The Poor Investor – Investigatory Value Investing

"Faber est suae quisque fortunae" -Appius Claudius Caecus

Category Archives: Books

The Investing Book You Haven’t Read

As a do-it-yourself investor, I love to read investing books. However, there are only a few books that have really had great educational value, the rest were merely entertainment.

Here are the books which have helped me the most:

  1. One Up on Wall Street, by Peter Lynch
  2. The Intelligent Investor, by Benjamin Graham
  3. Poor Charlie’s Almanack, by Charles Munger
  4. Common Stocks and Uncommon Profits, by Phil Fisher
  5. What Works on Wall Street, by James O’Shaughnessy
  6. See below.

Most of these books you’ve probably heard of or read yourself. If you haven’t read them, I suggest you do if you plan on investing on your own. However, there’s one more book (6) that also goes on this list that most people haven’t read. This book, in my opinion, is essential to the go-it-alone investor. The book is called “100 to 1 in the Stock Market,” by Thomas Phelps. The only problem is the book is out of print and hard to find. Your best bet is borrowing it from your local library.

Thomas Phelps offers some good advice as to what to look for when trying to find a 100- to-1 investment:

  1. Inventions that enable us to do things we have always wanted to do but could never do before. 
  2. New methods or new equipment that helps people do commonplace things easier, faster or at less cost than ever before.
  3. Processes or equipment to improve or maintain the quality of a service while reducing or eliminating the labor required.
  4. New and cheaper sources of energy.
  5. New methods of doing essential jobs with less or no ecological damage.
  6. Improved methods or equipment for recycling the materials used by civilized man instead of making mountains of waste and oceans of sewage.
  7. New methods for delivering the morning newspaper without carriers or waste.
  8. New methods or equipment for transporting people and goods on land without wheels.

He even gives 365 examples of 100-to-1 stocks (from 1932-1971) which could have turned $10,000 into $1,000,000 if bought right and held tight.  Some of  the more familiar of these include:

  • J.C. Penney Co.
  • Deere & Co.
  • Abbott Laboratories
  • Dr. Pepper
  • Lockheed
  • Greyhound Corp.
  • Philip Morris
  • Merck & Co.
  • Goodyear Tire & Rubber
  • Motorola
  • International Business Machines
  • Johnson & Johnson

These stocks all gained at least 100x their original value and some obviously much more.

Let’s say you decided to invest using Mr. Phelps’ method using $10,000 (+any additional money for fees).  Furthermore, say you decide to devote a year to trying to uncover 25 stocks which you thought fit the bill as 100-to-1 type companies.  After this, you divide your money equally into the 25, buying $400 of each company, and hold them for 20 years.  If you only identified 3 out of 25 stocks that went 100-to-1, and say the rest went to zero, even factoring in that year you were looking for the stock, you would have a compound annual growth rate of 12.56%, and $120,000.

Here is the CAGR for identifying 1 out of 25 to 10 out of 25:

  1. 6.82%
  2. 10.41%
  3. 12.56%
  4. 14.11%
  5. 15.33%
  6. 16.34%
  7. 17.20%
  8. 17.94%
  9. 18.61%
  10. 19.20%

Even identifying 2 out of 25 is nothing to scoff at, which beats the average S&P 500 return, including dividends, by ~1%.  Not to mention, this method does not include the dividends you might gain from the companies you invest in.

This method, just like any other, is not fool-proof—and although I don’t know the odds, common sense tells me that they are heavily stacked against you in trying to find 100-to-1 type companies.  Keeping that in mind, I leave you with a parable Mr. Phelps shares with us in the beginning of his book:

“Ask and It Shall Be Given to You”

Five poor Arabs slept on the sand. A bright light woke them. Out of it came an angel.
“Each of you can have one wish,” the angel said.
“Praise be to Allah,” exulted the first Arab to catch his breath. “Give me a donkey.”
Instantly a donkey stood at his side.
“Fool,” thought the second Arab. “He should have asked for more.”
“Give me 10 donkeys,” the second Arab begged.
No sooner said than done. He had ten donkeys.
The third Arab had heard and seen how the first two had fared.
“To Allah all things are possible,” he said. “Give me a caravan with a hundred camels, a hundred donkeys, tents, rugs, food, wine, and servants.”
They came so fast that the third Arab was ashamed to be seen in his rags before such an entourage. But his shame did not last long. Deftly his servants dressed him in robes befitting his new status.
The fourth Arab was more than ready when his turn came.
“Make me a king,” he commanded.
So quickly did the crown appear on his head that he bruised his knuckles from scratching where an instant before there had been nothing but an itch. The palace gardens stretched out before him almost as far as the eye could see, and the palace turrets reached so high their pennants were lost in the desert haze.
Having seen his companions in misery ask too little, the fifth Arab resolved to make no such mistake.
“Make me Allah!” he ordered.
In a flash he found himself in sand, covered with leprous sores.

What Works on Wall Street

I recently finished a book entitled “What Works on Wall Street” by James P. O’Shaughnessy. In this book O’Shaughnessy explains the power of passive investing. In fact, O’Shaughnessy goes over several methods of passive investing which lower risk while increasing return, thus highlighting the fact that greater returns doesn’t always come with higher risk.  O’Shaughnessy even shows methods where great risk doesn’t translate into high returns, in fact, sometimes the returns are lower.  In this post I will highlight one of his lower risk methods as well as show you another method which translated into extraordinary gains, albeit with added risk.

The least risky strategy O’Shaughnessy covers is one he dubs “Cornerstone Value.” In this strategy O’Shaughnessy uses Compuset PC Plus, Research Insight, and FactSet Alpha to screen and test stocks. He screens stocks for ones he calls “Market Leaders.” These stocks are non- utility stocks with greater than average market caps, shares outstanding, cashflows, and sales of 50 percent greater than the average stock (this includes ADRs). He then uses $10,000 to buy the top 50 in terms of shareholder yield. He defines shareholder yield as stocks with the highest dividend yield and net buyback activity. O’Shaughnessy would then recycle this strategy every year, buying again the top 50 in terms of shareholder yield.

Over time he found that this strategy would have turned $10,000 into $17,567,144 from Dec. 31 1952 to Dec. 31 2003, versus $2,447,210 for the S&P 500. The amazing part about it was that these results were obtained with less risk using his approach. While the S&P 500 had a Sharpe ratio (reward-to-variability) of 0.42, Cornerstone Value had a Sharpe ratio of 0.65. The minimum and maximum annual return for the S&P 500 was -26.47% and 55.62%, respectively. However, the minimum and maximum for the Cornerstone Value approach was -15.00% and 58.20%. This strategy had 42 positive and 9 negative periods, versus 38 and 13 for the S&P 500. Also, maximum Peak- to-Trough decline was -28.18% for Cornerstone Value versus -44.73% for the S&P 500. Beta was 0.86 for Cornerstone Value and 1.00 for the S&P 500. By now you get a sense of how little risk this strategy carries with it.

Perhaps one of the best strategies O’Shaughnessy shows is one that is extremely simple. Buy 50 stocks with the highest relative strength trading at a price-to- sales ratio less than 1, hold for a year, then recycle. This strategy was able to turn $10,000 into $55,002,724. It had a higher maximum Peak-to-Trough decline of -53.40% versus -50.12% for all stocks during that time period. However, the Sharpe ratio fared better at 0.60 versus 0.46 for all stocks. Beta was 1.08 versus 0.99 for all stocks. In single-year returns it beat all stocks 39/52, rolling five-year compound return 43/48, and rolling 10-year compound return 43/43 times.

Some of you may be wondering at this point why O’Shaughnessy tends to focus on relative strength. What O’Shaughnessy hypothesizes is that by focusing on relative strength investors are getting into a stock as the market is beginning to notice it. By focusing on a value metric like price- to- sales, for instance, investors are making sure they aren’t paying too much for the momentum. However, for some of you interested in the latter method O’Shaughnessy cautions that investors are extremely unlikely to stick to a volatile strategy over the long -haul. The method has a correlation with the S&P 500 of 0.75 and may zig when the market zags. Though, this strategy is more consistent than many of his other strategies and thus the reason I chose it for this writing. But please keep in mind, in order for a strategy to work one must use it through hell and high water, even if he thinks the strategy is failing him. It is this sort of unwavering discipline that separates the successful investor from the unsuccessful.

Additionally, O’Shaughnessy highlights that these strategies can be done holding less than 50 stocks. However, the minimum he recommends is 25. He believes, as mentioned in the above paragraph, that investors are likely to run away from this strategy at the first sign of trouble. The volatility increases tremendously and the correlation with the overall market tends to drop holding less stocks. In his mind investors are much more likely to stick with a strategy that doesn’t deviate from the market too much.

——Written by: The Poor Investor

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