Beating the market is every investor’s elusive goal. It’s like those crazy nutjobs who are trying to find Bigfoot, or evidence of UFOs, or those guys who try to figure out the point of throw pillows. (They exist so women can have pillow fights in their underwear while the fellas are distracted with sports, duh.) Finding a way to beat the market is the holy grail of investing. If you do it once, you’re probably labeled as a bit of a fluke. If you do it twice, people start to think maybe you’re onto something. If you do it five years in a row, investors will line up and start throwing their money (and panties) at you. It’s good to beat the market.
So what if I told you that someone went back, did the work, and figured out an almost foolproof way to beat the market? You’d be interested, unless you don’t have a pulse. In that case you’d be dead, and you’d probably start stinking up the place. Nobody wants that. Anyway, it’s not nearly as hard as you think it is.
Recently, my homeslice JT from Money Mamba linked to a piece from investment firm Tweedy Browne, which took a look at over 50 studies done over the past half century, examining the best investments to make. It doesn’t matter the country, or the time, one strategy ended up consistently doing better than all the others. It’s value investing.
Basically, the way to beat the market is to buy companies for less than what they’re worth. How do you do that, anyway? There are two ways. Firstly, you can buy companies trading for significantly less than book value. Why would you do that? If you take a look at companies trading for less than book value now, you get names like Blackberry, or France Telecom, or other stocks investors think are going to zero. Perhaps, but let’s look at how well my strategy would have done between 1967-1984. From the Tweedy Browne piece:
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Do you see how easy that is? The return of the NYSE over that period was 8.6%. All you needed to do to was buy a basket of the cheapest stocks on a price to book basis, hold them for a year, and then rotate to a new basket. Doing that killed the market, at least over that 17 year time period.
This method of investing isn’t sexy, it’s not going to impress any of the ladies. You’ll be holding shares of all sorts of small cap names nobody has heard of, since stocks with big followings hardly ever get to the point where they’re ridiculously cheap. They’re just too well followed, so retail investors prop the price up when they go in looking for value. Oh hey, it’s yet another reason why you should buy small cap stocks.
So why doesn’t every hedge fund in the world do this? It’s because this strategy becomes significantly more difficult once you’ve got serious money behind you. Let’s look at Emerson Radio, a company trading for less than half of the value of its assets. It has a market cap of $43.6M. If I manage a billion dollar hedge fund, (And I will one day. I shall call it BOOB FUND.) one percent of my fund’s assets would buy close to 25% of the company. Oh, and this company trades an average of 34,000 shares a day. Most of the companies that trade for significant discounts to their book value are too small for large players to even look at.
But that leaves a gigantic sized opening for average guys like you. I am, of course, better than average in every way. I can’t remember the exact quote, but Warren Buffett has said he could easily make 50% a year if he only had a million bucks to invest. 50% may be a little out of reach for us, but we’d all be happy just beating the market, right?
Okay, maybe buying companies at low price to book values doesn’t do it for you. How about buying them at low price to earnings ratios then? Tweedy Browne has that covered too.
Buying cheap earnings is the exact same principle behind buying cheap assets. You’re looking for stocks that, for whatever reason, investors aren’t willing to love, even though their earnings are decent. Considering the market’s love of dividends, I’m willing to guess today’s list of these companies is filled with non-dividend payers.
So what’s an investor to do? Should you run out and blindly buy companies trading for less than book value? Well, yeah. Almost.
There are two improvements to the method I’d make. Firstly, avoid companies with a lot of debt. Debt is the enemy to a company trying to turn things around. A company with a clean balance sheet can afford to be patient, since they know creditors won’t come calling. When was the last time a company without debt declared bankruptcy?
Secondly, avoid companies with large amounts of goodwill or intangibles on their balance sheet. It’s almost a guarantee that goodwill will get wrote off during rough times, and that one action will damage the company’s book value significantly. I usually exclude goodwill or intangibles from my book value calculations, unless there’s an actual case to be made that they have value. (Like Blackberry’s intellectual property [i.e. patents] which is listed under their intangible assets.)
This method of investing isn’t exciting. You won’t impress your friends when you tell them about the boring no-name stocks you buy. But if you get results, who cares?