Excess Returns

A comparative study of the methods of the world's greatest investors

Frederik Vanhaverbeke

• Publisher: Harriman House
• Year: 2014
• ISBN:
  9780857194114
• Edition: 1
• Topic: Business
• Subtopic: Stocks
• Index: Business

An analysis of the investment approach of the world's top investors, showing how to achieve market-beating returnsIt is possible to beat the market. Taking this as a starting point, Excess Returns sets out to explore how exactly the most famous investors in the world have done it, year after year, sometimes by huge margins.Excess Returns is not a superficial survey of what investors have said about what they do. Rather, Frederik Vanhaverbeke applies a forensic analysis to hundreds of books, articles, letters and speeches made by dozens of top investors over the last century and synthesises his findings into a definitive blueprint of how exactly these investment legends have gone about their work.Among the legends whose work has been studied are Warren Buffett, Benjamin Graham, Anthony Bolton, Peter Lynch, Charles Munger, Joel Greenblatt, Seth Klarman, David Einhorn, Daniel Loeb, Lou Simpson, Prem Watsa and many more.Among the revealing insights, you will learn of the striking similarities in the craft of great investors, crucial subtleties in their methods that are ignored by many, and the unconscious errors investors commonly make and how these are counter to successful investing. Special attention is given to two often overlooked areas: effective investment philosophy and investment intelligence.The investing essentials covered include:- Finding bargain shares- Making a quantitative and qualitative business analysis- Valuation methods- Investing throughout the business cycle- Timing buy and sell decisions- And much, much more!Excess Returns is full of timeless and practical insights, presented in a unique style, to help investors focus on the most promising opportunities and lead the way to beating the market.

PART I

THE INVESTMENT PROCESS

CHAPTER B

FINDING BARGAINS

“People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable?”

JOHN TEMPLETON (TEMPLETON, 2008)

FROM CHAPTER A we know that fundamentals-based investors want to buy stocks that trade at a significant discount to their intrinsic value (i.e., bargains). Given the efficiency of the stock market, it would be a formidable and extremely time-consuming task to look for undervalued stocks if one lacks a compass that points to potential bargains.

Top investors know that mispricing is more common in some pockets of the market than in other. To avoid wasting their time on stocks that are most probably not worth further scrutiny, they often look for potential bargains in those pockets where they see a good reason for mispricing. And they avoid pockets with stocks that are unlikely to be undervalued.

In this chapter I will give a comprehensive overview of the places that top investors have identified as attractive and unattractive. Due to their inherent differences, a clear distinction is made between stocks in developed and emerging countries. The discussion will cover good ideas, ideas that are probably bad, and good short ideas.

In section B.I top investors’ favourite types of stocks in developed countries are discussed. Section B.II gives an overview of the stocks that most top investors shun. In section B.III attractive candidates for short sales in developed markets are summarised. Section B.IV explains how experienced investors hunt for bargains in emerging markets. The practical aspects of screening for bargains are discussed in section B.V. And finally, a concluding section provides a summary of the major lessons of the chapter.

B.I Good and bad ideas in developed markets

B.I.1 Good long ideas in developed markets

In developed countries top investors pay special attention to the following types of stocks:

a.	ignored stocks,
b.	negative-sentiment stocks,
c.	specific types of new stocks,
d.	opportunities in new trends and events,
e.	recommendations from the right people,
f.	stocks with catalysts,
g.	stocks that are removed from an index, and
h.	other miscellaneous opportunities.

Below, there is a thorough discussion of each of these eight categories. The reasons why these stocks tend to be mispriced or undervalued are clearly explained.

B.I.1.a Ignored stocks

A popular pool top investors like to fish in is stocks that are ignored. These are stocks that people don’t talk about, that receive no attention in the media, and that analysts don’t cover. Due to widespread disinterest, such stocks tend to be mispriced. There is one caveat, though. The mispricing implies that ignored stocks are equally likely to be undervalued as overvalued. So, the investor has to tread carefully in this area.

To identify stocks that are ignored, one can look for obvious signs of disinterest, such as lack of analyst coverage²³ and low institutional ownership. In a more targeted search, one can start with companies in one of the four categories of ignored stocks described below, and look for confirmation of disinterest in the form of low analyst coverage and low institutional ownership.

1. Dull and unfashionable stocks

Many people believe that nice (or spectacular) gains can be made on glamour stocks. Dull and unfashionable companies, by contrast, elicit a deep yawn. So, the average investor looks for action in glamour stocks and gives boring businesses a miss. This bias creates an opportunity for smart investors. More specifically, five types of stocks that tend to offer opportunities as they are considered dull, woebegone or unfashionable are:

1.	Businesses with a lackluster or unpopular image: many investors do not pay attention to (and analysts seldom recommend) companies that have an image problem. Here are two types of such businesses:
	•	Companies operating in depressing, disgusting and disagreeable areas; examples of such businesses according to Peter Lynch and John Neff are:
		(i)	Companies in the burial business: the burial industry is considered depressing even though it hasn’t changed much for centuries, even though it has few new entrants (undertaker is not a popular profession), and even though customers are unlikely to bargain (out of respect for the deceased loved ones). Peter Lynch says in One Up on Wall Street that one of his favourite all-time stock picks was the burial service company Service Corporation International which gained about 1000% between 1980 and 1990.
		(ii)	Companies active in toxic waste and garbage are considered disgusting. When he managed the Magellan Fund, Peter Lynch bought, for instance, Waste Management, Inc., which went up a hundredfold.
		(iii)	Companies that make things out of disgusting raw materials; an example pointed out by Peter Lynch is the company Envirodyne, which bought a leading producer of intestinal byproducts in 1985. This company turned into a ten bagger within three years after this transaction.
	•	Socially irresponsible businesses: some institutional investors are prohibited to invest in (and many other investors don’t want to have a stake in) businesses that produce ‘unethical’ goods, such as weapons and cigarettes.
2.	Companies in low-growth industries: few people know that companies in shrinking or low-growth industries can be profitable investments. A study by Jeremy Siegel found that there is significant potential in unpopular low-growth industries. Indeed, many stocks in shrinking industries like energy and railroads have beaten the S&P 500 by a significant margin between 1957 and 2007.^24
3.	Companies with dull or ridiculous names: Peter Lynch admitted that whenever he came across a company with a dull or ridiculous name (e.g., Pep Boys), he took a closer look. What tends to make such stocks undervalued is not that it is smart for a company to have a ridiculous name – as a bad name is actually a sign of poor marketing – but the fact that most people (especially professional investors) do not want to be associated with companies that sound ridiculous.
4.	Boring and established businesses: for instance, Philip Carret liked waterworks and bridge construction businesses.
5.	Cheap stocks with relatively low expected growth: John Neff believes that companies with low growth expectations are systematically ignored by the market, even when their stock is really cheap. The best risk-return payoff in these types of stocks is often found in companies that combine the following characteristics:
	•	Moderate growth, where earnings are expected to grow about 7% a year in the next five years.
	•	Low valuations, where the PEG ratio of the company is lower than half the PEG ratio of the market.
	•	A nice dividend.
	•	A strong track record in growing quarterly earnings.

2. Companies with little or complex information

Most investors and professionals don’t bother examining companies that are hard to analyse or companies about which relatively little reliable information exists. Disinterest in such stocks tends to cause mispricing and extra effort to find hidden assets that are overlooked by those who don’t have the courage to dig deeper can be very rewarding. Top investors like Seth Klarman and John Templeton deliberately seek out such challenging issues.

For instance, in the 1960s investors tended to avoid Japan due to its opaque accounting rules. John Templeton saw in this a compelling opportunity for those (including himself) who took the trouble to understand the hidden assets and liabilities. Another excellent example is the investment of John Templeton in Teléfonos de Mexico in the mid-1980s, which is described in Investing the Templeton Way. Templeton was convinced the company’s numbers were unreliable so he undertook the heroic action to count the number of telephones in the country. By multiplying this number with the applicable rate, he found out that the market was vastly understating the value of the company.

3. Small companies

“It seems clear that there is a greater opportunity to find bargains (and overpriced stocks, for that matter) in the small-cap arena both because there are more stocks to choose from and because smaller stocks are more likely to be lightly analysed and, as a result, more likely to be mispriced.”

Joel Greenblatt (Greenblatt, 2006)

Some people argue that the universe of small caps is more appealing than the large cap space as small caps have more room for growth. For instance, small firms are less likely to have prod...