Wednesday, July 2, 2008

From Joel Greenblatt to Jim Rogers, Part IV: Conclusion

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. This is the last in the series.

Trying to Find Good Companies When they are Cheap and Poised to Benefit from Macro Trends

Joel Greenblatt's method of screening for good (as defined by ROIC) stocks that are currently cheap (as defined by EBIT/EV) makes intuitive sense. The idea of buying stocks that are poised to continue benefiting (or, even better, start benefiting) from macro trends makes intuitive sense as well (at least it does to me). What I have tried to do so far this year is buy only the Magic Formula stocks that I think have the potential to benefit from macro trends. This has been a challenge, because these sorts of stocks have been relatively scarce on the Magic Formula list.

Why This Sort of Stock has been Hard to Find on the Magic Formula List

Part of the reason for this is that good companies that are benefiting from macro trends often don't stay cheap long. One such example is Graham Corporation (GHM), a small cap company based in Batavia, NY that manufactures vacuum and heat transfer equipment. That may not sound too exciting, but this sentence from Yahoo! Finance's description of Graham's business will give you an idea of the macro trend tail winds behind the company (emphasis mine):

Graham Corporation's products are used in a range of industrial process applications comprising petroleum refineries, chemical and petrochemical plants, fertilizer plants, pharmaceutical plants, plastics plants, liquefied natural gas production facilities, soap manufacturing plants, air conditioning systems, food processing plants, and other process industries, as well as power generation facilities, including fossil fuel, nuclear, cogeneration, and geothermal power plants.

I had my eye on Graham in March, when it was trading in the mid-$30s, and planned to buy it the following month, when I was scheduled to make my Magic Formula trades. Before I was ready to buy it, Graham announced blowout earnings and the stock shot up 20 points, taking it off the Magic Formula list. It's up another 20 points since. Since then, I haven't seen any company on the Magic Formula list positioned to benefit from as many macro trends as Graham Corp.

Another reason it has been relatively hard to find stocks poised to benefit from macro trends on the Magic Formula list is that the list excludes most foreign stocks and ADRs1. The reason for this is simply that Greenblatt didn't have the data to back-test his system with non-North American stocks; he has said that he still believes that the strategy of buying good stocks cheaply should work in other markets as well.

Combining Joel Greenblatt's Value Methodology with Jim Rogers's Insight that we are in a Secular Bull Market in Commodities

The secular bull market in commodities that Jim Rogers describes (see my earlier post Jim Rogers versus Vitaliy Katsenelson, Part I) is the mother of all macro trends. Since Rogers has written that non-commodity producing companies operating in regions benefiting from the secular bull market in commodities may profit indirectly from it2, one way to find more Magic Formula-type stocks benefiting from macro trends may be to apply the Magic Formula screens to stocks in countries benefiting from the secular bull market in commodities. I suspect that a basket of high earnings yield, high return on invested capital stocks in a country such as Australia will outperform a similar basket of American stocks over the next several years. I haven't found (yet) a website that I can use to screen for Magic Formula-type stocks in other countries, but I did recently buy stock in a foreign company after (incorrectly, as it turned out) crunching the Magic Formula metrics on it myself. That company was Alloy Steel International (AYSI.OB), and since I've already threatened to write a post about it, you can expect that post soon.

Although I continue to look for stock ideas on the Magic Formula Investing website, I no longer limit myself to it, and am more concerned with finding stocks that appear to be undervalued based on their future prospects and positioned to benefit from relevant macro trends.

1In practice, the Magic Formula list has been a little inconsistent with respect to foreign companies. Although it doesn't list any ADRs, it does occasionally list foreign companies that are listed directly on the Nasdaq, e.g., ELOS (Israel), and CAST (China).

2E.g., if an iron mine is operating full tilt and paying a lot of overtime, the miners may have more cash to spend at local restaurants, retailers, etc.


Marsh_Gerda said...

Good stuff Dave. I think you're looking in the right direction. One stock you might want to look at is WH. They are foreign and you'll see they're involved in manufacturing pipes for oil & gas exploration and drilling. I get an earning yield of 18% and ROC of 37%.

DaveinHackensack said...

Thanks, Marsh. That's an interesting picks & shovels play on the oil boom. I'll have to do a little more homework on it.

Rudy G. said...

It seems your mistake in March was in waiting for your 'magic formula' timing. Had you just bought what seemed to be a perfevt stock at a great price you'd be richer and happier today.

Perhaps you should give up on 'mechanical investing' and just do what's appropriate at any given time.

DaveinHackensack said...

Rudy G.,

I did buy another stock early in March (TIRTZ.OB), so I wasn't adhering to the MF timing that mechanically, but after doing that I had no cash left to buy GHM. I guess the bigger mistake I made in March was not being willing to buy the stock on margin. In hindsight, I didn't put enough trust in my own thoughts on the importance of macro trends back then to do so. I also didn't pay attention to when the company was going to announce earnings, which was another mistake on my part.

Good point generally though, about the problem with adhering too mechanically to any system. As for just doing "what's appropriate at any given time", that's good advice as well, though of course the devil is in the details.

Daniel said...

Great series. You've listed two mistakes--one a stock which you bought that went down and one which you didn't buy that went up.

Question: you seem to be focusing on the outcome here. Would the latter have been a mistake if the company did not report blow-out earnings but instead missed what was expected by just a little bit (and got sold off unreasonably)?

What if the latter company took a knock to current earnings in order to expand production that would be long-term beneficial but hurt short-term results and by extension in today's market obliterate the stock price?

These are the things one can't simply know by running a screen, and I know you're doing work beyond that, but even then there's a shortage of information, and time to put together what of it there is available.

I don't know the thought process you went through with both in detail but, focusing on the method, where would you say you primarily went wrong with either? By focusing on the past as opposed to the future?

Or are you laying the blame on not investing with the macro trend? In such a case, if oil reversed over the next year, which it can easily do despite being in a long-term uptrend, would you be making a mistake?

It's an interesting subject and we'll all judge our methods somewhat differently, but I think if you had an understanding of both businesses, the risks involved in each, and bought both at a steep discount from the fair value of the company (judged not over the course of the next year but over the next decade), then if the market sold off either short-term it is it which has made the mistake (to be taken advantage of or not) and not you.

Again, great series. The above hopefully doesn't sound anything like a lecture, this is stuff I've been thinking about and hopefully improving upon myself. Just putting it out there for some feedback and possibly to help.

DaveinHackensack said...

Thanks for the great questions, Daniel. You bring up a good point about Graham Corp. (my mistake of omission), that the quarterly earnings could have been a slight miss, and the stock could have sold off. That's true (and it's true generally of any stock approaching its quarterly earnings announcement), but even if that quarter had been a slight miss, I think I would still have been wrong not to buy Graham in March. The reason is that the odds of that quarter being a miss were low, based on both the strong macro trend tailwinds behind Graham and the trend of its earnings over the previous few quarters.

Thinking about this a little more, an experience I had with a completely different, much more speculative stock a few months earlier, at the end of '07, may have influenced my decision to buy the royalty trust early instead of buying Graham early in March. At the end of '07, I was debating whether or not to wait until earnings were announced to buy the speculative stock. I decided to buy before, and it was promptly trading for a ~50% discount after the earnings call. Of course that speculative stock -- which had no track record of consistent earnings, and wasn't positioned to benefit from any macro trends -- was a completely different situation. Nevertheless, it may have influenced me.

It's also true that often a stock will spike up after a positive quarter, and then after the dust settles, you'll be able to buy it for the pre-spike price. With Graham, the odds were against that, since it was levered to almost every positive macro trend: oil, infrastructure (power plants), fertilizer, and food.

Regarding your question about a cyclical correction in oil, I don't think I'd be making a mistake by buying or holding an oil stock now if we had a cyclical correction later this year. The macro trend that concerns me with respect to oil is the secular trend I see over the next 5+ years, not the cyclical fluctuations between now and then. I'd look at a cyclical correction between now and then as a buying opportunity.

As far as where I went wrong with my mistake of commission (BBSI), that was in not realizing what percentage of BBSI's business was in California, and not connecting the dots between that, the knock-on effects of the real estate bust and the disproportionate impact it would have on the California economy.