Joel Greenblatt Reveals His Big Secret: Value-Weighting

April 12, 2011 by HWWProject Leave a Comment

Joel Greenblatt, well-known Hedge fund manager, author and creator of the ‘Magic Formula’ investing books, is out today with a new book where he reveals his secret to investing. The book’s title is: “The Big Secret for the Small Investor: The Shortest Route to Long-Term Investment Success”

This “secret” is not a new method for picking stocks (his Magic Formula does that exceedingly well), the secret is better asset management. Specifically, placing larger bets on stocks which are selling at deeper values. Greenblatt’s firm has created stock market indexes using this “Value-Weighting” approach. He describes it in a Morningstar article as:

[emphasis mine] “We just took the logic that, if we can buy a stock at a bargain price that we want to own more of that one. So, instead of weighting by market cap or equally weighting or by economic size, we weight by how cheap we can buy a company. So, the bigger bargain that we find, the more we own of it. So, we actually took the largest 1,400 companies listed in the United States, and we put together an index of 800 to 1,000 of those companies. And we didn’t equally weight them, we weighted them according to value.

So, we have heavier weights in those stocks that we believe are the cheapest, and we have very simple metrics that we use to decide which are the cheapest stocks and we buy more of those and every day we go out and rebalance the portfolio, so that it’s constantly and continually rebalanced towards the cheapest stocks that we can find based on those simple metrics. And over time, over the last 20 years when we tested them doing this kind of thing beat a market cap-weighted index by about 6% a year and it had the same volatility and the same beta as market cap-weighted index, but you’ve got six extra points which was very exciting to us and it makes total sense to us. Why wouldn’t you want to concentrate in the cheapest stocks that you can find?”

Any of this sound familiar? Sounds exactly like the Kelly Formula to me. The Kelly Formula gives you the optimal fraction of your wealth to place in any betting/investing situation. The Kelly Formula directly addresses Greenblatt’s secret – to weight your portfolio heavier with the most undervalued stocks. Greenblatt doesn’t give details of his own weighting formula – but I’ve done that for you in this article: The Kelly Formula for Stock Investing: Growth-Optimized Money Management.

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New Stock in my Portfolio

Last week I purchased Hewlett-Packard (HPQ) at $40.30. I calculate HPQ to be 35% undervalued. HPQ has been a consistent grower of Owner Earnings (Free Cash Flow). I used my Kelly Formula spreadsheet to determine how much to invest. HPQ is not deeply undervalued, and being a Tech stock leads me to a lower confidence than usual. I ended at a 3% commitment to the stock. This stock will be followed on the ‘Current Portfolio’ tab on the spreadsheet which is accessed on the Home page (viewable with a free Google Account).

Lessons Learned From A 112% Profit

March 21, 2011 by HWWProject 1 Comment

I sold Hornbeck Offshore Services (HOS) today at a 112% profit. Hornbeck is one of two Oil Services firms (the other is Geokinetics) that I purchased last summer during the BP Oil spill fiasco, when there were threats to shut down all drilling in the Gulf of Mexico. I knew the U.S. would not abandon our Gulf oil supplies. I described the purchase in this article: Buying When there’s Blood in the Street.

I put a lot of hard work into picking stocks. And it feels good to double my money, and be able to say I beat the S&P 500 by 91%. I was very confident in the value of HOS and Geokinetics (which I’m still holding at a 120% profit). At purchase each of these stocks was easily more than 70% undervalued, a level rarely seen in stocks which have shown steady growth in free cash flow. I knew that the market would one day revalue these stocks more appropriately.

Yet the truth is I didn’t make enough money in HOS. I put 3% of my portfolio into HOS, the standard % I was using last year. That was before I had [re]discovered the Kelly Formula. This formula calculates how much to bet in any gambling situation (from poker to stocks). It assumes that your objective is long term capital growth (ie. getting rich) without going broke. This is much different than when you daftar Sbobet:(: one is a real gamble on sports, while one in an investment. It is mathematically the fastest way to grow your wealth in any betting game. Both Warren Buffet and PIMCO bond manager Bill Gross are said to use the Kelly formula for money management.

Under the Kelly criterion, I should have placed 9% of my portfolio into HOS and another 9% into Geokinetics. Now that they both have doubled, my portfolio would be up nearly 20% from just these 2 stocks. Instead I’m up a decent 6% gain.

After much research into the Kelly Formula, I created an Excel spreadsheet to tell me how much to bet on each stock purchase. This is a fundamental problem for the investor, one I’m glad to finally feel confident that I’ve got a better system for money management. The Kelly Formula spreadsheet is described in this article: The Kelly Formula for Stock Investing: Growth-Optimized Money Management.

More info on the Kelly Formula (also known as ‘Fortune’s Formula’) can be found here and here.

Other Portfolio News
I’m beginning to report my trades using a momentum system applied to commodities, currencies and bonds. You can see these on the Home page using the interactive ‘Google Docs’ spreadsheet (some browsers require you log in with a free Google account).

Also I have a new Gold timing system that backtests very well. May roll it out soon.

A Small Bet On Best Buy

February 26, 2011 by HWWProject Leave a Comment

I purchased Best Buy (BBY) yesterday at $32.30 per share. Best Buy is the largest consumer electronics outlet in the world. The company operates more than 1,400 stores throughout the US and Canada, and another 2,600 stores in Europe and China, mostly under the Best Buy, Best Buy Mobile, and The Car Phone Warehouse banners.

Best Buy is suffering from the threat of Wal-mart’s further expansion into electronics, as well as online competition. Due to these, Best Buy stock is selling near its 52-week low. It is priced as if it has no growth in its future, yet I have to believe there’s room for more than just Wal-Mart in this space.

Some numbers on the stock:

price to peak earnings = 8
Free Cash Flow yield =12%
dividend yield = 1.77%
Return on Capital = 21%

This was a very tough decision to purchase for the following reasons:
1) The threat from Wal-mart and online competition may be real.
2) People are buying fewer movies and music from stores thanks to Netflix /Itunes.
3) Best Buy has a lower profit margin of 4%, I generally want a minimum of 5%

Despite these concerns I went ahead and purchased. And I used my new ‘Kelly Formula for Stocks’ Excel spreadsheet to determine how much to invest. The Kelly spreadsheet instructed me to invest 2% of my portfolio in the stock.

Best Buy is selling at a 35% discount to my estimate of Intrinsic Value.

Update: Demark on CNBC says Monthly TD-Combo Signal has confirmed an 11 to 17% Market Correction

February 23, 2011 by HWWProject Leave a Comment

Tom Demark was on CNBC yesterday with news that his TD-Combo signal has been confirmed on a monthly timeframe, now joining the daily and weekly signals. With this in place, Demark is even more confident in his prediction for an 11 to 17% market decline.

The interview can be seen here via CNBC.

The TD-Combo signal, as well as Demark’s TD-Sequential signal, measure trend exhaustion in the market. When they trigger on a monthly timeframe they often coincide with major market turning points.

U.K. Market Technican article: TD-Sequential and TD-Combo

January 21, 2011 by HWWProject Leave a Comment

Click below to download a Market Technician Journal from the U.K. which includes an article describing the TD-Setup, Sequential, and Combo indicators. The Demark article is:

Market Technician No 56
This article is a summary of a talk given to the Society on 10th May, 2006 By Tim McCullough

Side Note: the Journal also includes a fantastic Paul Desmond Article about the nature of Bull market tops-

Beating The Early Buffett Partnership: 50% Average Return On My Last 20 Stock Picks

January 10, 2011 by HWWProject Leave a Comment

My last 20 stock picks have averaged an amazing 50% return. Certainly the bull market of the last 2 years has had much to do with that high number. Yet if instead of purchasing each stock, I had purchased shares of an S&P 500 index fund, these same 20 purchases would have returned less than 23%. That 27% outperformance of my portfolio versus the stock market is what makes me proudest, and more and more confident in my stock picking methods.

Well-known ‘Value-oriented’ mutual fund managers often tell their investors that they have a goal of outperforming the S&P 500 by an average of 10% per year over time. It’s what Mason Hawkins of Longleaf Partners fund aims for, as well as Bruce Berkowitz of Fairholme Fund. It’s also what Warren Buffet told his early partnership investors to expect back when he directly managed money. Very few succeed at this. So my 27% outperformance, though only 2 years, is quite an accomplishment.

These stock picks were accomplished thru my understanding of Buffet’s definition of Owner Earnings. I calculate the true ‘Owner Earnings’ for a company over the past 10 years, then predict these earnings into the future. Then I sit on my hands, watch the portfolio, and wait for the market to deliver a stock at an acceptable discount to it’s Intrinsic Value.

I give a brief overview of the process here: Dave’s Complete Guide to Value Investing though I don’t give away the details on how to calculate Owner Earnings (or of equal importance: at what rate to project them into the future and properly discount them). That whole process took me 15 years to figure out.

I’m still grumbling that I missed a 70% return in Gymboree recently, by not watching my stock list for just a few days last summer!

30% In 3 Months With Blackberry (RIMM) – I’ll Take It

January 10, 2011 by HWWProject Leave a Comment

I purchased the stock of Research in Motion (RIMM), maker of the Blackberry phone, on September 21st, 2010 – a short 3 months ago. When bought at $47.53, it was at a 25% discount to my calculated Intrinsic Value. It steadily rose from day 1 and was sold on Jan. 5th at $61.78, a quick 30% rise in 3 months.

That’s what I do best. Buy great companies at good prices. I only purchase those who have shown historically steady and predictable cash flow growth and buy when they are undervalued. Then sell them at their Intrinsic Value based on Discounted Cash Flow analysis. It’s what investing is all about. Buy with a Margin of Safety, Sell at Intrinsic Value. Hold cash when nothing is available at my price.

Here’s the article where I purchased it: Walking the Worlds RIMM

If I had instead bought an S&P 500 index fund on September 21st, it would have returned 11.5%, which is an unbelievable 3 months for the market. But I”ll take 30% any day.

It’s Make Or Break Time On The Demark Short Trade

November 10, 2010 by HWWProject Leave a Comment

It’s make-or-break time on my Short trade. I went short the market, based on a TD Sequential signal, with a fair portion of my portfolio back in mid-September using inverse etf’s. Bad timing. Several of them are down 25%. My overall portfolio is down about 6-7% across the several accounts I trade thanks to great performance from my stocks. Though I’ve handily beaten the market over the past few years it still hurts to underperform during a bull run.

Bad risk management. I put too much into the trade, and I should have analyzed the TD Risk Level before going in. The Risk Level is calculated by finding the bar (week) with the highest high of the TD Countdown, and adding it’s range to it’s High. For this trade the high week was week of April 19th, and adding it’s range to it’s high gives 124.0 The chart below shows this:

Note: to confuse matters, the TD Risk Level is either 124.0 or 125.0 depending on which data service I use – whether a trade week ends on a Monday or Friday. Anyway, we are up to these levels now and if the market closes above them, the trade is off.

So it’s now make or break. But last week I broke a little, and sold off a few triple-inverse etf’s (CZI and DRV) at a 25% loss. 25% is a standard stop-loss many traders use. I’m still holding three remaining short etf’s and plan to until/unless the TD Risk Level is breached.

I should probably quit this Demark thing and stick to picking value stocks. Partially due to my intense study of Demark this summer, I missed a 70% return opportunity in Gymboree (GYMB) – see my last post. Picking good stocks at great prices has made plenty of investors wealthy and I’m pretty decent at it now.

But I know this. These Demark signals very often make fantastic calls. I see it in my spreadsheet on hundreds of stocks/etf’s I’ve studied. I just need to learn to be a better trader in order to use it.

Gymboree: I Missed A 70% Return Opportunity

October 19, 2010 by HWWProject Leave a Comment

Gymboree (GYMB) came onto my radar screen in early May when it became a Magic Formula stock. It was then trading around $45 per share. I calculated it’s Intrinsic Value at $55.20, and set a 30% desired Margin-of-Safety for an entry price of $38.70. Over several weeks in late August / early September, GYMB traded below my desired entry price a number of times. I missed them. No good excuses. And because I missed the purchase, I missed a 70% return when Bain Capital announced a buyout of Gymboree, at $65.40 per share on October 11th.

Here’s a chart showing the opportunity:

I’m comforted in my methods by learning that Gymboree management had been asking $55-$60 per share before Bain came along.

I’ve been so focused on shorting the market that I missed an easy 70% return by buying a great value stock. Not a good excuse. Note to self: Pay better attention to my active stock list. Opportunities can come and go quickly.

Walking The World’s RIMM

September 23, 2010 by HWWProject 1 Comment

Purchased Research in Motion (RIMM) today, maker of the Blackberry phone. RIMM generates too much cash to ignore, and is selling at a discount to conservative growth estimates. RIMM has had explosive growth of free cash over the last 10 years. FCF keeps growing around 45% per year, revenue over 50% per year.

Being a tech stock we have to be conservative about future growth, but RIMM seems intent on using it’s cash stockpile to keep up with consumer and business demands:

RIMM battles back with Blackpad

I purchased this stock at $47.53.

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