I find it ironic that more research is being done today than at any point in time in the past, yet a lot of value investors are failing to beat the market.
Ironically, the mountain of articles on popular investing websites just aren’t helping. Part of the problem might be due to the “more brains” problem Graham cited years ago. Since everybody on Dalal Street is so smart, all those brains ultimately cancel each other out.
This glut of brain power, investment research, and investors clamouring for bargains does not mean that you can’t beat the market. But, knowing how to pick value stocks is a key requirement, along with having a good strategy and being prepared to do things that most other investors aren’t.
Where You Should Hunt When Picking Value Stocks
One core piece of the puzzle is leveraging your biggest competitive advantage as a small investor: your size. Let me explain…
Professional money managers manage billions each year. Legal regulations make owning more than 10% of a single company, or having a single company make up more than 5% of assets, a real burden for a fund company. Given that managers want to keep positions below 5% of their fund, the pool of investment candidates open to money managers is tiny. These restrictions essentially limit a manager’s universe of stocks to comparatively larger cap stocks.
With that much money sloshing around the markets, medium, and large cap companies are, understandably, extremely picked-over. This suggests a powerful advantage that small investors can leverage: investing where the professionals cannot invest.
That really comes down to investing in small cap and micro cap companies. It’s in this universe, among the thousands of tiny publicly traded companies available, that a small investor can pick the most promising value stocks, which will become big enough to attract the big investors later on.
What Value Stocks to Concentrate On
15 years of experience in investing has taught me a few very valuable lessons.
The first is that, despite your research, you’re probably not as important to the end result as you’d like to think you are. Sure, you can conduct an analysis and your stock can go up just as you predicted, but it may not have advanced for the reasons you thought. Sometimes the stocks that you assume that will workout well… don’t. And, at other times, the stocks you thought were real dogs will advance in price.
Another core insight I’ve had over the previous decade is that I (and likely you, as well) am not Warren Buffett. Small investors can’t bring the same amount of skill and experience to investing as he does, and blindly following how he invests today is what I call falling into the Warren Buffett trap.
Luckily, a small investor doesn’t have to have Buffett’s investing prowess to know how to pick value stocks and succeed as an investor. Investing is a probabilistic exercise, and I’ve found leveraging a statistical investment strategy (ie. “Mechanical” investing style), extremely rewarding. Leveraging them means being able to earn the same investment returns that drew you to value investing in the first place… without you having to be an investing guru.
By simply buying a basket of stocks that are undervalued relative to some value metric, you can leverage those statistical returns to propel your portfolio to large profits.
Different value picking strategies :
The sorts of strategies that I’m talking about fall into the “classic value investing” or “deep value investing” categories. These are the value strategies that Benjamin Graham talked about years ago when he taught his students how to pick value stocks. These strategies have been extensively tested, and used successfully in practice for decades.
Low PE – One of these strategies is the classic Low Price to Earnings strategy. This strategy has been employed successfully by contrarian managers such as David Dreman, whose funds returned 16-17% per year over decades. In general, long back testing researches show that in the US market, a Low PE strategy is good for an average annual return of 16%.
Low PB – Low Price to Book value is another classic value metric that yields market beating results. Using the strategy investors should expect to bag a CAGR as high as 14.5%. That’s a fat 45% in excess of the market return over the course of your life. (Again numbers as per research in US market)
Low PC – One of the more recent classic value strategies, and focuses on finding stocks low relative to Cash Flow. This strategy performs a bit better, recording a CAGR of just over 18%.
High Dividend Yield – Mario Levis at the University of Bath conducted a study called, “Stock Market Anomalies: A Reassessment Based on the UK Evidence.” He found that the highest dividend yielding stocks returned 19.3% on average. Not bad for a basket of cheap stocks!
Net Nets – Then there is Ben Graham’s famous net net stock strategy. Essentially a net net stock is a low Price to Book stock but where the “B” in the P/B ratio has been stripped of all long-term assets. That’s about the easiest way to explain the concept. Basically the price has to be lesser than the net current asset value. (NCAV). This strategy almost gave 25% over several decades.
Of course, the catch is that while you can always find enough stocks to fill a portfolio using the first 4 strategies, during bull markets domestic net nets dry up, making it almost impossible to use the strategy.
How to go about it?
The easiest and safest way to go about it is to adopt one strategy given the market condition and select the basket based on that strategy. Different market situations favor different strategies, like in Bull market net nets are hard to get and low PE and PC stocks tend to out perform other strategies. With you experience and understanding you got to adopt a strategy and stick to it. This will give you a large pool of stocks. Then you should use certain parameters like growth, promoter quality, business quality, balance sheet quality, opportunity size etc to bring them down to 10-15 stocks.
I believe value picking is not difficult. What is difficult to generate conviction on ones idea. Happy value picking.