The Guru Investor Blog

Two of the top-performing growth-focused approaches in 2011 were Reese's Momentum Investor strategy and his James O'Shaughnessy-based strategy. A 10-stock portfolio picked using the former surged 20.9% in 2011, while a 10-stock portfolio picked using the latter jumped 13.3%. (The O'Shaughnessy-based model picks some growth and some value stocks, but in 2011 its big winners tended to be from the growth side.) Reese details both strategies in the year-end report, looking at how the approaches work and where they found big winners in 2011.

The report also includes year-by-year performance data for all of Reese’s “Guru Strategies”, each of which is based on the approach of a different investing great. The vast majority of his guru-inspired portfolios finished 2011 far ahead of the broader market since their inceptions, most of which were in 2003.

Reese also looks at some of his value strategies, including his Warren Buffett-based approach. A 10-stock portfolio picked using the strategy returned 10.2% for the year, far outpacing the market. He also says not to expect value strategies as a group to continue to struggle. “History has shown that while fundamentals and value may fall by the wayside for short periods in the stock market, investors always come back to them,” Reese writes. “So while emotion and macroeconomic factors drove the market in 2011, I don’t expect that to last forever, especially as the fundamental position of the market continues to improve. … The combination of attractive valuations, an improving economy, and a corporate sector that has become much more efficient and streamlined in recent years — not to mention a financial sector that is in far better, less risky position than it was a few years ago — bodes well for stocks going forward. Yes, the European debt crisis is scary, and the U.S. has its own debt and deficit troubles to worry about. But with many investors not only fearing but expecting the worst on those fronts, some very bad scenarios are already baked into stock prices. That certainly doesn’t mean that stocks can’t go lower; but it does mean that the downside should be somewhat limited, while the upside should be significant.”

“Improving book value levels and ratios show companies recovering from tough times, prepared for uncertainty, and capable of profits without excess leverage,” Berkowitz writes in Fairholme Capital’s year-end manager’s report (click here for a PDF copy). “The Fund's performance last year makes little sense in light of such positive trends and we can only hypothesize from public comments that investors did not fathom our financials' assets. There appears little understanding of how loan and insurance contracts age and run-off, bad begets good over time, and how U.S. Generally Accepted Accounting Principles (GAAP) create undue quarterly volatility in book values.”

“Current events always reverberate much louder than the financial histories of past cycles; positive results and actions are now needed to swing market sentiment and prices toward more balanced views and values,” Berkowitz adds. “AIG's $1B common stock buy-back, Buffett's transaction with Bank of America, CIT's rapid debt refinancing, and MBIA CEO Jay Brown's repeated stock purchases all point to improving fundamentals — the process has started.” He offers his take on why big Fairholme holdings like AIG, Sears, and Bank of America are still good stocks.

Berkowitz says that, just as he asks investors not to be swayed by short-term performance in great years, so too does he ask that they not be swayed by short-term performance in bad years. “One circling of the Sun is too short a time to differentiate between good and lucky,” he says. “Thus, we remain optimistic given our performance since inception and a belief that while history does not exactly repeat, it does rhyme. Unemployment is coming down and elections are near. Our favorite economist, Warren Buffett, is bullish on America. Year-end reports show continuing, positive trends. Our companies are strong and cheap. Shareholders have kept their courage and conviction under stress. Fairholme has kept its word to focus on value-based, long-term investments. We will stay the course.”

Taken from the February 3, 2012 issue of The Validea Hot List

In 2000, however, Piotroski showed that you don’t need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge — just a straightforward assessment of a company’s balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios — i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it’s been shunning a winner.

Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor’s portfolio by at least 7.5 percentage points annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn’t would have produced an impressive 23% average annual return from 1976 and 1996.

Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market handily, returning 6.0% annualized vs. 1.8% for the S&P 500. But it’s not for the faint of heart, as it can be very volatile — in fact, its beta of 1.37 is the highest of any of my 10-stock portfolios. It fared very well in 2004, 2005, and 2006, before struggling in 2007, 2008, and 2009. Then it roared back in 2010, gaining 55.9% — more than four times the S&P 500′s 12.8% gain. Last year, however, it was again hit hard, losing 24.4% while the broader market was flat. But so far in 2012 it has again bounced back strong, already gaining 17.8% vs. the S&P’s 5.3% gain. (All 2012 and since-inception figures through Feb. 1.) The big swings are likely a result of the strategy keying on smaller, beaten-down stocks at a time when investors have been prone to bouts of fear — primarily about macroeconomic issues. When those macro issues spark anxiety, investors dump smaller unloved stocks; then, when the fears subside, they dive back into the smaller value plays. So while you can make some nice profits over the long haul following a strategy like this, you have to have discipline — or else you’ll end up buying high, like after 2010, and selling low, like after 2011.

Let’s take a look at how Piotroski’s approach, and the model I base on it, work.

Diving into The Balance Sheet

Piotroski wasn’t the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren’t rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.

The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that’s the figure I use.

That’s the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business — not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski’ other financial criteria don’t necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn’t be the type of strong performer Piotroski was targeting. Looking at how a company’s fundamentals had been changing allowed him to not only get an idea of the firm’s financial position, but also of whether that position was improving or declining.

Among the other “change” criteria Piotroski examined were the long-term debt/assets ratio, which he wanted to be steady or declining; the current ratio (current assets/current liabilities), which he wanted to be steady or increasing; gross margin, which should be steady or rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks currently in its 10-stock portfolio:

SkyWest, Inc. (SKYW)

Alpha Natural Resources (ANR)

HealthWays, Inc. (HWAY)

AU Optronics Corp. (AUO)

Digital Generation, Inc. (DGIT)

Legg Mason, Inc. (LM)

Brasil Telecom SA (BTM)

Ternium S.A. (TX)

ArcelorMittal (MT)

Invacare Corporation (IVC)

Think Small — And Boring

One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks.

For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products, though it will go into more “interesting” areas when valuations are right (as it is right now, with a few tech stocks among its holdings). But while they’re not the flashiest firms, they’re quite often the type of stocks that can pay excellent returns over the long haul.

The flaw, Siegel said at a TD Ameritrade Institutional conference, involves the 2008 year, Financial Advisor magazine reports. That year, three S&P members – Citigroup, AIG and Bank of America-lost a total of $450 billion, a big reason why the index’s components’ earnings fell 80% for the year. Siegel says that distorted the S&P figures — he says national income accounts indicate that U.S. corporate profits overall fell 25% in ’08, a big fall but not nearly as big as the S&P’s earnings decline.

Seigel also said he sees recent corporate profit growth as sustainable. He thinks the S&P 500 should rise to nearly 1,600 if inflation stays normal, and over 2,000 if we enter a low-inflation era.

Dreman also talks a bit about portfolio management, saying he keeps a diversified portfolio of 50 to 60 stocks, with all the stocks weighted similarly. He adds that he buys stocks below the market valuation multiple, and always sells when it reaches the market average multiple, though he may sell sooner on “very bad news”. One change he’s made since the financial crisis: He’ll sell stocks of companies that post losses, even a short-term loss, and won’t buy them again until they are turning a profit.

Speaking as part of Barron’s 2012 Roundtable, Gabelli says big growth in auto sales in China, as well as an aging fleet of existing vehicles and the need for different types of trucks due to the widening of the Panama Canal, bode well for a number of auto stocks. Among the picks he likes are Genuine Parts, a replacement auto parts maker, and Navistar International, which sells trucks and buses.

In the cloud computer arena, Gabelli likes firms that “provide co-location services, allowing you to place your computer in their facility.” Among his picks: Internap Network Services and Cincinnati Bell. He’s also interested in the snack food industry, where he sees several potential spinoff possibilities and acquisition targets. Snyder’s-Lance is one firm he thinks could benefit from being acquired.

Gabelli also likes “financial engineering” plays, including spinoffs like Fortune Brands Home & Security (as well as its former parent, Beam).

This portion of the Roundtable also includes 2012 forecasts from several other prominent investors, including PIMCO bond guru Bill Gross. “A titanic struggle is occurring between delevering and reflating on the part of the central banks,” Gross says. “Reflation has been successful, but in some ways the Fed has gone too far. The central bank’s role is to promote liquidity and preserve credit extension throughout the economy, but they have allowed too much risky credit to be created in the process.”

Gross says that “if the economy is threatened by delevering, which could lead to inflation or deflation, we are going to experience financial repression for the next five to 15 years. It is a necessary condition.” His tips to avoid that repression: Invest in certain closed-end funds that can borrow money at 0.25% rates, and lend it out safely at 4%, 5%, or 6%. He also likes some high-yielding utility stocks and some state bonds that are on the safer side.

“There are two sensible approaches to investing — either 100 percent active or 100 percent passive,” Swensen said at the John C. Bogle Legacy Forum hosted by Bloomberg Link, according to Bloomberg. Unless an investor has access to “incredibly high- qualified professionals,” they “should be 100 percent passive — that includes almost all individual investors and most institutional investors,” he said.

A big reason is that most funds are focused more on compiling fees than on increasing returns for clients, Swensen said. He also criticized the high fees that many hedge funds charge, and offered a critical take on high-frequency traders. “I've always viewed high-frequency trading as a tax on the rest of us,” he said. “A bunch of smart people taking advantage of order-execution rules as opposed to doing something good for the market place.”

In a column for Morningstar.com, Greenblatt explains why investors who tried to implement his “magic formula” investing plan by themselves have fared worse than those who have asked for the plan to be professionally managed. And he says that “the best performing ‘self-managed’ account didn't actually do anything. What I mean is that after the initial account was opened, the client bought stocks from the list and never touched them again for the entire two year period. ... I don't know if that's good news, but I like the message it appears to send — simply, when it comes to long-term investing, doing ‘less’ is often ‘more.’”

Greenblatt offers a handful of reasons why self-managed investors tend to underperform. They include:

Self-managed investors avoid buying many of the biggest winners.

“Most people and especially professional managers want to make money now,” Greenblatt explains. “A company that may face short term issues isn't where most investors look for near term profits. Many self-managed investors just eliminate companies from the list that they just know from reading the newspaper face a near term problem or some uncertainty.” Unfortunately for them, Greenblatt says, many of those stocks end up being the biggest winners.

Many self-managed investors change their game plan after a strategy underperforms for a period of time.

A case in point, Greenblatt says, can be found in the best-performing mutual fund of the 2000s. While the fund gained 18% per year during a period in which the broader market was flat, the average investor in the fund actually lost 11% per year, he says, “because of the capital movements of investors who bailed out during periods after the fund had underperformed for awhile”.

Many self-managed investors buy more AFTER good periods of performance.

“Most investors sell right AFTER bad performance and buy right AFTER good performance. This is a great way to lower long term investment returns,” Greenblatt says.