People get married to a stock. They hold it even when the evidence begins to deteriorate, perhaps in the growth of earnings or in the acceleration of earnings. Our ranking system would start to pick up that information and lower our preference for the stock. But again, individuals do not like to admit error. They tend to stick to it longer than they should. -- Samuel Eisenstadt

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Samuel Eisenstadt Of Value Line

11/22/00 03:49:48 PM PST
by David Penn

For more than 50 years, Samuel Eisenstadt has been one of the major reasons for the phenomenal success of Value Line, Inc., developers of the Value Line Ranking System. Eisenstadt is research chairman, senior vice president, and a director of the company, and his primary areas of responsibility include the application of various quantitative methods to securities valuation and forecasting. A frequent lecturer on Value Line techniques to business school audiences and financial analyst societies, Eisenstadt has successfully debated prominent efficient market proponents and was a pioneer in challenging their thesis that the markets could not be beat.

Working Money's David Penn interviewed Eisenstadt on October 16, 2000.

People get married to a stock. They hold it even when the evidence begins to deteriorate, perhaps in the growth of earnings or in the acceleration of earnings. Our ranking system would start to pick up that information and lower our preference for the stock. But again, individuals do not like to admit error. They tend to stick to it longer than they should. -- Samuel Eisenstadt

How long have you been at Value Line? Oh, forever. I've been with Value Line since May 1946.

Value Line was founded in 1931, when the attitude toward the market was quite a bit different than it is today. How would you say Value Line has changed since then? It has become a lot more quantitative. We've introduced statistical methods that were not used in the early years, such as multiple regressions and cross-sectional analysis. As a whole, it's much more mathematical than it ever was.

Was your background in mathematics before you started at Value Line? My degree was in statistics. At Value Line, I had the opportunity to apply the mathematics I learned in college. The data was voluminous, and the problem such that it looked like mathematics could help.

Were your statistical studies intended to prepare you for a career in finance? Oh, no. I majored in statistics because I had an affinity for mathematics. What I was going to do with that specialty, I was not even sure myself. When I got out of school, I went into the service. I got out at the end of 1945 and was employed by Value Line in the middle of 1946. I got into the finance field by pure happenstance. I literally started as a proofreader; that was my initial exposure to this field. As I got exposed to it, I saw the abundance of numbers and the applicability of statistical techniques to analyze those numbers. We started to apply schoolbook techniques. By "schoolbook," I mean regression analysis, which had not been used before then in the company.

I've always been curious about the name "Value Line." The name goes back to the 1930s, when Arnold Bernhard started the company. In the early years, he was making a visual attempt to measure value by constructing a line and comparing it with the price history of the stock. When the price history was below the value line, which was constructed from earnings, that indicated undervalued or, conversely, overvalued.

What was the goal? It was an attempt to establish a discipline. A very early attempt. Almost a pioneering attempt. The problem was that in the fitting process, it had to be more judgmental. There were quantitative ways of fitting that so that two people would come to the same conclusion. This is really what is known as regression analysis. So we started to do that. Instead of a visual value line, we developed a mathematical value line. And we lived with that procedure from 1946 until about 1965.

What happened in 1965? We made a radical departure, largely at my suggestion. Instead of looking at individual stocks and doing each one as a separate analysis with a separate formula and a separate fitting, we thought maybe we ought to develop one regression analysis that covered all stocks. Then apply the same formula to all stocks and, instead of looking at them over time, look at them at a single point in time. This is known in statistics as cross-sectional analysis.

What had you been doing up to then? Up to then, we had been doing time series analysis, over a long period. This new way gave us relative values. It told us which stocks were attractive and which ones were less attractive at a point in time. That's really what we were trying to do. As soon as we switched over to this new procedure, the results took a sharp turn for the better. And we have essentially been living with that approach since. We've added bells and whistles as we've gone along, but the cross-sectional procedure was the radical departure.

What got you thinking about moving away from time series to cross-sectional analysis? Mostly the desire to get better results. We were getting decent results with the time series, but when you're looking across a long period and doing an analysis, you're picking years. You're picking years of overvaluation and undervaluation. You're going to say, Oh, maybe in 1946 it was overpriced, but in 1953 it was underpriced. That wasn't our main problem. We're looking for stocks that are overvalued and undervalued. So the observations ought to be over stocks, rather than over years. And if your observations are over stocks, you're talking cross-sectional analysis. That solves the problem. Then it says, the best stocks are these and the worst stocks are these.

Even though you were working as a mathematician, was investment something that you had considered when you started? No, I really knew nothing about the market. It was on-the-job training for me as far as learning about investing was concerned. To me, it was a problem that needed a solution, almost like doing a crossword puzzle. Here was data, here were techniques, here was the challenge -- to find undervalued stocks. And it still is, because by no means do we have all the answers. We're still looking. We're looking in terms of variables and factors to use, and in terms of techniques. New methodologies are always coming in and we're on the alert.

You said you started in 1946. When did you actually become the chairman of research at Value Line? In 1987, when Arnold Bernhard, the founder of the company, passed away.

What are some of your day-to-day responsibilities as research chairman? My main responsibility is in the quantitative area. I'm generally in charge of the research activities in the quantitative department. I also help other areas of the company when quantitative problems come up. I am less involved in the security analysis area, where the analysts come in. We have a director of security analysis. He's in charge of the analysts. My area of responsibility is more in terms of the quantitative techniques, whether it's for ranking stocks or mutual funds, which we rank as well.

Anyone who takes a quick look at Value Line knows the organization provides a wealth of information. Other organizations also provide information on the Internet and in print. What do you think separates Value Line from the pack? Well, for one we have commentary, which you don't find much of on the Internet. Our analysts cover these stocks and discuss development. Further, we have measurements that others do not provide. We have proprietary ranking systems that have been very successful over the years. I think that's what makes Value Line more valuable than the information you'll find on the Internet.

One of your best-known products is the Value Line Investment Survey. Can you give us an overview of what that consists of? The Value Line Investment Survey covers about 1,700 stocks. These stocks include all the major companies, certainly all the companies in the Standard & Poor's 500, plus many more mid- and small-capitalization companies. We cover about 95 industries, so it's a broad overview of the market. We provide statistics for 10 or 15 years of data with fairly detailed breakdowns. We provide more current data, such as quarterly information. We provide data on the capitalization of the companies. And of course, we have commentary. We also provide rankings, which give advice. Most of the stuff you'll find on the Internet is primarily descriptive. The data we provide is actually predictive, in terms of the rankings.

I want to talk about the rankings in just a second, but first, when you were talking about the difference between descriptive discussions and commentary on the stocks, does the survey talk mostly about the stocks as stocks, or does it talk about them more as the companies behind the stocks? We discuss them in terms of companies. We make projections. We project earnings a year or two ahead, and three to five years out. We make price projections three to five years out. It's hazardous, but we do it because people want it. I don't think you'll find that generally available on the Internet. The difference is, what you get on the Internet is primarily news, descriptive information. Whereas we try to make the service valuable for making investment decisions, with respect to our estimates and our rankings.

Can you tell me a bit more about the timeliness ranking system? The timeliness ranking system dates back to 1965. The system is a quantitative approach that, surprisingly, uses known information, primarily, to predict relative price performance six to 12 months in the future. We've been doing this since 1965 with an impressive degree of success, so much so that it has attracted the attention of academicians. I'm sure you're acquainted with the efficient market hypothesis, which argues that the market follows a random walk and, therefore, it's impossible to make meaningful predictions. The efficient market theory states that the market knows all there is to know about the price of a stock, and hence we can't base decisions on that information. Our ranking system has proved otherwise for a very long period.

What do you look at in your ranking system? We basically look at earnings and prices. We look at 10-year records of earnings and prices. Then we look at current information. Are earnings better than expected? How do earnings compare to other companies? This is all done on a relative basis, looking over a universe of 1,700 companies and doing it almost instantaneously. This is only possible in the computer age. We compare every stock to every other stock in the universe. And that's the basis for our rankings. We rank stocks from 1 to 5. There are 100 group 1s, 300 group 2s, a big group 3, 300 group 4s, and 100 group 5s. And these are determined quantitatively. The rankings aren't emotional, which is a great advantage that Value Line has. It's not based on any analyst's judgment or decision. It's based on hard numbers.

It must confound academicians that you're not using some secret concoction of data. The ranking system is based on information that's readily available. That's right. We've debated with the academicians. We debated with Fischer Black, a prominent figure in efficient market academics. We invited him to check our results and test them. He was impressed with what we had done. He went back to the University of Chicago, which is literally the home of the efficient market theory, and delivered a paper that became known as "Yes, Virginia, There Is Hope."

In 1980 or 1981, I went to the University of Chicago and debated some academics there, too. Our argument was, no matter what you preach, we have numbers that prove otherwise. It was written up in the Chicago press. Since then, the Value Line ranking system has been a popular subject for dissertations and master's theses because it is a living disproof of the efficient market argument.

What do academics say to you in these debates when you have the numbers right there in front of them? I debated Rex Sinquefeld in front of an MBA group at the University of Chicago. He said: "Well, maybe you've got these numbers. If they work out as well as that, eventually, everybody is going to use them and it's going to stop working." That was his argument. My response was that as long as there are schools like the University of Chicago teaching what they teach, there was hope for us. That was in 1980, and here we are 20 years later and this stuff still works.

Do you have any other ranking systems? Yes, we have another one we call the technical ranking system. That system is based on price action only. It has had an astounding degree of success. Now this is shocking, particularly to the academics; they would argue that maybe somebody is a superior analyst with great vision who can foresee the future and pick stocks on the basis of fundamentals. But with the technical ranking system, we have a procedure that bypasses that altogether and states, "Give me 52 weeks of the price history of a stock and I'll tell you how it's going to perform over the next three to six months."

How do you do that? We convert these prices into relative prices by dividing, taking the market out, and then we develop a formula that relates 10 different time trends. We break that year up into 10 different trends from the earliest to the most recent -- maybe 11-month, 10-month, nine-month, and eight-month trends from the beginning to the present. We don't know a priori if those 10 time trends are important, and if they're important, what we should look at. Are the short ones important? The long ones? A combination? Again, we rely on multiple regression analysis. We apply that to these trends and then come up with a statistically significant formula. That means it's giving you an advantage over chance. There's something at work here. The relationship isn't all that high, but it clearly gives you an advantage over the next person.

There is predictive information in this, and this information yields rankings. We can order the 1,700 stocks from the best to the worst. And that ranking system has been phenomenal, particularly in recent years, when the market has become more momentum-driven.

Now, the interesting thing in this, and you might also say counterintuitive, is that if you're looking at these 10 trends, you would want the best of each. Best over 10 months, nine months, eight %C9 but that's not necessarily the case. There are some trends where you would like negative results; essentially, the approach looks for stocks outperforming over a longer period and perhaps even underperforming in the recent period. In brokerage jargon, it favors buying strength on weakness. It almost provides some justification for what technicians try to do, except they don't do it mathematically, they do it by chart reading. This is not chart reading. This is done purely mathematically. Judgment does not enter into it. We get a ranking every week of all 1,700 stocks and it takes all these trends into account.

When you say "buying strength on weakness," would that be similar to a technical value approach? What do you mean by a "technical value approach"? There is no value in it because there is no fundamental data. There are no earnings. There's only price. You might say it's quantitative chart reading. It's taking a pattern of price behavior and eliciting predictive information from that pattern.

You mentioned that chart reading and technical analysis are somewhat similar to the technical ranking system. Do you have an opinion about technical analysis? Generally, it's very low. I'll tell you why. Most technical analysis I'm aware of is done with chart reading. Give two technicians a chart and they'll read it differently. It's almost like the problem I mentioned in the early period of Value Line, in the fitting process. Some chart configurations are in the eye of the beholder. A different beholder may see them differently. Doing it quantitatively eliminates that problem. The computer finds the combinations that have historically worked; it eliminates judgment. Perhaps we can't do it completely, but at Value Line we try to minimize dependence on judgment.

I remember reading a quote -- it might have been from Barron's -- in which you stated that emotions are the enemy. I'm convinced of that. Especially in terms of timing the market. You're most bullish at a peak when things look great and everything couldn't be better, and you're most bearish at bottoms when it looks like all hell is breaking loose. Those are the emotions we really have to counteract. We have a model we've developed that tries to do that, that determines our invested position. That also is based on quantitative approach and it determines what our market position is going to be. It's unemotional. Often, it goes against the market. When the market is falling and the data is right, it may say it's time to get in. Your emotions would carry you otherwise. That's very important, both in stocks and in the overall market.

What are some common mistakes that investors make when they mix emotions into their investing decisions? A prominent one is to hold onto a loser longer than they should. It's a question of pride. You made a decision, you bought it, but it was a wrong decision. There's resistance to admitting that. Maybe holding onto stocks too long. This is one of those things that the technical and timeliness rankings help with, because if a stock goes bad, the rankings deteriorate after a while. It's telling you, enough already. Call it quits and put your money into areas where you have a better chance.

How does that relate to the buy and hold phenomenon we've noticed over the past couple of years? A lot of investors believe in buy and hold almost like gospel. People get married to a stock. They hold it even when the evidence begins to deteriorate, perhaps in the growth of earnings or in the acceleration of earnings. Our ranking system would start to pick up that information and lower our preference for the stock. But again, individuals do not like to admit error. They tend to stick to it longer than they should. It works that way, too, at the other end. We will lower a stock's rank, even if it appears to be going up and acting decently, if it's losing ground relative to the rest of the market in terms of price and earnings performance. Our ranking system will go down. I don't even have to know the name of the stock or the industry. To me, a stock is a number. That number tells me what to do.

Value Line employs upward of 70 analysts. On the Internet, different analysts' opinions are available, but those analysts are often not as independent as they could be. Our analysts are independent. We're not tied to any brokerage houses or underwriters. We're completely objective in what we have to say. We're not afraid to recommend a sale for a company if the data so indicates. Whereas in a brokerage house or investment banking firm, there are conflicts involved.

Do you think those conflicts are understated? I don't think people fully realize the degree of conflict that's out there. There is supposed to be a wall between the underwriting and the investment advisory part of a brokerage house, but I wonder how independent they are. We don't have that problem here.

Now that Websites and a number of other entities put out information for investors, do you think that has started to change how investors approach the market? I think the availability of data is certainly making the investing public more educated than they used to be. Not only that, it speeds up the whole investment decision process. The earnings reports are available on the Internet almost the minute they come out, and people act very quickly. In the old days, you had to wait and find it in the newspaper, make studies, and maybe make a decision a week later. Now, the whole procedure has sped up tremendously.

Has that changed the way you and the folks at Value Line approach the markets? We're right on top of these things. We're electronic. We pick up the earnings as fast as they come out. We are still primarily a print publication so there is some delay in our reaching the public with our rankings, but we are getting more and more involved on the Internet. People can pick up the rank changes on Websites now, and we used to have those only in print publications. Eventually, it may go even further and go live on the Internet.

I'm curious about the possibility of education cutting both ways. You have investors with more information, but they don't necessarily know how to use it. Investors are literally drowning in data. I've seen studies that indicate you can probably discard 95-96% of all the data out there, and use what's left to make a decision. A lot of it is so detailed it may be too descriptive yet interesting, but it's not crucial to making an investment decision.

For the average investor who is just starting to look at stocks, what are some of the first things he or she should pay attention to? First of all, they should examine themselves. What is their tolerance for risk? You don't want someone who has a low tolerance for risk buying stocks that are very volatile. They have to decide what kind of investor they are. Are they only willing to take a moderate amount of risk? Or are they going to play the roulette wheel? We have data that distinguishes that. We rank stocks based on their safety, so investors can decide.

Investors should decide what category they fall in, then look at the earnings history of the company they're interested in, the price history of the company, and the price to earnings ratio. Look at P/E ratios of companies in the same industry. How does this company compare? What is the outlook for earnings? You're looking for a stock that's cheap, but you don't want a cheap stock that's going to get cheaper. Next, what do the growth and earnings look like? What are people estimating? If the stock is cheap and the outlook for earnings good, and it falls within your risk tolerance, it's a stock you would want to buy.

Without Value Line, investors would have to go through those processes themselves. Value Line bypasses all that and makes investing easier. We rank stocks for them. We tell them what we expect the stock to do. We expect group 1 stocks to outperform the market, and we have 35 years of history to show they have done so most of the time. We make life easier for investors.

A lot of companies are popular and widely held, but have low earnings. How do you factor that in? Stocks with zero earnings or even negative earnings present no problem for us, because we take the P/E ratio apart. We work with prices and with earnings, but not the ratio. The P/E ratio is a nasty number to work with. When that denominator gets very small -- not just when it's negative, but when it's in the pennies -- the ratio becomes meaningless. So we solve the P/E ratio problem by separating the components and doing regression analysis, which can get a bit technical.

I know Value Line's ranking system makes it easier to compare stocks. How important is it for the average investor to understand the business behind the stocks they purchase? At Value Line, it's not really all that important. If investors are looking for appreciation, all they have to do is favor group 1 stocks, almost regardless of what industry the stocks are in. But of course, some individuals who like to make their own decisions will have industry preferences. In recent years, they have played the technology game very successfully -- rather unsuccessfully in the last three or four months, but overall, they've done well. Our rankings have generally favored technology stocks. We would have helped investors make that decision.

Regarding diversification within and between industries, is it possible those group 1 or group 2 stocks may be dominated by certain industries? How much of a problem is that? We recommend that our subscribers try to diversify within at least four or five different industry groups, which they can find within group 1. Otherwise, their volatility will be tremendous. In other words, out of 100 group 1s, we're certainly not advising that they pick 10 technology stocks and buy those. In recent years, as I said, you would have done great in the technology stocks by not diversifying, but the risk was enormous. That's where the safety rank comes in. Pay attention to the safety rank and make sure you have some diversification across the board, in industry groups, and even across safety ranks. You may want to take a flyer on an unsafe stock, but make sure you balance that with some safe stocks.

Some people suggest the Value Line Geometric Index is one of the best measures of the average stock in the market. Value Line has two indices, the Value Line Geometric Index and the Value Line Arithmetic Index. Have those indices ever told you something that wasn't reflected in the more widely followed indices? Oh, sure. As a matter of fact, this year is a good illustration of that. The difference between the Value Line Arithmetic Index and the other indices that we know, such as the Standard & Poor's 500 and the Dow Jones Industrial Average, is that the Value Line is an equally weighted index. Every stock is equally important. GE doesn't get any more weight than a small electronics manufacturer. So you get a different picture of the market than you would from, say, the S&P, which weights the big companies, and the Dow Jones, which includes only the big companies.

The picture you got from Value Line this year was quite different. The Value Line index, until the last month or so, had been making new highs for the year, whereas the overall market had been very weak. As of today, the Value Line Arithmetic Index is up 2% since the beginning of the year, the S&P including income is down 8.7%, and the Dow Jones is down 11.7%. The Value Line is still up. That tells us that the Value Line Arithmetic Index picks up the behavior of smaller companies, which the others largely either ignore, in the case of Dow Jones, or give very little weight to, in the case of the S&P. We give equal weight to them. So you can immediately see that a lot of the strength in the market this year has been primarily in the mid- or smaller-cap stocks.

I imagine information would help buttress the argument that the economy is still doing well, even in the face of some difficulties in certain sectors and among some of the larger-cap stocks. That's right. With larger-cap companies, you have a valuation problem. Stocks in the S&P and largely in the technology area are selling at P/E ratios that people are finally beginning to realize are unsustainable, especially when there's evidence of earnings slowdown. The value is probably in the mid- and smaller-cap area. For example, the S&P P/E ratios are around 30, whereas the median P/E ratio of a stock in the Value Line survey is at 14 times earnings. Which, by historical standards, is not excessive. If you look at the Dow Jones and the S&P, though, they are frightening.

When you first started investing, were you pretty much going along with what you were working on at Value Line? Oh, yes. A lot of my personal investments have been in our own mutual funds. And the reason for that, I might add, is because if I were to buy group 1 stocks, which I certainly would favor because that is the product of our research, I might run into conflicts with our subscribers. I have tried to avoid that. We have rules at the company that you can't front-run? on these things. There are too many potential conflicts. It's not as exciting or as financially rewarding as buying individual stocks, but it does avoid the problem.

This interview will be in our January/February 2001 issue. What are you looking at in the future? We haven't done our projections into next year yet. We generally do that in December. We did something recently that carried us through June 2001, and we came up with a preliminary projection for the Djia. It came to something in the 11,800 area, which was our average price projection for this year as well. Right now, it's going to take some doing to get there, because the average for the year so far is quite a bit lower.

Interestingly, our current position on the market is getting more positive with the sharp drop in stocks, especially in the last week or so. We're at the stage of upgrading our exposure to stocks. For most of this year, we have been suggesting a 50% invested position in stocks. For us, that's cautious. For brokerage houses, it may be fairly aggressive, but we go on a scale from zero to 100%, so 50% is pretty cautious. We're in the process of upgrading that to 60-70%. Our model takes interest rates and stock prices into account, plus numerous other factors. Those factors have become more positive in recent weeks, so we're going to be taking a more positive position. We're not saying hock the house and buy stocks, but we're saying, well, instead of 50%, maybe 60-70% would be a more reasonable approach right now.

Thanks, Sam.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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