We think this guide will help you to hack investing, the simple way.
Believe it or not, over the past decade, a revolutionary investing strategy has emerged.
Whether you believe invalue investing,dividend investingortrend followingyou are going to love this, because never before has one strategy brought them all together.
An investing system backed by the peer-reviewed, gold standard of academic research and top money managers. It draws from the experiences of professional investors from the worlds richest man Warren Buffett to commodities speculator Richard Dennis, who turned $1,600 into $200 million within a decade.
This guide shows you exactly howaridiculously simple,yet powerful investing approachcan reduce yourinvestment risks, and bring youmarket-beating returns.
You wonder what caused the exhaustion since you have had enough sleep the previous night. Noticing your eye bags, a sales representative approaches you to share how the multi-vitamin supplements can help you get through your day with more vigour.
You listen, and your rational self asks a question.
Similarly, how do you know if a particular investment strategy would really work?
So you search the internet for answers. You come across a credible organisation which has conducted scientific research into the effects of supplements only to conclude that the benefits are marginal. Since the research is conducted independently and replicated by other researchers, you would want to assign more weight to them rather than your friend or the salesperson. You would be more inclined to believe what these doctors, scientists and nutritionists are saying.
You want to know if the supplement really works, but who can you look to for answers? If you attempt to ask your friends, those who take supplements will say they work while those who have not will convince you otherwise. The answers will be biased based on personal circumstances.
Unable to overcome the doubt, you say no to the sales representative despite his repeated attempts to convince you.
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Your close friend might recommended you a stock because he has heard some rumours about a takeover. The stock is going to sell at twice its current price soon, he whispers. You may have attended a talk by an investment guru who forecasts boldly that the market is going to crash and you should sell all your stocks and stay in cash. Or you might have met up with a financial advisor who tells you not to listen to both your friend and the guru and that you should stick to prudent long term investments. He then proceeds to show you a set of unit trusts you should be investing in.
Each is a self-proclaimed expert. Each touts his method to be the best. Who can you trust?
Can their investment strategy pass the vitamin test?
Like vitamins, finance has also been backed by established research. For stocks investing, there are proven Factors or metrics that will produce higher investment returns. If you have bought stocks that exhibit the characteristics, you will achieve better investment results.
These Factors and metrics have undergone rigorous statistical tests with decades of data as a validation process. The studies must also be able to stand against the stringent peer review process, whereby the findings remain consistent when other researchers repeat the tests.
Hence, these Factors can be considered proven and dependable primary drivers of investment returns.
Here is a simple analogy. If you want to build muscles you will need sufficient protein in your diet. Chicken meat is high in protein. Muscles are akin to investment returns, chicken meat is the asset that you buy (Eg. Stocks) and protein is the Factor you seek (Eg. Value).
1934 was the year Security Analysis was first published.
Benjamin Graham and David Dodd were the authors. Atthat time, investing was largely speculative with very little talk about stock valuation. Security Analysis changed all that by dealing with the subject in depth.
It bought about a paradigm shift for investors and the financial industry andthe book laid the foundations for investment analysis today. Security Analysis is a timeless classic and Benjamin Graham is often referred to as the Father of Value Investing.
Young Warren Buffett (left) and Benjamin Graham (right)
Interestingly, Graham did not use the term Value Investing in his literature. This term was coined after people realised he has started a movement. The movement has grown even stronger with the years. The flag bearer for Value Investing is none other than Grahams disciple Warren Buffett.
Few would deny that Warren Buffett is the most successful investor of our time. He has spoken about his journey several times on print and on TV. He first got interested in investing after reading Security Analysis. He came to know that Graham and Dodd were teaching at Columbia Business School and he wrote to Dodd asking to be accepted to the school. He succeeded.
First edition Security Analysisselling at USD 20,000
Graham had a profound influence on Warren Buffetts initial years as an investor. Buffett diligently followed Grahams teaching to buy stocks which trading very cheaply against the value of its assets. The company he runs today, Berkshire Hathaway, was one of the cheap stocks Buffett came across in the early days.
Buffett was not the only disciple. In 1984, Buffett wrote an article The Superinvestors of Graham-and-Doddsville in honour of the 50th anniversary of the publication of Security Analysis.
In the article Buffett shared the market beating results of several value investing practitioners. It was a testament for Grahams investment philosophy and a tribute to his teacher.
The Superinvestors of Graham-and-Doddsvilleby Warren Buffett
Margin of Safety, Klarmans out-of-print book on Amazon
Value investing is still widely practised today by legends like Seth Klarman of Baupost Group and Joel Greenblatt of Gotham Capital. They are more famous than most value investors because they share their ideas publicly. Otherwise, value investors are a pretty reserved bunch and most prefer to make good money quietly. Klarmans out-of-print book, Margin of Safety, is selling close to US$1,000 for a used copy. Greenblatt is known for his quantitative value investing strategy, Magic Formula Investing, which has achieved market beating results since it was published in 2006.
Mention Value Investing, and most people would immediately picture the gentile and avuncular Warren Buffett. He is the most successful investor in the world, and such an association is only normal. However, what we have in mind when we say Value Investing is somewhat different from what Buffett has in mind. Let us explain.
Warren Buffett was schooled under Benjamin Graham at the Columbia School of Business. After receiving his Degree, Buffett went on to work at Grahams firm before managing money on his own. He was a keen follower and a very successful applicant of Benjamin Grahams philosophy. He termed it the cigar butt investment approach and he explained it inBerkshire Hathaways 2014 shareholders letter.
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffsI obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performanceMost of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked. But a major weakness in this approach gradually became apparent:Cigar-butt investing was scalable only to a point. With large sums, it would never work well.
What prompted Buffett to give up on buying value small caps was that he became a victim of his own success. He made too much money from the strategy such that his capital became too large to invest in small and undervalued companies. He admittedly and regretfully said in 1999 to Businessweek:
If I was running $1 million today, or $10 million for that matter, Id be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return Ive ever achievedwere in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. Its a huge structural advantage not to have a lot of money.I think I could make you 50% a year on $1 million.No, I know I could.I guarantee that. The universe I cant play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.
Buffett met Charlie Munger in the early part of his career and together they built a new investment approach that was often in opposition to Grahams teachings. While Graham advocated paying for a fraction of the asset value of a company, Buffett and Munger had no problem paying above the asset value as long as they are confident that the companys cash flow would outgrow the premium in the future. While Graham advocated a well diversified portfolio to minimise risk, Buffett and Munger swung for the fences with concentrated bets.
Charlie Munger (left) & Warren Buffett (right)
These were strong divergence from Grahams original strategy. Buffett eventually proved that it was a right move with the amount of wealth he had gathered applying his new found strategy together with Charlie Munger.
But as retail investors, we do not have many advantages if we were to copy Buffetts approach. His business acumen and access to management are out of reach for the average joe. Without which, assessing the investment potential would be very inaccurate due to the many assumptions involved.
The good news is that retail investors do have an advantage that Buffett does not have. We can fully exploit the Value and Size Factors by sticking to Grahams philosophy buying small and undervalued companies the exact method Buffett made his earlier fortunes with.
For the longest time, academics have firmly believed that thestock market is efficient.
They believed that all the information surrounding a company or a stock would have been reflected in its price. Hence, no investor has an advantage over another. This rendered stock selection a futile activity. Instead of expending effort to select stocks, investors should just focus on asset allocation, diversifying into a large number of stocks, bonds and cash. This is known as theModern Portfolio Theory. It has since permeated the entire financial industry and has established itself as the cornerstone of portfolio management.
Eugene F. Fama (left) and Kenneth R. French (right)
The Cross-Section of Expected Stock ReturnsbyEugene F. FamaandKenneth R. French.
The Cross-Section of Expected Stock Returns, by Eugene F. Fama and Kenneth R. French, was published in The Journal of Finance Vol. XLVII, No. 2 June 1992. We will dissect the key findings of this paper in the following paragraphs.
First, Fama and French defined cheapness by Book-to-Market value. This is an inverse of the more commonly known Price-to-Book value. This is appropriate since Book Value is the accounting value or the net worth of a company, while Market Value is the price that the investors are willing to pay to own the company. This is also consistent with how Graham defined value, buying assets for a fraction of their worth.
Fama and French complied all the U.S. stocks and ranked them from the lowest to the highest according to their Book-to-Market value. They were then divided equally into 10 groups. The first group consists of the top 10 percent lowest Book-to-Market stocks, or the most expensive ones. The last group consists of the top 10 percent highest Book-to-Market stocks, or the cheapest ones.
This ranking and grouping was revised annually and the performance of each group measured from Jul 1963 to Dec 1990. During this period, the cheapest group gained an average of 1.63% per month while the most expensive group gained an average of 0.64% per month. There was an outperformance of 0.99% per month buying the cheapest group of stocks!
Figure 1 Stocks ranked and grouped by Book-to-Market and their corresponding monthly returns
Next, Fama and French ranked all the stocks listed in the U.S. by market capitalisation and again sorted them in ten groups. The first group consist of the top 10 percent largest stocks by market capitalisation while the last group consist of 10 percent of the smallest stocks.
This ranking and grouping was carried out annually and the performance of each group was again measured from Jul 1963 to Dec 1990. The largest group returned 0.89% per month while the smallest group returned 1.47% per month, an outperformance of 0.58%!
Figure 2 Stocks ranked and grouped by Market Capitalisation and their corresponding monthly returns
Lastly, Fama and French applied both the Book-to-Market and Market Capitalisation groupings to the stocks. They discovered that the smallest and cheapest group of stocks delivered the best performance in the study period, with a 1.92% return per month. This is higher than buying the smallest or cheapest group independently. This suggests that an investment style that focuses on small cap value has a statistical edge to achieve higher returns.
Figure 3 Combining Book-to-Market and Market Capitalisation Applied Together (ME refers to Market Equity or commonly known as Market Capitalisation)
Over the years, this paper has grown to become the definitive reference for Factor Investing. The model within came to be known as the Fama-French Three Factor Model. As with all good academic research, it throws up a lot more questions than it answers. In the process, it serves as an inspiration for the rest of academia to seek out other Factors that affect investment returns.
The Conservative Net Asset Value (CNAV) strategy is a means to exploitValueandSize Factors, focusing on smaller cap stocks trading below their asset value (less liabilities). The strategy consists of two key metrics and a 3-step qualitative analysis.
One of Benjamin Grahams most famous strategies was the Net Current Asset Value (Net-Net) whereby an investor can find bargains in stocks which are trading below two-thirds of net current assets (defined as Current Assets minus Total Liabilities).
Walter Schlosskept the philosophy close to his heart and has applied it throughout his investment career. He makes a good point about investing in assets,
Try to buy assets at a discount than to buy earnings. Earnings can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.
The late Dr Michael Leong, the founder explains the concept in his book Your First $1,000,000, Making it in Stocks. He prefers to invest in free businesses where the companys cash and properties are worth more than the total liabilities. An investor will not be paying a single cent for future earnings. The way he frames the perspective is brilliant! In other words, pay a fraction for the good assets that the company owns, instead of paying a premium for future earnings.
We gather a very important principle from these brilliant people Pay a very low price for very high value of assets.
Going one step further, we do not just take the book value of a company. This is because not all assets are of the same quality. For example, cash is of higher quality than inventories. The latter can expire after a period of time.
Hence, we only take into account the full value of cash and properties, and half the value for equipment, receivables, investments, inventories and intangibles. And only income generating intangibles such as operating rights and customer relationships are considered. Goodwill and other non-income generating intangibles are excluded.
In doing so, the CNAV will always be lower than the NAV of any stock. This additional conservativeness adds to our margin of safety.
It is easy to find many stocks trading at low multiples of their book value. Many of them are cheap due to their poor fundamentals. Hence, we need to further filter this pool of cheap stocks to enhance our probability of success.
Imagine you are in a fashion shop. The latest arrivals get the most attention and are sold at a premium (think hot stocks or familiar blue chips). In a corner there is a pile of clothes which remained unsold from the previous season and they are now trading at big discounts (cold and illiquid stocks).
Not all the clothes in this bargain pile are worth our time. They must be relatively less attractive since no one buys them in the first place. However, you can find nice ones (value stocks) sometimes if you are willing to dive in and search in the pile.
Although conceptually shopping for clothes and picking stocks are similar, the latter is actually more complex to understand and execute properly.
We turn toDr Joseph Piotroskis F-scoreto find fundamentally strong low price-to-book stocks that are worth investing in. He used a 9-point system to evaluate the financial stability of the lowest 20% price-to-book stocks and found that the returns are boosted by 7.5% per year.
As we have already added conservativeness in our net asset value,we do not need to adopt the full 9-point F-score. A proxy 3-point system known as POF score would be used instead. POF is detailed in the following paragraphs.
While our focus is on asset-based valuation, we do not totally disregard earnings as well. The company should be making profits with its assets, indicated by a low Price-To-Earnings Multiple. Since we do not pay a single cent for earnings, the earnings need not be outstanding. Companies making huge losses would definitely not qualify for this criteria
We have to look at the cashflow to ensure the profits declared are received in cash. A positive operating cashflow will ensure that the company is not bleeding cash while running its business. The operating cashflow also give us a better indication if the products and services are still in demand by the society. If not, the business should not continue to exist. A negative operating cashflow would mean that the company needs to dip into their cash to fund their current operations, which will eventually lower the companys NAV and CNAV. The company may even need to borrow money if their cash is insufficient and this raises further concerns for the investors.
Lastly, we will look at the gearing of the company. We do not want the company to have to repay a mountain of debts going forward. Should interest rate rises, the company may have to dip into their operating cashflow or even deplete their assets. Equity holders carry the cost of debt at the end of the day and hence the lower the debt, the stronger it is.
We use a time stop of 3 years to get out of a position.
Behavioural economists,De BondtandThaler, came to the realisation that people do not make decisions rationally. Their decisions were distorted by the vast amount of cognitive errors they have to contend with.
Does the Stock Market Overreact?Werner F. M. De Bondt and Richard Thaler. The Journal of Finance
Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul., 1985), pp. 793-805
They were keen to discover how much of this is translated into stock prices. Are stocks priced correctly at all? Do investors overreact when it comes to stock prices? If they do, does it mean that stocks exposed to good news have become over-priced? Could it be that stocks that have had a bad run are actually undervalued in comparison with the general market? They set out to test their hypothesis.
They did so by mining price data from the New York Stock Exchange (NYSE) from January 1926 to December 1982. In the process, they created Winner and Loser portfolios of 35 stocks each. These are the top and bottom performing stocks for the entire market at each rolling time period.
The hypothesis is straightforward. If there is no overreaction involved, the winners will continue to outperform while the losers will continue to languish. However, if human beings being the imperfect decision makers they are display overreaction to stock price on the basis of good or bad news, the winners will eventually perform in a worse off fashion than the general market. And stocks in the loser portfolio will eventually catch up.
Over the last half-century, loser portfolios of 35 stocks outperform the market by, on average, 19.6%, thirty six months after portfolio formation. Winner portfolios earn about 5% less than the market. This is consistent with the overreaction hypothesis.
From the outcome, there is little doubt investors get caught up with euphoria and over pay for stocks having a good run. They also become fearful of poor performing stocks, selling them and causing their prices to fall beyond what is reasonable.
Two other details about the study caught my attention.
De Bondt and Thaler choose the time frame of 36 months because it is consistent with Benjamin Grahams contention thatthe interval required for a substantial undervaluation to correct itself averages 1.5 to 2.5 years.
As the graph has shown, most of the reversal took place from the second year onwards. This is consistent with Grahams observations. It takes time for the market to eventually function as the proverbial weighing machine.
Secondly, the overreaction effect is larger for the loser portfolio than the winner portfolio. Stocks that have been beaten down due to investors overreacting to their bad performance eventually recovered faster and more than stocks whom investors have overvalued.
In asecond study in 1987, Debondt and Thaler found that investors focused too much on short term earnings and naively extrapolated the good news into the future, and hence caused the stock prices to be overvalued.
They repeated the experiment in the first study, examining the 35 extreme winning stocks (Winner Portfolio) and the 35 worst performing stocks (Loser Portfolio). They wanted to track the change in earnings per share over the next four years.
They found out that the Loser Portfolio saw their earnings per share increase by 234.5 percent in the following four years while the Winner Portfolio experienced decreased earnings per share by 12.3 percent.
Eyquem Investment Management LLCplotted the changes in the average earnings per share of these two portfolios in the following diagram. This was taken from Tobias Carlisles book,Deep Value
The Undervalued Portfolio which had their Earnings Per Share dropped 30%, went on to improve their earnings by 24.4 percent in the following four years. The Overvalued Portfolio, which had 43 percent gain in Earnings Per Share in the past three years, only managed to achieve 8.2% in the next four years.
This imply that earnings also tend to revert to the mean.
If more people adopt your strategy, would it not stop working?
If the strategy is so good, why are you sharing it with everyone?
The truth is, investing in CNAV stocks is very unnatural and uncomfortable. Not many people are psychologically capable of investing in this manner.
For example, everybody knows that the strategy to keep lean and fit is to exercise more and eat less. But not many people can execute this strategy to achieve what they want.
CNAV stocks tend to be unknown companies which many investors have never heard of. It is easier to buy a stock that is a household name than an unknown one. Unfamiliar names do not give the sense of assurance to the investors. Investors subconsciously think that these companies are more likely to collapse than ones that they are more familiar with.
These undervalued stocks tend to have problems that put investors off. The business may be making losses, the industry may be in a downturn, or simply the earnings are just not sexy enough. There are many reasons not to like the stock. Similarly, it is much easier to invest in stocks that are basked in good news growing earnings, record profits, all-time high stock price, etc. Investors are willing to pay for good news in anticipation of better news. After all, isnt investing all about buying good companies and avoiding bad ones? This problem is a second-level one. The good news and even potential good news have been factored into the price. In fact, investors often overcompensate for the good news without even realising it.
To make things worse, there is little liquidity in CNAV stocks. The lack of volume increase the doubts about these small companies. We are wired with the herd instinct and intuitively believe such stocks are lousy because few investors are invested in it. We have always based our judgement on the effect of the crowd. We want to buy books and watch movies with lots of good reviews. We like to try the food with the longest queue. We also apply the same crowd effect on the stock market to determine if a stock is good.
Due to the low liquidity, the bid and ask spread tends to be wider. This means that a little buying or selling can move the stock price by large percentages. Such large fluctuations do not bode well with investors as most are unable to handle volatility. Investors tend to overestimate their tolerance for volatility. They want 0%downside and 20% upside. Such investments do not exist in this world. It is a naive demand projected on stock market reality. Sadly, the only outcome is disappointment for the investor.
The reason why value investing works in the first place is because the majority of the investors are unable to overcome their psychological barriers. This results underpricing of value stocks. It is precisely this mis-pricing that we are trying to exploit.
Trend followers are a group of traders who believe that price movements is the most important signal.
Go long if the price trend is up and short if the trend is down. Such a simplistic notion is often dismissed by investors who do not share the same belief. Value investors would find this approach absurd since their mantra is to buy an asset that has gone down in price and not buy something when the price has gone up.
Trend following has a history as long as value investing, with generations of practitioners delivering above market returns.
Jesse Livermore, one of the first trend followers. He was worth $100 million (todays money est. $1.1 to $14 Billion) at the peak of his fortune in 1929.
Richard Donchianmay not be a familiar name to most people. This is despite him being known as the Father of Trend Following. It was Donchian who developed a rule-based and systematic approach to determine the entry and exit decisions for his trades.
The most famous trend following story has to be about the Turtles.Richard Denniswas a successful trader and reportedly turned $1,600 to $200 million in 10 years. He believed that successful trading could be taught while his friend, William Eckhardt, believed otherwise. They had a wager and Dennis recruited over 20 people without trading experience from various backgrounds. Dennis called his disciples Turtles and taught them a simple trend following system, buying when prices increased above their recent range, and selling when they fell below their recent range.
The story was written in the bookThe Complete TurtleTraderby Michael W. Covel
Winning Commodity Traders May Be Made, Not Born.Richard Dennis sharing his top 14 commodity-trading advisers trading performance on WSJ.
The more successful Turtles were given $250,000 to $2 million to trade and when this experiment ended five years later, the Turtles earned an aggregate profit of $175 million. Besides proving that trading success could be taught, it also showed that trend following strategy can produce serious investment gains when executed well.
For time-series Momentum, we decide to go long or short by looking at the historical prices of a security, independent of the other securities. The other form of trend following is known as cross-sectional Momentum whereby we need to compare the historical returns among a group of assets to determine which ones to go long or short. Both approaches have been proven to produce above market returns.
Narasimhan jegadeesh, Ph.D. Finance, Columbia University
Sheridan Titman, Ph.D. Carnegie, Finance, Mellon University
Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiencyby Narasimhan Jegadeesh and Sheridan Titman [The Journal of Finance, Vol. 48, No. 1(Mar.,1993), pp. 65-91.]
One of the most widely quoted and influential research about momentum is Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency by Narasimhan Jegadeesh and Sheridan Titman [The Journal of Finance, Vol. 48, No. 1(Mar.,1993), pp. 65-91.]
Jegadeesh and Titman divided the stocks into 10 groups by their historical performance for the past 3 to 12 months. They went on to observe the performance of these groups in the next 3 to 12 months. The stock selection was purely based on h