How to create your ideal value investing strategy
This is the second briefing note in a series that explores how you can build a portfolio of shares by using the tools available at Stockopedia. Previously we examined some of the key considerations that need to be made before getting started in the stockmarket (especially the fees trade-off when managing your own portfolio). In this article we tackle the main ingredient of any systematic approach to building a portfolio – the underlying strategy.
An investment strategy acts like a prism. There are more stocks and possible investment opportunities than you can possibly analyse or keep track of. Having a way to filter out low probability candidates and decide what’s important will save you valuable time. As Lewis Carroll observed, if you don't know where you’re going, any road will get you there. Just as a road map can help steer you to your final destination, an investing strategy can help you get your investments back on track if the markets steer you out of line.
Choosing a strategy is a highly personal decision for investors and you should do your own research or seek professional advice when deciding on one. To illustrate how best to use the tools on Stockopedia, this series will explore three of the most popular systematic investing approaches – value, growth and income. Some of the strategies we will discuss have made more than 30% over the past 12 months alone but past performance is no guarantee of the futre, of course. All of them are underpinned by strong academic and market evidence that they work in the long term but they will appeal to different investors depending on individual preferences and risk appetites. Later on in the series we will look at how you can use your preferred strategy to easily generate a portfolio.
Get the value advantage
The first of our preferred house approaches at Stockopedia is value investing, which is arguably the most successful stock selection strategies ever. We like value investing so much that we wrote a book about it – you can download it here. When Benjamin Graham began urging investors to scrutinise out-of-favour and apparently mispriced stocks in the aftermath of the Great Depression, he lit the touch paper on a technique that has not only endured but prospered. The success of his one-time student and value investing advocate Warren Buffett is testament to that.
But while few investors can resist the idea of scouring the market for a bargain, most have no idea how to do it. In large part, the challenge with value investing is that it is counterintuitive to almost all human instincts. Acting contrary to others and resisting glamour stocks in favour of unloved and occasionally obscure companies can be a fearsome prospect. But with the right systematic approach you can detach yourself from the natural instincts that can sway judgments and let the strategy do the hard work. Unlike a value hunter such as Buffett, who makes large bets on single stocks, you can become a value farmer by creating a broad value portfolio from which you can ‘harvest’ profits.
A rocket fuelled magic formula
“A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.”
After decades of research and market testing it should come as no surprise that there is a multitude of value investing strategies at your disposal. These range from what Buffett describes as ‘cigar butt’ investing all the way through to buying good quality stocks at a fair price.
To illustrate how best to use our tools on Stockopedia, we have picked a variant of the value approach that looks for good quality companies that can be bought on the cheap but with the added comfort of displaying strong and improving financial characteristics. This particular strategy has been popularised both by Interactive Investor blogger, Richard Beddard, as well as Morgan Stanley and MFIE Capital. It’s a strategy that will appeal to contrarian investors seeking apparently mispriced stocks and are willing to accept the risk of casualties in return for some strong performances. It also brings with it some robust scrutiny of company financials as an indicator of which stocks are genuinely mispriced rather then being cheap for a good reason.
First step… quality
The ‘quality’ element of this strategy is based on what's known as Magic Formula Investing, as detailed in The Little Book That Beats The Market by US hedge fund manager, Joel Greenblatt (you can read much more about how and why it works here). The formula looks for two metrics in a stock: a high return on capital (a good company) and a high earnings yield (a cheap stock). Return on capital is a measure of how effective a company is at making a profit from its assets. The earnings yield takes its operating profit and divides it by its enterprise value – the higher the yield the ‘cheaper’ the stock. The screen ranks the market from high to low for each indicator and adds the two ranks together to get an overall Magic Formula.
For our purposes, Magic Formula is a useful starting point because it requires a diversified portfolio of between 20-30 stocks to hedge against fatalities. By producing a market rank it also offers a constant supply of potential stocks so there is no risk of suddenly finding a limited number of replacements when it comes to rebalancing the portfolio.
While Magic Formula has a claimed stellar record against the market even Greenblatt acknowledged that it wasn’t a magic bullet that always worked. Given that some of these stocks are likely to have even the bravest investors breaking a sweat, what’s needed is some extra security – and we get that from an academic tool called the Piotroski F-Score.
Next step… safety
The F-Score is essentially a toolkit designed to find which companies in a basket of apparently underpriced stocks display the best prospects for future outperformance. It was developed by US finance professor Joseph Piotroski as a way of analysing the cheapest stocks in the market using accounting-based criteria. Whereas Piotroski starts his own strategy by ranking the market on a price-to-book value basis, we’re replacing that with our list of Magic Formula stocks. But we can still use his nine-point checklist to dig deeper into our companies.
Importantly, the F-Score covers a range of fundamentals and ratios spanning profitability signals, leverage, liquidity and source of funds and, finally, operating efficiency. Each ‘pass’ scores one point, giving you a single overall figure at the end that indicates which companies are in the best financial shape. You can read more about the details of the Piotroski F-Score here. The additional safety filter that we will add is that we will have a preference for companies scoring between 6 and 9 out of 9 on this checklist. In his research, Piotroski claimed that by investing in companies scoring 8 or 9 over a 20-year test period through to 1996, investment returns could be increased by 7.5% each year.
A potent combination
Individually, Greenblatt’s Magic Formula and Piotroski’s F-Score have earned the admiration of investors and the strategies frequently put in market beating performances. But by combining them we bring together a quality-based value screen with a military-grade financial obstacle course that should produce stock candidates that really are worth further scrutiny. As we’ve mentioned, this combination hasn’t been lost by other analysts either. In 2010, investment strategies organisation MFIE tested a range of systematic value screens and found that with a blend of Magic Formula and Piotroski F-Score “you can increase your performance substantially”. The researchers also concluded that a portfolio of around 30 stocks bought and held for one year offered optimal diversification, which complements the Magic Formula/Piotroski twin approach.
Now for reality
In the next article in this series we’ll look at how you can take a sample strategy like this one, and screen the market to find the companies that qualify. Simultaneously, we will also share a sample investing strategy that covers growth stocks (and then dividend stocks). The important point here is that regardless of your strategy (and remember that these strategies can be tweaked and changed endlessly to suit your needs) the next step is to bring it to life. That means using Stockopedia’s tools to input the screening criteria to easily generate an initial potential portfolio of stocks.
In this series:
- How to get started in the stockmarket with Stockopedia
- How to create your ideal investing strategy (value, growth, dividends)
- How to turn a strategy into a portfolio with Stockopedia
- How to give your portfolio the best chance of success
- How to manage your portfolio over the longer term