From Graham to Greenblatt kcchongnz

kcchongnz

Publish date: Thu, 10 Mar 2016, 11:38 PM

Posted by murali > Mar 9, 2016 09:36 PM | Report Abuse

I think average Joe lose money in stock market...somebody mentioned before 80% investor in the market lose money..dont know how true is it...

The above statement was posted in my recent thread, “When market retreats, Pong Pong Pong again” in the link appended below.

http://klse.i3investor.com/blogs/kcchongnz/92727.jsp

My opinion on the above statement is not far from the truth. However, I would like to replace the phrase “lose money”, with “grossly underperforming the broad market”, as you know, during a bull market, many people make money too, but most of them will lose back more of what they have gained when the market turns the other way. There are numerous academic research showing this phenomenon.

I have analysed and mentioned that the broad market has had a compounded annual return of just 6% over the last 10 years in the link, “Investing and the eighth wonder of the world” below.

http://klse.i3investor.com/blogs/kcchongnz/92412.jsp

So with such a poor return from the stock market, why would I encourage youngsters to work hard, save and invest in the stock market? Why don’t they just put their money in the bank with an interest rate of 4%, which would most likely beat the performance of an average investor from the stock market, and with little risk?

Here lies the secret which was revealed in my previous thread, “Does fundamental value investing has any predictive power?” in the link below.

http://klse.i3investor.com/blogs/kcchongnz/92580.jsp

Value Investing, the era of Benjamin Graham

The link above described some rigorous studies that using value investing such as just buying cheap in any form, be it be low P/B, P/E or P/CF (and also P/D) give better return than the broad markets and with lower risks. The higher return is more pronounced for small market capitalized stocks.

I have also shown the track records of certain school of investors, the school of value investing following the philosophies and methodologies of the grand master of value investing, Benjamin Graham, who had generated annual compounded returns (CAR) of between 18% and 29% over long track records lasting between 13 to 28 years, out-performing the broad market by very wide margins.

A 40-year old who has zero net worth now but can just save RM1000 a month from now on, and increases his saving by 4% a year in accordance to his growth in income, would have accumulated a tidy sum of RM2.7m when he retires in 20 years’ time if he can manage to earn a return of 20% from the stock market, compare to just RM500,000, if he places all his money in the bank, with an interest of 4%.

That is the power of compounding, compounding at a higher return over a long period of time can make a big difference in your retirement sum.

However, the above quantitative strategy is more suitable for fund managers having a lot of money from investors to invest in a diversified basket of tens or hundreds of stocks, such that the expected return likely to be achieved with less risks. Individual investors with less financial resources would have difficulty following those value investing strategies.

The link below explains why using a low P/E investing strategy with a few stocks can have some problems if individual investors do not know enough what the denominator in P/E ratio means; and the E can mean anything from hell to heaven.

The link below explains some problems on E produced in the income statements of some companies.

http://klse.i3investor.com/blogs/kcchongnz/63417.jsp

What can individual investors do? Just forget about investing in the stock market? That would be a mistake as I have shown you the difference in wealth creation from higher compounded growth rate (CAGR), than a lower one as shown above.

Let us go the Joel Greenblatt’s Magic Formula again. I could hear someone shouting, “Magic Formula, not again!” Can’t blame him, as I have talked about this Magic Formula many times, like a broken record.

But you see, even though I have mentioned and explain this Magic Formula many times, I doubt few readers bother about it, and even less understand or care to understand what I was talking about. Can’t blame anybody, because each of us is in his own profession, and you can’t expect he is good at everything, unless he cares about his financial wellbeing in the future. But this is very important in investing, and hence sorry, I will repeat it.

From Graham to Greenblatt.

The first thing Greenblatt did in his Magic Formula in value investing is to replace the problematic P/E ratio, which is only relevant to equity shareholders to the equivalent metric of enterprise value/Ebit, or operating income, which is for the whole firm.

Why EV/Ebit for the whole firm and not P/E just for the equity shareholders? What are the advantages? Please refer to this link again as it explains in details.

http://klse.i3investor.com/blogs/kcchongnz/63417.jsp

So if low P/E works, low EV/Ebit should work better as explained. Greenblatt reverses this metric to earnings yield, or EY, which is Ebit/EV. It is easier to use this to compare with the return on alternative investments, such as the return from bank interest or bonds, or return of property investment. That is another one up. What next?

Greenblatt, besides looking at cheapness, with his better “cheapness” metric of EY, also looks at the “goodness” of a company; and only buy not only it is cheap, it must also be cheap. How can you go wrong then?

How to gauge “goodness” about a company?

What straight come to most retail investors’ mind would be profit and EPS growth, the profit of this quarter must be better than the profit of the next quarter, and so on. But is there really such thing as the profit of the next quarter of a company is always better than the previous quarter? What about seasonality? What about economic cycle, product cycle, business cycle etc.?

This is what Warren Buffett says:

“Customarily, most investors measure annual company performance by looking at earnings per share (EPS). Did they increase over last year? Are they high enough to brag about? For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record EPS. There is nothing spectacular about a company that increases EPS by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way below its borrowing costs.

The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS. To measure a company's annual performance, Buffett prefers return on equity or ROE. -- The ratio of operating earnings to shareholders' equity.”

How can a company be good if it has RM100m equity, but earns only RM3m, or just 3% return on its equity? The company might as well liquidate its assets, pay creditors and return the balance money to shareholders so that they can earn better return from somewhere else, even better to put the money in fixed deposit which is close to riskless.

How can a company good if it keeps on collecting money from shareholders with right issues, or “free” warrants and later pay money to convert to underlying share, and with those earn higher profit, but below the cost of its capitals?

Hence a good company is one which return higher than its cost of equity, or a high ROE. If you require a return of 10% investing in a stock of a company, surely you will expect the company to earn a return higher than 10%. Won’t you?

Buy good company with high ROE when it is cheap. Isn’t it better than just buy a good company? So what is the chance that you can you go wrong using this investing strategy?

But ROE also has various problems too as shown in this link.

http://klse.i3investor.com/blogs/kcchongnz/52949.jsp

If investors are not careful, it can divert attention from business fundamentals and lead to nasty surprises. Companies can resort to financial strategies to artificially maintain a healthy ROE, even though operational profitability is eroding, just to keep investors happy.

Greenblatt refine this “goodness” metric with a better one; return on invested capital, or ROIC, the profit for the whole firm with all the capitals employed, from the equity shareholders as well as from the debt holders. It is the effectiveness of the company’s employment of capital.

ROIC and EY, are they any use in real life investing?

The Magic Formula quantitative investing

In his The Little Book that Beats the Market, Joel Greenblatt, a top-performing hedge fund manager since the 1980s, describes a Magic Formula to beat the market. The secret of his magic formula is actually no magic to it at all. It is basically “a long-term investment strategy designed to buy a group of above-average companies with high ROIC when they are available at below-average prices with high EY” as shown in the link below.

http://klse.i3investor.com/blogs/kcchongnz/51631.jsp

The Magic formula outperformed S&P500 17 out of the 22 years from 1988 to 2009, and achieved a compounded annual growth of 23.8% as compared to the 9.6% of S&P.

$10000 invested 22 years ago in 1988 has grown to $1.09m by the end of 2009, compared to if invested in the broad market of just $75000 during the same period, even after the US sublime crisis in 2008-2009. This is by no means a small feat.

Don’t always talk about the US market. What is the performance of the principle of Magic Formula in Bursa? Show me your records.

Here I have to use my longest established record in i3investor which was set up on 20 January 2013, named “GE13 Watch” in the link below to illustrate.

http://klse.i3investor.com/servlets/pfs/13147.jsp

Performance of GE13 Watch

The portfolio consists of a diversified portfolio of 10 stocks in Consumer Products, Industry Products, Constructions, Property Development, Services, and Technology. The prices are adjusted for all corporate exercises and dividend payments as obtained from Yahoo Finance. They were generally selected from good companies based on high ROIC, and selling cheap with high EY at the time of selection on 20^th January 2013 as shown in column 7 and 9 in Table1 in the Appendix.

During the three years and two months’ period from 20^th January 2013 to to-date on 10^th March 2016, KLCI only went up by a meagre 3.7% from 1631 to 1691. The Small Cap Index went up much higher by 24.9% during the same period. However, the GE13 Portfolio, went up by an average of 132.7%, or a CAGR of 31% as shown in Table 1, way outperforms both the indices.

All 10 stocks in the portfolio except the only underperformer of Pantech (-6.3%), have positive total returns which varies from the lowest of 4.2% for Plenitude to 502% for Prestariang. The high exceptional performers were, Prestariang (502%), SKP Resources (316%), Pintaras (166%), and NTPM (141%).

The three highest returns companies of Prestariang, SKP Resources and Pintaras were accompanied with highest Magic Formula scores of ROIC and EY. The worst performer, Pantech, not that bad though at a loss of 6.3%, has the lowest Magic Formula score. How obvious was that.

GE13 Watch is just one of my published portfolios in i3investor. I have two to three portfolios which have done well too, and they are likely to do as well in the long term.

Can the experience of the Magic Formula in US and my personal experience using the financial statements in Bursa be used to counter the argument below?

Posted by PureBULL . > Mar 7, 2016 07:01 AM | Report Abuse

It's a game with expiry date. Never spend too much time to analyze their engineered P&L n Cash-flow statements.
Use a simpler n better way to monitor them, like price action theory or weekly candle sticks to determine its trend.

Do you think I should discard my own investing methodologies and strategies which have been proven successful for me and start using other methods?

One of my course participants obviously does not think so as shown below:

After more than two months into this course and having read all your postings, I am convinced that fundamental analysis and value investing is the best method that would slowly, safely and surely lead to success and rewards in the long term.

Having done 3 exercises on income statements, balance sheet and cash flow analysis, I can now read and understand your article contributions in i3investor forum and appreciate its values in a more meaningful and joyful way.

Thanks for your reply and the various advisory and investment options you have recommended.

To kick start my investment journey with you, I would like to accept your offer of a portfolio consisting of 10 stocks with detail analysis given progressively within three months. I believe this option suite me best as a beginner. It gives me the opportunity to read and learn from your detail analysis and in the process also enhances my knowledge and develops my skills.

Perhaps, in the days ahead when we know each other better with greater degree of mutual respect and trustworthiness we can then move on further to exploit greater business opportunity on a large scale.

Thanks and regards

Blank 9/3/16

Do you buy my proven successful investment principles and methodologies and wish to learn about it, or may be require my other services?

Please contact me at

ckc14training2@gmail.com

K C Chong

Appendix

Table 1: Return of Magic formula in Bursa

Discussions

2 people like this. Showing 39 of 39 comments

Terry Tan

Very good sharing Mr KcChong. Keep up with the good work!

2016-03-10 23:59

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