Articles from Jul 2006

The Little Book That Beats the Market- Update

Baron had an article about The Little Book That Beats the Market sometime back. They attribute the superior returns to database selection. Even if you account for the database selection, you can still get market beating returns with the strategy in the book. The concept is still valid and there are number of value managers who show great returns following similar strategy.

The Little Book's Little Flaw
THE LITTLE BOOK THAT BEATS THE MARKET has become a bestseller since it appeared in November. In it, hedge-fund manager Joel Greenblatt describes a "magic formula" for picking stocks and shows how the formula identified winners when tested on an historical database. The awesome test results helped The Little Book win rave reviews. Stocks selected by Greenblatt's magic formula from 1988 to 2004 would have beaten the market by nearly 20 percentage points annually, he says, with yearly returns averaging almost 31%, versus 12% for the overall market. "It can't be this easy!" he writes."The results are just too good!"
But should you expect to nearly triple the market's performance, working just minutes every few months, if you apply his formula over the long haul? Greenblatt's strategy does make sense and probably would beat the market by some margin. But don't count on
30%-plus: Investment formulas that look great in a historical "back test" often prove less powerful in the real world. Trading commissions and other irksome frictions hurt performance, of course, but there are more fundamental limits to the predictive power of the kind of study The Little Book crows about. Simply put, the magic formula's jumbo returns were probably limited to the data Greenblatt used in his test.

To get a rough sense of how data-specific the magic formula might be, Barron's arranged to test it on a different financial database. From the beginning of 1997 through 2002, The Little Book reports 16% average returns on large-capitalization portfolios chosen from a Compustat database. But on data from Bloomberg,Barron's found, the strategy averaged 10% annual returns in that span. Readers should probably moderate their expectations, therefore, if they plan to use the magic formula on freely available databases -- like that offered at www.smartmoney.com1, the Website of Smart Money (the monthly magazine published by Hearst and Dow Jones, Barron's parent).

ETF trends

Two sectors, pharmaceuticals and telecommunication are showing clear trend of high volume buying.

ADRE,BLDRS Emerging Markets 50 ADR Index Fund ETF
EEM,iShares MSCI Emerging Markets Index Fund ETF
EWW,iShares MSCI Mexico Index Fund ETF
ILF,iShares S&P Latin America 40 Index Fund ETF
IXP,iShares S&P Global Telecommunications Sector Index Fund ETF
IYZ,iShares Dow Jones US Telecommunications Sector Index Fund ETF
PPH,HOLDRS Pharmaceutical
VWO,Vanguard Emerging Mkts Etf
XLV,SPDRs Select Sector Health Care ETF

Gap and trap

The market is following the gap and trap pattern. The morning strength does not lead to more strength in the afternoon. The month end effect will ensure that we stay in range. The action typically sucks in bulls and unnerves the bear.

Earnings so far are much better than expected.

Through the close on Tuesday, a total of 212, or 42.4%% of the S&P 500 stocks have reported their second quarter results (defined as the fiscal period ending in May, June or July). Thus far the results have been very encouraging. The median year-over-year growth rate is 13.1%. As in recent quarters, positive surprises have been swamping disappointments, with the ratio currently running at almost 5:1. The median surprise has been 3.4%. This is almost identical to the 3.5% median surprise that this same group of companies delivered in the first quarter. In every sector, positive surprises far exceed disappointments.
It looks pretty certain that we will have yet another quarter of double-digit year-over-year growth in earnings. If anything, the 13.1% growth shown so far is more likely to increase than decline when all the results are in. The forward looking growth rates, for the third quarter, and 2006, are the median growth rates of only those firms that have reported so far, not the sector or the S&P 500 as a whole. The median expected 2006 growth for those that have reported is 10.5%. However the median expected 2006 growth rate for the S&P 500 as a whole is 12.2%. Every sector except the two Consumer sectors is currently showing double-digit growth for the quarter. Thus, more of the high expected growth firms, at least for the year as a whole, are yet to report.

For every sector except Materials, growth is expected to slow, often significantly, in the third quarter. Many firms which may have reported better than expected numbers for the second quarter have issued downbeat guidance for the second half. A great example of this is among the Homebuilders, where four of the five firms in the sector have already reported for the second quarter, and all had positive surprises. On the other hand, all made it very clear that it was the last good quarter to be expected from them for quite some time. For several quarters now, the “next quarter” has been expected to be softer than the “current quarter”, at least until that “next quarter” gets reported. In other words, it appears that firms are following an under promise and over deliver strategy with respect to their guidance.

Backdating of options is no big deal

There is lot of attention on backdating of options and I got couple of emails from readers blaming current market weakness on the backdating scandal and predicting dire consequences due to it.
The current market weakness is not related to it. It has to do with other issues like interest rates, inflation, valuation and so on. After a four year rally a market weakness and correction is a very normal market reaction.
In my view the backdating of options is no big deal.History of Wall Street is full of scandal after scandals. If you go back in history and see some of the other insider and management scandals, this one is a insignificant event. Ever since the market existed the insiders have always tried to game the system. The regulators have always lagged in enforcing the rules. Most of the time rules are put in place to avoid future scandals. But the nature of fraud and scandals keep changing.
The market takes care of all such irregularities over a period of time. This scandal will have impact on individual companies and managers in those companies but it is not going to affect the market for long. Any one who claims it is going to have significant impact is not well versed in history of speculation.
If you have a methodology which works and if you have a system with structural edge , you should just ignore such scandals. The gurus and pundit scream about it because that is what they get paid for. It also appeals to their blind cult followers.

The Little Book That Beats the Market

I have been catching up on my summer reading and one of the book I finished reading in two hours last night was The Little Book That Beats the Market by Joel Greenbalt. It is a easy to read fun book which details a simple value investing trading system in a very simple to understand language. Joel Greenbalt is a hedge fund manager with an impressive 40% anualised return since 1985.
There are many books on value investing and I have read almost everyone of them but this slim book is by far the best value investing book your money can buy. It lays out the case for value investing in simple easy to understand language.
The book boils down the value investing methodology to finding stocks with high return on capital and earning yields. The methodology suggest buying the top 30 stocks ranked by the two parameters and holding for more than a year to take advantage of tax laws. The most important thing for a simple approach like this to work is to have conviction in the logic behind it. If you are savvy enough you can improve on the stock selection and improve your returns.
You can find the stock meeting his criteria at his free web site.

The bounce might be over

This weeks high magnitude bounce to frustrate the bears may be over. As the earning season winds down the bearish action should resume. Only select sectors are likely to buck the strength.

More leaders breaking down

The earning season continues to slam some old leaders and some new plays might be emerging.
Stocks which had rallied for long time based on stellar earning are finding a slight miss or lukewarm guidance is being punished heavily. Much of these change is reflected in the sector leadership also.
The quarterly earning reporting period establishes new trends both on long and short side. Many of these trends have legs and last few quarters.
Some of the stocks in oil sector are finding renewed buying interest and are set to extend their rallies.

Leaders down
ACLI,American Commercial Lines Inc
CHH,Choice Hotels International Inc
CRS,Carpenter Technol Corp
FTI,Fmc Technologies
ISRG,Intuitive Surgical Inc
LVS,Las Vegas Sands
NTRI,NutriSystem Inc

The stocks below are finding buying interest post earnings or in anticipation of earnings.

Earning Effect

ACL,Alcon Inc
DFG,Delphi Financial Group A
DO,Diamond Offshre Drilling
FTK,Flotek Industries Inc
GIFI,Gulf Island Fabrication
ICLR,Icon Plc Ads
JLL,Jones Lang Lasalle Inc
NOV,National Oilwell Varco Inc
SNA,Snap-On Inc
TRMB,Trimble Navigation Ltd
TSAI,Transaction Sys Architects Inc
YCC,Yankee Candle Co Inc

Don't bet against the dollar

This cover of Economist appeared at the height of bearishness on dollar. Since then the dollar started going up. People with big pockets like Warren Buffet had big bets against dollars and the conventional wisdom was doom and gloom for dollar. Since then the dollar continues to defy the skeptics.

Here is an insightful explanation as to why.
The explanation for the stability--strength, in fact--of the U.S. dollar, even as the current account deficit has since 1990 risen from zero to 7 percent of GDP, lies with the globalization of wealth storage by rapidly growing countries--both advanced and emerging. Wealth is increasing rapidly in emerging markets, China of course being the largest, but also in Europe and Japan, not to mention the oil-exporting countries. The United States offers the largest menu of wealth storage options, not only in terms of variety, but also in terms of liquidity (defined as the ability to move huge sums--tens of billions of dollars worth) with only a small impact on price.

20 Stocks to watch

These are some of the stocks I am keenly watching currently or have positions in (some of them). They have the mojo.

AEM,Agnico-Eagle Mines Ltd
AEPI,Aep Industries Inc
AMAG,Advanced Magnetics Inc
AP,Ampco-Pittsburgh Corp
CPY,Cpi Corp
EMCI,Emc Insurance Group Inc
EZPW,Ezcorp Inc Cl A
FAL,Falconbridge Ltd
FMCN,Focus Media Holding Ltd ADR
HANS,Hansen Natural Corp
IBCA,Intervest Bncshs Cp Cl A
ILMN,Illumina Inc
LCC,US Airways Group Inc
LFC,China Life Insurance Company
MWRK,Mothers Work Inc
NEU,Newmarket Corp
OMG,Om Group Inc
TXUI,Texas United Bancshares Inc
VOL,Volt Info Sciences Inc
WBD,Wimm Bill Dann Foods Ojsc

Best Broker- Interactive Brokers

Business Week has an article on Best Brokers on the web site. For active investors by far the best broker is Interactive Brokers. I have tried most of the brokers in their list but my favorite is IB. It has the best execution. The application is easy to use and very stable. It is very technology focused company and the founder himself is a successful trader.

Talk about cheap: At Interactive Brokers, a stock trade costs 0.5 cents a share, with a minimum of $1 a trade. That's below what most institutional investors pay. The catch is that the firm charges a $10 monthly maintenance fee if you don't spend at least $10 trading. But for many investors, the $120 minimum annual cost is well worth it. According to the J.D. Power survey, the average online investor made 36 trades in 2005, up from 23 in 2003. Even at Scottrade, 36 trades amounts to $252 a year, more than double Interactive Brokers' $120.

For active investors, the margin rate -- what it costs to borrow from the broker to leverage your holdings or sell stocks short -- may also be an important factor. Every broker has a tiered pricing system for margin loans, with larger amounts getting the best rates. Here again, Interactive Brokers has the best deal: just 7% for borrowings of $100,000 or less and as low as 5.5% for $3 million or more.