There is no Magic Formula in investing or Business (other than THE Magic Formula)

There is no magic formula to investing or anything. That being said, there are a few guidelines that (much like bumpers on a bowling lane) can save you from going into the gutter. These guidelines aren’t 100% guarantees but will definitely put the odds in your favor.

First a note to new investors: When first starting out in investing it’s important to decide how active or passive you want to be in your investing endeavors. If you are going to actively pick stocks/investments you should know that this will take up at least a couple hours a week and may not result in you performing as well as you could by investing in a low cost index fund. The passive approach is usually an allocation approach where you or your adviser (which may or may not be a robot) decides on a breakdown between stocks or bonds and re-balances on a regular schedule. The active approach is one where the investor seeks out individual investments based on their own merit. The passive approach takes all investments given a simple criteria and buys them all. Even if they are dogs with fleas! Passive investors usually choose the S&P 500 but a more favorable category given the historical out-performance would most likely be a small cap-value ETF with sufficient diversification.

When first starting out in investing, rather than going through the specific details of what makes an investment a good deal in today’s market, it’s easier to look at individual characteristics of investments that have done well in the past.

So, what has worked in investing?

In the stock market it is Value stocks, Small Capitalization/illiquidity, certain special situations, Insider purchases or company buybacks and in a smaller subset of investments large earnings growth and high quality.

Growth Vs. Value

Low price/(earnings, assets, cash flow) investments are usually called value investments whereas low dividend yields and high price to earnings etc. are usually called popular or growth investments. Growth stocks may or may not also be associated with high returns on invested capital (ROIC) and high returns on equity (ROE) whereas value stocks may be low in regards to both categories. (Value stocks may have a low ROE simply because they have a lot of excess capital). There are many sub-styles of value investing where investors may or may not be concerned with a company being of high quality or not. Quality investing can be defined separately as investing in companies that are high ROE and ROIC or have large economic moats that competitors may find hard to penetrate.

On average and over long periods of time: value stocks perform better than growth stocks. The following chart sums this up fairly well.

Annual Returns S&P 500 Large Cap Growth Large Cap Value Small Cap Growth Small Cap Value
1992 7.62 5.94 11.12 7.84 23.42
1993 10.08 6.77 15.67 15.62 19.92
1994 1.32 0.9 -0.9 -2.06 -1.13
1995 37.58 36.05 35.8 33.77 23.58
1996 22.96 21.84 21.36 14.16 20.8
1997 33.36 29.04 31.83 12.09 30.3
1998 28.58 37.59 16.94 1.1 -6.58
1999 21.04 33.99 9.07 52.13 0.2
2000 -9.1 -21.05 4.48 -15.34 19.47
2001 -11.89 -22.15 -7.09 -11.1 15.61
2002 -22.1 -28 -17.6 -28.95 -11.32
2003 28.68 28.36 29.02 46.66 46.78
2004 10.88 6.88 14.25 12.55 21.45
2005 4.91 6.42 6.66 4.75 6.08
2006 15.79 6.9 20.27 12 20.31
2007 5.49 13.39 1.15 8.37 -7.18
2008 -37 -39.92 -36.93 -40.58 -30.87
2009 26.46 37.86 22.33 36.25 26.79
2010 15.06 15.92 14.27 27.59 25.12
2011 2.11 -0.13 -0.89 -3.16 -5.16
2012 16 15.59 16.69 14.77 16.81
2013 32.39 34.45 32.88 42.15 34.89
2014 13.69 11.69 12.23 3.79 3.63
2015 1.38 5.64 -3.74 -1.27 -7.32
2016 11.96 16.47 25.59 27.97 40.33
Average 10.690 10.418 10.978 10.844 13.037

So for the past 25 years large cap value has outperformed the S&P 500 (the standard passive investment vehicle for investors) by a measly couple hundred basis points. Whereas value has outperformed by 2 and 1/2 percent. It’s interesting to note that growth stocks on average have under-performed by a couple hundred basis points. During certain time periods, however, growth outperformed, for instance, the several years before the dot-com bust. All of these funds re-balance each year so that the constituents of the value or growth portfolios are not necessarily the same as they were the year before.

As unbelievable as it sounds. There are many companies available for sale in the stock market that are so cheap that their cash minus all of their liabilities is higher than the market capitalization of the company. For example a company may have $105m in cash and 5m in total liabilities with 50m shares outstanding. The company would have net cash of $2/share but the stock may trade for only $1. If the company makes money and is expected to into the future then the investment is a safe and cheap investment.

Many of the best individual stock investments of all time are companies that could be placed in the growth category. It would be hard to make 100x on your money from many deep value investments. To paraphrase famous Warren Buffett sidekick Charlie Munger: when you invest in a company that has a return on capital of 6% for 40 years you can’t expect to make much more than 6% a year. In other words in the short run it is very shrewd to hold onto value stocks but in the long run it probably isn’t. This brings up the issue with individual value stocks is that they can become value traps. If a company is worth $10 but never grows in value an investor that purchases the stock at $5 wouldn’t earn a decent return at all if the stock takes 20 years to realize the $10 value.

This is where THE Magic Formula comes in. The Magic Formula is a construct of Joel Greenblatt, an investor who has one of the best long term track records of all time. Taking notes from Warren Buffett’s investing style the screener attempts to find value stocks that are also high quality. The magic formula finds 30 companies ranked by the lowest earnings yield (defined as EBIT/Enterprise value) and highest returns on capital (defined as net fixed assets + working capital). The Magic Formula outperforms the market in most time periods studied. The interesting things is that, also in most periods, the Magic Formula itself under-performs just the simple earnings yield criterion by itself. This realization was tackled by Tobias Carlisle in his book, “Deep Value.”

Small Capitalization/Illiquidity

As we can also see from the previous chart. Small cap stocks of any variety usually outperform larger cap stocks. The reasons for this may be institutional to the fund management business. A fund manager with a $10b with 100 1% positions would invest $100m in each position. They can’t easily invest in many companies under $1b in market cap because they would own over 10% or more of a company which would limit the managers liquidity.

Illiquidity in and of itself is a great portender to returns solely because many investors psychologically are uninterested in being tangled up in an investment which they can’t sell at a moments notice. To longer term investors this is of no concern, particularly if the investment is a purchase at what may be considered well below what the Private Market Value of the company is. Another way to think about how irrationally the dislike of illiquidity is is that if something terrible bad happens to the company no matter if the company is illiquid or not the stock will drop.

Special Situations

This is somewhat of a catchall category that includes (and is not limited to) the following investments situations:

  • Merger Arbitrage
    • Standard Merger Arbitrage
    • Premergers
    • Bidding Wars
    • Appraisals
  • Spin-offs
  • Rights Offerings
  • Liquidations
  • Mutual Conversions

Merger Arbitrage occurs after a merger is announced between 2 (or occasionally more) companies. Mergers can be for cash, stock in the acquiring company or other securities of the acquiring company. The returns from this style of investment are usually small on an actual basis but since the investment is not tied up for a long period of time the annual returns may be substantially higher. If a merger is announced and the indicated return is 5% in 1 month then the annual return on that investment is nearly 80% on a compound basis.

Premergers are similar to merger arbitrage but they occur before a definitive agreement is in place. Premergers often times have an activist on-board of the company agitating to have the company sold at a premium.

Bidding Wars are among the best investment opportunities available in all of the markets. These occur when there are multiple acquirers that have made their intentions public. Occasionally astronomical returns can be made in very short periods of time.

Appraisal Arbitrage occurs when investors believe that the acquiring company of the investor is buying the target company for way below fair value. Investors in the target company can sue (or threaten to sue) in order to receive a greater return. Investors have occasionally been able to reap substantial returns from this strategy but investors have in very few cases actually received a lower price than the original merger price.

Spin-offs occur when a company with multiple divisions decides to simplify it’s business. A company will dividend stock in a subsidiary company so that the owner of the parent company will end up owning two different stocks at the end of the transaction. There are many angles to think about with this category which I will outline in other posts.

Rights offerings. A rights offering is when a company raises money from current shareholders of the stock. Rights offerings are particularly powerful when a company is in deep financial distress and the proceeds of the rights offering are used to pay off indebtedness.

Liquidations occur when a company decides to distribute assets to shareholders. The company may sell divisions or individual salable assets and then pay out dividends to investors. This is a particularly under-followed area of investing.

Mutual Conversions are a great opportunity for the current investment landscape. Mutual companies are companies which are owned by customers or suppliers. Most mutual conversion candidates are either insurance or bank concerns. The key about mutual conversions is that there are currently no stockholders of the company so when the company decides to IPO the proceeds go directly to the company and not to a third party. If a company IPOs at $10/ share you essentially get your $10 back and buy the company for free (minus a few investment banking fees). The initial opportunity to get in before the IPO is not often available for the outside investor. But the outside investor can take advantage of the fact that 70% of Mutual companies are eventually taken over at substantial premiums after consummation of a 3 year moratorium as required by law. This tied into the fact that banking concerns are already in the focus of the private markets only adds to the appeal.

Insider Purchases/Buybacks

Large insider purchases are an obvious indicator that an investment is cheap or it is a “tell” that a transaction may be undertaken in the future. The most recent newsworthy example of this was Jamie Dimon’s multi-million dollar purchase of JP Morgan stock during a lull in the early months of 2016. An investor following Dimon’s move would have made a ~50% return in a short amount of time.

Buybacks CAN also be a great indicator of future returns. In aggregate most companies make terrible capital allocation mistakes but a select few managers have delivered ginormous return through well-timed share buybacks. John Malone being perhaps one of the best users of this particular capital allocation tool. Several of the companies that Malone controls have bought back more than 30% of their stock in the past 10 years. An investment in Malone’s TCI corp and later various Liberty Media vehicles would have outperformed Buffett’s Berkshire Hathaway by more than 5-10% per year.

Buybacks can also be a signal in so called “mop-up” situations. A mop-up situation is where a company owns a significant portion of a publicly traded company say 89%. A company may announce a buyback of 1% in order to conduct a short-form merger. A past example of this activity was American Independence Holdings which was majority owned by Independence Holding. They initiated a tender offer which foretold an eventual take out at a price several times the going rate of the initial tender offer.

This about wraps up the preliminary post. In the future I’m going to elaborate more on the concepts mentioned above as well as write about investing in specific stocks, real estate, starting businesses and overall on the skills and knowledge necessary to become rich. 

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