Can we be certain that buying cheap stocks works?
I've talked a lot about my investment strategy of buying cheap stocks. I've also explained why I do it.
The rationale can be divided into logic and data. The data or empirical evidence consists of academic studies, backtests I've done personally, quantitative strategy books, and the careers of famed cheap stock investors such of Walter Schloss and Peter Cundill, and is all quite compelling.
And I think the logic behind buying cheap stocks is powerful as well - the disconnect between mean-reverting/cyclical reality and the extrapolating human mind. So I think the case for buying cheap stocks is a good one.
But thinking scientifically, I must admit that I can't know for sure that it will work in the future for me specifically. What if funds using mechanical decision processes like Renaissance Technologies become a big enough share of market capital and trading that the phenomenon is arbitraged away? I wouldn't expect it to as there will always be a 'cheapest' stock in a market if we view cheap relatively, but we shouldn't dismiss the possibility.
And what if we are somehow missing something in all these studies. I understand that there are many factors like transaction costs (bid/ask spreads, commissions), volume limitations, friction created by client fund flows, taxes, etc. that can make the strategies in these studies impossible to replicate to the same success if they are not being accounted for in the studies themselves. My understanding is that most academic studies performed today are rigorously done and designed to account for all these factors, but what if they aren't and what if there are other limiting factors that, in our excitement, we are all missing?
The point is that "buying cheap stocks works" is not true or valid in the sense that gravity is. It is not a law of physics; not a scientific certainty. I've been exploring epistemology recently and concluded that there really are very few things we really know with absolute certainty. Induction is usually present somewhere in most of what we know. We learn things through reasoning and observation, but most of what we know is only known associatively or to a reasonably high probability. We truly "know" very few things in the absolute sense.
Where does that leave us with our conclusions about buying cheap stocks? How do you execute a strategy, investing:
- the majority of you and your clients' net worth
- your time
- and your future in
while not being absolutely certain it will work?
You become aware of what you are doing and make the decision to accept the risk of being wrong.
While I can't know for certain that what I'm doing will work, I am extremely confident it will, and my confidence is high enough that betting my career on it seems like a highly favorable bet.
When I think about what I'm doing now and want to execute in the future in this uncertain but confident context, I realize that my investment career and life will basically be the ultimate personal test for me of whether this works. It will hopefully be a 50 year "forward test" with all the frictional costs and challenges associated with executing strategies in reality. My life is an experiment - and I'm okay with that.
Expand Your Perspective
Given that the main reason cheap, ugly stocks outperform is that we tend to extrapolate instead of expect cyclicality, what can do to help make our analytical expectations better match financial reality?
One easy thing is to simply look at more years of financials. I like to look at at least 10 years so that I am capturing at least 1 full business cycle. Morningstar's key ratios page has 10 years of financials for free on global companies in a nice format.
It may also help to look at the long term averages for margins, sales, etc. and use those as a starting point instead of the most recent quarter or year's results or even the last few.
Does It Work?
An excellent recent Farnam Street post discusses the approach of Lee Kuan Yew, the legendary first prime minister of Singapore. Yew did not get hung up abstraction, philosophy, and ideology. He and his associates had ideas to solve Singapore's problems, experimented with them, and stuck with what worked. He advocates a pragmatic approach where everything is only as good as its efficacy.
I think sometimes I can get hung up:
- in abstraction (kind of like the first section of this post above)
- perfecting my investment approach
- reading theoretical books
- questioning myself
- writing about what I'm doing (kind of like this post)
This distracts me from actually getting stuff done; from actually doing real research on real companies. I've sought feedback from readers and they've confirmed this in some ways. Here's a few comments from my last post:
I also think that Yew's rule, in a way, embodies the empirical, scientific approach. His team would have ideas of things they could do and experimented to see if it worked. They tested and tested and only really cared about truth and results.
On that note, one practical thing I did recently was go through a screen of all cheap stocks in Singapore. Some practical advice is to invest in Singapore! It's a great economic story and there are dozens of very cheap stocks of real companies there. Here's a list of Singapore ETFs and ten ADRs of Singapore companies:
- iShares MSCI Singapore Small-Cap ETF (NYSEARCA:EWSS)
- iShares MSCI Singapore ETF (NYSEARCA:EWS)
- Cosco (OTCPK:CSCMY)
- Asti (OTC:AIHGY)
- Capita Land (OTCPK:CLLDY)
- City Developments (OTCPK:CDEVY)
- DBS (OTCPK:DBSDY)
- Del Monte Pacific (OTCPK:PDMXY)
- First Ship Lease Trust (OTCQX:FSHPY)
- Neptune Orient Lines (OTCPK:NPTOY)
- Raffles Medical (OTC:RAFLY)
- Singapore Telecom (OTCPK:SGAPY)
One I own is Captii (SGX:AWV). If anyone is interested in my expanded notes or thoughts on the stock, shoot me an email or SA message.
Last I updated the numbers a few months ago, it traded at the following multiples:
- All things are numbers - Pythagoras
- The most effective men of action are often intellectually second-rate. - Bertrand Russell
- Global bond issuances at decade high, and interest rates at five millennia low.
- Position risk≠portfolio risk. Probability of >90% loss in 1 yr. = 5% for net nets vs. 2% for all stocks. As a group though, net nets suffered less down years than global stock universe. - Montier
- An interview I did last week
- Are backtests wrong? Are we missing something?
Cheap Stock Digest = ~weekly ~1,000-word collection of short-form thoughts, investment idea pitches, quotes, and empirical data. Like it? Follow me with the FOLLOW button next to name at top.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long Captii (SGX:AWV)
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.