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Monday, July 10, 2006

value redux

In addition to my life long obsession with the 3 b’s(books, broads and booze),I am also hopelessly addicted to the value line research service and am constantly looking for ways to use the vast amounts of information provided to improve my investing and even trading results. Take away my quote machine and computer but hands off the value line. I t is, hands down, the finest research service available to investors.

Whilst wiling away the hours on the beach last week, enjoying the sun, surf, sand and bevy of barely dressed shapely adorables parading at lands edge, I spent a lot of time reviewing approaches and methods of investing, always looking for the edge that provides superior returns. I developed several ideas that were scribbled on post its and bought home to test out. As I am always surprised when my tiny brain produces something that works, I was gratified to find that several methods appear to over results superior to the mkt as a whole. I share them now in hopes of ideas, comments and criticism.

First is a classic value+yield approach that has been talked up by authors such as O Higgins, shaugnessy and even our own senator. Looking from 1986 though the end of 2004, I screened for stocks that have a return on total capital of at least 8%, A dividend yield of at least 3% and a price to book value of less than two.In addition to avoid deeply troubled companies we only selected stocks ranked 1,2 or 3 from the VL service in hopes of avoiding the dividend slashing book writing off disasters frequently found among 4 and 5 ranked stocks. It finds solid stocks, earning decent returns and paying out cash to shareholders that have not made huge runs in price. Simple conservative stuff, and it delivers simple conservative returns that do in fact beat the market average of 16% a year over the 18-year period versus the markets 12. More importantly it only has 2 losing years in 18, with the max year over year loss being just 8% along with fairly shallow drawdowns intra-year. By the way, I rebalanced once a quarter in all the tests.

In the second test I look at a classic value screen stocks selling below book value. One of the biggest problems with stocks that sell below book is that many of them are deeply flawed, unprofitable companies with no hope of recovery. To try and eliminate some of this, I added the criteria of selecting only those companies who earned at least 8% on net worth. Again we find market beating returns of 17% a year over 18 years to the markets 12.Deeper draw downs and more overall losing years here, so dropping the dividend requirement and buying deeper asset discounts hardly seems worth the extra percentage point.

Next, for comparative purpose I wanted to look at “growth” stocks, a bit far afield from my usual value bent. But first to decide on a true definition of growth. I wanted to avoid the pure momentum stocks that are so often confused with growth stocks.I also felt that stocks with managed earning ala the west Virginians company or the enron types. I looked for companies where not only were reported earnings growing rapidly..At least 20% annually over the past 5 years, but the earnings were reinvested in the enterprise successfully producing book value growth of at least the same over the time frame. To my mind this showed that not only was the business growing but also profits were being used to improve the corporation and were “real”, not just accounting mirages or temporary. To further insure that these were true growth stocks, only those ranked 1 or better by the value line service were included. And the results are..Drum roll please…it smokes almost everything else I ve ever looked at. 21% compounded over 18 years versus the markets 12. For comparison the entire list of 1 ranked stocks averaged 17..Not bad but 20% less than those who grew their company as fast as their earnings? This strategy beats the market in 15 of the last 18 years. As a value guy I checked to see if screening further by pe ratio helped improve returns, In fact, it degraded them horrible if you put an upper pe limit on the list.

There it is. MELVIN SAYS GROWTH BEATS VALUE. This akin to Darwin cavorting with adam and eve, abelson being bullish, taleb selling premium,buffet finally confesses to being a short term trader.

Uh..not quite. Performing even better than that were stocks that met multiple criteria. Less than 1.5 times book, pe less than 12,debt less than 50% of capital, earnings over past 5 years of at least 5% and projected earnings growth of at least 5%. What we are looking for here are sound companies, good solid balance sheets, growing at some rate equal to or better than the underlying economy. We pick up two types of companies for the most part. Sound business hit by what the chair calls a one-off event, earning miss etc that have plunged, or super cyclicals entering the rapid growth phase that causes pes to contract. This year for instance it would have had you long homebuilders and energy companies for the most part.

REWRITE: MELVIN SAY THERE IS NO DIFFERENCE BETWEEN GROWTH AND VALUE. In the end there is only growth, growth bought at a low right price and momentum.

The only better performing screen was one I have talked about at length in years past. Value Line 1 and 2 ranked stocks priced below 10. This thing rocks. It is the rocket ship of investing strategies producing an eye popping 25% annualized. HOWEVER, it has draw downs and loss years that might make the baseball maven or the late lamented mr e have sleepless nights.40 and 50% drawdowns are not only not unusual..They are the norm. This screen catches small cap stocks that value line has affirmed are starting to turn the corner. They are mostly unprofitable and are considered turnarounds. Removing loss companies from the list reduces returns to market level without decreasing risk in any measurable manner. If one forms a strong opinion that small cap growth is about to rebound however, this list of stocks explodes into the stratosphere and has several 80% plus years in the past 18.

I view screens such as this as a starting point and have never been able to just buy the list blindly, preferring as chris browne of tweedy browne once said, act like an insurance company..underwrite by the numbers(run the screen) and then investigate(look for insider activity,read the reports).However, if one could develop reasonably reliable market entry and exit strategies for,growth,yield and small cap, they can be a powerful starting place.