Readers’ Links, Comments and Questions

DJIA-1900

A Reader’s Article on Value Traps

I found a very interesting piece of writing about Value Traps and Value investing

http://www.wyliemallory.com/blog/how-does-one-avoid-blowups-in-deep-value-investing/

I must say lot of valuable advice from a seasoned investor.  

I read the linked article, but I wonder if the folks here took away the key lesson(s)

OK, why was this investment a “Value Trap?”   What can we learn from this example or ignore in this article?   Are you investing when buying this bank?  What makes a bank very different from investing in a widget factory?  The article goes on to say you should wait for a catalyst.  Is there a flaw to that argument?   What about checklists?   Can checklists save you from faulty thinking?

A Frustrated Reader:

Moreover, I wonder if it would be possible to have an index or anything like that in order to program and coordinate all classes and materials.

I teach under the chaos-and-mayhem method to force you to choose what is important to you.  In a more serious light, we are going chapter-by-chapter in DEEP VALUE and it is supplement by Quantitative Value and other readings. 

Next, use the search box in the upper right corner of this blog to type in: Lesson 1 Deep Value.   Then scroll to the links and begin there. The blog supplements the readings. You should have already received a link to the book folder.   Much of the materials are supplementary.   For example, we read in Chapter 3 in Deep Value about Buffett’s career, so various case studies were linked in the various posts that correspond to the chapter like See’s Candies or Dempster Mills.  Also, the Essays of Warren Buffett were sent out, but that is up to you if you want to read further (I highly recommend that you do and reread every year).

A Reader provides links:

Was on reddit’s Security Analysis sub (www.reddit.com/r/securityanalysis) and stumbled upon these notes from some other readers, good supplementary reading:

II Notes: https://docs.google.com/document/d/106U79BVHzzeCiO5SjWD1eCz4Lp6nm3VJ0rYThUk1Shg/edit

Buffett Notes: https://drive.google.com/file/d/0B8B1Rxv9hy1oOGM4eFZfcjF2eVk/view

For reference, if you don’t have the Buffett Annual Letters: http://www.rbcpa.com/WEB_letters/WEB_Letters_pre_berkshire.html

A Reader with Good Questions

John,

While I agree completely with your analysis, I think its worth noting additionally that:

  1. Quant Value proponents (e.g. Graham, Greenblatt & Carlisle) are not arguing that any given filter (EV to EBIDTA for instance) accurately measures the intrinsic value of a given company.  Agreed
  2. But rather they argue that some filters (or combinations of filters) can capture mis-pricings in a basket of stocks.  Agreed
  3. And on average, over time the captured mis-pricings will deliver a return that dramatically exceeds the index and all but the most exceptional stock-pickers.  Agreed.  “Experts” may even degrade the results of a quant model!
  4. So while a given filter (EV to EBITDA for instance) may be just the beginning of the analysis for a stock-picker working a concentrated portfolio,
  5. that same filter alone may be enough for a Quant Value portfolio to outperform 99%+ of stock-pickers,
  6. and with far less work.

To the extent this finding is true and replicable in real time, it is a remarkable finding.  What puzzles me is this:

  • Given a huge economic opportunity–some screens deliver 2X market returns in back tests
  • Given the Quant Value idea has been around for 75+ years–since Graham described the Net Net idea in Security Analysis
  • And given the vast resources dedicated to optimizing portfolios

Why are there so few examples of this simple idea being executed effectively in real time?

The best answers I’ve heard to this question (most of which were mentioned by Greenblatt in TLBTBTM) are:

  • Quant Value strategies are difficult to stick with because they will under-perform the market for years at a time
  • Much of the excess return is found in small cap stocks so it cannot be run in a large portfolio
  • The stocks selected by the Quant Value screens are “ugly” stocks which are difficult to own and defend

While all these explanations make sense, it still appears to me that the lure of 2X market returns would be enough to overcome them.  So I am left with the puzzle: why is this opportunity not more widely exploited?  I would be interested to hear any thoughts from the group on this…

I will post tomorrow my thoughts on your other questions.

DJIA-1997

7 responses to “Readers’ Links, Comments and Questions

  1. I think part of it also has to do with marketing (at least for professional investors) as it is tough to sell people on the idea that a) you let a computer pick the stocks b) you are often investing in crappy/ugly/struggling businesses. It’s a much better marketing pitch to say you are doing a deep dive on high quality businesses. I think Tobias even alludes to this point this in the YouTube video where he is asked why Greenblatt uses a quality factor in his model when it has been shown to detract from returns.

  2. I’d like to offer my own observations on Mallory’s blog article.

    “Depth of research is your best risk-reduction tool. By definition, deep value opportunities have elevated complexity and uncertainty. You will get paid only if you figure out the situation better than the majority of investors, despite all distortions.” I think depth of research is often overplayed as an idea. The point of deep value stocks is that you can buy them in bulk, knowing that the basket will work out well. If you tinker with the formula, you may do well. You just hold your nose and buy.

    “Identify catalysts. Experienced value investors don’t invest until they identify possible catalysts” Really? Says who? Anthony Bolton says he never looked for catalysts, as they were never usually obvious. Other investors have said that value is its own catalyst.

    “To make sure you have a balanced view, always list pros and cons” Well, OK, but where does that get you? I’ve seen Motley Fool article after article where they list pros and cons of such-and-such a company. But listing pros and cons isn’t a decision. It’s just a list. Given, as the author states, that there is a high level of uncertainty of how the events will play out, you never know just which of the pros and cons will play out.

  3. Many good points. When I saw the investment idea as a Greek Bank, I knew it wasn’t a value trap but a rank speculation. Since a bank doesn’t control 90 percent of the capital it is using (deposits) it is susceptible to instant insolvency. Also, how to value a Greek Bank’s loan book with an economy in free-fall? Catalysts–if you can see it, so can all. Will you pay a premium for such a catalyst? Checklists? How about don’t invest. I rate the article a D+. The article never even addresses the valuation of the bank other than the shorts saying bad debts will rise.

  4. Hi John, I also don’t completely agree with the blog on value traps. I actually just took a look at NBG and could not understand how to value it so I skipped it. Some good points he mentions is to learn what the short sellers are thinking because they are very very good at analysis.

    My biggest disagreement is when he said you can’t use simple valuation methods such as price multiple and dcf. So is he telling us to use excel spreadsheets and complex financial models? I know a value investor ( forgot his name) but he saids he just find the sustainable ebit and slap as multiple on it. That’s all and it works for him!! So I think simpler is better.

  5. Let me tell you what a value trap is – Janet Yellen is a #?)$*! value trap.

    The background is that I bought some shares in a little gold miner and, due largely to dumb luck, I bought the shares shortly after the most recent nadir in the USD gold price. Since then the USD gold price has enjoyed a little bit of a resurgence and our local currency has fallen substantially against the USD. So, the market price of my shares has shot up much quicker than I could have expected. I’m now struggling with the problem of whether to sell or whether to let the price run a little more.

    The problem is that practically every time Janet Yellen opens her mouth, the USD gold price seems to drop!

    Something tells me that I should take my unrealised profit and head for the hills. The problem is that with commdodity companies you are fighting against two levels of speculation – one level of speculation at the commodity level, which in turn feeds into the second level, namely, the speculation in the shares. That can lead to some opportunities because there are two levels of “reflexivity” (as Soros would call it) to take advantage of. But it makes for wild ride and the share prices can fall away pretty quickly.

    Any thoughts?

  6. That reminds me … while we are on the subject of gold miners, I thought I should note that I do something really wierd in terms of calculating EV. I usually calculate the EV of gold miners by taking into account any gold bullion on hand or gold “in transit” as the equivalent of cash. (I even do the same with dore, which is an unrefined alloy gold and silver.)

    This leads to some interesting results. We have one small miner on our local stock exchange which is coming up to the end of its mine life. The funny thing is that over the last few years it’s production has been fairly steady, but the company’s sales have fallen off a cliff – basically the company is stockpiling gold bullion – it shows the gold bullion as inventory on its balance sheet, booked at the lowever of cost or market, but the footnotes show that the market value of the gold is much more. One way of looking at it is that this company is a gold miner which is turning itself into an ETF! The way this company is going it will pretty soon have a negative EV, based on my unusual way of calculating EV.

    Does anyone think that I’m nuts?

  7. No, you are valuing the gold at replacement value (current market prices). Just be sure you have an idea of what management will do with shareholder capital–pour it down the drain in exploration? Good luck.

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