Monthly Archives: March 2012

Lynch & Buffett: A Dynamic Duo?

Legendary investors Peter Lynch and Warren Buffett have each posted exceptional returns on their own, so what would happen if they teamed up to pick stocks? In a “Number Cruncher” column for Canada’s Globe and Mail, John Heinzl uses Validea Canada’s guru-based screeners to try to answer that question.

In January, Globe and Mail put together a nine-stock portfolio of Canadian stocks that passed both Validea Canada’s Lynch- and Buffett-inspired strategies. And while it’s still early, the results have been very strong: “From the inception date on Jan. 18 through March 28, eight of the nine stocks rose, led by double-digit gains in Bird Construction and MTY Food Group,” Heinzl writes. “Over all, the portfolio posted an advance of 7.3 per cent, excluding dividends. That handily beat the advance of 0.7 per cent for the S&P/TSX composite index over the same period, also excluding dividends. So far, it looks as if our little experiment is working.”

Validea Canada tracks a 10-stock portfolio picked using the Lynch approach and another 10-stock portfolio picked using the Buffett approach. Since its Aug. 6, 2010 inception, the Buffett-inspired portfolio is up 16.9% vs. 4.6% for the S&P/TSX Composite, while the Lynch-based portfolio is up 11.8%.

High-Quality — Not Value — Key To Buffett’s Success

Warren Buffett is known as a value investor, but a recently released research paper has found that most of Buffett’s success over the long term is due not to value investing, but to his focus on high-quality companies.

The paper, “Betting Against Beta” (click here for a PDF copy), was authored by Andrea Frazzini of AQR, a quantitative fund manager, and Lasse Pedersen of AQR and New York University’s Stern business school, and was highlighted recently by the Financial Times’ James Mackintosh. “Value has helped, but accounts for only a couple of percentage points of outperformance each year, against the 15 points Berkshire has achieved” under Buffett, Mackintosh writes. “Instead, the genius of Buffett and Berkshire was to be boring. … More than half of the outperformance of Berkshire since 1976 is explained by its buying high-quality companies. For its portfolio holdings (ignoring the insurance company and other operating businesses) almost all its outperformance was down simply to the focus on high-quality stocks.”

There’s a second piece to the high-quality approach — Frazzini and Pederson found that Berkshire has produced exceptional returns by buying low-beta stocks, and applying leverage. What’s more, they “found this anomaly works in every market they tried,” Mackintosh writes. “In all cases, taking less risk leads to higher returns relative to the amount of risk taken. Equalise the risk — adding borrowing to the lower-risk approach — and investors can beat the market without any extra volatility.”

In their paper, Pederson and Frazzini say they find evidence that “since constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures.” They also found evidence that a “betting-against-beta” (BAB) approach, which is long leveraged low-beta assets and short high-beta assets, “produces significant positive risk-adjusted returns”.

Mackintosh says ordinary investors should be cautious about using leverage. But, he adds, “They cannot expect to replicate Buffett’s returns, but they should be able to profit from his strategy by building a portfolio of high-quality companies, gaining a better return for the risk they are taking, even if they use less (or no) leverage.”


Berkowitz’s Checklist and Lessons

After struggling in 2011, Morningstar Fund Manager of the Decade Bruce Berkowitz is rebounding strong in 2012, with his Fairholme fund in the top 1% of funds in its category year-to-date, according to And at a recent Columbia Investment Management Association conference, Berkowitz laid out his checklist for analyzing a company and its stock, and Market Folly offered a summary:

1. Can you kill it? Is there adult supervision at the company?
2. Is the company essential? Does it depend upon the kindness of strangers?
3. What can the company make? Profitability for owners.
4. Management – honest in past and present?
5. Catalysts – Buybacks? Misunderstood? Is enterprise having a big problem that is fixable? Everyone’s been burned by the stock so afraid to buy it.

Berkowitz also offered the top lessons he wished he learned long ago. Among them:

  • You always have to have cash, especially when no one else has it.
  • You only see reality under extreme stress
  • Volatility is not risk!
  • Always assume you will have bad luck.
  • If you have to use more than 6th grade math, you’re in trouble.

Market Folly also notes that Berkowitz says he is now 100% in financials. He says AIG, Bank of America, and CIT Group are misunderstood, and he likes holding companies like Berkshire Hathaway and Sears Holdings. He has plenty of interest in the U.S., but no interest in European investments.

Beating the Market with Simplicity — and Discipline

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 Joel Greenblatt-inspired strategy, which has averaged annual returns of 6.2% since its December 2005 inception vs. 1.7% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Greenblatt-based investment strategy.

Taken from the March 30, 2012 issue of The Validea Hot List

Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don’t realize is that while it is difficult, it doesn’t have to be complicated. You don’t need incomprehensible, esoteric formulas and you don’t need to spend every waking hour analyzing stocks — Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his “Magic Formula” — a purely quantitative approach had just two variables: return on capital and earnings yield.

Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500’s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt’s “Little Book” — it’s only 176 pages long and small enough to fit in your jacket pocket — broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the “Magic Formula” is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense — and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn’t use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company’s stock, but instead by enterprise value — which includes not only the total price of the firm’s stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm — including both its assets and its debts. In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn’t contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past four years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 11.1%; the Greenblatt-based portfolio has gained about 46% — that’s 6.2% annualized, vs. 1.7% annualized for the S&P. The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in ’08 — not good, but much better than the S&P 500’s 38.5% loss — and surged 63.1% in 2009, vs. 23.5% for the S&P. It beat the market slightly in 2010, had a rough 2011 (losing 15.3%), and has lagged so far this year. Greenblatt stresses that the strategy won’t beat the market every month or even every year, however, which is important to remember. Over the long haul, though, it should produce excellent returns.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.

Here’s a look at the current holdings of my Greenblatt-based portfolio. Among the holdings are four firms from the much-maligned for-profit education industry, a sign of how the strategy isn’t afraid to head into rough waters to find bargains.

Bridgepoint Education Inc. (BPI)

Apollo Group Inc. (APOL)

ITT Educational Services (ESI)

GT Advanced Technologies Inc. (GTAT)

Strayer Education Inc. (STRA)

C&J Energy Services Inc. (CJES)

Iconix Brand Group, Inc. (ICON)

VAALCO Energy, Inc. (EGY)

AmSurg Corp (AMSG)

PDL BioPharma, Inc. (PDLI)

“Magic”? Or Discipline?

While Greenblatt’s methodology is completely quantitative, one of the most important aspects of his approach is psychological — and it’s something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn’t in the specifics of the variables; it’s having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn’t always work — a notion that is true for any good strategy.

Little-Known Manager, Huge Returns

A recent article in Investment News highlights a mutual fund manager you probably don’t know — but you should.

The manager, James Wang of the Oceanstone Fund, has returned 41% over the past five years — annualized. That beats the S&P 500 by about 39% per year. “Indeed, a $10,000 investment at the fund’s inception would be worth more than $65,000 today,” writes Jason Kephart. The fund has trounced the market since the March 2009 bottom, but also managed to limit losses to just 9% in 2008, a remarkable feat.

Wang is a bit of a recluse, refusing interviews and not showing up at last month’s Lipper Fund Awards, where he was honored. But, Kephart notes, “Mr. Wang does reveal something of his strategy in his annual reports. As of June 30, Mr. Wang was looking for companies trading below their ‘intrinsic’ value. ‘Short-term, stock market can be volatile and unpredictable. Long-term, the deciding factor of stock price, as always, is value. Going forward, the fund strives to find at least some of the undervalued stocks when they become available in U.S. stock market, in an effort to achieve a good long-term return for the shareholders,’ he wrote.”

Information is available on Wang’s holdings as of the end of 2011, and it shows an interesting mix of conservative and risky holdings. About 20% of his portfolio was in a money market fund at the end of the year, for example, his largest position, according to Morningstar. But his next largest holding was Bank of America stock, which made up 11.4% of his portfolio. Rounding out his top 5 holdings were three stocks: Archer-Daniels Midland, Arrow Electronics, and General Motors. Blue chips like Dell, Microsoft, JP Morgan Chase, and Goldman Sachs were also among his 18 equity holdings.

Valuation Expert Says Market Only “Slightly Expensive”

An expert on stock valuation who warned about the late-1990s Internet bubble says that stocks aren’t near bubble territory today. 

Stocks are only “slightly expensive relative to their long-term average,” John Campbell, who is the chairman of Harvard’s Economics Department — and who was with Robert Shiller the co-author of a late-1996 paper that warned Federal Reserve officials of a stock market bubble — tells MarketWatch’s Mark Hulbert. Back when they presented their paper to Fed Chairman Alan Greenspan and other Fed officials in the 90s, Campbell and Shiller warned that the cyclically adjusted price/earnings ratio (CAPE ) was nearly 28, among the highest readings in history, Hulbert notes. Now, the CAPE (which uses inflation-adjusted average earnings for the past decade) is high — 21.9 — but still well below where it stood when the Internet bubble ballooned.

And Campbell says there are other factors that are making today’s 21.9 figure better than it may seem. “Campbell added [that] stocks may be justified in being priced at slightly above-average valuations,” Hulbert writes. “That’s because, he said, there appears to be no good alternatives. The bond market, for example, which is the only other asset class that could readily absorb even a portion of the trillions invested in the stock market, is particularly unattractive for long-term investments right now.”

Hulbert also ntoes that the CAPE looks a lot better when compared to more recent averages. “The CAPE has been higher in recent decades than it was in the latter part of the 19th and early part of the 20th centuries,” he says. “And when compared to its average level in these most recent decades, the current CAPE level doesn’t appear to be so out of line. In fact, it is only 12% higher than the average level of the last 50 years, and it is right in line with its average level of the last 30 years.”

Lee and Rosenberg Square off on Stocks

Thomas Lee, chief U.S. equity strategist at JPMorgan Chase, and David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, went head-to-head recently on Bloomberg in discussing their differing opinions on where the stock market is headed. Lee is more bullish than Rosenberg, saying that history has shown that when the equity risk premium is high — which it is right now — stocks still tend to do well even if the economy isn’t great. Rosenberg isn’t as optimistic on the economy and broader market, saying that economic data has not been as good as many believe it has been lately, in part because seasonal factors have made some numbers look better than they are in reality. But he’s not exactly a huge bear either. He’s not saying investors should dump stocks; instead, he says they should be invested in more defensive areas of the market, like high-quality stocks and those that are paying high or increasing dividends.

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