The Poor Investor

Investigatory Value Investing

Monthly Archives: February 2012

Mutual Funds: Stealing Money from Investors Since 1890

When it comes to performance, mutual funds are hardly a model for success.  Now, to be fair, while it is often said that 80% of mutual funds fail to beat the market, this is not really true.  In fact, Jeremy Siegel, in “Stocks for the Long Run,” found that the number of mutual funds which beat the S&P (excluding fees), varied between 10-85% from 1970-2000.  Although, the first study on mutual funds (Jensen 1969) showed that “active mutual fund managers were unable to add value and, in fact, tended to underperform the market by approximately the amount of their added expenses” (Malkiel).  In Malkiel’s own study he found that “about three-quarters of actively managed funds have failed to beat the index.”  Jensen’s original study, he found, was influenced largely by survivorship bias.  Suffice it to say that, though, overall, the data is hardly reassuring.

So, if mutual funds are so terrible why are most people still paying mutual fund managers to underperform?  The answer lies in a quote by John C. Bogle, the creator of index funds and the founder of Vanguard:

“Well I don’t run Vanguard any longer, but I will take plenty of responsibility for having those active funds in all of the years I ran it. And the answer to that is really a couple of things. One, a lot of investors, no matter how persuasive the case for indexing is, and it’s overpoweringly persuasive, just don’t quite get it. They want a little more activity. They want something to watch. Index funds, as you all know, are roughly as exciting as watching paint dry or maybe watching the grass grow. They create great returns but they’re not that exciting.”

For many of us it is hard, or just extremely boring, to throw in the towel and surrender to the index fund.  Others, probably the majority, most likely care very little which fund their money is thrown into or just don’t have the time or inclination to want to deal with the hassle of selecting a fund, opting instead for maybe a target date fund or other funds their employer’s account representative throws them into.  Others still, probably don’t know the data that has shown mutual funds to be consistent underperformers.  For these various reasons, and probably a whole host of others, people are, by and large, throwing away their hard-earned money.

If you have the choice of where to put your money most of us should opt for index funds.  As Warren Buffet has said, “If you buy equities across the board, which means an index fund, and if you do it over time so that you don’t put all your money at the wrong time, and it’s a low-cost index fund, that’s probably the best investment that most people could make.”  By following his advice, investors can also take advantage of dollar-cost averaging.  Furthermore, if a percentage of your paycheck automatically goes into buying an index fund you can take a set-it-and-forget-it mentality.  You don’t have to worry about how your fund is performing or if you bought at the right price.

For those that are still hellbent on buying a mutual fund, there’s a few things you should know.  First of all, lower fee funds have beaten out higher fee funds in terms of performance (source).  Secondly, investors that pay higher up-front fees, called load fees, tend to do better than those who pay none.  Why?  According to James O’Shaughnessy, in How to Retire Rich, “The fee that load investors paid helped them keep their money in the market longer, and they ended up doing better as a result, even after paying the load.”  If, psychologically, you can handle staying in a fund through thick and thin, avoid the fee, if not, you might want to consider it.  Third, the fund manager is probably the most important aspect of a fund’s success.  Just like us, fund managers are subject to the same investing foibles: buying into hype, buying too high, selling too low, etc.  So, you need to make sure the fund manager has a long history of success, at least five years.  Then, make sure that same fund manager still runs the fund when you buy into it as fund managers often change.  If one guy ran the fund beating the market for several years, like Peter Lynch did with Fidelity Magellan, and then another person takes over, that new person may run the fund straight into the ground.  Fourth, look for a fund with low turnover.  Turnover is very costly (explanation).  Also, turnover is most likely, though not always, a sign of a bad manager.  Fifth, know that fund size erodes performance.  And lastly, know that fund performance increases with the size of other funds in the same family.  (Information about these last two is found here in this data).

Some examples of well-run mutual funds are the following (links shows performance relative to the S&P 500):

  • Weitz Partners III Opportunity: WPOPX
  • Fidelity Contrafund: FCNTX
  • Davis New York Venture Fund: NYVTX
  • CGM Focus Fund: CGMFX

—-Written by: The Poor Investor


Who is Kenneth Fisher?

While I am sure many of you have heard of Philip Fisher, how many actually recognize the name Kenneth Fisher?  My guess is Ken will always be hidden, to a large extent, in his father’s shadow.  For us this is a good thing because his method of investing is better off largely hidden from the public eye, just as if you came across an abandoned gold mine you wouldn’t want everyone else knowing about it.

One of the reasons I decided to look into Kenneth Fisher in the first place is because I was sure that his father had taught him plenty about investing.  If you can’t learn anything more from Phil, who better than his son?  In fact, Forbes publishes Fisher’s stock pick performance and has shown he has beaten the S&P 500 11 out of 14 years (Fisher’s record)(full article).  In addition to being an excellent investor, he is also an accomplished businessman, author, and runs his own company, Fisher Investments.  On top of that, he’s a nice guy as well as a moral beacon for those of us in the business and investment world.  He is also on a mission to save the redwood tree.

Kenneth Fisher was the first value investor to use P/S ratios as an analytical tool.  However, instead of just casually glancing at them, Fisher used them almost religiously.  Fisher, today, largely believes that his P/S ratio method may be obsolete because of its widespread use.  However, given the extreme volatility of this market, as of late, I have found this method quite useful in finding undervalued companies.

In Fisher’s book, Superstocks, although he talks mainly about his P/S ratio methodology he also discusses some other important elements of successful investing.  He reiterates the use of scuttlebutt, Phil Fisher’s term for talking to all parties involved with a company from the CEO down to the janitor in order to find out critical information which might influence your investment in said company.  Another important element Fisher addresses is the stability of a company’s profit margin.  Fisher believes a company’s profit margin should be at least 5% and should not deviate significantly from this value in the downward direction.  A high stable profit margin, he believes, reflects that the management is doing its job for investors and always striving to beat competition.  Fisher strongly believes management is the most important aspect of any investment, echoing his father.  This belief has well-served many investors, Warren Buffet included.  The bottom line, if management is not committed and shareholder-friendly, two musts, then your long-term investments are doomed to failure.  He also discusses price-to-research ratios and this has helped me to identify a few stocks I would have normally written off more quickly (one that comes to mind in particular is Nanosphere).

In other writings he talks about how an investor’s worst enemy is largely himself, believing that investors are hard-wired to perform poorly.  Myopic loss aversion so drives investors that they sell too early and permanently lock in losses.  He also refers to the stock market as “The Great Humiliator” as it unabashedly takes money from anyone, rich or poor, without discrimination.  He has studied PE ratios and firmly believes they are utterly useless for investment analysis, a finding that John Neff would surely disagree with.  However, he strongly advocates earnings yields in evaluating the stock market (taking the PE and flipping it) to determine whether it makes sense for companies to borrow money to buy back their own stock. Fisher believes in the American economy and also believes that the trade deficit is nothing to worry about.  He believes an account deficit only indicates that the world thinks America is a better place to invest than any other.

When asked about his investment philosophy Fisher states:

“You’re not going to like what I’m going to tell you here. People have always believed that the kind of equity they invest in is superior to other kinds. ‘I’m a growth guy,’ ‘I’m a value guy,’ ‘I’m a small cap guy,’ ‘I’m an emerging markets guy.’ The fact of the matter is these people share a spiritual core with Osama Bin Laden.  They’re narrow minded fanatics. And, they miss the big picture. In the long term all major categories of equity must have almost identical real risk adjusted returns. Because if you don’t believe that, you believe that a category of equity is more powerful than capitalism itself.”

And with that I will leave you.

——Written by: The Poor Investor

What Works on Wall Street

I recently finished a book entitled “What Works on Wall Street” by James P. O’Shaughnessy. In this book O’Shaughnessy explains the power of passive investing. In fact, O’Shaughnessy goes over several methods of passive investing which lower risk while increasing return, thus highlighting the fact that greater returns doesn’t always come with higher risk.  O’Shaughnessy even shows methods where great risk doesn’t translate into high returns, in fact, sometimes the returns are lower.  In this post I will highlight one of his lower risk methods as well as show you another method which translated into extraordinary gains, albeit with added risk.

The least risky strategy O’Shaughnessy covers is one he dubs “Cornerstone Value.” In this strategy O’Shaughnessy uses Compuset PC Plus, Research Insight, and FactSet Alpha to screen and test stocks. He screens stocks for ones he calls “Market Leaders.” These stocks are non- utility stocks with greater than average market caps, shares outstanding, cashflows, and sales of 50 percent greater than the average stock (this includes ADRs). He then uses $10,000 to buy the top 50 in terms of shareholder yield. He defines shareholder yield as stocks with the highest dividend yield and net buyback activity. O’Shaughnessy would then recycle this strategy every year, buying again the top 50 in terms of shareholder yield.

Over time he found that this strategy would have turned $10,000 into $17,567,144 from Dec. 31 1952 to Dec. 31 2003, versus $2,447,210 for the S&P 500. The amazing part about it was that these results were obtained with less risk using his approach. While the S&P 500 had a Sharpe ratio (reward-to-variability) of 0.42, Cornerstone Value had a Sharpe ratio of 0.65. The minimum and maximum annual return for the S&P 500 was -26.47% and 55.62%, respectively. However, the minimum and maximum for the Cornerstone Value approach was -15.00% and 58.20%. This strategy had 42 positive and 9 negative periods, versus 38 and 13 for the S&P 500. Also, maximum Peak- to-Trough decline was -28.18% for Cornerstone Value versus -44.73% for the S&P 500. Beta was 0.86 for Cornerstone Value and 1.00 for the S&P 500. By now you get a sense of how little risk this strategy carries with it.

Perhaps one of the best strategies O’Shaughnessy shows is one that is extremely simple. Buy 50 stocks with the highest relative strength trading at a price-to- sales ratio less than 1, hold for a year, then recycle. This strategy was able to turn $10,000 into $55,002,724. It had a higher maximum Peak-to-Trough decline of -53.40% versus -50.12% for all stocks during that time period. However, the Sharpe ratio fared better at 0.60 versus 0.46 for all stocks. Beta was 1.08 versus 0.99 for all stocks. In single-year returns it beat all stocks 39/52, rolling five-year compound return 43/48, and rolling 10-year compound return 43/43 times.

Some of you may be wondering at this point why O’Shaughnessy tends to focus on relative strength. What O’Shaughnessy hypothesizes is that by focusing on relative strength investors are getting into a stock as the market is beginning to notice it. By focusing on a value metric like price- to- sales, for instance, investors are making sure they aren’t paying too much for the momentum. However, for some of you interested in the latter method O’Shaughnessy cautions that investors are extremely unlikely to stick to a volatile strategy over the long -haul. The method has a correlation with the S&P 500 of 0.75 and may zig when the market zags. Though, this strategy is more consistent than many of his other strategies and thus the reason I chose it for this writing. But please keep in mind, in order for a strategy to work one must use it through hell and high water, even if he thinks the strategy is failing him. It is this sort of unwavering discipline that separates the successful investor from the unsuccessful.

Additionally, O’Shaughnessy highlights that these strategies can be done holding less than 50 stocks. However, the minimum he recommends is 25. He believes, as mentioned in the above paragraph, that investors are likely to run away from this strategy at the first sign of trouble. The volatility increases tremendously and the correlation with the overall market tends to drop holding less stocks. In his mind investors are much more likely to stick with a strategy that doesn’t deviate from the market too much.

——Written by: The Poor Investor

Shelby Davis: A Lost Legacy

In the pantheon of investing greats one of the least talked about, but most successful, is Shelby Davis.   Starting at age 38, he took $50,000, provided by his wife Kathyrn, and amassed it into a $900 million fortune in 47 years.  This amounts to an annual compound rate of return of over 23% during that time span.  While his investing process can be summed up as growth-at-a-reasonable-price, not too much else is know about his investing process; he hardly wrote anything down as to not waste money on paper (he often wrote on the back of envelopes and scraps of paper which were tossed away).  His extreme frugality helped him to save every penny he could to invest in “compounding machines,” as he called them.  When he died he left his money in a charitable trust and left little to nothing for his two children; he was the epitome of a penny-pincher.

Shelby Davis received his bachelor’s in Russian history at Princeton (1930), his master’s degree at Columbia (1931), and his doctorate in political science at the University of Geneva (1934).  Before starting his investment firm, Shelby Cullom Davis & Company in 1947, he worked odd jobs as a European correspondent with CBS in Geneva, as a “statistician” (before “stock analyst” was invented) for his brother-in-law’s Delaware fund, as a speechwriter and economic advisor for Thomas E. Dewey (then Governor of New York), a freelance writer, and author.  He also worked for the War Production Board in Washington in 1942.  A year prior to this he bought a seat on the New York Stock Exchange merely because it was cheap, having no use for it himself.  He paid $33,000 for the seat which had fetched $625,000 in 1929.  By the time Davis died in May of 1994 his seat was worth $830,000.  His last job before he started working on his investment portfolio was as First Deputy Superintendent of Insurance where he worked from 1944 to 1947.

Davis’ work analyzing insurance gave him an upper hand by the time he started his portfolio.  He saw clear advantages in the insurance industry.  Most insurers, he noticed, were selling well below book value.  Dividends were large in this industry and if you bought an insurance company at market price you were basically getting the dividend stream for free.  He also noticed that while life insurance policies were selling like hotcakes, policyholders weren’t dying.  Insurance companies, he realized, were growth companies in disguise.  Having studied Ben Graham’s writings Shelby knew of the power of buying these equities.  Shelby bought out Frank Brokaw & Co., a street away from Wall Street, and turned it into Shelby Cullom Davis & Co.  This is when his seat on the New York Stock Exchange started to show its use and he began to capitalize on that investment using it for his business.

Although he bought insurance stocks his portfolio acted like a modern-day tech portfolio, rising from $100,000 to $234,790 in one year (he always bought on margin).  His biggest holding that year was Crum & Forster.  By the early 1950’s Davis became a millionaire by sticking with insurance stocks.  Insurance companies that had once traded at stodgy multiples (P/E’s of 3-4) and low earnings now traded at P/E’s of 15-20 with high earnings.  Shelby called this the “Davis Double Play,” an initial boost from earnings and another from investors bidding up the multiple.  He largely focused on fundamentals before choosing his investments, looking for a solid balance sheet and making sure the insurer did not hold risky assets like junk bonds.  He then focused on the management quality and made trips to meet with management and drill them.  Diversification was also one of his strategies as he believed you needed to own enough stocks so that the ones you were wrong on were compensated by the ones you were right on.  Although he never gave a “magic number,” in the mid-1950’s he held up to 32 insurance companies.

After a trip to Japan in the mid 1960’s Davis was convinced that investing in Japanese insurance stocks was a winning bet.  There were substantially far less insurers in Japan and many of these were selling at well below book value, sometimes even half of book value.  He quickly snatched up American Insurance Underwriters (later acquired by AIG) and American Family (now AFLAC), both which had big dealings in Japan.  He also added Tokio Marine & Fire, Sumitomo Marine & Fire, Taisho Marine & Fire, and Yasuda Marine & Fire to his holdings.  Davis, after successfully investing in Japanese stocks, began buying stocks in Africa, Europe, the Far East, and Russia.

Like Buffett, Davis snapped up shares of GEICO when it was on the verge of failure.  Davis even snapped up a large enough share to be placed on the board. Davis, enraged by a proposed stock sale plan by Buffett and David Byrne, eventually sold off all his shares and left the board, a decision he would live to regret. Shortly after, he increased his position in AIG but soon began straying from insurance holdings.  Davis got ahold of Value Line during this time and used the analysis to his benefit.  At this point his normal portfolio, usually 30-35 stocks, consisted of hundreds of holdings, often highly rated by Value Line, which he day-traded for small gains and actually profited in a flat market.

Although he deviated somewhat from insurance companies over his lifetime, 11/12 of his most successful investments were still in that industry.  These included AIG, the four Japanese companies above, Berkshire Hathaway, AON, Torchmark, Chubb, Capital Holdings, and Progressive.  The odd man out was Fannie Mae.  He had some other minor successes but the bulk of his portfolio was due to these 12.  If anything can be learned from his investing it’s that holding a few big winners for a long time can go a long way.

Note:  His son, also Shelby Davis, went on to be a successful investor in his own right.  So too did his grandsons Chris and Andrew.

If you’d like to learn more about Shelby C. Davis’ life and investing style I urge you to read The Davis Dynasty by John Rothchild.

——Written by: The Poor Investor

Investing in the Stock Market: What Beginners Should Know

There seems to be a contradiction in what the “experts” tell us about investing in the stock market.  I’ve heard investment professionals who have said the process is simple and that individuals just make it too complicated.  On the other end of the spectrum, I’ve heard that investing is extremely difficult and only those that put in extraordinary amounts of time and effort will be able to be successful.  I’ve also heard the in-between argument, that it’s not too difficult but you still have to “do your homework.”  My belief is that they’re all right.  However, investing really is only as complicated as you want to make it.

The concept of investing itself is very simple.  Investing is foregoing money now to obtain more money in the future; more, meaning, after taxes and inflation are considered.  When it comes to stocks, an investor is buying a slice, or fractional ownership, of something, usually a business.  One can either buy a slice of a company, a sector, or a slice of a market index.  For instance, you can invest in General Electric (a company), an exchange-traded fund that tracks clean energy (a sector), or an S&P 500 index fund that gives you the exact return of the S&P 500 (a market index).  Each of these provide various levels of challenges and time commitments; hence, why investing is only as complicated as you want to make it.  Moving from an individual company to a market index is, generally, going from the most to the least complicated.  (There are other variations of these forms of investing, such as investing in mutual funds, that will be covered in a separate post).

Let’s start with the least complicated: the market index.  There are many market indices to choose from, the NASDAQ, S&P 500, Dow Jones Industrial Average, Willshire 5000, to name just a few.  If you’re going to go this route you should at least study the basics of market index investing, such as fee structure and how to buy into an index fund, be familiar with the makeup of each of these indices, and know the benefits of dollar-cost averaging and tax-deferred accounts (such as a Roth IRA).  Then just decide which market you’d like to buy into.  This is all the leg work you have to do on your own.  Then, after learning about index funds and what they’re all about, you can basically take a “set it and forget it mentality.  This is why investing in index funds is called passive investing.  Set up a tax-deferred account for automatic disbursement into an index fund with a small percentage of each paycheck and every year or so you can check on it just to make sure your money’s still there.  By the time you’re ready to retire you should have a pretty nice nest egg. For example, the S&P 500 has returned around 9.4% annually, from 1965-2010, with dividends reinvested.  $100 invested in a Roth IRA in the S&P 500 at the start of 1965 without any annual contributions would have grown to nearly $5700 at this rate.  If you started with the same $100 and contributed $100 each year, it would have grown to nearly $71,000 (fees are usually nearly negligible for index funds).  In my opinion, index investing is the best way for the majority of people to invest because all the complexity is taken out of the process.

Next, let’s look at ETFs, or exchange-traded funds.  These are baskets of securities that track the ups and downs of various markets or sectors.  The ETF market has grown over the years and gives an individual investor nearly every opportunity to invest in whatever market he or she wants.  There are index fund ETFs for nearly every market index.  For instance, the ETF with ticker symbol SPY tracks the S&P 500.  If you want to invest in gold, there’s a gold ETF, symbol GLD.  Sick of rising gas prices?  Invest in an oil ETF, symbol OIL.  Or, how about a double oil ETF that goes up or down at twice the rate of oil?  There’s that too, symbol UCO.  However, be careful to look at the fee structures of these as many can be costly.  ETFs are considered more complicated than index funds because, for one, they trade the way stocks do.  Also, there are many more options.  If you want to invest in an agriculture ETF, for instance, you really need to know the ins-and-outs of the agriculture market.  Mix that agriculture ETF with a gold ETF and now you have to track and learn about both markets.  Plus, you can’t just have a set-it and forget-it mentality with all ETFs, it really depends on which ones you buy.  Some you need to track daily, others, hardly ever.  Some are extremely volatile.  Personally, I am wary of ETFs and do not invest in them myself for various reasons.

(See this interesting article about ETFs:

Depending on how one looks at stocks, investing in an individual company can be the most complicated, yet the most rewarding.  Buying a stock is just buying a slice, or part ownership, of a company.  Sounds simple, right?  Someone can even make the process extremely simple by saying, “I shop at Walmart and really like the store so I’m going to buy the stock.”  This can, and does, work out for people… sometimes.  But is this really a prudent way to invest?  Do you really want to risk your hard-earned money taking this approach?  My belief is that in order to invest prudently in a company you should know the basics of accounting, business fundamentals, and have studied the stock market well.  You should also know yourself really well to be a disciplined person who does not let emotions get to them and can view the world objectively.  If you do not meet that criteria, at the very minimum, I do not believe you should invest in individual companies.  There are way too many pitfalls to investing in individual companies where permanent loss of capital can be the end result.  Also, if you’re going to invest in individual companies, your goal is to beat out index investing at the very least, a pretty tall order (remember the S&P 500’s 9.4% annual return?).  So, if you can passively invest at around a 9.4% return annually, you really need to be extremely dedicated to learning about individual companies if you’re going to go at it alone.  However, for those who wish to put in the time and effort, investing in individual companies can be the most rewarding, as the greatest investor, Warren Buffett, can surely attest to.  If you had invested $1,000 in 1965 in the stock of Berkshire Hathaway, Warren Buffet’s company, you would have nearly $4 million today.

The main goal of this blog is to explore the last part of the investing process presented, investing in stocks, with the ultimate goal of empowering the individual investor.  Over many posts, I’ll explore the strategies and philosophies of the greatest investors, analyze individual companies, present market history and data, show tools which can be used to guide the investment process, discuss my own strategies, explore business fundamentals, psychology, and other topics related to investing.  

——Written by: The Poor Investor

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