The Problem with Mechanical Investment Strategies and How You Can Find Your Own Ideas


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Written by

Jae Jun

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What You’ll Learn

  • Why I’m chicken to take a 100% mechanical approach
  • The problems encountered with mechanical strategies
  • How Edward Life Sciences (EW) is a prime example of an issue with mechanical investing
  • How to find and be flowing with stock ideas

Mechanical investment strategies are becoming more popular because

  • it’s an unemotional approach
  • it’s easy to follow
  • it’s backtested
  • the profits look wonderful for the amount of work you put in

I’m still a control freak when it comes to my portfolio because ultimately I’m the one responsible for losing it or making it grow.

My very first lesson of a 100% loss on a high fee variable life insurance, was a real life example of how I’m the one that cares the most about my portfolio.

Despite all the research and the books out there on mechanical value investing and the backtested data that show it works, I still can’t bring myself to invest my entire portfolio in that way.

When buying a basket of stocks by following a set of rules, there are big winners from stocks I would never buy.

And there are big losses from stocks I would possible buy.

The problem is that the range is very wide and the true secret to a mechanical strategy is to stick it out for at least 3-4 years no matter what.

It’s not about the stocks with this type of investing.

You may have to buy the worst stock ever in your eyes, but it goes up 500% in one year.

You also don’t sell based on valuation.

It’s all about the discipline to trust the research and backtest. Buy when the rule says. Sell when the rule says.

But that’s my weakness.

If something shoots up 300%, and is above my valuation, then it’s time to sell.

Edward Lifesciences (EW) Shows Why I Don’t Fully Trust Mechanical Strategies

After some rummaging around, I find Edward Lifesciences in a screen and the numbers are fantastic.

Here’s what I’m seeing.

  • Strong margins
  • revenues have gone up every year. No down year.
  • Slight increase in R&D expense compared to 10 years ago
  • some recent acquisition or something because the last year operating margin is 50% compared to the prior year of 25%.
  • decrease in shares outstanding
  • healthy balance sheet
  • lots of cash
  • goodwill and intangibles hasn’t increased much
  • no short term debt
  • increase in long term debt (expected)
  • FCF machine. 10+ years of positive FCF

Here’s my very first quick valuation. A very nice looking graph for a solid business. The type of graph I want to see for stocks I’m interested in buying.

EW DCF Looks Great!

EW DCF Looks Great!

Check these numbers out from the Ratios section of the OSV stock analyzer.

EW-amazing-ratios

Amazing improvements… or is it?

So how did Edward Lifesciences make such a huge jump to elite operational status?

It’s due to a one time payment of $750m from Medtronic (MDT) to settle intellectual infringement along with ongoing royalties until April 2022.

When you include all the extra, it comes out to a value over $1b.

EW-MDT-settlement

In May 2014, the Company entered into an agreement with Medtronic, Inc. and its affiliates (“Medtronic”) to settle all outstanding patent litigation between the companies, including all cases related to transcatheter heart valves. Pursuant to the agreement, all pending cases or appeals in courts and patent offices worldwide have been dismissed, and the parties will not litigate patent disputes with each other in the field of transcatheter valves for the eight-year term of the agreement. Under the terms of a patent cross-license that is part of the agreement, Medtronic made a one-time, upfront payment to the Company in the amount of $750.0 million. In addition, Medtronic will pay the Company quarterly license royalty payments through April 2022. For sales in the United States, the royalty payments will be based on a percentage of Medtronic’s sales of transcatheter aortic valves, subject to a minimum annual payment of $40.0 million and a maximum annual payment of $60.0 million. A separate royalty payment will be calculated based on sales of Medtronic transcatheter aortic valves manufactured in the United States but sold elsewhere.

The deal is awesome for Edward Lifesciences, but far from what I imagined by looking at the numbers.

So the EPS of $7.48 in 2014 compared to $3.42 in 2013 is due to a one time non recurring income.

One of the keys to determining quality of earnings is to verify that it’s not made up of non recurring income.

As you can see, screeners and mechanical approaches will show EW as a buy, but a quick look to see whether the actual operations match the numbers shows a false signal.

Also, this example shows how investing has two parts.

The numbers side and the research side.

They both have to check out. I certainly got excited because I thought I had found a gem.

Next time though.

Finding Stock Ideas in this Market

It’s tough to say whether the market is expensive or not. I read this article by the Brooklyn Investor the other day about market valuations.

Here’s what grabbed me.

So, Buffett’s response (at the 2015 annual meeting) to questions regarding the valuation of the stock market was interesting.  He used to just say it’s in a “zone of reasonableness”, but this time said that if interest rates stay at current low levels, the stock market is cheap, and if interest rates normalize, it is expensive. Well, he has been saying for a while that stocks are better than bonds.

Coming from where we’ve been over the past decade, it’s easy to think that the market is expensive based on an absolute measurement.

You saw the lows of the 2008 crash so right now, everything feels and looks expensive.

But is it?

Hard to say.

There’s a lot of context that needs to go into market valuations so before where I was thinking the market was too expensive, I’m now thinking compared to what? And what is market valuation reliant on?

I don’t have the answer here but I’m in no hurry to be fully invested.

If Wholefoods (WFM), Amerco (UHAL) or Apple (AAPL) fall lower, then I’ll be adding.

In the meantime, I’m following my process of monitoring sites and resources I follow and loading stocks into my investment analyzer to see what comes up.

Finding stocks is a lot like looking for a job.

The fantasy is that a killer stock will fall into your lap and all you have to do it click the buy button.

Just like how many people think they can mass send a generic resume to list of employers and believe one of them has to hit.

Couldn’t be further from the truth.

Finding stocks requires a lot of manual work and flow of ideas. If you’re not used to searching for stocks, it’s excruciating difficult.

But it’s very easy.

  • Start with a product
  • Look up who makes it
  • Look up competitors
  • Look up competitors of competitors
  • Look up competitor lists on Google or Yahoo
  • Load all these stocks into some calculator to filter the list down even more

This way, you’ll end up with 10-20 stocks easily and then it’s time for deeper research.

Stock analysis is just like this funnel.

funnel

 

It’s just the top part of the funnel that is frustrating when you don’t know where to look.

I’ve already organized a list of places to get ideas for you which is what I personally refer to.

It’s enough to keep me busy for a whole year.

Another way you can get stock ideas is from something like this iphone app.

(Disclosure: a personal friend made this app, but it’s an awesome way to get ideas flowing)

The app provides an amazing way of showing you what is around you. It’s a Peter Lynch way of finding stock ideas. You can also take photos of an object and it will find which company or competitor makes the product.

So that opens up a whole new way of looking and finding ideas.

Try it out. The app is invite only, but I got a code that you can use to bypass all that.

Get the app at iTunes and use code buffett007

Summing Up

Mechanical strategies isn’t cut for everyone.

Just know what it really requires before jumping in. It’s going to be a lifesaver for some and torture for others.

In the meantime, use the methods above to find your own ideas and broaden your circle of competence.

There’s a reason why they say;

slow and steady wins the race.

What is Old School Value?

Old School Value is a suite of value investing tools designed to fatten your portfolio by identifying what stocks to buy and sell.

It is a stock grader, value screener, and valuation tools for the busy investor designed to help you pick stocks 4x faster.

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