Wednesday, February 07, 2007

Stock Market Investing

Here is something I thought I should pass on to my, apparently 5 readers. Last summer I changed the way I invest in the stock market from holding very, very few companies, 3 or 4, that I knew something about, knew people who worked there, etc. and hopefully were local, for a very long time, kind of the Peter Lynch school of investing, to a theory that was more Graham Dodd, Warren Buffet, by investment guru Joel Greenblatt, I first heard about on a weekend radio show on KVI 570 called Sound Investing. You can download the exact show I listed to, Feb. 3rd 2006, as an MP3 file here. Mr. Greenblatt is a well know investor who has done remarkably well. I would strongly suggest you read his Wikipedia bio.

Here is the 2 minute version of the theory. Buy good companies when they are cheap. The whole theory is laid out in an unbelievably easy to read book by Mr. Greenblatt. According to the theory, over the long haul, the market is efficient and companies are priced correctly but over shorter periods of time, the market is not as efficient. If you buy good companies that for now are cheap and you buy enough of them and hold them for a year, the market will recognize most of the inefficiencies and you will make money, better than normal market averages. So what defines a good company and a cheap company? 2 stats, earning yield (cheap) and return on capital (good). So you rank all of the companies by these two stats and pick stocks that have the highest rankings for both. Sounds like a lot of research… well it would be if someone had not already done it for you…. A list of the stocks, already ranked, is waiting for you, free of charge, at least for now, on a web site.

So let’s cut to the chase, how well does this work? A 17 year backtesting showed returns around 30% a year. That was not a typo. While the market in general did something like 11% for that same time period. So… let’s say that you took 2 portfolios of $10,000 and invested one in something that averaged 30% a year and the other in something that averaged 11% a year. What would be the value of those portfolios after 20 years? The 11% portfolio would have $80,623, the 30% portfolio would have $1,900,496. That is not a typo. The 30% portfolio is 23.5 times as large. That is not a type. Now understand that backtesting is simply how would this have worked in the past. There is NOTHING THAT SAYS THIS WILL CONTINUE TO HAPPEN. Please read that again.

So what are the nuts and bolts of what you do? Buy 20 – 30 stocks spread out over the course of a year, putting equal amounts into each stock. When a stock’s 1 year anniversary comes up, sell the stock and buy another on the list. That is about it. Seriously. I am not kidding. Well actually there are some minor details such as sell any losing stocks right before 1 year and winners right after 1 year for tax purposes. There are other issues that come up such as what to do if one of your stocks is bought out or what do you do if after one year the stock is still on the list. Like I said, minor details. Spend the 2 hours to read the book.

So I decided to buy 20 stocks, 5 each quarter. I started in July of 2006 and as of now have 3 groups of 5, 15 stocks in total. As of right now, the performance is as such, my July 2006 stocks are up 20.68%, My Oct. 2006 stocks are down 7.34%, my January 2007 stock are up 2.8%. Those are actual, not annualized numbers. The January 2007 stocks were bought in the last week of January so I have had them for less than 2 weeks. The other two groups were bought the first week or two of the month. I think my early returns and the fact that they vary so much kind of answers the next obvious question…

Why has this theory not caught on like wildfire? Because sometimes the returns are not that great for a significant time period and most of us are not patient enough to withstand the down periods. As Joel Greenblatt recently said:

Here comes the bad news. It is difficult for emotional human beings to execute a strict formula with patience and persistence. In a recent talk at a New York Barnes & Noble bookstore, Joel Greenblatt warned a crowd of about 300 fans seeking his autograph, "The magic formula is not that magic because it can underperform for a number of years in a row. Most people quit something that doesn't work for one or two years. It is tough to stick with a formula. And even if you would stick with it, you customers won't, especially after it failed to work for two years. Not many professionals and individuals can pull it off."

Yes, the results of the formula are amazing over a long period of time. But...there are still 1, 2 and even 3 year periods when the formula doesn't work at all! Most people just don't have the patience or the discipline to stick to it through the tough periods. And for those who do, the reward over the long term could be substantial.
A word of warning… for me, the one big shock is how turbulent some of these stocks are. Much more than I was use to but not a big problem for me since I am fairly risk tolerant. Also not as big a deal once you own more than a handful of these stocks if you are looking at the total portfolio values and not just that one or two stocks that are way up or way down. For example, in November, 1 month after I purchased my Oct. stocks, my July portfolio was losing money yet my Oct. portfolio was up almost 10%. Not the case today. These stocks can move, a lot, in a hurry. For this to work you need to be willing to ride the waves, both up and down and to be honest, I have actually enjoyed the excitement of volatility.

1 comment:

hup1psh said...

Great post; I am an MFI'er; started 2/28/06 and am at 28% IRR; was 48% before 2/27/07; but still well pleased. There is a great Magic Formula discussion group on Yahoo to help steady the hand on the tiller; about 1600 members; 25 or so active mostly educated posters. Happy Investing to you.