Making 5-7% - Trying to Beat the Market

By pjain      Published Dec. 27, 2019, 2:47 a.m. in blog Invest   

Trying to Beat the Market Key Takeaways

Need to stick to A Strategies due to Fluctuations

Investing like diets only work if you stick to them. If you ditch the strategy mid-stream then unlikely to see the result.

Behaviorial Investing

  • SPY get 9%, MFs get 7% (mainly on fees), Actual investors get only 5% (as buy hi-sell lo)

Loss Aversion Bias

  • For good evolutionary reasons (survivors ran away from strange rattles in bush), humans are averse to loss when they make choices between risky outcomes.
  • So we like to be right and hence often seek high-probability events.

High RoE Cash on Tangible Assets

  • $200k on $400k McDonalds great franchise, repeatable, but if retailer ONLY shops broccoli, little return say 2%/yr - you will want to buy into the 50% Return and expand that franchise or buy the ENTIRE business.

  • Why Buffet bought buckets of Apples or Cokes

  • huge free cash flow gushers
  • huge returns on capital, high margins (coke = sugar water)
  • Has a great niche and MOAT - dominating a major industry
  • Smart Management
  • Can fight growth slowdowns (most dow) through R&D or acquisitions

Cigar Butt vs Smart Concentrators vs Huge Portfolios

  1. BUY ULTRA-CHEAP - NET ASSET VALUE! Buffett in early stage followed Ben Graham when he had smaller funds used this fair company-at super low price or "cigar-butt strategy" when buying dying companies like Dempster Mills and Sanborn Maps.

  2. BUY QUALITY WITH SOME DISCOUNT “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” WB philosophy got modified by Charlie Munger.

  3. BRK in 2016+ It was only later when Buffet's capital base became HUGE, that he had to move on to invest in larger companies and even tech like Apple and IBM that he would never have invested in before. He still sits on $130b+ in cash - unable to find good value as stock valuations kept rising.

Mean Reversion, Luck-Skill-Process and Un-excellent companies

Tobais challenges Warren Buffett's advice in his book "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market". He explained and proved, using various studies backed with real data, that buying fair companies at wonderful prices provided higher returns than buying wonderful companies.

What Goes Up Must Come Down Tobias attributed the performance of cheap stocks to "mean reversion". Basically the top "wonderful" quintile of companies still tend to outperform (from 1000 companies) but the bottom 80% tend to all revert to some mean 8-10 years out.

  • Legg Mason's Michael Mauboussin take on mean reversion is that
  • if 100% skill there will NOT be reversion - faster or better fellow will ALWAYS win
  • if any contribution of luck - then SOME reversion will happen
  • Real mix say 60% skill,40% luck eg like kids of tall parents likely to be taller but less than parents
  • In Investing PROCESS matters in face of luck - they will win more and lose less than others

Moat: Has a great niche, competitive advantage, dominating a major industry

Wide-moat stocks or funds are more like the small-value or quality tilt portfolios in that they are trying to capture the quality factor and have a consistent methodology applied over time.

Excellent Quality may or may not get good returns

  • Tom Peters 1982 identified principles behind 43 "excellent" managed companies - however a study found over LONG periods they underperformed the SPY500 and the worst unexcellent companies massively outperformed (but with a huge multi-decade timeframe).

Dividend Traps are worse than Cigar-Butt Traps

It seems like the 'ugliest' stocks tend to deliver better returns in the future!

Undervalued Stocks That Do NOT Pay Dividends, Tend To Perform Better - by Henry Oppenheimer, 1983 who classified quintiles by value. 1. The most undervalued group beat the most expensive group by more than 10 percent a year - and performance was inversely to overvaluation. 2. He split the stocks into two groups of only profitable stocks, and only loss makers. Oppenheimer found the loss makers beat the profitable group. 3. He split the profitable group again. The first group was comprised of dividend-paying stocks. The second group paid no dividend. Oppenheimer found the stocks that didn’t pay a dividend beat the ones that did.

Mixing Index and Long/Short Strategies based on Valuation

Gotham Index Plus GINDX had 34%+ beat of the Standard & Poor’s 500 index over 10-15 years track record. Most people have a difficult time sticking with strategies that underperform from time to time. Gotham Index Plus minimizes that time and makes it easier to hold onto the fund - as compared to founder's prior fund that had very high volatility. With this strategy, you have a lot less tracking error—the divergence between a fund’s return and that of its benchmark—and we can still take advantage of our stock-picking ability.

  • Gotham looked at forward average annualized returns of 20 year period from 1992 (for 2000 largest companies in the US), the correlations below show that the undervalued stocks had far better returns than the overvalued. A caveat is that 20 year look really smoothens the curve and has a HIGH correlation.
  • Most undervalued 20 companies 1% percentile had 34%, but the most overvalued had no appreciation over 20 years!
  • But if looked at 3-5 years, the correlation would be only 0.55.

  • Buy 100c of SPY500

  • Going long on 90c worth of 250 or roughly half of undervalued
  • Going short on 90c on the roughly overvalued of that index.
  • Valuation is done by his metrics - but often pretty much any measure of value works.
  • The holding of a stock ranges 2-3 years - as valuation changes.

Small Cap does give performance - but can get swung if buy too much!

  • Even if you are able buy a ton of a good small cap that is 0.01% of SPY mcap by weight, its value can get swung if you buy a million dollars worth of its stock. But even if you buy that much, it does little to boost performance due to its small market cap.

Rating MFs

Hindsight performance does not work

When the market goes up or an active investor outperforms, people pile in. When the market goes down or that investor lags behind, people pile out. They chase returns because that’s all they really have.

Multiple studies will tell you there is very little correlation between the past one, three, five and the next one, three, five.

Star-Rating MFs don't work

Hiring five-star rated funds doesn't work

Promotional Fin-Media Managers don't work

Hiring talking head money managers (they are plenty of them on cable business channels).

Value Investing

Any metric works well

Value Metrics

The value premium metrics aren't sensitive to accounting gamesmanship. - Price to earnings works but earnings is way the heck down the balance sheet from sales. - Price to sales also works

The value investing is easier to manage and returns premium is impressive because it can be measured in many ways that work equally well. Price to earnings works, price to book works, cash flow to book works, EBIT/EV works, EBITDA/EV works, price to employees works, and taking rolling averages several measures works. Quant or data mining methods miss the mark for the value premium as any plausible way of measuring the value premium seems to track the value premium.

Value Metrics Process

  1. What is built into the current stock price - reverse engineer

    What has to happen for its financial performance for that to make sense

  2. Fundamental factors .. what are keys of this performance, how likely

  3. Forecasting = trends more likely to continue - don't count on turnarounds
  4. Growth does slow down .. unlikely to do 40%+ for next 5 years! (Though top CEOs outperform!)
  5. What changes are happening in the ecosystem

  6. Value = NPV of future cash flows - DCV

Quality Investing and Metrics

Some companies are higher quality than other companies but quality can be easily quantified.

Few metrics work well for Quality

  • Gross Profits vs before it pays for things like its employees salaries?
  • Operating profits are a more natural choice than gross profits, but don't work nearly as well.
  • Earnings (scaled by total assets) is also a natural choice for measuring quality and also doesn't work.

Why is quality so much more "fussy" about how we measure it than value? One hindsight explanation could be that the higher up one looks in the income statement, the less "noise" there is in the numbers, and the less room there is for manipulation of the numbers. But if net profits or EPS worked best, one could do hindsight justification on reasons for them!

  • Novy-Marx uses gross profits (scaled by total assets) to measure quality. But gross profits is an odd choice.
  • Cliff Asness has a quality minus junk factor. Unfortunately, his factor is the result of aggregating no less than 16 (if I remember right) individual measures. This is not especially simple.

Margin of Safety - reflects the uncertainty - need more

  • decision to buy or not!
  • Range of valuation - over-under - does it make sense to buy this

Probabilistic Expectation Value = Distribution!

  • Process is to identify gaps between a company’s stock price and its expected value which is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price ) for a given outcome by the probability that the outcome materializes. In horse races, the should not be on which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory.
  • In finance, the only certainty is that there is no certainty. This principle is especially true for the investment industry, which deals largely with uncertainty. In contrast, the casino business deals largely with risk. With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like -Decisions are a matter of weighing probabilities. Balance the probability of an outcome (frequency) with the outcome’s payoff (magnitude) -Despite uncertainty, we must act. We must base the vast majority of our decisions on imperfect or incomplete information. Sometime additional information often only confuses the decision-making process -Judge decisions not only on results, but also on how they were made. A good process is one that carefully considers price against expected value

  • SRC

Knowledge, Information in Investing

Lattice Frameworks to Understand

Follow what they are doing not what they are Saying

Selective, Insider Views

Behaviorial Investing and Mr Market Distortions

Recency Bias - Rear View Investing

  • Rear View is VERY important from humans
  • In reality - treat every day as BRAND new
  • Cheap can become cheaper ..

Hot News - Pump and Dump is Common

The financial press, doubtless inspired by press releases, gushes over the launch of "innovative" new funds and ETFs. If they don't perform well, that fact is never publicized--you just sort of stop hearing about them.

My expectations of the financial press are extremely low. They're limited to reporting on "new things", not analyzing them, and certainly not following up if they don't work out. "All the news that's fit to print", is very different from "The select stuff you actually need to know".

Market Valuation Metrics and Timing forward returns

Valuations are far higher end 2019 than this note .. In last 30 years SP500 has been as highly valued only 15% of time, on which forward 12-month returns were only 2-4%. - Joel Greenblat mid'18 Warren Buffet strongly advocates the ratio of Market Valuation to GDP - it shows that in 2000, 2007 and now, there were well over 100%. Clearly that seems to work well for him in timing forward returns. * The yield curve is another indicator of chances of recession - when it turns negative, usually there is one 12 to 18 months later. However, since 2009, helicopter money and QE by Fed, ECB, BoJ all have prevented recessions.


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