The investment industry deals largely with uncertainty. In contrast, the casino business deals largely with risk. With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky. (page 11: More Than You Know–Mauboussin
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that is what it’s all about.” -Warren Buffett
Treasury Secretary Robert E. Rubin Remarks to the University of Pennsylvania Commencement Philadelphia, PA
As I think back over the years, I have been guided by four principles for decision-making.
First, the only certainty is that there is no certainty.
Second, every decision, as a consequence, is a matter of weighing probabilities.
Third, despite uncertainty we must decide and we must act.
And lastly, we need to judge decisions not only on the results, but on how they were made.
When my father was in college, he too had signed up for a course in philosophy with a renowned professor. On the first day of class, the professor debated the question of whether you could prove that the table at the front of the room existed. My father is very bright and very pragmatic. He went to the front of the room, pounded on the table with his hand, decided it was there — and promptly dropped the course.
My view is quite the opposite. I believe that there are no absolutes.
If there are no absolutes then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.
The business I was in for 26 years was all about making decisions in exactly this way.
I remember once, many years ago, when a securities trader at another firm told me he had purchased a large block of stock. He did this because he was sure — absolutely certain — a particular set of events would occur. I looked, and I agreed that there were no evident roadblocks. He, with his absolute belief, took a very, very large position. I, highly optimistic but recognizing uncertainty, took a large position. Something totally unexpected happened. The projected events did not occur. I caused my firm to lose a lot of money, but not more than it could absorb. He lost an amount way beyond reason — and his job.
A healthy respect for uncertainty, and focus on probability, drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments. And understanding that difference between certainty and likelihood can make all the difference. It might even save your job.
Third, being decisive in the face of uncertainty. In the end, all decisions are based on imperfect or incomplete information. But decisions must be made — and on a timely basis — whether in school, on the trading floor, or in the White House.
I remember one night at Treasury, a group of us were in the Deputy Secretary’s Office, deciding whether or not the U.S. should take the very significant step of moving to shore up the value of another nation’s currency. It was, to say the least, a very complicated situation. As we talked, new information became available and new considerations were raised. The discussion could have gone on indefinitely. But we didn’t have that luxury: markets wait for no one. And, so, as the clocked ticked down and the Asian markets were ready to open, we made the best decision in light of what we knew at the time. The circumstances for decision making may never be ideal. But you must decide nonetheless.
Fourth, and finally, judging decisions. Decisions tend to be judged solely on the results they produce. But I believe the right test should focus heavily on the quality of the decision making itself.
Two examples illustrate my point.
In 1995, the United States put together a financial support program to help Mexico’s economy, which was then in crisis. Mexico stabilized and U.S. taxpayers even made money on the deal. Some said that the Mexico program was a good decision because it worked.
In contrast, last year, the U.S. supported an International Monetary Fund program designed to strengthen the Russian economy. The program was not successful and we were criticized on the grounds the program did not succeed.
I believe that the Mexican decision was right, not only because it worked, but also because of how we made the decision. And I believe the Russian decision was also right. The stakes were high, and the risk was worth taking. It’s not that results don=t matter. They do. But judging solely on results is a serious deterrent to taking the risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated, affects the way decisions are made. I believe the public would be better served, and their elected officials and others in Washington would be able to do a more effective job, if judgments were based on the quality of decision-making instead of focusing solely on outcomes.
Time and again during my tenure as Treasury Secretary and when I was on Wall Street, I have faced difficult decisions. But the lessons is always the same: good decision-making is the key to good outcomes. Reject absolute answers and recognize uncertainty. Weigh the probabilities. Don’t let uncertainty paralyze you. And evaluate decisions not just on the results, but on how they are made.
The other thing I’d like to leave with you is that you will be entering a world of vastly increased interdependence — one in which your lives will be enormously affected by decisions made outside of our borders. We must recognize this reality and reject the voices of withdrawal to face the challenges of interdependence. Then, we can realize the immense potential of the modern era, for our economy and our society.
You’ve just completed an important milestone in developing your ability to deal effectively with the complex choices of the world in which you will live and work. By continuing to build on this foundation throughout your life, you will be well prepared for the great opportunities and challenges of the new century.
On pages 56 to 59 of this chapter the author discusses the case for a checklist. Atul Gawande in his book The Checklist Manifesto: How to Get Things Right argues for a broader implementation of checklists. The author believes that in many fields, the problem is not a lack of knowledge but in making sure we apply our knowledge consistently and correctly.
The Quantitative Value Checklist
Avoid Stocks that can cause a permanent loss of capital or avoid frauds and financial distress/bankruptcy.
Find stocks with the cheapest quality.
Find stocks with the cheapest prices.
Find stocks with corroborative signals like insider buying, buyback announcements, etc.
As students may know, I throw A LOT of information at you to force a choice on your part. You have to focus on what material can be adapted to your needs. In the three books above, you will find many interesting ideas that may be helpful in learning how to build your own list.
The more experienced you are, then the shorter the checklist. The point of a checklist is to be disciplined and not overlook the obvious while freeing up your mind for the big picture. Yes, you check off if there is insider buying, but if insiders are absent, but the company has a strong franchise and the price is attractive, then those factors may be overwhelmingly positive. You may ask, “Do I understand this business?” Then it may take weeks of industry reading to say yes or no.
Checklists are helpful, but only if you adapt them to your method.
Next, we will be reading Chapter 3, Eliminating Frauds in Quantitative Value.We are trying to improve our ability to build a margin of safety.
The Problem with Investor Time-frames
Note the dark line in the chart above representing the returns of the Goodhaven Fund. Two analysts/PMs split off from Fairholme and started in mid-2011. They had a big inflow in early 2014 and then some of their investors panicked as they vastly “underperformed the market.” I don’t know if these managers are good or bad but making a decision on twelve to twenty-four months of data is absurd unless the managers completely changed their stripes (method of investing). Therein lies opportunity for those with longer holding periods like five years or more.
The view from Grant’s (Mar. 20th, 2015) is that risk can usually be found where you aren’t looking for it. You get to thinking, for example, that government bonds are perfectly and unconditionally safe. You would so conclude after 33.5 years of a bond bull market. Yet, the same asset struck many as perfectly and unconditionally unsafe at the 33.5 year point in the preceding 1946-81 bond bear market. Nothing in investing is for certain or forever, “Many shall be restored that now are fallen, and many shall fall that are now in honor,” wrote Horace (65 B.C. to 8 B.C.).
A reader asked about the
sharpe_ratio.asp. I think any metric that uses volatility as risk is absurd. The video below will give you a better understanding of what REAL risk is–permanent loss of life! I know some may disagree–see: FAJ My Top 10 Peeves and a value investor’s view: Risk Revisited
A Reader’s Question
I’m a value investor from Italy, and I’ve been following your blog since a few months ago. I appreciate a lot your work and the way you share your knowledge with the others. I’ve been doing my own research in American stocks, and create a portfolio that I think is doing well.
I’m a retail small value investor with no MBA, or any especial degree in accounting.
How can a “middle class working hero” approach the world of finance? Do you think any money manager be interested in my research, or I’m only wasting my time?
My advice: First, you can post this to the firstname.lastname@example.org because there are many smart, experienced investors who may offer another perspective.
First, why American stocks (especially now since many are high-priced?) versus Italian or Greek stocks? Can you develop an area of expertise NEAR where you are? In other words, what makes YOU unique where you can add unique value? Where can you find the biggest edge. Do you have expertise or experience in a particular industry? Have you spoken to or research Italian Money Managers? Send your write-up to a few of them. The worst that can happen is they give you a thumbs down but you obtain feedback/and learn.
Not having an MBA is no big deal, but you should learn accounting up to the intermediate level so you can translate the financial information into information useful for an investor. GAAP earning don’t always equal owner’s earnings. Study online for free or attend a class or grind through a textbook but do ALL the problem-sets.
If you know your portfolio is doing well, keep good records that you can show to potential investors or employers. Do you have a clear investment process that you can follow?
I am a first year MBA student in XXXX. I am from a background of (being) a software engineer and an equity researcher in China. I was very interested in Value Investing and tried to apply it to personal investment in past 8 years. Currently, I am exploring career opportunities in the Investment Management area and see that you have been working and teaching in this area for a long time. I would learn more about your experience in this area and get some advice from you.
I would write-up investment ideas within your circle of competence to show fund managers your critical thinking skills and approach to investing. Or if you have a great understanding of a particular industry or company that is public you can present your ideas to the fund managers who own the company. Show your past investment results. Why did you make the decisions you made? Try to sell your ideas to the appropriate money managers. But only you can determine what your strengths particular interests. Your reports should meld your interests with your skills.
Our activist friend, Carl Icahn’s High River LP, Icahn Partners LP and Icahn Partners Master Fund LP collectively bought 6.6 million Chesapeake shares on March 11 at $14.15 each, bringing the investor’s total stake in the company to 11 percent, according to a filing on Monday. Prior to the purchases, Icahn controlled about 9.9 percent of Oklahoma City-based Chesapeake. That compares with an 11.11 percent stake owned by Southeastern Asset Management Inc. as of Dec. 31, the largest holding according to the latest filings.
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. 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 results
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. We are just covering material in Chapter 2.
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 (Full article: 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), “so how did the ‘professionally managed’ accounts do during the same period?” 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, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.
Let’s put it another way: on average the people who “self-managed” 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, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re 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 there’s 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 they’re still “good” businesses that earn high returns on capital), usually means you’re 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 isn’t 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. It’s hard to stick with a strategy that’s not working for a little while. The best performing mutual fund for the decade of the 2000’s 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.
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 don’t like to lose money. Beating the market by losing less than the market isn’t 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 didn’t 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.
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. It did get darker..as iron prices fell another 10% and still falling.
Price Iron Ore
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.
Prof. Damodaran is responding to a poster who is asking about Vale’s plummeting stock price. If you are a long-term bull you want declining prices to bankrupt weak companies in the industry so as to rationalize supply.
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.
Times are hard. 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. No criminal or civil complaints. He owns his farm free and clear–he is a farmer like you! 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.
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?).
When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert. See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.
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 far—I hope—is 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: Notes from Joel Greenblatt’s class 2002:
Read: What Works on Wall Street by James P O’Shaughnessy. 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 doesn’t 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 can’t 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 don’t forget MCX), and so on do extraordinary better than those that are willing to buy stocks with the richest valuation. 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, it’s 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, “In the realm of ideas everything depends on enthusiasm; in the real world, all rests on perseverance.” 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. 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: “One of the recurring themes of my research is that we just can’t forecast There isn’t 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.—Edwin Lefevre.
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. –Ben Graham
Richard Brealey, a respected data analysis, estimated that to make reasonable assumptions about a strategy’s validity (95% confidence level or statistically relevant) you would need 25 years of data.
Short periods are valueless
Consider the “soaring sixties” 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 500’s 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 invest—the 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 “expensive) 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%.
David Iben is a deep value investor currently focused on highly cyclical industries like coal, uranium, and gold mining. He has a mandate to go anywhere to invest in big or small companies. He seeks out value. The world is now bifurcated between a highly valued U.S. stock market and the cheaper emerging markets. Social media and Biotech stocks trade at rich valuations while depressed cyclical resource companies languish.
Value to us is a pre-requisite and thus we never pay more than a company’s estimated risk-adjusted intrinsic value. But, failing to think deeply and independently about what constitutes value and how best to derive it, can be harmful. Following in the footsteps of growth investors who had allowed themselves to become too formulaic or put in a box in the late 90s, some value investors were hurt by overly restrictive definitions of value in 2007 and 2008 (Price/Book and Price/Earnings, etc). We find it valuable to use many valuation metrics. Additionally, emphasis is placed on those metrics that are most appropriate to a certain industry. For example, asset heavy and/or cyclical companies often are tough to appraise using Price/Earnings or Price-to-Cash Flow. Price to book value, liquidation value, replacement value, land value, etc. usually prove helpful. These metrics often are not helpful for asset light companies, where Discounted Cash Flow scenario analysis is more useful. Applying these metrics across industries, countries, and regions helps illuminate mispricing. Looking at different industries through different lenses, through focused lenses, using industry appropriate metrics and qualitative factors is important. Barriers to entry are an important factor. Potential winners possess different key attributes. Supply and demand are extremely important detriments of margin sustainability. The investor herd has a strong tendency to use trend line analysis, assuming that past growth will lead to future growth. A more reasoned, independent assessment will often foretell margin collapses as industries overdo it, thereby sowing the seeds of their own self-destruction.
Currently, opportunities are being created when the establishment pays too little heed to supply growth. This fallacy extends to money. Many seem to believe that the Federal Reserve has succeeded in quintupling the supply of dollars without a loss of intrinsic value. That is impossible. Evidence of the loss of value is abundantly clear. Gold supply held by the U. S. Treasury has not increased. As economic theory would predict, the price of gold went up. Following 12 straight years of advance and apparently overshooting, the price has since corrected 40%. The trend followers have their rulers out again, confusing a correction in a supply/demand induced uptrend with a new counter-trend.
We view this as opportunity. At the same time, bonds are priced as if they were scarce rather than too abundant to be managed. It is no secret that this is due to open, market manipulation by the central banks. Intrinsic value must eventually be reflected in market prices. These are abnormally challenging times. Fortunately, we believe markets aren’t fully efficient.
If you listen to his conference calls and read his insights, you will have a great education in counter-cyclical investing. It is easy to know what to do but hard to do!
I will be asking for your suggestions for the deep value course. I am collating one reader’s suggestions which I will post next. Some of you may be quite experienced and advanced investors who tire of the theoretical course materials as well as the mechanical aspect of quantitative investing. We will discuss this next………….Thanks for your patience.