Brilliant CFA interview with C. Thomas Howard on behavioral investing. Howard takes an unconventional approach, but there is some solid research backing up his process:
What are the five criteria?
One is dividends; we buy stocks that pay dividends. Companies that pay dividends are saying to the market, “We believe we have earnings into the foreseeable future.” It’s a powerful signal. It’s putting your money where your mouth is. In identifying behavioral price distortions, I look for situations where people are putting their money where their mouth is.
Analyst earnings estimates are the second factor. Based on the forward P/E, analysts are saying they believe there’s enough future earnings to justify the current price. Now I have two opinions on the company—management’s opinion and the sell-side analyst’s.
Third, I want companies with as much debt as possible. If I find one with negative net worth, I’m thrilled. Now, when most people hear that, their lip curls and they say, “That’s bad.” The reason debt is attractive is because the underwriter or the bank worked closely with the company and decided they could make the loan and the firm would repay it. I’ve now got a commitment from three sides—again, people putting their money where their mouth is, saying, “Yes, we believe in this company.” The greater the debt, the better I like it.
Then, I use a price-to-sales ratio. Sales are the least manipulated of accounting measures and have been shown to be one of the best predictors. And I have a minimum sales threshold. Those are my five criteria.
Aren’t these basic balance sheet metrics rather than distortions?
They are distortions. Investors tend to underreact to dividends; they don’t realize how powerful a signal it is. The typical response to dividends is a downgrade of growth prospects. It turns out it’s just the absolute opposite of that—the higher the dividend, the higher the return, the higher the growth of the company. Investors also tend to overreact to debt. If a company has lots of debt, they tend to run away from it. I’m harnessing these particular behavioral mistakes.
What names do you hold in your portfolio?
I don’t know the names of the stocks I own.
Really? Are you serious?
I’m serious.
How does that work on an operational basis?
I have to know them long enough to tell our traders to trade them, but beyond that, I don’t remember the names. The reason is a component of my process. I ruthlessly drive emotion out of my decision process. I make no attempt to remember names any longer than it takes for me to say, “Trade this stock.” I just don’t remember. Now, I do look at them from time to time. They’ll float through my brain, but it’s nothing that I keep track of.
Why should I remember the name of a stock? It’s not part of my process. I believe the name of a stock creates emotional problems. You could wipe out the name and call this stock “123.”
Are you saying you don’t place importance on names, or are you actually saying you don’t remember the names?
I literally don’t know the name. I cannot name the 10 stocks that I currently own.
Read the rest of C. Thomas Howard’s interview with the CFA Institute Magazine on behavioral investing.
Buy Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.
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Banks don’t really underwrite deals anymore – they simply do “best effort” deals and lop off the risk to institutional investors ( e.g. mutual funds and CLOs)
Of course Banks don’t want to bring obviously terrible paper to the Street for reputation reasons but there is so much demand out there these days for higher-yielding paper and thus they have adopted a caveat emptor attitude…Therefore I wouldn’t place much faith in the lead left bank’s “sign-off” on a deal.
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Maybe I’m a little new to the value investing world, but honestly that debt trick strikes me as a good idea. I’ve had people try to tell me to avoid that sort of thing since banks aren’t a good judge of risk (since they’re probably getting their money back one way or another) but the idea of considering it a showing of faith might carry some weight. Really depends on the company, and maybe the AMOUNT of debt in question, but I might be willing to give this a try.
Still, not knowing the names of your stocks? Yeah, that’s a little iffy. Maybe that’s just my OCD kicking in.
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Tobias–I was under the impression that you were a fan of Dr. Howard’s methodology. But when I see your comments on people’s responses, it appears that you side more with the naysayers and skeptics. So which is it–are you friend or foe of Howard’s strategy?
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Neither. I don’t agree with his 5 criteria, but I understand the behavioral reasons for his not knowing the names of the stocks in his portfolio. Thought it was an interesting approach to the cognitive bias problem of cherry picking ugly names and underperforming.
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[…] week’s action tells us a lot about your strategy. (dashofinsight.com)TweetPocketInstapaperCan you invest without knowing the companies in your portfolio? (greenbackd.com)TweetPocketInstapaperThree questions to ask yourself about risk. […]
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It’s an impressive record for sure, although the strategy has had an impressive tailwind from declining long-term bond rates, which a) reduce the cost of debt over time with each refinance and b) provides less competition for dividend-paying stocks (which directly inflates underlying asset values).
Also, this strategy is not new. The Fidelity Leveraged Company Stock Fund (FLVCX) has an excellent long-term track record (although I’m 100% sure the manager is VERY aware of every stock he owns!)
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This guy honestly sounds like a moron. Who would trust analysts or bankers when they have interests that do not align with providing an honest assessment?
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By relying on managers, analysts, and banks he’s simply substituting their biases for his own. I looked his fund up on Morningstar and it has him down as small cap value with an annualized 3-year return of 30%. Morningstar also notes that his leverage is about 1.6x.
The Russell 2000 value indexes have returned roughly 18 – 20% in that time, so if you apply the leverage then he’s really just par for the course. It was an interesting idea, none-the-less. I couldn’t find a deeper history, though he says it’s been running for 12 years. I’m skeptical on this one.
One thing he does have going for him is that Damodaran did a lecture about using options pricing to value companies with lots of debt and negative equity. He concluded that value might be found there since most people avoid those stocks and that creditors aren’t necessarily motivated to push these companies into bankruptcy if there are any other viable options.
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Agreed on the biases. Price-to-forward earnings / analysts’ estimates tested so badly in Quantitative Value we didn’t even enter it into the horse race. The low price-to-I/B/E/S estimates value decile underperformed the market by 1 percent per year: https://greenbackd.com/tag/ibes-forecasts/
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Very impressive track record – 25% CAGR for 12 years! However, if you look at his criteria, they have been custom-built for the macro environment. Continuously declining long-term rates created two tailwinds for his portfolio: 1) It continuously reduced borrowing costs for highly leveraged companies; and 2) Drove up values of high yielding stocks (look at what utilities, MLPs and REITs have done over the same time period).
He basically made a leveraged bet on declining interest rates. Still impressive, though.
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Agreed. It could also be another way of saying, “I buy low price-to-book value companies.” The low P/B screens are always filled with leveraged pigs.
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Dividends – some companies pay dividends for other reasons. Some REIT’s and other companies that capitalize operating costs to inflate operating income pay dividends to keep the stock price up so that they can fund the continuous drain on cash.
Debt – relying on a bank’s judgement to endorse an investment. Anyone who has been through a few recessions would know that bankers do not have a good track record for judging risk.
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Of all the tests I’ve run, finding value using low price-to-dividends tested the worst: https://greenbackd.com/2014/06/16/investing-using-dividend-yield-backtests-1926-to-2013/
Agreed on the debt. I was a little surprised by that one.
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