Magic Formula Investing

July 27, 2007

Just following up from my post about Joel Greenblatt’s book You Can Be A Stock Market Genius, I have discovered another of his books – The Little Book That Beats The Market.

The book touts a “value-oriented” approach that looks for bargain stocks whose share price is cheap relative to the company’s profitability. His version is a “magic formula” that ranks stocks on the basis of two variables—the earnings yield and the business’s return on capital.

The book has an associated website which (after you register) will let you rank stocks based on the criteria suggested in the book. Being earnings yield and return on captial. I have registered and the site looks to be an excellent free resource.

Free Exchange

July 27, 2007

I am constantly impressed by the quality of posts on The Economist‘s blog Free Exchange.

There was this post about Efficient Market Hypothsis which was good, without even considering the excellent comments.

  • Weak: you can’t beat the market by trading on historical prices.  Almost everyone believes this except that guy you see on Saturday morning financial shows.  If he was making money doing this, he wouldn’t need to be seeking publicity on a Saturday morning financial show.
  • Semi-strong: you can’t beat the market by trading on public information, because by the time you know about it, so does the guy you’re trying to trade with.  This is not quite true, but beating the market this way is now essentially an engineering problem, rather than an economic issue.  If you can make your computer fast enough to push through a trade before the other guy’s computer has reacted to the new information, you can make money.  But it is hard to do, and requires not just technical genius but also an expensive up-front capital investment
  • Strong: All public and non-public information is incorporated into the stock price.  I don’t believe this is true.  But I believe it is sort of true, thanks to insider trading.  Stocks show considerable evidence of movement on things like proposed mergers, and bad earnings, after those things are known inside the company, but before they are announced.  But the fact that it is possible to make money insider trading, as it seems to have been, dictates against the strongest version of this.

And this post about a recent news items that states:

If your friends and family get fat, chances are you will too, researchers report in a startling new study that suggests obesity is ‘socially contagious’ and can spread easily from person to person.

The Free Exchange blog then follows with an excellent post that gives an addional insight via standard economic theory.

If something, such as your friends getting fat, reduces a cost of obesity then it well may cause you to become obese.  But if you are rational and now switch to being obese you must be better off than before.  So your friends’ weight gain has made you happier.

Suppose you must decide whether to do X.  (X could represent choosing to eat a lot.)  Initially you reject X .  But then a cost of doing X goes down.  If you still don’t do X you are made no worse off by the cost reduction.  If, however, you switch to X you must now be better off than before (or else you would not have switched) so whatever has reduced the cost of X has increased your happiness.

You Can Be a Stock Market Genius

July 27, 2007

I have finished reading Joel Greenblatt‘s book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. Which I highly recommend.

The main points I got out of the book are:

  • Spin-offs are an attractive area to invest in. Investors that receive shares in a spin-off normally do not want to hold them and sell soon after the spin-off. For example an institutional investor may not even be allowed to hold shares below a certain market cap or outside of the S&P500.
    • Look for institutional investors that do not want the shares and will sell them immediately, depressing the price.
    • Insiders want to buy the shares, look for management making an investment.
    • The transaction may unlock hidden value, the business may be able to operate more efficiently after being spun-off from the parent company.
  • Holding companies can offer good opportunities. For example a company that holds some listed shares, might trade at a discount. Or at the same value, letting you buy the core business for close to zero.
  • Merger securities. Can offer investment opportunities for the same reason as spin-offs. The people receiving the securities do not want them, so look to sell them straight away. Plus always look at the details in the SEC filings.
  • Companies coming out of bankruptcy. These may not be looked at by other investors due to lack of coverage or unwillingness to invest in a company that has been bankrupt.
  • LEAP options can offer extra upside for investments.
  • Options can be useful when investing in spin-off opportunities. Any option that can be exercised after the spin-off entitles the holder to receive a share in both the parent and the spin-off.
  • Steal other people’s ideas. Read investment newsletters, read other investors’ annual reports and announcements.

The book has a number of case studies which are useful in understanding each of the concepts and showing that they really do work (or have worked in the past).

Morningstar Investment Methodology

July 27, 2007

On looking around Morningstar’s website I came across two documents, Morningstar’s approach to equity research and their equity research methodology. They offer a great overview of how Morningstar think about company valuation and market prices.

Here is a quote from the start the document about equity research:

At Morningstar, we evaluate stocks as pieces of a business, not as pieces of paper. We think that purchasing shares of superior businesses at discounts to their intrinsic value and allowing them to compound their value over long periods of time is the surest way to create wealth in the stock market.

Key topics covered include:

  • Economic Moat
  • Discounted Cash Flow
  • Discount Rate
  • Fair Value
  • Business Risk
  • Margin of Safety
  • Consider Buying/Consider Selling
  • Stewardship Grades

Top 15 Value Opportunities

July 11, 2007

Whitney Tilson lists the 15 most common types of value opportunities in this article. These are the types of opportunities that Whitney has capitalised on during his investing career: 

  1. Out-of-favour blue chips.
  2. Turnrounds of broken businesses.
  3. Cyclicals at the bottom of the cycle.
  4. Distressed industries.
  5. Overlooked small-caps.
  6. Fallen growth angels.
  7. Growth at a reasonable price.
  8. Piggybacking on activism.
  9. Spin-offs.
  10. Post-bankruptcies.
  11. Let someone else do the investing. Think Berkshire Hathaway etc.
  12. Free/mispriced option. Where an ongoing businesses justifies the current market price and an investor gets a valuable option in the form of a new market opportunity or turnround of a floundering business.
  13. Declining cash cow.
  14. Oddball companies. Companies that have a revolutionary business models that are poorly understood, resulting in cheap stock prices. Classic examples are Southwest Airlines, Dell and Kinder Morgan.
  15. Discount to the sum of the parts. Like Tyco before the recent spin-offs.

USG – Discount to Intrinsic Value ?

July 9, 2007

USG is a manufacture and distributor of building materials. I came across the company when reading about how Berkshire Hathaway owns almost 20%. 

USG entered bankruptcy in June 2001 due in part to Asbestos claims. The company emerged from Chapter 11 in June 2006 and by December 2006 had settled all Asbestos claims by paying US$3bn into a separate fund. 

One way to look at USG is using the framework from Equity Private regarding how to frame a problem. 

1.         Present the current state of affairs. 

USG is currently undervalued (based on some high level analysis) by the market as it has recently emerged from bankruptcy and the current concern about a weak US housing market impacting earnings.

2.         Present the inefficiency embedded in the state. 

All asbestos claims have been settled. The company has spent it’s time in bankruptcy building new more efficient manufacturing operations.

3.         Explain the problem that has thus far prevented a correction of the inefficiency. 

Other investors may not be willing to look at a company with a history of bankruptcy. Perhaps lack of analyst coverage.

4.         Present the new development that now permits the correction.

The company is currently under appreciated. And over time the market will begin to look more favourably on USG.

There are a number of blog posts talking about what a good investment USG is, here are some of the better posts I have come across.

Burger’s Business, Investing and Politics

The Texas Hedge Report

Blogging Stocks

Guru focus

  • Visitors poll thinks the intrinsic value of USG is US$82 a share vs the current (9 Jul 07) share price of US$50.

I plan to post some more material about USG in the future.

Investment Tools

July 9, 2007

Here are a few investment tools I came across from Top 5 Hacks for Intelligent Investors and Valuation Tools from Financial Times from FatPitchFinancials.

Excel Add-In

This Excel Add-In lets you take financial data from Yahoo Finance, Google Finance, MorningStar, Reuters etc straight into Excel. For example you want the market cap of MSFT from Yahoo Finance in your Excel spreadsheet. Just install the add-in and use the formula “=RCHGetElementNumber(“MSFT”, 941)”. Quote from the orginal post.

You can turbo charge you stock financial spreadsheets using an excellent and free Excel Stock Market Functions Add-in. You can download this great tool that lets you add data from MSN, Yahoo, Google, Reuters, ADVFN, Morningstar, and more directly into your Excel spreadsheet cells by joining the smf_addin group.

Note to download the add-in you have to join the associated Yahoo Group.

FT – DCF model

The Lex column from the Financial Times has an online DCF calculator / model. This is good for people that don’t want to build a model in Excel and are happy to plug in a few high level assumptions to generate a valuation.