Mobius Sees Derivatives Leading to Another Crisis

Templeton Asset Management’s Mark Mobius says the continuing use and growth of derivatives in financial markets is going to lead to another financial crisis.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius says, according to Bloomberg. “Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

Mobius says, however, that crises mean opportunity. “With every crisis comes great opportunity,” he said, adding that when markets crash, “that’s when we’re going to be able to invest and do a good job”.

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Herro on Strategy, and Why He Likes Japan

Top fund manager David Herro says discipline and longer-term thinking are keys to successful investing. “You have to be grounded, first of all,” Herro tells WealthTrack’s Consuelo Mack. “You have to have a very sound investment philosophy from which to operate from. And number two, and perhaps most importantly, is you have to apply discipline. All too often people might have a sound philosophy, and then the moment that philosophy hits a little adversity, they abandon it, and they run.” Herro also says his investment approach focuses on finding cheap stocks of quality firms. He says he looks for cheapness by comparing the amount of free cash a business generates to its enterprise value; he says quality firms are those that are “able to achieve satisfactory rates of return over the medium and long-term” and have “a management team that proactively, and in a successful manner allocates the free cash which that business generates.” Herro says his long-term, disciplined approach has him focusing on some unloved areas right now: Japanese companies, consumer staples, and even some financials.

 

 

The Piotroski Method: An Overlooked Guru Turns Up Overlooked Gems

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joseph Piotroski-inspired strategy, which has averaged 8.2% annualized returns since its inception more than seven years ago, over a period in which the S&P 500 has returned 2.0% per year. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas from the Piotroski-based investment strategy.

Taken from the May 27, 2011 issue of The Validea Hot List

Guru Spotlight: Joseph Piotroski

If you haven’t heard of Joseph Piotroski, you’re not alone. He’s probably the least well-known of the investment “gurus” who inspired my strategies. Actually, he’s not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don’t need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge — just a straightforward assessment of a company’s balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios — i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it’s been shunning a winner.

Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor’s portfolio by at least 7.5 percentage points annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn’t would have produced an impressive 23% average annual return from 1976 and 1996.

Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market, though with some big ups and downs. It fared very well in 2004, 2005, and 2006, before being hit hard in 2008 and 2009. But it roared back in 2010, gaining 55.9% — more than four times the S&P 500′s 12.8% gain. In the seven-plus years since its inception, it has returned 76.6%, or 8.2% annualized, during a period in which the S&P has gained just 15.2%, or 2.0% annually.

Let’s take a look at how Piotroski’s approach, and the model I base on it, work.

Diving into The Balance Sheet

Piotroski wasn’t the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren’t rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.

The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that’s the figure I use.

That’s the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business — not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski’ other financial criteria don’t necessarily look for fundamental excellence, but instead for improvement. Among the “improvement” criteria Piotroski examined were the long-term debt/assets ratio; the current ratio (current assets/current liabilities); gross margin; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns.

As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks currently in its 10-stock portfolio:

SkyWest, Inc. (SKYW)
Smith Micro Software Inc. (SMSI)
Benchmark Electronics, Inc. (BHE)
AU Optronics Corp. (AUO)
Iridium Communications Inc. (IRDM)
Xyratex Ltd. (XRTX)
Hanwha SolarOne Co. Ltd. (HSOL)
Fushi Copperweld, Inc. (FSIN)
SunTech Power Holdings Co., Ltd. (STP)
The E.W. Scripps Company (SSP)

Think Small — And Boring

One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks. Of the 10 current holdings in my Piotroski portfolio, only one (AU Optronics) has a market cap above $1.4 billion.

For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products, though it will go into more “interesting” areas when valuations are right (as it is right now, with a few tech stocks among its holdings). But while they’re not the flashiest firms, they’re quite often the type of stocks that can pay excellent returns over the long haul.

Keep It Simple with Global Blue Chips

While many investors dabble in commodities and currencies, Joe Rosenberg, chief investment strategist of the Loews conglomerate, says to focus on large-cap U.S. multi-national stocks.

Rosenberg tells Fortune that he looks for companies that are financially sound, showing rising profits, and selling inexpensively relative to profits and free cash flow. Among the specific criteria he uses:

  • Market cap: Greater than $10 billion
  • Earnings growth (before interest and taxes) in past five years: Greater than 5%
  • Avg. return on capital over past five years: Greater than 12%
  • Free cash flow yield: At least 6%

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Great and Expensive or Good and Cheap?

While stocks with great growth stories often attract investors’ attention, Jim Oberweis says companies that aren’t quite as attractive but have better stock valuations can be a better investment.

“As much as I love businesses with seemingly bulletproof growth stories, it is the combination of business quality, growth opportunities and stock price that really matters when it comes to returns,” Oberweis writes in his latest Forbes column. “A good business at a really cheap valuation might trump a great business at a very high valuation. The key lies in understanding a business’ flaws and assessing if the valuation properly discounts them (or ideally, overdiscounts them). I call these ‘growth stocks with wrinkles.’”

These stocks can sometimes come with uncertainty that scares many investors away. “If the price is cheap enough, however, the overall investment potential can be just as good as the most glamorous growth story,” Oberweis says. He looks at three such picks, including Colorado-based Advanced Energy Industries.

Gross On The Deficit, and Big Blue Chips

PIMCO’s Bill Gross says he doesn’t think the U.S. will seriously tackle its deficit issues until the 2012 presidential election, and says blue-chip U.S. stocks are a “much more attractive” alternative to Treasuries based on their current yields.

“It’s obvious that both Democrats and Republicans want to address the problems with spending and, yes, want to address the problem with revenue-raising,” Gross told CNBC. “It’s probably a few years away and debt holders will simply have to adjust to that stretch of a time span.”

Gross also says a temporary default on debt payments by the U.S. would be a “disastrous signal to the world credit markets”. It would impact the dollar more than bonds, he says, as investors would turn to the Euro and Chinese yuan.

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Gabelli Looks for the Unloved

Value investor Mario Gabelli says he likes to buy shares of companies that are “ignored and unloved”, and those that are potential buyout targets. Gabelli also tells Bloomberg that he focuses on stocks that benefit from aging demographics, whether it be aging people or aging facilities and infrastructure.