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The 4 Dimensions Of Value Investing

Summary Value investing can be much more than just calculating the intrinsic value of a business. The more traditional value investing tends to focus only on quantitative metrics, such as P/E, P/B, EV/EBIT or EV to maintenance cash flow. Buffett and his followers introduced a new value investing approach which is more scalable and in longer term, which I call “quality-value investing”. Besides quantitative metrics and qualitative factors, there is the 3rd dimension: the certainty or the information edge. Finally, the 4th dimension is not about monetary gains, but about the emotional gains in the investment process, as well as an investment in the investor himself/herself. The Two Camps in Value Investing When Benjamin Graham wrote his famous book “The Security Analysis” 82 years ago, he built the foundation of value investing approach. This book became a timeless piece, and is still being followed everyday by many famous value investors. Interestingly, although all the value investors seem to be under the same title of “value investment”, their approaches could be dramatically different. One major and obvious difference is the focus on quality. Graham had his deep belief that any forecast is unreliable, and therefore we should always fallback to the “facts”, which are the numbers we have seen in the past. Apparently, this is a pure quantitative approach. On the other hand, Buffett and his followers started to deviate from Graham’s traditional approach, and started to focus on the quality side of the business. As Buffett said, he would rather invest in a great business at a fair price, than invest in a fair business at a great price. In reality, deep value investors (Graham’s followers) would not only invest in a fair business, but also often invest in a poor business with a poor management. Another difference is on the time horizon. While value investors are usually the long term investors, and have much longer time horizon than the other market participants, Buffett usually has even longer time horizon than the deep value investors. As he said, his favorite holding period is “forever”. However, many famous deep value investors clearly said they would sell when the stock price reaches its intrinsic value. Some of these deep value investors even criticized Buffett’s saying, or at least didn’t really understand the logic behind it. In my understanding, this difference comes from the roots of different focus. Deep value focus on pure quantitative metrics, such as P/B, P/E, EV/FCF, EV to maintenance cash flow, current ratio, debt ratio, growth rates, and dividend yield. There are two benefits of this kind of pure quantitative approaches: 1. It is objective. In investing, one of the biggest enemies of investors is their emotion, or their behavioral bias. Not only we are emotionally influenced by the price actions, the changes of fundamentals and recent events can also have a great influence on the perception of investors. Because of this influence, investors tend to focus more on the recent events, or more on the outlooks, and less on the historical facts. This kind of over-reaction or behavioral bias is often the reason why deep value investing worked. There are numerous research papers which showed that simple quantitative metrics such as P/B or P/E can generate a significant edge for investors. The pure quantitative approach is not limited to Graham’s formulas either. The famous “Magic Formula” only had two quantitative metrics in it: P/E and ROE. 2. It is easy to be well diversified. Since it is a pure quantitative approach, it doesn’t really need to analyze the business or understand the industry. Therefore, it is very easy to pick many different stocks and achieve high diversification. While I acknowledge the merits of deep value investing, it is also my belief that the pure quantitative approaches will be less effective in the future. This is because information is more available today, and there are more quantitative algorithms being created by backtesting the historical data. It is also easier to implement these investment approaches in an automated algorithm, which takes emotions completely out of the game. In other words, the competition on the deep value approach will be more intensive, and any deep value investment opportunity you can find is more likely to be a value trap, especially when that stock is a large cap or mid-cap. That said, Graham’s basic philosophy is still valid today: we have to focus on facts and avoid any over-confidence in our ability to forecast. This fact makes the first dimension (the quantitative metrics) to be the most important and most basic element of value investment. Without these metrics, we should not talk about “value” at all. While the quantitative metrics are important, we should also not underestimate the importance of qualitative factors (the 2nd dimension), such as the competitive advantages, the management’s ability and integrity, the pricing power of a business, and the industry outlooks. Not only these qualitative factors can give us more assurance of the business’ future, it also makes an exit strategy less important. As we all know, it takes a lot of work to understand an industry and a business. If we have to constantly find new opportunities after exiting the previous investment, it could be very tiring and it also increases the risks of misunderstanding the new opportunity. Beyond that, there is also the impact of taxes when you realize the capital gains. That is why Buffett said his favorite holding period is forever. After all, it is very hard to find a really good investment opportunity, and it takes a lot of effort to truly understand it. Plus, if you know you have to find the best exiting point, you will be tempted to sell too soon. When you increase your investment time horizon, it can also help to create a more scalable strategy, since you only need to slowly build the positions, and not worry too much about the need of liquidating the position with the best timing, or responding to any events quickly. The longer time horizon can also make qualitative factors much more important than quantitative factors. For example, if a stock is being traded at P/E 5, a deep value investor might get it and fetch a quick 100% gain within 1-2 years when the sentiment recovers. However, when you have to hold onto a poor business for 10 years, the poor business, even if it is not bleeding (losing money) every year, could be destroying value by reinvesting earnings with very low ROIC. So over a long period of time, any discount can be superficial and eventually get wiped out by the poor economics or poor management of the business. That is why when Buffett said “if you don’t want to hold it for 10 years, you shouldn’t hold it for 10 minutes”, many deep value investors couldn’t agree, simply because that philosophy doesn’t really apply to many deep value cases. On the other hand, for a good business with a good manager, even if you have to pay some premium for it, because of the good ROIC and high growth, your “sin” will often be more than covered by the good economics of the business when you hold it for many years. For example, a lot of investors were hesitating to buy Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) 20 – 30 years ago, when its P/B was more than 2. But at least in retrospect, that seemingly overpayment would be more than paid off later. The same thing can be said for many great businesses in their early stages, such as Microsoft (NASDAQ: MSFT ), Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), and Wal-Mart (NYSE: WMT ). Even today, when Berkshire Hathaway is already too big to grow very fast, the smart capital allocation along with many high quality world class businesses in its holdings make it an attractive investment for people who seek stable growth. Therefore, I believe it still deserves some premium in its valuation. For sure, today’s deep value investment can be much more than just a pure quantitative strategy. Deep value investors do often understand the business very well, and they often pay attention to the quality factors as well. However, their primary focus is still on the quantitative metrics, and they don’t require the business being a high quality business and don’t often require the business having a good management. Furthermore, even Buffett himself still invested in some low quality businesses from time to time. For example, after he had remained pessimistic on newspaper industry for many years, he still purchased many small newspaper businesses a couple of years ago, knowing that these businesses would slowly decline and could eventually die. Still, when the valuation was attractive from a discounted cash flow perspective, he felt that was a sensible thing to do. The 3rd Dimension: Certainty and Edge If the quantitative metrics can give us a view of the past, the qualitative factors should give us a “flavor” of the future (of course, investment is all about estimating the future). However, these two views can be totally unreliable if we don’t know enough about the business and the industry, and all our calculations could be based on imagination rather than facts. That is why we need the 3rd dimension: the certainty and the information edge. Every investment thesis is about finding and filling-in the missing pieces of a big puzzle. Investment, like any other business, is also highly competitive. Good businesses are unlikely to be sold cheap, and cheap ones are very likely to be value traps. The key about solving this big puzzle is about collecting as much information as you can. It is also about interpreting the basic information you collected, which requires some insights of the economics and the industry. In order to beat the market, we should also have an information edge, some unique insight or deep understanding that can help us to find the value discrepancy, and help us to maintain the confidence when facing emotional challenges. Buffett likes to call this as “The Circle of Competence”. It is a field where we can have an edge, a field where we can have more certainty than the other investors. After all, the term “uncertainty” is not equivalent to “true randomness”. When you try to guess the color of a ball in a box, that color is not a “true” random variable, since it is already fixed and known to some people, but just not known to you because you don’t have that information. Therefore, “certainty” is directly related to how much information we have. One obvious question following this is: how can we invest if we don’t have any circle of competence? Or what if all the stocks in my circle of competence are too expensive? I think there are several answers to this question: The first and the most important method to tackle this problem is to learn as much as you can. After all, nobody started with a circle of competence. It is all about constant learning over one’s lifetime. Learning has also become increasingly easier in this internet era as more and more information becomes easily available online. If we don’t have time to learn a new field, we could also simply wait until the opportunity shows in our existing circle of competence. Or try to copy a “superinvestor”, but I am not sure if that approach really works or not. Finally, less certainty in an investment means that we need to rely more on diversification, which again falls back to the more quantitative approach I have mentioned above. As I said, this approach may still work, but I would expect its effectiveness gets weaken over time. The 4th Dimension: Emotional Rewards While investors are normally only concerned about the potential monetary rewards in any investment, there is another hidden element in the investment process which is just as important: the emotional rewards. As a human being, the ultimate goal an investor seeks or should seek is always the “happiness”. While the investment profits can help us to get more happiness, we shouldn’t forget that much of our happiness is not related to money at all. Much of our pleasure directly comes from a constructive process. Much like a businessman who enjoys building his/her business, investors like to find the next gold mine or solve the next grand puzzle. It is a game they love. But beyond that, investors are also partners in a business. They are the owners of a business, even if they may only own a small fraction of it, and may not have any control on the business decisions. Nevertheless, just like a fan of a NBA team, the investors can enjoy seeing the business growing, and enjoy seeing the constructive process of building a business. This also makes a “quality-value” approach more attractive than a deep value approach. When you invest in a high quality business with a good manager, you often end up being happier in your investment life. You would worry less about management cheating on you or destroying value. There are less uphill battles against a deteriorating industry trend, or poor economics of the business. There is less energy spent on a proxy fight with a bad management. Besides the emotional rewards, there is another important side effect coming out of happy investing: when you truly like a business or a industry (not just because of the potential profits), you will spend a lot more time to learn about that business and industry. This will boost your edge in the 3rd dimension: your information edge. More importantly, this will become a very rewarding learning process that will be beneficial in the long run. In other words, when you invest on something that is truly interesting to you, you also invest in yourself by increasing your expertise in that industry. This benefit can be as significant as any monetary gains you could get from the investment itself, because just as Buffett said, “the best investment is always investing in yourself, it is the investment in education.” Summary The reason I call these 4 elements as 4 dimensions is that they are mostly uncorrelated factors. As investors are busy hunting their next best opportunity every day, it is also important to sit back and think through the process on a very high level. After all, it is more important to head in the right direction than moving at an amazing speed.

Building The Ultimate Bank Basket

Summary Building a basket is like creating a custom-made ETF. Simple strategies work better than complex systems. The nuts and bolts of building a custom bank basket explained. Investors like to act like art collectors. They spend years hunting for a specific Monet (or a rare investment holding) and are willing to spend anything to prevent it from slipping through their fingers. On the surface this behavior makes sense, good companies supposedly only come along rarely, and investors are rewarded for taking advantage of opportunity. Where the analogy breaks down is that art is supply constrained, there is a limited set of outstanding Monet paintings and no new paintings. There are thousands of traded companies, and tens of thousands of companies are being started every week. If an investor misses one opportunity another comes along quickly. In the world of bank investing, there are over 1,200 banks with tickers that are in theory tradable. Many of these banks are very small and illiquid and only appropriate for experienced and patient investors. But even if one eliminates all non-SEC filing banks from their pool of investments, there are still over 500 SEC filing traded banks. The question becomes: “How does one find bank investments with so many options?” I’ve made a mistake many investors do when faced with finding the best companies in a pile of potential opportunities. I’ve spent far too much time looking at inconsequential details trying to find the absolute best idea. I’ve come to the conclusion that this is a waste of time. Let me explain. Back in 2011 and 2012, I started to look at Japanese net-net stocks. These are stocks trading for 2/3 of net current assets (current assets – all liabilities). Through screening, I identified hundreds of Japanese companies trading as net-nets. The problem was there were more companies than my portfolio had room to buy, so I needed to narrow down the list. Keep in mind that every single company on the list was cheap, the market was valuing all of these companies for less than their liquidation value. What I ended up doing was spending a lot of time comparing companies against each other with metrics that had no predictive value for investment success. I ended up selecting a handful of what I thought were the best companies on my list. My companies did well, but I could have done just as well picking blindly from the initial pool of undervalued companies. As investors we fool ourselves into thinking we’re smarter than we are, and that we can identify the best performing stock from a pool of very cheap stocks ahead of time. There might be a few super-genius investors who can do such a thing, but for the rest of us mere mortals, our best bet to outperformance is by fishing in a very small pond loaded with fish. In the world of bank investing, there are plenty of companies selling at discounts to intrinsic value no matter how you define intrinsic value. For example, I ran a simple screen on CompleteBankData.com looking for banks trading below 1x TBV with a 7% or higher ROE and low non-performing assets and my search returned 10 banks. This might not seem like stringent criteria, but this search finds banks with an above average ROE at less than book value. If I drop my ROE requirement to greater than 4%, more than 30 banks match my criteria. If one were to look for banks earning an above average ROE at less than 1.5x TBV, which is the median TBV value, they’d have 96 banks to analyze. The point is that one can hunt through that list of 10 banks, or 30 banks, or 96 banks and try to identify the top one or two banks to add to a portfolio. Or an investor can take a simpler approach. In the aggregate, these banks are likely to outperform. They are all undervalued, and all have quality assets. It’s far easier to build a basket of banks and gain exposure to an area of the market not covered by ETFs rather than find the best. The second advantage to building a basket of bank stocks is that you don’t need to be an expert on bank investing to gain exposure to a segment of the market. Building your own basket is akin to buying a custom ETF. How to Build a Bank Basket? It’s easy to agree with the concept of building a basket of banking stocks, but sometimes the actual execution is difficult. “What stocks do I buy?” “How long do I hold them?” “How many should I own?” are some of the questions you might be asking about this. Let’s break down how to build an actual basket of bank stocks. Identify an investment criteria The first step is to identify the criteria you’ll use to select an investment. My advice is to keep it simple, simple criteria is better than complex criteria. For example, look for profitable banks selling below TBV with good assets. A screen for this might be: P/TBV < 1, ROE > 1%, NPA/Assets < 3%. Once you have a criteria you're satisfied with run the screen on your preferred screening platform. Sifting for investment candidates I don't recommend buying every company that matches the screen blindly. I put in the bare minimum amount of effort validating data and criteria matches. Sometimes a bank will report a high ROE as a result of a onetime gain. Or a bank might have quality assets in one or two recent quarters but struggled with significant issues in the past. Or sometimes a bank will match a screen but is in the middle of a merger or another transformative transaction. I quickly go through my matches and remove these companies. Buying and holding Once you've identified your basket candidates, it's time to buy them. If you like a clean separation of basket holdings versus non-basket holdings, I'd recommend opening a new brokerage account for these banks. Buy them as you would any stock, use limit orders and be patient in getting your trades filled. The hardest part of owning a basket of banks is holding them. I recommend at least a one-year holding period if not a three-year holding period for each name in the basket. As some banks are merged or sell, recycle those funds into new names that match the strategy. The hardest part of owning a basket of bank stocks is simply staying still and resisting the urge to tinker with the basket. Best of luck!

ETFs And Stocks To Add On Solid Jobs Data

After weak back-to-back months of job growth in nearly two years, U.S. hiring numbers came in stronger than expected in October, easily dodging the impact of a global slowdown and a struggling manufacturing sector. The U.S. economy added 271,000 jobs in October, much above the market expectation of 180,000. This marks the strongest pace of a one-month jobs gain in 2015, and came from increased employment in the higher-paying sectors, in particular, professional and business services. Meanwhile, unemployment dropped to a new seven-year low to 5% from 5.1% in September, and average hourly wages accelerated nine cents to $25.20, bringing the year-over-year increase to 2.5% – the sharpest growth since July 2009. The robust data suggests that the U.S. economy is rebounding strongly after a lazy summer, and is continuing to outpace the other economies. Additionally, solid pay gains will increase consumer spending in the crucial holiday season, which will translate into stepped-up economic activities. Market Impact This has bolstered the chance of an interest rates hike, the first in almost a decade, in December. The jobs data even supports the comments of the FOMC meeting held in October and the latest Fed testimony that hinted at a December lift-off if the U.S. economy remains on track. As a result, the stock market has seen a big rotation in trade, and this trend will likely continue at least in the near term. This is especially true as investors are taking money out of the income-yielding sectors like utilities and REITs and putting them in the sectors like financials that are expected to benefit from the rising interest rates. On the other hand, yields on two-year Treasury bonds soared to the highest levels in more than five years, while the U.S. dollar climbed to a seven-month high against the basket of major currencies. Further, staffing stocks also have seen smooth trading. Given this, we have highlighted three ETFs and stocks that are the direct beneficiaries of the job gains and will likely see smooth trading in the days ahead. ETFs to Consider PowerShares DB USD Bull ETF (NYSEARCA: UUP ) A healing job market and the resultant improving economy will pull in more capital into the country and lead to appreciation of the U.S. dollar. UUP is the prime beneficiary of the rising dollar, as it offers exposure against a basket of six world currencies – the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. This is done by tracking the Deutsche Bank Long US Dollar Index Futures Index Excess Return plus the interest income from the fund’s holdings of U.S. Treasury securities. In terms of holdings, UUP allocates nearly 58% in euro and 25.5% collectively in Japanese yen and British pound. The fund has so far managed an asset base of $994.9 million, while it sees an average daily volume of around 2.1 million shares. It charges 80 bps in total fees and expenses, and added 1.2% on the day following the jobs report. The fund has a Zacks ETF Rank of 3 or “Hold” rating, with a Medium risk outlook. Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA: DBEF ) The strength in the greenback and global monetary easing is once again compelling investors to recycle their portfolio into the currency hedged ETFs. For those seeking exposure to the developed market with no currency risk, DBEF could be an intriguing pick. The fund follows the MSCI EAFE US Dollar Hedged Index and holds 916 securities in its basket, with none accounting for more than 1.98% share. However, it is skewed toward the financial sector, which makes up for one-fourth of the portfolio, while consumer discretionary, industrials, consumer staples and healthcare round off the top five with double-digit exposure each. Among countries, Japan takes the top spot at 22%, closely followed by United Kingdom (18%), France (10%) and Switzerland (10%). The ETF has AUM of $13.9 billion, and trades in solid volume of more than 3.9 million shares a day. It charges 35 bps in fees per year from investors, and gained 0.6% on the day. DBEF has a Zacks ETF Rank of 3, with a Medium risk outlook. iPath U.S. Treasury Steepener ETN (NASDAQ: STPP ) As yield rise, bonds and the related ETFs falls. But this product directly capitalizes on rising interest rates and performs better when the yield curve is rising. The ETN looks to follow the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts. The fund takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. STPP charges 0.75% in fees and expenses, while volume is light at around 1,000 shares a day. Additionally, it is an unpopular bond ETF, with AUM of just $2.5 million. The note surged 2.4% following the robust jobs data. Stocks to Consider In the stock world, the direct beneficiary of healthy hiring is the staffing industry. The industry bodes well at least in the near term, given the superb Zacks Industry Rank (in the top 5%) at the time of writing. Investors seeking to ride out the optimism could look at a few top-ranked stocks having a Zacks Rank #1 (Strong Buy) or #2 (Buy) with a Growth Style Score of B or better using the Zacks Stock Screener . Cross Country Healthcare Inc. (NASDAQ: CCRN ) Based in Boca Raton, Florida, Cross Country is a leading healthcare staffing services’ company which primarily focuses on providing nurse and allied, and physician staffing services and workforce solutions to the healthcare market. The stock has seen solid earnings estimate revisions of 7 cents for the current quarter over the past 30 days. Full-year earnings are expected to increase at a whopping rate of 286.1% versus the industry average of 19.4%, reflecting massive growth prospects. The stock rose 7.3% in Friday’s trading session, and currently has a Zacks Rank #1 with a Growth Style Score of “A”. Heidrick & Struggles International Inc. (NASDAQ: HSII ) Based in Chicago, Illinois, Heidrick & Struggles International is one of the leading global executive search firms. With years of experience in fulfilling clients’ leadership needs, it offers and conducts executive search services in every major business center in the world. The stock has seen upward earnings estimate revision by a couple of cents for the current quarter over the past one month. The company is expected to post earnings at a growth rate of 179.3% annually this year. HSII gained 3.7% on Friday, and has a Zacks Rank #1 with a Growth Style Score of “A”. TrueBlue Inc. (NYSE: TBI ) Based in Tacoma, Washington, TrueBlue is a leading provider of staffing, recruitment process outsourcing and managed services in the United States, Canada and Puerto Rico. This company has also seen rising estimates of four cents for the ongoing quarter, and expects to grow earnings at rate of 24.5% annually for the full year. The stock was up 3.7% in the Friday session, and has a Zacks Rank #2 with a Growth Style Score of ‘B’. Original Post