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MagicDiligence (< 20)

How 10 Investment Gurus Beat the Market

Recs

13

October 13, 2010 – Comments (1)

John Reese's book The Guru Investor is an interesting look at the stock investing philosophies and methods of 10 renowned, successful investors, most of which have written extensively about their systems. One of the gurus profiled is none other than Joel Greenblatt, the father of Magic Formula Investing, the strategy followed by MagicDiligence. The other gurus are lumped into three groups:

The Value Legends

These gurus focused on buying stocks that were under-priced based mainly on one of three valuation metrics: price to earnings (P/E), price to sales (P/S), or price to book value (P/B).

Benjamin Graham: Known as the "father" of value investing. Wrote The Intelligent Investor, mentored Warren Buffett. Famous for his "margin of safety" principal. Looked for P/E ratios below 15, (P/E * P/B) <= 22.

John Neff: Author of John Neff on Investing, 30-year manager of the Windsor Fund, routinely one of the top 5% of all U.S. mutual funds. Looked for low P/E stocks (40-60% of market average) with moderate growth rates (7-20% trailing 5 year). Always included dividend into calculated growth rate.

David Dreman: CIO of Kemper-Dremen High Return Fund - ranked #1 in Lipper for more time periods than any other. Well-known as a consummate contrarian investor, student of investor psychology. Wrote Contrarian Investment Strategies. Looked for P/E, P/B, P/CF ratios in bottom 20% of market with recent business momentum.

Warren Buffett: America's 2nd richest man, renowned head of Berkshire Hathaway. Shareholder letters, compiled in The Essays of Warren Buffett (review), give glimpse into his investment strategies. Looks for businesses that have repeat purchases, stable products, low capital expenditures - leading to earnings predictability. Also high, sustained returns on equity, indicating a long-term economic moat.

The Growth/Value Legends

These investors put a focus on increasing sales and profit growth, while also setting strict valuation rules to avoid overpaying for that growth.

Peter Lynch: Famous manager of Fidelity Magellan, delivering a 29.2% annual return during Lynch's 13 years at the helm. Author of One Up On Wall Street. Inventor of P/E/G ratio, looks for stocks with P/E ratio under 3-5 year growth rate. Liked growth rates of 20-25%, which are sustainable. Had rules for different categories of stocks.

Ken Fisher: Son of growth legend Philip Fisher, runs Fisher Investments, writes for Forbes, and author of several books, most notably Super Stocks. Known for focusing on price-to-sales ratio, looking for 0.75 or less (0.40 for cyclical stocks).

Martin Zweig: Authored Winning on Wall Street, ran a newsletter ranked #1 by Hulbert Financial Digest over 15 years. Focused on accelerating revenue growth at reasonable price (no more than 3x market P/E). Also one of the first gurus to utilize the "put-call" ratio, and put emphasis on insider buying.

The Pure Quants

This final group believes in simply having a computer rank stocks by certain criteria, then buying a number of stocks from the ranking. They advocate little or no qualitative research.

James O'Shaughnessy: Researcher who compiled What Works on Wall Street (review). Found that cheap valuation plus relative strength a powerful indicator of future returns (especially P/S ratio). Also focused on earnings persistence.

Joel Greenblatt: Hedge fund manager, father of Magic Formula Investing, author of The Little Book That Beats the Market. Two variables: high earnings yield (EV/EBIT, cheap price) and high returns on capital (quality company). Buy 20-30 stocks, hold for one year, rinse and repeat.

Joseph Piotroski: University of Chicago and Stanford accounting professor. Looked for low price/book ratios, then applied a 9-point test of profitability, financial strength, and business momentum (the Piotroski score). Stocks scoring 8 or 9 are considered strong buys.

Even though all of these gurus have their own unique "systems" for finding attractive investments, a few common points showed themselves over and over:

* Do not invest emotionally. Pick a proven plan and stick to it even when things are not working.

* All gurus require some measure of financial health, most commonly low debt-to-equity and high current ratios.

* When to sell is a tough decision, but gurus have basically two rules: when a stock reaches a reasonable fair value, or when it no longer fulfills quantitative requirements.

* Certain business qualities are favored by several gurus. Companies that make repeat purchase products, recurring services, or operate in dull or niche industries. These factors make profitability more predictable.

The Guru Investor is certainly worth any stock investor's time. It is a great introduction to a variety of historically successful investing styles, and a good entry point to digging deeper into styles that may interest you, as most profiled gurus have one or more books available.

One thing that may turn some readers off is that the book is clearly an "infomercial" for Reese's Validea.com website, as he attempts to systematically find "guru stocks" using a collection of quantitative, mathematical formulas. However, I found the results of Reese's tracking portfolios quite interesting, as nearly all of them spanked the market over the first 5 year period. Even more interesting is his suggestion to focus on stocks that meet the criteria of several gurus, a clear indicator that the issue may have intriguing investment merits.

A good, fairly light (not a ton of math!), informative read, MagicDiligence recommends The Guru Investor.

1 Comments – Post Your Own

#1) On October 13, 2010 at 11:37 PM, tekennedy (68.11) wrote:

Good article, I appreciate the summary +1 rec.  I got a weird sense of deja vu as this is a lot like Million Dollar Portfolio, written by the Fool.  It has summaries of different investment styles and tried selling their services.  Happily I checked out CAPS.

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