Category Archives: Value Investing

Quantitative Value Investing, Value Investing

Growth doesn’t bring much to the party

business

Counterintuitive Findings

Prior to reading Deep Value by Tobias Carlisle, I always thought that the key in value investing was to find cheap companies that could grow fast.

Buffett even discussed the merits of combining growth and value in his 1992 letter:

Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

A key point of Tobias’ book is that growth is not how value delivers returns. The discount from intrinsic value and the closing of that gap is the key driver of return in a value portfolio.

De Bont & Thaler

He cites two studies in the book that are compelling because of how counterintuitive they are. They were both conducted by Werner De Bondt and Richard Thaler. The first study looked at the best-performing stocks and compared them to the worst performing stocks in terms of price performance. They found that the worst performers go on to outperform the best by a substantial margin.

They also looked at this in terms of fundamental earnings growth. They reached the same conclusion: the worst companies outperform the best.

A Simple Backtest

I decided to backtest more recent data myself to see if this still holds true. In an S&P 500 universe, I performed a backtest going back to 1999. I compared the performance of the 30 companies with the fastest growth in earnings per share to a portfolio of the 30 worst stocks, rebalanced annually.

Just as De Bont & Thaler determined before, the 30 worst companies continue to outperform the 30 best.

bestvsworst

Keep in mind: there is no other factor involved here except for 1-year earnings growth. We’re not even looking at these stocks in a value universe: it’s simply the 30 fastest growers vs. the 30 worst.

Value Drives Returns

The evidence suggests that value alone is the best determinant of future returns. Growth isn’t nearly as powerful.

For instance, I also tested the performance of a universe of stocks with a P/E less than 10. This universe of stocks delivered an 11.69% rate of return since 1999. Within this winning universe, if you bought the 20 stocks with the best earnings per share growth then the return actually declined to 9.77%. Fast growing value stocks actually underperform the overall value universe.

The same is also true from a macro standpoint. Looking at the performance of the S&P 500 since the 1950s, the greater determinant of future returns is starting valuation, not actual business performance.

decades

As you can see, the valuation of the market at the start of the decade (Shiller CAPE and the average investor allocation to equities – both valuation metrics are discussed in this blog post) are far more predictive of future returns than actual business performance.

Look at where the divergence is widest — the 1980s versus the 2000s.

The 2000s was a much better decade than the 1980s in terms of actual business performance. During the 2000s, earnings grew by 191%. In the 1980s, earnings only grew by 16.40%.

However, the 1980s witnessed a 409% total return for the S&P 500, while the 2000s actually clocked in a net decline of 9%.

Of course, there were macro events driving both markets. In the 1980s, returns were bolstered by interest rates declining from all-time highs once inflation was brought under control. At the end of the 2000s, we suffered the worst financial crisis since the Great Depression and the worst recession since the early 1980s, which negatively impacted stocks at the end of the decade.

With that said, the key factor behind the returns was the overall valuation of the market, not macro events or even business performance.

The undervaluation of the US market in the early 1980s was the true force that propelled the bull market forward.  In 1980, the Shiller CAPE for the US market was 8.85 and the average investor allocation to equities was only 23%.

In contrast, the overvaluation of the US market in 2000 was the key force that drove down returns over the next decade. In 2000, the Shiller CAPE was 43.77 and the average investor allocation to equities was 50.84%. Actual corporate results were impressive but that wasn’t enough. Valuation mattered more.

Conclusion

The conclusion is both simple and radically counterintuitive: valuation matters more than growth in predicting future returns for a single company stock or an entire market.

In the long run, growth simply doesn’t bring much to the party.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Value Investing

Walter Schloss: Superinvestor

I came across this interview with Walter Schloss and it was packed with interesting quotes and insights.

Walter Schloss started his career on Wall Street in 1934 as a runner at the age of 18. He read Graham and Dodd’s Security Analysis and later went to work for Graham in his partnership. When Graham closed his partnership, Schloss went on to manage money himself. He managed money from 1956 through 2003 and delivered a 15.3% rate of return.

Here is what “Adam Smith” had to say about him in the 1972 book Supermoney:

“He has no connections or access to useful information. Practically no one in Wall Street knows him and he is not fed any ideas. He looks up the numbers in the manuals and sends for the annual reports, and that’s about it.”

Buffett had this to say about him:

“He knows how to identify securities that sell at considerably less than their value to a private owner: And that’s all he does… He owns many more stocks than I do and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That is one of his strengths; no one has much influence on him.”

While others deviated from the Grahamian value approach, Schloss stuck to it for the rest of his career. He started off buying net-nets. When net-net opportunities dried up and his capital expanded, he focused his attention on low price-to-book names.

Here are some great quotes from the interview:

  1. Ben Graham: “In the ’20s he had a deal where he took 50 percent of the profits but he took 50 percent of the losses. And that worked great until 1929 when the market went down and obviously, his stocks were affected, too, and he was not only affected by that, but many of these people then pulled out because they needed money for their own purposes or they had lost a lot of money other places. So, he figured out how he could possibly never have this happen to him again. he was very upset about losing money. A lot of us are. So he worked on a number of ways of doing this and one of them was buying companies below working capital and in the ’30s there were a lot of companies that developed that way.”
  2. Work at Graham-Newman: “Anyhow, at that time my job was to find stocks which were under valued. And we looked at stocks selling below working capital, which was not very many.”
  3. Increasing positions in beaten up stocks: “Well, a lot of people don’t like it if you buy a stock at $30 for a customer and then they see it at $25. You want to buy more of it at $25. The guy doesn’t like that and you don’t like to remind him of it. So, one of the reasons I think that you have to educate your customers or yourself, really that you have a strong stomach and be willing to take an unrealized loss. Don’t sell it, but be willing to buy more when it goes down, which is contrary, really, to what people do in this business.”
  4. More on undervaluation: “Basically we like to buy stocks which we feel are undervalued and then we have the guts to buy more when they go down.”
  5. Why the “superinvestors” who worked for Graham succeeded: “I think number one none of us smoked. We were all rational. I don’t think that we got emotional when things went against us and of course Warren is the extreme example of that.
  6. On buying foreign stocks: “Well, my problem with foreign companies is I do not trust the politics. I don’t know enough about the background of the companies. I must tell you, I think the SEC does a very good job and I feel more comfortable holding an American company.”
  7. Selling: “Sell is tough. It’s the worst, it’s the most difficult thing of all and you have an idea of what you want to sell it at and then you sometimes are influenced by the changes that take place. We owned Southdown. It’s a cement company. We bought a lot of it at 12 1/2. Oh, this was great. And we doubled our money and we sold it at something like $28, $30 a share and that was pretty good in two years. When next I looked it was $70 a share. So, you get very humbled by some of your mistakes. But we just felt that at that level it was, you know, it was not cheap.”
  8. Shifting from net-nets to low price-to-book: “Yes, it’s changed because the market’s changed. I can’t buy any working capital stocks anymore so instead of saying well I can’t buy em’, I’m not going to play the game, you have to decide what you want to do. And so we decided that we want to buy stocks if we can that are depressed and have some book value and are not too, selling near their lows instead of their highs and nobody likes them.”
  9. Q: Tweedy Browne is very quantitative, and Buffett’s more qualitative. Where are you in that spectrum? A: “I’m more in the Tweedy Browne side. Warren is brilliant, there’s nobody ever been like him and there never will be anybody like him. But we cannot be like him. You’ve got to satisfy yourself on what you want to do. Now, there are people that are clones of Warren Buffett. They’ll buy whatever Warren Buffett has. Fine. I don’t know, I don’t feel too comfortable doing that and the other thing is this. We happen to run a partnership and each year we buy stocks and they go up, we sell them and then we try to buy something cheaper.”
  10. Why he didn’t pursue Buffet-Munger style concentration: “Psychologically I can’t, and Warren as I say, is brilliant, he’s not only a good analyst, but he’s a very good judge of businesses and he knows, I mean my gosh, he buys a company the guy’s killing himself working for Warren. I would have thought he’d retire. But Warren is a very good judge of people and he’s a very good judge of businesses. And what Warren does is fine. It’s just that it’s not our — we just really can’t do it that way and find five businesses he understands, and most of them are financial businesses, and he’s very good at it. But you’ve got to know your limitations.”
  11. Selling short: “We did it a couple times and we’re always very upset after we do it. So I’d say not anymore.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

 

Value Investing

When and How Will Value Strike Back?

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stocks

Has the bull market erased bargains?

I was listening to an investing podcast the other day and heard an interesting conversation. The guest pointed out that during the internet bubble of 1999, there were a significantly higher number of bargains than there is today. The guest further lamented that in the current environment, the bargains aren’t as widely available as they were back then.

This is an important point. As discussed in my previous post, growth has trumped value for some time now, which is a historical aberration. The disconnect will certainly end, but it’s difficult to say when and how it will happen.

The resolution in the early 2000s of the value-growth disconnect was the ideal situation. The broader market entered a tailspin for nearly three years, but value experienced a significant bull market at the same time, seemingly disconnected from the carnage that took place in large cap stocks.

This is obviously how I would like to see the current situation shake out, but I suspect that the value bull market of the early 2000s was due primarily to the number of bargain stocks that were available because everyone was fixated over the likes of Qualcomm, Cisco, Amazon, Redhat, etc.

I decided to take a look at the data for myself. I looked at the number of earnings bargains available in 1999 and compared them to today, as well as a few other points in time in recent market history. The universe of stocks I looked at was the S&P 1500. The data is below.

number of bargains

Bargain Availability Through the Years

Bargains were available in 1999, but certainly not to the extent that existed during the financial crisis. In 1999, there were 102 stocks with an earnings yield over 10%. As a group, they returned 18.10% in 1999. The number rose to 171 in 2000, and the return was 32.47% for that year. This occurred while the S&P 500 experienced a decline of 10%.

By 2005, the number of stocks yielding over 10% shrunk to 50 and the group returned 8.26% that year, slightly below the S&P 500’s return of 11% that year.

Obviously, the greatest moment in history to buy value stocks was early 2009. At the beginning of 2009, there were 474 stocks (nearly 1/3 of the universe) with an earnings yield over 10%. As a group, they returned 62.78% throughout 2009.

The number of bargains shrunk to 158 in 2012. The population shrunk as we emerged from the financial crisis, but bargains were still more plentiful than they were in the 1999-2008 period. As a group, they returned 10.26% in 2012 and 50.96% in 2013.

Today, the number has shrunk to 64. This is lower than 1999, but it hardly seems as if bargain stocks are no longer available. They are still out there, they are still behaviorally difficult to buy, and this suggests to me that the value premium will remain alive and well. However, I think that the low availability makes it unlikely to value’s resurgence will play out like it did in the early 2000s.

That ’70s Stock Market

The key question is how all of this will play out. History suggests that bigger populations of bargain stocks bode well for future returns. It’s not an iron clad rule that you could plug a formula into, but that’s the general trend.

This suggests that value is limited but not eliminated in today’s market. It also seems unlikely that we will experience a resurgence of value as incredible as that of the early 2000s when value experienced a bull market while the broader market declined.

I would like to believe that this will occur again, but I doubt we will be that lucky.

I think a more likely scenario for the next shakeout will be something more like the 1970s. The late ’60s and early ’70s was one of those times (like the late ’90s and today) where growth trumped value and the S&P 500 soared.

In the early ’70s and late ’90s, everyone preached buy and hold while it worked and few practiced it once times became tough. In all of these eras, popular sentiment was that value investing was dead and that everyone who wasn’t buying sexy growth names was a relic of the past who just didn’t understand how magical the new era was, paying 50 times earnings makes sense because . . .  Copy machines/dial-up-internet/smart phones/blockchain, it’s a new era, markets are so efficient and competitive these days, blah blah blah.

When the shakeout went down in the ’70s, value stocks fell with the broader market. They didn’t experience a bull market like they did in the early 2000s.

For a good look at value returns during this period, I took a look at this analysis of the simple Ben Graham strategy over at Alpha Architect. I also thought a good record to examine were the annual returns of Walter Schloss, whose strategy focused on low price-to-book names. Below is a snapshot of the 1970s from the perspective of the S&P, Walter Schloss and the systematic low P/E low debt Ben Graham strategy.

70s

As you can see, in the 1970s, value delivered the highest returns, but the road was bumpy. Unlike the early 2000s, value didn’t go up while the broader market declined. Value stocks went down with everything else.

During the 1973-74 bear market, Walter Schloss held up better than both the broader market and the systematic Ben Graham approach (a variation of which I’m following with my portfolio). I suspect that Walter Schloss’ decent performance in the recession of 1973-74 is due to his zero exposure to the Nifty Fifty and I also suspect that he held a significant amount of cash.

Walter Schloss was a classic Graham investor focused on asset value. If the bargains weren’t available, he didn’t buy them. This allowed him to experience only single digit losses during the 1973-1974 period.

The systematic Ben Graham strategy didn’t hold up as well, but I think that’s likely because it was fully invested while Walter Schloss was not.

The Future

I don’t know what the future holds, but I do know that buying expensive hyped up stocks is dangerous, regardless of how seductive it looks in the throes of a late bull market. Value will outperform growth and the broader market over time, but the road will be rocky and require patience. In investing, I think patience and discipline are more important than any other characteristic, including intelligence.

While I would love to see a repeat of the early 2000s value bull market, I don’t think we will be that lucky. Due to the fewer bargains available today than were available in the 1999-2000 period, I think a repeat of the 1970s is more likely, which was painful at times, but ultimately rewarding to those who had the patience to stick with a value approach and the discipline to avoid the sexy glamour stocks.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Portfolio Commentary, Value Investing

The Madness of Men

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The Madness of Men

Value investing has been enduring a tough time. This is certainly true for my own portfolio. I’m down 7.72% year to date compared to an 8.34% gain for the S&P 500. It’s times like this that it helps to look to history.

We’re currently in an era where investors are gobbling up growth companies and they don’t care what the price is. I remember the same mood back when I was in high school. People forget, but the bubble wasn’t simply concentrated in dot-com stocks. The bubble was pervasive among even the most stable of blue chip companies: Cisco, Microsoft, Coca Cola.

Going further back in history, the same euphoria characterized the Nifty Fifty era. The Nifty Fifty was a group of 50 stocks in the early 1970s that grew by leaps and bounds in the 1960s. Many of them were exceptional companies (like McDonalds and Xerox), but the euphoria pushed their valuations to extraordinary levels. Predictably, valuations came crashing down and investors were burned.

Taking things back even further, the same mood characterized the South Seas bubble. That bubble was fueled by optimism over the age of exploration and it famously burned Isaac Newton. Newton remarked of the collapse: “I can calculate the movement of the stars, but not the madness of men.”

Every bubble has something in common. There is something new and exciting in the air that promises to change our lives and this fuels speculation. It starts with a truth (i.e., real estate is an excellent investment for the middle class) and then descends into temporary madness. Of course, the market always corrects this madness. Eventually.

During the dot-com bubble, it was the promise of the internet. The internet was going to transform the way we live and everyone could see it . . . so, Cisco Systems was valued more than General Electric and Pets.com was a thing. They were right about the promise of the internet but wrong about the impact on stocks. Adding fuel to the fire was the promise of the “new economy”. Productivity was surging at the time. Productivity is the key ingredient in economic growth, so the belief was that we were entering an era of permanently higher growth. This fueled predictions of the federal budget deficit going to zero in 10-20 years. In truth, productivity was simply reverting to the mean after stagnation in the 1970s and 1980s. Keep this in mind when commentators say that the current productivity slump is permanent and means that the US economy will never grow faster than 2%.

With the Nifty Fifty, it was optimism about the power of the post-World War II American economy. The 1950s were a good time for the American economy and the 1960s were even better. The unemployment rate was only 3.9% by the end of the decade. Americans experienced abundance that was foreign to them in the past. Suburbs popped up everywhere and car ownership became ubiquitous. In the 1970s, the good times took a hit due to inflation, an oil shock, and the confidence-sapping Watergate scandal. Also, disco. Unaware of what was about to happen, investors thought that you could simply buy the fastest growing companies in the world’s fastest growing economy, and price didn’t matter.

With the South Seas bubble, it was the promise of the age of exploration. The New World opened up two continents that were rich in natural resources and abundance. Surely, investing in the company that would dominate trade in the new era was a surefire bet.

Now, the euphoria is fueled by the promise of scaled up e-commerce in the form of Amazon, cryptocurrency (personally, I only trust a currency that is secured by the full faith and credit of people with guns, aircraft carriers, stealth planes and nuclear weapons), the transformation of our lives by smartphones and the promise of whatever Elon Musk thinks is cool (electric cars, cars that drive themselves, hyper loops, USB ports in our brains, etc.)

Euclidean Technologies Q2 2017 Letter

I was reading Euclidean Technologies Q2-2017 letter and came across this historical nugget:

“Among large-cap stocks, the spread between value and growth is now larger than at any point over the past six decades, with one exception—the top of the dot-com bubble.”  Barrons, June 28, 2017

The letter is a great read and is well worth your time. The letter makes two very key points:

  1. Value stocks are going through the longest cycle since World War II of underperformance versus growth. Each period of time that growth outperforms value, value eventually stages a significant resurgence. Their chart showing this history can be accessed here.
  2. They also have a great analysis of the performance of different valuation metrics since 1970. They find that using enterprise values instead of raw market prices in a valuation ratio works best. They find that all of the major valuations work and, as is demonstrated in Deep Value, the acquirer’s multiple (in both the EBIT and EBITDA variations) exhibit the highest performance. The comparison of different valuation metrics can be accessed here.

Conclusion

I don’t know when or how the current cycle will shake out. I am confident in one thing: buying expensive stocks is dangerous and buying cheap stocks is a safe long term bet, no matter how you slice it. The current disconnect will not last forever.

I think indexing makes sense over the long run and I don’t think we’re on the brink of a 1929 or 2008 scenario. With that said, I do think that this current environment is fueled by performance chasing, just as it was in the 1990s. Just like the 1990s, money is pouring into large cap index funds. As index funds concentrate their bets on the biggest components of the index, those companies see their valuations increase. This isn’t due to any change in their actual business performance but is due to their weighting in the index. The money pouring into index funds is not permanent capital and I suspect many will head for the hills once the current cycle turns on them, as usually happens.

Most investment strategies work and make no mistake: indexing is simply a strategy. It’s a smart, tax efficient and cheap strategy. It will only work for investors if they stick to it, which they typically don’t, as demonstrated by this chart.

Value is having a tough time, but it’s times like this that are the reason value investing works over the long run. If value investing delivered double digit returns every year consistently, then everybody would do it.

The strategy I am pursuing is consistent with Ben Graham’s recommended strategy from the 1970s: buying low P/E stocks that have safe balance sheets. I look at other factors (such as the enterprise multiple), but that’s the gist of what I’m doing. When looking at my own performance, I compare it to this backtest of the strategy done over at Alpha Architect. In 1998, the 20-stock variation of the strategy lost 9.01%, compared to a 26% gain in the S&P 500. In 1999, the strategy gained 4.55% against a gain of 19.53% in the S&P.

The worst year for the strategy was 1969, in which it lost 28%. The S&P lost only 8% that year.

Over the long run, however, Ben’s simple (but not easy) strategy delivered a 15% rate of return. That’s the long run return I’m striving for with this IRA over the next few decades.

I don’t know how long the doldrums will last, but I do know they will end. It may take years, but I’m not going to abandon it. The only thing I may change if the market takes a hit is to shift my focus to asset-based investing (i.e., net nets and stocks below tangible book). The only reason I’m not doing that now is that they are not available in sufficient quantities.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Book Review, Value Investing

“Deep Value” by Tobias Carlisle

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deep

“Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!

Mr. Market is Crazy

For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent Investor, Security Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.

It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.

I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.

In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.

Why does it work?

While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?

Ben Graham was actually asked this question by Congress in the following exchange:

Chairman J. William Fulbright: What causes a cheap stock to find its value?

Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.

This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.

Mean Reversion

The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.

What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.

Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.

I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.

Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.

The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.

The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.

Mean reversion in business is the main force driving the realization of value.

The Illusion of “Quality”

Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.

Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.

This lesson is reinforced throughout the book with real world examples and massive quantities of data.

The Acquirer’s Multiple

Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.

The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.

Another reason it works is that the metric is most often used by acquirers such as private equity firms.

What is Deep Value?

Another goal of this book is explaining how “deep value” is distinct from other types of value investing.

Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.

Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.

The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.

The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.

The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.

The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.

Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.

The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.

Practical Application

Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.

Recommendation

It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

investing, Value Investing

Can a Small Investor Beat Wall Street?

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One of the common responses I hear when I tell people that I buy and sell stocks using my own analysis goes something like this:

“Why even bother? There are so many smart people researching these stocks with far more time to devote to it than you. They have better information and can do more homework. You might as well buy an index fund.”

Indeed, there are many people trying to beat the market and Wall Street spends a vast amount of money on research and analysis, which is likely superior to the analysis that I have the time to do.

The Data

I decided to step back and check the actual data about Wall Street recommendations. I wondered what would happen if you systematically bought baskets of each Wall Street recommendation (buy, sell, etc.), held on to them for a year and then re-balanced annually. The results from the Russell 3000 universe are below:

Wall Street Analyst

If Wall Street analysis were on point, there would be a more linear result. Each basket should outperform the next.

Instead, the actual data produces this choppy result. Neutral ratings outperform buys and strong buys. Meanwhile, those rare “strong sell” ratings actually outperform the sell recommendations.

This analysis of Morningstar star ratings comes to a similar conclusion. Morningstar assigns star ratings to mutual funds (5 stars are the best, 1 star is the worst). The paper linked to analyzes the resulting returns after Morningstar issues the rating. The 5 star ratings outperform the 1 star ratings, but in the lower end it gets lumpy. The 1 star rated funds outperform the 2 and 3 star funds.

Also, consider this tidbit of stock market history which is quite shocking: in November of 2001, more than half of Wall Street analysts rated Enron as a buy or better.

Why This Result?

This leaves one to speculate: why do we get this result? I think there are three key reasons:

1. Human nature makes us extrapolate the present into the future. Analysts aren’t immune to this tendency.

Any analyst can look at Amazon, for instance, and tell me that they are doing a great job at growing their revenues. Any analyst can look at the retail sector and tell me that retail is hurting as more consumers shift their buying preferences online. In 2006, any analyst could tell you that the financial sector was enjoying a nice upswing and would also provide you with a very convincing explanation (i.e., the “financial supermarkets” created in the wake of Gramm-Leach-Biley were leading to higher returns on equity for banks) or that the energy sector was doing well thanks to advancing oil prices (they would probably say that oil would continue to increase due to growing demand from emerging market economies and peak oil). In 1999, any analyst could have looked at the growth in fiber-optics and told you that JDS Uniphase was doing very well and would continue to do so because the rapidly growing information economy would fuel greater demand for fiber optic cable. Analysts are frequently deceived because they underestimate the tendency of things to change. Some have expressed this sentiment with greater eloquence.

When you look at a Wall Street research recommendation, what you’re seeing is the conventional wisdom. The conventional wisdom is usually an extrapolation of what is going on right now into the future. The conventional wisdom usually becomes more ingrained when we listen to really smart people provide convincing explanations for why the trend will continue.

Things change and the conventional wisdom is frequently incorrect. It is human nature to take trends and extrapolate them into the future. This worked for our ancestors trying to evade a predator, but it doesn’t work when trying to predict changes in the modern world. The tendency of trends to reverse (for great businesses to falter, for bad businesses to turn around) defies the ingrained expectations of human nature.

2. Wall Street doesn’t care about valuation as much as it should.

Valuation plays another role. Stocks with “strong buy” recommendations are frequently overvalued. Of the 32 analysts covering Amazon, for instance, 23 of them have a strong buy recommendation. Clearly, valuation isn’t even considered the analysis, as Amazon currently has a P/E ratio of 179.84. Amazon might continue it’s ascendancy, but history shows that stocks with such lofty valuations frequently under-perform. Amazon’s business may continue to succeed, but that doesn’t mean that the stock is a good investment when the lofty valuation is taken into consideration.

3. Wall Street prizes access to management.

Wall Street values good relationships with companies. Sell ratings or critical analysis hurts the relationship that banks have with companies. As this Bloomberg article explains, relationships are the reason that only 6% of the 11,000 Wall Street recommendations are sell ratings.

Relationships are critical to Wall Street. A good relationship with a company means that the Wall Street banks are more likely to underwrite deals for those companies, such as mergers and acquisitions, which generate high fees for the banks. Good relationships can also improve their odds in being selected to underwrite new loans for that company, another important source of income.

Another reason is that they want access to management to get better information about the companies. They feel that access to management is a critical component of gathering information about potential investments.

My unconventional view is that talking to management can be counterproductive. Management is always going to say things that are positive about the company no matter what, so what’s the point of even entertaining them? CEOs typically get their jobs not because of any technical expertise, but because they are masters at dealing with people. They are typically wildly charismatic people.

Charisma is usually not matched off with any real expertise or insight. When Wall Street analysts talk to management, they are simply being charmed by a charismatic person into believing a more optimistic portrayal of the company than is actually deserved. I think an investor is better off going to sec.gov and reading through the financial data published in quarterly and annual reports rather than allowing themselves to be manipulated by a charismatic management team.

The great Walter Schloss had this to say about meeting with management: “When I buy a stock, I never visit or talk to management because I think that a company’s financial figures are good enough to tell the story. Besides, management always says something good about the company, which may affect my judgment.”

Conclusion

My conclusion is simple: small time investors can win at this game even though we are at an informational disadvantage. This is because much of the Wall Street “analysis” is clouded by behavioral biases, an under-appreciation for value and a tendency to be manipulated by management.

A small investor can also operate in corners of the market where Wall Street banks fail to look, as their focus is usually on extremely large companies that can generate fee income.

Moreover, as has been discussed previously on this blog, Wall Street is increasingly short term oriented. In a world where investors obsess over their returns on shorter and shorter time periods, an investor with a long term outlook and willingness to under-perform in the short run is at a significant behavioral advantage.

I’ll end this with a quote on this subject from the master himself, Benjamin Graham:

“The typical investor has a great advantage over the large institutions . . . Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.