Market darling vs. ugly ducklings

skc said:

I can't really tell which line is which in your second chart.

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That's kind of the point. They cross all the time meaning that over time horizons that would matter to you, choosing good stocks matters more than choosing those that reside within high or low price multiple classifications.

skc said:

I guess part of this exercise was to force a learning on myself that I don't need to look for low PE stocks alone for investment. I am always too quick to dismiss stocks which I deem "high PE, much growth priced in". I wanted to select some stocks that appear "expensive" but still "undervalued". Be contrarian to the contrarian, if that makes any sense.

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Hopefully the data helps you with that sense. You don't have to trawl within low price multiple to find good opportunities. There is a statistical edge. But that edge is very small on a case by case basis. If you've got a better idea than about 52/48 for a given stock, that idea overcomes the edge we are talking about. Perhaps that will aid with your conviction to pursue the direction you want to head into.

Some argue that the market is too wide to cover well. I don't know. You seem to do it just fine. Some also argue that low price multiple stocks tend to require a different kind of analytical/investment skillset than their mirror. If you think that, then perhaps there is a preferred habitat. It just doesn't have to be in low price multiple. But, then again, you pair trade and are possibly active at both ends given the strategy anyway.

skc said:

I know that it isn't going to prove anything statistically.

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skc said:

Thanks KTP. Great amazing effort as always. You've gone through much more than I can hope to do in this thread.

I am very glad that the thread has generated much knoweldgeable discussion. However, I am going to abandon the original idea of the thread... which is simply interesting but not worthy of the time committment required.

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Thanks skc.


I have another idea then.

Here are the bottom 50 stocks sorted by PE out of my universe (which has most ASX revenue making stocks). I've only included stocks with market cap over $20m.

ALL, QBE, EGG, VTG, LTN, SHR, SGM, KRS, IMD, SDM,
AAC, CND, EML, RQL, PBD, ECV, API, VAH, CKL, GXL,
GFF, ASL, EGN, GLB, SXL, BBG, DVN, HLO, AAX, MCP,
CRH, FUN, BOL, EHL, BLY, ARI, MLB, SBB, NWH, RMD,
MLD, MAH, WDS, VET, UOS, DCG, BYL, TSM, UGL, CTN

Could everyone have a go at selecting 20 stocks out of it. The purpose of the exercise is to see whether human judgement (smart Beta as RY put it), can beat automatic selection by tilting it in a more profitable direction.

By default, bottom 20 stocks will be selected, as the benchmark. Everyone can then fine-tune their portfolio by removing/adding any stocks out of the 50 in the list.

I am happy to keep track of it, and report progress periodically. Entries close this week.

My entry will be the default bottom 20. Noone else can select that. My game, my rules.

All participants promise to buy me a beer in the future for the effort.

Who's in?

skc said:

I guess part of this exercise was to force a learning on myself that I don't need to look for low PE stocks alone for investment. I am always too quick to dismiss stocks which I deem "high PE, much growth priced in". I wanted to select some stocks that appear "expensive" but still "undervalued". Be contrarian to the contrarian, if that makes any sense.

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http://www.amazon.com/gp/aw/d/1614272387/ref=redir_mdp_mobile/190-9620163-4504713

You have probably read the above book but there is a really great chapter in this book which talks about PE ratios, Philip's advice is do not focus on them, as they do not aid the speculator, instead focus on the business trends and industry trends. According to Philip there are four types of stocks:

1. Stocks trading at low yields that are cash generating businesses with increasing sales in a great industry.
2. Stocks trading at high yields due to the business/industry having an uncertain future.
3. Stocks of a business that are returning to normal earning power.
4. Stocks of a business that is failing and will hopefully liquidate.

Money is made on 1. and 3. the rest are more likely to lose you money. Wise words.

Why not buy a basket of market darlings and basket of stocks that are returning to normal earning power (i.e.no current PE but earning history)?

I like these threads, should have trained to be a quant.

Cheers.

I only recognise about 20 of them: QBE, EGG, VTG, SGM, ECV, API, CKL, GFF, SXL, HLO, MCP, CRH, FUN, BOL, MLB, SBB, RMD, VET, UOS, UGL

Ugly Duckling Screen (PE < 15, SP > -30%). Picked 10 of the most interesting to me:

SUL, TRS, VET, STO, UGL, MRM, CUP, EAX, HIL, MWR

Intuitively I find it hard to believe all 10 suddenly turned to rubbish.

skc said:

In this thread I want to just forward test a simple theory...

On the market there are expensive stocks and there are cheap stocks. "Expensive" stocks enjoy high PE multiple, high growth expectations and lower dividends. Conversely, "cheap" stocks generally have lower PE multiple, low or negative growth expectations and (potentially) higher historical dividends.

Many investors are wired to look for cheap stocks, hoping for a rise in value. But I wonder if a basket of expensive stocks would indeed outperform a basket of cheap stocks over a 2-5 year timeframe. If it does, it means that the market actually priced the stocks correctly (i.e. stocks were expensive or cheap for a reason).

So I have picked 20 stocks that appeared expensive and 20 stocks that appeared cheap... it's nothing more than a superficial scan of PE and my shallow understanding of the stock. I will try to include some deliberated diversification amongst different sectors. I will also avoided resources, as changes in commodity price would over-ride any meaningful findings from this exercise.

I will put up the 2 lists tomorrow... but in the mean time if you like to nominate some stocks for either list, please feel free to contribute (I don't guarantee it will be included).

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A couple of thoughts.

To determine cheap or expensive you really need to consider what returns a company can make over its cost of capital (excess return), how sustainable that excess return is and how much capital (growth) can be applied at the excess rate. When the valuation drivers are considered correctly there are cheap stocks on high PE’s and expensive stocks on Low PE’s etc.

The only way I know of determining valuation on fundamental grounds is via its internal cash generation potential. For example I only think something is cheap if its discounted estimated future cash flows are more then I can buy it for. BUT for this definition of value, placing a timeframe for the market to recognise the cheapness introduces a problem, knowing when or if the market will recognise the cheapness is not part of the valuation analysis – The market may never give you a chance to commute the cash flow and you will just have to rely on a very long term cash generation from the business to realise the required return.

So I question the validity of the valuation metric and the time frame. But valuation metrics like Low P/E, P/B or P/R have shown some outperformance pretty consistently in the studies over set time periods. Probably because the most hated stocks and the most loved stocks are both overdone, and make a big enough impact on those fairly arbitrary valuation measures.

Unless you are running a quant fund it’s not worth chasing the outperformance because you simply have to diversify too much to get the results.

Should the concept influence your thinking? Not anywhere near as much as understanding the drivers of growth or how the market reacts to news if your profit generation is reliant on a sell transaction at some future date.

Can human judgement improve the quant approach as per KTP’s theory? Yes and no. If you can nail the valuation drivers you’ll probably never look at the arbitrary valuation measures again and won’t walk this quant path. But if you do go the quant path, don't meddle with the proven results or you risk not getting the system identified advantage you are chasing.

I see these fundamental ratio systems no different to a price based systems except they lack the time effectiveness of information and means for risk control which price based systems have and hence require large diversification (ie hold All the percentile) to ensure you extract the advantage.

Ps KTP not sure about some of those stocks being low P/E. Just at a quick glance ALL,AAC,GXL,RMD,MLB,TSM all may be data issues or major business changes.

Take a bow. Welcome back, Craft. Missed you.

craft said:

So I question the validity of the valuation metric and the time frame. But valuation metrics like Low P/E, P/B or P/R have shown some outperformance pretty consistently in the studies over set time periods. Probably because the most hated stocks and the most loved stocks are both overdone, and make a big enough impact on those fairly arbitrary valuation measures.

Unless you are running a quant fund it’s not worth chasing the outperformance because you simply have to diversify too much to get the results.

Should the concept influence your thinking? Not anywhere near as much as understanding the drivers of growth or how the market reacts to news if your profit generation is reliant on a sell transaction at some future date.

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I use 2 process to search for investment opportunities.
1. I read company announcements or other 3rd party sources talking about the company, and I investigate.
2. I run a market scan of low P/E, P/B, EPS growth etc and investigate those that meed the quantitative filters. I do that because of the commonly-accepted truism that "cheap" stocks outperform over time.

What that means is that I can easily miss out on many quality investments that are priced high as indicated by the quantitative filters. I suppose the simple answer is to adjust the filters so it doesn't exclude those "expensive" but undervalued companies.

craft said:

Ps KTP not sure about some of those stocks being low P/E. Just at a quick glance ALL,AAC,GXL,RMD,MLB,TSM all may be data issues or major business changes.

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That's why I tend to take a grain of salt on the academic papers. It's difficult to clean up fundamental data across different companies by the best analysts. I doubt they are done well (if at all) by the researchers and I don't know how they would affect research outcomes.

craft said:

A couple of thoughts.

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Yay! Craft is back.

craft said:

So I question the validity of the valuation metric and the time frame. But valuation metrics like Low P/E, P/B or P/R have shown some outperformance pretty consistently in the studies over set time periods. Probably because the most hated stocks and the most loved stocks are both overdone, and make a big enough impact on those fairly arbitrary valuation measures.

Unless you are running a quant fund it’s not worth chasing the outperformance because you simply have to diversify too much to get the results.

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PE, PB and PR are the most known and test strategies. Their effectiveness has been greatly reduced over time due to this. There are others that work better, although the problem remains the same for all of them. Effectiveness reduces over time as others catch on. Still, a quant would expect to perform better than a simple PE filter by finding other holes in the market.

craft said:

Should the concept influence your thinking? Not anywhere near as much as understanding the drivers of growth or how the market reacts to news if your profit generation is reliant on a sell transaction at some future date.

Can human judgement improve the quant approach as per KTP’s theory? Yes and no. If you can nail the valuation drivers you’ll probably never look at the arbitrary valuation measures again and won’t walk this quant path. But if you do go the quant path, don't meddle with the proven results or you risk not getting the system identified advantage you are chasing.

I see these fundamental ratio systems no different to a price based systems except they lack the time effectiveness of information and means for risk control which price based systems have and hence require large diversification (ie hold All the percentile) to ensure you extract the advantage.

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I agree it is not the best approach. By in the absence of enough skill, I think it is a safe approach that has a good chance of generating a return above an index.

craft said:

Ps KTP not sure about some of those stocks being low P/E. Just at a quick glance ALL,AAC,GXL,RMD,MLB,TSM all may be data issues or major business changes.

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Excellent point. Most of the research wouldn't have filtered these anomalies out properly. But, the outperformance of those strategies is shown despite having these kind of stocks in.

It seems that a simple way to improve an automated system is to remove these exceptions manually. Surprisingly, it doesn't necessarily improve the result.

Similar to adjuvants in vaccines. Taking them out reduces the effectiveness, even though there's no reason for them to be there. Here's a good quote about it:

“Adjuvants have been whimsically called the dirty little secret of vaccines [4] in the scientific community. This dates from the early days of commercial vaccine manufacture, when significant variations in the effectiveness of different batches of the same vaccine were observed, correctly assumed to be due to contamination of the reaction vessels. However, it was soon found that more scrupulous attention to cleanliness actually seemed to reduce the effectiveness of the vaccines, and that the contaminants – “dirt” – actually enhanced the immune respnse.”

skc said:

I use 2 process to search for investment opportunities.
1. I read company announcements or other 3rd party sources talking about the company, and I investigate.
2. I run a market scan of low P/E, P/B, EPS growth etc and investigate those that meed the quantitative filters. I do that because of the commonly-accepted truism that "cheap" stocks outperform over time.

What that means is that I can easily miss out on many quality investments that are priced high as indicated by the quantitative filters. I suppose the simple answer is to adjust the filters so it doesn't exclude those "expensive" but undervalued companies.

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Here’s some irony for you.

I scratch and fart around with all different sorts of scans and sources for putting new ideas across my radar but I consider the ultimate scan for value to be Significant New Highs. It might sound contradictory for a value investor and sure it throws up a heap of expensive stuff as well, but it’s a failsafe that anything I should be looking at now can’t get past and has probably been the first identification on many of my more successful valuation oriented purchases.

The trick though with a new highs scan is that it identifies both diamonds and coal as carbon – you have to be able to distinguish between the two with some other process/judgement.

craft said:

Significant New Highs

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It is very real. You are profiting from others cutting their winners too early (and keeping their losers too long).

craft said:

Here’s some irony for you.

I scratch and fart around with all different sorts of scans and sources for putting new ideas across my radar but I consider the ultimate scan for value to be Significant New Highs. It might sound contradictory for a value investor and sure it throws up a heap of expensive stuff as well, but it’s a failsafe that anything I should be looking at now can’t get past and has probably been the first identification on many of my more successful valuation oriented purchases.

The trick though with a new highs scan is that it identifies both diamonds and coal as carbon – you have to be able to distinguish between the two with some other process/judgement.

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Just wanted to say thanks craft - your posts are very thought provoking as always.

A screen (or call it coattailing) I like to use is to follow releases / letters / substantial shareholder notices from fund managers or others I respect and cherry-pick their ideas, especially if they have not performed yet as thought. The difficulty then of course is being able to stand back and evaluate the business in your own right without being influenced by their thoughts (ie beware of social proof).