Investing, Magic Formula
May 25, 2011
Richard Beddard
11 Comments

Mines flood Nifty Thrifty screen

Last night I ran a mechanical screen, the Nifty Thrifty, in preparation for a quarterly article I write for Money Observer magazine. Since I’d tweaked the screen, I wanted to see what kind of results it came up with before running it for real at the end of the month.

I don’t talk about the Nifty Thrifty much here because this blog is about the Thrifty 30 portfolio, which is in some ways similar, but in others completely different.

Thrifty 30 holdings are picked by a human (me) and not an algorithm and while I tend to favour obscure companies when picking them myself, only the UKs biggest companies with market capitalisations over £500m are allowed in the Nifty Thrifty.

Nevertheless the two portfolios follow the same principle; I’m looking for good companies at cheap prices that are not likely to be getting into serious trouble.

Over the long-run I’m very interested to see which portfolio does better. The Nifty Thrifty is a lot less effort to run, but the Thrifty 30 is my baby.

The Nifty Thrifty is inspired by Joel Greenblatt’s ‘magic formula’, which I have discussed at length here. I use Earnings Yield as a measure of value, Return on Assets as a measure of quality, and Piotroski’s F_Score to improve the algorithm’s timing. Each qualifying company is ranked by these three measures (the higher the better) and an overall ranking derived. Here are yesterday’s top fourteen:

110524NiftyThrifty

I’m still in shock. Six are miners and three are energy companies. If I include all of them, as I should according to the formula, one third of the Nifty Thrifty portfolio will be in natural resources. And if next year is a bad year for resource companies, it will be a bad year for the Nifty Thrifty.

As a value investor, I’m leery about resource companies. Their performance depends on the high prices of the commodities they mine. When prices fall, their profit margins collapse and suddenly they don’t look like such good investments.

Maybe I made a mistake including miners in the first place. Greenblatt excludes financial companies and utilities from his formula. I think his measures of value and quality aren’t appropriate for banks and insurance companies and he doesn’t like utilities because their profits are constrained by regulators.

But magic formula portfolios are often rich in energy and resource companies even though one of the basic principles of the magic formula is that companies earning a high return on capital or assets one year will reinvest those returns in money making enterprise in forthcoming years. That may not be true of resource companies, if the price of copper, or oil has fallen down a deep shaft.

Most companies are sensitive to outside forces to some degree, and I suppose you can’t be too fussy or you might as well hand pick the companies from a very small pool. But resource companies are surely among the most extreme cases.

Looking back at the credit crunch, the top three companies in my list performed very badly. Rio Tinto shares fell 85% top to bottom, Eurasian Natural Resources fell 87%, and Antofagasta fell 65%.

You’d have to be very unlucky to suffer the full extent of those drops, but my testing of the magic formula showed that three of the portfolios formed in the year leading up to the crisis did worse than the FTSE-100. That only happened one other time in a decade of testing forty individual portfolios.

Miners did feature in those losing portfolios. Kazakhmys was ranked fourth in the portfolio formed on 31 December 2007 and became its biggest loser, falling 75%. Vedanta, ranked sixth fell 56%, and Antofagasta, ranked second lost 14%. BHP Billiton, ranked 26, actually gained 22% though.

Most of these companies have recovered from the credit crunch and resumed their apparently remorseless rises on the back of a commodities boom that has lasted more than a decade now, but it’s too late for the one year magic formula portfolios that invested in them in the months before they dropped in price.

In the latest version of his book, The Little Book That Still Beats the Market, Greenblatt expresses surprise, and perhaps a bit of a disappointment than the magic formula beats bull markets, and loses to bear markets when you might expect a value portfolio to do better in a bear market.

It’s just a theory but maybe the energy and resource companies in magic formula selections explain some of the puzzle.

Anyway, the preponderance of miners and oil producers in this months table leaves me with a conundrum if, as is likely, it’s replicated in a few days time when I repeat the exercise for the magazine. Do I ignore the miners, or include them? Or do I exercise some common sense, and include the highest ranked, but replace the lower ranked resource companies with the next most highly ranked company that isn’t a resource company to achieve a more diverse portfolio. You’ll have to check the Money Observer website in a week or so to find out.

I see fellow magic formula investor Mark Carter likes BHP Billiton because it’s a magic formula company, but if you read his write up, and the update below it, you’ll see the kind of handwringing a value guy does when adding a resource company to his portfolio.

11 Comments

  • Steve Baines May 25, 2011 at 6:29 pm

    I written on this issue previously myself (http://cautiousbull.wordpress.com/2011/01/10/the-ftse-100-just-isnt-british/) , but a UK stock listing is a relatively artificial starting point to begin screening a particular investment universe given that the London Stock Exchange has recently been flooded with listings from emerging market mining companies. In my view, many businesses listed in the United States and the rest of Europe have far greater operational business connections with the United Kingdom than companies such as Kazahkmys and Vedanta. Perhaps an additional criteria could be added to the screen that the business should achieve a certain proportion of its sales from the UK (or maybe Western Europe)?

    Reply
    • Richard Beddard May 26, 2011 at 9:16 am

      Interesting Steve, I didn’t realise how un-British the FTSE-100 is!

      Reply
  • blippy May 25, 2011 at 8:35 pm

    Interesting article Richard.

    “Do I ignore the miners, or include them? Or do I exercise some common sense, and include the highest ranked, but replace the lower ranked resource companies with the next most highly ranked company that isn’t a resource company to achieve a more diverse portfolio.”

    When I experiment with mechanical-type portfolios, what I usually insist on is sector diversification. I’m a little bit flexible, because after all a sector like “Services” encompasses so many diverse activities. I approach things from the angle of “I don’t know”. So I wouldn’t ignore miners, because you don’t know for sure that they’ll go down. But you don’t want to turn the whole thing into a sector bet, I don’t think that makes sense from diversification viewpoint.

    “I see fellow magic formula investor Mark Carter likes BHP Billiton because it’s a magic formula company,”

    The way I screen on Sharelock, BTL is still an MFI company. Empirical Finance (http://data.empiricalfinancellc.com/) do their own MFI list, and it did not appear in the top 20 when i looked at it recently. Unfortunately, their screener doesn’t appear to be working at the moment, so I don’t know what’s going on there. It stopped working awhile before that, too, so it’s a little mysterious. I did notice some correspondence between my list and theirs; which may or not prove anything.

    “In the latest version of his book, The Little Book That Still Beats the Market, Greenblatt expresses surprise, and perhaps a bit of a disappointment than the magic formula beats bull markets, and loses to bear markets when you might expect a value portfolio to do better in a bear market.”

    Ah, well, that’s the thing! I underperformed the market in 2008 when the market tanked, and outperformed it in 2009 when the market made a sharp recovery. I adopted a value approach in both years, and it looks like I got a similar qualitative behaviour to Greenblatt.

    Actually, I think I know what’s going on.

    I engaged in a discussion about cyclical shares on an MFI board, asking “how do you know you’re not buying cyclical shares at the top of the market”. The answer I received was that things can go on longer than you expect. I’m not sure I was entirely satisfied with that answer.

    What I’m beginning to increasingly think is that it’s not so much stock selection that’s important, but proper sector selection in relation to the current market cycle. The market is anticipatory. It marks down companies that have a more (economic) cyclical nature when it perceives trouble ahead. Now, the market may be wrong and irrational, but then again, it might not be. It’s precisely this kind of judgement which poses a problem for a typical value investor. He may be buying a company that looks good on the usual valuation metrics, but those numbers might be leading him directly into a trap.

    Two things I’ve been looking at very recently is a home-brew cyclicity measure, and beta. Yes, beta! The cyclicity measure is basically just a Spearman rank (it measures “monotonicity”) of company EPS over time. Cyclicals end up scoring very low values, whereas defensives end up scoring very high.

    Another interesting measure is beta, from the dreaded CAPM (Capital Asset Pricing Model) EMH (Efficient Market Hypothesis). No self-respecting value-investor will, of course, have any truck with beta. EMH has come under particular attack recently, and it doesn’t seem that the professors who teach it have much faith in it, either. So you may wonder why I’m becoming increasingly interested in it. And the answer is … I’m actually beginning to believe it has at least some merit.

    If you take a company like RIO, it has a beta of 1.8 – meaning that it tends to amplify changes in the market. Two other companies that I want to mention are financials: AV (Aviva) with a beta of 1.4, and SDR (Schroders) with 1.2. All of them are above 1, making them more volatile than the market. Well, this isn’t just a mere historical statistic, there’s a logic to it. AV and SDR tend to invest heavily in the markets. SDR makes it living from the AUM (assets under management). So, when you think about it, it’s no surprise that a company like SDR crashes during market slumps, and soars during recoveries.

    Constrast that with a company like BATS (Brit Amer Tobacco), which has a beta of 0.8, which is less than 1. Numerically, that’s telling you that its stock market prices is relatively damped. And this is exactly what you’d expect: BATS routinely chugs out profits, and usually raises them a little every year, come rain or shine. So its share price is in a more constrained band.

    So – Efficient Market Hypothesis – maybe not so harmful after all.

    This brings me back to my original point – it’s not so much about the shares you choose, but about sectors. After the market tanks, buy high-beta shares. After it’s risen a lot, back off and buy low-beta shares. Or, put it another way, when markets are low, it’s time to load up on risk (but I don’t mean wild flaky gambles), and when markets are high, it’s time to take risk off the table.

    This brings us back to the miners. IF the market tanks, then I suspect that they’ll get clobbered despite their apparently low valuations. In terms of the market cycle, maybe we’re about half way in a bull market that started in, let’s say, 2009′ish. The market certainly has had a decent run, so there’s reason to be cautious. But there’s no reason to be fearful, as valuations don’t look especially stetched. So it’s difficult to say how things will turn out. I do get a sense, though, that the market is becoming increasingly risk-averse judging by the comments I read. And things are feeling “a little bit toppy” and volatile, as if the market is struggling to advance.

    By way of backing this up, I chose two defensive companies at random, and two more-sensitive stocks. During the last 3 months, the defensive companies BATS is up 8.7%, and TSCO (Tesco) is up 2.6%. The high-beta stocks, BLT and AV, are down: BLT is down 3.6%, and AV. is down 8.5%. The Footsie is down 2.2%. See how that’s working? Money appears to be shifting from the risky stocks to the safer stocks. Remember, I haven’t chosen those particular stocks with hindsight to “prove” my point, yet they seem to be telling a consistent story.

    It would appear, then, that IF the market struggles to make progress, then it is value stocks that would be more likely to see poor returns, whilst the “quality” ones are likely to fare much better. And therein lies the dilemma with value stocks.

    The problem for me is that I don’t know if the market is going to finish higher or lower than it is now. Market sentiment is souring at the moment, making a defensive strategy look increasingly attractive. But the whole Greece/Japan/Chinese/Commodity thing could all blow over in a few months, in which case it will be business as usual, with value stocks staging a strong comeback.

    The whole commodity thing is a very difficult call, isn’t it? I buy both sides of the argument, with Jim Rogers on one side, and the preponderence of miners in the Footsie on the other.

    Anyone got a crystal ball that’s clearer than mine?

    Reply
    • Crucible May 25, 2011 at 10:38 pm

      Blippy,

      I actually quite like beta as a way of measuring risk. That’s not to say I buy into EMH at all, bit beta as one of many measures of risk does make sense to me, as it’s fairly well grounded in facts. The only problem I have with it is over what time period to calculate it..

      I suppose the thing I often forget about investing is reminded to me by a quote from Keynes:”Markets can remain irrational longer than you can remain solvent.” To me, this means that even though one should chase deep value in the knowledge that it tends to out-perform, one should keep a thought to general investor sentiment and what the market tends to do.

      A lot of stocks get dumped for arbitrary reasons, and understanding why/how the market moves how it does, I think, opens up a whole new layer of possibility on top of solidly understanding fundamentals. I chuckled, for example, when I realised the correlation/causual chain between the stock I was following (sorry to bring this up again!), the market, and the US outlook; S&P revised US’s credit outlook to negative (a relatively minor alteration), which knocked the footsie down 2%. Are UK stocks worth 2% less because S&P confirmed basically what investors knew already – America was struggling with a deficit problem? Furthermore the housebuilder I was following tumbled with the market. Does the housebuilder I’m following, which has the entirety of its operations in the UK, really lose 2% of its value on this basis? Yes, the inter-linking of the financial markets and the importance of inter-bank lending.. but I don’t buy the story.

      Still, this sounds like I know more than I do, so I’ll sum it up in a couple of phrases: the markets overreacts, I think, and links stocks too much. This opens up opportunities!

      @Richard,

      I’ve been looking at the miners: Kazakhmys was showing up on a lot of screens. I’m still torn between saying screw it, and shoving BHP Billiton/Rio Tinto (the large caps) in my basket by virtue of their financial strength and seeming cheapness, and reprimanding myself for even thinking such a thing.

      I don’t *really* understand, fundamentally, the drivers of commodity prices. Superficially I do, but I couldn’t tell you if the recent ramp was a result of Chinese demand which’ll only build, or an unsustainable bubble.

      They do look cheap though..

      Reply
    • Richard Beddard May 26, 2011 at 9:39 am

      Thanks Blippy,

      On switching between value and defensive/growth depending on the market’s temperature (where it is in the cycle from boom to bust) I think you’re right in theory but I don’t think I can do it in practice (in fact you summed up why towards the end of your comment: “The problem for me is that I don’t know if the market is going to finish higher or lower than it is now”). I set out this reasoning when I summarised some research from Morgan Stanley on the market cycle and as I look back at it now, I think this was post was quite a significant one in the development of my investment philosophy: http://blog.iii.co.uk/reward-without-the-risk/

      Basically, if you’re just looking at value (i.e. low PB/PE), then yes, I concede, you may do worse than average in bear markets and recover more strongly than average in bull markets (if you’re still standing). But if you take the wider view of value – that it’s about eliminating as much risk as you can – in other words you focus on the balance sheet too you can beat the bear. That only leaves the fag-end of bull markets, in which (imo) it might be best just to retreat to cash when there are no cheap companies with strong balance sheets – the alternative could court disaster.

      On beta I think the problem with it is it works until it doesn’t. It tells you which shares have been most volatile, which is an indicator of risk, or at least the market’s perception of it. The problem is value investors are looking for exceptions, where the share price is doing something you wouldn’t expect (usually falling to very low levels, beyond that which you’d reasonably expect it to). In that case the share would have a high beta but be a good investment. So, if I were to pay any attention to beta I’d probably seek out high beta stocks and then see if any of them were better than their betas implied! I don’t, though.

      Reply
      • Mark Carter May 26, 2011 at 2:13 pm

        Nice link, Richard. Many thanks.

        I remember seeing a chart somewhere showing a typical market cycle, and the kind of sectors that did well during each phase. I can’t seem to find it, though. Has anyone come across this chart?

        Reply
  • Trustamind May 26, 2011 at 5:39 pm

    Thanks for the post. I have similar experiences.

    I also have a ranking system similar to Magic Formula. Roughly speaking, Magic Formula has two components: valuation and return on capital. I added one more: financial condition. I tweaked a little bit the formulas within valuation and return on capital, though.

    Although I traded my ranking system for only a couple of months, I see the same thing you discussed here. One month ago, all the top names are mining companies, including RIO. But not anymore. I think some bad fundamental numbers entered the earnings reports during this earnings season. As a result, the ranks of top ranked mining companies dropped abruptly.

    Nonetheless, I believe it is normal that certain sectors / industries are favored at certain phases of a business cycle. This is actually the well studied Sector Rotation phenomenon. I don’t have predictive power so I worry less what’s going to happen one year down the road. But I believe I’m in good hands as long as my ranking system tracks the fundamentals closely. If commodity price crashed in the future, the fundamental numbers will crash, too. My ranking system will reflect the changes and I’ll exit the positions. In fact this already happened with my ranking system. As mentioned before, now the mining companies are not top ranked anymore and I don’t have any of them in my portfolio.

    One key point I’d like to mention is: How often do you update the ranks. I insisted to update the ranks every week with my ranking system. Fundamental numbers change slowly, but the changes are usually abrupt. For example, the rank of RIO dropped about 20% one month ago. I think if I don’t update the ranks frequently, I’ll miss big profit or get caught by big loss.

    Another thing is I’m not sure which EY are you using. Some value investor will use 10 year average. But I’ll use ttm number. For one, ttm is more popular so it’s going to have bigger impact on price, at least in short term. For two, ttm is more sensitive to changes. There will be fluctuations, but I think it pays to follow the fluctuations in the long run.

    Reply
    • Richard Beddard May 27, 2011 at 10:45 am

      Hi Trustamind, good too hear from you. I update the rankings quarterly, but only trade once a year – in the style recommended by Greenblatt. I wouldn’t try and time individual buys and sells as it’s meant to be a mechanical system. I use the 1 year historic earnings yield (also as used by Greenblatt) for the Nifty Thrifty (i.e. mechanical magic formula inspired portfolio). On this blog, where I track the Thirfty 30, I use the ten year though. Personally, I’m much more comfortable with it.

      Reply
      • Trustamind May 27, 2011 at 6:02 pm

        Yeah, I see. It would be different if the system is used for initial screen and long term holding. I’d be concerned too if I see a lot of mining companies when planning to hold them for years. I don’t have much experience on Shiller P/E or anything alike. Just on top at my mind that it might be helpful to look at Coefficient of Variation (learnt this from Geoff Gannon). Mining companies are highly cyclical so their CV should be bad in a span of 10 years. But it may or may not be a good idea to fabricate CV into the screen.

        I’m studying your blog, and find this one (http://blog.iii.co.uk/reward-without-the-risk/) is very interesting. I use my ranking system to rank sector ETFs, and map it to Sector Rotation to gain some insight on where we are in a business cycle. For example, currently the top ranked offensive sector ETF is energy, and the top ranked defensive sector ETF is healthcare. On the road map of Sector Rotation (http://marketscalpel.com/approach/rotation/sectorRotationConventionGraphic.htm), both sector belong to late expansion phase. So probably we are in late expansion phase right now.

        I was thinking that growth vs. value can be used in the same way. Your post maps growth / value to a business cycle. I’d like to borrow your chart for my research.

        One quick question. On the chart I see growth, value, and balance sheet. What would be a good ETF that represents balance sheet? Telecom?

        Thanks.

        Reply
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    [...] Mines flood Nifty Thrifty screen [...]

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