Deep Value Stocks

Deep Value Stocks image
Origin
In 2005 Joel Greenblatt, founder and former fund manager at Gotham Asset Management, released a book now considered one of the classics of finance literature, The Little Book That Beats the Market. This was then followed up in 2010 with The Little Book That Still Beats The Market (an update to the literature). In this book Joel describes a rules-based, disciplined investment strategy that teaches people a relatively simple and easy-to-understand method of value investing.

Evidencing spectacular returns that beat the market this process has been back tested, researched and re-back tested providing returns that always outperform the S&P500 over a long period of time.

Whilst the books evidences returns of 33% against the S&P500's 14% between 1988 and 2004, investors should be cautious of their return expectations. Nonetheless, third party research has shown that between 2003 and 2015 this strategy provided annualised returns of 11.4% compared to 8.7% from the S&P500, and between 1988 and 2009 this strategy returned 23.76% versus the S&P500's 9.55%.

Unfortunately, these returns come with a downside, the name of the strategy ..... The Magic Formula.

Whilst, it seems odd that a strategy such as this can perform so well and be freely available to the average investor, it leads many to ask why everybody isn't doing it. Well, Warren Buffett said it best "Investing is simple, but not easy". The main issue with the Magic Formula is human emotion. When it comes to money all investors become emotionally involved. Have I done the right thing? It's going down, should I sell? It's going up, should I buy? etc. This emotional rollercoaster tends to cause investors to make irrational decisions.

When it comes to the Magic Formula, discipline is key. As you will see when/if you read the book (I highly recommend you do) investments into this strategy can fluctuate up and down significantly (it's not uncommon for a stocks price to drop 80%). However, should the process be followed, without intervention, over a period of at least 5 years returns demonstrated can be achieved.

What to look for
The Magic Formula has a number of set rules and a process in which to follow:
  1. Establish a minimum market capitalisation (usually greater than $50 million).
  2. Exclude utility and financial stocks.
  3. Exclude foreign companies (American Depositary Receipts).
  4. Determine company's Earnings Yield = EBIT / Enterprise Value.
  5. Determine company's Return of Capital = EBIT / (Net Fixed Assets + Working Capital).
  6. Rank all companies above chosen market capitalisation by highest Earnings Yield and highest Return on Capital (ranked as percentages).
  7. Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year-mark.
  9. Continue over a long-term (5-10+ years) period.
Thankfully, Mr Greenblatt has made this easy by providing an up-to-date list of companies that have been ranked accordingly on www.magicformulainvesting.com

How does this fit into the AVI Strategy
For obvious reasons this part of the AVI Strategy has been called Deep Value Stocks, as no-one wants to hear about some "Magic Formula" when discussing their investments.

As mentioned earlier, this process is simple but not easy to perform. However, as part of the AVI strategy the Deep Value Stocks can be viewed as a cohesive whole (an Exchange Traded Fund if you will) and therefore the individual performance of stocks purchased can be completely ignored. Some say ignorance is bliss, but in this case being ignorant about the stocks chosen is also a blessing. Discouraging meddling with stock purchases and sales and enabling long term adherence to the process is key.

One goal of the AVI Strategy is targeted at removing the desire to meddle with these Deep Value Stocks. As such. the overall portfolio weighting has been kept conservative at 30%. On the basis of 2 stocks being purchased per month this equates to near 1.25% per stock.

Whilst this part of the AVI Strategy can be described as semi-passive, its staggering performance expectations raises the question as to why its weighting is only 30% in the portfolio.

Passive investing supplies the foundation for the AVI Strategy, however Deep Value Investing involves the purchase of individual stocks. These individual stock can encourage idle hands to become detrimentally busy, therefore by maintaining a smaller weighting in the portfolio than other passive investments (see Passive Exchange Traded Funds) the temptation is lessened and returns outperform the benchmark (S&P500) over a long (5-10+ years) period of time.