Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? It is not the growth destroys returns, but that the market already recognizes the high-growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long-term returns, and become too pessimistic during busts, selling down stocks and creating the conditions for high long-term returns. Jay Ritter says that irrationality generates volatility “and mean reversion over multi-year horizons.” Graham would agree (p. 88, DEEP VALUE).
The implications for mean reversion in stocks are counter-intuitive. Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market. Stocks with big market prices losses and historically declining earnings tend to see their earnings grow faster, and out perform the market. Undervalued stocks with historically declining earnings grow earnings faster than overvalued stocks with rapidly increasing earnings. This is mean reversion, and, as Ben Graham said, it’s the phenonmenon that leads value strategies to beat the market.
The update to Lakonishok’s research Contrarian Investments Extrapolation and Risk demonstrates that, aside from short periods of under-performance, value stocks generate a consistent value premium, and beat both the market and glamour stocks over the long haul. ….Researchers believe the reasons are because they are contrarian to overreaction and naive extrapolation. Efficient market academics Eugene Fama and Ken French, counter that value strategies outperform because they are riskier. However, Lakonishok found that while value strategies do disproportionately well in good times, its performance in bad times is also impressive. Value strategies are also outperform during “bad” states for the world such as recession and extreme down markets.
When Lakonishok compared the growth rates implied by the market price to the actual growth rates appearing after the selection date, they found a remarkable result–one that supports Graham’s intuition–value stocks grow fundamentals faster than glamour stocks. The high prices paid for glamour stocks imply that the market expects them to generate high rates of growth. Contrary to this expectation, however, the growth rates do not persist. Growth stocks;s growth rates mean-revert from fast growth to slow growth.
If you read all the links and research papers in the past two posts for this chapter in DEEP VALUE, you know that:
Out-of-favor value stocks beat glamour stocks because….
the actual growth rates of fundamental sales and earnings of glamour stocks relative to value stocks after selection are much lower than they were in the past, or as the multiples on those stocks indicate the market expects them to be.
Value strategies appear to be less risky than glamour strategies.
So why do investors persist in buying glamour? For behavioral reasons like anchoring and “overreaction bias.” We will next explore chapter 6 in Deep Value.
Let’s go back to DEEP VALUE, Chapter 5: A Clockwork Market: Mean reversion and the Wheel of Fortune.
As a value investor you are doing either:
Buying a franchise, where barriers to entry allow for profitable growth, before mean reversion sets in or
Buying assets where the normalized earnings’ power of those assets is below norm (Asset value = Earnings Power Value) and earnings’ power will mean revert to normal.
Therefore the concept of Regression to the Mean is powerful. By putting the words, “Many shall be restored that now are fallend and many shall fall that now are in honor” on the facing page of Security Analysis, Graham gave the most prominent position in his seminal text to the idea that Fortuna’s wheel turns too for securities, lowering those that have risen and lifting those that have fallen. The line, from Horace’s Ars Poetica, echoes the phrase spoken by the wise men of legend who boiled down the history of mortal affairs into the four words, “This too will pass.” This is regression toward the mean. (p. 79).
The more extreme the initial price movement, the greater will be the subsequent adjustment in the opposite direction. There tends to be a price trend before reversal. The reasons are manifold, but the most obvious is that the trials aren’t independent—our own trading decisions are affected by the buying or selling preceding our trade.
Two economists known for research into both market behavior and individual decision-making, Werner De Bondt and Richard Thaler, theorized that it is this overreaction to meaningless price movements that creates the conditions for mean reversion. Note page 800 in the link Does Stock Market Overreact— the loser and winner portfolios. Losers win out.
In a second study, Further Evidence of Inv Overreaction Thaler, Thaler and De Bondt revisited the research from a new perspective. They hypothesized that the mean reversion they obserbed in stock prices in the first study might have been caused by investors focusing too much on the short-term. this fixation on the recent past and failure to look beyond the immediate future would cause investors to miscalculate future earnings by failing to account for mean reversion. If earnings were also mean reversing, then extreme stock price increases and decreases might, paradoxically, be predictive of mean-reversion not just in stock prices, but in earnings too. A stock price that has fallen a great deal becomes a good candidate for subsequent earnings growth, a vice versa for a stock price that has gone up a lot. As you can see from the two research reports that the undervalued portfolio delivered better earnings and price performance.
The above research stand the conventional wisdom on its head and show compelling evidence for mean reversion in stocks in a variety of forms.
Buffett Discusses Mean Reversion in the Stock Market
In the 1964 to 1981 period, Buffett wrote, U.S. GNP almost quintuples, rising 373 percent. The market, by contrast, went nowhere.
The evidence is that valuation, rather than economic growth, determines investment returns at the market and country level. Research suggests that chasing growth economies is akin to chasing overvalued stocks, and generates disappointing results. See
The growth illusion
WHEN investors pick the countries they want to back, they tend to be guided by economic growth prospects. The faster an economy grows, they reason, the faster corporate profits will grow in the country concerned, and thus the higher the returns investors will achieve.
Alas, this is not the case. Work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School established this back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting. In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintle of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year’s GDP growth rate and the next year’s investment returns.
Why might this be? One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses. The third factor may be that growth is siphoned off by insiders – executives and the like – at the expense of shareholders.
Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.
What does work? Over the long run (but not the short), it is valuation; the higher the starting price-earnings ratio when you buy a market, the lower the return over the next 10 years. That is why buying shares back in 1999 and 2000 has provided to be such a bad deal.
High Growth Depresses Future Stock Returns
Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? The market ALREADY recognizes the high growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long term returns, and become too pessimistic during busts, selling down stocks and creating e conditions for high long-term returns. More research on that here:
I will finish this chapter in the next post. If you do not have DEEP VALUE or Quantitative Value, then join the deep value group found here: http://csinvesting.org/2015/01/14/deep-value-group-at-google/ and I will send.
If you only understand one concept besides Margin of Safety in investing then let it be Reversion to the Mean.
“Value investing is about praying on the emotions of the seller,” 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 McElvaine’s funds are about 25% in cash to provide an opportunity to buy assets if prices return to Tim’s 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 Tim’s 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 it’s undervalued and going higher, or is it a value-trap, as so often cheap stocks get cheaper.
“You don’t know,” Dad and McElvaine agreed, which reminded me of something Tim taught me 6-7 years ago:
“You’ve got to kiss a lot of toads in this business to find your prince.”
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 Buffett’s letters and I love contrasting his words with his actions…I love how he criticizes hedge funds, yet he had the first hedge fund,” Mr. Loeb said. “He 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. – Business Insider LINK
I have been too busy to do another lesson but be ready next week! For those attending the Berkshire Hathaway Meeting in Omaha enjoy the experience. Flash your Deep-Value Group card for up to 95% discounts.
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.
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.
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.
CLF-2014 Year End Earnings-Release $7.5 billion write-off and thus $1.4 billion in NEGATIVE equity. Headed to bankruptcy? I wouldn’t bet on it, but there go the screens for low multiples of book value. Investors typically run from stocks like this.
Revlon VL has had negative equity for over a decade, but increased cash flow is what has driven this stock higher.
Negative shareholder equity–at least from a securities perspective–is not a problem in and of itself generally in the U.S. It can result from any number of corporate histories. Corporate valuations tend to vary widely from their shareholder equities. I am not aware of any state’s corporate law that considers it a problem, in and of itself, either. In Delaware, the measure that matters is “surplus,” which is drawn from a corporation’s market value rather than its book value. Delaware corporations, for example, can pay dividends, borrow money, issue new securities to investors, etc. notwithstanding a negative s/h equity, so long as they have adequate “surplus” meet minimum capital and other legal requirements. I would say s/h equity, while important, is seen more as an accounting function that can-but does not always-track the actual value of a company. The only time I have ever seen it come up as a legal matter is in the case of one company that wanted to self-insure itself for workers compensation liabilities. The state denied the company’s application to self-insure on the basis of negative shareholder equity–notwithstanding its market capitalization was in the hundreds of millions. It was just a requirement buried in the state’s regulations that used s/h equity as its measure of a corporations value (and, thus, its ability to pay worker’s comp claims).
Look at Revlon. Here is a firm with about 1.2 bil in assets and 1.9 bil in debt, giving it negative equity of 0.7 bil. This is less than it was a few years ago, when its equity was about negative 1 billion. Yet it survives, and is an NYSE firm.
Your example is very good because it shows that a change in stockholders’ equity can be a good measure of performance. Revlon’s increase in s/h equity shows that it is performing well, even though it is negative (and will probably be for years to come). Although, like book value, there are plenty of other reasons s/h equity change absent a valuation change. A general example is companies that have (from prior years) built a huge bank of net operating losses (NOLs), which can shield a company from tax liability for a long time. These NOLs, while having value cannot be booked as assets unless the company is showing, according to accounting standards, that it will actually use them. Once a company that has been losing money (and accumulating NOLs as well as, likely, shareholder deficit) becomes consistently profitable, these NOLs can be booked as an asset. The asset is the value of future tax savings. That can turn a company’s negative book value into a positive book value overnight–even though the company’s market value hasn’t changed at all. This can also happen the other way. I recall this happening to Ford around the time of the financial crisis. They booked a massive loss in one quarter largely on the basis of the elimination from their balance sheet a tax asset based on the value of their NOLs. It was a bad quarter for them to be sure (like everyone else), but the accounting loss magnified it several times in a way that didn’t track performance. Ford, after all, was the only major car company in the U.S. that avoided bankruptcy during the crisis.
I bring the negative equity to your attention because it seems like a good search strategy to find mis-valuation. First, many screens wouldn’t pick these companies, second most investors would shun them, investors often fixate on accounting convention rather than underlying economics, and finally it seems very counter-intuitive.