Explore underappreciated aspects of stock markets: flaws of price-weighted indices, advantages of market cap weighting, active management vs passive investing, limitations of P.E. ratio, dilution in stocks and foreign exchange fees, optimizing fees and taxes, market cap vs GDP in global index funds, and reliability of market cap vs GDP as an indicator.
Market capitalization is a better measure than price-weighted indices for assessing stock performance.
Most stocks, especially active-managed ones, are likely to underperform the market.
Using the geometric mean, not the normal average, accurately reflects compounded returns.
The P/E ratio does not consider a company's debt, making the enterprise value divided by EBITDA a more comprehensive measure.
Understanding stock-based compensation is crucial for evaluating potential shareholder value.
Deep dives
Price-weighted indices are not indicative of how well stocks are doing
Price-weighted indices like the Dow Jones are not indicative of how well stocks are performing. Market capitalization is a better measure, as it takes into account the number of shares available to trade and the share price. Price-weighted indices disproportionately increase the value of stocks that have increased in price, even if the number of shares listed is not large.
Most stocks underperform their index
A study found that the median stock in the Russell 3000 index underperforms the entire market by -54%. Two-thirds of the excess returns above the Russell 3000 were negative, and 40% of stocks had negative returns in absolute terms. This suggests that most stocks, especially active-managed ones, are likely to be losers.
The importance of using the geometric mean for compounded returns
When calculating compounded returns, it is important to use the geometric mean, not the normal average. This is because returns are compounded based on previous gains, and the geometric mean accurately captures this exponential growth. Using the normal average can lead to overestimating portfolio performance and future forecasts.
The limitations of the price-to-earnings ratio (P/E ratio)
The P/E ratio does not factor in a company's debt, which can be misleading. The enterprise value divided by EBITDA is a more comprehensive measure as it accounts for debt, cash, and other liabilities. However, P/E ratios are still widely used because they are easily accessible and provide a rough estimate of a company's value.
The importance of considering growth when valuing companies
The PEG ratio, which factors in a company's earnings growth, is a useful metric for valuing growth stocks. Stocks with higher growth rates may appear cheaper when using the PEG ratio compared to the traditional P/E ratio. However, all valuation metrics provide only a partial picture and must be used in conjunction with other analysis.
The impact of stock-based compensation on shareholder value
Stock-based compensation, such as stock grants and options, can dilute existing shareholders' ownership and reduce the value of their holdings. Companies that heavily rely on stock-based compensation may have higher dilution levels, which can impact shareholder returns. Understanding the level of stock-based compensation is crucial when evaluating the potential for shareholder value.
The impact of currency conversion fees on returns
Currency conversion fees, particularly on non-sterling trades, can significantly impact returns. Different platforms have varying fees, and it is crucial to understand and compare these fees when trading international stocks or funds. High conversion fees can erode returns and should be factored into investment decisions.
The impact of transaction taxes, such as stamp duty
Transaction taxes, such as stamp duty on UK stock purchases, can add additional costs to investing in certain markets. Stamp duty is a 0.5% tax on each transaction, which can reduce overall returns. While transaction taxes are present in many countries, they can affect investor behavior and market efficiency.
The impact of withholding tax on dividend income
Withholding tax is a tax imposed on dividends paid by foreign companies, and the amount varies by country. It can significantly impact the income received from dividends in foreign stocks. Some countries have tax treaties that allow for reduced withholding tax rates, and investors should be aware of the potential impact on their dividend income.
Considering how platform fees are paid to optimize tax efficiency
Paying platform fees from the appropriate account, such as a bank account for ISAs and the pension itself for SIPs, can help optimize tax efficiency. By paying fees from the right account, investors can maximize the benefits of tax-efficient accounts and reduce the impact of taxes on investment returns.
To succeed at investing, you need to get the big decisions right. But the details matter too. We explore ten under-appreciated aspects of stock markets that, while seemingly trivial, can greatly affect your returns.
We look at everything from index construction to valuation measures to platform fees.
And in today’s Dumb Question of the Week: Why do global index funds use market-cap weighting rather than GDP?
This podcast is for informational and entertainment purposes and is not financial advice. We do not provide recommendations or endorse any decision to buy, sell or hold any security. We cannot be held responsible for any actions listeners may take and investors are encouraged to seek independent financial advice.
Copyright 2023 Many Happy Returns
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