"Beating Buffett"

Occasional commenter Stockdoxc/Dr. Paul Price has his own blog now, BeatingBuffett.com, with an apparently soon-to-be launched subscription-based service. From his "about" page:

Like Warren Buffett, we believe in ‘Value Investing’. Unlike Mr. Buffett, who is so rich that money has ceased to matter for him, we’re still looking to make better than market returns while limiting risk.

Over 31 years of investing we’ve been refining our techniques to allow for achieving outstanding results without incurring margin interest costs. The strategic use of option sales combined with solid fundamental analysis leads to wide statistical bands of high profitability while incurring below average risk.

Our service attempts to identify stocks with well defined upside and limited risk. We then typically add the options component and clearly spell out the best-case and static returns. Break even points are identified and calculated for every suggested trade.

We constantly update company news on our featured selections. We also report on the actual net profit or loss on all closed-out positions. All short and long stock and options positions (held by the authors) are fully disclosed at the time of publication.

Best of luck on the new site, Paul.

Better Late than Never

In the Chronicle of Higher Education, Joseph Cronin and Howard Horton ask, "Will Higher Education Be the Next Bubble to Burst?" (Hat Tip: Dr. Paul Price). Readers of this blog may recall that we raised this question in a post on October 1^st of last year, and later noted two subsequent Forbes articles on this question.

Dramatis Personae

For those confused by the sniping in some recent comment threads, this post may offer a partial explanation.

Dramatis Personae

- Dr. Paul Price aka Stockdoxc99: A retired dentist and stockbroker and prolific poster at GuruFocus and Seeking Alpha. Paul tends to invest in a broad portfolio of stocks he determines to be values based largely on historic earnings data and forward estimates from Value Line and other sources. He also constructs options strategies around various positions.

- William Spetrino, Jr., aka Billytickets: Former prolific poster on GuruFocus, blogger, and author of the book "Consume, Consume, Consume Some More: Spend More, Work Less". He tends to invest in a concentrated portfolio of large cap, blue chip consumer names (e.g., MO, KFT) and Berkshire Hathaway.

- Daniel Wahl aka DanielW: American ex-pat living in Vietnam, blogger and investor. Tends to invest in a fairly concentrated portfolio selected after in-depth fundamental research, and is willing to invest in companies before they are profitable based on an analysis of their assets and profit potential. A former poster on GuruFocus and Seeking Alpha.

Sources of Animosity

Between Daniel Wahl and Paul/Stockdoxc: Daniel Wahl once criticized Paul's understanding of risk, by pointing out that a stock's current price in relation to its previous highs and lows indicates nothing about the stock's prospects going forward. Paul then countered with criticisms of Daniel's understanding of risk. At the time, the investments Daniel had mentioned on GuruFocus, e.g., LEAPs on Potash Corp. of Saskatchewan, were on a tear. Last year, when some of those investments began to decline (e.g., the zinc miner Strategic Resources) Paul became more zealous in his criticisms. Their dispute then got personal.

Between BillyTickets and Paul/Stockdoxc: I don't remember the origins of this one. Maybe one of the principals can explain.

Between Daniel Wahl and BillyTickets: There is no animosity that I am aware of between these two.

Bill Gross on the Q Ratio

For commenter Dr. Paul Price, aka Stockdoxc, who prefers to see the glass as half-full, above is the Q Ratio chart from Bill Gross's December Investment Outlook, and below is Gross's explanation of the metric.

I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.

One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.

The Sopranos' Over-the-Top Take on Selling a Sketchy Stock

In the comment thread of an earlier post ("Destiny Media Update"), a commenter's Sopranos reference brought to mind this scene, set in the boiler room of a 'boutique' investment bank, where an honest broker is disciplined for refusing to pump shares of a scam dot-com company called Webistics to his clients.

M&Ms for Investing

Morbidity and Mortality conferences ("M&Ms") are regular meetings where hospital physicians discuss, without fear of punishment, their cases that had bad outcomes. The point of the exercise is to catch and correct errors and improve the way physicians diagnose and treat their patients. What prompted me to think of this was a recent discussion on the GuruFocus website, particularly this comment by prolific poster, former dentist, and stockbroker Dr. Paul Price (aka "Stockdoxc99") to Daniel Wahl,

Defending your methods regarding your highly touted pick of SRA Corp. after its 96% drop is akin to saying...

"The patient died... but the operation was a success".

Daniel Wahl had already reexamined his investment process on the zinc miner SRA Corp (TSX: SRZ.TO) on a post on his blog, and after noting that in the comment thread and making the M&M analogy, I wrote,

As in investing, there is the process and there is the outcome; sometimes a poor outcome is due to a poor process, in which case the process can and should be improved, and sometimes regardless of the process the outcome would still have been poor.

I went on to suggest that it might be useful for GuruFocus to create its own version of an M&M forum for bad investment outcomes. There's no shortage of commenters eager to point out others' losses, but usually this is done in a spirit of schadenfreude, and not in an attempt to learn from any mistakes that might have been made. I thought an M&M approach might make more sense, where investors could discuss what went wrong without insult.

A quick Google search of M&Ms brought me to an essay by Vincent A. Gaudiani, MD on the Cardiothoracic Surgery Network (CTSNet) that suggests that physicians' M&Ms have their own issues. Dr. Gaudiani writes of the M&Ms he participated in during his residency,

The huge disparity in experience level and the residency hierarchy often led to one-upmanship and a focus on affixing blame for failure as if adverse outcomes implied inadequate performance or lax intent. In other words, it was misused to create winners and losers. As we will see in a moment this is an entirely foolish and juvenile misuse of M&M.

Dr. Gaudiani also notes that problems with M&Ms continue post-residency,

Second and equally foolish is the deafening silence and acceptance of adverse outcomes that often accompanies M&M in the private setting. Experienced practitioners know that they too will have adverse outcomes and therefore choose to judge not.

[...]

To the extent that these misapplications of M&M conference prevail, they subvert the value of meeting in the first place.

It's a little disheartening, though not entirely surprising, to see the same sort of bad faith at work among physicians that you find among commenters on investing websites. Dr. Gaudiani offers some ideas to improve M&Ms. Some of this could apply to investing M&Ms as well:

For its part the community must value learning and desire to improve above all else and abandon invidious judgment. Practitioners must have the honesty and humility to recognize their contribution to an adverse outcome [...]. A few ideas may facilitate this process:

- Ask at which point critical decisions were taken that increased the likelihood of the adverse outcome.
- Ask what information or analyses might have led to a better outcome.
- Avoid defending or attacking a bad outcome. Neither helps.

Food for thought. Worth reading the rest of Dr. Gaudini's short essay.

Why Worry about Small, Thinly-Traded Stocks?

That question was posed by a someone commenting on the previous post ("How One Investor Found a Home Run Stock"). I initially responded in a comment, but it was a good enough question to warrant answering it more fully in a separate post.

As I noted in my comment, the reason such small stocks are worth paying attention to is that these stocks are more likely to be mis-priced, since they usually have no analyst coverage, little media attention, are ignored by most institutional investors, etc. This gives them the potential for higher returns than more widely-followed stocks. Recent academic literature supports this. See, for example, "Information Diffusion Based Explanations of Asset Pricing Anomalies", by Bolmatis and Sekeris. In this study the authors found that,

Stocks that have no-trade days outperform other stocks by a wide margin, even after correcting for their higher risk as captured by their larger betas. This result is expected when comparing stocks with large differences in information availability.

Mark Hulbert, of the Hulbert Financial Digest, wrote about this study last month in the New York Times (Strategies: "Roses among the Wall Flowers"), and fund manager Aaron Edelheit commented on this article in his blog ("This is What I Do for a Living!"). In that post, Edelheit wrote,

Academic studies finally back up what I have found in 10 years of investing:

No trade stocks outperform

In addition to Edelheit, another professional investor who has achieved excellent returns by investing in these sorts of stocks is Paul Sonkin, of the Hummingbird Value Funds.

It's true that investing in such small cap stocks is risky, but it's also true that there's plenty of risk in investing in many large cap stocks, as investors who bought shares in such stalwarts as Citigroup or Motorola over a year ago can attest to. Perhaps the conventional wisdom of risk-versus-reward (i.e., large cap is less risky than smaller cap; domestic is less risky than foreign) needs to be reconsidered. If an investor is going to take on significant risk investing in common stocks, he ought to have the potential of a significant upside to compensate him for taking on that risk.

Here is another way to think about size-versus-risk. Think of a small, local business where you live, one that is profitable and that has been so for decades. If there were a way for you to buy a small piece of that business (at a fair price, of course) would you buy it? Chances are, if that small, local business were publicly-traded it would be a micro-cap. Would that, in and of itself, make it a more risky¹ investment?

Another point the commenter made was that the recent paucity of comments on this blog was due to my posts about "super-obscure" stocks. He may well be right. I'd venture that for most people, reading about stocks you don't own and have no intention of buying is boring. I remember, years ago, as a trainee in a small brokerage/investment bank in Midtown Manhattan, how boring it was to read the WSJ's "Abreast of the Market" column everyday as I was instructed to do. I didn't own any of those stocks, and so I had no interest in them. Perhaps I'll add some more general interest posts in the future, but I'll continue to write about small stocks, because that is what interests me. If you are more interested in reading about more widely-followed companies, including Dow Components, Buffett picks, etc., you may want to peruse the Value Strategies & Ideas" forum on GuruFocus.

¹Risky in terms of the chance of you suffering a permanent loss of principal, not risky in terms of price volatility.