Diversified mechanical investing vs. Focused research-driven for a beginner

[Patmo]

The popular strategy now seems to be a focused one where you do a lot of research to buy a few really good companies for not too expensive. With my first thread in the ideas subforum bombing pretty hard, I think I'm still far from having the experience and competencies required to follow such a strategy successfully. Maybe as I improve I will narrow down the number of stocks I hold, but until I feel confident enough to do so it may be better to follow the more classical style of value investing, where you grab a fairly large basket of cheap stocks with cursory research rather than deep analysis, qualitative or otherwise.

 

From what I understand, simply picking among the cheapest stocks by P/E, P/B etc does well over time. If I slowly build and maintain a 20-30 stock portfolio that meets criteria I feel comfortable with, I should be able to get by. This allows me to be involved in the process and reduces the risk of error, even if the few bad apples cost me in terms of total return vs. a well-run concentrated portfolio. Meanwhile I can practice and develop my valuation skills, and my qualitative judgement should naturally follow suit.

 

What does everyone think?

 

[PatientCheetah]

The popular strategy now seems to be a focused one where you do a lot of research to buy a few really good companies for not too expensive. With my first thread in the ideas subforum bombing pretty hard, I think I'm still far from having the experience and competencies required to follow such a strategy successfully. Maybe as I improve I will narrow down the number of stocks I hold, but until I feel confident enough to do so it may be better to follow the more classical style of value investing, where you grab a fairly large basket of cheap stocks with cursory research rather than deep analysis, qualitative or otherwise.

 

From what I understand, simply picking among the cheapest stocks by P/E, P/B etc does well over time. If I slowly build and maintain a 20-30 stock portfolio that meets criteria I feel comfortable with, I should be able to get by. This allows me to be involved in the process and reduces the risk of error, even if the few bad apples cost me in terms of total return vs. a well-run concentrated portfolio. Meanwhile I can practice and develop my valuation skills, and my qualitative judgement should naturally follow suit.

 

What does everyone think?

 

I think you are better off trying to find average priced stocks with above average ROIC. When you find them, spend the time on understanding why the ROIC is above average and if it will be durable. I did what you were planning to do back in the days with bad results on average. When the overall market is not on sales, stocks that are too cheap are usually cheap for a reason - frauds, unsustainable trends, declining industry, etc. Also, staying away from small/nano caps and OTCs in general.

 

-X

[no_free_lunch]

The popular strategy now seems to be a focused one where you do a lot of research to buy a few really good companies for not too expensive. With my first thread in the ideas subforum bombing pretty hard, I think I'm still far from having the experience and competencies required to follow such a strategy successfully. Maybe as I improve I will narrow down the number of stocks I hold, but until I feel confident enough to do so it may be better to follow the more classical style of value investing, where you grab a fairly large basket of cheap stocks with cursory research rather than deep analysis, qualitative or otherwise.

 

From what I understand, simply picking among the cheapest stocks by P/E, P/B etc does well over time. If I slowly build and maintain a 20-30 stock portfolio that meets criteria I feel comfortable with, I should be able to get by. This allows me to be involved in the process and reduces the risk of error, even if the few bad apples cost me in terms of total return vs. a well-run concentrated portfolio. Meanwhile I can practice and develop my valuation skills, and my qualitative judgement should naturally follow suit.

 

What does everyone think?

 

 

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing. 

[oddballstocks]

The popular strategy now seems to be a focused one where you do a lot of research to buy a few really good companies for not too expensive. With my first thread in the ideas subforum bombing pretty hard, I think I'm still far from having the experience and competencies required to follow such a strategy successfully. Maybe as I improve I will narrow down the number of stocks I hold, but until I feel confident enough to do so it may be better to follow the more classical style of value investing, where you grab a fairly large basket of cheap stocks with cursory research rather than deep analysis, qualitative or otherwise.

 

From what I understand, simply picking among the cheapest stocks by P/E, P/B etc does well over time. If I slowly build and maintain a 20-30 stock portfolio that meets criteria I feel comfortable with, I should be able to get by. This allows me to be involved in the process and reduces the risk of error, even if the few bad apples cost me in terms of total return vs. a well-run concentrated portfolio. Meanwhile I can practice and develop my valuation skills, and my qualitative judgement should naturally follow suit.

 

What does everyone think?

 

 

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing.

 

Yes, buying cheap stocks doesn't work...low P/E, low P/B stocks...nope they never recover.  You'll just be sinking your money into value-traps.  Terrible businesses priced cheaply never rebound.  Who wants to own a dowdy company?  Everyone knows that high flying next generation bio-tech and tech stocks are the future.  Those stocks "grow" and who doesn't want their money to grow?

 

Academics have proven that value investing doesn't work, might as well stick to an ETF.....

[no_free_lunch]

oddballstocks,

 

Why don't you go to the site I linked and see how low P/E or low P/B has done.  There obviously needs to be some qualitative variables used as well.  Use your brains rather than just slinging insults around.

[Packer16]

I think you have to use screens intelligently.  In many screens I have seen companies that are not what they appear.  For example, the company is structured in such a way that the screen is misleading like a firm holding having large minority interests but the screens using consolidated data.  Also some of the firms are declining revenue firms which are difficult to value.  I think you really have to know how to value businesses and the key inputs if you are going to use the data screens spit out correctly.

 

Packer

[oddballstocks]

oddballstocks,

 

Why don't you go to the site I linked and see how low P/E or low P/B has done.  There obviously needs to be some qualitative variables used as well.  Use your brains rather than just slinging insults around.

 

I guess my humor went unappreciated, probably because it's brainless..

 

I did go to the site, I have no idea what database they use which is critical in backtesting.  It appeared like they used Valueline, I don't know if that has bias or not or if it's point in time.  Compustat is supposedly the best, although Joel Greenblatt spent $20m revising the Compustat data to get a better version, so who knows. 

 

I'm happy to invest in cheap stocks, most are which low P/E or low P/B.  I realize that low multiple value investing is elementary and many smarter investors graduate to moats, FCF generators and compounders, but I'm perfectly content to swim in the baby pool.  Some other famed investors spent their careers in the baby pool with satisfactory results.  I'd rather do something simple well verses just surviving by doing something complicated.

 

I will second Packer's comment, most screen data is junk.  I haven't had much luck finding good investments with screeners.  The best ideas come from news flow and going through lists A-Z.

[jschembs]

The popular strategy now seems to be a focused one where you do a lot of research to buy a few really good companies for not too expensive. With my first thread in the ideas subforum bombing pretty hard, I think I'm still far from having the experience and competencies required to follow such a strategy successfully. Maybe as I improve I will narrow down the number of stocks I hold, but until I feel confident enough to do so it may be better to follow the more classical style of value investing, where you grab a fairly large basket of cheap stocks with cursory research rather than deep analysis, qualitative or otherwise.

 

From what I understand, simply picking among the cheapest stocks by P/E, P/B etc does well over time. If I slowly build and maintain a 20-30 stock portfolio that meets criteria I feel comfortable with, I should be able to get by. This allows me to be involved in the process and reduces the risk of error, even if the few bad apples cost me in terms of total return vs. a well-run concentrated portfolio. Meanwhile I can practice and develop my valuation skills, and my qualitative judgement should naturally follow suit.

 

What does everyone think?

 

 

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing.

 

Yes, buying cheap stocks doesn't work...low P/E, low P/B stocks...nope they never recover.  You'll just be sinking your money into value-traps.  Terrible businesses priced cheaply never rebound.  Who wants to own a dowdy company?  Everyone knows that high flying next generation bio-tech and tech stocks are the future.  Those stocks "grow" and who doesn't want their money to grow?

 

Academics have proven that value investing doesn't work, might as well stick to an ETF.....

 

Nate, never thought I'd see such sarcasm from you!

 

This board often debates the benefits and drawbacks of various approaches. For whatever it's worth, here are my two cents:

 

1. In most cases, buying cheap index funds, with strict rebalancing rules, is the best option.

2. For those who buy into the old Ben Graham philosophy, Nate's approach is great, and likely to earn returns in excess of (1).

3. For those who enjoy digging into financial statements, and are comfortable with concentration, following Buffett circa decades 1 and 2 IMO is best.

[Hielko]

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing.

There is a reason that almost every academic study adjust results based on a value factor (low P/B) because low P/B stocks do outperform. It's part of the reason that the CAPM-model has been expanded to the 3/4-factor Fama–French model. It's open to interpretation whether or not that means that value stocks deliver risk adjusted out-performance, but if you cannot find low P/B stocks outperforming in a back test you are doing something wrong.

[Kraven]

oddballstocks,

 

Why don't you go to the site I linked and see how low P/E or low P/B has done.  There obviously needs to be some qualitative variables used as well.  Use your brains rather than just slinging insults around.

 

I guess my humor went unappreciated, probably because it's brainless..

 

I did go to the site, I have no idea what database they use which is critical in backtesting.  It appeared like they used Valueline, I don't know if that has bias or not or if it's point in time.  Compustat is supposedly the best, although Joel Greenblatt spent $20m revising the Compustat data to get a better version, so who knows. 

 

I'm happy to invest in cheap stocks, most are which low P/E or low P/B.  I realize that low multiple value investing is elementary and many smarter investors graduate to moats, FCF generators and compounders, but I'm perfectly content to swim in the baby pool.  Some other famed investors spent their careers in the baby pool with satisfactory results.  I'd rather do something simple well verses just surviving by doing something complicated.

 

I will second Packer's comment, most screen data is junk.  I haven't had much luck finding good investments with screeners.  The best ideas come from news flow and going through lists A-Z.

 

I like to just dangle my feet in the baby pool.  I see the big capital allocation kids with their fancy moats and compounding machines and say to myself, "self, someday . . . someday." 

[no_free_lunch]

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing.

There is a reason that almost every academic study adjust results based on a value factor (low P/B) because low P/B stocks do outperform. It's part of the reason that the CAPM-model has been expanded to the 3/4-factor Fama–French model. It's open to interpretation whether or not that means that value stocks deliver risk adjusted out-performance, but if you cannot find low P/B stocks outperforming in a back test you are doing something wrong.

 

Maybe, I mean it makes sense but I am just saying that I can't prove it.  To be honest when I started looking at screeners it was not to disprove mechanical value investing but rather to prove and verify it.  I haven't been able to convince myself that it works and I haven't read anything that has changed my mind.

 

If you look at the data there are actually a lot of value screens that have worked over the last 25 years in aggregate but something happened around 2006/2007.  Since then, many of these screens which worked very consistenly have been very consistenly under-performing and in total since 06/07 have significantly underperformed the market.  I have tried with several different sceening websites and had similar results. 

 

So it's not that I don't believe that investing in cheap stocks work, otherwise I wouldn't be on this site.  I just think that that's one filter and you need to do additional screening to figure things out.  Cyclical earnings, one-time items, business changes, accounting methods all need to be considered.

[Packer16]

That is why a focused research-driven approach may be better to begin with so you can understand the value drivers and use screens as one tool to identify potential mispricings.  I make the assumption that most stocks are priced appropriately then look for the outliers.

 

Packer

[wachtwoord]

I don't have a truly constructive addition to this thread but I just clicked http://finance.yahoo.com/blogs/breakout/why--cheap--stocks-are-for-suckers-134049217.html on Yahoo Finance and it made me chuckle and think of this thread.

[jschembs]

I don't have a truly constructive addition to this thread but I just clicked http://finance.yahoo.com/blogs/breakout/why--cheap--stocks-are-for-suckers-134049217.html on Yahoo Finance and it made me chuckle and think of this thread.

 

Is he seriously conflating cheap with low stock price?

[crastogi]

oddballstocks,

 

Why don't you go to the site I linked and see how low P/E or low P/B has done.  There obviously needs to be some qualitative variables used as well.  Use your brains rather than just slinging insults around.

 

I guess my humor went unappreciated, probably because it's brainless..

 

I did go to the site, I have no idea what database they use which is critical in backtesting.  It appeared like they used Valueline, I don't know if that has bias or not or if it's point in time.  Compustat is supposedly the best, although Joel Greenblatt spent $20m revising the Compustat data to get a better version, so who knows. 

 

I'm happy to invest in cheap stocks, most are which low P/E or low P/B.  I realize that low multiple value investing is elementary and many smarter investors graduate to moats, FCF generators and compounders, but I'm perfectly content to swim in the baby pool.  Some other famed investors spent their careers in the baby pool with satisfactory results.  I'd rather do something simple well verses just surviving by doing something complicated.

 

I will second Packer's comment, most screen data is junk.  I haven't had much luck finding good investments with screeners.  The best ideas come from news flow and going through lists A-Z.

 

I like to just dangle my feet in the baby pool.  I see the big capital allocation kids with their fancy moats and compounding machines and say to myself, "self, someday . . . someday."

 

Me too :)  I seem to have near drowning experiences in the Big Boy pool. 

[Patmo]

This idea that stocks with low PE,PB, etc do well comes up a lot.  Is that true though?  Go to this site http://www.backtest.org/ and try testing your ideas out.  I found that most of these strategies don't do well.  I am very skeptical of mechanical investing.

There is a reason that almost every academic study adjust results based on a value factor (low P/B) because low P/B stocks do outperform. It's part of the reason that the CAPM-model has been expanded to the 3/4-factor Fama–French model. It's open to interpretation whether or not that means that value stocks deliver risk adjusted out-performance, but if you cannot find low P/B stocks outperforming in a back test you are doing something wrong.

 

Maybe, I mean it makes sense but I am just saying that I can't prove it.  To be honest when I started looking at screeners it was not to disprove mechanical value investing but rather to prove and verify it.  I haven't been able to convince myself that it works and I haven't read anything that has changed my mind.

 

If you look at the data there are actually a lot of value screens that have worked over the last 25 years in aggregate but something happened around 2006/2007.  Since then, many of these screens which worked very consistenly have been very consistenly under-performing and in total since 06/07 have significantly underperformed the market.  I have tried with several different sceening websites and had similar results. 

 

So it's not that I don't believe that investing in cheap stocks work, otherwise I wouldn't be on this site.  I just think that that's one filter and you need to do additional screening to figure things out.  Cyclical earnings, one-time items, business changes, accounting methods all need to be considered.

 

Well as I said in my initial post I intend on building up to 20-30 over time, meaning I won't just buy purely all the cheapest currently but the few I like that meet my criteria, and do so again in the future. I've spotted 6 as of now but didn't rush into buying them all yet. Maybe by this time next year I'll have 30 stocks, maybe not.

[ItsAValueTrap]

I would develop your circle of competence and stick within it.

 

Some industries are easier than others.

 

Very difficult:

Mining

Insurance

Financial companies with large derivatives books (e.g. investment banks)

Pharma

[yadayada]

I really like munger's idea of adopting mental models. For example you could apply these two mental models to make sense of price in economics: what feels fair and supply and demand. If you apply the 'fair' model then nothing makes sense (why the hell do movie stars make 30x as much as doctors??), but then you might stumble upon the supply and demand model and suddenly everything makes sense. And it will become alot easier to understand why a movie star makes 30 million when a doctor would make much much  less.

 

I would just collect a whole bunch of those mental models and test them in reality. In the end, the idea is that you have build a whole load of these mental models to make sense of the vast amount of information annual reports and other sources of information that you have to filter through.

 

If you read books or articles about investing, try to find what type of models the authors use and see if they  make sense.

 

it is also a good idea to do this outside investing I think. Alot of people make bad decisions because they try to fit all the incoming information into one mental model, trying to shove a square through a circle shaped hole really. To do this well you need to constantly test them and be critical of them. And if something doesn't add up then you need to be willing to adopt other mental models to try and make sense of the situation. Ofcourse bias comes in here and prevents alot of people from doing this. And for a lot of people it is no longer a mental model, but it starts to become a believe. That is why you always need to keep testing them, as soon as it becomes a believe, it means you stopped testing your model against reality.

 

This is a good link to read more:

 

http://stockshastra.moneyworks4me.com/basics-of-investing/stock-investing-using-charlie-mungers-lollapalooza-effect/

 

Also like this one on multiples:

http://ify.valuewalk.com/wp-content/uploads/2014/02/document-805915460.pdf

 

 

[Palantir]

I am wondering why is it always one or the other? Why can't you do both? I think it's pretty silly to say, "I'm only going to invest in deep value micro caps and net-nets", or "I'm only going to invest in moat firms".

[Aurelius]

I am also new to investing. What I've found is it takes a lot of time and effort to become better. One thing is to understand value investing. It's quite another to identify stocks where you have an edge.

 

I'm quite surprised why no one has recommended "Pabrai's approach". Copy other great investors. I can't think of another industry where a complete novice can get the same results as the very best in that industry.

 

Why not follow 10 or so great investors and invest in a mechanic way in whatever they are investing in. Try to get in at the same price as they are. Get out when they exit. Keep 10-25 stocks (or more I suppose). Manual of ideas (the book) has devoted a chapter on this type of investing - some nuggets to consider.

 

You should reduce risk this way. If you insist on doing some work your self so you can practice and become better, why not fish in a pool selected by the best?

[jouni1]

you can't actually copy them all the time. usually the stocks in 13F's have gone up considerably when you get the information.

 

i agree that copying smarter people is a wise strategy, but a complete novice can't get the same results as the filers of 13f's by copying them. he's always a bit late (not always a bad thing).

[Hielko]

Another problem is that you often don't know the thesis, so you don't know what you need to monitor and when to exit. And it's also possible that a stock is part of a more complex trade. Sometimes it might just be a hedge for another position.

[txitxo]

What does everyone think?

 

  To do mechanical investing and remain sane, you need to buy many stocks, at least 30 (I buy ~50). Any mechanical method works probabilistically, and the selection has to be almost blind (of course you have to thoroughly check that the numbers your screener is giving you are real and representative, in the sense of really telling you the whole story about the company). The most profitable stocks tend to look terrible from a moat-and-quality point of view (they are so cheap because not even value investors want them) and you have to use a basket approach to dilute individual risks. If does not make much sense mathematically (since the average return would be higher with fewer, better stocks) but it works psychologically, since you never have too much tied up in a individual company and don't worry excessively about them.

[matjone]

txitco, do you mind if I ask how long you've followed that strategy and what your returns have been?

 

I used an old Ben Graham method for a little while, buying stocks under 10x earnings with an equity/asset ratio above 50%.  I made money but lagged the market.

[txitxo]

txitco, do you mind if I ask how long you've followed that strategy and what your returns have been?

 

I used an old Ben Graham method for a little while, buying stocks under 10x earnings with an equity/asset ratio above 50%.  I made money but lagged the market.

 

Well, the last version of the method, which I started implementing at the end of 2012, and which adds a mild momentum indicator, has yielded  about 68% since the start of 2013, in euros. I caught things like SQI, Montupet, Mondo TV, Mota Engil, etc. before they went up like a rocket. As a comparison,  European small caps have probably gone up by 20% during the same period. I try to buy only in countries with CAPE < 18, the last few months European stocks have started to disappear from the top of the screen and I am buying stuff from Australia and Singapore. The "value buddies" forum somebody tipped me about here has become very useful.