Feeds:
Posts
Comments

Posts Tagged ‘Joel Greenblatt’

 

I read widely about investing and the strategy I am most drawn to is Value Investing. To me, value strategies make the most sense because they encapsulate a fundamental principle of investment: buy bargains. Of course, the label value investing encompasses a wide array of different investing strategies. I find many of these strategies attractive, however I feel that some can be applied by individual Do-It-Yourself (DIY) investors while others are best left to professionals. In this post I describe a Value Investing Hierarchy where I organize value investing techniques into 4 categories, ordered by ease of implementation for a DIY investor.

 

Category 1:  Quantitative Value Strategies

There are numerous quantitative value investment strategies that focus on ordering a predefined index based on a group of financial attributes and then selecting the cheapest subset in that index for investment. Usually the prescription is to rebalance annually by reapplying the strategy to the index each year. For example, the Dogs of the DOW strategy, which I have written about considerably on this blog, fits into this category. Another famous quantitative strategy is the Magic Formula invented by Joel Greenblatt and made famous in his book The Little Book that Beats the Market.  According to Morningstar, the strategy returned 19.9% from the beginning of 1998 to September 30th 2009 which compares very favourably to the S&P 500’s return of 9.4%, see here.  The Magic Formula ranks companies in a given index based on two factors: return on capital (a quality measure) and earnings yield (a value measure), then selects a subset of the highest ranking companies for purchase. For step by step instructions on implementing the strategy see here.

I include these strategies in Category 1 of my hierarchy because they can be implemented by a DIY investor relatively easily. Simple calculations using freely available financial data are all that is required. Importantly, they do not require intensive research or particular insight into the operation of a business or the quality of management. To make it even easier, many of these strategies are freely available on the internet with the annual rebalanced list calculated and published for you each year. The Dogs of the Dow for any given year can be obtained here, and the Magic Formula list can be obtained here.

 

Category 2: Quality at a Fair Price

Buying quality companies at a fair price is a value strategy famously employed by Warren Buffet. His value metric is a high return on invested capital (ROIC) over long operating histories. Buffet describes companies that achieve this level of performance as possessing a wide moat and buys them when he estimates they are trading at a discount. Implementing this strategy is more difficult for a DIY investor to execute because it involves an intimate understanding of the business as well as an assessment of a company’s management. Not impossible, but it does require more work. Buffet suggests staying within a circle of competence and developing an intimate understanding of the companies within that circle. Buffet’s circle contains many well understood businesses for which information is easily obtainable. For example, the Coca-Cola Company is the largest holding in Berkshire Hathaway’s portfolio and the most widely recognized brand name in the world.

The other important facet of this strategy is assessing a company’s management. This is the more difficult part since unlike Buffett, a typical DIYer doesn’t have access to the management of publicly traded companies. However, you could decide to supplant an assessment of management by using as a proxy the quality of the fund managers that invest in these companies. For example, if you believe that Warren Buffet is good at assessing management you could restrict your circle of competence to the companies Warren Buffet invests in. GuruFocus tracks the investments of Buffet and a number of other investment gurus and the data is updated quarterly. Oftentimes you can purchase the securities they’ve purchased at a discount to the price they paid. Of course, you would also have to wait an entire quarter to find out if they’ve sold a company.

An advantage of assessing management by proxy is that gurus such as Buffet are much more accessible than the managers of the companies they invest in.  Indeed, there is a tome of writing about Buffet and his investing style, not to mention that Buffett publishes his thoughts himself in his annual investment letter which is available here and contains invaluable insight. However, if Buffett’s circle of competence is deemed too restrictive, there are other gurus who have built impressive long term track records employing a similar style. Donald Yachtman and Prem Watsa (for Canadians) are two managers who have very similar strategies and have achieved above average returns.

Another option for assessing management is to pay for it.  For example, as part of its paid subscriber service, Morningstar publishes an assessment of management for many of the wide moat companies that the gurus tracked by GuruFocus invest in. The service is relatively inexpensive at $15-$20 per month and the analyses are updated regularly. In my opinion, these analyst reports and specifically the assessment of management can provide a DIY investor with enough information to draw reasonable conclusions.

 

Category 3: Deep Value Investing

This category encapsulates a set of strategies that attempt to buy stocks at deep discounts to intrinsic value. The strategy employed by Ben Graham, the father of value investing, would fall into this category. Similar in some respects to Category 1, the strategies in Category 3 focus on quantitative analysis of a company’s financials. For example, Ben Graham had a very stringent set of requirements that a company had to meet before he would consider investing:

 

Figure 1: Benjamin Graham’s Criteria for the Defensive Investor
 
P/E Ratio less than 15.
P/Book Ratio less than 1.5.
Book Value over 0.
Current Ratio over 2.
Earnings growth of 33% over 10 years.
Uninterrupted dividends over 20 years.
Some earnings in each of the past 10 years.
Annual revenue of more than $100 Million (1950).

Source: The Intelligent Investor, 4th Revised Edition (pages 184-185).

 

I found this table at the StingyInvestor site, see here. In contrast to the strategy in Category 1, this technique does not sort stocks from within an index, and thus, there may be periods when no stocks pass the stringent requirements. Norm Rothery, the founder of the StingyInvestor publishes a relaxed version of the Ben Graham screen that returned 26% annually from 2000-2008, see here.

Deep value strategies rely heavily on quantitative analysis and unlike the strategies of Category 2, are not typically concerned with the quality of a company or an assessment of management.  Although this should make it easy for a DIYer, I rank deep value strategies on the third rung of my hierarchy because the stocks selected are often unfamiliar small cap companies that could be thinly traded. An investor would have to be sophisticated enough to take on this illiquidity risk. However, although this is the prevailing wisdom regarding illiquid stocks, I have to add that the concern over illiquidity may be unwarranted. Roger Ibbotson has published research showing that small cap, low liquidity stocks do very well over time returning 17.87% from 1972-2009 (see here). Filtering low liquidity stocks on value parameters does even better, returning 20.63% over the same time period.

 

Category 4: Distressed Debt

I categorize strategies that focus on distressed debt on the lowest rung of my hierarchy. I debated whether to include it here; however I am attracted to it as one of the purest forms of value investing. It requires the ability to examine a debt instrument that is selling at an 80% discount to face value and determining that it is actually worth 60%. I believe that this is a particularly inefficient segment of the market because distress situations involve sellers who are motivated to sell at deep discounts, giving well informed buyers an advantage. Seth Klarman, one of my favourite gurus, is famous for investing successfully in distress debt situations. One of his most famous investments was the purchase of Enron bonds when they were selling at 10-15 cents on the dollar.  The bonds are currently believed to be worth more than 50 cents on the dollar. Klarman describes this as his favourite type of investment since the situation was complex, difficult to analyze and no one wanted anything to do with Enron. This resulted in a mispricing of the debt and Klarman employed an analyst to focus on the bonds for 4 years in an attempt to understand Enron’s liabilities. You can read a good summary of his approach here.

 

While the distress debt investment that Klarman is famous for is best left to professionals, there are other distress debt situations that are available to DIY investors. For example, I would classify purchasing real estate under Power of Sale in this category. This kind of investing isn’t as simple as buying and selling equities on an exchange but can be profitable assuming there is an actual mispricing of the asset and the DIYer is clever enough to find it.

Here is a summary of my value investing hierarchy:

 

 

 

This is my attempt to organize the various value strategies I’ve come across and is not meant to be conclusive or comprehensive. Further, while the gurus mentioned in this article are often associated with the strategies I`ve assigned to them, they do not necessarily restrict themselves to that strategy exclusively.  For example, Joel Greenblatt is also a famous distress debt investor and Warren Buffett made his first fortune in investing by using Graham’s deep value strategy. The unifying theme however is that they always buy bargains.

 

 

Advertisements

Read Full Post »