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June Issue Of Hidden Value Stocks

June Issue Of Hidden Value Stocks

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We asked a ton of ValueWalk readers what their #1 goal was for improving their value investing.

Can you guess what they said?

No, it wasn’t more coverage of Apple or Tesla, those are already well covered by the likes of CNBC, sell side firms and blogs.

Nor was it more coverage of risky leveraged trades, ETNs.

They wanted good small-cap investment ideas that are vetted and have liquidity, but not well covered by Wall Street, Bloomberg, CNBC, sell-side analysts, blogs or even closed sites like SumZero or Value Investing Club.

This answer makes sense: we all want to collect more winners in our portfolio.

But after following investments of ultra-famous investors (Buffett, Dalio, Icahn), reading diligently through 10-Qs at night, and even combing through article after article on obscure forums and blogs, it can be hard to find qualified “special situation” ideas that aren’t already widely known.

So, to meet this key need of our readers, ValueWalk launched the Hidden Value Stock newsletter.

The Hidden Value Stock newsletter is a 20+ page deep dive report that gives you detailed analysis behind specific small and mid cap stocks that two under-the-radar value investing hedge funds like, as well as interviews with the fund managers about their investing process.

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6 Jun

The Small-Cap Investing Handbook Part Six: Peter’s Principles

This is part six of a ten-part series on our Small-Cap Investing Guide.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

 

For the other parts of this Small-Cap Investing Guide series please follow the links below:

So far in this series, I’ve looked at the academic research on small-cap investing but while academic research is always interesting, it’s no substitute for real-world experience. With that being the case, in parts five and six of this series are devoted to Peter Lynch.

Small-Cap Investing Guide Part Six: Peter’s Principles

Why spend so much time on Lynch and his principles? Well, when it comes to real world experience you just can’t beat the experience and record of Lynch.

There have been plenty of other successful small-cap investors throughout history but Lynch is the only investor to be able to have successfully replicated his stock picking success with thousands of equities.

So, here are Peter Lynch’s 21 “Peter’s Principles”, which are intended to sum up the points made in his book, Beating the Street.

Peter Lynch Small-Cap Investing Handbook

Small-Cap Investing Handbook – Peter Lynch’s Principles

Principle #1
When the operas outnumber the football games three to zero, you know there is something wrong with your life.
This point relates specifically to Lynch’s desire to spend more time with his family rather than trying to keep up with all his equities, but the idea behind the principle is simply to remember to make time for what you love in life.

Principle #2
Gentlemen who prefer bonds don’t know what they are missing.

Bonds are inferior to stocks.

Principle #3
Never invest in any idea you can’t illustrate with a crayon.

Buffett has a similar process whereby he avoids what he does not understand. This is the same principle.

Principle #4
You can’t see the future through a rearview mirror.

Past returns are not a guide to future success.

Principle #5
There’s no point paying Yo-Yo Ma to play a radio.

There’s no point paying a bond manager when you can just go and buy the bonds yourself for no annual management fee. The same principle can be used with high costs active funds that closet index.

Principle #6
As long as you’re picking a fund, you might as well pick a good one.

It pays to do your research.

Principle #7
The extravagance of any corporate office is directly proportional to management’s reluctance to reward shareholders.

Excellent companies are thrifty.
Principle #8
When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.

This goes against principle two, but it’s offered as a sort of defensive strategy.

Principle #9
Not all common stocks are equally common.

Some companies are very special. Others are junk.

Principle #10
Never look back when you’re driving on the autobahn.

Principle #11
The best stock to buy may be the one you already own.

Principle #12
A sure cure for taking a stock for granted is a big drop in the price.

Nothing brings you back down to earth after a string of winning positions more than a sudden loss.

Principle #13
Never bet on a comeback while they’re playing “Taps”.

(“Taps” is the name of that bugle tune they play at military funerals. In stock terms, it never pays to buy a stock just because its share price has fallen.)

Principle #14
If you like the store, chances are you’ll love the stock.

Successful companies can be spotted before their stock market darlings by watching how many people use the store. Footfall will reveal more about future sales growth than backward looking financials.

Principle #15
When insiders are buying, it’s a good sign – unless they happen to be New England bankers.

(Refers to the management of a number of Texas and New England banks who violated principle #13, continuing to add to their holdings right up until the very end.)

Principle #16
In business, competition is never as healthy as total domination.

A dominating monopoly company will generate much better returns for investors than several smaller companies fighting for market share.

Principle #17
All else being equal, invest in the company with the fewest color photographs in the annual report.

To understand this principle, all you need to do it look at the annual report of Berkshire Hathaway.

Principle #18
When even the analysts are bored, it’s time to start buying.

When analysts get bored by the company’s lack of progress, the company may be boring enough to buy.

Principle #19
Unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

Cyclicals can be a great way to make a buck if you buy them at the bottom, so it helps to look for opportunity in depressed stocks, rather than think of all the reasons why a cyclical is going to take losses. Optimism is required.

Principle #20
Corporations, like people, change their names for one of two reasons: either they’ve gotten married, or they’ve been involved in some fiasco that they hope the public will forget.

If it’s the latter, it’s best to stay away.

Principle #21
Whatever the Queen is selling, buy it.

If countries privatize formal state-owned companies, they usually do so on such attractive terms that shareholders are almost guaranteed to make great profits.

Stay tuned for our Small-Cap Investing Guide part VII!

The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

This is part five of a ten-part series on small-cap investing.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

 

For the other parts of this series please follow the links below:

So far in this series, I’ve looked at the academic research on small-cap investing but while academic research is always interesting, it’s no substitute for real-world experience. With that being the case, in the next few parts, I’m going to explore some tips, tricks, and experiences from the world’s most successful small-cap investors.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s rules   

Peter Lynch is without a doubt the most successful small-cap investor to have ever lived. Anyone can generate 20%+ p.a. returns from small-caps for a few consecutive years but few have been able to establish a record similar to that of Lynch.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

While managing the Fidelity Investments Magellen Fund, Lynch produced an average annual return for investors of 29.2% between 1977 and 1990, double the return of the S&P 500 over the same period, and catapulting the fund into the ranks of the best performing fund in the world. No doubt, if Lynch had continued to manage the fund throughout the 90s during the great dot-com bull run, the fund’s long term returns would be even more impressive.

As well as managing Magellen, Lynch also wrote several books on the topic of investing and these timeless investing books have really helped cement his reputation as one of history’s greatest investors. Within these books, Lynch made it extremely apparent that the average investor has what it takes to beat Wall Street at its own game and by following a few simple rules, investors could make money from small caps.

These 25 (26) Golden Rules Of Investing, are printed at the end of Lynch’s book, Beating the Street and no series on small-cap investing would be complete without them.

So, without further ado here are Peter Lynch’s 25 Golden Rules Of Investing:

  1. Investing is fun, exciting, and dangerous if you don’t do any work.
  1. Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
  1. Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.
  1. Behind every stock is a company, find out what it’s doing.
  1. Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
  1. You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn’t count.
  1. Long shots almost always miss the mark.
  1. Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any time.
  1. If you can’t find any companies that you think are attractive, put your money into the bank until you discover some.
  1. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
  1. Avoid hot stocks in hot industries. Great companies in cold, no growth industries are consistent big winners.
  1. With small companies, you’re better off to wait until they turn a profit before you invest.
  1. If you’re thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
  1. If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.
  1. In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.
  1. A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
  1. Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
  1. There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
  1. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
  1. If you study 10 companies, you’ll find 1 for which the story is better than expected. If you study 50, you’ll find 5. There are always pleasant surprises to be found in the stock market – companies whose achievements are being overlooked on Wall Street.
  1. If you don’t study any companies, you’ll have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
  1. Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
  1. If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it’s a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.
  1. The capital gains tax penalizes investors who do too much switching from one mutual fund to another. If you’ve invested in one fund or several funds that have done well, don’t abandon them capriciously. Stick with them.
  1. Among the major markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some of your assets in an overseas fund with a good record.
  1. In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

The Small-Cap Investing Handbook Part Four: Quality Over Quantity

This is part four of a ten-part series on small-cap returns.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

Also see

Handbook Part Four: Small-cap investing returns

As covered in the first three parts of this series, there is plenty of evidence which shows that small caps outperform their large cap peers but not on an aggregate basis.

The small-cap premium has disappeared since it was first discovered in 1980, but some small-cap stocks, particularly those that are high quality, continue to outperform. As covered in part three, these rare breed stocks are difficult but not impossible to find, and the rewards on offer certainly justify the additional work required to find these hidden gems.

A November 2015 Research Affiliates article by Vitali Kalesnik and Noah Beck succinctly summarizes small-cap investing as, “Small caps are not the fish, they are the fishing spot—not the source of alpha, but rather a place where alpha can be found.” This is, I believe, one of the most accurate ways of describing the small-cap market based on everything I have read so far. However, it is imperative for investors to understand the need to appreciate quality when looking at small caps, something Kalesnik and Beck’s article goes into detail on.

One of the metrics the duo considers is the distress and volatility characteristics of stocks by size. Using data from 1988 to 2014, the researchers find that the S&P credit rating difference between small-cap stocks (B rated) and large cap stocks (A+ rated) indicates the higher likelihood (over 200 times) of smaller stocks being delisted, often because of default.

Unsurprisingly, portfolio volatility for the firms with the lowest credit ratings is also higher at 20.6% compared to 14.3% for the larger companies with a higher credit rating. Small caps have a delisting rate of 2.38%, 23,700% times greater than that of large caps’ delisting rate of 0.01%. Volatility too is much greater in the small-cap arena when you dig below the surface. The article notes:

“A comparison of the median stock volatility of the highest and lowest quintiles is significantly more striking: the median volatility of the smallest stocks (50.5%) is almost 100% more volatile than the median volatility of the largest stocks (25.5%). Also, the dispersion in stock volatility is much greater for small stocks than for large stocks, with a 25th–75th percentile range of 32.1%–76.0% compared to 19.8%–33.2%, respectively.”

Small-cap returns are worth the risk

This additional volatility and risk of bankruptcy is worth trying to navigate thanks to the higher returns on offer from (high quality) small caps. So far in this series, we’ve seen evidence which shows that the small-cap premium exists, although there’s been little in the way of discussion as to why this premium exists. The Kalesnik and Beck article attempts to answer this question by taking a look at the average bid–ask spreads for each of the size quintiles over the period 1988–2014. The bid–ask spread serves as a proxy for trading costs. Higher trading costs reduce the attractions of equities; some investors will avoid stocks with high bid-ask spreads altogether as it severely limits profitability.

A stock with a spread of 5% instantly gives you a loss of 5% after the initial purchase excluding dealing costs, which is unpalatable to investors. Institutional investors also avoid such equities as the widespread and illiquid market means it’s difficult to build a position. Longer term investors, however, have no need to worry about a 5% spread — especially if they are targeting gains of 100% to 200% in the long term.

Still, Kalesnik and Beck find in their article that over the 27 year period studied, the average bid-ask spread for the smallest quintile of the market averaged 4.56%, compared to a spread of 0.46% for the largest quintile. These findings go some way to explaining why the small-cap premium exists and why it is possible to find more mispriced securities in this area of the market than any other.

The authors of the Research Affiliates small-cap article go on to look at the performance of value strategies in large-cap and small-cap universes between 1967 and 2014, and what they find only supports the conclusion that small-cap strategies do outperform but to achieve the best results you have to focus on quality.

The figures show that by using a traditional price-to-book value strategy for large caps over the period studied, investors were able to achieve a return of 13.1% per annum. The same approach used for small caps produces the return of 16.6%. However, where small caps really show the greatest level of outperformance is on the cash flow-to-price value (and quality) metric.

Using this ratio to screen market produced a return of 17% per annum for value small caps, compared to 13% for large-cap peers. What’s more, for the long-short study, the t-stat of the cash flow-to-price metric was significant the 1% level. More evidence that quality small-cap returns are the key to outperformance.

Small-Cap Investing: Quality Over Quantity all-cap returns

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