Boole Microcap Fund - Page 18 of 18 - Quantitative Deep Value Investing

Lions and Tigers and Bears, Oh My!

(Image: Zen Buddha Silence by Marilyn Barbone.)

January 29, 2017

As humans, the ancient part of our brains – including the amygdala – alerts us subconsciously if there is the slightest sight or sound of something that could be dangerous (e.g., a lion, a tiger, or a bear). Such an alert happens so fast that our body prepares for fight or flight long before we are even conscious of the potential threat.

Unfortunately, plummeting stock prices very often trigger the same fear response in our ancient brains. This often causes us to make bad decisions.

THE VIRTUES OF AUTOMATED INVESTING

One key to investing is to learn to minimize the number of mistakes we make. A great way to minimize our mistakes is to follow an automatic system for investment decisions.

For many investors, the best automatic approach is simply to buy and hold low-cost broad market index funds. These investors, if they stick with it over several decades, will do better than 90-95% of all investors. And this winning strategy requires very little time to implement.

For investors who want a proven, relatively low-risk way to beat the market, a quantitative value investment approach is a good option. One of the best research papers on why a value investing strategy beats the market over time, without taking more risk, is “Contrarian Investment, Extrapolation, and Risk,” by Josef Lakonishok, Andrei Schleifer, and Robert Vishny. Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf?m=1360042367

Lakonishok, Schleifer, and Vishny were so convinced by the evidence that they started LSV Asset Management, which today has over $87 billion in assets under management. LSV uses a quantitative value investment approach which automatically selects a portfolio of stocks based on the factors supported by their research, including low price to earnings and low price to cash flow. See: http://lsvasset.com/

KNOWING OURSELVES

The truth is that most of us do not know ourselves very well at all. But recent advances in psychology and neuroscience have made it possible for us to know ourselves much better. Slowly but surely, studying our own mistakes and studying the best psychology can help us to make better decisions over time.

When it comes to decision making under uncertainty – and this includes investing – there are many great books that are absolute must-reads, including the following:

Daniel Kahneman, Thinking, Fast and Slow (Farrar, Straus and Giroux, 2013, 2011)
Charles T. Munger, Poor Charlie’s Almanack, edited by Peter Kaufman (Walsworth Publishing Company, Expanded Third Edition, 2005)

There are many more great authors on decision making under uncertainty, including Michael Mauboussin, James Montier, and Richard Thaler, to name just a few. But in the interest of brevity, this blog post focuses on a chapter from James Montier’s Value Investing (Wiley, 2009), Chapter 13: The Psychology of Bear Markets.

KING SOLOMON

Montier writes that Abraham Lincoln relayed the following story:

Solomon once charged his wise men to invent him a sentence, to be ever in view, which should be true and appropriate in all times and situations. They presented him with the words ‘And this, too, shall pass away’. How much it expresses! How chastening in the hour of pride. How consoling in the depths of affliction… (page 123)

Unfortunately, says Montier, when it comes to investing, we are often overwhelmed by fear or greed instead of training ourselves to slow down and to use careful logical analysis. We have two mental systems, one that is automatic and intuitive, and the other that is capable of deliberate, rational thinking. The automatic system is the more ancient system, and we share it with many other animals.

The problem is that paper stock losses cause fear. The fear response is very powerful and largely unconscious initially, originating in the amygdala. It prepares the body for fight or flight even before the conscious mind has had time to analyze the situation.

Most of the time in our evolutionary history, a fear response to movement in the grass was appropriate for maximizing the chances of survival. A rapid response to a potential threat had a low cost in the case of a false positive, notes Montier. But a false negative – not reacting to the movement in the grass, but having it turn out to be a lion – was potentially fatal.

Yet a fear response to paper stock losses is almost always harmful for long-term investors. When stocks drop a lot (10-40%), many long-term investors with time horizons of at least ten or twenty years are overwhelmed by fear and sell when they should be buying. For instance, many long-term investors were overwhelmed by fear (and loss aversion) in the bear market of late 2008 to early 2009. Long-term investors who sold missed out on a more than 200% recovery (from the lows) for the S&P 500 Index.

Conversely, long-term investors who have mastered their fears – by having an automatic investment system, or by having trained their own responses, or both – bought in late 2008 and early 2009 and are much better off as a result.

FEAR AND BEAR MARKETS

James Montier describes a study by Shiv et al. (2005). It is a game at the start of which each player receives $20. The game has 20 rounds. Each round, the player can decide to bet $1 or not. Then a fair coin is flipped. If it comes up heads, the player who bet $1 gets $2.50 back. If it comes up tails, the player who bet $1 loses the $1.

It is optimal for the player to bet $1 in each of the 20 rounds because the game has a clear positive expected value – the wins will outweigh the losses on average. Also, the decision to bet $1 each round should not depend upon whether one won or lost in the previous round. Each flip is independent of the previous flip.

What actually happened, however, was that people invested less than 40% of the time after suffering a loss. Furthermore, the longer the game continued, the lower the percentage of players who decided to bet.

As losses add up, people become more and more fearful, and less and less willing to invest even though the best time to invest is during a period of extended losses (like late 2008 and early 2009). Montier writes:

The parallels with bear markets are (I hope) obvious. The evidence above suggests that it is outright fear that drives people to ignore bargains when they are available in the market, if they have previously suffered a loss. The longer they find themselves in this position the worse their decision making appears to become. (page 125)

THE BLANK SLATE

Montier observes:

Investors should consider trying to adopt the Buddhist approach to time. That is to say, the past is gone and can’t be changed, the future is unknown, and so we must focus on the present. The decision to invest or not should be a function of the current situation (from my perspective the degree of value on offer) not governed by our prior experiences (or indeed our future hopes). However, this blank slate is mentally very hard to achieve. Our brains seem to be wired to focus on the short term and to fear loss in an extreme fashion. These mental hurdles are barriers to sensible investment decision making in a bear market. (page 127)

A bear market can occur at virtually any time. At some point in the next five or so years – possibly even this year – there will likely be a bear market in which stocks drop at least 20-25% (and possibly much more). It’s essential for all investors that we have an automatic, checklist-like approach to plummeting stock prices in order to maximize rational decisions and minimize irrational decisions. It’s also essential for many of us as investors that we develop a keen understanding of our own emotional responses to plummeting stock prices.

Knowing in detail how we will feel in the face of plummeting stock prices, and having a rational set of responses (ideally automatic and preprogrammed), is one of the keys to successful long-term investing.

CHECK STOCK PRICES AS INFREQUENTLY AS POSSIBLE

One important rule for long-term investors is to check stock prices as infrequently as humanly possible. A flashing, plummeting stock price is a subliminal message that very often will activate our subconscious fear response – SELL! SELL!

For a long-term index fund investor, it is possible to check stock prices only a few times per year or less. Similarly for a long-term value investor, one should check prices as infrequently as possible.

If we are tempted to check stock prices, especially when prices are plummeting, there are simple techniques we can use to avoid the temptation. Obviously being deeply engaged in a work project is ideal. Or we can read, watch a movie, or even go to the beach. Many long-term value investors recommend going to the beach – ideally with a stack of great books or annual reports – instead of checking or worrying aboutcratering prices.

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years. – Warren Buffett

Invest only if you would be comfortable owning a stock even if you had no way of knowing its daily share price. – Ben Graham

When we own stocks, we are part owners of the underlying businesses. So if we are happy with the businesses we own, we should never waste time worrying about or checking fallingprices. If we understand and believe in the underlying business, then a dropping stock price is a wonderful opportunity to increase our ownership of the business. A good rule is to add to our position for each 10% or 15% drop in price.

If we own a low-cost S&P 500 index fund, then we are part owners of five hundred American businesses. As long as we believe the U.S. economy will do well over the coming decades – and it will do well, even if grows a bit more slowly than in the past – then when the index drops a great deal, it’s a wonderful opportunity to add to our position as a part owner of American businesses.

As long as we have uncorrelated or negatively correlated positions in our overall portfolio – such as cash, cash equivalents, or gold – it is simple to implement an automatic rebalancing rule. For instance, during or after a period of falling stock prices, we would use some cash (or gold) to increase our ownership of the businesses we like best. Ideally, this rebalancing is preprogrammed to occur at the end of a specified time period (e.g., quarter or year).

Just for fun, a 30-second link from the Wizard of Oz: https://www.youtube.com/watch?v=NecK4MwOfeI

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: [email protected]

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Index Funds Beat 90-95% of All Investors Over Time

(Image: Zen Buddha Silence by Marilyn Barbone.)

January 8, 2017

John Bogle wrote The Little Book of Common Sense Investing in 2007 (Wiley). It’s a terrific book for all investors. Here are some key points:

INTRODUCTION – Don’t Allow a Winner’s Game to Become a Loser’s Game

Owning a slice of all American businesses is a positive-sum game, especially over the course of many decades. On the whole, the capitalist system creates enormous wealth for its owners over the very long term due to innovation and growth.

Trying to do better than long-term owners of all American businesses–that is, trying to beat the broad market index over time–is a zero-sum game. For each investor who does better than the broad market index, another investor must do worse. Beating the stock market is a zero-sum game, but that is BEFORE the deduction of costs.

AFTER the deduction of costs, beating the market is a loser’s game. Bogle explains:

So who wins? You know who wins. The man in the middle (actually, the men and women in the middle, the brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system) is the only sure winner in the game of investing. Our financial croupiers always win. In the casino, the house always wins. In horse racing, the track always wins. In the powerball lottery, the state always wins. Investing is no different.

The vast majority of investors who invest directly in stocks trail the market, net of costs, over the longer term. Even more so, the vast majority of investors who invest in mutual funds trail the market, net of costs, over the longer term.

The basic arithmetic has a simple bottom line: The vast majority of all investors would be best off, over the longer term (several decades or more), by simply buying and holding low-cost broad market index funds.

Many top investors, including Warren Buffett and Charlie Munger, have emphatically agreed with John Bogle’s conclusion.

A PARABLE – The Gotrocks Family

Warren Buffett tells the parable of the Gotrocks family in the 2005 Berkshire Hathaway Annual Letter: http://berkshirehathaway.com/letters/2005ltr.pdf

Bogle gives his version of the parable: At the beginning, a large family called the Gotrocks owns 100 percent of every stock in the United States, thus benefitting from the long-term productivity of all businesses.

Their investment had compounded over the decades, creating enormous wealth, because the Gotrocks family was playing a winner’s game.

But then a few ‘fast-talking Helpers’ arrive, and they convince some ‘smart’ Gotrocks cousins that they can earn a larger share than their relatives by selling some of their shares to other family members and by buying some shares from others in return.

The net result is that the family wealth starts compounding at a slower rate overall because some of the return is now given to the Helpers as trading fees.

The cousins decide that they need more help in order to actually do better than their relatives, so they hire another set of Helpers to pick which stocks to buy and which to sell. Now the family wealth overall compounds at an even slower rate, since it is reduced by two layers of fees to Helpers.

So the cousins decide to hire even more Helpers, who promise to help the cousins pick the right stock-picking Helpers. Once again, the family wealth overall now compounds even more slowly.

After some period of time, the family calls a meeting. They ask:

“How is it that our original 100 percent share of the pie–made up each year of all those dividends and earnings–has dwindled to just 60 percent?”

The wisest family member, an old uncle, notes that the entire reduction in overall returns is exactly equal to the fees and expenses related to all of the Helpers. Thus, in order for the family to again benefit from 100 percent of the growth of all American businesses, they should simply get rid of all the Helpers.

The family follows the uncle’s advice and soon they are again benefitting 100 percent from the wealth created by all American businesses over time.

Owning a low-cost index fund is exactly the same idea. Bogle quotes Jack R. Meyer, former president of Harvard Management Company:

Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value.

Burton Malkiel:

Active management as a whole cannot achieve gross returns exceeding the market as a whole and therefore they must, on average, underperform the indexes by the amount of these expense and transaction costs disadvantages.

RATIONAL EXUBERANCE – Business Reality Trumps Market Expectations

Warren Buffett:

The most that owners in the aggregate can earn between now and Judgment Day is what their businesses in the aggregate earn.

Bogle adds:

… History, if only we would take the trouble to look at it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by business–the annual dividend yield plus the annual rate of earnings growth–and the cumulative returns earned by the U.S. stock market.

From 1900 to 2005, the average annual return on stocks was 9.6 percent, nearly equal to the investment return of 9.5 percent–4.5 percent from dividend yield and 5 percent from earnings growth.

The extra 0.1 percent can be related to a speculative return, or it may reflect “an upward long-term trend in stock valuations.”

The results from 106 years of compounding:

Each dollar initially invested in 1900 at an investment return of 9.5 percent grew by the close of 2005 to $15,062.

The initial amount is thus multiplied over 15,000 times. Bogle calls this “the ultimate winner’s game.”

Borrowing from John Maynard Keynes, Bogle says there are two components that drive long-term stock market returns: a fundamental component and a speculative component. The fundamental driver of long-term stock market returns has averaged 9.5 percent, 4.5 percent from dividends and 5 percent from earnings growth.

The speculative component of long-term stock market returns is determined by changes inP/E multiples. Some periods see P/E multiples rise, causing the average annual returns to be higher than what the fundamental component alone would dictate. Other periods see P/E multiples fall, causing the average annual returns to be lower than what the fundamental component alone would dictate.

These speculative swings are due to many factors, including investor confidence, the level of interest rates, and changes in general price levels (high inflation or deflation). However, the speculative swings cannot be predicted at all. Bogle says:

After more than 55 years in this business, I have absolutely no idea how to forecast these swings… I’m not alone. I don’t know anyone who has done so successfully, or even anyone who knows anyone who has done so. In fact, 70 years of financial research shows that no one has done so.

Great investors such as Warren Buffett and Peter Lynch have made the same point: No one can forecast accurately with any sort of consistency. By chance alone, there will always be some forecasters in any given period who turn out to be correct. But it’s impossible to say ahead of time which forecasters those will be. And when one does find, after the fact, the forecasters who were correct, that says nothing about which forecasters will be correct in the next period.

By the mid 1990’s, P/E multiples had been increasing for at least a decade and were high by historical standards, so one would have thought they would then go lower. But they kept increasing until they reached a new record in 2000, far higher than ever before. Similarly, in 2012 to 2013, assuming history was any guide, one would have thought that P/E multiples would decline for awhile, but that hasn’t been true at all.

In fact, if one assumes that most major central banks are going to keep rates very low for decades, then P/E multiples will continue to be much higher on average than has been the case historically. As Warren Buffett remarked recently, near-zero rates indefinitely would mean P/E multiples of 50 or more.

Moreover, the return on invested capital–on the whole–may be structurally higher, since technology companies have become much more important in the U.S. and global economies. All else equal, this also implies higher P/E multiples than has been the case historically.

Some of the smartest have been predicting lower U.S. stocks since 2012-2013, but the opposite has happened. This is just one example out of many throughout history where very smart folks made highly confident financial forecasts that turned out to be completely wrong.

The rational investor simply buys and holds for the longer term, keeping fees and expenses at an absolute minimum, without trying to time the market. This approach, buying and holding low-cost broad market index funds, will allow any investor to beat roughly 90-95% of all investors over the course of decades. Writes Bogle:

So how do you cast your lot with business? Simply by buying a portfolio that owns the shares of every business in the United States and then holding it forever. It is a simple concept that guarantees you will win the investment game played by most other investors who–as a group–are guaranteed to lose.

HOW MOST INVESTORS TURN A WINNER’S GAME INTO A LOSER’S GAME – The Relentless Rules of Humble Arithmetic

After subtracting the costs of financial intermediation–all those management fees, all those brokerage commissions, all those sales loads, all those advertising costs, all those operating costs–the returns of investors as a group must, and will, and do fall short of the market return by an amount precisely equal to the aggregate amount of those costs.

It’s obvious based on humble arithmetic that:

(1) Beating the market BEFOREcosts is a zero-sum game;

(2) Beating the market AFTER costs is a loser’s game.

Most individual investors choose mutual funds rather than individual stocks. Bogle describes the costs:

In equity mutual funds, management fees and operating expenses–combined, called the expense ratio–average about 1.5 percent per year of fund assets. Then add, say, another 0.5 percent in sales charges, assuming that a 5 percent initial sales charge is spread over a 10-year holding period. If the shares are held for five years, the cost would be twice that figure–1 percent per year.

But then add a giant additional cost, all the more pernicious by being invisible. I am referring to the hidden cost of portfolio turnover, estimated at a full 1 percent per year.

Bottom line

… the ‘all-in’ cost of equity fund ownership can come to as much as 3 percent to 3.5 percent per year.

Nonetheless, observes Bogle, most investors continue to ignore this reality, perhaps because “it flies in the face of their deep-seated beliefs, biases, overconfidence, and uncritical acceptance of the way that financial markets have worked, seemingly forever.”

Of course, financial intermediaries on the whole have very strong financial incentives to ignore the fact that low-cost index funds would be best for the vast majority of investors. Bogles paraphrases Upton Sinclair:

It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.

Moreover, it’s easy for investors to ignore the costs of investing, writes Bogle. Many costs (including transaction costs, sales charges, and taxes) are largely hidden from view. Moreover, if it has been a good period for the market–with reasonably high returns–then the ‘all-in’ costs of 2.5 or 3 percent per year can be much less noticeable. Finally, investors tend to focus on short-term returns (a few years). But it’s only after several decades that the enormous superiority of a low-cost index fund–versus the average equity mutual fund–is obvious.

Bogle gives an example: Assume, reasonably enough, that the stock market total return will be 8 percent per year over the coming 50 years. The costs of the average mutual fund can be estimated at 2.5 percent per year. After the first ten years, an index investment will be $21,600, while the average mutual fund investment will reach $17,100. Many investors may not really notice it at this point. But after 50 years, a simple index investment will reach $469,000, while the average mutual fund investment will reach $145,400.

Thus, after 50 years, costs for the mutual fund investor will have taken almost 70 percent of the index returns:

The investor, who put up 100 percent of the capital and assumed 100 percent of the risk, earned only 31 percent of the market return. The system of financial intermediation, which put up zero percent of the capital and assumed zero percent of the risk, essentially confiscated 70 percent of that return–surely the lion’s share. What you see here–and please don’t ever forget it!–is that over the long term, the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.

THE GRAND ILLUSION – Surprise! The Returns Reported by Mutual Funds Aren’t Actually Earned by Mutual Fund Investors

Historically, while mutual funds have trailed the index by roughly 2.5 percent per year on average, the average investor in mutual funds has done much worse (typically 2-3 percent worse, meaning the average investor in mutual funds trailed the market by 4.5 to 5.5 percent per year).

The average investor in mutual funds has repeatedly made two large mistakes: (1) buying after an extended period during which the stock market has done well, and selling after the stock market has done poorly; (2) buying mutual funds that have done well recently, and selling mutual funds that have done poorly recently. This is just the opposite of what generally would help individual investors. The late 1990’s are a good example given by Bogle:

As the market soared, investors poured ever larger sums of money into equity funds. They invested a net total of only $18 billion in 1990 when stocks were cheap, but $420 billion in 1999 and 2000, when stocks were overvalued… What’s more, they also chose overwhelmingly the highest-risk growth funds, to the virtual exclusion of more conservative value-oriented funds. While only 20 percent of their money went into risky aggressive growth funds in 1990, they poured fully 95 percent into such funds when they peaked during 1999 and early 2000.

Bogle continues:

When the annual returns of these aggressive funds are compounded over the full period, the deterioration is stunning: a cumulative fund return averaging more than 112 percent; a cumulative shareholder return averaging negative 4.5 percent. That’s a lag of more than 117 percentage points! This astonishing penalty, then, makes clear the perils of fund selection and timing. It also illustrates the value of indexing and the necessity of setting a sound course and then sticking to it, come what may.

One great virtue of buying and holding low-cost index funds is that it can neutralize cognitive biases. Cognitive biases are largely innate, and if left unchecked, they inevitably lead most investors to make the certain mistakes again and again, such as overconfidently extrapolating the recent past. For more on cognitive biases, see:https://boolefund.com/cognitive-biases/

Another virtue of index fund investing, as mentioned, is that it requires very little effort or time to implement. The index fund investor need not worry about individual stocks or mutual funds, nor need she waste time trying to predict what the stock market or the economy will do in any given year.

Bogle quotes Charles Schwab, who himself prefers index funds:

It’s fun to play around… it’s human nature to try to select the right horse… (But) for the average person, I’m more of an indexer… The predictability is so high… For 10, 15, 20 years you’ll be in the 85^th percentile of performance. Why would you screw it up?

Finally, for investors with taxable accounts, index fund investors have had roughly a third the taxes as the average mutual fund investor. This is due to the much lower turnover of index funds.

SELECTING LONG-TERM WINNERS

Bogle looks back (from 2007) to 1970 to see how many mutual funds from that year have done well over time. In 1970, there were 355 mutual funds. 223 of those were no longer in business by 2007. In addition to the 223 mutual funds that closed, there was another 60 mutual funds that significantly underperformed the S&P 500 Index by more than 1% per year. So together, 283 funds–almost 80% of the original 355–were not long-term winners. And another 48 funds provided returns that essentially matched the S&P 500 Index.

So that leaves only 24 mutual funds–one out of every 14–that did better than the S&P 500 Index from 1970 to 2007. Writes Bogle:

Let’s face it: those are terrible odds! What’s more, the margin of superiority of 15 of those 24 funds over the S&P 500 Index was less than 2 percentage points per year, a superiority that may be due as much to luck as skill.

Bogle says that there were nine long-term winners, funds that outpaced the market by 2 percentage points or more of annual return over 35 years. But Bogle points out that six out of those nine long-term winners achieved their superior records many years ago, often when they were of much smaller size. Increasing fund size is an inevitable drag on long-term investment performance. Bogle says that one of these funds peaked in 1982, and two others peaked in 1983. The other three peaked in 1993.

So there are only three funds out of the original 355–only 8/10 of 1%–that both survived and created an excellent long-term record that is still ongoing (as of 2007).

For the individual investor looking at the next 35 years, what are the odds of picking a mutual fund that will be able to clearly outpace the broad market, net of costs? If the last 35 years are any guide, the odds may be 1-3% (or even less).

Thus, writes Bogle, a low-cost index fund tends to grow its margin of superiority over time. After several decades, an investor in low-cost index funds is likely to be better off, net of costs, than roughly 90% of all investors. After 50 years, an investor in low-cost index funds is likely to be better off, net of costs, than roughly 95% (or more) of all investors.

If one can be virtually guaranteed, by simple arithmetic, to outpace roughly 90-95% (or more) of all investors over time, with very little time or effort required, why wouldn’t one choose this option? It is, in fact, the best option for the vast majority of investors.

YESTERDAY’S WINNERS, TOMORROW’S LOSERS

Bogle shows a fascinating chart of the top 10 performing mutual funds from 1997 to 1999. These top performing mutual funds had the following rankings in 2000 to 2002, out of a total of 851 mutual funds altogether:

If you think those rankings are bad, the average investor in these funds, on a cumulative basis, did much worse! Over the six year period of 1997 to 2002, these funds had a net gain of 13 percent overall. But investors in these funds, by piling in largely after the funds had gone up, and by selling largely after the funds had gone down, incurred a net loss of 57 percent overall.

The biggest mistake that most investors make is overconfidently extrapolating the recent past, i.e., buying after a fund has done well and selling after a fund has done poorly. But market timing very rarely works except by luck. (One approach that can work well is to have a portion in stocks and a portion in fixed-income and cash – with the portions decided ahead of time based on risk tolerance and age – and then rebalance to the target allocations periodically.)

THE HUMBLE, RELENTLESS ARITHMETIC OF INDEX FUNDS

Warren Buffett himself, arguably the best investor ever, has very consistently argued that thevast majorityof all investors would be best off just buying and holding a simple, low-cost index fund.

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.–Warren Buffett, 1993 Letter to shareholders.

Link:http://www.berkshirehathaway.com/letters/1993.html

See also the 2014 Berkshire Letter, such as this passage (page 19):

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in ‘safe’ Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

The commission of the investment sins listed above is not limited to ‘the little guy.’ Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

There are a few investment managers, of course, who are very good–though in the short run, it’s difficult to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors–large and small–should instead read Jack Bogle’s The Little Book of Common Sense Investing.

Link: http://berkshirehathaway.com/letters/2014ltr.pdf

BOOLE MICROCAP FUND

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: [email protected]

The Piotroski F_Score

(Image: Zen Buddha Silence by Marilyn Barbone.)

December 18, 2016

There are several ways to measure cheapness, including low EV/EBIT, low P/E, and low P/B. Historically, these metrics have effectively identified groups of cheap stocks that outperform the market over time. Many academic studies of value investing have focused on low P/B stocks (equivalently, high book-to-market stocks).

If you look at the cheapest group of low P/B stocks (quintile or decile), you find that, during most historical periods, this group has outperformed the market and has done so with less risk. Here “risk” is defined–following Lakonishok, Shleifer, and Vishny–in terms of performance in bear markets, recessions, or other “bad states” of the world, and in terms of more traditional betas and standard deviations. Link to the 1994 paper by Lakonishok, Schleifer, and Vishny: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf?m=1360042367

And yet each individual low P/B stock is more likely than the average stock to underperform the market and is, in that sense, riskier.

Joseph Piotroski, a professor of accounting at the University of Chicago (currently at Stanford), noticed this disparity. Even though low P/B stocks as a group have beaten the market during most historical time periods, Piotroski found that 57% of the low P/B stocks underperformed the market. The outperformance of the low P/B group has been driven by only 43% of the stocks in the group, while it has been held back by the other 57%.

Given that low P/B stocks are often distressed, Piotroski wondered whether you could distinguish between “cheap and strong” companies and “cheap but weak” companies. Piotroski invented a measure called the F_Score for this purpose. Applying the F_Score to the group of low P/B stocks (the cheapest quintile) improved performance by 7.5% per year between 1976 and 1996. The biggest improvements in performance were concentrated incheap micro caps with no analyst coverage.

THE PIOTROSKI F_SCORE

Piotroski invented his F_Score by thinking about what measures you would expect to distinguish between “cheap and strong” companies and “cheap but weak” companies. He focused on recent changes in fundamentals that could be detected in a company’s financial statements. Piotroski identified three areas to look for improving fundamentals:

Profitability and Cash Flow
Leverage and Liquidity
Operating Efficiency

Piotroski thought of four measures for profitability and cash flow, three for leverage and liquidity, and two for operating efficiency. Each measure is binary, “1” for good and “0” for bad. Thus for a given cheap company, a total score of “9”–a “1” on each of the nine measures–would indicate the maximum possible financial strength, whereas a “0” would indicate the minimum. Because the F_Score is applied to cheap–often distressed–stocks, it’s reasonable to expect it to help in general. And it does.

Link to Piotroski’s paper, “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers” (2002, University of Chicago Graduate School of Business): http://www.chicagobooth.edu/~/media/FE874EE65F624AAEBD0166B1974FD74D.pdf

PROFITABILITY AND CASH FLOW

As Piotroski notes, current profitability and cash flow are indicative of a firm’s ability to generate cash internally. A distressed company showing a positive trend in earnings and cash flows is more likely to do well.

Piotroski has four measures for profitability and cash flow:

ROA measures current net income before extraordinary items.
CFO measures current cash flow from operations.
Î”ROA measures this year’s ROA minus last year’s ROA.
ACCRUAL measures cash flow from operations versus net income before extraordinary items.

If ROA > 0–if net income before extraordinary items is positive–then the indicator variable F_ROA = 1, otherwise F_ROA = 0.

If CFO > 0–if cash flow from operations is positive–then the indicator variable F_CFO = 1, otherwise F_CFO = 0.

If Î”ROA > 0–if net income before extraordinary items has increased from the prior year–then the indicator variable F_Î”ROA = 1, otherwise F_Î”ROA = 0.

If CFO > ROA–if cash flow from operations is greater than net income before extraordinary items–then F_ACCRUAL = 1, otherwise F_ACCRUAL = 0.

The logic is straightforward. If the firm in question–which is cheap and likely to be distressed–is showing positive net income and cash flow, the firm is generating cash internally. Similarly, an improvement in net income is a positive signal. Finally, cash flow from operations being larger than net income before extraordinary items is positive: distressed firms have an incentive to distort or “manage” earnings (to prevent covenant violations), but it is much harder to distort cash.

LEVERAGE AND LIQUIDITY

Because many cheap firms are distressed, an increase in debt, a decrease in liquidity, or the use of external financing is a bad signal. Thus, Piotroski invented the following three simple measures:

Î”LEVER captures change in the firm’s long-term debt level.
Î”LIQUID measures change in the firm’s current ratio.
EQ_OFFER indicates whether the firm has issued common equity.

If Î”LEVER < 0–if the long-term debt level fell–then the indicator variable F_Î”LEVER = 1, otherwise F_Î”LEVER = 0.

If Î”LIQUID > 0–if the current ratio (current assets divided by current liabilities) improved–then the indicator variable F_Î”LIQUID = 1, otherwise F_Î”LIQUID = 0.

If the firm did not issue common equity, then the indicator variable EQ_OFFER = 1, otherwise EQ_OFFER = 0.

If a distressed firm does not have to raise external capital via an increase in long-term debt, that is a positive signal about its ability to generate sufficient cash internally. Also, an improvement in liquidity bodes well for the firm’s ability to service current debt obligations. If a distressed firm has to issue new equity to raise cash, that’s not a good signal, especially if the new equity is cheaply priced.

OPERATING EFFICIENCY

Piotroski looked at two key constructs in a decomposition of return on assets: gross margin ratio and asset turnover. Both are signals of the efficiency of the firm’s operations.

Î”MARGIN measures the firm’s current gross margin ratio relative to the previous year.
Î”TURN measures the firm’s current asset turnover relative to the previous year.

If Î”MARGIN > 0–if the gross margin ratio has improved–then the indicator variable F_Î”MARGIN = 1, otherwise F_Î”MARGIN = 0.

If Î”TURN > 0–if asset turnover increased–then the indicator variable F_Î”TURN = 1, otherwise F_Î”TURN = 0.

An improvement in margins means a reduction in costs or an increase in the price of the firm’s product. An increase in asset turnover–greater productivity of the asset base–can result from more efficient operations (greater sales/assets) or an increase in sales. Increased sales may signify improved market conditions for the firm’s product.

MUCH IMPROVED PERFORMANCE

The overall F_SCORE is the sum of the nine individual binary signals:

F_SCORE = F_ROA + F_Î”ROA + F_CFO + F_ACCRUAL + F_Î”MARGIN + F_Î”TURN + F_Î”LEVER + F_Î”LIQUIDITY + EQ_OFFER.

From the low P/B quintile, Piotroski isolated all the companies that had F_SCORES of 8 or 9. This low P/B, high F_SCORE portfolio outperformed the low P/B quintile by 7.5% per year between 1976 and 1996. The biggest improvements in performance were concentrated incheap micro caps with no analyst coverage.

BOOLE MICROCAP FUND

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: [email protected]

Simple Quant Models Beat Experts in a Wide Variety of Areas

(Image: Zen Buddha Silence by Marilyn Barbone.)

December 11, 2016

CLINICAL VS. MECHANICAL PREDICTION: A META-ANALYSIS

William Grove, David Zald, Boyd Lebow, Beth Snitz, and Chad Nelson did a meta-analysis (a study of studies) of 136 different studies of human experts vs. simple quant models. Here is a link to the paper by Grove et al. (2000):http://datacolada.org/wp-content/uploads/2014/01/Grove-et-al.-2000.pdf

Here is what Grove et al. discovered about 136 different studies:

64 clearly favored the model
64 showed approximately the same result between the model and human judgment
8 found in favor of human judgment

(NOTE: All eight cases where human judgment prevailed had one thing in common: the humans had more information than the quant models.)

Across all 136 studies that Grove et al. examined, experts were correct in 66.5% of the cases, while the quant models did significantly better with an average hit ratio of 73.2%.

Paul Meehl, one of the founding fathers of the importance of quant models versus human judgments, had this to say:

There is no controversy in social science which shows such a large body of qualitatively diverse studies coming out so uniformly in the same direction as this one… predicting everything from the outcomes of football games to the diagnosis of liver disease. And when you can hardly come up with a half a dozen studies showing even a weak tendency in favor of the clinician, it is time to draw a practical conclusion.

BOOLE MICROCAP FUND

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: [email protected]