A Few Extra Percent of Gain: Part 4
Board: Macro Economics
This post is Chapter 4 of “Looking For a Few Extra Percent of Gain.” Links to the first three chapters (posts) are at the bottom of this post. Hopefully, the chapters are in a logical progression
Last week I posted about the Fama-French “3 Factor Model” aka 3FM. The 3FM has the traditional beta plus new factors for a company’s market cap and “value.” 3FM had a simple definition of value based on the book value/ (stock) price for each company. 3FM showed that high book value/price companies outperformed low book value/price companies. 3FM also showed that low market cap companies outperform high market cap companies.
So you say: “Yoda, this is easy. All I need to know is which stocks/funds/ETF’s to buy that have the optimal 3FM factors?” At this point, I could just list a few issues for your consideration and wish you good investing . . . but that would be too easy. Before we head down this path, we need to understand what we are buying and how it is supposed to work. It is NOT sufficient to know ex-post that it did work because maybe this time is really, really different!
One very important concept to understand is the difference between say an SP 500 index fund and a 3FM optimized SP 500 fund. The same points apply to any kind of 3FM optimized fund.
The SP 500 index is conceived as the 500 highest US equities ranked by market capitalization. The index is calculated by adding up the market cap of each company. The highest market cap companies like Apple and Exxon make up a much larger percent of the overall index than say the smallest market cap company. As of 9/16/11, the total market cap of the SP 500 was $11.6 Trillion. Exxon (XOM) and Apple (APPL) have market caps of about $370 billion. So XOM and APPL each are about 3.2% of the SP 500. At the opposite end of market caps is AK Steel (AKS) with a $935 million market cap. It represents 0.008% of the SP 500. After adding up the 500 market caps, you divide by a number to calculate the SP 500 value.
Humans, as opposed to computers, at the Standard and Poors company decide which 500 companies will be in the SP 500. Their goal is to have a very static list of companies with very low turnover. It is intended to be an “unmanaged” index. Once a company is added to the SP 500, it is difficult to be removed.
If we wanted to apply 3FM to the SP 500, we could:
1) Inversely weigh market cap such that the lowest market cap companies were a higher percentage of the index than the highest market cap. Even if we said we just wanted an equal weight for all market caps, it would be a major change to the composition of the index. You would have much fewer shares of AAPL, XOM and relatively many more shares of AKS. Note that there are a few ETF’s/FUNDS that do exactly this. They are usually called “equal weighted” SP 500. I am not going to cover this, but suffice to say, the last time I reviewed the data, the equal weighted SP 500 had outperformed the regular SP 500.
2) Weigh each stock on Book Value to Price (BVP) and have more shares of high BVP stocks compared to low BVP stocks. I am going to invert this ratio to make it Price to Book Value (PBV) since more people are familiar with this term. Now we will want to have more shares of low PBV issues.
3) Recalculate the relative weightings for these two factors on a regular basis, say one time per year. Rebalance the portfolio at that time by buying and selling as appropriate.
IMPORTANT POINT 1 is that we have changed from a passive portfolio to an active managed portfolio. When the current SP 500 list was constructed it called for buying X shares of AAPL, Y shares of XOM, and Z shares of AKS. The SP 500 will NEVER change the number of shares it owns of each stock. (Yes, this is a slight exaggeration but it is valid to make the point.)
When we use 3FM to construct the portfolio, we will constantly be changing the number of shares of each stock in the portfolio. We might only do it one day per year, but it is a fundamental change from passive to active management. Most investors do NOT understand this point IMO. Yes, active management in this sense is not the same as many mutual fund managers where they are making daily changes to the portfolio. All of the Fama-French research is based on monthly rebalancing. This seems unrealistic to me for the average fund and/or average investor. I do NOT know how often the Fama-French real life funds are rebalanced.
THIS REBALANCING THE NUMBER OF SHARES IS WHAT ADDS THE EXTRA FEW PERCENT OF PORTFOLIO GAIN. It is a mechanical way to force you to buy low-sell high. It is conceptually similar to rebalancing your overall portfolio between asset classes.
This also certifies you as a member of the “contrarian investor club”, particularly as it pertains to Price to Book Value rebalancing. The concept is that Mr. Market beats down the price of out favor companies to low PBV’s. At the same time, Mr. Market raises the price of can’t miss companies to high PBV’s. The 3FM factor for PBV’s is a different way of saying “overweight beaten down companies and underweight irrationally price companies.”
So far, there is probably nothing controversial in this post. Most METARites probably knew and agree with most everything so far. Here is where it gets hard.
I went and ranked the current SP 500 companies on PBV. Here are the 20 lowest, i.e. beaten down “value” stocks that should be overweighted.
[See post for tables.]
Like I said, this is where it gets hard. Eighteen of the twenty most beaten down stocks are in the financial industry, i.e. banks and insurance companies. I will confess to you that I did NOT realize how beaten down the insurance companies were. Everybody knows about the banks, because you hear about them every day, but the insurance companies are not as widely discussed. The median PBV for all 500 stocks is 2.13. The reported PBV for the SP 500 is 1.91, so clearly the low PBV’s are very beaten down and the high PBV’s are irrationally exuberant.
Instead of talking about industry groups, I want focus on one single stock as a proxy for our 3FM PBV discussion. The stock I choose is Bank of America aka BAC. You will note that it is currently has a PBV ratio of .35. The market is saying that you can buy its assets for 35 cents on the dollar. Would you rather buy BAC at 35 cents on the dollar or Colgate-Palmolive (CL) for 1,543 cents on the dollar?
What Fama and French’s research tells you is that statistically BAC will outperform CL over many years. The expected return is much higher. Only one small assumption here: BAC must survive in its current form and NOT go bankrupt in some fashion.
BAC is a perfect example for contrarian investors IMO.
1) On the buy side, you have Warren Buffet and Bruce Berkowitz of the Fairholme Fund strongly advocating the stock. The motto of the Fairholme Fund is “Ignore the Crowd.” Both Buffet and Berkowitz base their buy opinions on a detailed examination of BAC’s fundamentals. Both investors think the assets are “good” and you can currently buy them on the cheap.
2) On the sell side is noted bank analysis, Chris Whalen of Institutional Risk Analytics. He is very blunt that the mother company of BAC is technically insolvent and should be restructured/ bankrupted today. Note that he is NOT suggesting the bank literally close its doors and cease doing business. His point is that stockholders should lose 99.9% of their investment. Bond holders should take some large hair cut, say up to 50%.
3) On the buy side, we have an unusual ally in Rob Arnott. Rob bases his buy recommendation purely on mechanical evaluation of these numbers like PBV. Rob has stated that statistically he expects BAC to outperform AAPL over the long term! This is exactly the same as Rob saying “I believe the 3FM is still valid.” (Note these are my words, not literally Rob’s words.)
Rob Arnott link:
4) Clearly the public investor majority opinion has been on the sell side. On 11/20/2006, BAC hit a high of 50.08. Today (9/21/11), it closed at 6.38, down 87% from its high. This implies that the public does NOT believe the BAC book value is accurate. They are pricing BAC like it has a zero or negative book value.
Another important fact is that BAC traded for an average PBV of ~ 1.67 back in 2006.
LITMUS TEST FOR CONTRARIAN INVESTORS: Would you buy BAC today under the belief that it will survive and mean revert to say at 1.5 PBV? If it reverts to 1.5 PBV, the stock price will increase > 4X. If you answer yes, you are a certified contrarian investor. If you answered no, then I am not sure you should be trying to get those few extra points of gain using techniques like this. You can choose to ignore “what it going on under the hood” that produces the extra gain, but I think it is important to at least conceptually understand what is going on.
3FM assumes that BAC will survive and return to a “normal” PBV. 3FM and nearly all value strategies performed poorly in the 2007-2008 credit crisis. 3FM would have guided you to OVERWEIGHT GM, Fannie and Freddie. We know how that worked out with common stockholders losing close to 100% of their investment.
The question going forward is: are we in for another credit crisis style crash where several large companies go bankrupt, or will the entire financial stormy weather pass and all companies survive?
ACTIONABLE INVESTMENT IDEA is for those that passed the contrarian investor litmus test. Since we know that the financial industry is beaten down at this point in time, statistically speaking it is a reasonable speculation to overweight this sector. For the really brave at heart, you could buy small allocations of a few specific stocks like BAC. By small allocations, I mean something on the order of 1% of your portfolio per stock for 5 different stocks MAXIMUM. If all 5 go to zero, you will lose 5%. If all five revert to their mean PBV’s, they should double to triple over a few years. If that happens, you will get an extra 5% to 10% overall portfolio gain. I think most investors would be better suited to invest in the whole financial sector, instead of a few specific stocks. The ETF I suggest is Financial Select Sector SPDR aka XLF. It has 82 stocks representing all of the major banks and insurance companies.
Details on XLF:
IN NO CIRCUMSTNANCES DO I RECOMMEND YOU GO HOG WILD AND ALLOCATE A MAJOR PERCENTAGE OF YOUR PORTFOLIO TO THE FINANCIAL SECTOR. I am comfortable with a 5% allocation up to 10% if you are using the ETF. And, by the way, THERE IS EVERY CHANCE IN THE WORLD THAT THE SECTOR WILL GET CHEAPER BEFORE IT HITS BOTTOM. Today, XLF lost 4.95%. It has lost money YTD and the last 1, 3 and 5 years. THIS IS A MULTI YEAR BET AT A MINIMUM.
What can go wrong?
1) Credit Crisis 2 hits and several of the large financials are ALLOWED to go bankrupt.
2) Armageddon hits and all equities sink with financials leading the way down.
3) Specific companies compete for the worst CEO of the decade by hiring Ken Lewis type managers. I think Ken is a lock to win the award, but sometimes those ingenious boards surprise me.
As long as there is adequate interest, I have several more chapters to post. Like I said in the beginning, I am attempting to present these in a systematic fashion, instead of a seeming random stream of consciousness.
Related topic: why insurance companies are suffering from Reuters:
Link to Chapter 1- The Most Important Asset Class in Your Portfolio
Link to Chapter 2- Setting Realistic Return Goals which is not very optimists in 2011
Link to Chapter 3- History and evolution of Fama- French 3 Factor Model