1971, the US generally had a trade surplus.

After the ending of the gold standard, the US dollar became a fiat money that can theoretically be printed at will. When the trade deficit with China was $350 billion last year, what it actually meant was that China sent us $350 billion worth of goods, and we gave them our printed paper(fiat money dollar) in exchange. The USA is the only country that can do that because the dollar is the world currency! I suspect China is secretly envious of our position. Read the rest of this entry »

trade war .jpgLet’s start with some basic facts. As of 2017, the US imports goods worth about $550 billion from China, while only exporting about $175 billion to China. The trade imbalance is about $375 billion in China’s favor. President Trump believes China is making off with $375 billion of the US’s money every year and he is out to stop that. He announced tariffs on $60 billion worth of Chinese goods yesterday, mostly targeting high-tech imports from China.

The biggest high-tech import item from China is … round of applause …the iPhone, totalling about $70 billion a year since China is the final assembly place of all iPhones using parts from Japan, Korea, Taiwan, the US and China.

If an iPhone sells for $1000 in the US, it is counted as $1000 worth of Chinese imports, but 60% of all its economic value is captured by Apple. China probably captures less than 10% of the economic value. The rest is shared primarily by Japan, Korea, Taiwan. A tariff on the iPhone will harm Apple more than China, and also hurt Japan, Korea and Taiwan along the way.

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It just caught my attention today that buried deep in the CNBC website was this headline:

Ameriprise Puts Retirement Savers at Disadvantage in High-Fee Funds, Says SEC

As the consequence of getting caught, the billion dollar company agreed to pay a fine of $230,000. If this is not a slap on the wrist I don’t know what is. Is it going to deter Ameriprise or any other brokerages from ripping off their clients? Nah, I don’t think so.

In a statement, Ameriprise pointed out “… It’s important to note that this is a long-standing industry topic and numerous firms have settled with SEC and FINRA on similar matters.”

This is actually a very honest statement that makes it clear that the dishonest practice of costly hidden fees is quite prevalent in the industry. I only take issue with their use of the word “topic” as if no harm has been done.

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If you go to the Morningstar website to do research on a very popular fund, the Vanguard S&P 500 Index Fund or VFINX, you may find this information after some digging around:

Screen Shot 2018-02-17 at 6.28.32 PM.png
The Investment Return is basically what the fund produces. (If the fund is a S&P 500 Index fund, then its investment return is basically synonymous to what the market produces.) The Investor Return is what the average fund investor receives. So why on earth would the typical investor get less than half of what the fund produces?

The answer is actually pretty simple: most investors just don’t have the mental wherewithal to stay in the market when it drops. They pulled out at the bottom of the market, thereby missing much of the rebound rally in 2009. See this fund flow chart below.

_Enable image display to see chart_

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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