AAII Investor Update: Buy Good Stocks Cheap

Thursday, November 10, 2011
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Magic Formula Screen
This strategy applies Joel Greenblatt’s investing philosophy to find bargain stocks.

AAII Discussion Boards
Which popular investment philosophy do you associate yourself with?

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Joel Greenblatt offered to provide some insights for this week’s newsletter. Joel is the CIO of Gotham Asset Management and author of several investing books. He will also deliver the keynote speech tomorrow (Friday) at our Investor Conference.

Here’s what Joel had to say:

When it comes to investing in the stock market, investors have plenty of options:

1. They can do it themselves.

Trillions of dollars are invested this way. (Of course, the only problem here is that most people have no idea how to analyze and choose individual stocks. Wait, did I say the only problem? I really meant that most investors who aren’t AAII members have no idea how to construct a stock portfolio, most have no idea when to buy and sell, and most have no idea how much to invest in the market in the first place. Okay, that’s better.)

2. They can give it to professionals to invest.

Trillions of dollars are invested this way. (Though after fees and other institutional impediments are factored in, most professional managers don’t add value. In fact, most professionals actually underperform the market averages over time. Oh, I almost forgot—it may be even harder to pick good professional managers than it is to pick good individual stocks.)

3. They can invest in traditional index funds.

Trillions are also invested this way. (This is a great way to match the major market averages, to pay very low fees, and to beat most professional and individual investors. Then again, investing this way is seriously flawed—and almost a guarantee of subpar investment returns over time.)

4. They can do something else…

For years individual investors have asked me how they should go about investing their savings in the stock market. After all, I’m a longtime business school professor and institutional money manager, and they figure I should know. Yet for years, I haven’t had a good answer.

But I believe there actually is a way for individual investors to beat the professionals and the popular index funds by following a disciplined approach based on the simple principles laid out by Benjamin Graham and Warren Buffett. Of course, Graham said: Buy it “cheap.” Figure out what a business is worth and pay a lot less. What a company is worth and what is “cheap” are good questions, but there are actually simple metrics that can help us confront many of these challenges.

Graham’s most famous student, Warren Buffett, added a little twist to Graham’s basic principle that is probably responsible for making Buffett one of the richest men in the world. Buffett essentially said: Cheap is nice, but buying a “good” business cheap is even better. Obviously, what makes a “good” business is another excellent question, but this challenge can be partially met by looking at some simple metrics that Buffett has addressed through his writings over time.

What’s left is merely to put these principles and metrics into action in a disciplined way that takes into account an individual’s investment goals and tolerance for risk. Buffett is a fan of return on capital, and so am I. By first seeking out companies with high levels of return on capital and then focusing on the ones with the most attractive valuations, individual investors can give themselves an advantage over professional investors when trying to “beat the market.”

—Joel Greenblatt, CIO, Gotham Asset Management

AAII’s Greenblatt Magic Formula Screen

Joel’s philosophy toward picking stocks is the basis for AAII’s Magic Formula Screen. This screen is an interpretation of the criteria detailed in his book, “The Little Book that Beats the Market” (John Wiley & Sons, 2005).

The screen identifies companies realizing a return of capital in excess of 25%. It then narrows down the list to the 30 stocks with highest earnings yield. (Earnings yield and valuation are inversely related; high earnings yield equates to low valuation.)

The Magic Formula Screen, and a list of passing companies, can be accessed in the screening section of AAII.com.

Do you associate yourself with a popular investment philosophy (e.g., Magic Formula, Buffett, CAN SLIM, etc.)? If so, which one? Tell us on the AAII.com Discussion Boards.

The Week Ahead

Earnings season shifts to the retailers next week, with Dow components Home Depot (HD) and Walmart (WMT) reporting on Tuesday. Joining them will be more than 25 S&P 500 member companies, including Lowe’s (LOW) on Monday and Target (TGT) on Wednesday.

Several economic reports will be released on Tuesday: the October Producer Price Index (PPI), October retail sales, the November Empire State index, and September business inventories. Wednesday will feature the October Consumer Price Index (CPI), October industrial production and capacity utilization, and the National Association of Home Builders’ November housing market index. October housing starts and building permits and the November Philadelphia Fed survey will be published on Thursday. Friday will feature the October leading indicators index.

The Treasury Department will auction $11 billion of 10-year Treasury Inflation-Protected Securities (TIPS) on Thursday.

Several Federal Reserve officials are scheduled to speak next week. Richmond Federal Reserve Bank President Jeffrey Lacker will make public appearances on Tuesday and Wednesday. St. Louis Federal Reserve Bank President James Bullard, Chicago Federal Reserve Bank President Charles Evans, San Francisco Federal Reserve Bank President John Williams and Dallas Federal Reserve Bank President Richard Fisher will speak publicly on Tuesday. Boston Federal Reserve Bank President Eric Rosengren will speak publicly on Wednesday. Cleveland Federal Reserve Bank President Sandra Pianalto will speak publicly on Thursday.

November stock options will expire on Friday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 44.7%, up 4.6 points
  Neutral: 30.7%, up 0.5 points
  Bearish: 24.6%, down 5.1 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 4.6 percentage points to 44.7%. This is the highest percentage of optimism since February 17, 2011. This is also the third consecutive week that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, edged up 0.5 percentage points to 30.7%. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.1 percentage points to 24.6%. This is the lowest level of pessimism since January 13, 2011. Bearish sentiment has now been below its historical average for three consecutive weeks.

Many respondents took this week's survey before yesterday's 389-point drop in the Dow. Thus the results reflect optimism caused by the rebound that stock prices had been experiencing. Even with the improvement in bullish sentiment, individual investors remain cautious, however, given the events in Europe, the slow level of U.S. economic growth, and Washington politics.

In honor of this week's AAII Conference, which is being held in Las Vegas, we asked AAII members who their favorite Vegas act was (past or present). Elvis Presley and Circ de Soleil received the most votes.

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor