The Evolution of the Stock Market and Indexing
Exploration of the history of stock markets and a possible twist on classic index funds
The stock market has played a pivotal role in shaping the modern capitalist world, enabling continuous compound economic growth, and driving human civilisation to unprecedented heights. In this article, we will explore the history of the stock market, from its emergence around 400 years ago during the age of colonisation to the evolution of modern index investing strategies. We delve into the distinction between investing and speculation. Finally, we examine the evolution of index investing and some recent adaptations that capture the essence of value investing in a modern, passive investment framework.
The modern stock market, which came into existence approximately 400 years ago, can trace its origins back to the remarkable period of economic growth that swept across Europe following the discovery of the the Americas around 500 years ago. This era, known as the age of colonisation, witnessed the emergence of early business entities which were established to capitalise on the vast commercial opportunities presented by the newfound lands.
These fledgling companies required significant capital to finance their high-risk, capital-intensive colonial ventures. Initially, European monarchs shouldered the responsibility of funding these enterprises, but as costs escalated, they sought assistance from the nobility, giving birth to the earliest joint-stock companies. Characterised by dispersed ownership, these companies opened the doors for a broader spectrum of investors to partake in their financial growth.
However, ordinary people lacked the knowledge and expertise required to accurately value investments. To overcome this hurdle, equity was subdivided into smaller units, making it more accessible for investment and enabling seamless trading. This innovative approach enabled the innate human desires for wealth accumulation and risk-taking, leading to the rise of the stock market as speculation gained traction, ultimately fuelling the growth of numerous companies.
As participation in the stock market increased, more and more companies were enticed to list, utilizing the funds raised to expand their operations and generate wealth. This economic expansion enabled a higher level of consumption, effectively contributing to a virtuous cycle that propelled the economy forward. As a result, the stock market became an essential driver of economic growth, continuously evolving to accommodate the needs of investors and businesses alike.
As the stock market continued to develop and adapt to the changing economic landscape, it played a crucial role in the emergence of the modern capitalist system and market economy. This period of transformation coincided with a groundbreaking scientific and technological revolution that forever changed the way societies functioned and interacted. The convergence of these pivotal factors gave rise to a phenomenon never before witnessed in the annals of human history: continuous, compound economic growth.
This sustained economic expansion, which has persisted for several centuries, has been instrumental in elevating human civilization to unparalleled heights. It has resulted in the widespread availability of new technologies, enhanced living standards, increased access to education, and improved healthcare systems. Furthermore, it has fostered global interconnectedness, opening up new avenues for international trade and investment.
The power of compound growth cannot be overstated. For instance, consider a company that consistently grows its earnings at a rate of 6-7% per year. Although this rate may not appear overly impressive, over the span of 200 years, the company's earnings would have grown by more than a million times, highlighting the staggering potential of compounding.
The stock market serves as a platform for two primary types of participants: investors and speculators. Investors are primarily concerned with forecasting a company's future performance, basing their decisions on diligent research and analysis. They seek to identify companies with strong fundamentals, growth potential, and competitive advantages, aiming to benefit from long-term, sustainable economic growth. In doing so, they contribute to the stock market's overall health and can achieve consistent returns over time.
On the other hand, speculators are more focused on predicting short-term market behavior, often leveraging price fluctuations and market inefficiencies to make quick profits. Unlike investors, speculators treat the stock market as a zero-sum game, where one party's gains are offset by another's losses. Speculation can add volatility to the market, potentially exacerbating market swings and making it harder for long-term investors to navigate.
Distinguishing between investing and speculation is a crucial aspect of achieving success in the stock market. However, this task is often complicated by the information asymmetry inherent in the asset management industry. Speculators may present a myriad of theories and predictions, leaving inexperienced investors perplexed and vulnerable to making suboptimal decisions. By understanding the difference between investing and speculation, and embracing the concept of Mr. Market - the idea of the stock market as a moody, unpredictable character - investors can avoid falling prey to the "information exploitation tax" and make more informed, rational decisions.
Index investing is a popular long-term investment strategy that aims to capture the overall market's net gains, resulting from the consistent, long-term growth of the underlying economy. This approach is based on the premise that, over time, speculation tends to balance out to zero, while genuine economic growth remains the primary driver of market performance. By investing in a broad market index, investors can benefit from this growth without attempting to predict individual stock performance or engaging in short-term speculative trading.
In order for index investing to work effectively, the chosen index should represent a diverse cross-section of companies within the economy, encompassing various industries, sectors, and market capitalizations. This ensures that the index captures the overall economic and commercial performance of the market, reflecting the net result of all investing and speculating activities. A well-known example of such an index is the S&P 500, which represents 500 of the largest publicly traded companies in the United States, offering a comprehensive view of the U.S. economy. Another is MSCI world, which offers a comprehensive view of the world economy.
Index investing is particularly suited to economies that have entered the modern age and exhibit the potential for continuous compound growth. In such economies, the underlying assumption is that technological advancements, innovation, and productivity improvements will drive long-term economic expansion, leading to higher corporate earnings and, consequently, higher stock prices. By investing in a broad index, investors can effectively participate in the collective growth of the economy, profiting from the rising tide that lifts all boats.
This passive investment strategy offers several advantages, including lower costs due to minimal trading activity, reduced risk through diversification, and the potential for long-term, compound growth. By eliminating the need to constantly monitor individual stock performance or engage in market timing, index investing simplifies the investment process and allows investors to focus on the big picture: the long-term growth and prosperity of the overall economy.
Joel Greenblatt and Benjamin Graham, two highly influential investors, evolved their investment philosophies over time to create their own unique strategies that can be likened to index funds or “grouping” of companies. These strategies are centered around the idea of investing in fundamentally undervalued companies and weighting them based on their relative cheapness, aiming to outperform the broader market.
Benjamin Graham initially focused on a detailed analysis of individual companies' financial statements to identify undervalued stocks. However, as his career progressed, he began to embrace a more simplified approach to investing. Graham started advocating for a diversified portfolio of undervalued stocks, essentially creating a "value index" that would provide broad exposure to a group of undervalued companies.
In his later years, Graham proposed a mechanical approach to selecting undervalued stocks, known as the "Graham formula." This formula involved screening for stocks with low price-to-earnings (P/E) ratios and a low debt-to-equity ratio. By investing in a diversified basket of such stocks, Graham effectively created his own index of fundamentally cheap companies. This approach allowed investors to benefit from the market's inherent inefficiencies while minimizing the impact of individual stock risks.
Joel Greenblatt, a successful hedge fund manager and author, took the concept of value investing a step further by introducing his "Magic Formula." This formula combines two key investment metrics: return on invested capital (ROIC) and earnings yield. By ranking companies based on these metrics and investing in a basket of the top-ranked stocks, Greenblatt aimed to construct a portfolio of high-quality, undervalued companies.
The Magic Formula essentially creates an equal-weighted group of fundamentally cheap companies, as the selection process is driven by the companies' relative attractiveness based on their ROIC and earnings yield. Greenblatt's approach focuses on capturing the benefits of long-term value investing while reducing the need for deep-dive individual stock analysis. By investing in a diversified group of undervalued companies, the Magic Formula seeks to outperform the broader market over time.
Joel Greenblatt's investment firm, Gotham Capital, inspired by Ben Grahams later years has taken the application of the Magic Formula a step further by offering Exchange Traded Funds (ETFs) that implement this approach within an index fund structure. These ETFs provide investors with a convenient way to access index funds that are weighted based on the principles of Greenblatt's Magic Formula.
The “value-weighted” ETFs constructed by Gotham Capital aim to capture the benefits of value investing within a passive investment framework. By systematically ranking companies in the index based on their return on invested capital and earnings yield, these ETFs end up weighting the index heavily in a basket of high-quality, undervalued companies. Theoretically, this allows investors to participate in the long-term growth potential of these fundamentally cheap companies without having to conduct individual stock analysis. The results however, have been inconclusive so far.
In summary, both Benjamin Graham and Joel Greenblatt evolved their investment thinking to create strategies that resemble index funds or groups of companies, with the key difference being that their portfolios were built around undervalued stocks. By weighting companies based on their fundamental cheapness, these legendary investors sought to capitalise on market inefficiencies, offering the potential for superior long-term returns.
Could this be the next evolution of passive investment? I plan on checking in with Joel’s ETFs every year or so to see if his theory that they can consistently outperform overtime holds true.
- Oliver.