Triple Nine Society From Vidya #268/269 of October 2010
Reflections Of A Registered Subversive
by Bill Matson
always been suspicious of “conventional wisdom”. Too oen it seems
I’ to be created by “experts” more notable for their smooth talk and polit-
ical savvy than for the merit of their ideas. Even when contradicted by
mountains of empirical data, their constructs not only maintain their status with
the general public, but also within academia and other enclaves populated by
those who should know beer.
My guess is that TNS members are somewhat beer than average at distin-
guishing truth from spurious conventional wisdom, especially within the realm
of their professions. But whereas I can spot scams a mile away on Wall Street, I
know there are a multitude of arenas in which I am deceived and ripped off quite
regularly. It occurs to me that if all of us having conventional wisdom to refute
within our fields of expertise started sharing what we know in Vidya, this might
be useful to many readers — as well as potentially beneficial to the businesses of
those who contribute their insights.
A couple years ago, I wrote a piece for Vidya that challenged TNS to become
something of a Chamber of Commerce for its members. is notion seemed to
float off into the ether, and I prey much forgot about it myself. en orsten
resurrected it in his maiden editorial and asked me to write a Vidya article about
my own business.
I cringe within when asked for stock tips at cocktail parties. ough the person
asking the question may well be interested in what I have to say, others within
earshot are likely to become annoyed if they perceive my response as an aempt
to inappropriately commercialize a social occasion.
ere are important differences, though, between the interactions we expect
at social gatherings and what we hope to encounter through our participation in
TNS. While I’m certainly courting peril with this generalization, I am comfort-
able likening TNS to a hotel with many conference rooms. Some of these rooms
are for discussions of the Higgs boson, medieval literature, and other blatantly
non-commercial topics. Others are reserved for networkers, job hunters, sales-
people, and hyper-enthusiastic entrepreneurs.
I will now open a new room in which TNS members skewer the specious con-
ventional wisdom in their respective professions. And I will christen it by taking
on the Wall Street establishment, as well as several thousand finance professors
©2010 by Bill Matson 1
From Vidya #268/269 of October 2010 Triple Nine Society
and a squad of Nobel Prize-winning economists.
Efficient Market eory (EMT) holds that nobody can consistently beat the
market because all publicly available information is instantaneously incorpo-
rated into stock prices. EMT was the springboard for the careers of several Nobel
laureates and is the intellectual foundation of the multi-trillion dollar index fund
industry. It became popular among academics because the simplifying assump-
tion of an efficient market made it possible to apply a wide variety of mathemat-
ical tools to the construction of portfolios, as well as to the measurement and
control of risk.
True believers in EMT don’t need to read corporate financial statements or
press releases. So long as they stay well diversified, they don’t really need to
know much at all about the companies they own, nor need they care how much
they pay for their stocks. Somehow, in its infinite wisdom, the market will see
to it that everything they buy or sell is properly priced.
Mitch Hardy and I co-authored a + page book entitled Data Driven Invest-
ing that thoroughly refutes EMT. Published in , it is largely based on the tens
of millions of data points in S&P’s Compustat data base, a multi-decade compi-
lation of financial statement figures and daily stock price movements covering
thousands of companies.
In seeking to identify paerns within this data predictive of abnormally high
(and low) returns, what Mitch and I found, among many other things, was that:
a) small company stocks, on average, had consistently provided much higher
returns than large company stocks, and
b) companies whose market capitalizations were low multiples of company
sales, earnings, and book value significantly outperformed their high mul-
tiple counterparts. In other words, value outperformed growth .
Following a strategy of buying equal amounts of the smallest companies
with market caps over $ million (in dollars) and reconstructing the portfo-
lio every year on / would have resulted in a ,% return between January
and December (assuming zero commissions). is figure also assumes
that one could actually have executed one’s buys and sells every year at the De-
cember closing price. OK, this is an admiedly unrealistic number.
Market capitalization (or market cap) = Number of shares outstanding x Stock price
Book value = Assets - Liabilities
Low multiple stocks are commonly referred to as “value stocks”, while those with high multiples
are considered “growth stocks”
2 ©2010 by Bill Matson
Triple Nine Society From Vidya #268/269 of October 2010
But consider the returns obtainable, given the same assumptions, by invest-
ing in similar fashion in inflation-adjusted market caps just over $ million
(,%), $ million (,%), and $ billion (,%) — or in the largest
market cap companies (,%). Despite decades of underperformance by cor-
porate behemoths, the conventional wisdom has been that small companies are
speculations and that serious money belongs in GM and AT&T. ough this as-
sertion is somewhat inconsistent with EMT, an equally mainstream piece of con-
ventional wisdom, I construe it as % consistent with my conjecture that each
is dead wrong.
e disparities in returns between similarly constructed and annually rebal-
anced portfolios of value and growth stocks are even more breathtaking. e
companies having the lowest Market Cap/Book Value ratios would have re-
turned ,,% between and (a compounded annual return of .%).
ose with the highest ratios would have yielded a compounded annual return
of just .%.
I also applied our findings in managing my own money — in a test portfolio
whose results were documented through inclusion of my brokerage statements
in our book’s Appendix. Between July and March , it enjoyed returns
of %, with total gains of over $ million. (As you know, however, past perfor-
mance does not guarantee future performance.)
e most frequent criticism of Data Driven Investing is that we failed to ade-
quately assess the statistical validity of our conclusions. My position is that using
Gaussian measures (i.e. standard deviations, Sharp ratios, and the bell curve) to
describe financial market phenomena is absurdly inappropriate. Once again, I
find myself at a variance with conventional wisdom.
Any assertion that the bell curve is capable of explaining or predicting finan-
cial market activity is impossible to defend in view of such events as:
• the German Papiermark’s slide from . to . trillion per USD between
and ,
• the % decline of the S&P on //, which equates to approximately
a standard deviation phenomenon (based on historical daily price volatil-
ity figures) — on a Wall Street ruled by the bell curve, such a move could
be expected roughly once in every 10 years (i.e. once every hundred
trillion trillion trillion trillion trillion trillion trillion trillion trillion trillion
trillion years), and, more recently,
©2010 by Bill Matson 3
From Vidya #268/269 of October 2010 Triple Nine Society
• the “flash crash” and “flash recovery” of //, when the Dow lost roughly
% in minutes and gained nearly all of it back within the following hour.
ere is a silver lining on the cloud of denial in which believers in a Gaus-
sian Wall Street envelop themselves. Some securities have huge payoffs when
the unthinkable occurs, and those who underestimate the odds of the unthink-
able occurring tend to sell such securities too cheaply to those who have a more
realistic world view.
Many investors lack the time and resources to implement the strategies in our
book, so we started an investment management firm to do it for them. Cogni-
tion Capital Management, LLC (CCM) is a registered investment advisor, and our
forte is the management of value stock portfolios with a small company focus for
accounts of $, to $,, (or more). Information about our firm, including
our track record since , is available at www.cognitioncapital.com.
CCM actively supports investor rights, including the extension of fiduciary
standards to all financial advisors. Fiduciary responsibility can be summed up as
a duty to put client interests first. Whereas registered investment advisors, such
as CCM, have this obligation, stockbrokers and insurance agents generally do
not — though they typically lead their clients to believe otherwise.
e conventional wisdom among lawmakers, apparently, is that investors know
enough to avoid being ripped off by their advisors. To dramatize our opposition
to policies allowing stockbrokers employed by government-controlled institu-
tions to sidestep fiduciary responsibility, we became the first investment firm to
register with the state of South Carolina as a subversive organization.
I hope that other TNS members with a subversive bent will share their con-
ventional wisdom-puncturing insights in future!
4 ©2010 by Bill Matson
