Goodwill: Plug Variable or Real Asset?

Of all the items on a conventional accounting balance sheet, none gives me more trouble than goodwill. It is not an insignificant item for some companies, amounting to a large percentage of overall assets, but it does not show up on the balance sheets of other companies. To anyone who encounters it, there are five questions that follow: What is it? Why it is there? What does it measure? Can it change over time? What do we do with it?

What is it?
While goodwill connotes something substantial, it is a plug variable. Note that it shows up on a balance sheet only when a company does an acquisition. Some accounting text books define it as the difference between the price paid for a target company and the fair value of its assets, but that would be a lie. Stripped to basics, goodwill is the difference between the market price paid for a target company and the book value of its assets, with a little fair value modification thrown in for good measure. Thus, if company A pays $ 10 billion for company B, and the book value of company B's assets is $ 4 billion, there will be goodwill of $ 6 billion on company A's balance sheet after the acquisition.

Why is it there?
The answer to that is very simple. Because balance sheets need to balance. There are two fundamental disconnects between market value and accounting book value:
a. Book value reflects historical cost (not current value): An acquisition lays bare one of the fundamental problems with an accounting balance sheet, which is that the values of assets (at least operating ones) are recorded at historical cost, rather than current value. An acquisition of another company is at current market value and has to be recorded as such by the acquiring company. If you cannot write up the values of the acquired company's assets to reflect the price paid, you will have to record the difference as goodwill.
b. Value of growth potential:  The fair value of a company reflects both the value of its existing assets and the expected value of future growth potential. The former is what is captured in accounting balance sheets but market value includes the latter. Thus, when an acquirer buys a target company, it will have to pay a premium on book value (which reflects the value only of existing assets), even if existing assets were fairly valued.
In effect, acquisitions create an inconsistency in accounting. While internal investments made by a firm get recorded at historical cost, acquisitions are recorded at market value. Goodwill then reflects the accounting attempt to make things whole again.

What does it measure?
So, what does goodwill measure? Building on the last part, the goodwill in an acquiring company's balance sheet is a composite of three inputs:
a. Misvaluation of existing assets: As we noted in the last section, if existing assets are misvalued, there will be goodwill even in the absence of growth. Consequently, the more existing assets are misvalued, the greater will be the goodwill.
b. Growth potential: Goodwill be larger, when you acquire a firm with greater growth potential, since the market value will reflect this growth potential but book value will not.
c. Overpayment by the acquirer: There is substantial evidence that acquirers over pay for target firms and this overpayment is attributed to multiple factors - managerial self interest and hubris, over confidence on the part of managers, and conflicts of interests. Whatever the reason, this overpayment, if it occurs, has only one place to go and that is goodwill.
This can be illustrated with a simple example. Assume that company A acquires company B for $ 1 billion and that the book value of company B is $350 million. Assume further that the fair value of company B's existing assets is $400 million and that the value of its growth potential is $ 500 million. If existing assets are not marked up to fair value, the goodwill of $650 million has three components:
the misvaluation of existing assets ($400 - $350), the value of growth assets ($500 million) and overpayment ($100 million).
Accounting changes over the last decade have been directed at addressing the first of these three - misvaluation of existing assets. Thus, appraisers, working under the tight constraints of both accounting standards and tax rules, are allowed to reassess the value of existing assets to better reflect their current value. In the example above, this would lead to existing assets being reassessed to $ 400 million and goodwill to $ 600 million. For the most part, there is little that accountants can do about growth potential, since those assets exist only in investor perceptions.

Can it change over time? 
 To the extent that goodwill is market-based, the value of goodwill will change from period to period. Thus, the value of existing assets and existing assets can change from year to year and the overpayment has to be recognized at some point in time. Until a decade ago in the US and still in most parts of the world, these reassessments of goodwill are put on auto pilot, with goodwill being amortized over 30 or 40 years, irrespective of the facts on the ground.
In the last decade, accountants have argued that the value of goodwill can be reassessed to reflect changes in the three components and the change should be reflected in earnings. While the amortization or impairment of goodwill tries to reflect this reassessment, there are three issues in how it is done:
a. Timing lag: To make their assessment of whether and how much to reassess goodwill, accountants look to markets. Thus, the goodwill accrued by Time Warner from the acquisition of AOL was impaired by $54 billion in 2002, but only because technology stocks had collapsed in the market in the previous two years.  Since everyone in the market already had made this adjustment, the actual impairment of goodwill was treated by the market as being of no consequence.
b. Unidirectional: Goodwill impairments almost always seem to lower the value of goodwill. If this were a fair reassessment, you should see a significant number of companies where the value of goodwill gets assessed upwards.
c. Composite adjustment: The impairment of goodwill is provided as one number, when it includes reassessments of existing asset values, growth potential and overpayment. Since the implications of each are different for valuation, it is one more reason why goodwill impairment is not a particularly useful piece of information.
In summary, goodwill impairment has become an earnings management tool for many companies rather than a test of fair value changes. In the process, it has lost its informational content and is of little help to investors.

What should we do with goodwill?

Here is the million or billion dollar question. Assume that you are valuing a company with a significant goodwill item on its balance sheet. How should it affect the way in which we value or view the firm?
a. Book capital and Earnings: The minute a company acquires another company, the characteristics of book equity and capital change. Rather than reflect just historical values (which is the case when a company has only internal investments), they incorporate market values for at least the target company's assets. Thus, book capital for an acquisitive firm includes the three components mentioned above for a target firm - a mark-to-market of existing assets, growth assets and overpayment. Since the rest of the acquiring firm's assets remain at their old values, the resulting book equity and capital is inconsistently defined. Earnings are also contaminated for a different reason. The impairment of goodwill can cause big swings in earnings from period to period. Since earnings and book capital are the key inputs into return on equity and return on invested capital (ROIC), the presence of goodwill can dramatically alter these returns.
To correct for goodwill, many  analysts adopt the policy of ignoring it all together in the computation. Thus, return on capital is measured as:
ROC = Earnings before goodwill amortization/ (Book value of capital - Goodwill)
However, I have a paper on measuring returns where I have argued that while it is perfectly reasonable to net out the first two components of goodwill - misvaluation of existing assets and growth potential- from book capital, overpayment should not be netted out. In effect, companies like Time Warner should not be allowed to wipe out their mistakes and return their capital to pre-mistake levels, since stockholders have paid the price for these mistakes. Of course, separating out what portion of the goodwill is for overpayment is tough to do, but we need to make an effort. (I propose that we call this stupid goodwill and contrast it with smart goodwill)
b. Valuation: In a discounted cash flow valuation, goodwill really has no direct effect, since we estimate the value from expected future cash flows. Those cash flows will reflect the true value of existing assets and growth potential. Thus, it is in incorrect to add goodwill on to a DCF value, since it double counts these values. If you are doing asset based valuation, where you try to estimate current market values for individual assets on the balance sheet, it becomes trickier, since goodwill is not a conventional asset. Here, there is no easy way out. You have to either take the accounting estimate of goodwill as a fair value or estimate the value of future growth (which would require a DCF). In relative valuation, goodwill does not really affect much if you are using operating income multiples (Operating income or EBITDA is pre-goodwill amortization anyway) but it can affect equity earnings multiples (PE ratio or PEG ratios), since those earnings per share can be affected by goodwill charges. Goodwill can become a problem with book value based multiples. In effect, if you do not adjust for goodwill, companies that do a lot of acquisitions will have lower price to book and EV to Book ratios (and thus look cheaper) than companies that grow with internal investments.
One final thought. Given that goodwill, as an item, really changes nothing about the underlying assets and their value, no company should make or change decisions based upon the accounting measurement and treatment of goodwill. If you pay too much for a target company, what accountants do with or to goodwill cannot undo the damage already done.

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Accounting inconsistencies

In the next few posts, I plan to focus on the accounting inconsistencies that bedevil analysts. In particular, here are the items that I will highlight:

1. Goodwill: When a company acquires another, goodwill shows up on the balance sheet of the acquiring company. While the name connotes something of substantial value, goodwill as it is currently computed is really a plug variable, designed to make the balance sheet "balance". Goodwill skews book values of equity and capital and wreaks havoc on earnings.

2. Minority interests: This is perhaps the most misleading item on a balance sheet, at least to the non-accountant. While it suggests something of value that you own (an asset), it is a by-product of another accounting practice termed consolidation. In effect, a company that owns more than 50% of another is required to "consolidate" its financial statements and report 100% of that subsidiary's earnings, capital and assets as its own. Minority interest reflects the value of equity in the subsidiary that does not belong to the parent company and is thus a liability. Not only is the treatment of minority interest a problem in discounted cash flow valuations but it is also an issue when computing enterprise value and related multiples.

3. Investments in other companies: With a firm with minority holdings in other companies (less than 50%), accountants face a different issue. What is the value that should be attached to these holdings on the balance sheet? Unfortunately, there is no one template in accounting and these holdings are sometimes shown at original cost (what was paid to acquire the holdings), sometimes at an updated book value (reflecting retained earnings since acquisition) and sometimes marked to market. Thus, an unsuspecting analyst can make significant mistakes in valuation, if he or she makes an incorrect assumption about accounting treatment.

4. Extraordinary gains and losses: This should be simple, right. Any items that do not comprise regular operating income or earnings should be consigned to this line item. If that were the case, dealing with extrardinary items would be simple. Since they are extraordinary, we can assume that they will not occur in the normal course of events and ignore them. In practice, though, companies use extraordinary income (expenses) for line items that are recurrent but with shifting effects (exchange rates gains and losses), related to operating adjustments (restructuring charges) as well as a device to show higher operating earnings (by shifting operating expenses into the extraordinary expense column). Thus, separating the truly extraordinary from the ordinary has consequences for both discounted cash flow valuations (by changing base earnings) and earnings multiples (PE ratios, EV/EBITDA etc.)

5. Deferred taxes: Deferred taxes can show up either as assets or liabilities. A deferred tax asset reflects a company's belief that it has paid too much in taxes over prior periods and can thus expect to get tax relief in future periods. A deferred tax liability is a measure of the opposite - a company that has been able to use the tax code to good effect and paid less in taxes (legally) than it should have (assuming the statutory tax code were applied to taxable income) can reasonably expect to pay higher taxes in future periods and has to show this as a liability. While the logic for both items is impeccable, it is worth noting that they reflect expectations of future tax savings (in the case of deferred tax assets) and tax liabilities (in the case of deferred tax liabilities). There is no contractual obligation or time line for these expected cash flows and that can create problems in valuation.

6. Intangible assets: In the last decade, accountants have discovered that accounting standards are not consistent about how they deal with intangible assets as opposed to tangible assets. The rules on capitalizing the latter are well established and the assets on a manufacturing firm's balance sheets reflect the firm's investment in land, buildings and equipment. For firms with intangible assets, which can range from technological prowess (Google) to brand name (Coca Cola) to patents (Amgen), the treatment of the assets has generally been benign neglect. As a consequence, the earnings and book capital at these firms is skewed and can affect both intrinsic and relative valuations.

7. Leases: The biggest source of off-balance sheet debt in the world is leases. A firm that leases its assets (rather than borrowing money and buying these same assets) can hide these assets (and the implicit debt in these assets) if it can meet the accounting requirements for lease expenses to be treated as operating expenses. As a result, we understate the debt ratios of retail firms and restaurants and misvalue these firms.

While the accounting logic behind the treatment of each of these items make sense to accountant, I think that they lead to poor measures of earnings and value. The post that highlights each item will examine not only the potential problems created by the current accounting treatment but also present  solutions to those problem.

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Government Default and Riskfree Rates

I have several posts on potential government default and riskfree rates. I noticed this story in Business Week.

I know that this is only one observation but it is a troubling one. In emerging markets, it is not uncommon for companies to borrow money at rates lower than the government, but the saving grace is that the borrowings are in a foreign currency. I can see why bond holders saw less default risk in dollar bonds issued by Petrobras in 2004 than in dollar bonds issued by the Brazilian government.

In this case, lenders are actually perceiving less default risk to Berkshire Hathaway than to the US Government, for a US dollar bond. I know that Berkshire Hathaway has a much healthier balance sheet than the US government, but the US government has the power to print currency. Thus, I would not read too much analytical significance into the 3.5 basis point different. However, I think the market is sending a message to the US government which might or might not be getting through: You have to get your financial house in order soon or you will pay a price. Let's hope that someone is listening.

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How do you measure profitability?

I have assiduously stayed out of the health care debate that has dominated the news in the United States for the last year, since everyone involved in it seems to come out of it looking worse for the wear. However, there is one aspect of the debate which I have found fascinating, revolving around how profitable or unprofitable the health care business is for insurers, pharmaceutical firms and hospitals. Let me be clear up front, though. This is not a post about health care reform but about how best to measure profitability.

On one side of the debate, you have proponents of health care reform arguing that health care companies, in general, and health insurers, in particular, make huge profits. By extension, they also suggest that one way to reduce health care costs is to reduce these profits. On the other side of the debate, you have opponents of health care reform noting that health care firms really fall in the lower rung of the market in terms of profitability. Each side uses its own measure of profitability to make its point.

Generically, there are three ways to measure profitability and they all come with caveats:
1. Dollar profits: For shock value, there is nothing better than dollar profits. Since most of us are unused to thinking in billions of dollars, noting that an industry generated $ 100 billion in profits seems awe inspiring. In 2009, the aggregate numbers (in billions) for publicly traded firms in the health care business were as follows. In terms of dollar profits, pharmaceutical firms deliver much higher profits than other parts of the health care business. While $130 billion in pretax operating profits is large, note that the aggregate pretax operating income for the market is $3.5 billion. In terms of net profits, pharmaceutical firms account for almost 14% of the net profits for the entire market. The problem with dollar profits is that they have no moorings. A profit of $ 20 billion sounds large by itself, but does not look that large, if compared to revenues of $ 1 trillion or capital invested of $ 500 billion.

2. Profit margins: We can scale profits to total revenues. Looking at equity investors in firms, the most logical measure is net profit margin, obtained by dividing net profits by total sales. From the perspective of all claim holders in the firm, a more complete measure is the operating margin, estimated by dividing operating profits by revenues. The latter is less likely to be skewed by financing decisions. After all, a firm that borrows more will have less net income after interest expenses and a lower net margin. Looking at the health care business again, here are the numbers.
While pharmaceutical firms deliver much higher margins than the market, the rest of the health care business delivers margins in line with the market. I personally do not find profit margins, by themselves, to be particularly informative and here is why. As every introductory marketing book points out, there is a trade off between margins and turnover. In other words, you can set high prices (and high margins) and sell less or go for lower prices and higher sales. In retailing, for instance, you see both strategies at play. Walmart has low margins but uses its turnover ratio (measured as sales as a percent of capital) to end up with huge profits. Many luxury retailers have much higher margins than Walmart but struggle to report even meager profits. More generally, differences in the way business is conducted makes it impossible to compare margins across businesses.

3. Returns on investment: In my view, the only profitability measure that works across sectors is to measure the return generated on a dollar invested in a business. This return can be measured to just equity investors as the return on equity, obtained by dividing net income by equity invested in the business or to the entire firm as the return on invested capital, estimated by dividing after-tax operating income by capital invested (debt plus equity) in the business. Measuring the actual capital invested in a business is a difficult task and most practitioners fall back on using book values. Here are the return on equity and capital numbers for health care firms.
In my view, this table provides the most comprehensive measure of the profitability of each business. Pharmaceutical firms and health insurance companies generate returns significantly higher than their costs of equity and capital and relative to the market. I am not suggesting that returns on equity and capital are perfect. Since accountants can alter book value through their judgments and provisions, I have a paper on how best to adjust returns for the various problems in accounting measures:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105499
I do update all of these profitability measures on my website at the start of every year. The 2010 updates are available at:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html

My conclusion! Health care firms, at least in the aggregate, are financially healthy and generate returns on their investments that exceed their costs of equity (capital). While these excess returns may suggest to some that these firms are "too profitable" and that they should be taxed or regulated, two points are worth noting.
a. The first is that there is a survivorship bias, insofar as only the most successful firms in each group are represented in our samples of publicly traded firms. To illustrate, consider pharmaceutical firms. Many small biotechnology and pharmaceutical firms never make it through the FDA approval process and the capital invested in them gets wiped out when they go under. If we regulate or restrict the mature (and successful) pharmaceutical firms to generate only their cost of capital, where is the incentive to do research in the first place?
b. The second is that the aggregate profitability of the businesses should not obscure us to the reality that each of these businesses is splintered and that rules/regulations/market conditions vary widely across different products/services and markets. In other words, while insurance companies collectively generate profits, they can lose money in individual states (as Wellpoint was contending for its operations in California). Requiring the insured in other states to make up for the higher costs of health care in California will create a death spiral for the business.

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Equity Risk Premiums and the Fear of Catastrophe

As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.

The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.

It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.

On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.

How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.

I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382

You can rest assured that I will nag you on this topic for as long as I maintain this blog.

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The Fed Effect: Central Banks and Equity Value

Last week, the Federal Reserve announced that it would increase the Fed Funds rate by 0.25%. While the increase was small and the overall rate still remains low, by historical standards, concerns about the implications to the stock market surfaced almost immediately.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:

a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.

b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.

c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.

So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.

The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.

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Transactions Costs and Beating the Market

One of my books, Investment Fables, is directed at answering one of the most puzzling questions in investments: How is that there seem to be so many ways to beat the market on paper but that so few money managers seem to do it in practice? A key reason, in my view, is that transactions costs have a much greater impact on returns than we realize.

Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
http://www.amazon.com/Inefficient-Stock-Market-Robert-Haugen/dp/0130323667
And here is a link to sure fire money makers from practitioners:
http://www.amazon.com/Ways-Beat-Market-Hundred-Stock/dp/0793128544
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):
http://www.fullerthaler.com/

Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver "excess returns". Ergo, a money making strategy is born.. books are written.. mutual funds are created.

Now let's look at the bad news. The average active portfolio manager, who I assume is the primary user of these can't-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to "bad" portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year...

So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.

In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.

In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.

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