Investing lessons from Peter Lynch

Recently I have been reading 2 great books from Peter Lynch. One up on wall street and Beating the street. Both are great books and packed with advice for investors and examples of investments that went well and the ones that did you turn out good. There is not so much difference between the books, but for the beginner I would recommend to begin with one up on wall street. It’s more general, while beating the street has more specific examples of investment cases.

Peter Lynch is one of the greatest investors of all time and his track record is impressive. I noticed that there is much overlap and commonality between Warren Buffets investing wisdom and Peter Lynch’ wisdom and a lot of it is common sense in investing.

The books are fun to read with plenty of humour in them. There are no investing secrets in these books. To earn beat the market in the long-term, you need to do your homework and really understand the companies you are buying. Peter Lynch was known to work his ass off.

 

Here are some of my notes and keywords from the 2 books:

-Ignore the market, focus on business, not the general economy, politics and macro issues. You can’t predict the macro too much degree, and there are too many people analysing this, so there is very difficult to earn a good return on having some special insight on the macro economy. In contrast you can be able to have an edge looking at a small micro cap business that not so many is knowing about. You need to hunt for value in areas of the market where there is less competition!

– Develop a stock thesis/story for each stock you buy. Write it down. Follow the story of the stock as the time go. Does the story turns out like you expect? You need to know the reasons why you bought the stock and what you expect will happen in the future. This can be easy to forget so you should write it down. If the story does not turn out like you predicted you might want to sell the stock and learn from your mistake and avoid to to that mistake again.

-Put the stock in the correct category: Slow grower, stalwart, fast grower, cyclicals, assets plays, turnarounds. Knowing the type of stocks you are analysing and buying makes you know what to put weight on in your analysis (ratios) and also what you can expect the stock to behave like in the future.

-Invest only in simple business that it’s for you to understand. You need to understand how the company earns money and the factors affecting it. If not you will not be able to be confident in the long-term about the stock, you will also not know if it is smart to add more to a position if the stock price goes down, vs a person that understand the company. If you don’t understand the company you will be too affected by the “market” and the markets pricing of the stocks, since that will be your measurement of the success of your investment.

– Choose stocks with boring/dull names. Stocks with boring names gets more easily ignored by the market. Stocks with hot names these days like element, bio, crypto, tech etc.. draws more attention and are more likely to be overpriced.

– Choose companies that do something dull. Most investors gets exited about new technologies and things that might revolutionize the world. However these stocks usually does not provide the best returns unless you are very lucky with your picks. Companies that deals with garbage, pest, waste, dry cleaning, funeral service etc.. is drawing much less attention but still can be fantastic business to invest in.

– Consider choosing companies that does something disagreeable. Like cigarettes, addictive products. It’s usually less investors investing in these.

-Spinoffs can be great investments. Usually investors and funds will sell these spinoffs when they come into their account because of funds mandates or because investors just get another company into their account and the just sell off without considering the company. This can create opportunities for the diligent investor.

– Choose good stocks in non-growth industries. Again less competition from other investors and also less new startup business that will disrupt the industry.

– Look for niche companies. Companies that do something very specific that not many other companies do. Where they are the leading company with the biggest market share. Like for example Tandy leather factory

-Look for companies that sells a service or product that people MUST have and that they will buy again and again. (Cola, cigarettes, shaving blades)

-Invest in companies that will benefit from technological advancements, not companies that will get disrupted by improved technology.

-Look for insider buying in a company. That is usually a very strong sign that the company is doing well and that the management believes in the future of the company.

-Share buyback. Companies that is buying back shares when the stock price is low is doing good capital allocation, because the value of your stake in the company will  increase. However companies that buyback at high prices is destroying shareholder value.

-Invest in stocks that has a history of positive earnings! Don’t bet on the long shots and lottery ticket stocks.

-When cash exceeds debt it’s very favourable.

-Look at historical P/E values for the company you consider investing in. Are the current P/E high or low compared to historical P/E?

-If you underperform the S&P 500 index for more than 5 years or more, consider throwing in the towel and just put your money in an index fund instead and save yourself the work of investing.

-A portfolio for the private investor should consist of 3-10 stocks. You don’t want more because you need to know a lot about the stocks you own and keep updated on they story. If you keep 20-100 stocks you have not chance to know all of them very well and your returns will be too similar to an index fund.

-Don’t sell a stock too soon. Typical investor mistake. Cut the weeds and water the grass! Track the fundamentals, not the stock price.

-Sell a stock when your stocks story has played out or is no longer valid.

-Better to buy a 20% grower at 20 p/3 than a 10% grower at 10 p/e (because of the compounding effect)

– Compare business in the same industry with EBIT margins

-You want a relatively high profit margin company to its competitors in a long-term holding. In a shorter term turnarounds, a low profit margin gives a higher  % stock price/profit increase than a higher margin competitor.

-Review your portfolio companies story every few months.

-Fast grower stocks: Growth rate of 20-25% is ideal. Higher than 25% is not preferred.

-Look for companies where the EPS growth is higher than the P/E ratio. A sustained EPS growth rate twice the current P/E is ideal.

– Look for hidden assets in stocks. Understated value on the balance sheet, operating loss carryforwards, companies that owns shares of other companies, goodwill that has been written down to 0, but is still valuable.

-Look for companies that can raise their prices year after year without loosing customers. Like for example Phillip Morris (PM)

 

Stocks to avoid:

– The hottest stocks in the hottest industry. Usually insanely overpriced.

– Beware the next “something”

-Avoid companies that acquires unrelated business

-Beware of “whisper” stocks. Stocks with promising technology that is going to save the world. That is usually stocks with no substance.

-Beware of stocks with only one customer. Things can turn bad if they lose that one customer.

-Beware of stocks with exciting and cryptic names.

-Avoid stocks with very high P/E’s

-Be aware of capex insensitive businesses.

-Be aware of inventory buildup in retail companies.

-Be aware of companies with pension plans, especially in turnarounds.

 

Peter Lynch checklist:

– Can the company expand successfully? To other states? To other countries? Is there more room for expansion?

-How does the companies headquarter looks like? The more simple and mundane their HQ looks like the more promising the company is. Companies that “waste” a huge amount of money on an impressive building is usually not a good stock, because they will probably spend money on themselves instead of the shareholders.

 

Turnaround checklist:

-How much cash does the company have?

-How much debt?

-What is the debt structure?

-How are they going to turn around? (Cost cutting, selling of unprofitable business)

 

If you want to do fundamental analysis of stocks and determine the quality and intrinsic value of stocks you can check out the Warren Buffett Spreadsheet

 

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What is value investing?

Here is my views on what value investing is:

Value investing is to buy a stock for less than its intrinsic(fair value) value. To do so you need to be able to value the stock so that you can estimate the intrinsic value. If you can’t value the stocks in some way, then I would call it speculation and not value investing.
Remember that when you buy a stock you buy a small part of the whole company and not just a ticker symbol. If you wouldn’t buy the whole company(if you had the money) you should not buy a single share of the company. You sell the shares (company) when its stock price is substantially above the intrinsic value. You repeat this process again and again over the decades with each stock you buy. Value investors analyze the fundamental characteristics of the company (financial statements) speculators invest based on the recent price action of the stock with no regards to the fundamentals.

Why do you want to use a value investing strategy?
Simple: It’s a strategy that has been proven to give a very high return and beating the market for many decades.

Why does value investing works?
Investors tend to overreact to bad news and headlines of a company and at certain times stocks are sold off regardless of their value, creating a oppertunity for value investors to buy companies for much less than what they are worth. Over time the market realize its error and will later at some time price the stock correctly (at its intrinsic value)

Here is an illustration that shows what value investing is:

wmt intrinsic value

As you see from this graph WMT (Walmart) from 2001-2010 has from 2001 to 2007 has had a price higher than its intrinsic value. (not a good time to buy) But during this time the intrinsic value of the stock has grown while the price has been stagnant or even dropping somewhat. because this is a high quality company and the intrinsic value has steadily been growing.

As you see in 2007 the intrinsic value became higher than the stock price and until 2010 was growing faster than the stock price. (probably a good time to buy)

Some stocks are  difficult to value, because they are small fast growing companies, concepts stocks, cyclical commodity companies or just very poor quality companies. The future of these companies are very difficult to foresee, so it’s in many cases best to ignore companies you can’t value with confidence. They can of course be great investments but its much harder to analyse them and their success is more determined by luck and events that we cant foresee or predict.

So when you look for companies to value I advice to look for companies that you actually can estimate what they will earn in the future. That means that in general you should look for companies with these characteristics:

-Companies with a moat (sustainable competitive advantage) You want companies with a moat because these companies are more likely to increase their profits and intrinsic value over the next decades.
-Stable earnings growth past 10-20 years
-Stable margins (gross, operating and net margins)
-Low debt (less chance for the company to get into trouble and destroy value (intrinsic value)
-Good management ( You want a managment that is shareholder friendly and allocate the capital in the best possible way)
-High return on invested capital (indicate a moat)
-Positive and growing free cash flow past 10 years (Free cash flow can be used to pay a dividend to shareholder, pay back debt, invest in the business, buyback shares)
-History of share buyback at the correct times (when the stock is below its I.V) (This indicate that the management is a smart capital allocator)

You can look for these companies and analyse them in a fast and easy way with The Warren Buffett Spreadsheet

Value investing spreadsheet
Value investing spreadsheet

 

Companies with these characteristics are high quality companies. These are in general the companies you want to look for. The reasons are many:

-More likely that you will be able to hold and not sell during a bear market
-These companies tend to grow their earnings and then also their I.V over time, so time is the friend of the high quality companies and enemies of the poor quality companies.
-Less turnover in your portfolio ( you can probably hold these companies for 5-20 years)
-Less stressful to hold these companies(easier to be relaxed when you know that your portfolio consist of high quality companies that will grow their value over time)

Of course you need to buy these companies when they are on sale, that means not necessarily when the stock price has dropped, but when they are selling for substantially less than their intrinsic value. So how much is substantially? That depends on the predictability and quality of the company. With a high quality company you can allow yourself to buy with a 25% margin of safety. That is a price that is 25% lower than your estimated intrinsic value. For a lower quality company or a company operating in an industry where the future profits are harder to predict you want to have a higher MOS, maybe up to 50%.

Margin of safety is an important concept in value investing. You don’t want to buy the stock AT its intrinsic value, you want to buy it for LESS. You want to this because bad things can happen with the company that lower the intrinsic value of the company, so you want to have a MOS as a buffer in case the company does not perform as you expect.

Remember also that investing is a game of probabilities and nothing is certain. That means that you should diversify with at least 5 stocks.  You want to be better than market on the average. In a 10 stock portfolio you can expect at least 3 of them to underperform, but as long as the other stocks perform well it will offset the loss you got on the 3 underperforming stock. This is the interesting thing about stock investing. A stock can maximum go to zero, that means a 100% loss, but another stock in your portfolio can be a multibagger going up 10-100 fold from your buying price. Read more on why you should diversify

 

Also to make the value investing strategy to work you need to be:

Confident in your analysis, but still be able to change your mind if the fact change. (the fundamentals of the company change for the worse).

You need supreme patience and discipline: You need to be able to hold a stock for many years trough bear and bull markets, confidently sticking to your estimated intrinsic value of the stock.

You need to be able to be rational and sell when the fundamentals change for the company and there is no chance for improvement in the future ( like for example tech companies like Nokia and Kodak)

You need to be able to hold even if the company appear somewhat overpriced. You don’t want to sell a high quality company unless it become very overpriced.

You need to be able to sit with cash and not being invested for a long time untill you find a company with high quality selling for a low price. This can be mentally hard in a bull market when it seems like all other are making money taking big risks.

You must be able to stick to the value investing strategy even if value investing is out of fashion. In the past years growth stocks has been the hype and value stocks has underperformed. This has however changed lately. You might underperform the market for 3 years in a row with a value strategy and you must stick to the strategy to gain the long-term benefit, not jumping unto another strategy in times of underperformance.

You need to be brave and be confident in your analysis even if the market disagrees with you. With disagreement I mean that the market price the stock much lower than your estimated intrinsic value. Look here for my views on how you can beat the market.

That’s it. Who said value investing is easy? It’s not and to better your chances you should be a learning machine as Warren Buffett and Charlie Munger recommends and read some of my recommended investing books

Also check out my free value investing tools page with lots of checklists and excel spreadsheets for free download

 

Be a shameless cloner. Invest along with superinvestors

Don’t be ashamed to be a copycat or a cloner when it comes to investing. It can give you great long-term return while also reducing your investing stress by handing over decisions to other investors with more expertise, experience and a proven track record. You can basically outsource the investment process and thinking to these guys. Monish Pabrai who is a well know value investor, says that act of cloning other people’s best idea is a very powerful mental model. He stated in a lecture that it was 99% chance that you would do better by investing alongside the superinvestors instead of doing the stock picking yourself. I think this statement might be somewhat of an exaggeration, but I still think it’s an important statement and very important for the ones without the time and knowledge to analyse individual stocks themselves. Monish also told that he himself used the 13F’s to see what other great investors are buying and selling, and he considered it a goldmine for investors for idea generation.

One of the more underappreciated stock picking strategies is the strategy of buying and selling the same stocks as superinvestors are. Superinvestors are investors that has proven to have beaten the overall market for a long period of time. The reason why you should consider following this strategy is that these superinvestors are probably smarter than you, have more resources for doing deeper stock analysis than you and has a proven track record and more experience with picking the winner stocks. I think the main reason this strategy is not more followed is because most people think they are better at picking the winner stocks than the average investor. So they would rather do the stock picking themself than to rely on others, even if there is no data that supports that the average investor will outperform the superinvestors.

It’s also a myth that this strategy does not work because you will be too late to buy and sell the stocks of the investors you are following to get the desired returns. I have read that if you have copied Warren Buffett’s buys and sells for the last decades you would have beaten the S&P 500 with a wide margin. That is even if you had bought and sold the stocks at the worst timing after his buys and sells had been made public.

My ideas in this post comes from two books that covers the strategy of following the best investors. These two books are: Invest with the House by Mebane Faber, and Manual of ideas by John Mihaljevic.

 

How to follow superinvestors?
Investors that manage a certain amount of money (think it’s at least 100 mill $) have to file their stock holdings to the SEC every quarter. The filing is called 13F. This give anyone who want to look into the holdings of these investors as this is public information. Two great sources for this information can be found at Whalevisdom.com and Insidermonkey.com Here you can subscribe to E-mail alerts that will notify you when one of the investors you follow is filing a 13F. Another good source is Dataroma.com as they show the portfolios of the most famous long-term value investors.

There is a delay period of up to 90 days before you can get access to the buys and sells of these investors and that it something that you should keep in mind. I will come back to that later in the checklist. Also you should now that the 13F’s only shows the US stocks that the investor owns. There might not be a good idea to put all your investments into one single country. However among the US stocks there are several ADR’s which let you be exposed to the international stocks and ADR’s will be shown in the 13F’s.

 

How to implement the strategy?
Basically the strategy is buying and selling the same stocks as the superinvestor that you are following. For this or any strategy to work you need to keep consistent with the strategy for at least 10 years. That means you should not jump from superinvestor to a different one just because the one you have followed has not performed as you expected for the past 1-3 years. You should also follow investors that are long-term value investors, since their strategy will be aligned with your own. The hedge fund and superinvestors have been criticized lately for not being able to beat the S&P 500 the past years. To that I will say that the indexes have been mainly driven by the F.A.N.G stocks (Facebook, Amazon, Netflix, Google), which might be overpriced. At least we can say that the SP500 is overpriced on a shiller P/E, so there is no surprise that value as a strategy and then also value investors has underperformed the markets in the recent years. This might be the time for value investors and value stocks to outperform the high-flying tech stocks and other expensive stocks in the coming years.

 

Here is a checklist you should follow if you want to succeed following superinvestors.

 

  • The investor you follow must be a long-term value investor. One way to find out this is to look at the average numbers of quarters that the investor is holding a stock. In general the longer the better. The reason you want an average holding period for the stocks is that if you are following someone with a short holding period you risk buying stocks that the investor has sold when you get their 13F stock holdings in your inbox. I advise to look for managers with a holding period of at least 4 quarters.

 

  • You should buy their highest conviction stocks. That means you should only buy stocks that is one of their top 10 positions in terms of % of the total portfolio. You should also look for investors that has most of their money under management in their top 10 holdings, as that would indicate that they have a high conviction in these stocks. I think this number should be at least 50%. In my opinion you should also not invest in a stock that the manager has in their top 10 holdings if the stocks total percentage of the portfolio is less than 5%. That because 5% holding is not enough conviction even if that stock is in the top 10. Some managers have 50-100 stocks in their portfolio and equally distribute the money invested among them. These are manager we probably want to ignore.

 

  • Consider diversifying between several investors. I would suggest diversifying between your top 5 investors. The reason for this is that if you follow just 1 investor your risk will increase. The manager can lose his motivation, he might be unlucky with his picks, he might go trough a nasty divorce that all can affect his future performance. You want to catch the average outperformance that these superinvestors are able to do, so it is wise to diversify among 5-10. So in practice you can choose 3 stocks in the top 10 holdings for each of the 5 investors. Then you will have a portfolio of 15 stocks with 3 high conviction stocks diversified between 5 investors.

 

  • Be aware that the research on this strategy says that choosing the top one pick among these investors have performed much worse than if you had picked their top two or lower picks. The reason for this was that the top one picks had usually appreciated a lot in price and therefore was not a good buy. The stock’s price had already surpassed its intrinsic value. I think this problem can be solved by figuring out what price the manager had bought this stock at. I know that at Dataroma.com they inform about the estimated buyprice the manager had bought the stocks in his holding. In that way you will know if the top one holding has become the top holding because of a price increase or not.

 

  • Avoid investors who are macro oriented and who shorts stocks. Not really sure how you can determine this by only looking at the stocks and numbers. But usually you can Google search the name of the manager and understand more of his stock picking strategy

 

  • Avoid investors with a short track record. How long have they been in business? In the short time randomness and luck is the most important factor, in the long-term as more years pass luck become less of a factor and skill become more important. Choose managers who have a track record of at least 10 years.

 

  • Managers with huge amount of assets under management might be limited in their future returns as its limitations on how small stocks they can buy. It might be a good idea too clone investors who are not having too much money under their management as they will be more flexible in what kind of investment they can do.

 

  • It’s not really necessary, but it might help you if you choose stocks from the superinvestors that you also would consider good buys. That you also understand the business and the reason why you would buy this stock. If you also have a conviction it’s easier to hold onto the stocks even when the market crashes. If you have chosen stocks from the good managers, but you don’t understand the stocks it might be harder to hold onto them when the tide turns.

 

  • When to sell a stock can be a somewhat tricky question. You can sell the stock when the manager is selling the stock, or you can sell the stock when the stock you have chosen is no longer in the top 10 holding of the investor you follow. In that case you can replace it with one of the new stocks on that managers top 10 list.

 

  • There might be value in buying stocks that the manager is buying more of even if the price of the stock has gone down. That might be a very strong indication that the manager believes in the stock and you will have a oppertunity to buy the stock at a lower price than the manager has been able to do.

 

Here are some suggestions for superinvestors/funds that you might one to check out and consider to follow and clone:

-Monish Pabrai
-John Rodgers
-Tom Gayner
-Seth Klarman
-Tom Russo
-Jeffrey Ubben
-Chris Hohn
-Bill Ackman
-Francois Badelon
-Brian Bares
-Bruce Berkowitch
-David Einhorn
-Guy Spier
-Warren Buffett
-Glenn Greenberg
-Par Capital management
-Greenhaven associates
-Southernsun asset management
-Wynnefield capital management
-Akre capital management
-SPO-Advisory Corp
-Towle and Company

 

 

Conclusion:
Following and cloning the ideas of the best value investors with a proven track record can be a very sensible idea. But there can be difficulty in  choosing the managers to follow that will perform well in the future. High returns in the past does not guarantee a high return in the future, even for these investors. Also as any other strategy, it will only work if you keep faithful to the strategy over several years and you have to mentally be prepared to have several years of underperformance. Even the best investors as Warren Buffett and other great value investors have had 2-3 years in a row of underperformance compared to the index. You should also spend time figuring out which managers that has a strategy that you agree with.

 

Here are some screenshots from webpages that you can use to follow the superinvestors:

ValueAct Holdings: Current stock holdings: From highest percentage of total portfolio to lowestValueact holdingsTop 10 in % of total portfolio and average holding time in top 10: ValueAct Holdings. As you can see from the numbers market with a red circle, ValueAct has more than 90% of the assets in their top 10 stock picks, and the average holding period for the top 10 picks is more than 7 quarters. All good signs that this manager is following a long term value investing strategy.
ValueAct 13F

 

 

 

Why you should diversify

Charlie Munger and Warren Buffett are famous for advocating a concentrated portfolio of stocks. It seems common among many value investors to suggest that a portfolio of 3-5 quality stocks is enough diversification and also beneficial because you then will have the energy, time and concentration to really understand the companies you are buying.

The reasearch I have read says that any additional stocks above 15 has a very small effect on being more diversified and lessen your risk. I think I read that in The Magic Formula book of Joel Greenblatt.

Diversification

As you see from the graph the biggest effect of diversification happens up until 10 stocks or so. From there on the effect of adding more stocks to your portfolio has less effect.

The opposite of a concentrated portfolio is an index fund. With these you own several hundreds of stocks and your return will be close to the same as the markets return. With an index fund you are basically betting on a country’s long-term economic performance ( if you for example buy the SP 500 index fund). The downside of owning an index fund is that you both own the good stocks and also the crappy stocks in that index. In addition the index fund is usually market cap weighted, which means that more funds is going into stocks with the highest market caps and then probably also to the stocks that is overvalued. The benefit is that you don’t need to make many decisions and ongoing judgements so there is less chance that your irrational behavior is destroying the returns.

 

Here is what you seldom hear about diversification:

 

  • A concentrated portfolio can give you the best returns, but can also give you the worst returns. Investing is not about certainties. Nothing is 100% certain in investing. It’s about probabilities and being correct more than you are being wrong over a long time period. Holding only 3-5 stocks makes you very prone to business risk. Can you be really certain that the 3-5 picks that you have made will be performing as you expect? Choosing only 3-5 stocks can be considered overconfidence or it can be brilliance if you really know what you are doing. Investing is a marathon, not a sprint. So if you choose only 3 stocks and 2 of them suffers permanent capital loss, you can be almost wiped out at the beginning of the race. You want to have staying power and be in the game as long as possible and overall do more correct bets than wrong bets. To high concentration can make you prone to unexpected and uncontrollable events that you have little control over.

 

  • A concentrated portfolio can give you a much higher volatility than a more diversified. Are you emotionally able and willing to handle that volatility?

 

  • Even if you hold 10-20 stocks are you actually diversified enough? What about the correlation of the stocks in your portfolio. If you are holding 20 stocks and all of them are in the same industry, a downturn in that industry will drag down all of the stocks in your portfolio at the same time.

 

My advices for diversification:

  • The more experienced and skillful you are as an investor the more concentrated portfolio you can have, and visa versa.
  • For the typical value investor I would recommend 10-15 stocks in your portfolio
  • Diversify across industries and countries. Use the whole world as a hunting place for stocks.
  • Try to select stocks that are not correlated if a downturn happens.
  • If you have no experience with investing or are a beginner, consider buying some kind of value weighted index funds. If you want and if you gain more knowledge you can consider slowly adding more individual stocks in the mix.

 

 

The Acquirer’s Multiple: The numbers behind the strategy

You have maybe heard about the Acquirer’s Multiple. It’s a quantitative value strategy based on the multiple EV/operating income. The man behind this strategy is Tobias Carlisle and he also wrote a great book called Deep Value. The strategy is very simple. It’s basically buy stocks with the lowest EV/operating income ratio and rebalance your portfolio once per year. According to his book when doing a backtest using this strategy, the returns have been very impressive. From memory I think it was around 18% annualized. This strategy has worked very well when backtested trough the past decades. EV/Operating income is also considered the cleanest valuation multiple as it include the debt of the company and also its difficult for the management to manipulate operating income.

But will it work in the future?

There is no guaranty of that, and with today screeners and computing power it’s easy to get a list of the lowest EV/Operating income stocks in the whole universe of stocks. That was probably not easy to do in the years up to the year 2k.

Why does the Acquirer’s Multiple work?

I think the reason is of psychology and human nature. The stocks that typically shows up on the screener is usually unpopular, hated and companies where the future is uncertain. This is the reason for the sell off by investors and the low price. And this create a higher chance of mispricing when the emotion regarding a stocks is more towards the extreme. So buying a diversified portfolio of low EV/Operating income stocks will make you be able to take advantage of this mispricing. The key is to be diversified because some of these stocks really deserve the low price. Typically 20-30 stocks is recommended. Another reason is reversion to the mean. Most things are cyclical companies that has financially underperformed for a period tend to have a period of better performance.

A deeper look at the numbers behind the Acquirer’s Multiple

I was curious what numbers characterize the stock except the low EV/Operating income ratio. In the Deep value book the author explained that adding quality components like a high ROE actually decrease the returns instead of adding to the return. So I took all the 30 or something stocks and put it in a stock screener that give me all of the most important fundamentals ratios. I used a free trial of Uncle stock stock screener.

Here is what I found:

Acquirers’s multiple- Excel Spreadsheet

Here are the median numbers for the 31 stocks:

P/E: 9.39
EV/Operating income: 7.3
Dividend Yield: 1.7%
F-Score: 6.38
Z-Score: 3.26
M-Score: -2.44
Current ratio: 1.40
CF Coverage ratio: 65.2%
LT/Debt to equity: 52.9%
FCF/LT-Debt: 21.7%
Quick ratio: 0.87
ROIC 5t avg: 15.5%
ROIC: 16.7%
FCF/Total assets: 5y avg: 4.9%
FCF/Total assets: 6%
CROIC 5y avg: 7.6%
CROIC: 8.0%
ROE 5y avg: 17.3%
ROE: 20.2%
ROA 5y avg: 6.4%
ROA: 8.2%
FCF/sales 5y avg: 3.1%
FCF/sales: 3.5%
Gross margin CAGR: 1.9 %
Held by insiders: 0.5%
Held by institutions: 87.3%
Outstanding share 1 year growth (share buyback): -4.6%
Outstanding shares CAGR: -2.4%
Price YTD change: -13%
Gross margin 5y avg: 22.7%
EBIT margin 5y avg: 7.5%
Net margin 5y avg: 4.8%
Shareholders yield: 7.1%
Damn what a long list.

 

This is my take on these some of these numbers:

  • Ev/operating income ratio is low but not extremely low.
  • The F, Z, and M-score is all within the limits of what can be considered acceptable. This is an indication for me that there is indeed some addition screening is being done than just spitting out a list of low EV/OI stocks.
  • Low D/E around 0.5 which indicate good financial strength
  • surprisingly high ROIC and ROE. Above 15%. So this shows that these companies has not be crappy companies in the past.
  • The Gross, EBIT, and net margin are quite low.
  • Shareholder Yield very high at 7.1%. This shows that the management are returning back money to the shareholders in form of dividends or share buyback. This also can indicate that the management themself think that their own stock are selling too cheap compared to their intrinsic value

 

Conclusion:

Looking deeper into the numbers we can see that the quality of the stocks that is selected is not as of bad quality as I first imagined. On average they also seem to pass the financial forensic screening of F,Z and M-score. Historically the ROIC and ROE has been quite good. Seems like there is more to it than just a low EV/OI ratio. Also in contrast to what I remember reading in the Deep value book these stocks the high ROIC would decrease the annual return, but still it seems like the stocks also have been screened for a high ROIC.

 

How to beat the market

Beating the markets returns is difficult. Why? The reasons are many, but some of them are behavioral and others are trading costs.  Let’s start with the first one. To beat the market you need to have a portfolio of stocks that is different from the markets. That means that you can forget buying an index fund if your goal is to beat the market (As the index fund of course gives you the markets return)

So that means that you need a more concentrated portfolio of stocks. I don’t know any specific number but anywhere more than 50 stocks will probably give you a return that is closer to the markets return. So since you need a more consentrated portfolio (preferably 5-20 stocks) you will experience more volatility in the portefolio value. And that can hurt emotionally.

We know from research that the number one reason why the average investors underperform the market is that they buy on top and sell on the bottom. A higher volatility in your portfolio makes it easier to be affected to this behavioral error and do the exactly wrong thing at the wrong time. Apart from the need to handle higher volatility you also need to do a lot of more decisions about buying and selling stocks. This make you prone to get affected by the media, other investors, stocks tips etc.. that will increase the chances that some of the behavioral biases makes you make irrational choices that hurts your returns. One of these is frequent buying and selling stocks that will take away from your annual return in form of trading costs and taxes.

The next one I want to take about is that if you want to beat the market you need an opinion that is different from the market, and you need to be correct about it and the market need to be wrong. If the market is opinion is correct and yours is wrong you will lose money. If your opinion is the same as the markets opinion you will get the markets return. Just think about that for a second. You have to bet against what is the collective knowledge of maybe thousands of investors analysing a stocks future performance. You need have an opinion that is different from them, and you need to make a bet and you need to be right in you predictions. So whats the big deal about this?

Well, you need to be brave to be a contrarian and go against the common and popular opinion about a stock. We humans are social animals and its most comfortable to conform to the opinions of the masses. Also you need to be able to be comfortable looking like an idiot for a long time as the stock price can fall a lot after you buying it and you will still hold it until it reaches it’s intrinsic value. This can take up to many years, and in the meantime you will look stupidly wrong and the market will look correct and that you made a mistake. To handle all of this you need extreme patience, discipline, emotional intelligence, confidence, and at the same time humility.

Also when you know that for the most part the market is efficient (that means correct pricing of stocks) then you can say that you are bold when you bet against the market.

I am not saying that you should give up stock picking, and buy an index fund. Not at all, especially not in this current market conditions where US index funds are very highly priced. What I want is that you think about what it really requires and demand from you to beat the market over a long time period. Few investors manage to beat the market by a large margin over years and decades. Are you one of them?

  • Do you have more knowledge about analysing stocks than the average investors?
  • Are you willing and able to handle the increased volatility that can be experienced with a more concentrated portfolio?
  • Are you more knowledgeable than the seller of the stock that you are buying?
  • Are you able to handle to look wrong for and extended period of time, before you eventually are proven right (assuming you actually made a good bet)
  • Do you have more patience, discipline, emotional intelligence, confidence and humility than the average investor?

 

How often should you check your stock prices?

 

Addicted to checking the price of your stocks every day? How often do you check your stock prices?

 

It’s very easy to fall into the trap of checking your stocks prices or portfolio value on a daily basis. It’s very tempting and we feel that we somewhat have more control of the outcome when we do this. With today’s technology is also very fast and easy to do this. However the research shows that people who check their stocks frequently on average gets a lower annual return on their investments than people who check less frequently. Actually the one who had the highest returns where the ones that had forgotten they had a stock portfolio and people who had deceased! The reason for this is that checking your stock prices often will lead to over-trading which then will lead to lower returns because of higher transaction costs. Remember in investing we usually are our own worst enemy and seeing you stock prices or portfolio value going up and down on a daily basis will trigger our non rational part of our brain to do stupid things.

One of the reasons is that we feel more than twice as much emotional pain when we see a loss in our stock account than with the equal amount of gain. So that means that a sure way to feel miserable is to check in on your stocks daily, because the fluctuation in stock prices in the short-term is random, close to 50/50. One of the keys to successful investing is to be able to control your emotions and be disciplined, and checking the stock prices daily is making it much harder for yourself. Setting up the environment around you so that you get less affected by the emotional brain and use more of your rational brain is very important.

Also for the long-term investor there is no need to check the stock prices frequently. First; the markets daily fluctuation in prices does not tell us anything if you have done a good investment or not. That is only after 1 year or longer that you can use the market price as an indicator of you did a good buy or made a mistake. Also the reason in the short-term for the fluctuation in stock price is because of market participants need for liquidity or just for reasons neither I or any other “experts” really know. Second; companies does not change that fast. The business of a company does not change more frequently than maybe every quarter or even on a annual basis. So to check your stock price on a daily basis to check how your company is performing just don’t make sense for the long term investor.

It’s also quite stressful to look at your stock prices daily and one of your goals with investing is to invest with the least amount of stress on a daily basis. The less stress you have the higher chance of better investment decisions. Our brains don’t operate well under stress, because under stress we rely more on our instincts and emotions rather than our rational decision system; a sure way to reduce your chances of high investment returns.

I can assure you that the best value investors are not concerned about their stock prices on a daily basis, but are more concerned about the stocks financial performance on a quarterly and on a annual basis.

 

Here is my advice for avoiding falling into this trap:

 

  • Nothing bad happens if you stop following your stocks on daily basis. Relax and do other more useful things like reading great investments books.
  • Remember that your long-term returns will likely suffer if you frequently check your stocks prices.
  • Remove stock price apps from your smart phone/computer!
  • Do not check your stock prices more than maximum once per month. Even less frequent is also OK. I suggest looking at your stocks on the 1’st in the month if your really feel the need.
  • When you check your portfolio, don’t get concerned about the decline of individual stocks, but instead you should track the total value of your portfolio over longer time periods. Check out the total portfolio value tracker at the free investor material page
  • Set up automatic price alarms that will alert you when your stock is reaching its intrinsic value or when it’s dropping to a price that you would be interested in averaging down. Gurufocus.com has a great price alarm tool for this.