How to invest

Dreman’s main focus has been on finding and analyzing companies based on their low price relative to earnings, cash flow, book value or dividends.

David Dreman, well known for his book “Contrarian Investment Strategies” listed 41 contrarian investment rules.

I certainly do not agree with many of the rules but see for yourself, the full list of contrarian investment rules: part 1 | part 2

How to Find Contrarian Stocks

Market Cap Size – [PASS]

According to Dreman, investors should look at large caps rather than small caps because of the exposure and the interest generated on Wall Street.

Apple (AAPL) is the biggest tech company on the market and easily passes this test.

Earnings Trend – [PASS]

This criteria certainly is used by most gurus. The growth investing strategy applied to Apple, looked at earnings trends from various angles.

AAPL’s EPS the past two quarters has increased from $3.51 to $4.64.

Pass.

Past EPS Growth Rate and Estimated Growth Rate – [PASS]

AAPL’s past EPS growth rate over the last 6 months was about 39% which clearly beats the S&P growth rate of 18.5%.

Dreman takes it one step further to ensure that the company will continue to grow by looking at the estimated full year EPS growth. AAPL’s full year growth is expected to come in at 25%.

Again, AAPL is a pass based on positive earnings growth.

Price to Earnings (P/E) Ratio – [FAIL]

Dreman is very much a multiples valuation investor. He doesn’t perform many of today’s valuation methods and just sticks to companies selling at a cheap multiple.

The P/E of a company should be in the bottom 20% of the overall market.

AAPL has a P/E of 20.8 which is not in the bottom 20%. The lower 20% threshold P/E is 9.5 and so AAPL fails this test.

Price to Cash Flow (P/CF) Ratio – [FAIL]

The P/CF should be in the bottom 20% of the market.

AAPL’s P/CF is 19.2 which is above the lower 20% market threshold of 5.7

Fail.

Price to Book (P/B) Ratio – [FAIL]

The P/B should also be in the lower 20%.

AAPL P/B is 6 which is above the threshold level of 0.8

Price to Dividend (P/D) Ratio – [N/A]

AAPL does not pay a dividend so it automatically fails.

The P/D ratio should be in the bottom 20% of the market.

Since AAPL does not pass any of the ratio’s test, it cannot pass as a contrarian investment. The four ratio conditions determine whether a stock is either unloved or underfollowed. AAPL is neither.

Current Ratio – [PASS]

To identify strong companies, the current ratio should be greater than 2.

AAPL’s current ratio is 2.01 and just passes the test.

Payout Ratio – [N/A]

There is no dividend so AAPL gets a N/A here.

For other companies, the payout ratio is a good indicator to see whether the company has the ability to raise dividends.

Return on Equity – [PASS]

Dreman wants the company to have a high ROE as it ensures there are no structural flaws in the company. Instead of ROE, I prefer to use either ROIC or CROIC.

Nevertheless, ROE should be in the top 1/3 among the top 1500 large cap stocks which is 17.4%

AAPL ROE is 35.3% which is enormous hurdles over this criteria.

Yield - [FAIL]

Yield should also be above the market yield of 2.7% but since AAPL has no dividend, it is marked a fail.

Total Debt to Equity – [PASS]

Dreman wants to see companies with low debt. The lower, the stronger the balance sheet.

For a company the size of AAPL, it has no debt which is outstanding.

Contrarian Investment Result

Apple didn’t meet any of the important price ratios. It failed 3 out of 4 with the last criteria being an N/A.

Certainly doesn’t line up in the contrarian investment category but I have to admit that AAPL truly is an amazing company.

Disclosure

None

After Buffett and Graham, the third investor I read about early in my investing career was Peter Lynch, famous for his book “One Up On Wall Street“.

Peter Lynch definitely deserves a place in the Guru hall of fame with his averaged returns of 29% per year during the 13 years he ran the Fidelity Magellan Fund from 1977 to 1990.

Lynch is much more of a value investor than Martin Zweig or James O’Shaughnessy but still falls into the growth camp. He popularized the term GARP (Growth at A Reasonable Price) where the PEG ratio serves as the benchmark to determine whether a stock is undervalued.

5 Quick Tips from Peter Lynch

Although Peter Lynch looked for growth, his investing philosophy sounds a lot like Warren Buffett.

Here are some tips from Peter Lynch.

1. Know What You Own

IGOI and GEOY were prime examples of investing in what I saw and used in normal day to day life.

Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.

Never invest in any idea you can’t illustrate with a crayon.

2. Don’t Bother Trying to Predict the Markets

You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.

3. Behind Every Stock is  Company

I think you have to learn that there’s a company behind every stock, and that there’s only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.

Although it’s easy to forget sometimes, a share is not a lottery ticket… it’s part-ownership of a business.

4. Invest in Quality Companies

Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.

5. You Will Lose Money. Just Don’t be an Idiot.

There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or, worse, to buy more of it, when the fundamentals are deteriorating.

GARP Investment Strategy Checklist

Lynch lays out excellent stock selection criteria in his book “One Up On Wall Street“.

Let’s see whether DLB offers any value.

Company Classificiation

• Select one of the six classifications of the investment.

DLB is considered to be a fast grower.

PEG Ratio – [PASS]

• PE for DLB is 26.46 and growth rate is 31.55% based on the average of the 3,4 and 5 year historical growth rates.

PEG for DLB is 0.84 which is less than 1.

Sales and PE Ratio – [PASS]

• If sales is greater than $1 billion, the PE should be below 40 as large companies may not be able to support growth higher than a PE of 40.

DLB sales is just under $1 billion at $922.7M and the PE is 26.46.

EPS Growth Rate – [PASS]

• EPS growth range should be between 20% and 50%. Anything above 50% is unlikely to be sustainable.

EPS growth for DLB is 31.6% which satisfies the criteria.

Total Debt/Equity Ratio – [PASS]

• above 80% is considered high
• above 60% is mediocre and other statistics must be good
• below 50% is acceptable
• below 20% is great

DLB has ZERO debt. Superb.

FCF Yield – [NA]

This is a bonus and not a requirement.

• If the FCF yield (FCF/Price) is above 20% then it is a huge bonus and a sign that the company is very cheap.

DLB’s current FCF yield is 3.85% which isn’t that much greater than a risk free rate if you add the premium required for stocks.

Net Cash to Price Ratio – [NA]

Another bonus criteria.

• Net Cash = Cash and Marketable Securities – Long Term Debt

Net Cash/Price for DLB is 11.45% which is considered too low.

Dolby is Growth at A Reasonable Price

DLB is not cheap. It is reasonable. But if you consider the industry it is in and dive in to understand the business model, it is no wonder the company has been doing so well.

Disclosure

None

For value investing ideas, you just can’t beat Ben Graham. Benjamin Graham based value screens now make up 5 in my list of predefined value screens.

The two new Ben Graham screens are based on the stock selection criteria that we covered in detail and his famous stock valuation formula from “The Intelligent Investor” which I modified as below.

Screen 1: Graham Stock Checklist Screen

Out of the 10 original criteria, I found that the following 4 produced the best results.

• Criteria 1 out of 10: An earnings-to-price yield at least twice the AAA bond rate
• Criteria 2 out of 10: P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
• Criteria 6 out of 10: Total debt less than book value
• Criteria 7 out of 10: Current ratio great than 2

My thought process of how I came to my conclusions is in more detail in the linked articles.

I then created a test portfolio with the screen results. It’s too early to conclude anything, but so far, the stocks chosen by the screen is considerably outperforming the market.

Screen2: Graham Valuation Screen

I’m excited about this new screen.

You already know that Graham’s method of investing in discounted assets work. But there hasn’t been many discussions proving that the valuation equation actually works.

When tweaked the right way, it certainly does. Here’s the way I interpreted the equation into a screen.

First, the result from the many trials I performed.

Interesting how no stocks would have made the cut in 2001.

Now, how did I create this?

My Thought Process in Creating the Valuation Screen

Narrow Down Companies based on EPS

What I consider to be important when using EPS is to make sure that it is consistent and growing.

You do not want a company with EPS growth of 70%. It will be much too difficult to assess for a screener. Besides, everyone else is screening for huge growth.

The essence of value investing is finding a company at a cheap price. All the companies with huge growth rates are likely overvalued one way or another. What I did was search for, were companies that had temporary depressed EPS growth compared to the mean.

I did this by selecting companies where the 3 year EPS growth was less than the 10 year EPS growth rate. The 5 year and 1o year EPS also had to be positive.

Select EPS Value

Graham used the trailing twelve month (TTM) EPS but I believe I can do better.

There are plenty of sites that offer analyst EPS projections so I used the mean of these EPS estimates. My thought here is that if the current EPS growth rate is depressed but the projected EPS is set to be higher, then surely the passing companies should do better than most.

Specifying the Intrinsic Value Range

I used two versions of the Graham formula

[EPS x (7.5 + 1.5G) x 4.4]/Y and [EPS x (8.5 + 2G) x 4.4]/Y

The formula using 7.5 is considered to be the intrinsic value at the lower end of the range and the 8.5 equation as the upper range value.

Then, simply select all the companies trading with a 33% margin of safety to the lower intrinsic value.

Running the screen, the following list of stocks show up.

While not all the results are accurate, it’s a good start. Definitely lots of potential here.

Don’t forget to view the rest of the value screens.

Disclosure

None

A big part of my investing involves number crunching. Basically I’m very much a quantitative guy.

Meaning, I like to create various types of strategies based on historical numbers and spend a lot of time thinking how I can improve and test it.

It’s why I created the list of value screens and why I’m always in search of new and better ideas.

Of course, once I’ve narrowed down my ideas to a few stocks, I spend time to study and understand the company.

But, there are many investors called mechanical investors, who buy without performing any in depth research.

And many have had plenty of success.

Joel Greenblatt is the best example with his introduction to the Magic Formula investing approach. Another guru investor that I am introducing today is James O’Shaughnessy of O’Shaugnessy Asset Management.

Quant Investor James O’Shaughnessy

According to O’Shaughnessy’s background, he grew up listening to his father and uncle argue about their portfolio holdings. The arguments were heated and passionate which O’Shaughnessy enjoyed, but he also began to think that there must be a way to invest without the heated arguments and emotions.

That day came when he was granted access to Standard & Poor’s 45 years worth of stock information. He tested, tested and tested a truckload of strategies, screens and methodologies.

A surprise result from one of his tests was that, PE ratios wasn’t the best method to value a stock and that small cap stocks as a group didn’t offer an edge over large cap stocks.

Mechanical Investor James O’Shaughnessy

O’Shaughnessy is purely a quantitative approach investor.

That is, once he has narrowed a list of stocks, he will buy a bunch of 20-50 stocks by sticking to the numbers.

His books “What Works on Wall Street” and “How to Retire Rich” detail the investment strategy of growth and value.

O’Shaughnessy’s defines growth and value by the typical Wall Street standard.

Depending on the P/E, P/S or P/B of the stock, it will be considered either growth or value. But because I disagree with his definitions, I’ll label O’Shaughnessy as a mechanical investor, instead of a growth/value guy as he simply buys the top 25-50 stocks based on a certain strategy and then re-balances the portfolio every year.

The following is an investment checklist of O’Shaughnessy’s strategy for growth and value.

Cornerstone Growth & Value Strategy

With NFLX unstoppable lately, it will be a good example to use.

1. Market Cap shall be Greater than $150 million [Pass]

• $150 million market cap is the cut off point

The $150 million mark is required to eliminate illiquid stocks but at the same time allow for a small growth company.

Market cap is now $9 billion which satisfies this criteria.

2. EPS Persistence [Pass]

• Earnings per share must increase each year over the last 5 year period

NFLX is scorching hot. EPS has been $0.64, $0.71, $0.97, $1.32 and $1.98 over the past 5 years. Passes this test.

3. Price to Sales ratio

• Price/Sales ratio should be below 1.5

This is more of a “value” criteria. But when used in conjunction with EPS growth numbers, it can identify growth stocks that are still cheap to buy.

NFLX has a TTM (Trailing Twelve Month) price to sales ratio of 4.55, which is way above the required 1.5.

Too late to be buying NFLX.

4. Relative Strength [Fail]

• Relative Strength Index (RSI) should be among the top 50 of the stocks screened

A technical analysis term for momentum. It measures the speed and change of price movement. RSI is considered overbought when above 70 and oversold when below 30.

NFLX has a RSI of 97. From a momentum and technical analysis view, the stock is overbought.

5. Dividend Yield [Fail]

• Select the company with the highest dividend yield

O’Shaughnessy’s studies showed that  the best performing shares in the three year period after substantial market declines are high dividend paying stocks.

NFLX has no dividend yield and therefore fails the test. Since it has already failed two cases, NFLX would be discarded.

6. Shares Outstanding [??]

• Shares outstanding should be greater than the market average

This condition is harder to figure out because statistical data of the entire market is required.

7. Trailing 12 Month Sales [??]

• TTM sales should be 1.5 times greater than the mean of the market’s TTM sales.

Another condition that is difficult to screen and test without detailed statistical data of the market.

The Good and Bad of Mechanical Investing

As you can see from the investment checklist above, there is nothing difficult at all (except no. 6 & 7 due to the lack of data).

Mechanical investing has its advantages..

• No emotions involved
• Easy to keep track of
• Easy to buy and sell
• Can quickly filter a big list of stocks down to 50

and disadvantages..

• You don’t know what you are buying
• Lots of commission and fees involved
• There isn’t much of a way to improve. It’s either a hit or miss and you give up.
• Requires sticking to the strategy all the time

I am actually testing my own OSV mechanical portfolio at the moment. Up about 27% YTD. Ironic how it is killing my actual real portfolio performance.

Disclosure

None

You may already know Validea, but I recently saw their guru analysis and found it intriguing.

I’ve always been a fan of new stock valuation methods, checklists or strategies. The Guru checklists they offer is just my style when it comes to learning new analysis methods and seeing the framework of famous investors thought and analysis process.

But I figured that you don’t have to pay for something so simple because I can replicate the same checklist with the free stock evaluation spreadsheets or the premium stock valuation tool.

The prominent theme on Old School Value for a while will be looking into these strategies and checklists of guru’s. That way you can get an idea of what the pros looked at and decide whether it is worth implementing into your own investment checklist and strategy.

Guru Growth Investor – Martin Zweig

Value vs growth.

Most of the stuff you read from me is based on value investing. Pure growth stocks is something that I haven’t dabbled into.

To me value is buying something deep in the sale box for 50c and then selling it for $1. It may take a while and sometimes I end up with a dud, but in the end, there is usually a buyer.

Growth on the other hand is like buying the iPhone4 the day it comes out and then selling it to the person at the end of the line for twice the amount. This too usually has a buyer on the other end.

Either can work, but it is a matter of personality and preference.

Martin Zweig was a growth money manager back in the 1990’s as well as an investment newsletter writer. For Zweig, his growth strategy worked and his clients benefited. He was named stock picker of the year 2 times in a row and wrote a book titled “Winning on Wall Street”, which outlines his investing strategy.

Zweig’s basic investing strategy is to be fully invested in the market when market indications are positive (bullish) and to sell when the indications become negative (bearish). He places heavy emphasis on risk minimization and limiting losses.

The fact that he was able to generate returns of 16% per annum compounded return between 1980 and 1995 is impressive in itself.

Zweig focused on growth stocks, market timing and technical analysis, but what is it that made him so good? You may not agree with his style, but the numbers don’t lie.

I won’t be getting into his theories on market timing and technical analysis. Way too complicated for me.

If you already read the book or know that “the trend is your friend”, you don’t need an introduction at all. For other people like myself, might as well try and discover something to apply.

Martin Zweig’s Growth Investing Checklist and Framework

Martin Zweig’s religious focus was to check earnings consistency, trend and acceleration. The following points help to view the stock from different angles.

1. P/E Ratio [Pass]

“The data going all the way back to the 1930s show conclusively that stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the longer term”. – Martin Zweig

• Must be greater than 5
• Cannot be more than 3 times the current market P/E
• Never greater than 43

AAPL has a trailing 12 month P/E of 21. The current market P/E is roughly 17 so the first test is a pass.

2. Earnings Trend [Pass]

“If a company can show nice consistent earnings, I don’t care if it makes broomsticks or computer parts.” – Martin Zweig

• Revenue growth cannot be significantly less than earnings growth
• Revenue growth should not be due to cost cutting or something non sales related

AAPL’s revenue growth from 2009 to 2010 is 52%. Earnings growth rate is 67%.

The past 5 year revenue growth is 36.5% compared to a 5 year EPS growth of 58%.

The 5 year revenue growth is much lower than the EPS growth, but seeing as how the latest full year revenue growth rate exceeds the 5 year average, this criteria becomes a pass.

3. Quarterly Revenue Growth Rate [Pass]

• Quarterly revenue growth must be greater than the previous quarterly growth
• Growth rate between current quarter EPS to the same quarter a year ago must be positive

The EPS growth for AAPL between this quarter and last year’s quarter comes out to be 66.7%.

4. Current Quarter EPS [Pass]

• EPS must be positive

Current diluted EPS of $4.64 is positive which passes this test.

5. Quarterly EPS from Last Year [Pass]

• Quarter EPS from the same period last year must be positive

AAPL had an EPS of $2.77 the same period last year.

6. EPS Growth from 3 Quarters Compared to Past 3 Quarters [Pass]

• Growth rate of the latest 3 quarters compared to the same 3 quarterly period in the previous year

Growth from the last 3 quarter was an astonishing 67.5% compared to last years same 3 quarterly period EPS growth of 66.8%

7. EPS Growth Over Past 5 Years [Pass]

• EPS should increase easy year for the past 5 years

Over the past 5 years the EPS has been 2.27, 3.93, 6.78, 9.08 and 15.15. Easily passes this criteria.

8. Long Term EPS Growth [Pass]

• EPS growth over 5 years should be greater than 15%

With EPS growth at 57% over a 5 year period, AAPL clearly passes this test.

The Perfect Stock for Martin Zweig and Growth Stock Investors

As you can see from the items above, Zweig puts most of his focus on earnings. As a value investor, earnings doesn’t play that much of an important role but since EPS is what Wall Street looks at, it can’t be completely ignored.

AAPL passes all of the tests hands down.

No doubt that Martin Zweig would have owned AAPL if he was still managing money.

Which Feature do you Want?

On a side note, you can now vote for which feature you want implemented into the stock valuation calculators.

Make your vote count in the suggestions section.

Disclosure

None

Following on from the discussion of my first investing checklist, it’s time to reveal my new investment checklist.

Rather than a checklist of yes/no answers, the new checklist focuses on sets of core to do tasks with the real checklist being only a handful of questions in the “Final Evaluation” section.

I’ve also made it visual so that it makes it quicker and easier to follow. Rather than having a checklist of 100 items thrown at you, having a flow chart will make it easier to manage and keep track of what stage of the investing process you are on.

Investment Checklist Flowchart

Old School Value Investment Checklist Process

Core Investment Checklist

Here is the text version.

Do the Pre Work

Preliminary Background Reading

• Read previous thesis on Blogs / Investing Sites / Forums / Alerts
• Read news headlines

Valuation

Financial Statement Analysis

• Go through line by line
  • Income statement + competitive advantage analysis
  • Balance sheet + competitive advantage analysis
  • Cash Flow statement + competitive advantage analysis
  • Quality of Earnings (Inventory, tax, EPS)
• Competitor comparison
• Verify 15 value investing metrics and ratios
• Discounted Cash Flow/ Graham’s Value/ Earnings Power Value/ Multiples/ Sum of Parts

Dirty Work

• 2 annual reports
• 3 quarterly reports
  • specific attention to footnotes at the end of the report
  • managers discussion – consistency, candidness
• 2 letter to shareholders
  • compare words, numbers to annual report numbers
• Latest proxy
  • CEO compensation (% of sales)
  • Greed factor (bonuses, reimbursements, planes, boats, family donations)
  • Insider ownership
• Search CEO history, track record, personality

Emotional Check

• Write down how you are feeling
• Beware of
  • wanting to just buy and study later
  • hindsight bias
  • overconfidence
  • obligation to buy due to amount of research
  • reluctance to accept differing opinions
  • social proof bias
• If required, take a break and clear your mind. Get away from the excitement and  noise.

Final Evaluation (the only checklist you need at this point)

• What can go wrong?
• What are the risks? How likely are the risks?
• How can you lose money?
• How would you categorise this investment?
• How attractive is this idea compared to the other holdings? (There can only be ONE best idea. Not 2 or 3.)
• What is the expected holding time frame?
• What should be the portfolio sizing?
• What price will you sell?