How To Make Money In Value Stocks 2013 - Stockopedia

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2012 EditionHow to Make Money inValue StocksEverything you need to know to about the mostprofitable investing strategy everEdward Croft, Ben Hobson & David Brickell

HOW TO MAKE MONEY IN VALUE STOCKSby Edward Croft, Ben Hobson and David BrickellFirst Edition published by Stockopedia Ltd 3rd April 2012 Stockopedia 2012, All Rights ReservedStockopedia LtdOffice B224Macmillan HousePaddingtonLondonW2 1FTTelephone 0203 287 1269www.stockopedia.co.ukDisclaimerWhile every precaution has been taken in the preparation of this book,the authors and publisher assume no responsibility for errors oromissions, or for damages or losses resulting from the use of theinformation contained herein.In other words, if you do decide to trade with value investing principles,be aware of the risks, do your own research and seek professionaladvice!i

Section 1IntroductionThere are very few certainties when it comes to stock market investing,but here is one: in the coming months a previously unloved,misunderstood and undervalued company will make its shrewdshareholders a lot of money. It won’t be the only one.That prediction might be a little awry. While the expected surge in valuemay be months away, it could be weeks or even years. But for thoseinvestors that have spotted a pound that is currently valued at pence,timing isn’t quite as important as inevitability. Everyone else has got itwrong and sooner or later that stock will fly.Very few investors can resist the idea of seeking out a bargain but mosthave no idea how to do it. Too often, new investors in the stock marketare seduced by the latest frothy IPO or the hot exploration stock that allthe brokers are talking about. This book is about how you can makebetter profits in the market by focusing on neglected value stocks usingsome simple, modern and effective techniques.We will explore the origins, the concepts and the specific methods usedby some of the world’s most famous Value Investors as a means ofgenerating phenomenal wealth. At a time when investors are bombardedby information at an almost unbearable rate, this book is a critique ofwhat works and why and how individual investors can apply ‘City grade’information, thinking and investment models to their own advantage.More specifically, this book has been produced for subscribers ofStockopedia (www.stockopedia.co.uk), an web application and referencethat gives individual investors the upper hand by providing all theessential data, analysis and fundamental metrics they need to makewell-informed decisions.All of the strategies discussed in this book are being tracked in real-timeas part of our Stock Screening Centre, in some cases for the first timepublicly for UK stocks. At Stockopedia, we are ardent believers inlearning to make smarter investments and aim to arm investors with theknowledge, data, resources and ideas that they need to make money inany market. We hope that this guide helps you in your value investingjourney.2

Who, Why, What?1Why value investing is themost profitable investingstrategy of all time, who areits greatest advocates andwhat the investmentexperts are now getting sowrong.

Section 1What is valueinvesting?“Nowadays people seem to know the price of everythingand the value of nothing.” Oscar WildeStock market investors can broadly be defined as fitting one of a handfulof categories, among them: value, growth, momentum and income.There are a thousand analysts who would beg to differ on thatsimplification so we will qualify it by saying that there are off-shoots to allof those categories, and in some cases it’s difficult to try and separatethem. After all, who wouldn’t want to buy a cheap stock? And whowouldn’t be on the look out for a business, and a stock price, that willgrow?Nevertheless, at its core, the value investing school is a distinctphilosophy which involves searching for what is out of favour in order tofind a bargain.Value investing is simple For investors that are about to embark on a value investing strategy,there are two pieces of good news. The first is that bargain hunting, orbuying nickels for dimes, or however you like to view it, is among themost clear-cut strategies in investing. No-one can argue about theobjective or the intended result – it is the search for cheap stocks thathave been mispriced and will eventually rise in value and deliver a profit.The second piece of good news is that there are really only a handful ofkey principles that a successful Value Investor needs to focus on whenconsidering a purchase. Firstly, what is the stock’s intrinsic value (or howmuch is it really worth?) and secondly, are you leaving yourself a wideenough margin of safety to protect yourself from the vagaries ofunknowns to ensure a good return?So the basics are pretty basic. If you compare the price of a stock withyour confident valuation of its true worth and find you can buy itcomfortably lower than your required margin of safety then you may beon to a winner. but it’s not easy While that may all sound simple, value investing is much harder than itlooks because it runs against almost all human instincts. Investors feelsafest when buying the same stocks as everyone else and have atendency to favour glamour stocks in fast growing industries. Who wantsto be the guy holding the bombed out engineering stocks when everyoneelse is buying Apple?It is hard to develop a conviction about buying companies experiencinghard times, operating in mature industries, or facing similarly adversecircumstances and even harder to hold onto them in the face ofconsensus opinion and market volatility.4

which is precisely why it works But it’s precisely these behavioural tendencies that lead to so manyinvestors over-reacting and driving prices down so low in value stocks. Itis this over-reaction that leads to under-valuation which in turn providesthe profit-making opportunity for the Value Investor.As a result, the aspiring Value Investor must become immune to theseemotions and learn to be highly contrarian and stoic in nature, buyingwhen the irrational ‘Mr Market’ is selling and selling when he starts toagree with him. It is this contrarian nature that leads to significant payoffsas we shall see.Josef Lakonishok, Joel Greenblatt and Warren Buffett - will continue tobe hugely influential figures in investing circles.But before we get into the detail of the techniques, it will pay dividends todig into the track record of value investing’s most famous sons. Thefrankly astonishing profits of this group of investors illustrate why valueinvesting is the King of all stock market strategies.There are many approaches to harvesting value profits In the coming chapters, we will explore each of these key principles andideas in greater detail, identify some shortcuts to finding value stocksand consider five different value investing strategies that have beendeveloped by some of the world’s most successful investors. ValueInvestors can be broadly defined as fitting one of two distinct categoriesdepending on how they tackle the job at hand – they are either ‘valuehunters’ or ‘value farmers’. While hunters such as Warren Buffet focuson making large, highly focused bets on single stocks, the farmers takethese value investing ideas and apply them in a broader portfolio fashionin order to ‘harvest’ value-based profits from the market in a systematicfashion.While contradictory, these approaches have been shown to be equallysuccessful in generating profits for their adherents and as a result willensure that their authors - including Ben Graham, Joseph Piotroski,5

Section 2How profitable canvalue investing be?“I always knew I was going to be rich. I don't think I everdoubted it for a minute.” Warren BuffettTo answer this question it pays to go back to the beginning. While valueinvesting has roots that are as old as the Bible, it wasn’t until the 1920sthat professionals and academics began documenting their theories andtechniques. Many of those approaches have stood the test of time andelevated their practitioners to near legendary status as some of thewealthiest men of any day.Introducing an academic that made a fortune To start anywhere, you have to start with Benjamin Graham. Graham iswidely regarded as the Father of value investing as well as the wholeindustry of Security Analysis. This influence stems not only from hispublished works but also from the eventual fame and fortune of thepupils that he taught at Columbia University.In 1926, Graham started a partnership with Jerome Newman whichlasted until his retirement in 1956. Due to his personal experiences withthe great crash of 1929, he became pre-occupied with value and safetyand while lecturing at Columbia University published ‘Security Analysis’with a colleague David Dodd. It was a seminal moment. In the aftermathof the Great Depression, the two men deconstructed some early mythsabout how companies should be valued and urged savvy investors toscrutinise out-of-favour and apparently mispriced stocks foropportunities.Graham’s philosophy was to invest systematically in extremelyundervalued stocks seeking protection from individual bankruptcy byintroducing significant diversification and buying stocks at deepdiscounts to their true worth. It is thanks to Graham that we have awhole catalogue of bargain stock strategies at our disposal with suchobscure titles as ‘Net Nets’ and ‘NCAV’ and a whole ream of otherconcepts that we’ll explore, including Margin of Safety and Mr Market.In spite of being personally wiped out in the 1929 stock market crash, bythe time the Graham-Newman partnership was closed it had deliveredan average 17% annualised return to investors, outperforming themarket by a considerable margin and making the elderly Graham anexceptionally wealthy man.A lucky class While Graham was clearly an exceptional investor, it was those thatstudied under him that really shone. His most famous student was a manthat needs no introduction – Warren Buffett – who is now one of therichest men in the world. Famously, having taught Buffett classes atschool, Graham turned him down for a job, but Buffett persisted andeventually joined the partnership where he worked side by side with afew others by the names of Walter Schloss and Tom Knapp. These6

individuals who worked with Graham and others who studied under orwere influenced by him (such as Bill Ruane who managed the Sequoiafund) are all said to be schooled in ‘Graham and Dodd’ style valueinvesting.Is it likely that a group of individuals from the same school of thoughtcould all go on and beat the market for over a generation? For much ofthe last 25 years, academics have claimed that it would be impossibleand that anybody who has managed it must just be lucky. Nobel Prizeshave been lauded on these academics who have ‘proven’ that marketsare efficient. They claim that the market is a ruthless mechanism thatacts to instantly to arbitrage away mispricings so that the current price ofa stock is always the most accurate estimate of its value. If this so-called“Efficient Market Theory” is correct, then what hope can there be forstock pickers versus mechanical low cost index funds that track themarket?He asked investors to imagine that every American starts with a dollar ina coin flipping competition. After every round they lose or win that dollar.In only 20 rounds the 225 million who started would be reduced to just215 people holding all the cash and inevitably feeling a bit pumped upand egotistical. Now these academics would have you believe that you’dget the same results by re-running the experiment with orang-utans, butBuffett asked: what if you found that all those orang-utans came from thesame zoo and had been trained by the same zoo-keeper? You’dprobably want to find out more about his methods.InvestorNo. of YrsAnnualisedReturnS&P / DowReturnBuffett Partnership1329.5%7.4 % (Dow)Walter Schloss2821.3%8.4%Tweedy Browne1620%7%Bill Ruane1418.2%10%Charlie Munger1419.8%5.0% (Dow)Pacific Partners1832.9%7.8%Perlmeter Investments1823%7.0 % (Dow)Talented coin flippers?Astonishingly, in spite of the incredible assumptions on which thisconcept is based, the idea and maths of efficient market theory has hada major impact on the professional investment community. The growingdenial that markets can indeed offer up gross mispricings led to WarrenBuffett weighing into the argument in 1984 with a first class articleentitled “The Super-Investors of Graham and Doddsville”.In it, he demolished the academic theorists with an extended monologueexplaining why the performance history of Value Investors like WalterSchloss and Charlie Munger simply could not be explained by luck.7

“I think you will find that a disproportionate number of successful coinflippers in the investment world came from a very small intellectualvillage that could be called Graham-and-Doddsville.”In the paper, Buffett shows the track records of each of nine of thesedisciples of Graham and Dodd showing that they all generated annualcompound returns of between 18% and 29% over track records lastingbetween 14 to 30 years. Is it likely that these individuals from the sameschool of thought could all beat the market over a generation if the stockmarket was a place of luck? Warren Buffett doubted it most eloquentlywhen he said “I'd be a bum on the street with a tin cup if the market wasalways efficient”.Eventually even the academics start to cave in Despite being generally deaf to Buffet’s argument, the academicconsensus on efficient markets began to crack in 1992 with a paper byFama and French at the University of Chicago Booth School ofBusiness. They found that small cap stocks with a low price-to-bookvalue (i.e. value stocks) produced a basket of shares that outperformedthe rest of the market, effectively admitting that markets aren’t entirelyefficient.Two years later, a paper by Lakonishok, Shleifer, and Vishny split USstocks into ‘value’ and ‘glamour’ segments and concluded that, prettymuch whatever your definition of value was, value stocks consistentlyoutperformed glamour stocks by wide margins. Following up on this andother studies, Lakonishok concluded that value investing was likely toremain a “rewarding long term investing strategy”. As we will see laterLakonishok has certainly put his money where his mouth is – he hasturned his hand to running his own fund management firm withastonishing results.Responding to criticism that maybe Lakonishok’s findings were just a USphenomenon, the Brandes Institute in 2008 expanded on his work doneto include developed markets in North America, Europe, and Asia. Theyfound that value stocks did well on an individual country basis and in theaggregate, noting that while the degree of outperformance varied, themost significant finding was its consistency. Across valuation metrics,across time, across regions and across market capitalisations value wonout! This was confirmed when Robery Kahl, of US fund manager SabinoAsset Management, scrutinised ten academic studies on the subject andfound in all ten cases that the value portfolios outperformed the growthportfolios.So, in conclusion, there has never been any shortage of so-calledexperts, gurus, charlatans and rogues to advise the unsuspectinginvestor on failsafe ways to make money on the stock market. Youshould approach such claims with the scepticism they deserve. In thecase of value investing, however, the weight of historical and academicevidence is really overwhelming in support of its effectiveness. In thenext chapter, we’ll consider why this is.Further ReadingThe Super Investors of Graham and Doddsville - Warren BuffettWhat has worked in investing - Tweedy Browne8

Section 3Why does valueinvesting work?“Take all the fools out of this world and there wouldn't be any fun living init, or profit.” Josh BillingsSo value investing works. It’s been proven in the wild, it’s been tested inthe lab, it’s made people rich but if everyone knows that pastperformance is no guide to the future how can we be so sure that it’sgoing to work that we are willing to risk our capital?The reason value investing will continue to work is because humanbeings are fundamentally emotional and social creatures that exhibitpredictably irrational behavioural tendencies. Until the day (god forbid!)that man and machine become one and these tendencies are‘debugged’ from our habits, value opportunities and mispricings willcontinue to be available to in-the-know contrarian investors.Why do stocks become excessively cheap?There has been a flow of research in recent years into an arcane fieldthat aims to understand how human beings make decisions and whythey make them. So called ‘Behavioural Science’ has over the last 30years shown that we are not as rational as we would like to think. In factwe suffer from a whole ream of persistent mental biases andjudgemental errors that include: !Overconfidence in our abilitiesOne study has indicated that 93% of drivers believe that they are betterthan average which is clearly absurd. Stockpickers are no different. !Projecting the immediate past into the distant futureWhy is it only when a stock is going up that everyone wants to buy it?More investors want to buy it the more expensive it gets. !An excessive aversion to taking lossesPeople hang on to their losers and sell their winners! !Herd behaviour driven by a desire to be part of the crowdThis leads in its extreme to bubbles like dot com mania and the shunningof stocks at new lows. Misunderstanding randomnessSeeing patterns that don’t exist . Tea Leaves, Candlesticks andIchimoku Clouds anyone? !“Anchoring” on irrelevant informationIf you’ve ever seen the maven for a particular stock banging on in abulletin board you’ll understand this one!These ‘bugs’ in the human mind lead us into making systematically baddecisions at all points in our lives but especially in our financial lives. It’seven been shown that Market Professionals can be more prone tobiases than individuals due to the extra information that flows on theirterminals and the general over-confidence that comes with the territory.When such vast sums of money are being poorly allocated by error-9

prone individuals mispricings are bound to crop up which provideopportunities for the more stoic Value Investor.These mispricings happen both on an individual stock by stock basis butalso to the market as a whole. The tech bubble of the late 1990s and themore recent credit bubble/crunch showed how the market is subject tofads, whims and periods of irrational exuberance and despair. ValueInvestors need to cultivate and practice the ability to stand apart from thecrowd and develop a contrarian instinct to take advantage of these fads,rather than being seduced by them.For these reasons, Warren Buffet has observed that investing is not agame where the guy with the 160 IQ beats the guy with the 130 IQ.Instead, “once you have ordinary intelligence, what you need is thetemperament to control the urges that get other people into trouble ininvesting”. As a Value Investor, you have to buy whatever other peopleare selling and when other people are selling it, which is apsychologically difficult thing to do – “value managers have tounderstand their biases. They know they are scared, but they have toalso train their brain to buy at very scary moments, because that’s whatreally allows people to reap maximum rewards.”What real world catalysts drive stocks to extreme values?Investors have a natural tendency to over-react or under-react to newsabout stocks which can act as the key drivers of pushing stocks toextremes. As Lakonishok explained in his 1993 paper entitled ContrarianInvestment, Extrapolation, And Risk, we tend to extrapolate the past toofar into the future, even when strong historical growth rates are unlikelyto continue. Investors tend to wrongly equate a good company with agood investment irrespective of price, to ignore statistical evidence andto develop a ‘mindset’ about a company. If you apply that notion to theidea that value stocks generally have an air of pessimism about them,then it becomes clear why stocks can become undervalued.Adib Motiwala of Motiwala Capital suggests the following list of reasonsas to how a stock may become cheap. These are the kinds of newsevents that Value Investors should be keeping an eye open for on thenewswires. !Missing broker expectations of profit forecasts !Neglect from investors and analysts !A history of losses, fraud or accounting issues !Management issues – poor execution / key executive resignations !A complicated or unloved business operating in an out of favourindustry (eg: Waste Management) !Painted by a common brush (e.g. oil stocks during the BP crisis) !Cyclical stocks at the bottom of the business cycle !Forced selling of securities by funds (i.e. removal from an index orcredit crunch)In some cases, that re-rating will reflect an underlying permanent changeto the fundamentals of the business but, in many cases, it won’t. This iswhat creates the opportunity for the patient investor.How do value stocks get re-priced?Recognising the fallibility of the market of course raises the question ofhow this mispricing eventually gets corrected. Interestingly, the processby which value is realised or crystallised is one of the great riddles of the10

stock-market. As Graham noted in his testimony of the Senate BankingCommittee back in 1955, while it may sometimes take the market aninconveniently long time to adjust the price level of a stock back towardsits intrinsic value, the beauty of the market is that it usually does getthere eventually:Chairman: “When you find a special situation and you decide, just forillustration, that you can buy for 10 and it is worth 30, and you take aposition, and then you cannot realize it until a lot of other people decideit is worth 30, how is that process brought about – by advertising or whathappens?”Ben Graham: That is one of the mysteries of our business, and it is amystery to me as well as to everybody else. We know from experiencethat eventually the market catches up with value. It realizes it one way oranother.growth companies and sectors generally see earnings begin to growfaster as management teams take action to operate more efficiently.The result is that investor expectations play catch-up as the earningsgrowth rates of both high and low growth companies return to theiraverages over time. Companies that were temporarily unloved candisplay extraordinary turnarounds in their share prices in response tothese pivotal changes in expectations, handsomely rewarding theshrewd, contrarian players in the market.Of course there are catalysts other than just stock market investors whonotice when stock values get out of whack. Company managementthemselves can of course start ‘share buyback’ campaigns orcompetitors can notice their cheaply valued peers and make a takeoverbid. Remember everyone wants to make a buck, and when people see adollar lying on the ground they tend to be incentivised to pick it up.How long can it take for value to ‘out’?Part of the explanation is tied up with a concept known as ‘meanreversion’ or the tendency of values to return to their average level.When investors and analysts put a value on a stock or share, they havea natural tendency to project an expected future growth rates for thecompany. Because making those predictions is notoriously difficult, theywill often extrapolate from past growth rates.However, this process of estimating profit growth ignores the tendency ofgrowth rates to return to average levels. In other words, companies orsectors that are growing fast will inevitably see earnings growth slowdown as competition from other firms catches up. By contrast, slowBen Graham was always the master of a good analogy, stating that inthe short term the stock market behaves like a voting machine, but in thelong term it acts like a weighing machine. In other words value alwaysouts eventually. But how long should it take before you throw in thetowel?Joel Greenblatt in his excellent “Little Book that Beats the Market” hassome observations. In backtesting his ‘magic’ value investing formula hefound that it could underperform over 1 or 2 year periods but not once inany 3 year period over 17 years did the strategy underperform.11

It is the fact that value investing does indeed have periods ofunderperformance that gives all the rest of the investment world itchyfeet. 6 months of underperformance is too much for a fund manager tobear in an environment where he’s constantly being graded by quarterlyperformance milestones. It doesn’t take much for him to throw in thetowel on value investing and chase momentum or glamour strategies inthe hope of a short term gain.Value Investing rewards patient investors who have the tenacity andcontrarianism to wait out these periods of underperformance for thevalue to out. Bargains are not hard to find, the difficulty is in sticking tothem when all around you are telling you to throw in the towel. AsWarren Buffett has said “I don't try to jump over 7-foot hurdles: I look for1-foot hurdles that I can step over" the difficulty is that those 1-foothurdles lie far off the beaten track.So, if you don’t overtrade, have the discipline to hunt where others don’tlook, invest time and money in good tools, and have a self-criticallearning process that allows you to overcome your natural behaviouralbiases, then the potential to profit is enormous!Further ReadingThe Little Book of Behavioural Investing - James MontierThinking Fast & Slow - Daniel KahnemannSo what have we learnt?As a strategy, value investing scores highly on the basis of itsfundamental and psychological components. Academic research hasshown that value portfolios frequently outperform stocks selected on thebasis of growth or momentum. Meanwhile, the natural tendency ofinvestors to, a) be generally negative about value stocks and, b) overreact or under-react to news about stocks, means that marketpsychology is a major boon for value investing. For those prepared to lettheir natural instincts take over and extrapolate too much from the pastto predict the future, this is a problem. But for the contrarian ValueInvestor that is aware that others are contributing to the mispricing ofstocks, knowledge is power.12

Section 4Why can’t someonedo value investingfor me?“The secret of being a top-notch con man is being able to know what themark wants, and how to make him think he's getting it.” Ken Kesey, Oneflew over the cuckoo’s nestSo with compelling evidence of the power of value investing can yourfund manager be trusted to deliver the goods? Unfortunately, despite thegrowing evidence that value strategies work, it is unlikely that a wellthought-through value-based investing approach is being put to work foryou and your family or anyone else that saves money in a pension orunit trust or investment fund.Indeed in an age of high-tech, high-speed trading, herd behaviour andinformation overload, the evidence overwhelmingly suggests that valueinvesting simply doesn’t fit the mould for many institutional moneymanagers and that Graham & Doddsville Value Investing managers arebecoming increasingly hard to find.Who hires these guys?The extraordinary truth is that 75% of actively managed fundsunderperform their benchmark over the long term primarily due to highfees. Often the real cost of owning a fund is not published - once allthese hidden fees are added to the published expenses the total annualcost of owning a fund can be over 4%.As most fund managers typically make their money on fees rather thanfrom making good investments their incentives are skewed towardsgathering more money to manage rather than focusing on goodinvestment performance. The result? As their funds grow they have atendency to chase glamour and momentum in large cap stocks ratherthan aiming at small cap value that both the Value Investors AND theacademics have now shown provide the best returns in the market. Herdmentality takes over and your savings pay the price of mediocrity.The pressure on fund managers to report consistent quarterly returns ifthey want to keep their jobs has a terrible impact on their holdingperiods. They regularly indulge in ‘window dressing’ to make it appearthat they were smart in holding the glamour stocks and are typicallyholding stocks for shorter and shorter time horizons than are necessaryfor value strategies to pay off.More generally, a mountain of research suggests that fund managementis riddled with bad decision making, herd behaviour and excessivecompensation leading to significant underperformance in the long term.13

The only sane approach is to do it yourselfAll this adds up to the fact that you can be fairly sure that no-one isapplying the techniques of the world’s greatest investors on your behalf.So, if you want to reap the rewards you may have to do it yourself.If you really don’t have the time to spend on your own financial welfarethe simple way to ensure you beat the majority of fund managers is byinvesting in a tracker fund. Better than that you can invest in a growingnumber of Exchange Traded Funds that aim to follow the value investingcreed.But individuals who do have the time and discipline to do their ownresearch are generally going to be better off taking investing matters intotheir own hands. Forget all the media noise about ruthless high-speedmarkets and fearsome traders working to arbitrage away mispricing.There are cheap, neglected, misjudged stocks out there and with theright techniques up your sleeve it isn’t so hard to find them and profitfrom them.Further ReadingThe Little Book of Common Sense Investing - John BogleWhere are the customer’s yachts - Fred Schwed JrFree Capital - Guy Thomas14

Key Ideas2The foundations, principlesand key ideas of valueinvesting

Section 1Five key principles“Rules are not necessarily sacred, principles are.”Franklin D. RooseveltWe have b