SDS (Seductive ...'s  Instablog

There are thousands of books about effective market (some of them written by leaders of Effective Market Hypothesis /EMH/ are quite good) and already several dozens of books about ineffective market.

I think that existence of long-term premiums or /mostly/ discounts to net assets values for closed-end funds (en.wikipedia.org/wiki/Closed-end_fund) is the simplest evidence of stock market inefficiency (fig.1).

(click to enlarge)

Fig. 1

But at first glance EMH has good logic and to some extend confirmed by market data. So why EMH and it derivatives are wrong?

IMO the main EMH weakness is operation with such ill-defined term as risk and oversimplification of reality in sake of nice mathematics. For example initial assumption that risk (in terms of volatility, beta, covariances, etc...) is related to return is simple incorrect (see e.g., fig.2)

Fig.2

As the result EMH, MPT, CAMP, etc... are related to stock market as dresses for girls at podium of fashion show are related to dresses for average women (former are probably more elegant, later are that mass production should target).
I'd rather agree that market "is USUALLY incorrect than ALWAYS incorrect" just because market or stock crosses CORRECT point when it goes from negatively /positively/ incorrect to positively /negatively/ incorrect. It is at least very difficult to figure out the correct point in the permanent noise of stock market. Trade parties have usually opposite assumptions about the correct point and only in average (for zero sum game at zero fees) no party is right and only a guy who collects fees is a winner. So EMH zealots make shortcut and declare that each point is correct (which is not true IMO) and suggest reduce investor expenses e.g., via index funds (which is true IMO only when it is cheaper than individual stock selection). EMH zealots to some extend understand stupidity of the "ALWAYS correct" claim and prefer to refer to whole market which has smaller fluctuation than each single stock or limited group of stocks.

EMH zealots have found conformations in stock market data but EMH opponents also have found stock market data that contradict EMH (see for example "Finding Alpha" by Eric Falkenstein - short note about it in seekingalpha.com/instablog/725729-sds-se...). Any physicist well knows that any smart, logic and well established hypothesis should be dismiss if a correct experiment result contradicts the hypothesis. IMO, this is now the case for EMH because there are already several evidences that this hypothesis is incorrect.

I'd like to finish this post with quote from Eric Falkenstein book ""One of the biggest things people do is persuade others; and to be a good persuader, it helps to truly believe in that you are selling." I think it is applicable not only to EMH zealots but almost to anything we heard from Wall Street.

A Mexican store in San Jose, California posted sign "In God we trust, all others pay cash", they did not accept credit cards or checks and I do not pretend to be a God so I paid cash. I think this poster (footnote 1) might be a motto of dividend investors. I do not trust 100% any CFO although I use numbers they publish for stock analyses. I require cash from any stock I own.

Currently I invest

a) about 57% in companies from David Fish's CCC list;

b) about 6% in "slow" companies with mostly positive long-term DCR but zero DCR in some years;

c) about 15% in companies /mostly non-US/ without solid annual DCR patterns required by David Fish but with upside trend in dividends;

d) about 15% in companies that reduced or froze dividends /I bought some after dividend cuts/ and delisted from CCC;

e) about 4% in high yield stocks (YOC above 10%) with DCR<0 in some years;

f) about 3% in dividend capture situations.

Examples of dividends histories of companies I own are given in footnote 2A

I did not count here a big chunk in SP500 fund (dividends reinvested) within my 401k plan that cost me 0.05% (footnote 2B). I invest below 1% of my money in each company I own.

I consider myself as eclectic dividend investor although I am 93% dividend growth investor. That is why I consider David Fish CCC list is a free gem.

David Fish started CCC list in December 2007 and updates it each month. Initially 139 companies with at least 24 years of positive annual DCR were included in the 2007 list of Dividend Champions, there are 461 companies with at least 5 years of positive annual DCR in the latest list (105 Champions, 165 Contenders and 191 Challengers). Expansion occurs due to reduction of time frame for positive DCR (i.e. addition of Contenders (9/30/2008) and Challengers (7/27/2010) to Champions) and inclusion of companies with long dividend histories overlooked by David Fish in different CCC categories (e.g. Franklin Resources to Champions).

52 companies reduced dividends and 88 companies froze dividends in the period 1/1/2008-4/30/2012 and were delisted by David from CCC status (see worksheet "Changes" in Excel version of CCC list). I'd not blame companies for dividend freeze during strong economy recession in this period and I'd like to estimate probability of dividend cuts. Because some companies were initially overlooked I can get only lower boundary estimation (footnote 3) for cutters. Only 6 companies cut dividends before formation of Contenders worksheet, 12 Contenders cut dividends after September 2008 and 8 Challengers cut dividends after July 2010. For the sake of simplicity I assume linear time dependence for dividend cuts (in reality most cuts occurred in 2009-2010). In this case if full CCC (all companies included) were created in December 2007 I'd expect that at least 60 companies (33 Champions 14 Contenders and 13 Challengers) reduced dividends during the considered period. Therefore 11.52% = 60/ (461+60) companies qualified for CCC reduced dividends during economy recession at beginning of XXI century. It gives less than 3% annual "default rate" but keep in mind that I do low boundary estimation (again see footnote 3).

This ~ 3% probability of dividend cuts in stocks universe that fit David Fish criteria is almost the same as default rate for investment grade bonds. IMO it means that investment in CCC list is quite safe.

From now on "In God we trust, all others pay cash" becomes my investment motto.

Footnotes:

1. "In God we trust" is printed on each US paper money (I not sure that I can use term banknotes because USA Federal Reserve issues them). Actually there is the book "In God we trust, all others pay cash" by Jean Shepherd but I did not read it. I'm an atheist because I grew up in communist country with strong anti-religious propaganda and because my professional fields in physics and engineering do not required God existence.

2A. Examples of dividends histories of companies I own:

PBI

Fig. 1 Example of dividends for a) type company

EXC after 2002

Fig. 2 Example of dividends for b) type company

SLF in US $

Fig. 3 Example of dividends for c) type company

GE (bought before dividend cut) and HCBK (biught after cut)

Fig. 4 Examples of dividends for d) type company

STD

Fig. 5 Example of dividends for e) type company

NPK

Fig. 6 Example of dividends for f) type company

2B. I'd like to thank Vanguard for such reasonable fees for S&P500 fund. I'm looking forward for dividend ETFs with sub-0.1% fees. My brokerage commission and fees were 0.06% in 2011.

3. I do not blame David Fish for this, he is doing terrific public service for dividend growth investors. As far as I understand David Fish rejects a company ( for example found in December 2011 that paid dividends with steady positive DCR between 1900 and 2009, had negative DCR in 2010 and paid more dividends in 2011 that it paid in 2009) from CCC list and not mentions this company in "Changes" worksheet.

As an eclectic dividend investor (footnote 2) I'd like to know as much as possible about stocks and read a lot of financial books and papers (as much as I can do in my spare time as my SA "photo" indicates). I try to avoid second-hand information that often biased because we see that we want to see and usually neglect any promotional literature. Unfortunately many financial books contain only rephrasing of well known information from other books plus hidden or open promotion of author service (e.g., "scientific" asset allocation) or specific product (e.g., ETFs). Even books written by financial academics are often biased and incomplete. There are not too many terrific financial books and one of them just came to my hands.

Eric Falkenstein wrote terrible (in English, style and editors job) but at the same time perfect (in analysis) book "Finding Alpha: The Search for Alpha When Risk and Return Break Down" each serious investor must read. I'm so sorry that I missed it than it was published in 2009. I feel that finance is fishy and if I were a financial academic I would conduct similar study, but am not and don't have the resources. I should note that Eric Falkenstein assessment of physics is not always correct but nevertheless this book protect you from brainwashing machine of most financial publications and ETF (and other products) sellers.

There are few good reviews of the book made (at Amazon.com, SA /esp. David Merkel review/ and other WWW sites) so I'd not write another review. I think this book open eyes of many investors, market and finance students.