The Acquirers Multiple and Quantitative Value

After looking at momentum, I wanted to look at quant value screens/algorithms. Two interesting ones were "The Acquirer's Multiple", and "Quantitative Value".

The Acquirers Multiple

This single measurement is based on Enterprise Value (EV), which gives the cost you would pay to acquire the company. It takes into account a company's capital structure (eg: debt and cash), unlike market-cap based valuations such as PE. And it's more objective than book value.

Divide EV by earnings, usually EBIT¹. The resulting number measures how cheap the company is - the lower the better. You need to take a portfolio approach and buy 20-30 of them: these stocks go to zero occasionally² .

You end up with a bunch of shitty companies. Companies that are targets of lawsuits. Oil companies in the middle of a multi-year bear market. Retailers being killed by Amazon. Companies that no one wants to hold.

The theory behind this is mean reversion: After an industry has been is losing money for years, competition dries up, and eventually the remaining companies are profitable. They may not be very profitable, or have any growth prospects, but after their stocks have been priced for bankruptcy, any improvement in their situation means their stock prices will recover.

When trading using The Acquirer's Multiple, I should expect:

• Long periods of underperformance. This is true of value investing in general.
• Declines in bear markets:

(Source : Deep Value and the Acquirer's Multiple (28:20): QuantConn NYC 2016. This is not "The Acquirer's Multiple", but rather the lowest decile of value stocks - similar to TAM) 

The declines are less than momentum strategies, but still bigger than the S&P 500. I'd use the S&P 500's 200 MA to time the my entry.

• Long term returns of 15-17%. See results from 1964-2016 here.

Quantitative Value

This book gives is a more refined version of The Acquirer's Multiple. It uses EV/EBIT as its main screen, but does some other things:

1. First it screens out probable Frauds, Manipulations, and companies in financial distress, using statistical techniques.
2. Then finds the 10% of cheapest stocks by EBIT/EV.
3. Then tries to find stocks with strong Franchises (high ROA, ROC, FCF/assets, all over 8 years), and Financial Strength (profitability, stability, and operational improvements). The top half are chosen.

Backtesting

I was not able to do a reliable backtest on Quantopian because some fundamental data was missing. If I was trying again, I would try Portfolio123 or QuantRocket. Too bad. I would like to see the shape of the equity curve, the drawdowns, and how they would improve when we use a 200 MA to time entry. But I'm not willing to put any more time into this.

How would I trade this?

I could just buy the Quantitative Value ETF (QVAL), which selects stocks based on the book. Its holdings are equally divided among 50 stocks. Limited to the top 40% largest stocks (minimum market-cap is around 2bn). The expense ratio is 0.79%, meaning if I buy USD 100K and hold for a year, I'm paying $790.

I could also subscribe to the Acquirers Multiple screener for $500 a year, and buy stocks from their All Investable screen. I'd probably trade every week, and ease-in and out of the strategy based on the index's MA - similar to what I do for my momentum strategy.  After filling my portfolio, rebalancing would be quarterly.

Comparing the two: I'll probably go for the screener:

• It also filters out Frauds, Manipulations and Financial Distress (same as QVAL).
• It uses operating earnings instead of EBIT, which is slightly better.
• And it accesses smaller cap stocks (around 150m, depending on market conditions).
• It also eliminates stocks with high short interest (which QVAL doesn't do).
• The only thing it doesn't do is check for Franchise and Financial Strength.  This screen is based on purely cheapness and believes we can't distinguish quality.

Footnotes:

1 Tobias Carlisle preferred Operating Earnings (Revenue - COGS + SGA + D&A), as it excludes special items. See FAQ: "What are operating earnings?"↩
2 In an interview - which I can't find - Tobias Carlisle said that an average of 2% of stocks go to zero every year - market wide. For Acquirers Multiple stocks, the average is 6% a year. But that's the average - the bankruptcies tend to cluster in certain years.↩

Stock Market Momentum - Part 2

Rules & Implementation

My system is based on Andreas Clenow's "Stocks on the Move", a readable and entertaining book that adapts trend following strategies to stocks.  Its a long-only rotational trading system, where stocks are ranked by momentum and the highest ranking ones are bought.  It only buys or holds stocks that are above their 100 day MA.  And only takes new positions when the market index is above its 200 day MA.

I made some small changes:

• I don't size and re-balance positions by volatility.  It makes no sense when a position is $2-4K.  Its hard to code.  And I don't see the benefits since a stock's volatility can change in a heartbeat, and the whole market usually changes with it.  I just buy 25 stocks ¹.
• I use the lower 100-day Bollinger band (1 std-dev) instead of the 100 MA to filter if a stock is in an uptrend.  This takes volatility into account, unlike a moving average.  I want to hold winners as long as possible.
• His algorithm buys all positions when the market index is above its 200 MA.  I gradually 'ease in' to the market.

The 'easing in' part works like this. We usually hold 25 stocks.  The first day the index closes below its 200 MA, we will set the 'target number of stocks to hold' (N) to be 24.  We don't explicitly sell stocks to meet that target - the system just goes into 'bear mode' and stops buying (Stocks may be sold based on the other criteria).  For each day the index is below the 200 MA, N decreases by 1.  So N will be zero if the index is below the MA for 25 or more consecutive days.  The first day the index goes above the MA, N is incremented by 1.  And if we are holding less than N stocks, we buy up to N.  Therefore, the index needs to be above the ma for some time in order for us to be holding the full allocation of 25 stocks.

This subtracts from my returns a little, but I need it to be comfortable trading the system. Otherwise I won't be able to follow it.

I am running on Amibroker, and selecting stocks from the Russel 3000 with Norgate Data taking care of tracking index constituents.  I exclude stocks trading under $5, or with a median 90-day turnover less than $250K.   For slippage, buying and selling is at the day's average price.  Brokerage is $1 per trade from Interactive Brokers.  Starting amount USD 73K.  I run the system over the weekend and trade on Mondays.

Backtest Results

I get a 14.2% CAGR from 1999 to Aug 2018, and 17.4% from 1991 to Mar 2003.  Decent numbers.

Looking at monthly returns:

Returns are unpredictable.   We often get a few years of boring single digit positive or negative returns, followed by a year of stunningly good 30-60% returns.

The volatility is sickening.  There is a 61% drawdown in the 2000 tech wreck, and a 33% one in 2006.  20-30% drawdowns occur every few years.

Trading It

Can I stick with this?  Trend following strategies are notoriously frustrating.  You have to just follow the system mechanically, week in, week out, and not think about how much you're making.  Or losing.  From Nick Radge (What makes a Successful Trader? 37:00):

• We have created a system with positive expectancy.  Like a casino.
• Remove yourself from the trading environment. Place your trades, turn off the computer.  In the long term, positive expectancy will look after you.  All you have to do is be there for it.
• Think 'Next 1000 trades'.

When will I start?  The Russel 3000 index is currently below its 200 MA, so I'll let the market decide.

1 The tests I saw measuring different momentum with holding different numbers of stocks started with 50 as the smallest number.  I am using 25 due to low capital.  May increase it to 50 later if account size grows.↩

Stock Market Momentum - Part 1

I'm looking at a systematic, momentum-based stock market strategy.  Why?

• The existence of momentum in markets is proven by numerous academic studies.
• The system I have gives a nice CAGR 14-20%, over 10-15 year periods.
• I will be buying stocks that have gone up.  Completely different from the value stocks I normally buy.
• I want to be able to trade the markets systematically, without having an opinion. 

What is Momentum?

From academic studies, stocks that have gone up in the past 6-12 months are statistically likely to go up in the next 1-2 years ¹.  Most papers use similar methods to measure momentum, for example:

• Value and Momentum Everywhere: Found evidence of momentum worldwide in stock markets, stock indexes, currencies, bonds, and commodities.  For stocks specifically: they selected large, liquid stocks from 4 markets over nearly 40 years.  Stocks' momentum was ranked by their past 12 month return, skipping the latest month.  They were sorted into 3 equal sized groups: Lowest momentum, Medium momentum and Highest momentum.  And re-balanced monthly.  The Highest momentum group outperformed the Lowest by 5.4% (US market), 6% (UK), 8.1% (Europe) and 1.7% (Japan).   
• 212 Years of Price Momentum: Looked at US market from 1801 to 2012.  Same methodology as above.  The Highest Momentum group outperformed the Lowest one by around 4% a year.

Why does Momentum occur?

No one knows.  There are many papers arguing whether its due to 'risk factors' ², or behavior.  I think its behavior.  Humans are herd animals.  Once we see other people doing something, we want to do it too:

• Fads and Fashion.  Whether its primary school children playing, or women comparing handbags, how often have we seen some trend catch on, then grow in popularity, until everyone 'has one'?  At which point they become not cool anymore, and the cycle starts again.  Look at the stock charts of Crocs or Michael Kors for example. 

• Capex Cycle: For mining and heavy industry, it takes years to bring new capacity online, so they respond slowly to increased demand, while the price of their commodity/product shoots up over several years.  At the end of the cycle, prices are sky high and everybody is prospecting/investing.  Leading to oversupply and a crash.  Look at Rio Tinto's stock chart for example: up 7 times from 1999 to 2008, then losing all of that in 2009.

• Success begets success: As business become bigger and stronger, they entrench their position, leading them to become bigger and stronger.  Especially prevalent in technology, with winner-take-all network effects, like with Microsoft or Facebook.  Until someone new comes along, disrupting the market, and the cycle starts again.

Why is it still Profitable?

How can such a simple, dumb, and well known strategy - buying stocks that have gone up - still make money?  Shouldn't everyone be doing it, removing its effects from the market?

Momentum strategies are hard to follow.  They have long and hard drawdowns: a 30% loss every few years is normal.  50-60% losses occasionally occur (the 1929 great depression and the 2000 tech wreck).  And there are long periods...a year or more... of sitting around doing nothing.

There's an interesting presentation by Wes Grey on why Momentum still works.  He considers that, for most fund managers, there is too much career risk in following momentum strategies.  I especially like his 'God Portfolio' (33:00 to 37:00) - not even God can prevent drawdowns!

In the next post I'll look at the system I'm using, and what its like to trade it.


1 Not true for shorter or longer time frames: if we're predicting under one year into the future, or from two to five years, then stock prices tend to mean-revert.↩
2 i.e.: stocks that posses momentum have higher returns to compensate for being riskier.↩

Sold most of my stocks

Sold most of my stocks last week.  Just before the rebound : (

Reason was because both the S&P500 and Nasdaq Composite index fell convincingly below their 200 MA.

I still think there's a only a 1/3rd chance of a bear market - most likely this is a 10-20% correction.  But I don't want to take the chance.  If you think there's a 1/3rd chance of getting shot, you have to take action to prevent yourself getting shot.

The stocks I am holding now fall into three groups:

• Stocks I am willing to hold for 10 years.  Buffet style.
• Small speculative positions, where I don't mind losing the lot.  Small risk for big gains.
• A market-neutral pair trade.

I'm spending my time developing a simple automated trading system.  I want to be able to trade the market without having a view.

Bought Yangzijiang Shipbuilding

Yangzijiang is a shipbuilder, which builds dry bulk and container ships.

Why am I buying?

The shipping industry has come through a massive 6-year downturn.  Dry Bulk is recovering - the main supply-side metric is the order book: estimated at 10% of the fleet ^{1, 2}.  Containers have stopped collapsing: there may be a recovery in the smaller class ships (Post Panamax and below), while large container ships (New Panamax & UCLV) still look pressured by new supply - however - in the long term supply will be managed by the 3 major shipping alliances³.

Yangzijiang has been profitable through the downturn:

              (source: Morningstar)

Since building a ship is a long term endeavour, earnings numbers contain many assumptions (eg: currencies, steel costs).  I do not know enough to look at this.  But write offs have already been made:

• Yangzijiang made Rmb1.2bn worth of provisions in 4Q17 in view of the weaker USD and rising steel cost then. We note that ~70 vessels (out of total of 123 vessels) on its orderbook were provided for while the remaining 40+ vessels (largely the large containerships and small bulkers) were expected to be profitable when stress-tested at those levels.

         (Source: DBS Research report, May 2018)

Lastly, the stock is cheap.  Its trading just above its net cash is of 91c.  Most of its cash is short-duration ⁴ Hold-to-Maturity (HTM) investments.

Why is the stock trading so low?  Probably because of the feared effect of the trade war on the shipping industry.

Bought 8000 shares @ SGD 1.08.  Thats a 1% position.  I'd be willing to go up to 2% for an S-chip.

Edit: 12th Sep 2018: Bought another 7000 shares at $1.11 on 31st Aug.

1 p9, Starbulk Investor Presentation Q218.↩

2 Up to 15% is reasonable. ↩

3 May 2018 Value Investors Edge article: Subscription Required.↩

4 1-3 years.↩

Uranium Again

A few weeks ago, I sold my URA ETF due to changes in its constituents.  Took a loss of USD 1650.

To replace this, I have bought directly into Cameco, and a bucket of small uranium companies.  This makes up around 3% of my portfolio.

Bought Offshore oil companies

Over the past few days, I bought a small amount of US-listed offshore oil companies.  Rig holders, OSVs and drilling.  Around 3.5% of my portfolio.  I believe that, barring a recession, both shallow and deep water exploration and development will return over the next few years.

I finished buying the day before the market dived on Italy worries. We'll see how it goes.

Bought Cardinal Health (CAH)

This week, bought 417 shares @ USD 53.55 at a total cost of USD 22,332.

CAH released bad earnings early this month, due to write offs in its newly acquired medical equipment distribution.  This drove the stock price down 20%, allowing me to buy at just below 12X FCF.

Selling Kering. And Inner Peace.

Sold my Kering shares at Euro 477.50 on 31st April.  Profit was SGD 57K, or 180%.  Over 4 years.

Since I bought Kering in early 2014, its main brand Gucci has transformed from a bland, logo-driven luxury brand to a young, exciting one.  Unknown designer Alessandro Michele took over and revitalised the brand, making it younger, more colourful, and gender neutral.  I don't understand any of this fashion crap, but sales are up double digits for the last 7 consecutive quarters:

The brand's transformation is best captured in pictures.

Severed head at fashion show:

Collaboration with graffiti artist Gucci Ghost:

Handbags - the bread and butter of the industry - now with colourful prints:

Now Gucci is a trendy, hip brand, popular with millennials.  It is the hottest fashion brand in the world.

Hard to know if the decision to sell was correct.

At a PE of 30, Kering is now reasonably expensive.  But the trend is still up - both the stock price and fashion trends - and I cant see any sign of it stopping.  Its easy to see the stock doubling again from here due to increased sales combined with operating leverage.  OTOH, a lot of good news is already priced in.  Fashions come and go.  Trees don't grow to the sky.  Especially for a company that sells handbags - its not the next Google or Facebook.

I chose to sell because of:

• Valuation
• The chart was going parabolic.  Theres no real support to tell when the uptrend breaks.
• I want to lighten up on stocks near the end of the business cycle.

Someone once told me, even when a stock shoots up after you sell it, you should be happy for the guy who brought it from you.  Because even if he makes money that you could've made, he's still taking a greater risk than you.

Inner peace.

Bought McKesson (MCK)

Bought 150 shares last night at USD 150.57 for a total of USD 22,590.44.

I'm wary of buying stocks this late business cycle.  But the drug distributors' revenues did not fall in the last recession.  Their profitability depends on the supply side, not demand. Their profits - and stock price - have fallen in the past few years due to generic drug price deflation.

The main long term risk is the consolidation of their customer base, which causes price competition.  But I think its already priced into the stock price.  I don't see a catalyst now for the stock or its earnings to go up, but by the time I do, so will everyone else.  I'm willing to hold this for a few years, through the next recession.  When a company is part of an oligopoly, has recurring revenue from an essential good, and is selling at 11X FCF, how can you not buy it?

I'm now 50% invested:

Looking to sell the banks in the next 6-12 months as we come to the end of the business cycle.

Gazprom

I entered a small position in Gazprom, the Russian gas company, last year.

Gazprom is an indispensable supplier of piped gas to Europe, trading at a single digit PE.  It (and its underlying currency) trade in accordance with crude oil prices.  It was a 1% speculative position, due to the risk of forced privatisation.

This was based on a previous recommendation from Capitalist Exploits.  They turned negative on it due to increasing geopolitical risk: US shareholders have been given a deadline to dispose of their Rusal stock/bonds, and Gazprom could be next.

Sold it last week.  Profit around USD 600.

Covered FMG Short

Covered my FMG short at on 20th April at AUD 4.69.
It had closed above the 4.50-4.55 support level for several days.
Loss of AUD 2.8K.

Short Fortescue Metals Group

I am expecting Iron Ore to drop.  Most IO is used by China for building and infrastructure.

In the long run, China is trying to move away from infrastructure and manufacturing.  Over the years they brake, accelerate, brake, accelerate...as they try to slow down without causing a recession.

In the medium term, I think they are in the brake stage now.  They will be slowing down now, so they can stimulate in 2020 for Xi's election the year after.  China's growth credit (Total Social Financing plus Bonds) is slowing:

Source: MB Webinar - Nucleus Wealth Mgt (abt 30 mins in).

In the short term, there are record iron ore stocks at Chinese ports.   Most of it is low grade ore, unused because of China's pollution restrictions.

FMG is the 4th largest global iron ore supplier after Vale, BHP and Rio, and also 4th place on the cost curve.  It produces mostly lower quality 58% ore, versus high-quality 62% ore from the other three, and low quality 30+% from domestic Chinese producers.  Upgrading their mix will take time - meanwhile they have have to accept discounts.

FMG's stock price has recently broken support:

I am short 6,600 shares of FMG at AUD 4.27.  This is a short term trade, hoping to make 20-30%.

Main risks are:

• In the short term, the market shoots upwards if the correction ends.
• China may rescind their pollution curbs.
• In the long term, steel may be used for OBOR.  Or for buildings/infrastructure for the booming US economy.  Including a big, beautiful wall.

US Drug Wholesalers again

Another look at US Drug Wholesalers: Cardinal Health (CAH) and McKesson (MCK).  These companies are part of an oligopoly in an industry not affected by recessions or trade wars, and are cheap now.

Cashflows

These 2 companies have been highly profitable.   Lets look at their past numbers.

I use Cashflows From Operations (CFO).  Since they are distributors with large yearly swings in working capital, exclude working capital changes:

Sustaining capex (mostly PPE) is extremely low, so free cashflows almost matches CFO:

But both companies spend a lot on acquisitions, which consists of the majority of their Cashflows from Investments (CFI):

Here's a look at CFO vs acquisitions and disposals.  In some years, all CFO is used for acquisitions:

Why are they spending so much on acquisitions?

I wonder if some of the acquisition spending is actually part of sustaining capex.  In a fast changing industry that is constantly growing, do you need to constantly acquire new companies to maintain market share?  Running to stand still...

Valuation

FCF per share is below.  Again, I'm excluding working capital changes to smooth things out - this will inflate CFO a little, as more and more working capital (eg: inventory) is required as a business expands over time:

At $140, MCK is trading at ~11X estimated FCF, and at $60, CAH is around 12X.

Risks

Although their past numbers are really good, there are some risks not reflected in them.  Most of these are from the DrugChannels 2017-18 Economic Report on Pharmaceutical Wholesalers and specialty Distributors.

Their pharmacy end customers have been consolidating, putting pressure on Margins.  Operating margins for large pharmacy chains are estimated at ~ 0.5%, versus 1.5% for independent pharmacies.

Generic drugs account for an estimated 70% of their operating profits.  Pricing is horrendously complex, and is a set percentage of the Weighted average Cost price (WAC) - see pages 11 and 13 for examples - which means that rising generic drug prices boost profits.   Starting in 2011-12, there was a boom in generics drug prices due to an artificial shortage.  This has since been resolved, and prices have been coming down since 2016.  We need to keep this in mind when looking at the charts of the historical profits/cashflows above.  The report estimates that 1 in 5 generic drug prices have yet to fall, and that generic drug prices will continue on average to fall in the next 6-18 months.

Although spending on specialty drugs in set to increase, this is not expected to help wholesalers as most specialty drugs are prescribed through large chains and hospitals.  ie: their low margin clients.

Finally, there is a risk of litigation due to the opioid crisis, where the wholesalers were not monitoring - or just ignoring - suspicious orders.  I think McKesson is more vulnerable as they've been sued a lot before.

Conclusion

The positives are: this industry is an oligopoly with a defensible moat.  And pharmacy spending is not affected by recessions.

MCK has better historical numbers and trades at a slightly lower valuation.  But has more litigation risk. 

The stocks are trading at low valuations now due to:

• A price war last year, bought on by a consolidating customer base.
• Falling profits in 2016 dues to generic drug deflation.

These trends may continue.  I see no catalyst to move the stocks higher now.  But the industry is cheap.  Are the above risks already priced in?

Sold losing positions

Sometimes I take small speculative positions.  Either to bet a small amount for a possible large gain, or to begin investigating a company.  These 2 didn't work out, I don't have the confidence to hold them or the time to investigate further.

Bought 490 shares SECO at late Jan, sold them 29th Mar.  Loss of USD 850.

Sold 785 shares STNG  on 20th Feb at 2.34.  Loss of USD 1.1K.

Bought Boustead

I've followed Boustead for a while.  Also see TTI's blog for a more detailed look.

Here's my valuation for a stock price of 83c:

First, net cash is 28c/share.  This includes some cash required for working capital.  Gives a stock price of 55c.

Next, the segments with recurring earnings:

• I estimate Geo Spatial earned 2.8c/share in the last 12 months.  After estimating taxes subtracting some HQ costs
• (Boustead Singapore's share of) Boustead Project's Leasing Segment's after-tax earnings were 1c/share.

So 3.9c/share of recurring profits.  That gives an ex-cash PE of 14.

And we are getting the Engineering and Design&Build segments for free.  These should be coming off multi-year cyclical lows.

The risks are:

• Long term: Much of Boustead's past success is from the old CEO's capital allocation skills.  Will this continue under the next generation?  The company has been looking to deploy cash for a long time, without success.  Hopefully they will remain conservative.
• Short term: Geo-Spatial's revenues would drop if the AUD dropped.  Also if the Australian Government cut spending.

Bought 36000 shares at 82.5c on 6th Feb.  Thats half my position, will buy more if the stock price drops to 75-76c.  I'm content to hold them long term, and - at this stage in the business cycle - may end up holding them through the next crash/recession.

This stock does not seem to be affected much by the current correction.

Sold LBrands

2 days ago the stock dropped 15% on a bad sales report, breaking its uptrend:

This is not a Buffet-like stock that I want to hold for years, so I sold at $50.20.  Profit around USD 800.

I am now just under 60% in cash: