Investment strategy – Page 6

3 Ways to find a margin of safety

Ben Graham may not have invented the term ‘margin of safety’, but he did popularise it for investors by making it a core part of his investment philosophy. But what exactly does a margin of safety mean when it’s applied to investing, and how can you go about finding it?

How to become an even better investor

A long-time reader recently asked:

Once an investor has a strategy, how can he develop his potential? What should he be reading, or doing? Once you have a screen with certain criteria, then what? Its in our nature to fiddle, to feel like we are doing something, so what should an investor do to develop his potential further?

This is a great question that almost answers itself. It gets to the heart of the problem that many active investors have, and that’s the idea that they always have to be doing something.

Beating the market – You don’t have to swing for the fences

I’ve recently started re-reading the long collection of memos from the chairman of Oaktree Capital, Howard Marks. I didn’t get very far (halfway through the first memo from 1990) before reading something so important that I had to turn it into this editorial.

BAE Systems – How to re-value a company you already own

The overall process of investing is simple: Buy – Hold – Sell. Unless you’re a buy-and-forget investor, it makes sense to periodically check on the difference between the price of your investment and your estimation of its intrinsic value.

Does Size Matter in Investing?

I must be getting old. In fact, having recently turned 40, I have hard proof that I am (in the shape of the cards, socks and pants that I received). It’s not turning 40 that’s making me feel like an old curmudgeon, though, it’s my approach to risk.

How Much Diversification Is Enough?

When I started out as a value investor my original plan was to hold 10 companies. I thought that this would be enough diversification to reduce volatility by a sufficient amount such that I would be able to sleep well enough to stick with the investment program.

Merry Christmas 2011

It’s that time of year again when everything starts to slow down in preparation for some excessive consumption of mince pies and all things tasty and fattening.

Why Stock Tickers Are Bad For Your Wealth

Having share prices in your face 24/7 is like having a giant red sign on top of your house constantly flashing the price that everyone else (on average) thinks your house is worth.

Tips for Overcoming Overconfidence

I’ve made my fair share of investing mistakes and I’m sure that, despite my best efforts, I’ll continue to make them. The trick is to be honest with yourself and learn from them and learn to recognise them before you make the same ones again. For me, the biggest offender is overconfidence.

The Four Drivers of Long Term Equity Returns

As a stock picker, I’m investing to beat the market over the long term. Of course by ‘beat’ the market I mean that the value of my portfolio goes up more than the value of the market, including re-invested dividends.

5 Ways to Measure Debt

To most value investors, debt is one of the first things they look at when analysing a company. Since value investing, almost by definition, involves buying unpopular stocks, there is often some kind of bad news surrounding the company which will only be made worse by high levels of debt.

Why A Falling Share Price Is Often A Good Thing

One of my favourite value investing sites is The Value Perspective which is the web outlet for some of the (value) fund managers over at Schroders. In their latest piece, Andrew Lyddon talks about how the telecoms sector is not exactly a hot favourite. Despite the sector’s deserved reputation as a defensive play, share prices often fell and lagged far behind the wider market and even other defensive sectors.

When Not to Invest in Shares

Most of the academic research suggests that shares are the best investment vehicle. They have produced the biggest returns for a given amount of risk; so does this mean it always makes sense to invest all your savings in the stock market?

Time is the critical element

When do you want your money back? That’s the key question. One of the fundamental features of stock market investing is that you never know how much your investment is going to be worth tomorrow, next week or next year.

It’s not like putting money into a savings account where, ignoring inflation, the value of your savings never goes down. It’s also not like investing money in government or corporate bonds. If you buy a Tesco bond yielding 5% then you are virtually certain to get that 5% a year until the original investment is repaid. This repayment is on a date that you know even before buying the bond and it’s typically several whole years, usually 1 to 5 years.

So in the case of a savings account or bonds, everything is known beforehand and there is no uncertainty, or at least not very much.

That’s not the case with shares. Most people know that share prices go up and down, with the FTSE 100 level being quoted on the news every day. That’s something that even now as an experienced investor, I can see no reason for. Why would a lay investor care what the footsie is doing on a day-to-day basis? And if you need to know what the footsie is doing then surely you have a better information source than the 9 O’clock news?

Anyway, shares go up and shares go down. That’s the nature of the beast. Unfortunately, these moves up and down are completely unpredictable on a day-to-day and even year-to-year basis.

Time, and lots of it

This means that if you are saving up for a new car next year, putting the money into shares is probably a bad idea. You might come out of it with a 50% gain which of course beats the daylights out of a 3% savings account. But then again you might have a 30 or 40% loss which won’t be good for your choice of wheels.

But what if you have a lump sum to invest and you want it back in 5 years, perhaps for your 40th birthday? Somewhat intuitively, this does turn out to be a better idea. According to one of my favourite books, “The Intelligent Asset Allocator” by William Bernstein, a 5-year holding period will produce a positive return almost all of the time. This means the chance of you getting back less than you put in is small, but you still won’t have much idea of what you actually will get back. Generally, you could expect something between 0% and 20% a year, but it’s still a big unknown.

So at what point does investing in shares begin to be obviously better than bonds, as the academics seem to say? I think there are two main scenarios:

Investing for a lump sum several decades in the future

This is typically your children’s education or a retirement annuity. The end date is way off in the future but at some point, you’ll need to sell everything. If your time horizon is 20 years plus then you are virtually certain to make a positive return and probably something around 7-8% a year on average. That’s a rate that bonds can’t match.

The key to success here is to reduce the riskiness of the portfolio as you approach the end date. That’s because you don’t want to be in the position of being 100% in shares the year before your retirement, thinking you’re going to have a comfortable post-work life, only to be hit by a massive bear market which takes 50% out of your fund.

The general idea here is something called the Glide Path, which is a way of gliding the portfolio towards low-risk holdings as the remaining holding period reduces.

There are many different interpretations but as a stock picker with a semi-fixed selling schedule (1 holding out of around 20 each month) then I could just choose to leave the cash generated by each sale in cash, rather than reinvesting it. So over the last 20 months, I’d gradually move the portfolio to cash. This means being 100% in shares 20 months before the end date, which might be a bit much, so stretching this phase out over 40 months might be a less risky proposition.

In doing this you’ll have a nice smooth transition from 100% shares to 100% cash over the last few years, so there’ll be no need to panic if the market falls.

Investing for an income

If you don’t like annuities and already have enough money for your kid’s university fees, you may be investing purely for an income, i.e. you have zero intention of ever selling all of your holdings. This changes things in that your time horizon is effectively infinite which can change your investing worldview in some useful ways.

First, since you’re never going to sell up, you don’t (or shouldn’t) care about the market value of your portfolio. If the value of your portfolio takes a 50% hit, it doesn’t matter. As long as the underlying companies are sound and the income they generate is sustainable, this is simply an opportunity to buy more of the same investments with an even better dividend yield. In theory, this should save investors who follow this approach a lot of heartache. The size of the income is all that matters, even in the ‘build-up’ phase.

Second, it may help you focus on the income rather than all the other worries about where the market is going. All you’d want in this case is the largest income possible, growing at the fastest possible rate. Once it reaches the same size as your current salary you could then choose whether to retire early or not.

On top of that, if you continue to invest in the same manner by focusing on high yield, high growth shares, instead of moving your funds into something ‘safe’ like bonds as many people do, then your income may well continue to grow faster than inflation. This can happen even if you’re drawing all of the dividends.

Shares are not for next year’s holiday

Shares are probably the best long-term investment there is. They’re just not well suited to anything where you need your money back in less than 5 years, and 10 or 20 years would likely be better.

But if you have a long or infinite time horizon then high yield, high growth shares, or high quality, high-value shares, may just tick every box going.

Building an Income to Retire On

Remember the mantra from last time – income first, capital growth second, invest for the long term. With shares, income means dividends and the higher the yield the better. However, there’s more to it than that.

Are Your Shares as Safe as Houses?

Generally, there are two ways that people invest for their retirement. The first is in the stock and bond markets and the second is in property. In both cases, this can be either through a fund of some sort or directly as a stock picker or buy-to-let investor.

Are you a good investment manager?

Investors usually go down the stock-picking route because they think they can outperform both the ‘market’ (typically the FTSE 100) as well as professional fund managers. Of course, there is an element of interest and even excitement in stock picking, but at the end of the day if you’re investing thousands of pounds in your own stock picks you’re doing it to make more money than you could elsewhere.

A quantitative value investing model

The model that makes up about 80% of my stock-picking process has undergone several minor adjustments, one following quickly after the other. Since I have referred to it quite a bit recently I thought it might be useful to thrash out the details as well as its history.

Does value screening still work?

Over the years there have been many studies into how different investment strategies affect your potential returns over the long term.

Often these studies involve the selection of companies based on almost childishly simple criteria which ultimately turn out to uncover some hidden truth about market efficiency and the value premium.

Since I use these simple screens to make the bulk of my investment decisions, it seems prudent to check that these simple formulas still work when applied to the market as a whole.

Below is a graph of the returns of all companies* in the main and AIM markets in the UK over the last year, where the company had financial results data for the last 10 years (as I will be sorting by ROE10 shortly).

Sorted by the size of the returns the returns for over five hundred companies looks like this:

As you can see some did well and some did badly. The average return was 23.7% so this subset of companies strongly outperformed the FTSE 100 and similar indices, but that’s not the point of this exercise.

According to much research (not cited here), sorting by P/B (price/book ratio) is likely to show some sort of trend where low P/B stocks outperform the average and definitely outperform high P/B stocks. Sorting (descending) by the estimated P/B from one year ago** produces this:

The trend line does seem to indicate what the literature would have us believe – that on average lower P/B stocks have had better returns in the last year. Breaking the results into five equal groups, the average returns of each group were:

Group	1	2	3	4	5
Returns %	18.9	22.4	25.9	24.0	27.2

Before getting too excited though, remember that low P/B companies tend to be smaller and less liquid, i.e. with a wider spread. I think that the extra returns will be enough to outweigh the spread costs, but spread size is an important factor in low P/B and small-cap investing. Something to cover at length another day perhaps along with dividends.

Another point is the spread of returns. In each group, some companies did fantastically while others did terribly. Unless you can spot the difference beforehand you need to be sufficiently diversified, otherwise, you could end up with a massively underperforming portfolio no matter which group you pick from.

The next well-known and highly tested metric is market cap. When sorted by market cap (descending) from one year ago*** the returns look like this:

And the quintiles again:

Group	1	2	3	4	5
Returns %	20.4	20.1	26.8	23.8	27.5

So market cap is still a very useful tool in the selection of outperforming companies. However, the large spread issues are even greater here as by definition the smaller outperforming companies in group five are small and likely to have greater spreads, especially on the AIM index where most of these shares live.

Just from looking at the plot, it seems that the variation of returns from each company is much less for big companies (on the left) than for small ones. An efficient market proponent would probably say that’s part of the reason for the small cap premium, the variability of returns is that much greater.

The final metric is ROE10 (ROE averaged over the last 10 years), which on its own is most definitely not a value metric as it says nothing about price. I’ve included it here though as it’s a GARP metric which is closely related to value investing, but more importantly I’ve started using it recently to sift for winners.

It can be combined with the size and P/B metrics to aid and perhaps enhance them. Sorting by ROE10 (ascending) gives the following results:

And:

Group	1	2	3	4	5
Returns %	15.0	22.4	26.7	28.2	26.2

From this, it seems that investing in high-profitability companies turns out to have been more than worthwhile, regardless of the price paid for the shares, which is what growth investors have been saying all along. Note also that the spread of returns in the top performers (right of the plot) seems to be far less than that of top-performing small-cap or low P/B stocks. Interesting.

Now onto some combinations. If I multiply size and P/B it gives:

and:

Group	1	2	3	4	5
Returns %	21.8	14.9	26.3	24.3	31.2

If we look at group five, the smallest lowest P/B stocks, we get the highest returns so far, 31.2%. Of course, this is just a spreadsheet based on data with things like survivorship bias and other reliability issues, but it’s still nice to see that combining size and P/B gives the expected outcome of higher returns. Note though that group one is a bit of an anomaly (large cap high P/B stocks) with very few losses; perhaps this is the UK large company premium which has been found in a couple of studies.

Finally, if I combine P/B and ROE10 I get this:

and:

Group	1	2	3	4	5
Returns %	15.0	18.7	25.9	27.4	31.6

In this case, you have to ignore the first 115 or so companies (the first group pretty much) as they are all negative ROE10 companies where the results are messed up by the negative value. However, I wouldn’t recommend investing in them anyway as a negative ROE10 is not a good thing. The remaining four groups show a nice progression of returns up to a high of 31.6%. What’s also nice about this group is that you get high returns without always being in micro-cap stocks. The estimated average market cap of group five a year ago was 2.5 billion and less than half the companies are on the AIM index, which helps keep trading costs down via a smaller bid/ask spread.

In summary, value screening still seems to work; or at least it did last year. Adding ROE or perhaps any measure of earnings into the mix probably does have some benefits. Of course, there are many more screens, as many as investors can dream up; but whether you use this approach, the Magic Formula, low p/e or some other system, screening definitely still has something to offer the rational investor.

* Data from Sharelockholmes. 5 companies from over 550 were removed as outliers returning over 400% in the last year. Although keeping them in would have favoured the P/B ratio’s predictive ability, the other measures were random and skewed the data so I took them out. Of course in the real world you can’t do that, so perhaps that’s a good reason to pick low P/B stocks, to increase the chances of picking up a mega-mover.

** P/B 1 year ago is calculated from the current P/B and the last year’s returns, i.e. assumes that book value and the number of shares were unchanged. This is a naive assumption but I don’t think it is too unreasonable and hopefully, it hasn’t skewed the results.

*** Market cap 1 year ago just relies on the number of shares on average being the same, which is a reasonable assumption I think.

Adding ROE into the mix

Basing my company valuations on book value is nice and everything, and has a lot of historical and empirical support, but I’ve always had a nagging doubt about my core assumption in relation to earnings.

Are you really smarter than a chimpanzee?

My current investing goal is to outperform an ETF tracking the FTSE 100 total return over any given five-year period. However, after reading some more about expected returns and the various sources of those returns I think that goal needs some adjustment.