With the stock market rallying to record highs, investors are looking closely at how stocks will continue to fare. Considering everything from technological innovations to changing demographics to a drop in oil prices, how should investors proceed right now?
Prolific writer and Pomona College Professor of Economics Gary Smith has been fascinated with the stock market for more than 40 years. In his latest book, Money Machine, he delves into the power of value investing with engaging storytelling and healthy doses of stock market common sense. In the following Q&A, Smith explains more about Money Machine, a book that is receiving glowing reviews from outlets such as the New York Times.
You’ve written other books on investing, what inspired you to write Money Machine?
The chair of my doctoral thesis committee at Yale was James Tobin, who would be awarded the Nobel Prize in economics, in part for his analysis of financial markets. When I started teaching at Yale, I volunteered to create a stock market course and asked Jim to recommend a textbook. His immediate answer was The Theory of Investment Value, by John Burr Williams, which had been published more than thirty years earlier, in 1938, and was not really a textbook.
Tobin’s recommendation was inspiring. John Burr Williams and Benjamin Graham laid the foundation for value investing—assessing stocks based on the cash they generate rather than trying to predict zigs and zags in stock prices. Their way of thinking is central to the success of many legendary value investors, including Warren Buffett, Laurence Tisch and Michael Larson.
I didn’t use Williams’s treatise as a textbook but, over and over, I have relied on the insights I learned from Tobin, Williams, Graham and Buffett. I’ve been investing and teaching investing for more than 40 years now, and I’ve learned that some lessons are well worth learning, others are not. Their lessons are worth learning—especially now that we have become so enamored of black-box stock-trading algorithms.
Who are the audiences for the book?
I am hopeful that Money Machine will appeal to people who like good stories, especially if there is evidence behind the stories. I’ve gotten great feedback from several Pomona students I’ve taught over the years, some of whom even wrote blurbs.
Value investing is the center piece of the book. What is value investing and what are its advantages?
Think of a stock as a machine that generates cash every few months—cash that happens to be called dividends. The key question is how much you would pay to own the machine in order to get the cash. This is the stock’s intrinsic value. People who think this way are called value investors.
In contrast, speculators buy a stock not for the cash it dispenses, but to sell to others for a profit. To a speculator, a stock is worth what somebody else will pay for it, and the challenge is to guess what others will pay tomorrow for the stock you buy today. This guessing game is derisively called the Greater Fool Theory: Buy stocks at inflated prices and hope to sell to even bigger fools at still higher prices.
Value investing works because investors don't have to predict short-term ups and downs in stock prices—which is impossible.
What are some rules of thumb to identify value stocks?
- Bargains are not going to be found when investors are optimistic, but when they are pessimistic.
- Value investors do not buy metals — no matter how precious — because metals do not generate cash.
- It’s tempting to confuse a great company with a great stock.
How has academic research affected approaches on investment in the stock market?
I have learned from personal experience and academic research that the stock market is not as efficient as some theorists assume and not as predictable as some practitioners believe.
As an academic, I am skeptical of purported systems for beating the market, because I know the perils of torturing data. I am aware of human foibles and follies and try to resist them.
What advice do you have for students interested in investing or in a career in investments?
I have been fascinated by the stock market for 40 years now because it combines theory and data—and I love both. I tell students the Chinese proverb, “If you love your job, you will never work a day in your life.” Choose a career you love, and you will love your life.