I have long been fascinated with the concept of edge, ever since I started on the path of becoming a value investor. I don't see myself as a 'stock market genius' (rightfully so and also a reference to Joel Greenblatt's investment classic), and given that investing is an extremely competitive field and a zero-sum game, I always wondered what is my edge over the guy on the other side of the trade and whether I am the dumb money (or the patsy in the poker game that Warren Buffett referred to) offering liquidity to the smart money.
Recently, Jason Zweig, a financial writer best known for being the editor of the revised edition of Benjamin Graham's The Intelligent Investor (HarperCollins, 2003), published an article "A Portrait of the Investing Columnist As A (Very) Young Man" and the following paragraph caught my attention, as I share the same view as Zweig:
Decades ago, stock-picking was a handicraft in which information moved slowly and unevenly, so the person who knew the most could perform the best - by a wide margin. Think of Warren Buffett buying such tiny flecks of corporate plankton as Sanborn Map and Dempster Mill Manufacturing. Today, with more than 120,000 chartered financial analysts and 325,000 Bloomberg terminals worldwide and with Regulation FD requiring companies to disclose material information simultaneously to all investors, the playing field is close to perfectly level. If you're applying the tools that worked so well in the inefficient markets of the past to the efficient markets of today, you are wasting your time and energy...Today, being able to identify mispriced investments isn't nearly enough; you also must be able to identify where mispriced investments are still likely to be found. If investors are to prosper from inefficient markets, they have to evaluate which markets still are inefficient. Areas like microcap stocks or high-yield bonds, where index funds can't easily maneuver, offer some promise. Areas increasingly dominated by index funds offer little.
Earlier in December 2016, John Huber, Portfolio Manager at Saber Capital Management, wrote a similarly thought-provoking article "What Is Your Edge?" where he elaborated on the three types of investing edge: the Informational Advantage ('finding information that others don't have'), Analytical Advantage ('interpreting the same information differently') and Time-horizon Advantage ('maintain a 3-5 year time horizon as opposed to quarterly for most institutional investors'. This reminded me of the 2013 Value Investor Conference presentation by fund manager Robert Robotti, where he highlighted three investing edges as well: the Behavioral Edge ('take a longer-term view and have the ability to tolerate losing money'), the Analytical Edge ('develop a different conclusion than that of the market') and the Informational Edge ('building our information mosaic with network of industry relationships, focus on deep primary research, and experience serving on company boards'). Robotti's view is that the Behavioral Edge leads the firm to the Analytical Edge and the Informational Edge; in other words, it is only possible to exploit the Analytical Edge and the Informational Edge when one has the Behavioral Edge which provides the context of a longer-term perspective for differentiated views and in-depth research. Going back to John Huber's article, John also specifically emphasized the Time-horizon Advantage (similar to Robotti's Behavioral Edge), as per the last paragraph of his article:
In summary, I think the "edge" is less about knowing more than everyone else about a specific stock, and more about the mindset, the discipline, and the time horizon that you maintain as an investor. Thinking long-term is a commonly talked-about potential advantage, but one that is much less often acted upon. If you are a professional investor that is set up to capitalize on this, or an individual investor who has the right mindset, you can give yourself a significant edge in the stock market.
Michael Mauboussin, Managing Director and Head of Global Financial Strategies at Credit Suisse, recently published a new report titled "Looking for Easy Games - How Passive Investing Shapes Active Management." Mauboussin's report and his findings form the basis of my article today, where I try to draw relevant insights that are useful to readers seeking their elusive investment edge in 2017 and beyond.
Inefficient Markets Exhibit Greater Dispersion In Returns
Mauboussin quoted David Swensen, Yale University endowment's Chief Investment Officer's approach of using the dispersion of asset manager returns, more specifically the difference in results between first and third quartile managers, as a proxy for the opportunity for active management in his report. Based on analysis done by the S&P Dow Jones Indices Research, the dispersion between the first and third quartile managers over the past five years for actively-managed International Small Cap Equity funds is 3.6% compared with 2.8% for their U.S. Small Cap Core Equity counterparts. This ties in well with the current valuations for the U.S. and Asian stock markets.
While the U.S. market is setting record highs, the Asian stock markets are relatively undervalued. The MSCI Asia ex-Japan (MXASJ) Index is currently valued at approximately 1.5x P/B, compared with 3x P/B at its peak in 2007 and 1.19-1.23x P/B at its 2001, 2003 & 2009 troughs. In contrast, the U.S. market's Q-ratio (similar to P/B ratio, calculated as total price of the market divided by its replacement cost) is 1.01x as of end-December 2016, almost double that of its 2009 trough of 0.54x, according to research by Advisor Perspectives.
Also, a study conducted by Forager Funds on the number of stocks trading at a discount of 20% or more to their NTA in various global markets in March 2016, points to a similar conclusion - there are simply more bargains in Asia vis-a-vis the U.S. At the time of Forager Funds' research, over a quarter of stocks listed in Hong Kong, Singapore and Korea were trading at a discount of 20% or more to their Net Tangible Assets, compared to a mere 6% of stocks listed on the New York Stock Exchange and the London Stock Exchange.
Returning to Jason Zweig's quote in his article "If investors are to prosper from inefficient markets, they have to evaluate which markets still are inefficient," the message from the above-mentioned data is clear: international (including Asian) markets are more inefficient and undervalued relative to their U.S. counterparts, making the case for including non-U.S. stocks in one's portfolio much stronger.
Spin-offs: Selling Without Regard for Fundamental Value
In Mauboussin's report, he made reference to researchers who did a meta-analysis of more than 25 papers in the spin-off literature, and concluded that 'spin-offs are associated with strongly significant abnormal returns.' This conclusion shouldn't be surprising to anyone who has read Joel Greenblatt's book "You Can Be A Stock Market Genius."
In my public article "Reviewing 2016 Year-To-Date Spin-Offs For Value Investing Opportunities" published on the topic of spin-offs in May 2016 respectively, I identified Armstrong Flooring (NYSE:AFI) and Manitowoc Foodservice (MFS) as potential investment candidates. Both Armstrong Flooring and Manitowoc Foodservice have performed well since the time my article was published, with their share prices up 28% and 24% respectively.
I also profiled another spin-off, GCP Applied Technologies (NYSE:GCP), exclusively for my subscribers of the Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service on March 5, 2016 as a Magic Formula investment candidate, where I highlighted the company's investment merits such as market leadership (ranked first or second) in products with a low cost-to-customer benefit ratio, high customer retention rates and EBITDA-to-free cash flow conversion rates in excess of 80%. GCP Applied Technologies has since returned 41% for my subscribers, or an annualized gain of 49% in the period between March 2016 and December 2016.
The Value Premium: Statistically Inexpensive Low P/B and Low P/E Stocks
From learning about Fama and French's classic three-factor model on the outperformance of small-cap stocks and stocks with a low Price-to-Book ratio to reading Tweedy Browne's study of investment approaches and characteristics associated with exceptional returns titled "What Has Works In Investing," I have never really doubted the outperformance of statistically inexpensive value stocks.
The value premium forms the foundation of my value investing philosophy and process. I actively seek stocks with a huge gap between price and intrinsic value, leaning towards deep value balance sheet bargains (i.e. buying assets at a discount e.g. net cash stocks, net-nets, low P/B stocks, sum-of-the-parts discounts) and wide moat stocks (i.e. buying earnings power at a discount in great companies like "Magic Formula" stocks, high quality businesses, hidden champions and wide moat compounders).
Mauboussin opines in his report that the behavioral explanation that "uninformed investors extrapolate past earnings growth rates too far, overreact to positive or negative news, and act as if recent price action will continue" best explains the outperformance of statistically inexpensive value stocks based on the majority of findings from the academic research on this topic. This is very much in line with Robotti's focus on the behavioral edge and John Huber's emphasis on having the right mindset, the discipline, and the time horizon.
Wealth Transfers Via Buybacks and M&As
Mauboussin also wrote about how value is transferred between buyers and sellers of a stock via activities and events like share repurchases and M&As.
Mauboussin presented a simple rule for buybacks: when a company 'buys back undervalued stock, ongoing shareholders benefit at the expense of selling shareholders.' Famed value investor Monish Pabrai recently co-wrote an article in Forbes on an investment strategy called "The Uber Cannibals." Pabrai highlighted that The Uber Cannibals draws inspiration from Berkshire Hathaway's top holdings: IBM (NYSE:IBM), Coca-Cola (NYSE:KO) and American Express (NYSE:AXP) were all Munger Cannibals, which have bought back 59.5%, 26.8% and 24.7% of their shares respectively in the past 28 years. In addition, he presented the results of a backtest of a portfolio containing these three Munger Cannibals: this portfolio would have outperformed the S&P 500 by 4% on an annualized basis for the past 28 years. These five stocks, AutoZone (NYSE:AZO), Magellan Health (NASDAQ:MGLN), Marriott International (NYSE:MAR), NVR (NYSE:NVR) and Lowe's (NYSE:LOW) were identified as Pabrai as the Uber Cannibals for 2016 (other undisclosed quality and cheapness indicators in addition to share repurchase percentage were used as filters by automated algorithms in picking the top five).
I did similar work in September 2015, with my article titled "Seeking Munger Cannibals Among U.S. And Asian Stocks" where I provided a list of 50 mid- and small-cap cannibals stocks, which were sourced via screening for stocks which have been consistently buying back their own shares for the past one, three, five & 10-year periods at an annualized rate exceeding 3% for the past decade with market capitalizations between $100 million and $5 billion. Munger cannibals continue to be a source of wide-moat ideas for myself, as I keep some of these names on a watchlist regularly monitoring for adverse share price movements which will provide attractive entry points.
Moving on to M&A, Mauboussin wrote that "If an offer exceeds that value, there is a wealth transfer from the shareholders of the acquiring company to the shareholders of the selling company." A big theme for Asia in 2016 was privatizations and takeovers, particularly in Hong Kong and Singapore. For Asian-listed companies, privatization is one of the most common resource conversion events that arbitrage between public and private market valuations.
In July 2016, I identified Hong Kong-listed Luen Thai (311 HK) as a statistically cheap low P/B net-net with the founding family owning more than 70% of the company's shares exclusively for my subscribers. This turned out to be my biggest winner (a three-bagger in four months) for 2016, when Luen Thai was acquired by Shangtex, a state-owned enterprise following a general offer for the company's shares coupled with special cash dividends were declared relating to the offer and disposal of non-core assets. Given that valuations of Asian stocks remain undemanding, as per my analysis above, I would expect more privatizations and takeovers in Asia this year.
As Buffett once said "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ," I don't think that I have an analytical edge that I can leverage on to beat the market. Instead, I rely heavily on the Time-horizon Advantage and Informational Advantage as my "edge" in investing. This implies buying both deep value balance sheet bargains and wide moat compounders on the cheap when they are either inflicted by fear (Time-horizon Advantage - buy great companies on their knees e.g. Buffett's investment in American Express in the mid-1960s) or neglect (Informational Advantage - institutional investors can't buy certain stocks below a specific market capitalization or 30-day average trading dollar value, resulting in an inefficient market for micro-caps where the big boys are out of the trade). This is only possible because I am investing permanent capital with little or no restrictions on the country of listing, liquidity and market capitalization requirements.
Readers need to understand their own personality traits and take that into consideration formulating their own investment philosophy which will determine what kind of edge he or she can capitalize on. In my opinion, a patient and disciplined person will naturally be attracted to the concept of value investing and find that the Time-horizon Advantage/Behavioral Edge to be the most dependable edge that he or she should identify with.
For investors interested in other deep value and wide-moat stocks listed in the U.S. and Asia, please consider my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service.
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Asia/U.S. Deep-Value Wide-Moat Stocks Premium Research
Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service get full access to the list of deep value and wide-moat investment candidates and value traps, including "Magic Formula" stocks, wide-moat compounders, hidden champions, high-quality businesses, net-nets, net cash stocks, low-P/B stocks and sum-of-the-parts discounts.
Some of the potential investment candidates I profiled for my subscribers in January 2017 include the following:
1) A U.S.-listed deep value stock trading at 0.6 times P/NTA and at a significant discount to Comparable Company and Comparable Transaction (1.2-1.5x P/NTA) valuation multiples. This stock is a Munger Cannibal having bought back close to 40% of its shares outstanding since 2011 at prices below tangible book, and there is alignment of interests with insiders holding more than 10% of the company's shares.
2) An Asian-listed deep value net-net trading at 0.52x P/NCAV and 0.46x P/NTA with net cash accounting for 96% of its market capitalization. This company has to meet certain profitability and market capitalization requirements to comply with listing rules by latest 2018, which serves as a catalyst for value realization.
3) A U.S.-listed recession-proof, wide-moat (network effects, economies of scale and brand equity) stock. Valuations are undemanding at 15x P/E and 8x EV/EBITDA versus a 20% ROE, which has attracted a SuperInvestor to initiate a position in the second quarter of 2016 and triple his position in the third quarter of 2016 according to 13F filings. In addition, the founding family owns more than half of the company's shares outstanding.
4) An Asian-listed Magic Formula, wide-moat stock trading at a discount to its sum-of-the-parts valuation i.e. its listed subsidiary as a standalone entity is already worth more than the parent based on the respective market capitalizations of the two. It trades at 4x EV/EBIT and Acquirer's Multiple versus a trailing ROIC of approximately 25%. The company's moat lies with its economies of scale in production and its extensive distribution network.
Disclosure: I am/we are long GCP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.