The Poor Investor

Investigatory Value Investing

Tag Archives: James O’Shaughnessy

Bottom Digging During Market Tops

The S&P 500 has nearly tripled from a 2009 low of 735 to 2113 currently.  Just as a rising tide lifts all ships, so too does a rising stock market lift all stocks.  At greedy times like these, investors should be fearful and reexamine their portfolios.

…if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.  -Warren Buffett

Now, I’m not saying the market has reached its peak (though some do make compelling arguments).  I am not a market timer and I’ve written about the folly of forecasting in the past; I’m merely saying a prudent investor should not let greed get the better of him.  The following strategy is one that is more likely to be applicable during market highs as investors are more likely to have a preponderance of stocks trading at prices much higher than their actual values (aka, the rising tide theory mentioned above).

So what to do?  Well, I believe the prudent investor should lock in gains on stocks pushing well beyond their valuations (close to 52-week or all-time highs) and replace them with stocks trading at reasonable valuations.  Mr. Market is offering attractive prices for your stocks, let him have them.

But then we’re left with the problem of finding alternative investments.  As markets keep pushing higher and higher, investors are often left scratching their heads wondering where to find value.  Admittedly, this can be challenging, however, opportunities do still exist.

One place to look as stocks reach all-time highs are stocks reaching new 52-week lows.  Some noteworthy examples include PriceSmart, SodaStream, Turtle Beach Corp., and Fossil.  PriceSmart is the Sam’s Club of Central America and the Caribbean.  It’s trading at a small discount to its sales, has high insider ownership, and has consistently grown sales, 15% on average, over the past ten years.  At its current price of $17.07 after-market, SodaStream trades at a large discount to sales (72% of sales) and is nearly trading at its book value of $16.59.  Turtle Beach has near-total domination in the gaming headphone market with 50% of both the UK and US markets.  It trades at 60% of sales (which it looks to nearly double sales this year) and is led by smart management with a solid near-term plan, and patents, to enter industries such as health, automotive, TV and mobile.   I’ve already written my take on Fossil, you can read it here.

The next place to look is at overlooked stocks (often smaller capitalization, less than $100m) in industries where there is a low supply of investment opportunities.  One such industry is the coffee industry.

Now, before going into individual companies, let me preface this discussion by first noting some interesting dynamics at place in this market.  For one, coffee consumption is not nearly what it used to be.  In fact, in 1946 consumers drank 46.4 gallons of coffee per person (Figure 1).  Today, even with a coffee shop on every corner, consumers drink less than half as much at only 20-25 gallons of coffee per year as coffee was replaced predominantly by soda.  As consumers become more health-conscious, pop consumption should decrease and coffee, as a viable, healthy alternative, should have an increased level of consumption.  Secondly, there is a shift taking place where high-quality shade-grown coffee (high cost to grow) is being overtaken by the rise of poorer quality shade-free coffee (cheaper to grow).  This makes coffee plants much more susceptible to climate change and topsoil erosion.  As climate change concerns begin to grow, the downfall we’ve seen in coffee prices from $300 in 2011 to a current 52-week low of $140 is not likely to last.

Figure 1

Figure 1

Now, opportunities in this market surely exist in the form of large companies.  There is, of course, Green Mountain Coffee Roasters and Starbucks, but investors in those companies will soon bail when they see these companies for what they are—overvalued.  Starbucks trades at an all-time high ($94.30) and the highest price-to-sales ratio it has ever seen in the last ten years of 4.12.  Starbucks also trades inversely to coffee prices.  Green Mountain Coffee Roasters ($124.10) shares trade even higher at a price-to-sales of 4.31 and, like Starbucks, it is also inversely correlated to coffee prices.  As coffee prices rise investors will bail on these two companies (and valuations will come back down to earth).

So when investors bail, where will they look?  On the conservative end is Coffee Holding Co., trading at 28% of its total sales.  This company is well-managed by its owners, experienced coffee industry veterans, who have a 10% stake in the company’s shares.  They also support and believe in sustainable practices.  These beliefs lead to production of higher quality coffee (shade grown) that is not as susceptible to soil erosion and climate change.  Furthermore, as experienced coffee experts, they are well-hedged against fluctuating prices.  On the risky end is Jammin Java, better known by its Marley Coffee, which is trying to force itself to turn things around before it does a complete nose-dive.  If company-estimated year-end sales are to be believed, the company trades at a 10% discount to expected year-end sales.  However, this company is only for high-risk-oriented individuals who don’t mind getting cleaned out if things turn south.

Then, there’s the oil industry.  I don’t think I need to go into this a whole lot as many have already witnessed the price collapse at the pumps, so suffice it to say that there are many opportunities to be had in this sector, both large cap and small, and everything in between.  (Check out Cale Smith’s recent notes about the oil price phenomenon).  I’m pretty sure you could throw 10 darts at oil stocks right now and make at least 8 solid investments.

Another interesting idea is James O’Shaughnessy’s strategy of looking for stocks that he calls Reasonable Runaways.  These are stocks that have a high relative strength, greater than $150m in market cap and trade at a price-to-sales ratio less than 1.  I’ve modified this strategy a little bit by including companies that have large amounts of cash in excess of debt.  Some notable examples include FreightCar America Inc., BeBe Stores, Men’s Wearhouse, LSI Industries and FujiFilm Holdings.  While I have not had time to look into each of these companies it doesn’t matter— the theory of the Reasonable Runaways strategy is one of investor agnosticism.  The theory says that you are buying $1 worth of sales for less than a dollar (low P/S) just as investors are realizing the company is undervalued (high relative strength).  You simply run the screen, buy agnostically, and diversify your portfolio by giving equal weight to the top 20 or so companies with the highest price appreciations.  Sell after a year then repeat the process.  Since 1951 this strategy had a compound annual growth rate of over 18%.

While the S&P 500 may have reached its top, your portfolio doesn’t have to top-out.  You can simply shift your current best performers to companies that offer greater opportunity and more attractive valuations.  Employing several different search techniques, such as those mentioned above, can get you on the right track to optimizing your portfolio towards value and thus reducing your overall risk by increasing your margin of safety.  But don’t forget to hold on to a fair amount of just in case cash for when the market does plummet.  You’ll want to have that cash in your back pocket to snatch up undervalued companies when the falling tide lowers all the ships again and more opportunities abound.

Disclosure: Long Coffee Holding Company (JVA) and Fossil (FOSL)

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.


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