Boston — Remember the "dart-board theory of investment," alias the "random-walk hypothesis" or the "theory of efficient markets"? Well, Value Line Investment Survey and possibly the mutual funds have been poking holes in the theory.
This theory was popular in the financial community a few years back.To oversimplify, it holds that the investor needn't bother doing any investment research or buying expensive analyses of industries and stocks. He can get just as good a rate of return in the market by pinning up the stock tables from his newspaper on the wall and selecting stocks for a portfolio by throwing darts at the lists.
Variations in the performance of stock portfolios, certain academics argue, are not due to the investment sagacity or incompetence of the portfolio manager. They are the result of pure chance or differing levels of risk of the stocks in the portfolio. The major stock markets, these theorists hold, are "efficient," in that prices reflect all the publicly known information on each corporation. As each new fact comes along, there are enough intelligent buyers and sellers standing by to take into account the new information that the price change almost immediately to a new appropriate level. Thus, unless an investor has inside information not known to the investing public in general, he cannot beat the stock market averages with a portfolio except by good luck. Price movements of stocks, except for the result of new information, are a "random walk" like that of molecules in matter -- quite unpredictable.
If the random-walk thesis is valid, then the individual or institution with a stock portfolio might as well follow a strategy of "passive management" -- trying merely to match the broad stock market averages such as the Standard & Poor's 500 index. Exploiting this view, a considerable number of so-called "index funds" sprang up that attempted merely to do as well as the averages.
But if there are still "holes" in the market -- unrecognized but detectable opportunities to invest in stocks with future above-average performance -- then an "active management" strategy could be worth the effort.
Says Mark Tavel, research director for Value Line Investment Survey, "The active managers are getting some extra ammunition these days -- their record has been so good."
For example, mutual funds invested in common stocks last year enjoyed an average return of 31 percent. That's somewhat better than the 25.8 percent gain in the S&P 500. Some years back they were doing worse on average than this index.
Value Line itself ranks some 1,700 stocks at the start of each year in five groups, the No. 1 group being the highest rated. Assuming no changes during the year, a portfolio of Value Line's 100 stocks in group No. 1 shot up 50.2 percent in value last year; the 300 in group 2 increased 37.4 percent; the 900 in group 3 rose 20.8 percent; the 300 in group 4 climbed some 13.2 percent; and the 100 stocks in the bottom-rated group increased only 8.4 percent. On average, the 1, 700 stocks were up in value by 23.4 percent.
In theory, an efficient-market enthusiast might argue, Value Line was just lucky. But if so, the investment advisory firm has been consistently lucky -- an that's not so likely. Its group No. 1 (which varies somewhat from year to year) gained in total 749 percent during the years 1965 to 1980. During that time, the Dow Jones industrial average was up 1 percent and the New York Stock Exchange composite up 62 percent. The 1,700 stocks followed by Value Line on average rose 173 percent. This list includes many stocks not listed on the Big Board.
"There is no doubt in our minds that active management pays off," said Samuel Eisenstadt, chief statistician for Value Line.
To obtain such excellent performance, Value Line uses a somewhat mechanical system of ranking. It is based on three criteria:
1. The "nonparametric value" position of the stock -- a function of the "order" of its latest relative reported earnings and relative price in relation to the stock's past 10 years' experience.
2. Quarterly earnings momentum --each stock's quarterly earnings change from the same quarter in the preceding year is graded as to whether the change is above average, average, or below average.
3. An earnings surprise factor -- taking account of the deviation between a stock market analyst's earnings estimate for a particular quarter and the actual earnings report. Higher earnings than expected tend to boost the ranking of the stock, or vice versa.
Value Line's Mr. Tavel makes semiserious jokes about the problems Value Line has in keeping stock analysts because they do not make purchase or sell recommendations. They merely make earnings estimates, which are fed into computers, and the computers spit out the rankings.
"Does this make them happy?" he asks rhetorically, and replies, "No. Professionally fulfilled? No."
But the ranking system and scope of Value Line's stock analysis have apparently made subscribers happy. There are now some 90,000 of them, compared with about 75,000 at this time last year.
But will the spreading use of the system make the stock market more efficient and remove the possibility of extra gains by investing according to Value Line's ranking method? Mr. Eisenstadt says the system would have to be followed much more broadly than it is for this to happen, that there are too many skeptics about. "As long as there are schools like the University of Chicago teaching efficient markets, there is hope for us," he concluded.
The Dow Jones industrial average looked as if it might stay above 1,000 last week. But the index succumbed to prof it takers Friday and dropped to 994.78 at the close.