Tuesday 26 November 2013

The Importance of Self Reliance

Apologies for not posting for a while. My father passed away last week and so I have been rather pre-occupied with other matters.

This has been a period of intense reflection about my father and his life, which was quite extraordinary in many ways. He was a self-made man who started with almost nothing. He was both a very compassionate man, but also a hard worker who stressed self-reliance. It was a theme that featured prominently at his funeral and so I thought that this theme of self-reliance was worthy of a brief post.

The managed funds industry obviously likes to encourage investors to put money aside for a rainy day. However, in many respects, they abhor the notion of self reliance. Investing directly in the stock market is too difficult for ordinary investors - best to leave it to the experts. Oh and by the way, that so called expertise comes at a price, so be prepared to pay up, even if your investment fund under-performs the market.

Actually, investing in managed funds  is not necessary. Any, reasonably intelligent private investor with a clear strategy and discipline should be able to invest and outperform managed funds. This is because managed funds are, due to their size, dominated by large caps that are constantly being scrutinised. Thus opportunities to take advantage of mispricing are pretty low. In contrast, smallcaps offer more mispricing opportunities, Furthermore small private investors have a structural advantage over managed funds as they are able to build a stake in small caps without affecting the share price.

My father dabbled in the share market although he made most of his money through property investing. In any case, I think that his values around self-reliance are very similar to the basic theme of this blog. Don't trust anyone who is trying to get a slice of your hard-earned savings. There is not reason that you can't do this yourself. Start reading, develop a strategy that suits your skills and temperament, implement the strategy and most importantly, stick with it!

Sunday 10 November 2013

Review of Stockopedia

Stockopedia is  a UK based stocks and shares information service. There is some basic information available for free and a subscription is required to access the premium content. It currently costs £19.95 a month to access all their data on UK stocks. Is this worth paying for?

In a word, yes! Although ultimately all the underlying information is public data, Stockopedia does an excellent job of organising this information so that you can quickly make sense of it. Every UK listed stock has a raft of colour coded indicators and metrics. There are a range of different valuation tools that you can tweak to your hearts desire. There are also a host of different charting tools and metrics. Whatever you investing style, there are are a set of visually informative and easy to use tools to help you.

Stock screening

While all equities information services these days offer screeners, Stockopedia's is the best I've come across. It has a huge range of screening parameters and you can either create your own or 'fork' a pre-cooked screen from one of more than 65 guru screens. So if you want to emulate your favourite investment guru, Stockpedia makes it easy.

Stockopedia have also created their own unique guru screen called the "Screen of Screens". This counts the number of times a particular stock appears on any of the other long guru screens. This is an interesting idea as it highlights stocks that are attractive from a number of different angles. A hypothetical portfolio based on this screen has returned 77 per cent since the December 2011 compared with about 24 per cent for the FTSE 100.

StockRanks

In the last couple of months, Stockopedia have been experimenting with something they call "StockRanks". These are composite metrics for four broad factors, namely value, quality, growth and momentum. For example "value" combines six different valuation metrics namely: P/E, P/S, PBV, PFCF, earnings yield, dividend yield. Stocks are ranked in these score with 100 for the top scoring stock down to 0 for the lowest. Each of these ranking factors can then be combined depending on your investing style.

Initially, Stockopedia combined all  four ranking factors into a single composite score. However, their preferred composite measure now omits growth, just combining quality, value and momentum. Their research has established that there is a tendency to overpay for growth. Therefore, it is not a strong predictor of future share price movements.

More thoughts on Stock Ranking

I think that stock rankings are better than screens. A stock screener is essentially a checklist and if a share narrowly fails just one test, then it is screened out even if it scores very strongly on other criteria. Thus, stock screening will tend to leave some good candidates hidden. Ranking methods allow stocks to be weighted so that some moderate weakness in one criteria will not necessarily override strengths in others. Thus stock screens are quite blunt instruments, while stock rankings offer more careful calibration.

This idea of ranking stocks across multiple dimensions is key to my investment appoach. Greenblatt's argues that although his Magic Formula does not work all the time and the investor just needs to be patient. However, this doesn't seem completely satisfactory. If you are going to take a mechanical rules based approach to investing, it seems reasonable to aim to have something that works, if not all the time, then at least as often as possible.

The stock market goes through phases where certain investment styles do better. Over the last few years, value investing has performed better than quality based approaches. Momentum approaches have done particularly well in 2013. However, rather than trying to guess which style is going to do well in future, why not select stocks that have a number of strengths that should do well regardless of what particular style is performing best at the time? Stockopedia's StockRank does exactly that and therefore this is now the main basis on which I select stocks.

Back-testing

The only slight quibble I have with Stockopedia is the lack of any back-testing feature. The reasons given are that historical data are either unreliable or prohibitively expensive. However, some back-testing functionality may become available over time as Stockopedia build up their own data.

I went through a phase of doing a lot of back-testing for which I used Sharelock Holmes. This is what got me thinking about the limitations of stock screening and that some kind of weighted method on key metrics would work better. I didn't really pursue it as I didn't know how to go about it. Now that I have come across StockRanks, my conclusion is that these are going to be pretty hard to beat in terms of any mechanical rules based investing so back-testing seems like less of a priority.

Closing thoughts On Stockopedia

I really like the philosophy of Stockopedia. They are geared towards the DIY investor and do a great job at de-mystify equity investing. Why pay fees to fund managers, very few of whom consistently beat the market when for a modest fee you can access information and tools that give you every chance of doing better? Stockopedia has become my main source of information on UK stocks and I would be lost without it.

If you want to try it out go to the Stockopedia website.


Sunday 3 November 2013

Joel Greenblatt's Magic Formula

Introducing Greenblatt

I am keen to kick on and set out my investment manifesto. However, before we get to that I need to provide some more context.

Like musicians, investors are influenced by the greats that have come before them. Joel Greenblatt was influenced Warren Buffett who in turn was influenced by Ben Graham. From my first two posts you've probably guessed that I am a fan of Warren Buffett. Show me a private investor who isn't?

However, for me Joel Greenblatt is my single biggest influence.

The Little Book that Beats the Market 

Greenblatt's The Little Book that Beats the Market sets out in layman's terms the investment philosophy he used when running the hedge fund, Gotham Capital. Apart for being short (less than 150 pages), its written in a 'self help' style, full of whimsical anecdotes, like those self help books written in the 1930s by the likes of Dale Carnegie and Napoleon Hill.

Although a bit annoying in parts, Greenblatt does a good job of getting across the point that successful investing boils down to basic principles and discipline. In essence the advice is to buy great companies at bargain prices. While those words could have come straight from the mouth of Buffett, what Greenblatt does is to set out a mechanical approach for selecting stocks and managing a portfolio.

He selects stocks based on something he calls his  "Magic Formula". In very simple terms he uses earning yield as a  measure of value and return on capital employed (ROCE) as his measure of 'quality'. He ranks the universe of investable stocks on each these criteria and then adds them together. Stocks are then selected from the thirty or so lowest scoring stocks.

There is a good summary of "Magic Formula Investing" over on Stockopedia if you want to read more.

Does the Magic Formula work?

Greenblatt claimed that the MF is capable of making abnormal returns of up to 30% pa. However, independent testing has struggled to get anywhere near that. For example, over at Stockopedia the performance of Greenblatt MF screen has struggled to keep up with the FTSE 100, and currently ranks 50 out of 60 'guru' screens in terms of annualised performance.

There are a number of theories for this. Something I read a while back on a U.S. blog is that in recent years the MF has tended to flag up Chinese reverse take-over stocks that have mostly tanked. Ed Croft of Stockopedia has documented research by Wes Gray and Tobias Carlisle that suggests that the MF has a tendency to systematically overpay for quality. My own theory is something actually mentioned in the foreword of "TLBtBtM", which is: if lots of people start following a certain investment strategy then returns will diminish. I think that simplest explanations are most usually correct.

The MF is certainly the best known systematic/mechanical strategy around although I have no idea how many people are actually using it. I subscribe to a Yahoo group on MF Investing and if the recent postings, or rather lack of them, are anything to go by then it certainly seems like interest in the MF is waning.

Greenblatt himself says that the MF goes through phases when it doesn't work as well and that the trick is to be patient and wait for the inevitable upturn in performance. Interestingly, the Greenblatt MF screen on Stockopedia has had a bit of a surge recently increasing 14 per cent in the past 3 months. So, perhaps investors have given up on MF investing at just the wrong time?

Trust the Quant

Although I am inspired by Greenblatt I have reached the conclusion that his approach is not for me. First of all, I don't believe that following a well trodden path is an optimal strategy - its got to be better to seek an angle that fewer people are following.

Secondly, it seems to me that there has got to be better ways of identifying cheap stocks at good prices". Stockopedia have developed a more sophisticated approach for ranking stocks in terms of value and quality. For example, their method for ranking value uses earning yield with five other valuation metrics. That has got to give better results than just one.

However, the thing I do like about Greenblatt are the wonderfully simple things he has to say about mechanical investing. The idea of buying a stock and holding it for a year, The idea of buying and selling just once a quarter. The idea of selecting candidate stocks at random, rather than trying to apply additional discriminatory criteria. His overriding philosophy is to "trust the quant".

This is such a great mantra. My worst decisions always seem to be when I am panicked or acting impulsively. Learning to "trust the quant" is a way of allowing the intellect to subjugate those emotions that make us do stupid things. It is something I should start repeating to myself everyday!