The Poor Investor – Investigatory Value Investing

"Faber est suae quisque fortunae" -Appius Claudius Caecus

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.

Recommendation Update

I am retracting my buy recommendation on Heska due to new information obtained about the company. All the posts below will now have Heska crossed out.

Bull Markets, Mega Caps, and College Campuses

Sir John Templeton famously said, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” As we know right now, we are still no where near the “euphoria” stage, even though the markets have had an impressive run, with the S&P 500 alone up 15% YTD.

I would like to share a video with you from Davis Advisors that I think is helpful during this time. This may not be new information, but I think it’s good to have a refresher every so often, think of it as mental flossing:

Davis Funds: Insights

Also, according to Ken Fisher’s research, this “phase” of a bull market is usually best for mega-cap stocks. To his point, I do see value in companies such as Apple, Berkshire Hathaway, Eli Lilly, Sanofi, Proctor & Gamble, and Kimberly-Clark, to name a few.

I would also like to reiterate my “buy” recommendation on Heska (pick removed due to new information: 01/03/2013), Dell, Nvidia, and Atrion. Dell has been particularly attractive as of late as it hit a new 52-week low which it has since bounced off of quite nicely. I hope you took advantage, as my readers, and picked up shares along with me.

I would also like to add one more recommendation: American Campus Communities. Ron Baron explains the moat:

“There are five million obsolete college campus housing units that need to be replaced and renovated. Colleges can’t afford to do this. That’s the growth opportunity. American Campus is the largest provider of such housing with nearly 70,000 units. It builds and owns housing on college campuses with 80 year land leases that prevent others from competing against them.”

Not to mention, the company has an 11% profit margin and a 3% dividend. Also, as housing comes back, this stock will rise with the tide. Revenue and operating cash flow have steadily increased over the past 10 years (10-year average for revenue: 25.35%) while operating margins have remained near 18-25% during this time. With a moat firmly in place, I see no reason for this not to continue.

What I would not be holding now: bonds, gold, cash.

Disclosure: Long DELL & NVDA

Higgs Boson, Markowitz, and Graham

From Roumell Asset Management’s quarterly report— I feel this exemplifies the philosophy I espouse on this website quite well.  

A “unified theory” has long been the Holy Grail in theoretical physics that could account for both subatomic and universal realities. It appears the field has made a giant leap forward with the recent discovery of the Higgs boson particle, commonly referred to as the “God particle.” Higgs boson accounts for the various strains of information, analyses, and data that physicists, working with different approaches, have gained over the years from their efforts to better understand our universe. While some physicists prefer to focus on big-picture questions like how time and space interact, others prefer to ask why some particles have mass, while others, such as light, do not. Different starting points, same goal: knowledge.

Although investing is certainly not a hard science, it too has long pursued its own unified theory. On the one hand, financial planners and advisers use asset allocation to construct portfolios with multiple asset classes in order to spread risk and reduce volatility. Harry M. Markowitz is known for his pioneering work on Modern Portfolio Theory. Markowitz’s Portfolio Selection, which he wrote in 1952 while a graduate student at the University of Chicago, serves as the framework for planners using asset allocation as the primary portfolio construction tool. Markowitz argued that a portfolio should be designed using uncorrelated asset classes to maximize returns with the greatest efficiency (reduced volatility).

The shortcomings of the asset allocation model include today’s high level of correlation among asset classes. In addition, performance is tied to overall market returns and leaves little opportunity to exploit market inefficiencies. Of course, many investors in this camp believe security prices reflect all known information and are thus always efficiently priced.

In contrast to the investment allocators are individual securities investors. For value investors like us, Benjamin Graham wrote the gospel with its emphasis on specific security characteristics, margin of safety, and the temperament to see the process to fruition. Graham elegantly stated in 1934, “The field of analytical work may be said to rest upon a two-fold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for those disparities to correct themselves.” The mantra for security-specific investors is that market price diverges from intrinsic value often enough to add investment value, particularly in smaller overlooked and/or out-of-favor securities.

As decided adherents of the security-specific, bottom-up value investment camp, Roumell Asset Management does not begin with a belief that we should own a little of everything. Rather, we begin by searching for value in the marketplace, wherever it may be. We firmly believe that obsessing about price paid has a far greater impact on securing respectable returns than gauging what John Maynard Keynes referred to as “the average opinion of the average opinion.” There are multitudes of analysts, commentators, and investors putting forth their opinions about the upcoming direction of gold bullion, U.S. Treasury bonds, and the stock market. We have nothing of substantive value to add to this conversation. It’s not what we do.

A subtle but highly important distinction in reviewing market efficiency literature is necessary, in our view. To paraphrase Warren Buffett, the difference between markets being mostly efficient and always efficient is the difference between night and day.  Interestingly, Berkshire Hathaway seeded additional capital to its two recently hired portfolio managers and gave them authority to manage the funds “exactly as they see fit.”

The reasonable question to ask then is how much should a portfolio be constructed with an emphasis on hitting all the major asset-class boxes (large cap growth, small cap value, emerging market stocks, corporate bonds, etc.) versus putting together a portfolio of security-specific-focused managers with the latitude to go anywhere in their search for value? In other words, rather than arguing about who’s “right” perhaps it’s more reasonable to simply ask: How much Markowitz and how much Graham does an investor want in his or her portfolio? An allocator only need believe that markets are inefficient enough to warrant some exposure to security-specific, bottom-up investors, be they growth or value oriented.

We do not seek to change any investor’s mind regarding investment philosophy. Rather, we want our investors to understand our investment philosophy. Our clients can trust that 100% of our own investment capital will remain invested in our portfolio options because determined research, a deep appreciation for value, a contrarian bent, and a steady temperament are what make the most sense to us.

Notes from The Poor Investor:

 It never hurts to reiterate your basic investment philosophy or tenet to see if your actions correlate with that philosophy/tenet.  If they are out of sync either: a) change your actions, or, b) change your philosophy.  However, as a word of caution, before you start investing heavily on your own you should have a philosophy that is sound (meaning it stands the common sense test), proven (is backed up by reliable data/facts), and unchanging (is time-tested and perfect enough that it does not have to be modified).  If you are constantly changing you investment philosophy and/or method of investing then you are setting yourself up for failure.

And with that I’ll leave you with a quote from James P. O’Shaughnessy:

“…we can see the simple truth that using simple, straightforward and time-tested investment strategies leads to the best overall results in virtually all market environments.”

What’s Next?

A lot has happened since I last wrote…  Mitt Romney chose Paul Ryan to be his running mate.  The European Union seems to have gotten its act together, financially speaking.  Facebook reached a new low and Amazon reached a new high.  Even the auto market has maintained most of its steam in the wake of the European Crisis.  In conjunction with this mostly good news, the stock market has also risen to new heights—following its usual trajectory during an election year.

So what does this mean for the future of the stock market?  Well, I will not pretend to know what will happen with the stock market overall, but there are still plenty of stocks out there that I think will provide favorable returns for those who buy individual stocks.  Some of these names will be familiar, some not.  Bargains come in all shapes and sizes (see Ken Fisher’s Debunkery for more on that).

In regards to the aforementioned “bargains,” let’s start with the more familiar.  At a price-to-sales ratio of 0.3 and a dividend of 3%, Dell is my favorite pick out of all the bottom-dwellers.  There is fear that Dell might be a “value trap” and this very well could be, although, I believe Black Friday and Christmas will serve as important catalysts.  As I type from my Alienware computer (Dell-owned), I remember bargain-hunting for it around the same time as the holidays were fast-approaching.  Also, there is a high margin of safety in that Dell is largely considered a value trap.  Value traps may trap buyers, but usually don’t go any lower.  In the end, the catalysts may prove false, but the stock should not depreciate much from this price.

The next in the “familiar” category, is Nvidia.  Now, this may not be familiar to all, but, computer geeks should be plenty familiar with this company.  Although Nvidia was snubbed by Amazon, its new chips are used in Google’s Nexus 7 and will be used in Microsoft’s new Surface tablet.  With around $5/share in cash, the company is effectively trading at  near 11x earnings, for a company that usually trades around 14x earnings.

In the “unfamiliar” category, the company I’d like to start with is Heska.  This company operates in the veterinary market, selling diagnostic equipment and other products to veterinary clinics.  This is a growing market and its growth is expected to continue well into the future.  The company trades with no debt, 16% of the share price is accounted for by cash, and it has a dividend of 4.60%.  As a smaller company, it is still speculative, and will require more due diligence than the more familiar companies.  However, there is more room for reward here if the company can successfully navigate the next few years.

Last, and also in the unfamiliar category, is Atrion Corporation.  This company has shown tremendous growth potential in a growing market— healthcare.  The company manufactures cardiovascular, fluid delivery, and ophthalmic devices.  It has also ranked highly over the years in Value Line’s “earnings persistence.”  The company has a small dividend (1%), positive cash per share, no debt, and boasts a profit margin of 20%.  Although the company has faced some headwinds as of late, it seems poised to perform well in the coming years.  This is another long-term growth story that will require proper due diligence.

In the face of what else is to come, be assured that there are still plenty of stocks out there whose performance will have nothing to do with what else is to come.  These are just a few of them that you might be interested in.  Feel free to mention some more that you think offer a better opportunity for potential price appreciation over the next few years.

Until next time…

The Poor Investor

Thank You Facebook and Morgan Stanley

There is much to be said about the Facebook IPO but suffice it to say it was a huge disaster.  There was even talk in the Wall Street Journal about how the whole debacle may have hurt overall investor confidence.  Not surprisingly, the average Joe is probably more than likely to avoid IPOs in the future.  But would the average Joe be right to do so?  Maybe investors should thank Facebook and Morgan Stanley for botching the offering and turning them away from IPOs.

“Three out of four have been long-term disappointments,” said famed investor Peter Lynch of IPOs.  Let’s see if he is right.

From November 1st, 2010 to May 26, 2011 there were 157 IPOs for which I found accurate data.  If you had invested $100 in each of them at their initial offering price, you would have $14,735 today— a total loss of $965.  If you include brokerage fees, assuming $7 per stock bought, you’d be in the red by $2064, not including the fees to sell.  Your chance of investing in one of those 157 IPOs and actually making money (>$1): 36.3%.  Doubling your money or greater: 5.7%.  Hitting a ten-bagger: 0.0%.  Losing 50% or more: 24.2%.  Losing it all: 1.9%.

Turns out Peter Lynch wasn’t too far off.  Out of the IPOs investigated, approximately 3 out of 5 turned out to be long-term disappointments.

After looking over the data it’s unlikely that you’re going to do well with an IPO.  The odds are stacked against you.  Even worse, most companies are too new to have a history to go off of.  There’s also no guarantee that you’re going to get the IPO price.

When asked which stocks he’d avoid in the market at the Berkshire Hathaway annual meeting, Charlie Munger replied, “new issues.”  Perhaps investors should heed that advice.

Where to Look for Opportunities

In light of the recent plunge in Green Mountain Coffee Roasters’ (GMCR) share price, I thought it rather fitting to talk about where to look for opportunities in the stock market.  In my opinion, there are always opportunities out there.  Sometimes they’re hard to find, such as Vermillion, sometimes they’re right out in front of you, such as GMCR.  However, the real crux of the situation lies in deciphering whether they’re good opportunities, like buying shares of BP after the spill turned out to be, or bad ones, like buying shares of Kodak.  In choosing one versus the other, I’ll leave that up to you.

So just where do we find opportunities in the market?  Well, the question may not always be best posed as “where,” but instead, sometimes, as “when.”  The easiest when to look for opportunities is during a bear market, like the one that just occurred in the 2007-2009 period.  During this time, untold numbers of stocks were dirt cheap.  Berkshire Hathaway, perhaps one of the safest investments (perhaps even safer than US treasuries) was selling at nearly half of today’s price.  Another when is during a period of extreme panic or distress for an individual company, such as is the case of the aforementioned shares of GMCR, BP, and EK.  Even whole industries succumb to such malaise from time to time.  Coal, for example, is one such industry; shares of Peabody Energy Corp. and Arch Coal could prove to be bargains at these prices.  During a company’s turnaround also provides another when for shareholders looking for opportunities.  Successful turnarounds such as Ford Motor Co. and Nautilus Inc. (chart) come to mind here.

Sometimes market opportunities are pretty obvious.  Look for companies that are buying back their shares.  Warren Buffett bought IBM while it was reaching new highs partly due to the company’s diligent use of capital to buy back its own shares.  Look for companies trading below book value, below sales, with high dividend yields, at low price-to-earnings, low price-to-cash flow, near current company cash levels, and those growing at high returns on capital.  Current stocks that fall into some of these categories are names such as Hewlett-Packard, Chevron, and Exxon Mobil.  Companies on the verge of merging and those that are going private may also provide more obvious opportunities for investors.  US Airways, on the verge of a merger with American Airlines, could provide one such opportunity.

Sometimes the opportunities aren’t so obvious.  Companies that are on the bleeding edge of technology or the verge of new breakthroughs are of this type.  Vermillion, for instance, shot through the roof when it received FDA approval for its OVA1 cancer test.  Dendreon (DNDN) also saw its shares soar after receiving FDA approval for its cancer drug, Provenge.  In these instances, knowledge is your most important ally.  If you had followed the latest cancer research, as well as all the companies involved, with extreme dedication and focus, you may have also uncovered these opportunities.  Although these types of stocks can be found in any type of market, healthcare, biotechnology, cloud computing, and energy are some of the more common ones at this time.  Other less-than-obvious opportunities come in the form of companies exploring for vast natural resources or those that are highly leveraged, though these, especially the latter, require shrewd calculating as to what really is the risk-reward and whether or not its favorable.

The opportunities in the stock market are nearly limitless.  It all depends on the level of involvement you are willing to have to unearth them.  The list above is not nearly as exhaustive as it could be but hopefully serves as it was intended, to give you an idea of how to think about where to find market opportunities.  Don’t limit yourself to the obvious, as Ken Fisher says in his book, The Only Three Questions that Count, “Go crazy. Be creative. Flip things on their heads, backwards, and inside out. Hack them up and go over their guts. Instead of trying to be intuitive, think counter-intuitively—which may turn out to be way more intuitive.”  Sometimes finding opportunities means knowing where not to look just as much as knowing where to look.  And lastly, don’t mistake an opportunity for a good investment, only invest when the risk-reward is in your favor.

“Sell in May and Go Away!”

After reading this week’s Barron’s I saw an interesting little chart that showed the growth of $100 if the “sell in May” strategy were followed, also known as the Halloween indicator (original research paper).  Surprisingly, if you had followed a strategy of investing $100 in the S&P 500 since 04/30/45 during October – April periods versus May – September periods, your $100 would have turned into $9329 in the former period versus $99 in the latter.

The chart in Barron’s:

One would think, after seeing this chart, that selling in May, or maybe even April to get ahead of the curve, would be a prudent investment strategy.  However, if you extend the timeline out a bit more you get a picture that looks like this (this chart uses May-Oct. and Nov.-April, however, it is more representative due to the fact that the months are split 50/50, as opposed to 58/42 in the above chart):

Now, you may have noticed that November – April still outperformed.  However, clearly, if you had ignored the period from May – September you would have missed out on some nice gains during this time frame, as a buy-and-hold strategy through all periods worked best.  But what is the difference in periods due to?  If you look at the average returns by month since 1925, you’ll see quite readily:

It seems one of the major culprits is September.  So why not sell in September?

As Ken Fisher points out in his book “Debunkery,” from which this chart was first found, the two worst Septembers (which are notably in the May – October period) were down 29.6% in 1931 and 13.8% in 1937, due to the Great Depression.  All other months, on average, offered gains over the long haul.

What else accounts for the big downtrend in the May – October period:

  • Panic of 1901: May 17, 1901
  • Panic of 1907: October 1907
  • Black Monday: October 19, 1987
  • Friday the 13th mini-crash: October 13, 1989
  • Economic crisis in Asian: 1997 mini-crash: October 27, 1997
  • September 11th attacks: September 11, 2001
  • Internet bubble bursts: October 9, 2002
  • Global Financial Crisis starts: September 16, 2008
  • 2010 Flash Crash: May 6, 2010

To name a few…

Who is to say the next big stock market crashes won’t happen to coincide with April or July, the best performing months on average?

Bottom line: Don’t rely too much on statistical anomalies and try to “time the market” or you might be left holding the bag.

—-Written by: The Poor Investor

Is Diversifying Your Portfolio Harder Now?

I was reading an article from Fidelity called “Where to Look for Returns” and came across an interesting table I wanted to share with all of you:

For those of you looking to diversify your portfolios this appears to be a lot more difficult nowadays.  It also appears that these high correlations are not going to change anytime in the near future.  Furthermore, it is my belief that return enhancement via the effects of rebalancing (great article about rebalancing) may be reduced due to these high correlations.

Note: Personally, I use TIPS for portfolio diversification since historically (and currently) they still have the lowest correlation to equities.

—-Written by: The Poor Investor

Are You Wired for Investing?

Dear Readers,

Recently I came across a website that offers a variety of tests for investors and investment advisors: MarketPsych.com.  The test I found most beneficial on the website is for individual investors and is based off the Five Factor Model, also known as the “Big Five.”  In order to not interfere with the test validity I will not discuss too much more about it.

Link to test:

Individual Investor Personality Test

Here is another test, which tests your “Wall Street Risk IQ.”

Feel free to post your results and comments regarding whether you agree or disagree with the personality test.

—The Poor Investor

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