Markets can do ANYTHING in the short-term, so the following is not a prediction that miners will rise in price. However, what comes first–the price rising or the buying? đ Miners chop around in a trading range as money managers flee the sector and now sit with record low allocations to this sector. * How good are money managers (on the whole) picking the right sector to invest in? Â I leave it to you to find that out.
Wedgewood Partners: Franchises in Cyclical Market and a Lesson on Diversification
He points out diversification may mean the sources of profitability can be different among companies within a particular sector. (Refer to Competition Demystified by Bruce Greenwald for a course on this distinction). Note the high revenue conversion to free cash flow (page-14) for those companies compared to other companies in the oil services sector.
Now move on to wedgewood partners first quarter 2015 client letter crude realities. Â Note on page 13 how he looks at the oil services market–the structural attribute to focus on is drilling intensity. Â Interesting…. Look at pages 18 and 19 for a further discussion on NOV and CLB.
To learn, you might download those company’s recent annual reports and try to figure out their revenue to free cash flow conversion. Â Look at what the companies use for maintenance capex. Â Note how Core Labs is a free cash flow gusher (Charlie Munger would smile on this). Â Core Labs is a different business than SLB and NOV, but is grouped in the same industry/index. Â When sellers of ETF sell, they don’t distinguish among companies and therein lies opportunity for us. Yeah!
Today’s chart of the day focuses on sentiment in the basic materials sector. Regular readers of the blog already know that I have been closely following Merrill Lynch’s Fund Manager Survey for years now. This months survey was conducted in a period between 2nd to 9th April 2015 with a total of 177 panellists, with $494 billion of assets under management. The survey should be used as a very good contrarian indicator.
According to the recent survey, global fund manager allocation towards global materials declined sharply in the month of April to net 27% underweight from net 16% underweight the previous month. As we can clearly see from todays chart of the day, sentiment is very depressed right now. Merrill Lynch states that the current allocation is 1.8 standard deviation below its long term average.
Furthermore, the overall commodity and natural resources theme is very much disliked by global money managers. Commodity allocation is unchanged for the third straight month and remains at net 20% underweight. That is 1.2 standard deviations below its long term average and even more interestingly, fund managers remain underweight commodities for the 28th month in the row.
âValue investing is about praying on the emotions of the seller,â McElvaine said, noting that he loves to be a buyer of un-loved securities when their owners need out at any cost.
McElvaine pointed to a Globe and Mail headline about beat-up mining stocks being great tax-loss sale candidates this past December. He bought up shares in Sprott Resource Corp and Anglo American recently for trading at considerable discounts to NAV (more info at chat.ceo.ca/mcelvaine).
Six years into the global bull-market and McElvaineâs funds are about 25% in cash to provide an opportunity to buy assets if prices return to Timâs liking.
Is the US bull-market over? McElvaine talked about what could go right in the United States, and suggested that a great way to stimulate the US Economy would be to wipe out student loan debt, which is $1 trillion of $1.3 trillion owned by the US Government, according to McElvaine. That move could put $1 trillion back in the hands of the most aggressive consumers.
There was a brief moment before Timâs speech that my dad and I got to share a word with him, and I asked how do they know if a cheaply priced security represents a value gap, meaning itâs undervalued and going higher, or is it a value-trap, as so often cheap stocks get cheaper.
âYou donât know,â Dad and McElvaine agreed, which reminded me of something Tim taught me 6-7 years ago:
âYouâve got to kiss a lot of toads in this business to find your prince.â
Take the time to read his annual reports and transcripts, then go the extra mile and look at the annual reports of the companies he mentions–do you see what he sees?  For example, in the chat of his presentation for 2014 (see bold index and then the link) he mentions that Sprott Resource Corp is trading for about $1.00 Cdn while its NAV is above $3.00 or “It’s not pretty, but it’s cheap.”  Can you learn from his approach and analysis? What would you do differently? You have to be a contrarian with a calculator to buy what is hated.
Tomorrow: I will post a reader’s list of great annual reports.
—
I love reading Warren Buffettâs letters and I love contrasting his words with his actionsâŚI love how he criticizes hedge funds, yet he had the first hedge fund,â Mr. Loeb said. âHe criticizes activists, he was the first activist. He criticizes financial services companies, yet he loves to invest in them. He thinks that we should all pay taxes, yet he avoids them himself. â Business Insider LINK
Commodities (CRB Index) fall back to a 40-year support zone ($185/$205)
while:
As global commodities prices plummet, itâs incredibly convenient to pronounce the commodities super-cycle dead, isnât it? Yet banks from Goldman Sachs to Citigroup to Deutsche Bank are on record as saying itâs over.  http://www.wallstreetdaily.com/2014/12/08/jim-rogers-commodities-interview/
The point is not to follow the “experts” but search where there is carnage. I am looking at Templeton’s Russian and Eastern Europe Fund TRF Semi Annual Report because:
Hated Countries (Russia, Ukraine)
Currencies Down,
Commodity Exporters and
trading at a 10% discount so the 1.4% management fee is covered for six years.
Poor performance for the past few years
Things can and will probably get worse. So please don’t follow the blind (me) off the cliff. This is meant as an example of a SEARCH STRATEGY.
—
More on Reversion to the Mean and the Growth Illusion
We are beating this subject to death but you can’t understand how investing in bargains works without grasping these concepts.
Contrarian Strategy Extrapolation and Risk Abstract: Value strategies yield higher returns because these strategies exploit the sub-optimal behavior of the typical investor and not because these strategies are fundamentally riskier. Yes, this is an academic paper, but worth reading to understand WHY and HOW value (buying stocks with low expectations/and low price to business metrics like earnings, cash flow, EBITDA, etc.) provide better returns.
Growth Illusion
The Two Percent Dilution It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900â2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.
Our last lesson was in Mean Reversion (Chapter 5 in Deep Value) discussed http://wp.me/p2OaYY-2Ju  View this video on a very MEAN Reversion.
We must understand full cycles and reversion to the mean.  Let’s move on to reading Chapter 2: A Blueprint to a better Quantitative Value Strategy in Quantitative Value.
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. -Warren Buffett, Shareholder Letter, 2000.
A WONDERFUL BUSINESS
Greenblatt defined Buffett’s definition of a good business as a high Return on Capital (ROC) – EBIT/Capital
Capital is defined as fixed asses + working capital (current assets minus current liabilities) minus excess cash.
ROC measures how efficiently management has used the capital employed in the business. The measure excludes excess cash and interest-bearing assets from this calculation to focus only on those assets actually used in the business to generate the return.
A BARGAIN PRICE
High earning yield = EBIT/TEV
TEV + Market Cap. + Total debt – minus excess cash + Preferred Stock + minority interests, and excess cash means cash + current assets – current liabilities.EBIT/TEV enables and apples-to-apples comparison of stock with different capital structures.
Improving on the Magic Formula?
ROC defined as Gross profitability to total assets.
GPA = (Revenue – Cost of Goods Sold)/Total Assets
GPA is the “cleanest” measure of true economic profitability.
The authors found GPA outperformed as a quality measure the magic formula. Â Note on page 48, Table 2.3: Performance Stats for Common Quality Measures (1964 – 2011) that most simple quality measures do NOT provide any differentiation from the market!
The authors found that analyzing stocks along price and quality contours using the Magic Formula and its generic academic brother Quality and Price can produce market beating resultsÂ
The authors: “Our study demonstrates the utility of a quantitative approach to investing. Relentlessly pursuing a small edge over a long period of time, through booms and busts, good economies and bad, can lead to outstanding investment results.”
Ok, let’s come back to quality and avoiding value/death traps in the later chapters (3 and 4) in Quantitative Value. Â We are just covering material in Chapter 2.Â
INVESTORS BEHAVING BADLY
Investors and the Magic Formula
Adding Your Two Cents May Cost a Lot Over the Long Term by Joel Greenblatt
01-18-2012 Â (Full article:Â Adding Your Two Cents
Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who ‘self-managed’ his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.
So, what happened? Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two-year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.
“Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), âso how did the âprofessionally managedâ accounts do during the same period?â Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two-year period, thatâs a huge difference! Itâs especially huge since both âself-managedâ and âprofessionally managedâ chose investments from the same list of stocks and supposedly followed the same basic game plan.
Letâs put it another way: on average the people who âself-managedâ their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some! How’d that happen?
1. Self-managed investors avoided buying many of the biggest winners.
How? Well, the market prices certain businesses cheaply for reasons that are usually very well-known (The market is a discounting mechanism). Whether you read the newspaper or follow the news in some other way, youâll usually know whatâs âwrongâ with most stocks that appear at the top of the magic formula list. Thatâs part of the reason theyâre available cheap in the first place! Most likely, the near future for a company might not look quite as bright as the recent past or thereâs a great deal of uncertainty about the company for one reason or another. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if theyâre still âgoodâ businesses that earn high returns on capital), usually means youâre buying companies that are out of favor.
These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short-term issues isnât where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty. But many of these companies turn out to be the biggest future winners.
2. Many self-managed investors changed their game plan after the strategy under-performed for a period of time.
Many self-managed investors got discouraged after the magic formula strategy under-performed the market for a period of time and simply sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis. Itâs hard to stick with a strategy thatâs not working for a little while. The best performing mutual fund for the decade of the 2000âs actually earned over 18% per year over a decade where the popular market averages were essentially flat. However, because of the capital movements of investors who bailed out during periods after the fund had underperformed for a while, the average investor (weighted by dollars invested) actually turned that 18% annual gain into an 11% LOSS per year during the same 10 year period.[2]
3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).
This is a similar story to #2 above. Investors donât like to lose money. Beating the market by losing less than the market isnât that comforting. Many self-managed investors sold stocks without replacing them, held more cash, and/or stopped updating the strategy on a periodic basis after the markets and their portfolio declined for a period of time. It didnât matter whether the strategy was outperforming or underperforming over this same period. Investors in that best performing mutual fund of the decade that I mentioned above likely withdrew money after the fund declined regardless of whether it was outperforming a declining market during that same period.
4. Many self-managed investors bought more AFTER good periods of performance.
You get the idea. Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long-term investment returns.
Go-where-it-is-darkest-when-company.html (Vale-Brazilian Iron Ore Producer).  Prof. Damordaran values Vale and Lukoil on Nov. 20, 2015.  I am looking at Vale because they have some of the lowest cost assets of Iron Ore in the world.  They have good odds of surviving the downturn but where the trough is–who knows.Â
I think the author at least knew of the risks, but underestimated the extent of the cycle due to massive distortions caused by the world’s central banks. Â It did get darker..as iron prices fell another 10% and still falling.Â
Month
Price Iron Ore
Change
Aug 2014
92.63
–
Sep 2014
82.27
-11.18 %
Oct 2014
80.09
-2.65 %
Nov 2014
73.13
-8.69 %
Dec 2014
68.80
-5.92 %
Jan 2015
67.39
-2.05 %
Feb 2015
62.69
-6.97
Damodaran: I have not updated my valuation of Vale (as of Feb. 20th), but I have neither sold nor added to my position. It is unlikely that I will add to my position for a simple reason. I don’t like doubling down on bets, even if I feel strongly, because I feel like I am tempting fate.Â
Prof. Damodaran is responding to a poster who is asking about Vale’s plummeting stock price. Â If you are a long-term bull you want declining prices to bankrupt weak companies in the industry so as to rationalize supply.
An early sign of a turn: Gold vs. the Commodity Research Bureau Index (CRB). Since gold is commodity money it is much more sensitive to changes in financial conditions than consumable commodities.
I like to take note of extremes. However, the amount of central bank monetary distortion is so huge (note negative interest rate on government debt, huge deficits, QE, etc.) that extremes can go to new levels but when investors are on one side of the boat–be careful.
Also, visit www.hussmanfunds.com
PS: Once I clear my backlog, I will return to our lessons in Deep Value and Quantitative Value. Plus post the links to the videos of valua investing classes.
Oil service, oil producers, mining companies etc. are being hammered by a dollar “shortage.” Â Opportunity may be knocking. Remember what Klarman said about forced selling.
An overview of the situation:Â Dollar Shortage. With money supply rising in the US there is no dollar “shortage”, but there is a fear of inter-bank lending.
A Reader’s Question on Valuation Ratios.  This sheet may be good as a guide to go through an annual report, but none of those ratios means anything without context.  Is growth good? It depends. Only profitable growth within a franchise.  How about asset turnover?  For some companies like Costco asset turnover is critical but not for Boeing (gross margin).  Why not take those ratios and work through the financials of these trucking companies.  Which company is doing the best? Why? Follow the money!  Those ratios may help you structure the information you pull out from the financials. But first focus on how does the company provide a service to its customers and then trace the financial effects back to your returns as an investor.
We will get back to Deep Value next week and I will post links to valuation class videos. Â Have a great weekend and if you do try to emulate someone, then:
Times are hard. Â Your family has been struggling to make the mortgage payments on your farm since the 50% decline in corn prices.
Your lucky day! You get a call from a friend’s neighbor that he (The Pigeon King) desperately  needs breeders for his growing pigeon business. With a $125,000 investment financed with a second mortgage against your farm you can buy 360 pairs of pigeons at $165 a pair.  Then he offers to buy back the newly bred pigeons for $40 each (pigeons breed prolifically) with a ten-year contract.  He says these pigeons are for racing.  Then he gives you a list of five farmers in your state who are breeding pigeons for him.  Take your time and do your due-diligence, he says.
You check his credit ratings–all good. Â No criminal or civil complaints. He owns his farm free and clear–he is a farmer like you! Â After meeting with three of the pigeon farmers who confirm with check stubs that he has been paying them on time and as promised. The returns are good–in excess of 80% to 100% in terms of food and overhead to raise the chicks. Considering your time to look over your pigeons, you figure you can net a 50% pre-tax return on your capital. Plus, your contract allows you to sell whatever you produce at the stipulated price, so growth will be profitable.
Times are hard. What do you do? Before you decide, you are inspired by
You gotta have dreams and the will to believe!
You remember what you learned as a deep value investor over at csinvesting.org and you_________? Why? What INVESTING/BUSINESS principles help you in your decision?
This article, The Pigeon King (same as the link above but with additional commentary for easier reading) is one of the most amazing stories–a farce, a tragedy, a comedy AND chock full of lessons for the investor.  You may think you are too smart to be a pigeon or a bird-brain (sorry!) but ANYONE can be blind.  What checklist items stop you (besides it’s too good to be true?).
Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”
Comments on the Berkshire Hathaway 2014 letter, Â Part 1
Note the plug (page 6) for Where Are the Customersâ Yachts by Fred Schwed. That along with the Money Game by Adam Smith will teach you the ways of Wall Street. Also, see:
Intrinsic Value: Buffett reiterates that it is not a precise number for Berkshire nor, in fact for ANY stock.
GEICO delivers savings to its customers because it is a low-cost operation (source of structural competitive advantage). The companyâs low costs create a moatâan enduring oneâthat competitors are unable to cross. Note Buffettâs comment on the animated gecko, a LOW-COST spokesperson.
TESCO
Hereâs how he explained it:
âIn 2013, I soured somewhat on the companyâs then-management and sold 114 million shares, realizing a profit of $43 million. My leisurely pace in making sales would prove expensive. Charlie calls this sort of behavior âthumb-sucking.â (Considering what my delay cost us, he is being kind.)
âDuring 2014, Tescoâs problems worsened by the month. The companyâs market share fell, its margins contracted and accounting problems surfaced. In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives.â
Buffett said the dawdling resulted in an after-tax loss of $444 million by the time Berkshire was no longer a Tesco shareholder. That, he added, is about 0.2% of Berkshireâs net worth. Only three times in 50 years has Berkshire recorded losses from a sale equal to more than 1% of its net worth.
Unfortunately, we donât learn what exactly caused the loss. How did Buffett miscalculate intrinsic value?   Did management worsen, but if so, then how can an investor sidestep that?  I believe the economics changed as customers had more in-home deliveries and other choices coupled with poor store execution from Tesco. I was disappointed with this explanation of the Tesco loss, but Buffett would reply that it was only 1/5 of 1%.
Nominal vs. Real Returns
During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13 cents in 1965 as measured by the CPI (Flawed or whats wrong with cpi)
I prefer measuring in gold grams, because gold is a store of value and market-based rather than concocted by Federal bureaucrats.
There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as the transfer to others of purchasing power now with reasoned expectation of receiving more purchasing power–after taxes have been paid on nominal gainsâin the future.â  (I wonder why Mr. Buffett makes no mention of the financial repression of ZIRP and NIRP? It is the elephant in the room because of the devastating effect it has on savers and on calculating discount rates for investment.)
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securitiesâTreasuries, for exampleâwhose values have been tied to American currency. That was also true in the preceding half century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.  Buffett’s comments are backed up by history as shown here:and triumph_of_the_optimists
Stock prices will always be far more volatile than cash equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investmentsâfar riskier investments. Than widely âdiversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong. Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing power terms) than leaving funds in cash-equivalents. That is relevant to certain investors-say, investment banksâwhose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who canâand shouldâinvest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
Note the multi-decade horizon. Stocks were unchanged from 1964-1981, please see page 79: A Study of Market History through Graham Babson Buffett and Others.  Read what Buffett has to say about stock markets. Some say it is Time to exit because of high valuations for big-cap stocks in the U.S. market. So even if stocks decline for a decade but your holding period is MULTI-Decade, then hold tight.  Tough to do, but history seems to bear his thesis out: valuing-growth-stocks-revisiting-the-nifty-fifty.  I prefer to act like the pig farmer in A Study of Market History (see link above).
If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risk things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in âsafeâ Treasury bills or bank certificates of deposit. People who heeded this sermon (to panic) are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to âtimeâ market movements, inadequate diversification, the payment of high and unnecessary to managers and advisors and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. ….Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
A plug for Jack Bogle’s The Little Book of Common Sense Investing. Â Basically, Buffett is saying keep it simple, think and hold L O N G – T E R M, avoid high fees and commissions, and don’t use leverage.Â
Next, let’s look at Berkshire–Past, Present and Future in Part II
Why can’t 70% of professional money managers beat chimps?
High fees/costs, index hugging, inconsistency, overconfidence in their ability to be above average, lovers of stories, herding, and the institutional imperative? Don’t forget incentives that differ from achieving performance like asset gathering. See the case study at the end of this post.
We left off with a reader asking why do money managers do better or follow a deep value approach? http://wp.me/p2OaYY-2IZ
One goal of our Deep Value journey is to find a method that suits us. This method should have a large base case rate of beating an index over a long period of time, say fifty years.  The lesson learned so farâI hopeâis that CHEAPNESS wins whether that is price to book value, price to sales, price to cash flow.  My recent reading of the most recent 4th Edition of What Works on Wall Street shows that high EBITDA-to-EV has beaten out Price-to-Sales (3rd Edition) What Works on Wall Street, Third Edition as the best metric as a value factor. However, combined with quality of earnings metrics, it performs even better or about 18% to 19% per year since 1964 to 2009.  Our goal is to put the odds on our side and CONSISTENTLY play the odds through thick and thin. Our other edge is to realize how flawed our thinking is and thus we build protection against ourselves by developing a disciplined approach.
What Works:Â Notes from Joel Greenblattâs class 2002:
Read: What Works on Wall Street by James P OâShaughnessy. He started a fund in 1996-1997 but he underperformed the market by 25% and after three years in business of underperforming he sold his company at the bottom of the cycle.  The guy who wrote the book quit his system!  It seems like it is easy to do, but it is not easy to do.
This book, What Works on Wall Street, has born out its wisdom. The two funds that are patented that follow his strategy have been phenomenal. HFCGX is the patented fund based on his top idea of Cornerstone Growth; over the last 5 years it has had an average return of 13.44% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05). HFCVX is the patented fund based on his 2nd to best idea of Cornerstone Value; over the last 5 years it has had an average return of 6.47% per year vs. the Vanguard 500’s -2.01% per year (6/1/00 through 5/31/05).
The most interesting point is that the author points out those investors often are too emotionally involved to have the discipline to see the strategy through. Not only did the first reviewer bash the book because he did like the returns strategy JUST one year after the book came out, but Mr. O’Shaughnessy sold the funds to Hennessy Funds at the end of 1999 after it failed to surpass the returns of the bubble that soon after collapsed. Seven years after it was published an investor would be much wealthier had they followed the books top strategy instead of the investors who dog-piled onto the stocks of the market’s bubble.
We are going to try to understand why it works. Why it has to work over time. That is the only way you can stick it out.  The math never changes: 2 + 2 = 4.  That is the level of your understanding I want you to have by the time we are done. If I get that right, forget all this other stuff and noise, I will get my money. No genius required. Concepts will make you great and your ability to STICK IT OUT.
There is a lot of experience involved in valuation work, but it doesnât take a genius or high IQ points to know the basic concepts. The basic concepts are what will make you the money in the long run.  We are all capable of doing the valuation work.
—
Notes from the 4th Edition of What Works on Wall Street
Why Indexing Works
Indexing works because it sidesteps flawed decision-making and automates the simple strategy of buying the big stocks that make up the S&P 500. The mighty S&P 500 consistently beat 70 percent of traditionally managed funds over the long-term by doing nothing more than making a disciplined bet on large capitalization stocks.
Money Management Performance
Past records of most traditional mangers cannot be predictive of future returns because their behavior is inconsistent. You canât make forecasts based on inconsistent behavior.
Common Sense Prevails
We now have the ability to empirically compare different investment strategies and their ongoing performance over time. What you will see in coming chapters is that almost all of them are deeply consistent with what common sense would tell you was true. Strategies that buy stocks that are selling at deep discounts to cash flow, sales, earnings , EBITDA-to-enterprise value (Yeah, but donât forget MCX), and so on do extraordinary better than those that are willing to buy stocks with the richest valuation. Â WE will be sensitive to data mining.
Systematic, structured investing is a hybrid of active and passive management that automated the buy and sell decisions. If a stock meets a particular criteria, itâs bought. If not, not. No personal, emotional judgments enter into the process. Essentially, you are indexing a portfolio to a specific investment strategy and, by doing so, uniting the best of active and passive investing. The disciplined implementation of active strategies is the key to performance. Traditional managers usually follow a hit-and-miss approach to investing. Their lack of discipline accounts for their inability to beat simple approaches that never vary from the underlying strategy.
The ONE thing that unites the best money managers is consistency.
Successful investing requires, at a minimum, a structured decision-making process that can be easily defined and a stated investment philosophy that is consistently applied.
Goeth said, âIn the realm of ideas everything depends on enthusiasm; in the real world, all rests on perseverance.â While we may intellectually understand what we should do, we usually are overwhelmed by our nature, allowing the intensely emotional present to overpower our better judgment.
Human Judgment is limited
Why models beat humans
Models beat the human forecasters because they reliably and consistently apply the same criteria time after time. It is the total reliability of application of the model that accounts for its superior performance.
We are ALL above average.
Base rates are boring
We prefer gut reactions and stories to boring base rates.
Stocks with low PE ratios outperformed the market in 99 percent of all rolling 10-year periods between 1964 and 2009.
The best way to predict the future is to bet with the base rate that is derived from a large sample.
Base rates are boring while experience is vivid and fun. Â Never mind that stocks with high P/E ratios beat the market less than 1 percent of the time over all rolling 10-year periods between 1964 and 2009.
Montier in his book, Value Investing writes: âOne of the recurring themes of my research is that we just canât forecast There isnât a shred of evidence to suggest that we can.
We prefer the complex and artificial to the simple and unadorned.
Nowhere does history indulge in repetition so often or so uniformly as in Wall Street. When you read contemporary accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game does not change and neither does human nature.âEdwin Lefevre.
Brain Research
Because of the interrelated nature of the emotional and rational centers of our brain, we will never be able to fully overcome our tendency to make irrational choices. Simply being aware of this problem does not make it go away. To break from our human tendencies to chase performance and perceive patterns where there are none, we must find an investment strategy that removes subjective, human decision-making from the process and relies instead on smart, empirically proven systematic strategies. We can become wise by realizing how unwise we truly are.
Rules of the Game
It is amazing to reflect how little systematic knowledge Wall Street has to draw upon as regards the historical behavior of securities with defined characteristics. âBen Graham
Richard Brealey, a respected data analysis, estimated that to make reasonable assumptions about a strategyâs validity (95% confidence level or statistically relevant) you would need 25 years of data.
Short periods are valueless
Consider the âsoaring sixtiesâ when the go-go growth managers of that era switched stocks so fast that they were called gunslingers. The go-go investors of the era focused on the most rapidly growing companies without even considering how much they were paying for every dollar of growth. Between Jan 1, 1964, and Dec. 31, 1968, $10,000 invested in a portfolio that annually bought the 50 stocks in the Compustat data base with the best annual growth in sales soared to $33,000 in value , a compound return of 27.34 % a year. That more than doubled the S&P 500âs 10.16% annual return, which saw $10,000 grow to just $16,200. Unfortunately, the strategy went on to lose 15.7% per year for the following five years compared to a gain of two percent for the S&P 500.
Had this same hapless investor had access to long-term returns, he would have seen that buying stocks based just on their annual growth of sales was a horrible way to investâthe strategy returns just 3.88 percent per year between 1964 and 2009. Of course, the investor received similar results if he repeated the experiment between 1995 and 1999 and then the next five years.
EBITDA to EV was the best on an absolute basis for all the individual value factors we examine from 1964 to 2009 such as price to cash flow, price to earnings, etc.
EV/EBITDA in the lowest decile (the most EBITDA per EV) generated a 16.58% CAGR vs. 11.22% for the All Stocks universe with a standard deviation of returns of 17.71 percent, more than 1 percent below that of All stocks, 18.99 percent.  The worst five-year period for the metric was 2000 during the Internet Mania. These ups and downs for a strategy are all part of the bargain you must strike with yourself as a strategic investor.  Pages 103 to 124 in What Works (4th Ed.) The EV/EBITDA in the highest decile (the most âexpensive) did the worst of all the value metrics studied!
EV works well as a guide to under-and-over valuation when contrasted to EBITDA, SALES, and Free cash flow.
Price to book value ratios are a long-term winner with LONG periods of underperformance.
Accounting Ratios can help identify higher quality earnings:
Total accruals to total assets
Percentage change in net operating assets (NOA)
Total accruals to average asses.
Depreciation expense to capital expense.
We are looking for stocks with high earnings quality.
Accounting variables mater. How companies account for accruals, how quickly they depreciate capital expenses and their additions to debt all have a serious impact on the health of their stock price.
Successful investing relies heavily on buying stocks that have good prospects, but for which investors currently have low expectations. Stocks with great earnings gains and high net profit margins are basically high expectations stocks.
History shows that using high profit margins as the SOLE determinant for buying a stock leads to disappointing results. The only lesson here is that it is best to avoid stocks with the lowest net profit margins.
A Case Study in Why Money Managers Lose Even With a Winning Hand
Winning Stock Picker’s Losing Fund
Value Line Research Service Has Beaten Market Handily, But Its Own Fund Suffered By Jeff D. Opdyke and Jane J. Kim Staff Reporters of THE WALL STREET JOURNAL Updated Sept. 16, 2004 12:01 a.m. ET
Value Line Investment Survey is one of the top independent stock-research services, touted for its remarkable record of identifying winners. Warren Buffett and Peter Lynch, among other professional investors, laud its system.
But the company also runs a mutual fund, and in one of Wall Street’s odder paradoxes, it has performed terribly. Investors following the Value Line approach to buying and selling stocks would have racked up cumulative gains of nearly 76% over the five years ended in December, according to the investment-research firm. That period includes the worst bear market in a generation.
Why the Fund Lagged
Past managers bought stocks that in some cases were well below the company’s top-rated choices, hurting performance.
Style drift: The fund has swung among small-, mid- and large-cap shares.
High turnover of fund managers meant little consistent investment discipline.
By contrast, the mutual fund — one of the nation’s oldest, having started in 1950 — lost a cumulative 19% over the same five years. The discrepancy has a lot to do with the fact that the Value Line fund, despite its name, hasn’t rigorously followed the weekly investment advice printed by its parent Value Line Publishing Inc. It also highlights the penalty investors often face when their mutual fund churns its management team and plays around with its investing style. In fact, late last night the person running the fund, Jack Dempsey, said that as of yesterday he had been reassigned and no longer had responsibility for managing the assets. Value Line couldn’t be reached to comment.
Most of all, the discrepancy between the performance of the fund and the stocks it touts shows that investors don’t always get what they think they’re buying in a mutual fund. For even though Value Line’s success is built around stocks ranked No. 1 by the company’s research arm, the fund’s managers have in recent years dipped into stocks rated as low as No. 3.
Ironically, even while Value Line’s own fund struggles to match the Value Line Investment Survey’s success, an independent fund company that licenses the Value Line name is doing much better with Value Line’s investment approach.
The First Trust Value Line 100 closed-end fund, run by Lisle, Ill.,-based First Trust Portfolios, adheres far more rigorously to Value Line’s investment principles, owning only the top-rated stocks.
Each Friday, First Trust managers log on to the Value Line site to download the week’s list of Value Line’s 100 most-timely stocks. During the next week, they sell the stocks that have fallen off the list and buy those that have been added. The result: Since its inception in June 2003, the First Trust Value Line fund’s net-asset value is up 12.4%, slightly better than the 11.6% gain the Standard & Poor’s 500-stock index posted in the same period.
Value Line’s own fund, meanwhile, gained 3.1% in that same time. Because the fund has been such a laggard in recent years, investors have been walking away. Assets in the fund — in the $500 million range as recently as 1999 — are now less than $200 million, though some of that stems from market losses.
Part of the underperformance stems from previous fund managers who didn’t rely entirely on Value Line’s proven model, opting instead to venture into lower-rated stocks, betting that active fund managers could unearth overlooked gems that one day would shine as top-rated stocks. Thus, investors who thought they were buying into Value Line’s winning investment strategy instead were buying into fund managers who thought they could outperform by second-guessing the company’s research — a tactic that didn’t work well.
Because the fund wasn’t performing well, the company changed managers frequently, searching for one who could post winning returns.
Value Line appeared to be moving back toward its roots in March, when it put Mr. Dempsey in charge of the fund. He isn’t the traditional mutual-fund manager; he’s a computer programmer who for a decade helped refine Value Line’s investment models. Value Line, which uses a team-managed approach, has had at least five lead fund managers since 1998, including Mr. Dempsey, according to Morningstar.
In an interview prior to his reassignment, Mr. Dempsey said he had been restructuring the fund to follow the ranking system “in a much more stringent fashion.” Today, about 95% of the stocks in the fund are rated No. 1. Mr. Dempsey said his goal was to liquidate within a week stocks that fell below Value Line’s No. 1 ranking.
The Value Line survey produces independent research on Wall Street stocks. The weekly view of 1,700 stocks, which costs $538 a year online (www.valueline.com) and nearly $600 in print form, is particularly popular with do-it-yourself investors and the abundance of investment clubs in the U.S. Value Line rates stocks in a variety of ways, but is especially known for its so-called timeliness rank. Stocks ranked No. 1 are timely and expected to outperform the market; those ranked No. 5 are expected to lag.
Instead of running an actively managed fund in which a manager cherry-picks the stocks the fund owns, Value Line could operate what amounts to an index fund that simply owns the highest-ranked stocks in the survey. However, active managers believe they can improve the performance of a fund.
“As a fund manager, you want to add value,” Mr. Dempsey said. Still, he acknowledged that “it’s hard to beat our quantitative system.” In the short time that Mr. Dempsey was in charge — a nearly six-month period in which he transformed the portfolio — he accumulated losses of about 2%, compared with losses of 0.2% at the S&P 500. However, he topped the First Trust fund, which is down about 2.5% in the same period. Under Mr. Dempsey, the fund accumulated significant positions in stocks such as Research In Motion Ltd. and added new positions in Yahoo Inc. and Arrow Electronics Inc., among other companies, according to Morningstar.
Value Line, based in New York, doesn’t detail the inner workings of its proprietary stock-picking model. By and large, though, the strategy is built around stocks displaying price and earnings momentum and posting earnings surprises, says John James, chairman of the Oak Group, a Chicago company that runs hedge funds, some of which try to anticipate changes in Value Line’s stock rankings and then invest based on which stocks will rise to No. 1 from No. 2.
However Value Line’s model works, there’s no question the company’s research produces winning choices. Value Line’s list of stocks ranked No. 1 produced cumulative gains of nearly 1,300% from Dec. 31, 1988 through June, 30, 2004, according to Value Line. The S&P 500, by comparison, posted cumulative gains of 311%.
Enron-Case-Study-So-What-is-It-Worth My walk-through. I go straight to the balance sheet then calculate the returns on total capital in the business. These financial statements were easy to discard because of the size of the business and the poor returns. My estimate of $5 to $7 per share worth or 90% less than the current share price, was wrong. The company was worth $0.  This is more a case of institutional imperative and incentive-based bias. Wall Street was feeding at the financial trough to keep raising money for Enron (to keep the bad businesses afloat) so guess what the financial analysts (CFAs and MBAs) suggested? Buy!  I guess the market is not ALWAYS efficient.
Forget accounting scandals, this was a crappy business based on trading so no way to determine normalized earnings. Â When I was in Brazil and saw Enron’s newly-built generating plant sitting idle, I asked why. Â A project developer said he got paid by doing deals by their size not profitability, therefore, the bigger the white elephant, the better. Â When I called mutual funds who owned Enron as it was trading $77 per share to ask the analyst if he/she was aware of Enron’s declining businesses coupled with absurd price, I was told to shut up. As one analyst (Morgan Stanley?) told me, “I only believe what I want to believe and disregard the rest.”
The above august panel never answered why anyone would give capital to Enron? Â No one mentions the elephant in the room. Â Sad.
What does the above case have to do with net/nets and our course. Everything! Look at the numbers, think for thyself, ignore Wall Street, and be aware of incentives. Â Buying bad businesses at premium prices is a guarantee of financial death.
This is an aside, but based on the above Enron example, does value investing serve a SOCIAL purpose or benefit? Prof. Greenblatt doesn’t think so–you are just trading pieces of paper, but what do YOU think?
See these two venture capitalists explain the social purpose of their business:
