Posts tagged ‘value investing’

Got Growth?

Slide1

Investing in the stock market can be quite stressful, especially during periods of volatility…but investing doesn’t have to be nerve-racking. Investing legend T. Rowe price captured the beneficial sentiments of growth investing beautifully when he stated the following:

“The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.”

 

What I’ve learned over my investing career is that fretting over such things as downgrades, management changes, macroeconomic data, earnings misses, geopolitical headlines, and other irrelevant transitory factors leads to more heartache than gains. If you listen to a dozen so-called pundits, talking heads, journalists, or bloggers, what you quickly realize is that all you are often left with are a dozen different opinions. Opinions don’t matter…the facts do.

Finding Multi-Baggers: The Power of Compounding

Rather than succumbing to knee-jerk reactions from the worries of the day, great long-term investors realize the benefits of compounding. We know T. Rowe Price appreciated this principle because he agreed with Nobel Prize winning physicist Albert Einstein’s view that “compounding interest” should be considered the “8th wonder of the world” – see also how Christopher Columbus can turn a penny into $121 billion (Compounding: A Penny Saved is Billions Earned).

People generally refer to Warren Buffett as a “Value” investor, but in fact, despite the Ben Graham moniker, Buffett has owned some of the greatest growth stocks of all-time. For example, Coca Cola Co (KO) achieved roughly a 20x return from 1988 – 1998, as shown below:

Source: Yahoo! Finance

Source: Yahoo! Finance

If you look at other charts of Buffett’s long-term holdings, such as Wells Fargo & Company (WFC), American Express Co (AXP), and Procter & Gamble – Gillette (PG), the incredible compounded gains are just as astounding.

In recent decades, there is no question that stocks have benefited from P/E expansion. P/E ratios, or the average price paid for stocks, has increased from the early 1980s as long-term interest rates have declined from the high-teens to the low single-digits, but the real lifeblood for any stock is earnings growth (see also It’s the Earnings, Stupid). As growth investor extraordinaire Peter Lynch once said:

“People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”

 

As Lynch also pointed out, it only takes the identification of a few great multi-bagger stocks every decade to compile a tremendous track record, while simultaneously hiding many sins:

“Fortunately the long-range profits earned from really good common stocks should more than balance the losses from a normal percentage of such mistakes.”

 

The Scarcity of Growth

Ever since the technology bubble burst in 2000, Growth stocks have felt the pain. Since that period, the Russell 1000 Value index – R1KV (Ticker: IWD) has almost doubled in value and outperformed the Russell 1000 Growth index – R1KG (Ticker: IWF) by more than +60% (see chart below):

Source: Yahoo! Finance

Source: Yahoo! Finance

Although the R1KG index has yet to breach its previous year 2000 highs, ever since the onset of the Great Financial Crisis (end of 2007), the R1KG index has been on the comeback trail. Now, the Russell 1000 Growth index has outperformed its Value sister index by an impressive +25% (see chart below):

Source: Yahoo! Finance

Source: Yahoo! Finance

Why such a disparity? Well, in a PIMCO “New Normal & New Neutral” world where global growth forecasts are being cut by the IMF  and a paltry advance of 1.7% in U.S. GDP is expected, investors are on a feverish hunt for growth. U.S. investors are myopically focused on our 2.34% 10-Year Treasury yield, but if you look around the rest of the globe, many yields are at multi-hundred year lows. Consider 10-year yields in Germany sit at 0.96%; Japan at 0.50%; Ireland at 1.98%; and Hong Kong at 1.94% as a few examples. This scarcity of growth has led to outperformance in Growth stocks and this trend should continue until we see a clear sustainable acceleration in global growth.

If we dig a little deeper, you can see the 25% premium in the R1KG P/E ratio of 20.8x vs. 16.7x for the R1KV is well deserved. Historical 5-year earnings growth for the R1KG has been +52% higher than R1KV (17.8% vs. 11.7%, respectively). Going forward, the superior earnings performance is expected to continue. Long-term growth for the R1KG index is expected to be around 55% higher than the R1KV index (14% vs 9%).

In this 24/7, Facebook, Twitter society we live in, investing has never been more challenging with the avalanche of daily news. The ultra-low interest rates and lethargic global recovery hasn’t made my life at Sidoxia any easier. But one thing that is clear is that the investment tide is not lifting all Growth and Value stocks at the same pace. The benefits of long-term Growth investing are clear, and in an environment plagued by a scarcity of growth, it is becoming more important than ever when reviewing your investment portfolios to ask yourself, “Got Growth?”

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in KO/PG (non-discretionary accounts) and certain exchange traded fund positions, but at the time of publishing SCM had no direct position in TWTR, FB, WFC, AXP, IWF, IWD or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

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August 16, 2014 at 6:18 pm 1 comment

Hunting for Tennis Balls and Dead Cats

Tennis Cat Pic

When it comes to gravity, people understand what goes up, must come down. But the reverse is not always true for stocks. What goes down, does not necessarily need to come back up. Since the 2008-09 financial crisis there have been a large group of multi-billion dollar behemoth stocks that have defied gravity, but over the last few months, many of these highfliers have come back to earth. Despite the pause in some of these major technology, consumer, and internet stocks, the overall stock market appears relatively calm. In fact, the Dow Jones Industrials index is currently sitting at all-time record highs and the S&P 500 index is hovering around -1% from its peak. But below the surface, there is a large undercurrent resulting in an enormous rotation out of pricier momentum and growth stocks into more defensive and yield-heavy sectors of the market, like utilities and real estate.

To expose this concealed trend I have highlighted a group of 20 stocks below, valued at close to half a trillion dollars. Over the last 12 months, this selective group of technology, consumer, and internet stocks have lost over -$200,000,000,000 from their peak values. Here’s a look at the highlighted stocks:

Tennis Ball Dead Cat FINAL 5-14

With respect to all the punished stocks, the dilemma for investors amidst this depreciating price carnage is how to profitably hunt for the bouncing tennis balls while avoiding the dead cat bounces. By hunting bouncing tennis balls, I am referring to the identification of those companies that have crashed from indiscriminate selling, even though the companies’ positive business fundamentals remain fully intact. The so-called dead cats reflect those overpriced companies that lack the earnings power or trajectory to support a rebounding stock price. Like a cat falling from a high-rise building, there may exist a possibility of a small rebound, but for many severely broken momentum stocks, minor bounces are often short-lived.

For long-term investors, much of the recent rotation is healthy. Some of the froth I’ve been writing about in the biotech, internet, and technology has been mitigated. As a result, in many instances, outrageous or rich stock valuations have now become fairly priced or attractive.

Profiting from Collapses

Many investors do not realize that some of the greatest stocks of all-time have suffered multiple -50% drops before subsequently doubling, tripling, quadrupling or better. History provides many rebounding tennis ball examples, but let’s take a brief look at the Apple Inc. (AAPL) chart from 1980 – 2005 to drive home the point:

Apple 1980 - 2005

As you can see, there were at least five occasions when the stock got chopped in half (or worse) over the selected timeframe and another five occasions when the stock doubled (or better), including a +935% explosion in the 1997–2000 period, and a +503% advance from 2002–2005 when shares reached $45. The numbers get kookier when you consider Apple’s share price eventually reached $700 and closed early last week above $600.

These feast and famine patterns can be discovered for virtually all of the greatest all-time stocks. The massive volatility explains why it’s so difficult to stick with theses long-term winners. A more recent example of a tennis ball bounce would be Facebook Inc (FB). The -58% % plummet from its $42 IPO peak has been well-documented, and despite the more recent -21% pullback, the stock is still up +223% from its $18 lows.

On the flip side, an example of a dead cat bounce would include Cisco Systems Inc (CSCO). After the bursting of the 2000 technology bubble, Cisco has never fully recovered from its $82 peak value. There have been many fits and starts, including some periods of 50% declines and 100% gains, but due to excessive valuations in the late 1990s and changing competitive trends, Cisco still sits at $23 today (see chart below).

Slide1

It is important to remember that just because a stock goes down -50% in value doesn’t mean that it’s going to double or triple in value in the future. Price momentum can drive a stock in the short run, but in the long run, the important variables to track closely are cash flows and earnings (see It’s the Earnings, Stupid) . The level and direction of these factors ultimately correlate best with the ultimate fair value of stock prices. Therefore, if you are fishing in the growth or momentum stock pond, make sure to do your homework after a stock price collapses. It’s imperative that you carefully hunt down rebounding tennis balls and avoid the dead cat bounces.

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), AMZN, long NFLX bond, short NFLX stock, short LULU, and long CSCO (in a non-discretionary account), but at the time of publishing SCM had no direct position in TWTR, GRPN, YELP, ATHN, AVP, P, LNKD, BBY, ZNGA, WDAY, WFM, N, SSYS, JDSU, COH, CRM, FB or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

May 11, 2014 at 12:23 am 1 comment

Twinkie Investing – Sweet but Unhealthy

Source: Photobucket

It’s a sad day indeed in our history when the architect of the Twinkies masterpiece cream-filled sponge cakes (Hostess Brands) has been forced to close operations and begin bankruptcy liquidation proceedings. Food snobs may question the nutritional value of the artery-clogging delights, but there is no mistaking the instant pleasure provided to millions of stomachs over the 80+ years of the Twinkies dynasty. Most consumers understand that a healthy version of an organic Twinkie will not be found on the shelves of a local Whole Foods Market (WFM) store anytime soon. The reason people choose to consume these 150-calorie packages of baker bliss is due to the short-term ingestion joy, not the vitamin content (see Nutritional Facts below). Most people agree the sugar high gained from devouring half a box of Twinkies outweighs the long-term nourishing benefits reaped by eating a steamed serving of alfalfa sprouts.

Much like dieting, investing involves the trade-offs between short-term impulses and long-term choices. Unfortunately, the majority of investors choose to react to and consume short-term news stories, very much like the impulse Twinkie gorging, rather than objectively deciphering durable trends that can lead to outsized gains. Day trading and speculating on the headline du jour are often more exciting than investing, but these emotional decisions usually end up being costlier to investors over the long-run.  Politically, we face the same challenges as Washington weighs the simple, short-term decisions of kicking the fiscal debt and deficits down the road, versus facing the more demanding, long-term path of dealing with these challenges.

With controversial subjects like the fiscal cliff, entitlement reform, taxation, defense spending, and gay marriage blasting over our airwaves and blanketing newspapers, no wonder individuals are defaulting to reactionary moves. As you can see from the chart below, the desire for a knee jerk investment response has only increased over the last 70 years. The average holding period for equity mutual funds has gone from about 5 years (20% turnover) in the mid 1960s to significantly less than 1 year (> 100% turnover) in the recent decade. Advancements in technology have lowered the damaging costs of transacting, but the increased frequency, coupled with other costs (impact, spread, emotional, etc.), have been shown to be detrimental over time, according to John Bogle at the Vanguard Group.

Source: John Bogle (Vanguard Group)

During volatile periods, like this post-election period, it is always helpful to turn to the advice of sage investors, who have successfully managed through all types of unpredictable periods. Rather than listening to the talking heads on TV and radio, or reading the headline of the day, investors would be better served by following the advice of great long-term investors like these:

 “In the short run the market is a voting machine. In the long run it’s a weighing machine.” -Benjamin Graham (Famed value investor)

“Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” -Jack Gray (Grantham, Mayo, Van Otterloo)

“The stock market serves as a relocation center at which money is moved from the active to the patient.” - Warren Buffett (Berkshire Hathaway)

 “It was never my thinking that made big money for me. It always was my sitting.” – Jesse Livermore (Famed trader)

“The farther you can lengthen your time horizon in the investment process, the better off you will be.”- David Nelson (Legg Mason)

 “The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.” T. Rowe Price (Famed Growth Investor)

 “Time arbitrage just means exploiting the fact that most investors…tend to have very short-term time horizons.” -Bill Miller (Famed value investor)

“Long term is not a popular time-horizon for today’s hedge fund short-term mentality. Every wiggle is interpreted as a new secular trend.” -Don Hays (Hays Advisory – Investor/Strategist)

A legendary growth investor who had a major impact on how I shaped my investment philosophy is Peter Lynch. Mr. Lynch averaged a +29% return per year from 1977-1990. If you would have invested $10,000 in his Magellan fund on the first day he took the helm, you would have earned $280,000 by the day he retired 13 years later. Here’s what he has to say on the topic of long-term investing:

 “Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 “My best stocks performed in the 3rd year, 4th year, 5th year, not in the 3rd week or 4th week.”

 “The key to making money in stocks is not to get scared out of them.” 

“Worrying about the stock market 14 minutes per year is 12 minutes too many.”

It is important to remember that we have been through wars, assassinations, banking crises, currency crises, terrorist attacks, mad-cow disease, swine flu, recessions, and more. Through it all, our country and financial markets most have managed to survive in decent shape. Hostess and its iconic Twinkies brand may be gone for now, but removing these indulgent impulse items from your diet may be as beneficial as eliminating detrimental short-term investing urges.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct positions in WFM, BRKA/B, LM, TROW or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

November 18, 2012 at 9:38 pm 1 comment

Yacktman’s Triangle of Success

 

Donald Yacktman is no ordinary investor. As a matter of fact, he was a runner-up in Morningstar’s Fund Manager of the Decade award (see winner here). Besides stellar performance, how did Yacktman accomplish this honor? The answer is simple…a triangle. Yacktman wasn’t a geometry professor, but his investment philosophy is based on the three corners of this popular shape. Specifically, Yacktman looks to invest in companies trading at good prices, that are good businesses, with good management teams. Stated differently, one side of the investment philosophy represents a low purchase price, while the other sides represent good businesses and shareholder-oriented management.

Where the Magic Began

Like any legendary investor, experience plays a huge role in becoming a market master. Yacktman is no exception.  Yacktman is the President and Co-Chief Investment Officer of Yacktman Asset Management Co., overseeing about $7 billion in assets. Prior to founding the firm in April 1992, he worked for 10 years as a portfolio manager at Selected Financial Services, Inc. and before then he served 14 years as a portfolio manager at Stein Roe & Farnham. Geographically, he has been all over the map. He earned his economics degree from the University of Utah and an MBA with distinction from Harvard University. After working for a longtime in Chicago, he decided to start the Yacktman Funds in Austin, Texas. Who knows, maybe the next stop will be Alaska or Hawaii?

Despite all the successes, life has not always been a bed of roses for Yacktman. As a matter of fact, during the late-1990s, the fund board attempted to oust him and investors left in a mass exodus. Even after posting stellar results in 2000-2003 relative to the S&P 500, Yacktman underperformed significantly in three out of four years from 2004 – 2007.

Managing to sidestep the technology bubble in 2000 and then the financial sector bubble in 2008 contributed tremendously to Yacktman’s outperformance (see graph).

Source: Morningstar.com

As you can see, the long-term track record of the Yacktman fund has been exceptional (#1 fund on a 3 yr., 5 yr., and 10 yr basis), but anyone can eventually lose the Midas touch – Bill Miller’s 15 consecutive market-beating returns subsequently reversed into a financial disaster in the following years (see Revenge of the Dunce). Even with all the boos and cheers Yacktman has received over the years, some of that attention should be directed towards his son Stephen Yacktman (Co-Manager of Yacktman funds) and other Co-Manager Jason Subotky.

More Yacktman Investment Nuts & Bolts

There are other key elements to the Yacktman strategy beyond the triangle philosophy. For example, Yacktman preaches  the importance of patience, long-term thinking, and the ability to develop a repeatable process.

And how does Yacktman find these great opportunities for his funds? Driving the process of picking stocks is the ability to price equity securities like bonds. Using cash flows, inflation expectations, and forecasted growth, the Yacktman team derives a forward rate of return that they can compare against a broad set of investment alternatives, including bonds. This framework is very consistent with my free cash flow yield ranking system I use. If opportunities do not present themselves, Yacktman is not afraid to raise cash levels to unorthodox levels (e.g., around 30% cash near the 2007 peak).

Since the differential in return opportunities has narrowed between what Yacktman defines as high quality and low quality, he has shifted more of the portfolios toward Blue Chip companies, like News Corporation (NWS), PepsiCo, Inc. (PEP),  Coca-Cola Company (KO),  Procter & Gamble Company (PG), and Microsoft Corporation (MSFT).  Since the return opportunity spreads have narrowed, Yacktman feels he can get more bang for his risk buck by investing in quality large capitalization stocks.

With a long-run magical track record like Donald Yacktman’s, it is difficult to critically critique his systematic investment process. By implementing a few cornerstones of Yacktman’s investment philosophy, we should all be able to triangulate a better investment strategy four ourselves.

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in YACKX, YAFFX, NWS, PEP, PG, KO, MSFT, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

February 9, 2011 at 2:09 am 1 comment

The Accomplished Mole – Seth Klarman

I do quite a bit of reading and in my spare time I came across something very interesting. Here are some of the characteristics that describe this unique living mammal: 1) You will rarely see this creature in the open; 2) It roams freely and digs in deep, dark areas where many do not bother looking; and 3) This active being has challenged eyesight.

If you thought I was talking about a furry, burrowing mole (Soricomorpha Talpidae) you were on the right track, but what I actually was describing was legendary value investor Seth Klarman. He shares many of the same features as a mole, but has made a lot more money than his very distant evolutionary cousin.

The Making of a Legend

Photo source: SuperInvestorDigest.com

Before becoming the President of The Baupost Group, a Boston-based private investment partnership which manages about $22 billion in assets on behalf of wealthy private families and institutions, he worked for famed value investors Max Heine and Michael Price of the Mutual Shares (purchased by Franklin Templeton Investments). Klarman also published a classic book on investing, Margin of Safety, Risk Averse Investing Strategies for the Thoughtful Investor, which is now out of print and has fetched upwards of $1,000-2,000 per copy in used markets like Amazon.com (AMZN).

Klarman chooses to keep a low public profile, but recently his negative views on stock market and inflation risk have filtered out into the public domain. Nonetheless, he is still optimistic about certain distressed opportunities and believes the financial crisis has cultivated a more favorable, less competitive environment for investment managers due to the attrition of weaker investors.

Philosophy

Klarman despises narrow mandates – they are like shackles on potential returns. Opportunities do not lay dormant in one segment of the financial markets. Investors are fickle and fundamentals change. He believes superior results are achieved through a broadening of mandates. He prefers to invest in areas off the proverbial beaten path – the messier and more complicated the situation, the better. Currently his funds have significant investments in distressed debt instruments, many of which were capitulated forced sales by funds  that are unable to hold non-investment grade debt.

In order to make his wide net point to investing, Klarman uses real estate as an illustration device. For example, investors do not need to limit themselves to publicly traded REITs (Real Estate Investment Trusts) – they can also invest in the debt of a REIT, convertible real estate debt, equity of property (such as own building), bank loan on a building, municipal bond that’s backed by real estate, or commercial/residential mortgage backed securities. 

Klarman summarizes his thoughts by saying:

“If you have a broader mandate, they let you own all kinds of debt, all kinds of equity. Perhaps some private assets, like real estate. Perhaps hold cash when you can’t find anything great to do. You now have more weapons at your disposal to take advantage of conditions in the market.”

 

Klarman’s 3 Underlying Investment Pillars

Besides mentors Heine and Price, Klarman is quick to highlight his investment philosophy has been shaped by the likes of Warren Buffett and Benjamin Graham, among others. In addition to many of the basic tenets espoused by these investment greats, Klarman adds these three main investment pillars to his repertoire:

1)      Focus on risk first (the probability of loss) before return. Determine how much capital you can lose and what the probability of that loss is. Also, do not confuse volatility with risk. Volatility creates opportunities.

2)      Absolute performance, not relative performance, is paramount. The world is geared towards relative performance because of asset gathering incentives. Wealthy investors and institutions are more focused on absolute returns. Focus on benchmarks will insure mediocrity.

3)      Concentrate on bottom-up research, not top down. Accurately forecasting macroeconomic trends and also profiting from those predictions is nearly impossible to do over longer periods of time.  

These are great, but represent just a few of his instructional nuggets.

Performance

I did some digging regarding Klarman’s performance, and given the range of markets experienced over the last 25+ years, the results are nothing short of spectacular. Here is what I dug up from the Outstanding Investor Digest:

“Since its February 1, 1983 [2008] inception through December 31st, his Baupost Limited Partnership Class A-1 has provided its limited partners an average annual return of 16.5% net of fees and incentives, versus 10.1% for the S&P 500. During the “lost decade”, Baupost obliterated the averages, returning 14.8% and 15.9% for the 5 and 10-year periods ending December 31st versus -2.2% and -1.4%, respectively, for the S&P.”

 

Here is some additional color from Market Folly on Klarman’s incredible feats:

“Despite Klarman’s typically high levels of cash [sometimes in excess of 50%], Baupost has still generated astonishing performance. It was up 22% in 2006, 54% in 2007, and around 27% in 2009. During the crisis in 2008, Klarman’s funds lost “between 7% and the low teens.” Still though, he certainly outperformed the market indices and much of his investment management brethren in a time of panic.”

 

Although Seth Klarman has plowed over the competition and remained underground from the mass media, it’s still extremely difficult to ignore the long-term record of success of this accomplished mole. In the short-run, volatility may hurt his performance – especially if holding 20-30% cash. But as I was told at a young age by my grandmother, it is not prudent to make mountains out of molehills. Apparently, Klarman’s grandma taught her mole-like grandson how to make mountains of money from hills of opportunities. Klarman’s investors certainly stand to benefit as he continues to dig for value-based gems.

Watch interesting but lengthy presentation video given by Seth Klarman

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, and AMZN, but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 23, 2010 at 12:06 am 1 comment

Meat & Potatoes Investing with Joel Greenblatt

Steak & Potato

Joel Greenblatt has a long resume. Besides being the founder and managing partner of Gotham Capital, Mr. Greenblatt is the author of The Little Book That Beats the Market and an adjunct Professor at Columbia Business School. Now he is adding “Quant-fund Manager” to his work history.  In his recent CNBC interview (below), Greenblatt discusses the real-world portfolio implementation of his “Magic Formula” on www.FormulaInvesting.com, a new venture he has undertaken.

The Magic Formula as it turns out is not all that magical, but rather very simple. The formula is based on two straightforward meat and potato factors gathered from Standard & Poor’s data: 1) the trailing Price/Earnings ratio on a stock (value factor); and 2) the Return on Capital ratio of a stock using historical earnings. The portfolio management strategy is fairly basic as well. Twenty to thirty securities are selected from the model, with the ability of the investor to customize if they so choose, and the portfolios are rebalanced on an annual basis making sure any relevant tax-loss selling occurs before the end of the calendar year.

Based on the back-tests, the model portfolio was up +291% over the last 10 years versus down -2% for the S&P 500 index. For 2008, however, the performance of the Magic Formula was not too enchanting – down about -36% versus -37% for the S&P 500 index, according to Greenblatt.   

As with any back-test, or model, I am very skeptical about the output and inferences that can be drawn. Here are a few reasons why:

1)      Past ≠Future: Just because this strategy worked in the past doesn’t mean it will work in the future. Greenblatt admits that the strategy can underperform for long periods of time.

2)      Limited Data: Ten years is an extremely limited period of time to base a robust strategy on – much more data should be used.

3)      Cost Estimates: Following a potentially very illiquid, out of favor value strategy with possibly large sums of money can cause past results to look quite different. Factors such as trading costs and impact costs can be underappreciated in computer based back-tests.

4)      Data Mining: With any model, problems can arise when reams of data are sliced and diced for the sole purpose of creating a positive outcome. Often, there are no cause and effect between a variable and future returns, yet practitioners will jump to that conclusion because the factors fit the data.

To learn more about shortcomings in quantitative models, I suggest you learn more about butter production in Bangladesh (read article here). I will eagerly watch how Mr. Greenblatt’s “Magic Formula” works from a distance. In the mean time, I’m hungry. I think I’ll keep it simple…a steak and baked potato.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

November 2, 2009 at 2:00 am 1 comment


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