Fusing Business Momentum and Value

Business Momentum Look at Investing from a New AngleThe following article comes from one of the best discussion board posts I’ve read. The post is republished below with the permission of the author. This enriching and entertaining article exemplifies a style of fusion investing, the fusion of business momentum and value.

I hope you enjoy reading and thinking about this article as much as I did. It’s a fantastic example of looking at things from a new angle.

What did we do right in 2009?

One year of good return may be just a result of high tide lifting all boats or simply mean-reversion from a terrible year. Nevertheless, my biggest take-away from 2009 was a subtle but important change to my investment philosophy – I have changed my focus from “good and cheap” to “better and cheap”. I care more about change in fundamentals – I prefer a bad company that is getting better over a good company with no change in story. This new philosophy has led to solid stock picking, which generally out-performed the market with what I believe to be lower risk (“permanent loss of capital”). Equally important, this new framework gives me better guidelines to size my bets, especially betting heavily in situations where both the story is getting better and stock is cheap.

When I started investing a few years ago, I was firmly in the value investing school – concepts like “intrinsic value” and “Mr. Market”, coined by Ben Graham and popularized by Warren Buffett, clicked for me instantly. I spent time studying company fundamentals, coming up with an estimate of the intrinsic value, and trying to buy at a cheap or discounted price. In short, I was trying to buy “good and cheap”, and results were satisfactory.

Balancing between business and momentum

However, I have come to realize the quality of the company and absolute discount to intrinsic value are not everything – one has also to consider the time and factors it takes for the discount to narrow, which typically depend on the business cycle. Thus my new approach comes down to balancing between value and momentum. Value refers to the price paid for the business. Momentum, not to be confused with price momentum in quant and technical analysis, refers to business momentum, i.e. how well the business is doing. Improving momentum can come in the form of higher margin, accelerating topline growth, or improving ROIC. With the exception of select great companies in their growth phase, most companies’ stock price and business momentum move in cycles/curves similar to sine waves with peaks and troughs.

These two curves are closely related – when business momentum is good, stock price tends to go up, and vice versa. However, there is often a lag between the two curves, and depending on the part of the cycle, stock price will react to the change in business momentum very differently. I believe this is the crux of investing – how you identify which part of the cycle the company is in, which drivers to watch for and which valuation metrics to use. For example, earning revision is a powerful factor but completely useless at business peaks and troughs. P/E may be a good valuation metric in general, but unadjusted for margins, it is useless or even dangerous at extremes. [I stopped highlighting here as it’s all so good the entire article should be highlighted!]

For example, assume a retailer’s intrinsic value is $20, and buying at $15 may give an expected return of 33%. However, the same $15 price may correspond to two points on the momentum curve – one where the curve is turning up (story getting better) and the other where the curve is trending down. In the former case, you will probably get to $20 in 6-12 months. In the latter case, you may have to wait 18-24 months before the retailer corrects excess inventory and produces positive SSS (curve turning up again) to reach the $20 intrinsic value.

There are two obvious problems with buying at the latter point. First, time adjusted return is obviously inferior. Second, the stock price may first plunge to $6 before recovering. While a pure value investor may think a lower price makes it a better buy (even more margin of safety), reality is that an adverse price movement will slowly but surely inject doubt into my mind. Have I made a mistake? Is this a value trap? Very seldom does stock price move down without some deterioration of business fundamentals and some changes to the initial investment thesis. So unless one has an iron stomach (I don’t), it is very tough to keep calm during the price downdraft and continue to average down.

There is an even bigger issue – if you are prepared to average down, chances are that you will not buy a full position initially, and inevitably you will end up establishing similar-sized partial positions for all new ideas. Yet some of those ideas will have good business momentum and they are your surer bets, so you lose potential profits in positions that actually have the best risk/time adjusted return.

Does quantitative investing capture business momentum?

So doesn’t quant investing capture “better and cheap”, as preached by the noted quant investor Cliff Asness? Yes and no. I believe there are two problems with quant investing. First, it mistakes cause with effect – price momentum is the result of business momentum, and while the two will resemble each other at certain part of the cycle, they will diverge significantly at critical turning points. Second, the effectiveness of various factors differs significantly from industry to industry as well as at different parts of the business cycle. Quite simply, quant investors lack the domain knowledge of each industry and use the same factors or same weightings across sectors during different points of the cycle.

For example, quant investors will universally use factors such as earning revision, revenue/EPS surprise/breadth to capture business momentum. While this does a satisfactory job overall, it will not capture key drivers for each industry, which often cannot be retrieved from standardized financial statements, such as inventory/store for retailers, or asset inflows for asset managers. Often changes in these key drivers will long precede actual changes in earnings, so generalized quant investing could easily miss the turn. As another example, six months ago, both KIRK and ARO got the highest rating in our internal quant system, yet the two retailers could not be more different in terms of where they were in the business and margin cycle, and the subsequent divergence in stock performance illustrated the flaw in the quant investing approach.

Catching the turn

I certainly do not want to leave the impression that other investing approaches are inferior. Indeed, there are many ways to achieve success in investing, and everyone needs to find approaches to fit his or her own traits. I believe I have found mine by balancing between value and momentum. Put simply, I aim to invest in situations where fundamentals are about to turn or have turned while valuation is reasonable. I am certainly not reinventing wheels here, as this is the approach advocated by both Peter Lynch (“catching the turn”) and Warren Buffett (“What we really like to see in situations is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it”).

Well, this approach may sound good on paper, but how many of these “perfect” situations exist, given how efficient market is with so many hungry and smart investors poring over every corner of the market? I believe these opportunities happen more often than one may think, especially if one can invest in small-cap or micro-cap land. For example, I monitor about 50 names closely in the retail industry (which I shamelessly consider to be my circle of competence). This year alone, I identified 4 separate names that fit the criteria. They respectively returned 50%, 70%, 100% and 900%.

One may counter that retail stocks have done very well in general this year and question whether throwing darts randomly would have generated similar if not better results. I would argue that much of the return (especially the out-sized ones) was hope-based, and rational investors could not have predicted those returns ex-ante with any confidence to place a big bet, as some of those names could easily turn out to be zeros. Yet in all four names I identified, I was reasonably certain of the business momentum and earning surprise, and could accordingly place out-sized bets (10%+), with confidence that even if it did not play out according to plan, I would suffer very small losses due to valuation.

While hindsight is 20/20, I could also identify at least two retail names annually over the last few years that fit my “better and cheap” criteria. So they definitely occur, and one just needs to have the patience and courage to bet big when they do come along, usually when market is bad. Those situations can occur in large-cap stocks as well, such as FDX throughout this year. FDX had over $20B market cap, was followed by 25 analysts, yet the stock was at trough EV/sales, even though earnings had bottomed and was poised to recover through cost cuts and market share gains. Earning estimates have moved up 60% in 6 months and stock went up over 150%.

As with anything in investing, there are also drawbacks to my approach. One is depth vs. width – I need to be able to identify and evaluate key drivers for the companies and industries, and this takes significant amount of time. The rarity of these “perfect” situations forces me to turn over a lot of rocks. To date, I am reasonably comfortable with retail industry, and to a much lesser degree with software, asset managers and transport industries. I may soon reach (if not already) a point where I can not physically monitor more names. The other problem is scalability – most of my top ideas are in small to micro-cap land, so it is questionable whether my approach can really handle more than say $50-100M of assets. But that will be a nice problem to have, and I suspect I will just have to make the trade-off between absolute performance and AUM.

 

Originally posted Mar 4, 2010 

Are you concentrating hard enough?

I sure am!

The top two shares account for 78 percent of our concentrated share fund. The top three 92 percent.

So yes, we’re concentrated!

Two great investing principles

The five shares in the portfolio reflect two simple investing principles.

Two rules from two great investors, Peter Lynch and Warren Buffett.

Water your flowers and pull out the weeds, and only own a handful of companies.

I learnt both rules from Peter Lynch. Though it was Warren Buffett who popularised the concentrated approach with his catchy 20 ticket punch card analogy and his ‘You don’t have to swing at everything — you can wait for your pitch’ phrase.

Lynch was more mater-of-fact.

‘The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money.’

I illustrated that point in this post highlighting how the view of ‘the greater the loss the ever greater the gain required to make you whole again’, was wrong. For example instead of requiring a 400 percent gain to make up for an 80 percent loss as contended, due to the parallel nature of investing an 80 percent loss is balanced by an 80 percent gain.

The two largest positions are a result of watering of the flowers. Adding on the way up and then simply holding on. Though the second largest has now been trimmed three times. A potential fourth haircut inspired this post.

There are only five companies in the portfolio as the weeds have been pulled.

The third largest portfolio position deserves some water. It’s management are frugal and appear focused on safely growing and rewarding shareholders.

The smallest two positions are speculative long shots. They’ll only receive water if their odds of success shorten.

Please keep in mind there are many right paths. We hold close to 20 companies in our super fund. Plus our concentrated fund has and likely will hold more companies.

Can retail investors outperform the market?

Lies, damn lies, and statistics” was popularised by Mark Twain to describe the persuasive power of numbers.

For many years I’ve replaced damn lies with facts. Lies, facts and statistics.

Facts, like statistics, can tell you whatever you want to believe. Many people believe the are looking at the truth through the lens of either statistics or facts, but they are often simply seeing what they wish to. They then use the “lies” to entrench their position.

Facts and statistics are often the trees stopping us from seeing forest.

I’m not implying it’s always best to focus on the forest, sometimes it’s the trees we need to look at. The important part part is to have the right focus for the circumstances, an open mind, and not to swallow statistics or facts without chewing.

Statistics tell us that retail investors woefully under-perform the market. Stats also highlight around 75% of fund managers lag the market. Many people concentrate on those dire figures and in the case of ETF and index funds heavily publicise them.

So why would a retail investor bother trying to outperform the market? Statistics say it is highly unlikely and individual investors are seriously out-gunned by institutions.

The answer is, invert those statistics.

Can retail investors outperform the market?

Market returns are the average of all participants. So if the vast majority of participants under-perform the market then a minority must be trouncing the market.

I occasionally communicate with one  of these market thrashing investors. Here are his returns to October 2014

retail-investor-market-beating-performance

Those are some awesome numbers. For some perspective on how good his performance is consider this. Over the last 5 years he would have turned $100,000 into almost $410,000 and over the last 3 years $100,000 would have grown to almost $290,000. Simply phenomenal.

Now let’s compare his returns to mine.

investor-x-returns-vs-fusion

While we both handily thrashed the market, I trail by a considerable distance. Even though my performance over 5 years appears pretty close to his, it’s not. Instead of growing to $410,000 over 5 years, I would have “only” grown it to $309,000. A few percentage points makes a huge difference.

Investor X wonders why I hold such a high cash balance, around 50 percent at the moment.

One comment I would have, is the fact that you have moved to around 50% cash. I also watch Geoff Wilson’s performance with his LICs WAM, WAX and WAA, and he also likes to keep between 30-50% cash. I have always thought he could do a lot better if he was prepared to be more fully invested. Yes, you are both in an excellent position to take advantage of the down turn we are now in, but I wonder at the cost of lost opportunity. I rarely have more than 2-3% in cash. If I sell something, it is because I have found what I judge will a better investment to move onto.

Investor X is right. My returns would be much closer to his over the last 5 years if I was 100 percent invested. While close to meaningless, we’ve also compared monthly volatility and my portfolio is more volatile. So why do I hold so much cash?

The simply answer is personality. While investor X was able to live with a 60 percent fall during the GFC, I could not. Our portfolio dropped around 20 percent during the 2008 market crash. I prefer to sacrifice some upside to ensure I can sleep well at night.

The other answer is buy fear sell greed. While many market pundits present facts and statistics showing that the market is under or over value, or  just right, I focus on the trees, the individual companies. I raised cash in September as companies I held became overvalued. I’ll redeploy capital when it’s easy to do so, when companies I want to buy are being sold by fearful investors.

Investor X is older and probably wiser than me. He clearly has better performance over the last 5 years. But what happens if we layer on our respective 60 and 20 percent drops?

It turns out if we started with a $100,000 prior to the GFC and our returns included both the falls and gains from above then investor X’s portfolio would now be worth $164,000 while mine would be $247,000. Naturally if we exclude the GFC drop, but our portfolios fell by similar amounts now, the figures would be the same, i.e. $164k and $247k.

I’m not saying this is what happened or will occur, but I hope it illustrates why I focus on the downside. If not then perhaps this graph of gains required to make you whole again will.

See the difference. While it only take a 25 percent gain to make up for a 20 percent loss, it takes a massive 150 percent increase to recover from a 60 percent drop. (See this post on the lies behind this accepted fact and how it can take exactly the same percentage gain to make up for a loss.)

I am so far off topic I should change the title, but hopefully through the many diversions you can see two retail investors thrashing the market in two different ways. While there are many wrong paths, there is no one right path to market outperformance. Each investor must fine the path that is right for them.

Some paths are easier to follow as they are clearly marked. Value, momentum and small caps are 3 paths that have provided strong tailwinds for up to 9 decades now.

A little meat

During September I sold, Analytica Limited (ASX:ALT) and Global Health Limited (ASX:GLH), and reduced M2 Group (ASX:MTU) and My Net Fone Limited (ASX:MNF).

While I say it’s the companies I focus on, that is simply part of the story. Market corrections are not fair to all comers. Some stocks get whacked 90 percent, some might only drop 10 percent and there will even be a few gainers.

In general stocks that are any of overvalued, speculative, small caps, without earnings or popular are hardest hit.

I continue to hold some stocks that are likely to get clobbered in a correction. Two companies that jump to mind are Somnomed Limited (ASX:SOM) and Nearmap Limited (ASX:NEA). I hold these and would look to buy on a correction as it is simply too difficult to ‘time’ individual growth stocks.

Disclosure: Long MTU, MNF, SOM and NEA.

Does making financial predictions make you a dickhead?

The good news is making financial predictions won’t make you are dickhead, the bad news is you already are a dickhead!

Before I dive in to the very shallow pool of self congratulations that most financial pundits wallow in, allow me to recap part of my investment philosophy.

As a young lad my mother used to say, “According to you everyone is a dickhead except the Pascoes and Morels”. Bede Pascoe was my best friend and my mum was right. Bede and I thought most people were dickheads!

I was around 14 when I realised that I might also be a dickhead. I remember the incident well, which is unusual for me, and funnily enough Bede was the one who delivered my realisation.

My mantra changed slightly to “everyone’s a dickhead, including me”. The core tenant of my philosophy became that whatever theories or beliefs people held as truths were probably wrong. Yes 2 plus 2 equaled 4, at least most of the time, but I doubted most things, including lots I believed.

So when my interests turned to finance it was no surprise that I thought efficient markets theories were the spawn of complete smegheads.

Predicting the future

But what may surprise you is that I embraced predictions. Yes I have a crystal ball! It may be a tad cloudy, but all you need to make money in the markets is a slight edge. My crystal ball is one of the tools that delivers that edge.

When people believe in efficient markets or scoff at predictions they deliver me an edge.

My focus when investing is predicting the future. Predicting what a company is likely to achieve and how investors are likely to react. Predicting what is likely to happen over the next few years and how investors will respond. This crystal ball gazing works best when the market is mispricing a company, that is when the market focuses exclusively on either the good or bad news surrounding a company.

People are unable to entertain competing ideas let alone objectively price the outcome of those opposing ideas. The larger the herd the easier it becomes to predict the next move.  

Is making financial predictions unusual or bad?

Predictions have a bad wrap, but finance is all about making predictions.

Discounted cash flows are predictions. Not only that, they’re predictions of the worst kind. Predictions should be as vague as crystal balls are cloudy. But by wrapping a prediction in financial mathematics many fools suddenly believe they can predict to the cent what something is worth. They try to predict cash flows 10 or 20 years in to the future and worse yet try to accurately predict them.

Of course wise value investors realise that accurately assessing value in incredibly difficult to do, so they embrace the concept of margin of safety. Buying something for considerably less than you predict it’s worth gives you a margin of safety. A margin to compensate for your cloudy crystal ball.

Soon, I’m going to blow my own horn by showing you one of my predictions and how it played out. But before that here’s a few more predictions.

At around $41 when some analysts were belatedly jumping aboard the Xero (ASX: XRO) rocket and calling it a buy, I said it may be worth a nibble at under $30, but the load up time was around $19. Some people thought I was crazy and Xero would never again see such a low price. Well Xero has traded under $22 this week and you know what I now reckon that under $10 may be possible and under $5 not impossible.

I arrive at those figures by predicting the future based on the reliability of past events and investor reactions. In this case a major market correction or some other major event is likely to occur well before Xero is profitable. When that happens stocks without earnings will be taken the woodshed  and flogged to within an inch of their life. And that is the time to buy a company like Xero.

The wonderful thing is that it doesn’t mater if I’m wrong, it only maters if I’m right. I lose nothing if wrong, but am prepared to win if right. Compare that to those telling people to buy Xero at over $40. If they were wrong there was huge obvious downside, if everything went perfectly there was limited upside.

Here’s another prediction. The current yield chasing craze will end badly. Investors who are currently congratulating themselves on being masters of their own universe will be found to be naked as the yield tide goes out.

On to the main self congratulating event, here’s what I wrote in March 2013. Hopefully you can extract something useful for your future endeavours.

Finger Lickin’ Good

Collins Foods (ASX: CKF) owns, operates and franchises KFC and Sizzler restaurants…

A respected fund manager, Orbis Investment Management, continues to buy Collins Foods, and they now own 17.4 percent of outstanding shares. They’ve bought over 60 percent of shares traded in the last month.

Orbis has been virtually the only buyer of Collins Foods. The stock, a recent IPO at $2.50 per share, is seemingly hated and/or ignored by virtually the rest of the investing population.

Imagine how low the price may have fallen if Orbis had not been buying! $1 or less? Now that would be a one-foot hurdle!

We may still get $1, but at around $1.10 Collins is a good two-foot hurdle.

Orbis can only buy 2.6% more of Collins Food stock, so patient investors may soon be rewarded with a great entry price. Naturally there are no guarantees that we’ll get a lower price, but the odds are in our favour.

Over the medium term a rebound in Queensland trading conditions should stabilise the business and earnings.

Here’s a couple more comments I penned on Collins.

March 2012
Collins Foods (ASX: CKF) was close to being our top pick last month and again this month. If it weren’t for low trading volumes, this purveyor of grease and starch may have made the starting lineup. Institutional investors remain shy, and most retail investors are yet to notice the opportunity.

Investment arms of NAB sold down their holdings in December and January; respected Orbis Investment Management was a buyer. With bad news baked into its share price, any positive news will send shares rocketing, while further bad news is unlikely to have much effect. In sum, Collins presents limited downside risk with the possibility of a double within two years.

February 2012
Collins Foods (ASX: CKF) has been trading in a tight range since its disappointing inaugural results as a listed company. Institutional investors remain shy of a company that has already burnt several of their brethren, and most retail investors are yet to notice the opportunity.

Collins has now doubled! And after hitting $1 as I said it might.

Collins Food Group ASX:CKF share chart

While it may appear I’m simply blowing my own trumpet, I’m really sharing this for the lessons that can be learnt. It’s basic stuff that most people simply don’t make part of their investing DNA.

  • If the bad news is priced then the upside potential is probably being ignored and mispriced.
  • Be prepared! Imagine what could happen based on the facts at hand and be ready to respond to what occurs. I predicted share price could hit a $1 when Orbis could no longer buy, it did.
  •  Think about companies from a future perspective rather than linearly extrapolating historical data.

It’s that simple logic that led me to Acrux (ASX:ACR). The downside was more than priced in. Today’s price jump is no surprise. It wasn’t rocket science or advanced financial maths — there’s an oxymoron — it was simply assessing whether the risks were being over-weighted. The downside was priced in! That puts you in the wonderful position of any good or even alright news will be an upside catalyst.

Acrux Axiron sales increase chart

Here’s another example from 2013 using pSividia.

pSivida is hoping third time’s the charm. Alimera has submitted  ILUVIEN for FDA approval for a third time. The outcome is expected in October. If rejected, watch out below, pSivida longs will be  crushed. Here’s the crucial point for those looking for better odds. A rejection would make pSivida worthy of attention as it will still have the growing European cash flow, a promising pipeline and the possibility of eventual FDA approval if Alimera coughs up and performs the additional trials the FDA have always wanted. It may also have a share price starting with 1 — ouch!

The approval was rejected and that proved to be a great time to go long. While pSividia didn’t drop below $2 it did get within the ballpark.

So the next time people laugh about crystal balls you might want to ask them what they’re basing their investment decisions on. DCF? That’s the worst type of prediction. Historical financials? While useful, it’s what is gong to happen that counts.

Whatever they’re basing their decision on its most likely a crystal ball going by another name. They’re simply dickheads without enough insight to know that.

My name is Dean Morel and I’m a dickhead! A lot of my predictions are wrong, but as they cost me nothing I can keep making them all day. Sometimes my guesses are right and I take a swing.

Disclosure: You’re a dickhead, but you’d be an even greater one to think this is anything more than the ramblings of an idiot.  I’m long several of above mentioned companies. Needless to say this ain’t advice. Here’s the advice, pull your head out of your arse, look at the future, figure out what is likely to happen and what is priced in. Or like me, if you discover your head is too far up your arse then keep forcing it further up until it finally pops back out your neck. I’m not sure mine has popped out yet, but it’s getting close ‘cos it no longer smells like shit in here.

It’s OK to be wrong

My father was never ever wrong, or at least that’s what he thought. It’s still is a running joke in our family to try and get dad to say “sorry I was wrong“.

We used to joke about his inability to admit he was wrong, but I stopped laughing when, while studying psychology, we learnt about narcissism. Things aren’t as funny when they have a label, especially if it sounds as bad as narcissism. I felt a little sad that my dad, who I love, may not be a strong righteous man. That instead his pride, insecurity, lack of insight and self reflection were probably behind his inability to admit being wrong.

For whatever reasons I’ve swung the other way. I find it easy to admit I’m wrong and spend a lot of time trying to determine if I’m wrong and why I was wrong. I consider focusing on the downside and trying to figure out how you’re wrong important attributes for an investor, hence I’m often both stunned by and intolerant of other investors who are unable to admit being wrong. Before I get to my negative example I’d like to call out Cullen Roche at Pragmatic Capitalism for his shining example of self reflection. Even the title of Cullen’s article Three Things I Think I Think illustrates his humility.

I score Cullen 1.5 out of 3 this time on the things he thinks he thinks. I’m also pretty certain that he’s open minded enough to consider the excellent replies he has received and to perhaps change his mind. I’ll simply say you shouldn’t use outliers to form a general view. In this case the Forbes 400 rich list to form a view on social mobility. There are always exceptions to rules and while it’s good to think about them it’s also important to realise that exceptions don’t negate the general rule. In this case, it’s a bloody tough road if you come from a poor family and those of lucky enough to come from a middle class Western family or better should always remain humble enough to realise we’re lucky.

I loved Cullen’s second point. ‘Value’ investors all too often overlook the voting machine, but unlike Cullen I see no inconsistency in the concept that in the short-run the market is a voting machine and in the long-run it’s a weighing machine. Here’s what I said back in 2009.

In the Intelligent Investor Benjamin Graham commented on the market, “In the short-run it’s a voting machine, but in the long-run it is a weighing machine.” For some reason most market participants focus on the second part of that statement, they concentrate on the weighing machine. As a fusion investor I find equal value in both parts. In the short-run the market is a voting machine. In the short run the market is a voting machine. Come on say it with me 21 times a day for the next 21 days. Then you’ll no longer expect the market to ‘do something’ or to be in-line with your economic reality, you’ll no longer think the market is crazy.

People are driven by fear. They sold out on the way down out of fear of losses and now they’re buying back in out of fear of missing out. Understanding basic human nature is why psychologist are one of the best performing professional groups in the market. They understand the voting and respond to it.

Back in 2009 I said it was time to focus on the voting. Now it is time to focus on the weighing machine.

As I said in that 2009 article “Hopefully, you’re not surprised when I say there is no point in making [market] calls. You simply want to know where the game is at and the probability of each side winning.” It’s time to update my comment from back then. While I was on margin back then I’m now carrying a lot of cash. Why? Because bargains were plentiful in 2009 and now…well if you know any bargain please let me know.

My own view is there remains way to much focus on calling a bottom top and looking for signs of a market bottom top based on historical analysis. While it is important to be versed in the market’s history and use that knowledge as a rough guideline, my focus is on the here and now. Selling fully valued stocks and buying undervalued has been and remains my strategy.” [As an aside, I love this saying, if history was the key to financial success, librarians would be the richest people in the world.]

Finally this graph by Meb Faber via John Hussman brilliants illustrates why it’s not wise to disregard value. In the short-run anything can happen and the market is indeed often irrational, but in the long-run value counts.

CAPE-future-returns

If you don’t like ‘bitchy Dean’, it’s time to stop reading.

Equity markets are not zero sum

Over the weekend I tried to correct well known blogger/tweeter Tren Griffin on what I thought was simply a sloppy mistake. Tren said “Mr. Market is bi-polar. There’s a winner for every loser since the game is zero sum after fees. When muppets lose, someone else must win.

I’m sure most of you know, but for those who don’t “zero sum” is a simple concept that means exactly what it says on the can, that is, losses and gains equal zero. As equity markets return on average 10 percent a year they are clearly not zero sum. I’ve seen other bloggers go to some length to illustrate that equity markets are not zero sum, but for my money it doesn’t get any simpler than a 10 percent average annual gain is not equal to zero. Not even close.

In my book Tren then committed so many ‘crimes’ I feel obliged to call him out.

1. Rather than use his own logic and arguments he quoted others and stated they all agreed with him.

2. He was wrong. I’m not sure if it was a lack of comprehension or, more generously, if we were talking at cross purposes, but the linked articles highlighted that alpha is mostly a zero sum game. I agree with that and pointed out to Tren that he’d extrapolated the idea of alpha being zero sum to the entire equity market. Please let me reiterate, 10 percent annual returns clearly proves that gains and losses in the market do not sum to zero.

3. Tren continued to post links to articles that circled even further away from the point, e.g. active vs passive management. My dad used to do that, if he wasn’t winning an argument he’d change the framework rather then admit he was wrong.

I also disagree with the concept that for every winner there is a loser. Yes in aggregate market out-performance must come from under-performance.  But people sell and buy stocks for myriad reasons and to think in such simplistic terms as winner/loser is unlikely to be of any benefit to an investor. Except to think why they may be the loser! In this post Peter Phan provides a good anecdote of why this dogmatic rationality is problematic. Yes I know I’m linking to an article rather than using my own logic, what can I say, I love irony. Also Peter illustrates my point rather than highlights my mistake.

Further, market returns to individuals/institutions are not equally distributed. It’s closer to reality to say that for every winner there are 2-3 losers. It’s also worth considering that a 7 percent annual return, which some may call a loser, may actually be a winner on a risk adjusted basis. I could go on, but I doubt anyone is still reading.

Of course I could be wrong about all the above and I’m clearly out of sync with the majority of investors, as 16 people re-tweeted and 16 favourtied this tweet by Tren “Tech stocks are down from when they were up, but are still up from when they were really down. This up and down pattern will continue.” I read that to my 10 and 12 years kids and they laughed as much as I did. I thank Tren for giving us a lovely family moment. In fairness Tren may have simply been trying to better explain his point of view and I appreciate the time he took to reply to me, but wonder if that was driven by pride or selflessness.

And finally, it’s OK to be wrong, just don’t stay wrong.

Follow the volume breakout

This tweet by Assad Tannous was a light bulb moment for me.

Assad Tannous Follow Volume Breakouts

Assad inverted something I knew and feared into an avenue I wish to explore. More later.

Here’s Anteo Diagnostic‘s (ASX: ADO) chart, at 11.46 am 4.1 million shares had changed hands. So unless I’ve got the cheese touch it’s going to be a high volume up day. ADO is tantalising close to the major break of $0.19.

ado-volume-breakout

Here’s Assad breakout alert at $0.175.

I hope Assad is right and both good news and a new high follows this volume breakout.

I’m happy to wait for the news to add, as I’m a fundamental signal guy when it comes to speculative stocks.

Story stocks normally fail. Investing in the right story relies on luck more than most other investing endeavours. Yes, skill and experience improve ones odds, but most investors would do best by simply staying clear of story stocks like Anteo.

Disclosure: Long ADO

One path to market thrashing returns

The excellent investors site Ten Bag Fulls shared this great interview with micro-boutique fund manager Dean Mico.

Here’s my favourite quote and some quick thoughts on the Dean’s style.

So, in short, by keeping an open mind I now combine both fundamental and technical analysis. This has led me to develop a consistent, disciplined and repeatable approach that I have tailored to suit my personality and my style of investing and trading.

It’s cool to see new investors embracing fusion investing, fusing fundamental and technical analysis. But the highlighted is more important, as that’s applicable to every investor and hits the main notes to investing success. Go on read it again…disciplined repeatable approach tailored to suit your personality.

Dean’s approach to buying 150-200 percent initially is interesting. Personally I prefer the Turtle Trader / Peter Lynch approach of adding to winners. Each to their own, I simply mention this in case Dean or you haven’t read the Turtle Traders (pdf at bottom of linked page) or embraced Lynch.

I’m looking forward to seeing how Dean’s Edge Fund performs during the next cyclical bear leg, I hope and suspect he may do well, but there is a risk that he is simply a high beta investor or momentum follower.

If an investor uses the ABC/12345 or Dean’s GoldSilverBronze/12345 approach I’d suggest adding a layer of future thought. Codan (ASX: CDA) is a good example of how simply thinking about the company from a future perspective rather than linearly extrapolating historical data would have saved Dean some pain. The Motley Fool also recommended Codan and recently issued an apology for doing so.

I doubt there is any edge in focusing on companies with high returns on equity. In general individual investors tilt the scales in their favour by looking to exploit the excess returns offered by small caps, value stocks and momentum stocks.

There is plethora of research on all three, I’ve discussed them before here, here and here. I also highly recommend reading this post on fusing business momentum with value. While high ROE is one good filter to use, placing undue emphasis on it and extrapolating historical data is likely to deliver too many Codan experiences!

ROE investing is also a very crowded place at the moment. And being part of the crowd is one place you don’t want to be!

In summary investors should keep an open mind, develop a consistent, disciplined and repeatable approach that is tailored to suit their personality and style of investing.

What’s a Fundamental Setup

Most investors know about technical setups, even if they dismiss them. But fewer investors know about fundamental setups.

I trade fundamental setups. While there are many tools on my investing tool-belt, fundamental setups are definitely the hammer.

But before we can get to fundamental setups we must discuss forecasting.

Forecasting gets a bad rap. However, done well forecasting clears that crystal ball which you’re always bitching is cloudy.

The reason forecasting is so maligned is due to singular forecasts. 32 Celsius and sunny next Tuesday, 12 month price targets, the list is endless. It’s not the forecasters fault, as they provide what the majority want, the highest probability outcome.

Forecasting done well recognises multiple outcomes with probabilities assigned to each. At it’s simplest a weighted range.

Here’s an example using Prana Biotechnology ($PBT, $PRAN).

Within 8 weeks Prana should announce results for 2 pivotal trails, one is a company making event the second is even bigger, a major pharma pipe-line ass-saving blockbuster.

The first trial will be reported any day now. Let’s say it has a 50 percent chance of good results, while the second $10 billion plus blockbuster trial has an 80 percent chance of success. Prana’s share price is up a whopping 500 percent in the last eight months on anticipation. Yes I’ve enjoyed the ride!

If the results of the first trial are so-so or worse, the share price could easily halve.

In the unlikely (10 percent) event the results are bad then you’d loose three quarters of your investment. In case 3/4 doesn’t sound too bad, invert it. While a 50 percent loss only takes a double to make you whole again a 75 percent loss take a home-run — a 400 percent gain — to make you whole.   

If the results are good then the share price should quickly double. Good results would also provide a substantive floor under the share price in case the blockbuster results are disappointing, while simultaneously increasing probability of success for the blockbuster to 90 percent.

If the second trial results are excellent then Prana should be a ten bagger, a 1000 percent gainer, over the next couple of years.

Should you buy?

Prana Biotechnology $PRAN $PBT

The current risk reward profile based on the above simplified forecast is a risk of 55 percent of capital to make a double, that is roughly 2:1 reward to risk — 10% chance of a 75 percent loss, 40% odds of losing 50 percent and a 50% likelihood of doubling your money with an accompanying higher likelihood of further large returns. We could quantify those potential future returns, but we’ll keep this simple.

A 2:1 reward to risk is not great when dealing with speculative opportunities so I would not be a buyer now.

The fundamental setup I’d now look to buy is a failure at the first hurdle, so long as it is a stumble and not a glue factory fall. The share price will get hammered, yet the probability of success in second trial should only fall slightly.

Let’s say the share price falls the forecast 50 percent and at the same time the probability of good results from the second trial fall to 70%.

The risk reward then becomes a 10% chance losing 75%, 20% chance of losing 50%, 30% chance of 200 percent and 40% chance of 500%. That’s a risk of 58% for a possible 370% gain or over 6:1 reward to risk profile. That’s a much better fundamental setup than the current opportunity provides.

Alternatively a buy on thirds approach makes a lot of sense in this type of situation. That is, buy a third now, a third more after the HD results and then a final third only if the AD results are good. Your gains will be less, but importantly your risk will also be considerably less.

A third approach is to explore options as a means to play Prana.

Other fundamental setup examples

Here’s an example of a fundamental setup for pSividia last year.

A Peter Lynch favourite setup was the out of favour stalwart. A good example of the stalwart setup was QBE in 2012. I recommended QBE to TMF Share Advisor because there was very high probability of a getting a quick 30-40% gain out of QBE. That’s the type of return to expect from a stalwart setup, staying longer simply ensures your returns will quickly approach market averages.

One of my favourite setups is the fallen market darling. A great example here is CROX — remember Crocs? I recommended CROX as a turnaround play back in 2009. Another is when Netflix was taken out to the woodshed in late 2011 and 2012. If you forecast these events as having a probability of occurring then you’re prepared to buy if and when they do.

In summary, forecasting is good, nay essential, in fundamental investing. Forecasting clears my crystal ball helping me think more clearly about the future and thus assists me in finding the type of fundamental setups I like to invest in.

Disclosure: Long Prana – but have been a seller recently.

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