Book Reviews, Methodologies, Value Investing

Book Review: The Guru Investor

Book: The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies, by John P. Reese with Jack M. Forehand

Review: Good book. It summarizes the principles of famous investors into quantified mathematical criteria that can be used for screening. Of course the screening criteria are not a complete substitute but they are helpful to abstracting the key quantitative factors of each investor.

Key Points:

  1. Guru Investment Principles
    • No single strategy works in all time periods. Even if you know that sticking with a particular strategy is the right thing to do, it is very difficult to do so when the strategy goes through rough patches. To reduce the urge to ditch your strategy, combine strategies with low degrees of correlation to limit the volatility (e.g. use 10 strategies and weight each one equally). Another way is to choose stocks that meets the criteria of multiple strategies.
    • Humans are extremely bad at forecasting. Stick to a proven, purely quantitative strategy so as to neutralise your emotions. Quantitative models beat humans because they are always consistent and do not have emotional baggage.
      • A study by Philip Tetlock in his book Expert Political Judgment: How Good Is It? How Can We Know?, he found that experts cannot explain more than 20% of the total variability in outcomes when predicting future events. Statistical models on the other hand explained 47% of outcomes. Geoffrey Colvin from Fortune found that the more famous the experts, the worse they performed. James O’Shaughnessy in What Works on Wall Street cited a study that an actuarial model predicted college performance of students better than admissions officers. Researcher Jack Sawyer cites 45 studies where human and actuarial predictive ability were compared and humans performed worse in all of them. In some cases the humans were given more information than the model and were given the predicted results of the models, and yet the actuarial models still beat the humans.
    • Stick to your strategy for the long term. Most of the gains come on a limited number of days and no one knows when. It is key to set your expectations so that you do not jump out when things get rough. Declines are inevitable. 10% declines in the market occurred in more than half the years in the 20th century; 25% declines occurred on average every 6 years. Joel Greenblatt’s magic formula underperformed the market 25% of the time.
    • Diversify across sectors.
    • Don’t limit your investment to a particular style (e.g. small, big cap) or size. A good value is a good value.
    • A long-term investor means sticking to a strategy for the long haul, not sticking to a stock for long periods no matter the fundamentals.
  2. When to Sell
    • Do not set arbitrary targets to sell (e.g. sell when it goes up by 30%), since each stock is different. Cutting losses because the price has fallen, or taking profits because the price has risen, are arbitrary emotional decisions.
    • Buy a stock for strong fundamentals and good price, sell it when it no longer meets the criteria you used to buy it.
    • Monthly re-assessment produces the best result.
    • Another way is to stick to a firm rebalancing plan, set a target weight for each position and reset it when the weight becomes 10% more or less than the target weight.
    • If a firm is involved in a major accounting or earnings scandal, sell immediately because you cannot trust its public financial data.
    • No one makes the right decisions all the time. In the long run, a 60% success rate translates into huge gains, a 50% rate into solidi gains, and a 40% rate can still beat the market.
  3. Benjamin Graham
    • Trust investment considers the future “more as a hazard to be guarded against than as a source of profit through prophecy.”
    • In the long run, a stock’s price tends to move with and reflect the real value of its business.
    • Buy stocks with a high margin of safety.
    • Key criteria:
      • Not a technology company as they are risky
      • Trailing 12-month sales >= $340M
      • Current ratio >= 2, unless it is a utility or telecom
      • Long-term debt <= Net current assets
      • EPS Growth over past 10 years >= 30%, and no negative annual EPS in last 5 years. To calculate earnings, average across 3 years, e.g. earnings used for year 1 = average of earnings of year 0, 1, 2.
      • P/E <= 15. Earnings is the average of the last 3 years’ earnings.
      • P/B * P/E <= 22
      • Total Debt/Equity for industrial companies <= 100%. Long-term Debt/Equity for utilities, phone companies, railroads <= 230%.
      • Continuously paying dividends for the last 20 years.
  4. John Neff
    • Go for low P/Es. Indifferent financial performance by low P/E companies seldom exacts a penalty.
    • Stock prices almost always sell on the basis of expected earnings growth rates, shareholders essentially get periodic dividend payments for free.
    • Future growth rates should be reasonable and sustainable.
    • Profit margins can only expand for so long, attractive companies must demonstrate sales growth.
    • Key criteria:
      • P/E ratio >= 40% of market average and <= 60% of market average
      • EPS Growth >= 7% and <= 20%, high growth stocks are too risky
      • Future EPS Growth Rate > 6% for current year, and > 6% for long term
      • Sales Growth >= 70% of EPS Growth Rate, or < 70% of EPS Growth Rate but > 7% (don’t penalise companies for EPS spike that is not due to sales)
      • Total Return / PE Ratio >= ((Market total return / PE Ratio) * 2), or >= ((Industry total return / PE Ratio) * 2). Note Total Return = EPS Growth Rate + Dividend Yield.
      • Free Cash Flow > 0
      • EPS Q1 > Q5, Q2 > Q6, Q3 > Q7, Q4 > Q8. Shows consistent growth.
  5. On-going
  6. The book has a website here which also gives you 3 investment ideas per guru, and the author has a blog here.




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