Journeys of a Bumbling Investor

Rating: Above average

Background: Book that I picked up to learn about the "official" contrarian strategies.

Summary:

The key idea is that, buying a set of low P/E, P/CF, P/BV stocks (the study uses the top 1,500 largest companies from the Compustat database), holding it for a long period of time, will bring the greatest gains. The gains will be increased if

1. You sell off stocks that have not performed in 2-3 years, and
2. You sell off stocks when their P/E ratios have reached the market P/E ratio, and replace with another low P/E stock.

Appendix B of the book lists 41 rules for Contrarian Investing. A nice one is:

Rule 12

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

Finally, the book has a very good quote from Graham and Dodd's Security Analysis: "Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few also of the large companies suffer ultimate extinction. For most, this history is one of vicissitudes, of ups and downs, with changes in their relative standing." which results in Dreman's Rule 27

The push toward an average rate of return is a fundamental principle of competitive markets

This aids in a way, while estimating the intrinsic value of the company, by helping with the tough questions of "how long will this company be earning above market returns?", and also, "what long-run rate of return should I be projecting?"

I was searching around for the best way to download financial statements into Excel. Here's a summary.

Free sources:

1. MSN Money – have to use a web query to get it into excel, pretty decent, but due to the standardisation, the breakdown (e.g. of the cash flow statement) might not be as granular as you would like. Only has 5 years of data.
2. Reuters – have to use a web query as well, pretty decent, but the standardised fields are slightly different from MSN Money, so the figures that you calculate might be slightly different. Only has 5 years of data.
3. Edgarscan – comes in the form of an excel spreadsheet, but frequently have missing data for the multi-year 10K/Q spreadsheet, especially for recent years. The spreadsheet for the cashflow statement and income statement are good, very detailed. But the disadvantage of being too detailed is that its near-impossible to automate.
4. Better-Investing.org – gets data from S&P Compustat. Very detailed with many many years of data. But all data comes in a huge table (have to use web query), with a column on the field name, and columns to the right with all the values. Not logically organised into Balance Sheet, Income Statement, Cashflow Statement. Hence its gonna be a huge huge pain to arrange all the fields into their proper rows and make sure everything adds up.

Seems like if an automated process is desired, then Reuters/MSN would be the way to go.

Paid sources:

1. Spredgar – Pretty good, with 7 years of data. Places everything into an Excel spreadsheet neatly. But only has Balance Sheet and Income Statement data, no Cashflow Statement.

I don't know of any more sources that can download financial statements into Excel (I'm sure institutional investors have some costly service to do that, but that's out of my league =).

The simple P/E ratio is still being widely used as a proxy for how cheap/expensive a stock is. So what P/E ratio should you use to value your stock? 10? 20? 50? What is the logical basis behind the P/E ratio? Why 10, 20 or 50?

That's a major concern that needs to be answered. Consider Wal-Mart (WMT). If you take an average of WMT's P/E ratio over the past few years, you can probably get a number around 30. So now that its P/E ratio is 18, is it considered cheap? Should you project future earnings and multiply that by 30 to get WMT's price?

And what if I tell you that WMT's yearly average P/E ratio has been consistently declining over the past few years (see the 10-year summary on MSN Money)? Has something changed?

The answer to all these questions lie in the simple concept — intrinsic value aka fair value.

How much you should pay for a company depends on what the company is worth (sounds like a tautology). And what the company is worth now, is the present value of the future worth of the company. The fair P/E ratio is simply a result you get when you divide the fair value by the earnings, it is NOT something that you use in a fundamental manner to value a company.

This also explains the reason why, you can buy a company at a certain price, and even though year-after-year, sales increases, earnings increases, equity increases, but the share price may keep on dropping (with a decreasing P/E). More often that not, it is a case of overpaying for the company right at the start, without a strong basis in determining its intrinsic value.

I was digging around the Net to understand better the issue of expensing of employee stock options for companies.

Initially I had the mistaken idea that companies previously could choose to "capitalize" or expense the option grants, and was wondering how exactly do you "capitalize" an option grant, later I found out that you can't: the old alternative to expensing them is to disclose them in footnotes =)

Another point that I was trying to clarify was whether there is a tax rebate if the tax benefit from stock options is greater than the net income. Turns out that there isn't a rebate, so the actual tax benefit ($cash) shown in the cash flow statement might be less than the calculated benefit using the tax rate.

Good intro series on stock option accounting on Motley Fool:
http://www.fool.com/research/2000/features000908.htm
http://www.fool.com/research/2000/features001012.htm
http://www.fool.com/research/2000/features001228.htm

More detailed accounting and valuation treatment of employee stock options:
http://www.investopedia.com/features/eso/eso1.asp

Examples of how MSFT and CSCO uses the tax benefits:
http://www.fool.com/portfolios/rulemaker/2000/rulemaker000217.htm
http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2000/10/09/MN3707.DTL

General info on employee stock options:
http://executivecaliber.ws/sys-tmpl/expensingstockoptions/
http://executivecaliber.ws/sys-tmpl/fasbexpensestockoptions/
http://www.feinberglawgroup.com/stockopt.html
http://www.fairmark.com/execcomp/index.htm

A good link on tax issues for investors:
http://invest-faq.com/articles/index-tax.html