Tag Archives: value investing

The Importance Of Having An Investment Discipline

In investing, it’s necessary to have a system. Even if you’re a buy-and-hold investor, that’s a system. In fact, buy-and-hold investors have to do a little more than buy and hold – they have to rebalance their portfolios periodically. That involves a decision about whether to rebalance quarterly, semi-annually, or annually. And once you’ve made that decision, you have to follow through and do it. You can’t say, “Gee, the market is running so hard; I don’t want to take some money of the table now.” Or, “This decline is so painful; I can’t bear to throw more money at stocks now.” But you won’t be successful if you don’t stick to the discipline you established.

Other investors, who want to be more tactical or “enterprising” as Benjamin Graham called them, should have rules too. It can be overwhelming to try to apply valuation metrics and momentum metrics to asset classes, sectors, currencies – anything that moves – every single day, and to decide which metric to emphasize and which to jettison. I’ve seen more smart people mismanage money because they couldn’t boil down their intelligence into a system, or, once they did, follow it. Investing isn’t about intelligence as much as it’s about controlling your emotions.

Let’s say you follow momentum in the stock market. You might apply the 200-day moving average to tell you if the market is in an uptrend or a downtrend. Michael Batnick wrote an excellent post about this recently where he showed how a simple system or backtest using the 200-day moving average could beat the market with lower volatility – at least since 1997. But simple to understand doesn’t mean simple to execute for a variety of reasons. As he notes, there have been plenty of times since 1997 when simply owning stocks when they were above the 200-day moving average and exchanging them for bonds when they were below would have tested your patience. He asks rhetorically if someone would have been able to follow all the 160 signals the indicator produced over the 20-year period, if someone would have been able to take the 10 signals it delivered in 30 trading sessions, and, finally, if someone would have been able to stick with it when it was badly underperforming the S&P 500 Index.

Not following that simple rule – owning stocks above the 200-day moving average and exchange them for bonds below — wouldn’t have been the result of a lack of intelligence. It would have been the result of not being disciplined enough or not believing in the indicator when it was failing – or, more likely, convincing yourself that there’s another indicator you should be following just this one time because yours was failing. St. Augustine was noted for praying, “Lord, make me chaste, but not yet.” That’s the way many investors wind up operating. “I’ll follow my model or indicator, but not yet. Something else looks more attractive or like it’s working right now; so I’m going to go with that.”

Another problem besides multiple indicators that can distract you or seduce you away from the main one, is applying your indicator to many different things. Are you doing something like Batnick’s simple example of a moving average to the S&P 500 and bonds? Or are you applying the indicator to foreign stocks too? And what about emerging markets stocks. And how about different sectors and industries of the stock market and different areas of the bond market like corporates, Treasuries, mortgages, high yield, and emerging markets? And are you trying to build a portfolio from many asset classes to which you’re applying one or multiple indicators? Things can get complicated and dizzying in a hurry.

Any system you set up will disappoint you at times. No system exists that’s 100% foolproof. The trick is if you can keep using the system when it disappoints so that you’ll still be using it when it starts working again. This isn’t about how smart you are; it’s about how emotionally intelligent and focused you are.

Are Energy Stocks Cheap?

Oil prices have collapsed again from nearly $80 per barrel this past summer to under $50 per barrel now. Big price declines in the commodity always beg the question if there are any cheap stocks in the oil patch.

Let’s start with the domestic behemoth, ExxonMobil (XOM). It’s down from a high of nearly $90 per share this year to a little below $70. It’s trading at a P/E ratio of around 13, a Price/Sales ratio of around 1 and a Price/Book ratio of around 1.6. It’s also yielding well more than 4%. Those seem like reasonable multiples, but let’s move to a cash flow analysis.

The firm has averaged around $10 billion of free cash flow for the past five years, and that includes $14 billion year-to-date and $14.7 billion in 2017. Let’s say the firm averages only $10 billion per year for the next five years. Then let’s say it produces $15 billion in the sixth year and grows at the rate of inflation after that. If we apply a 10% discount rate to those numbers, we arrive at a company worth around $300 billion or a little more than its current market capitalization. In other words, the firm doesn’t have to perform better than it has recently to argue that its current price matches its value. Any improvement in free cash flow would mean its fair value is higher, and also that it should trade that way in a few years. If you have a little time, ExxonMobil should be a good bet if you make it one of a few stocks.

A smaller integrated company, Cenovus (CVE) looks attractive too. It trades at a P/E ratio of less than 5,  Price/Sales ratio of 0.52 and a Price/Book ratio of 0.62. It also yields around 2%. The stock has dropped from more than $10 per share earlier this year to less than $7 now.

Cenovus has averaged around d $300 million of free cash flow for the past five years. Let’s say it maintains that for the next five. Then let’s assume it can get to $400 million in the sixth year and grow at the rate of inflation after that. If we apply an 8% discount rate to those conservative numbers, we get a fair value of more than $9 billion. The stock has an $8.6 billion market capitalization now. Just as in the ExxonMobil case, we’re assuming that the company doesn’t improve very much over the next five years.

Last, let’s consider the largest oilfield services company, Schlumberger (SLB). The stock trades at a P/E of 34, a Price/Sales of 1.6, and a Price/Book ratio of 1.43. It yields around 5.3%.

That P/E ratio seems high, but the stock has average around $5.2 billion of free cash flow for the past five years. If it continues to do that for the next five, jumps to $5.5 billion in year six, and then grows at the rate of inflation, we get a company worth over $100 billion if we apply an 8% discount rate. The company’s market capitalization is currently a little over $50 billion.

This Long-Short Fund Has A Little “Magic” In It

At the end of March, the institutional share class of famed value investor Joel Greenblatt’s Gotham Index Plus fund (GINDX) passed its three-year mark and garnered a 5-star rating from Morningstar. That means, over its first three years, the long-short stock fund landed in the top-20% of the large blend fund category for its volatility-adjusted return.

Long-short funds have high fees because they pay dividends and margin costs on short positions, and this fund is no exception with an eye-watering 3.61% expense ratio. But it’s a good time to look under this fund’s hood to see if it still deserves a place in some portfolios.

Background on Greenblatt and the “Magic Formula”

As I wrote in a previous article, Joel Greenblatt began his career has a hedge fund manager using a strategy that could be described as special situations. He looked for corporate restructurings including spinoffs and bankruptcies and managed to post a 50% annualized return for a decade, albeit with significant volatility as he tells it. Greenblatt likes to write and teach, including holding a position as an adjunct professor at Columbia Business School, and the book that emerged from that experience became a hedge fund cult classic, You Can Be a Stock Market Genius.

After closing his fund, Greenblatt devised a strategy that could accommodate more assets called the “Magic Formula.” The strategy is really a simple smart beta two-factor model, picking stocks with the best combination of EBIT yield and return on invested capital. Greenblatt ran a backtest and realized picking the stocks that scored best on these two factors at the start of each year would have beaten the index by 4 percentage points annualized over a quarter century. Three books came out of testing this strategy – The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor.

When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his first book on the strategy and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact, it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods. In fact, value strategies work over the long run precisely because they don’t work over shorter periods. Everyone piles out when the strategy is faltering, leaving stocks poised for outperformance. The “magic” of the formula is really based on the human psychology or behavior that causes many of us to be bad investors.

Using the Magic Formula to Go Long & Short

Now Greenblatt and his partner Robert Goldstein have based a series of long-short funds on the strategy, which, to varying degrees, own the stocks that score best on his formula and short the stocks that score the worst on it. For each dollar invested, the Gotham Index Plus fund gains 100% exposure to the S&P 500 Index. It also selects long and short positions from the 500-700 larges U.S stocks that are that most expensive or cheapest on Gotham’s assessment of value or the Magic Formula. The resulting portfolio is 190% long and 90% short.

So the fund combines full exposure to the index with active management. Part of the fund tracks the market, and another part of the fund uses a value strategy to own and short stocks. The benefit of having both market exposure and exposure to an active strategy is that investors who still want to beat the market don’t have to withstand such severe fallow periods that every value investor endures and that the fund would likely have if it were just invested in the magic formula strategy.

The Verdict

With such a high expense ratio, however, the fund must outperform significantly when the strategy is working – and not underperform significantly when it’s not. The avoidance of underperformance versus the index is especially true since one of Greenblatt’s objectives is to provide an index-like experience for investors so that they won’t get shaken out when the active strategy is out of favor. That seems like a tall order. Nevertheless, for the 41 months the fund has been in existence it has outperformed the index. Over that period, the fund’s compounded annualized return is 14.54%, while the S&P 500 Index’s return is 12.75%.


Over long periods of time that difference – 1.79 percentage points – adds up to serious returns. For example a $100,000 investment earning 7% for 25 years would grow to around $540,000, while the same investment for the same period of time earning 8.79% would growth to around $820,000,

Interestingly, the Gotham Index Plus fund has a 1.42% Sharpe Ratio for the past 36 months according to Morningstar, while the index has a Sharpe Ratio of 1.55%. This implies that the index has a slightly better volatility adjusted performance. But the Sharpe Ratio views all volatility (up and down) as the same, whereas investors obviously don’t. Indeed, the Sortino Ratio of the fund, which penalizes an investment only for downside volatility, is higher – 3.42% — than the index’s 3.30%. Additionally, the fund has captured 105% of the index’s upside moves and 77% of the downside moves.

So far, despite its breathtaking expense ratio, the Gotham Index Plus fund has delivered on its promise – outstripping the index by a decent amount over a 41-month period, while delivering a roughly similar volatility experience. Investors should consider that other long-short funds must pay dividends and margin costs too. It’s noteworthy though that if the stock market endured a steep decline, the fund would then be paying even higher fees assuming dividends weren’t cut too badly in that event. If the expense ratio on the fund reached, say, nearly 6% instead of nearly 4% now, the fund might do fine, but would it overcome the index as easily? Of course, such a big decline in the stock market itself, although painful in absolute terms, might be a relative boon for the fund as both its long and short magic formula components could outperform the index during a big drop. And stocks would be cheaper after such a decline, arguably favoring the fund’s strategy.  But 6% or more seems like a rather high hurdle.

It’s difficult to recommend a fund this expensive. But paying dividends and margin costs is part of shorting. And if you aim to find a mechanical, smart beta-like long-short fund that can beat the market over the longer haul, this fund’s strategy has a decent chance.

30-Stocks To Add Some “Magic” To Your Portfolio

Index giant Vanguard manages more than $5 trillion of capital today, up from $1 trillion in 2010. Vanguard manages assets mostly indexed on a capitalization weighted scale, meaning companies are ranked according to their stock market value. But, while Vanguard and other traditional index providers have grown dramatically, a slew of alternative index funds called “smart beta” has also become popular. These funds rank stocks on metrics such as their underlying businesses’ economic footprint, valuation metrics, price momentum, volatility, and other “factors.”

One of the more interesting smart beta strategies is Joel Greenblatt’s “magic formula,” which is a simple two-factor model. A former hedge fund manager who enjoyed wild success trafficking in special situations like spinoffs and corporate restructurings, Greenblatt published two books called The Little Book that Beats the Market and The Big Secret for the Small Investor detailing a formula that ranks stocks based on their EBIT/Enterprise Value (a modified earnings yield or E/P ratio) and return on invested capital (ROIC). Cheapness is generally what the great value investor Benjamin Graham stood for, and business quality or returns on invested capital is generally what Graham’s most famous student, Warren Buffett, stands for. Combining the two investment touchstones, the strategy simply owns the stocks with the best combination of these two metrics, and swaps them out for whichever ones score best the next year.

When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his book and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods.

Greenblatt runs Gotham Capital now, a firm that offers mutual funds that invest in variations of this strategy. Most of the funds are long the stocks that score best on the two metrics and short the stocks that score worst in various proportions. Rather than looking at fund holdings, which are updated every quarter, we thought it would be interesting to run the screen on Greenblatt’s website (www.magicformulainvesting.com), which is more up to date, to see which stocks score the best on the screen. We ran it for the top-30 companies over $5 billion in market capitalization.

We also included current dividend yields, although that’s not part of Greenblatt’s screen. Dividend yields can be misleading when screening for stocks because high yields can be indications that the dividend is about to be cut. They also don’t tell you anything directly about profitability and cheapness, although some analysts make inferences about profitability from them. Nevertheless, we included them anyway to show that if investors use Greenblatt’s screen they can capture a current yield of 2.5%. If you run the screen for smaller capitalization stocks, it’s doubtful that you’ll get such a hefty yield. Greenblatt’s screening website allows you to screen stocks from $1 million to $5 billion in market capitalization.

Incidentally, Morningstar recently ran an article highlighting 10 cheap high-quality stocks with growing yields, and two stocks on the Greenblatt screen made Morningstar’s list for independent reasons – pharmaceutical and healthcare supply companies McKesson (MCK) and AmerisourceBergen (ABC) Morningstar analysts use a discounted cash flow model to analyze stocks, assigning a “moat” or competitive advantage rating, forecasting future cash flows and applying a discount rate to arrive at a present value.

Here’s the Greenblatt list:

Disclosure: Clarity Financial, LLC currently, or is planning to, hold positions in KLAC and CVS.


Building A US Stock Portfolio With Smart Beta Funds

Two articles in the finance press this weekend wondered if value stocks were poised to outperform. In Barron’s, Reshma Kapadia interviewed value managers and recounted how poorly value stocks have done over the past decade. Similarly, in the Wall Street Journal, Jason Zweig noted that value stocks, and the funds dedicated to picking or tracking them, should do better, but cautioned that nobody knows when that will happen. Investors seeking to profit from a value premium likely will require patience.

Indeed for a decade now, growth has outperformed value by more than three percentage points annualized. The Russell 1000 Growth Index has returned nearly 11%, while the Russell 1000 Value Index has returned a little more than 7%.

Ever since the publication of an academic paper in 1992 by Eugene Fama and Kenneth French proclaiming a higher expected return from stocks with value metrics, investors have increasingly assumed that value stocks  would outperform growth stocks. Fama and French defined value stocks as those with low price/book value ratios, but the definition has increasingly encompassed stocks with low price/earnings ratios and low price/cash flow ratios. Certain sectors tend to trade with low price/book and price/earnings metrics such as energy, materials, financials, and utilities. Other sectors tend to trade with higher multiples. Those include technology and healthcare. Given the run technology stocks such as Facebook, Amazon, Netflix, and Google have had in recent years, it’s not surprising that growth has done well.

Fama and French thought value stocks returned more because they were more volatile. Risk is volatility, according to modern academic finance, and you get paid – at least eventually – for accepting and tolerating risk. That, of course, begs the question of whether it’s risk if you always get paid. But Fama and French might point to the last decade and say that it can sometimes take a long time, and that’s punishment enough for some investors.

Zweig is correct to say that nobody knows exactly when the trend will turn. However, investors have already waited a long time during which growth stocks have outperformed value stocks. It might be a decent bet to assume that if you can wait another decade, value should return to favor. In other words, it’s not necessary to call the exact turn of the trend if you’ve got a long enough time frame.

Six funds to consider for capturing a value premium are the iShares Russell 1000 Value ETF (IWD), iShares MSCI USA Equal Weighted ETF (EUSA), PowerShares FTSE RAFI US 1000 ETF (PRF), PIMCO RAE Fundamental Index Plus fund (PXTIX), iShares Edge MSCI USA Value Factor ETF (EUSA), and the DoubleLine Shiller Enhanced CAPE fund (DSEEX).

“Traditional” Value

The iShares Russell 1000 Value ETF, which tracks the Russell 1000 Value Index, is the most straightforward approach. This fund has 26% of its portfolio in financials and 9% in technology. That’s a marked difference than the iShares Russell 1000 ETF (IWB), which has 24% in technology and less than 15% in financials. And that kind of sector exposure differential is what you’d expect.

The iShares MSCI USA Equal Weighted fund is another well-known approach to capturing a value premium — or of eliminating the “noise”or high ranking of the most loved stocks associated with capitalization weighted indexing. It simply tracks an index of equally weighted stocks, lowering the weighting of the most loved and elevating the weighting of the least loved. Each stock currently occupies around 0.20% of the portfolio. This approach breaks the link between a stock’s market capitalization and its rank in the index.

Equal weighted indexing isn’t perfect though. It has capacity constraints because the 500th biggest stock in the S&P 500, for example, can only take so many dollars chasing it before its price gets pushed up too high. An approach that still captures the value premium, but doesn’t suffer from the capacity constraints of equal weighting, is the PowerShares RAFI US 1000. This fund tracks the Research Affiliates Fundamental Index, which re-ranks the stocks in the Russell 1000 by sales, book value, cash flow, and dividends.

A fourth option is the PIMCO RAE Fundamental Plus (PXTIX), which gains exposure to a modified RAFI Index through a derivative collateralized by a bond portfolio. This fund has two sources of return – the difference in the return of the bond portfolio compared to the price of the derivative and the performance of the modified index. The index is modified by the managers’ active insights to enhance returns. This fund is better suited to tax-advantaged accounts because of the use of derivatives.

Fifth, the iShares Edge MSCI USA Value Factor fund targets the cheapest stocks within each sector of its “parent” index, the MSCI USA Index. It ranks stocks against their sector peers, and chooses the cheapest ones within each sector, creating an “underlying” index that it tracks. The underlying index, therefore, maintains the sector allocation of the parent index. That means the fund avoids the typical sector overweights that one finds in other value funds. But it also means the fund won’t avoid or underweight expensive sectors. It will only own the cheapest stocks in those sectors. Indeed in the fund’s most recent Summary Prospectus, it warns that “a significant portion of the Underlying Index is represented by securities of information technology companies.”

A Value Fund That Likes Technology?

Finally, investors seeking to break the link between market capitalization and index rank and to capture a value premium should also consider the DoubleLine Shiller Enhanced CAPE Fund – especially if Zweig is correct in arguing there’s no telling when “traditional” value stocks will start to outperform again.

Like the iShares Edge MSCI USA Value Factor fund, the DoubleLine fund also approaches the world by looking at market sectors, but in a different way. It evaluates sectors of the S&P 500 Index by the Shiller PE or “CAPE” (current price relative to the past decade’s worth of real, average earnings). Each sector is judged according to its own historical valuation, and the fund consists of four of the five sectors that rank the cheapest relative to their own histories. After identifying the five cheapest sectors on a CAPE basis, the fund rejects the sector with the worst one-year price momentum among the cheapest, leaving it with exposure to four of the five cheapest sectors.

Like the PIMCO fund, this one gains exposure to stock sectors through a derivative collateralized with a bond portfolio. It also, consequently, has two sources of return.

The unique aspect of this fund is that it doesn’t tend to be consistently heavy in energy, materials, utilities, and financials, which usually enjoy significant representation in value-oriented funds. (Of course, it could be exposed to those sectors, if they were the cheapest on a CAPE basis relative to their own histories and none of them triggered the negative price momentum filter.) Surprisingly, according to its most recently published fact sheet, the fund now has exposure to the technology, healthcare, consumer staples and consumer discretionary sectors, which are often associated with better-than-average growth and profitability. This ought to give those waiting for a more traditional value rebound or those who think technology stocks are uniformly expensive pause.

Investors unable to resolve the mixed signals of traditional value sector underperformance and growth sector cheapness on a CAPE basis can pair the DoubleLine fund with one of the other value funds. This combination allows investors to break the link between market capitalization and rank of stocks in their portfolios, but doesn’t necessarily overweight traditional value sectors and stocks. It helps investors benefit from different approaches to value.

See A Bubble? Get Out Of The Way.

In early March, we reprinted an article I wrote for Citywire on bubbles. That article focused on an academic paper called “Bubbles for Fama” by Robin Greenwood, Andrei Shleifer, and Yang You on spotting bubbles. It tried to provide a definition that would satisfy proponents of the efficient markets hypothesis who doubt that bubbles exist.. The authors noted that 100% run-ups of asset prices in a two-year period resulted in a heightened probability of a subsequent crash.

Early this week, Research Affiliates weighed in on which assets might be in a bubble today, citing another research paper by Greenwood and Shleifer discussing how investors behave with strong “extrapolative tendencies.” In other words, investors anticipate strong returns after strong return periods, when future returns are likely to be lower, and also anticipate weak returns after weak returns periods, when future returns are likely to be higher.

What’s A Bubble?

But before we get to that argument, Research Affiliates founder, Robert Arnott, and his colleagues, Shane Shepherd and Bradford Cornell try to keep the definition of a bubble simple. They argue a bubble is a “circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals.” (Can you say Bitcoin?) There are bubbles now in technology stocks and cryptocurrencies, according to Research Affiliates. Overall, the U.S. stock market is very expensive too.

The authors are aware that modern academic finance would find their definition lacking. Adherents of the efficient markets hypothesis think “[t]he market’s willingness to bear these risks {of high prices relative to reasonable projections of cash flows] varies over time. . . . .high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low so as to justify the prices.” Of course, if risk premia or required returns can vary so widely, what’s the difference between and efficient market and an inefficient one?

More realistic observations come from behavioral finance which shows that investors bring their own psychological baggage to markets even when they know and understand formula-based valuation models. Moreover, Greenwood and Shleifer show that investors are so tied to recent price trends that they anticipate higher expected returns after big price runs when valuation models anticipate subpar returns, and lower expected returns when valuation models anticipate robust returns. Moreover, investors bet accordingly, putting more money into stocks after they have gone up, and withholding it after they’ve gone down.

What Can Investors Do?

If you’ve spotted a bubble, the temptation is to short it. But that turns out to be very difficult, despite the success of the hedge funds depicted in Michael Lewis’s The Big Short.  Arnott et. al. recount the story of Zimbabwe at around the time of the financial crisis. At first, when Zimbabwe’s currency crashed, the stock market soared. Then the stock market crashed as the currency continued to crash more. And finally, when the currency collapsed, so did the stock market for good. The problem with having shorted stocks in this case is that their initial run up might have bankrupted you. And even when asset prices don’t react to a currency failure the way Zimbabwe stocks did in 2008 by shooting up initially and then cratering, bubbles can keep getting bigger and bigger. Not everyone facing a bubble has the advantage that the hedge funds doing “the big short” had — knowledge of when most of the adjustable rate mortgages issued would reset at higher rates, causing most borrowers saddled with them to default. A bubble might be easy to spot, but it’s hard to trade.

Instead of shorting, the easiest thing to do when you spot a bubble is to avoid it. Nobody needs to own Bitcoin or cryptocurrency. Also, nobody needs to own any technology stocks right now. Moreover, there are many stock markets around the world cheaper than the U.S. market. The cheapest stock markets around the world are the emerging markets, according to both Research Affiliates and Grantham, Mayo, van Oterloo (GMO) in Boston. It’s true EM stocks often come with an extra dose of volatility, but their valuations are lower than that of the U.S stock market. Also, none of this means those are the only stocks you should own though. There are ways to mitigate overvaluation of U.S. stocks such as with an ETF that owns more of the cheapest ones like the iShares MSCI USA Equal Weighted ETF (EUSA) or the PowerShares FTSE RAFI US 1000 ETF (PRF). But when things are expensive, it’s fine to stay away from them.

Even being relatively conservative by overweighting emerging markets stocks rather than shorting U.S. stocks entails some “maverick risk,” as Research Affiliates calls it. This is sometimes called “career risk,” because clients will fire and advisor or asset manager who deviates too much from a benchmark or his peers for too long a period of time. Investors must be honest with themselves about how much maverick risk they can tolerate, and advisors must be careful not to exceed their clients’ tolerance for maverick risk.

Most of all, when contemplating asset prices and prospective returns, remember that your mind may be playing tricks on you when you expect unusually large or unusually small returns. Don’t extrapolate recent return history into the future. The future might hold the opposite scenario from the recent past.