Friday, December 23, 2011

Geoff Gannon's latest post is on net-nets, the importance of return on equity, and potential catalysts for net-nets.

A net-net is a stock selling for less than the value of its current assets – cash, receivables, inventory, and prepaid expenses — minus all liabilities. Basically, it’s a stock selling for less than its liquidation value.

In Ben Graham's day (during the depression) he could by net-nets that were selling for less than 2/3rds of their net current assets.

Warren Buffet once found a stock with $20 of cash that was selling for $3.

Monday, December 19, 2011

The magic formula in New Zealand

The bookbookfund doesn't invest in New Zealand equities, but I do on my personal account. Ever since I read Joel Greenblatt's The Little Book That Beats The Market I've been interested as to how his "magic formula" would work in New Zealand.

Briefly, the magic formula is:

Establish a minimum market capitalization (usually greater than $50 million).

Exclude utility and financial stocks.

Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).

Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.

Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

Continue over a long-term (3–5+ year) period.

I got hold of New Zealand stock market data here.

With that data, I ranked all the stocks by earnings yield and by return on invested capital, aggregating their rankings and then ranking the aggregate (to get the best "combo"). Then I created portfolios of ten stocks a piece (if you buy 30 you may as well buy the whole NZ market), starting January 2004 (where I have data back to), to the present day. I only rebalanced every year, in January.

I used sharesight to input the portfolios, as that site then gives me all the dividends so I can count those too as well as any capital gain.

There was corrupted data from the Stern University NZ data for 2007 so I was not able to rebalance on January of that year (I had to keep my 2006 portfolio for two years instead of one). There were a few other issues when inputting data where I had to use a second choice, but I still got plenty of big winners and big losers.

Overall, from 1 January 2004 to the present day, the "magic formula in NZ" strategy returned a 8.93% cumulative annual growth rate. My first fake portfolio had $150 000 worth of shares at the start of 2004, and with annual rebalancing (except for 2007) it has a current value of $296 508. Not bad, but not particularly astounding.

But I checked the return of the smartFONZ index fund over that period. Unfortunately, this exchange traded index fund didn't start until part way through 2004. To account for this, I took the value of the magic formula portfolio at Jan 2005 ($181 486) and pretended that instead of persisting with the magic formula strategy, I simply purchased the index fund and waited. That strategy returned 0.6% cumulative annual growth rate (including dividends), and that's including the $31 486 advantage from using the magic formula in its first year! Compared to that terrible growth, the magic formula looks pretty magical.

This was a very rough experiment: none of the data or methods I used were particularly sound. I found the best free excel ready data I could, and used sharesight - a pretty powerful portfolio tracker.

If I make further investments in the NZ sharemarket, I'll definitely be looking at where potential companies rank in the "magic formula".

Saturday, December 17, 2011

Follow me on twitter

Bookbookfund has a twitter account:!/Bookbookfund

I'm still working on a post with actual content.

Sunday, December 11, 2011

Valuation ratios

When you take two fundamental measures of a stock or business and divide one by the other you get a financial ratio. A valuation ratio is a financial ratio that directly relates to the market price of the stock or business. P/E is the price/earnings ratio, or the current market price divided by the trailing twelve months’ earnings. All else being equal (a condition that doesn’t usually hold), a stock or business with a lower price/earnings ratio than another is “cheaper”. This is because you’re “buying” the earnings of the business for a cheaper price.

The price/earnings ratio is the most commonly cited financial ratio because it’s one of the simplest to understand, use, and find. Selecting stocks based on low price/earnings ratio beats the market. Cameron Truong shows in this paper that if you divided the universe of stocks listed on the New Zealand stock exchange into five groups ranked by the lowness of their price/earnings ratio, the group with the lowest price/earnings ratio (the “best p/e quintile”) returned 18.81% per year from 1997 to 2007, and the “worst p/e quintile” returned -1.95%. Note that this is using backtested data, but forming a strategy that can be replicated going forward (ie, it’s not using future data to make current decisions to buy or sell, it’s using past data to make current decisions to buy or sell).

Results like this (although not of this magnitude) are generally repeated in all stock markets over time. Dr Truong has other papers showing the lack of efficiency in the NZ stock market. If this lack of efficiency is actually reality, it’s not surprising that such a simple strategy has positive abnormal returns.

One other very recent paper using more complete data from the USA is Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years. Wesley R Gray (check his blog and website) and Jack Vogel take five common financial ratios and backtest their performance over the last 40 years.

The five valuation ratios are:

• Earnings to market capitilisation (E/M)
• Earnings before interest and taxes and depreciation and amortization to total enterprise value (EBITDA/TEV)
• Free cash flow to total enterprise value (FCF/TEV)
• Gross profits to total enterprise value (GP/TEV)
• Book to market (B/M)

Here are their results:
The “CAGR” is the compound annual growth rate. Gray and Vogel divide into quintiles as well and find that the “best quintile” of EBITDA/TEV (on an equal weighted basis, rather than weighed by market cap) returns 17.66% as compared with the “worst quintile” of 7.97%. So if you just ranked all the stocks every year from 1970 and bought the 20% that were “cheapest” on the EBITDA/TEV metric, you would have returned 17.66% on average over 40 years. If you started with $10 000, you would have $6 685 805 after 40 years. Backtesting has some problems, but the paper corrects for the most glaring ones.

Other “value investing” metrics also have abnormal positive returns (the best kind of abnormal returns) but EBITDA/TEV seems to be the most abnormal (and hence most positive).
Knowing this now, I would like to run Truong’s data through an EBITDA/TEV backtest. I emailed Dr Truong and got his data, but I’m not sure when I’ll find time to run the test (plus I don’t have all the fancy software or any research assistants). If I get round to it I’ll post results here. It’s not directly relevant to the bookbookfund because we’re not investing in NZ equities, but I invest in some NZ equities on my personal account so am generally interested.

On the more general point of valuation metrics, some of the investments in the bookbookfund are chosen because of their high valuation ratio rank in the universe of US stocks. Two of those currently in the portfolio are Dell and Microsoft. I may come back to one or both of those in a later post.

Thursday, December 8, 2011

A very special situation

The value investors’ club is an online community of 250 members who share their ideas on value investments. Membership is by application with roughly a 6% acceptance rate – the application must include a detailed investment idea. I applied earlier this year and was rejected.

For non-members, the website is accessible with a 45 day delay – 45 days after an idea is posted to the website, anyone (who registers a free account) can access the idea. The idea below is from the website. The opportunity closed within the 45 days so we weren’t able to take advantage of the idea. But because it was such a cool and unique situation, I’m going to briefly describe it.

Norilsk Nickel is a Russian company whose shares trade on the Russian stock exchange.

When shares are only traded on one exchange, sometimes they are traded over the counter (OTC) on another exchange. In Norilsk’s case, they are traded as “American Depositary Shares” (ADS) on the “pink sheets” (a private company that provides an over the counter market in the U.S). Each Norilsk ADS represents 1/10th of a Norilsk share.

On September 8, 2011, the company announced a share buyback, where shareholders could tender their shares to the company, and the company would pay the shareholders out. The company was to buy back 7.71% of the outstanding shares, at $30.60 per ADS (or $306 per common share). That was to cost $4.5 billion in total.

After the announcement, the ADS were trading around $20. Why would they trade at $20 when they could be sold back to the company at $30.60 a few weeks later? Because the company was only buying back 7.71%, and if more than 14.7 million shares were tendered, shares in the offer would be purchased on a pro-rata basis. This means that if you bought hundreds of thousands of dollars worth of shares, you’d only be able to sell a tiny fraction back to the company.

But here’s the very special situation: the shares were not pro-rated for tenders of 1 000 ADSs or less (or 100 common shares or less). So if you tendered 1 000 ADS, the company was compelled to buy at $30.60. So you could buy 1 000 ADS for $20 000, and receive $30 600 about 4 weeks later when you tendered them to the company. Normally situations like this exist for mere minutes, as everyone buys up the shares and the price increases to the $30.60 (or slightly below to account for the risk that the transaction doesn’t go ahead). They didn’t in this case, because the only people “guaranteed” the $30.60 for each share were people who only wanted to sell 1 000 or less. Most professional arbitrageurs wouldn’t bother with this opportunity, because the maximum gain is likely to be around $10 600. If you’re managing millions of dollars of assets this isn’t particularly attractive – the time it takes to take a good look at the transaction isn’t worth your while when you can only put a tiny proportion of your funds into the opportunity.

The company specified likely scenarios where they wouldn’t buy the shares back, but these were limited and seemed unlikely. This was a perfect opportunity for Value Investors Club members – a diverse group where each could take advantage of a smaller opportunity, rather than one fund being able to deploy a large amount of capital itself.

So what happened? The deal closed, and everyone who bought 1000 shares at $20 each made about $10 600 in four weeks. Unfortunately, as we (currently) have only delayed membership, the bookbook fund was unable to increase its net worth by 20% in four weeks. But it shows the type of opportunities that are part of what we’re looking for. I’ll deal with other types of opportunities (more general underpricing) in a later post.

Monday, December 5, 2011

Why is it called the bookbook fund?

A couple of months ago I had a business idea. I noticed that lots of successful companies were effectively bare bones publishers for other people's content: Blogger is a publisher of people's brief writing, Youtube is a publisher of videos, Twitter is a publisher of brief thoughts, and Facebook is a publisher of all these things.

I had an extra coffee that morning so I was daydreaming at my desk about becoming a wealthy and influential person. I thought there was a giant gap in the market for bare bones ebook publishing.

My idea was a website that allowed you to upload a text file, have it converted to an ebook, and share it with everyone. If you wanted to charge for it (maybe you were sharing your university notes with the class but wanted $5 per copy, or maybe you just wrote a book that you wanted to self-publish), the website publisher would take a % of the sale price.

I came up with the name bookbook - it's like facebook but for books, so call it bookbook. It's catchy. I talked to my brother and my friend about it at lunch and they both thought it was a pretty good idea. I went back to work and spent the rest of the day thinking about the TED talk I'd probably end up giving.

When I get home, I googled "ebook publisher" and noticed there were about 10 professional looking sites that already did the same thing. So I scrapped the idea.

Then when I decided I could invest in underpriced equities and make good long term returns, I realised that bookbook was more than a business idea five years too late - it was also a cool name. So we're using that name.