Tuesday, January 5, 2016

Book review: DIY Financial Advisor

DIY Financial Advisor picks up on and expands the general themes in co-author Wes Gray's excellent 2012 book Quantitative Value . Gray and his latest co-authors, Jack Vogel and David Foulke, try to show individual investors simple methods for managing their entire investment portfolio, not just stocks. That way, they can potentially cut off their financial advisor and 'do it yourself', or at least be informed on what to look for in a capable, honest financial advisor.

The first major part of the book shows why you can do better than the pros. It retreads some famous studies showing how expert decision makers often fail compared to simple rules-based systems in a variety of fields, including investments. It is an indictment of human judgment, especially as exercised by knowledgeable experts. The authors tackle a few myths about relying on experts, such as the myths that complexity and qualitative informative adds value, and they present a number of biases exhibited by everyone, pros and amateurs alike. A lot of this goes into theories and explanations provided by behavioral finance, which always deserves explorations of its own.

The second major part comprises the vast majority of the book. In there, the authors present some simple methodologies that touch the essential elements of investing: asset allocation, risk management and security selection. In each of those aspects, they present simpler techniques that beat most other highly complex methods studied. For instance, naïvely equal-weighting between different asset classes is shown to equal or outperform far more sophisticated models like mean-variance. The authors also favor simple value and momentum criteria for stock selection.

The research is fascinating and my own observations and tests would suggest that simplifying things do seem to make investing easier. Having said that, the final chapter of the book, which presents obstacles why people would be hesitant to applying the suggested models, is probably the least convincing. The reasons presented there are fair enough but there is a much bigger one that trumps them combined: the authors, just like in Quantitative Value, overstate the ease with which this can be applied by most investors. The hardcore individual investors that this book should appeal to will likely find a lot of value here, but the complete solution presented is not all that easy to follow or implement. For the casual investors who picked this up on the basis of the title “DIY Financial Advisor”, thinking that this would truly be something they could do themselves, they are very likely to be lost halfway through the book. Financial advisors exist in part because a lot of people couldn’t be bothered to follow investing even should they have the time, which they don’t often have.

Nonetheless, the research pieces presented, if you have the patience to understand them, are very compelling and, to their immense credit, the authors provide a blueprint for evaluating other investment advisor services. I should also point that a lot of this research is present throughout their website AlphaArchitect.com and they also provide free tools if you do wish to implement their strategies yourself. They also recently launched a series of ETFs, which select stocks either through value criteria or through momentum criteria, that at least make implementing the stock selection aspect much more palatable. As for the book itself, all in all, DIY Financial Advisor is very-well researched, presents some compelling things to reflect upon and is a solid addition to your investing library.

Disclosure: DIY Financial Advisor and Quantitative Value were purchased with my own money. I do not receive any compensation from the authors for this review. If you buy these books through Amazon though my site, I do get a small commission.

Wednesday, September 30, 2015

Recommended September Buy: Oceaneering

Ticker OII (NYSE)
Fiscal Year End December
Recent price (Closing Price on September 30, 2015) $39.28
Market Capitalization $3.97 Billion
52 week range $37.00 – $72.19
Enterprise Value to EBIT (last full year) 7.5
EV to EBIT (7 year average earnings) 11.5
Enterprise Value to sustainable Free Cash Flow (last full year) 9.6
EV to SFCF (7 year average earnings) 17.0
Enterprise Value to Book 2.8
EV to Book (7 year average Book value) 3.1

Having originated as a group of diving services companies, Oceaneering is now a provider of equipment and services to the offshore oil and gas industry. According to its filings, the company has over a third of all Remotely Operated Vehicles, small submersible vehicles for deepwater tasks, in the world. It also provides and rents out other specialty offshore oilfield products, as well as services ranging from installation and maintenance to testing and inspection. Finally Oceaneering also uses its marine expertise to provide services to the US Navy, NASA and the theme park industry.

I picked Oceaneering for notching a score of 8 on Alpha Architect’s) tweaked Piotroski F-Score. It came up short only on having higher Long term debt and lower total asset turnover than in the previous year. Oceaneering is undervalued based on its ratio of Enterprise Value to Average EBIT, which is just under 12 times currently, while I estimate it to be worth around 17 times its average EBIT. It also does not seem to be overvalued based on its ratio of Enterprise Value to Average Book value. Oceaneering’s lowest Return on Invested Capital in the past 10 years was 13% and it has been much higher most other years. Despite the slump in oil prices, Oceaneering’s operations and profits have not been hurt nearly as much as other companies. It should still be able to generate returns of around 14% this year. Should oil prices rebound in the next couple of years, these numbers would be higher but the company is still generating enough profitability in the current environment. Oceaneering constitutes a buy at below $42 per share.

Disclosure: I own shares in Oceaneering

Oceaneering, Sept 2014 to Sept 2015

Recommended September Buy: Corning

Ticker GLW (NYSE)
Fiscal Year End December
Recent price (Closing Price on September 30, 2015) $17.11
Market Capitalization $21.60 Billion
52 week range $15.42 – $25.16
Enterprise Value to EBIT (last full year) 6.7
EV to EBIT (7 year average earnings) 8.4
Enterprise Value to sustainable Free Cash Flow (last full year) 7.0
EV to SFCF (7 year average earnings) 11.2
Enterprise Value to Book 1.1
EV to Book (7 year average Book value) 1.3

Corning is a producer of specialty glass and ceramics components for various technology fields. Its biggest business line is the Display Technologies segment, which makes glass substrates used the production of LCD displays for TVs, mobiles devices, etc. It accounts for about 40% of the company’s revenues. The Optical Communications line provides optical fiber solutions, both hardware and services, to the telecom industry, displacing traditional copper based systems. Environmental Technologies produces ceramic substrates and filter products. These are particularly used in motor vehicles to help control emissions. The Life Sciences segment caters to laboratories, supplying them with various highly specialized laboratory products from surfaces to dishes. Finally, the Specialty Materials segment manufactures products that don’t neatly fit into the previous categories, except maybe for the Gorilla Glass brand, which currently is Corning’s most visible product.

Corning registered a Piotroski score of 8 (based on Alpha Architect’s) modifications), failing only to improve its Current ratio and its Gross margin. When it comes to valuation, it is cheap on almost all metrics. I picked it for trading at over 30% to its value based on its average sustainable Free Cash Flow, but it also trades at consistent discounts based on its book value and on earnings before interest and taxes. Historically Corning has not been this cheap relative to its performance in a long time. Its depressed price would seem to reflect fears that its display business, its biggest profit engine, will get pressured by competitors. But the company remains solidly profitable. It has the financial resources and knowledge to innovate and overcome any likely short-term setbacks.

Disclosure: I own shares in Corning Inc.

Corning, Sept 2014 to Sept 2015

Monday, August 31, 2015

Recommended August Buy: Intel Corp.

Ticker INTC (Nasdaq)
Fiscal Year End December
Recent price (Closing Price on August 10, 2015) $29.64
Market Capitalization $138.1 Billion
52 week range $27.62 – $37.90
Enterprise Value to EBIT (last full year) 9.5
EV to EBIT (7 year average earnings) 11.5
Enterprise Value to sustainable Free Cash Flow (last full year) 12.6
EV to SFCF (7 year average earnings) 13.9
Enterprise Value to Book 2.7
EV to Book (7 year average Book value) 3.1

Intel is the largest semiconductor producer in the world. It is largely known to consumers for producing the processors and chipsets in personal computers and notebooks, whether they be Windows-based or Apple. It holds about four fifths of the microprocessor market. The company also dominates in processors for servers, a sizable and growing segment of its overall business as the traditional PC market stagnates. Intel is now also trying to catch up in serving the smartphone and tablet industries, where it was late at producing energy efficient processors for those products. Intel also now has a software security service in its McAfee subsidiary, bought in 2010. It hopes to integrate more security features directly into its hardware.

I identified Intel for notching a score of 8 on Piotroski’s F-Score (I use the 10-point variant detailed in Tobias Carlisle and Wes Gray’s excellent book Quantitative Value, as well as on Wes Gray’s website Alpha Architect). It came up short only on the Current Ratio test and the Free Cash Flow on Assets test. More importantly, Intel is undervalued based on its ratio of Enterprise Value to Average (7 year) Book value, which is just under 3.0 times currently. While this superficially doesn’t seem particularly cheap, it is so in light of Intel generating strong average Returns on invested capital, well above its cost of capital. I estimate its Return on invested capital at 20% over the last 7 years, while I estimate its cost of capital to be 9%. These numbers should roughly indicative of Intel’s future capacity. The PC market, while contracting, is unlikely to completely die out, at least not too soon. Intel’s efforts in the mobile space appear to be starting to pay off and the server segment will continue to do well. Meanwhile, Intel’s financial position appears strong and it certainly has more resources than a lot of its competitors. Therefore I recommend it as a buy.

Disclosure: I own shares in Intel Corp.

Intel Corp Aug 2014 to Aug 2015

Recommended August Buy: Laurentian Bank of Canada

Ticker LB (Toronto Stock Exchange)
Fiscal Year End October
Recent price (Closing Price on August 10, 2015) CAD $48.98
Market Capitalization CAD $1.40 Billion
52 week range $46.05 – $51.84
Price-to-Earnings (last full year) 9.9
Price-to-Earnings (7 year average earnings) 11.5
Price-to-Book 1.0
Price-to-Book (7 year average Book value) 1.07

Laurentian Bank of Canada is a financial institution based in Montreal. The bank has four main business lines. Its Retail Services are offered through 156 branches in the province of Quebec (and 1 in Ottawa, Ontario), offering a wide line of personal banking services. The Commercial segment operates throughout the country, providing loans and other financing services to small and medium businesses. The bank claims to specialize especially in such niches as real estate developers, agriculture, health professionals and equipment financing. B2B Bank, the third main line, provides banking and investment solutions exclusively through independent financial advisors and non-bank financial institutions. This business in particular has grown significantly through recently acquiring other businesses such as AGF Trust and probably needs some time to adjust to its changes. The fourth segment, Laurentian Securities and Capital Markets, is focused mainly on investment banking and underwriting to small companies.

Laurentian Bank came up for meeting my modified Piotroski score for financial firms, obtaining a score of 5 out of 6. It’s only negative mark comes from issuing more shares compared to the previous year (a fairly recurring occurrence for the company in recent years). I also believe the company to be valued well below its intrinsic value, trading at about 1.07 times its average Book value. Also noteworthy, though it doesn’t factor in my calculations, Laurentian Bank pays a quarterly dividend of $0.56 a share, which translates to a hefty dividend yield of about 4%. The company reported quarterly earnings of $1.16 and $1.34 per share the last two quarters, so the dividend seems very sustainable and should be a reliable source of returns for the next few years.

Laurentian Bank has some acquisitions to digest from the last few years. But as it stands it trades at a substantial discount to its current value, at least compared to what other Canadian banks such as Canadian Western Bank trade at, with the further possibility of growth in its business across the country.

Disclosure: I own shares in Laurentian Bank of Canada

Laurentian Bank Aug 2014 to Aug 2015

Sunday, August 16, 2015

A Systematic Framework For Selecting Financial Stocks

I’ve thought for a long time about better ways to select stocks in the financial sector. Many screens explicitly or indirectly exclude financial stocks. It’s become a somewhat popular chorus in recent years that financials are too risky or too opaque to invest in. However I do not take this view, I’m of the opinion that no asset class or sector is inherently unattractive. There is plenty of money to be made in analyzing financial stocks judging by the portfolios of some of the more renown value funds such as Arlington Value and Tweedy Browne. 

I’ve settled for customizing Piotroski’s Fundamental F-Score as a way of quickly and efficiently sorting promising financial companies from the ugly ones. Recall that the original F-Score is a 9-point scoring system used to screen promising stocks. For each of the 9 measurements that improved over the last year, a company would score a 1; otherwise it would get 0. With scores ranging from 0 to 9, companies with low scores were unattractive and companies with higher scores were attractive. The F-Score alone was found to produce good results historically. However, financial companies are explicitly screened out. Indeed, a lot of the metrics would not apply to financial sector stocks anyways. Therefore I removed from consideration the following tests that I felt were irrelevant to the sector.

- Positive Free Cash Flow
- Current ratio improves over the previous year
- Gross margin improves over the previous year
- Total asset turnover improves over the previous year 

I kept the remaining 5 tests and added one more of my own to capture improvement in overall leverage (from having thrown away the current ratio test), therefore making it a 6-point scoring system, with the following tests:

1) Net income is positive, score 1, otherwise 0
2) Return On Assets latest year is greater than ROA previous year, score 1, otherwise score 0
3) Operating cash flow is greater than Net income, score 1, otherwise 0
4) Ratio of long-term debt to total assets latest year is equal or less than Ratio of long-term debt to total assets previous year, score 1, otherwise 0
5) Shares outstanding latest year is equal or less than Shares outstanding previous year, score 1, otherwise 0
6) (New) Financial leverage (total assets divided by total equity) latest year is equal or les than Financial leverage previous year, score 1, otherwise 0

Using Portfolio123’s screen building tool, I backtested groupings of this modified Piotroski score against an equal-weighted portfolio of all the Financial sector stocks in the total market S&P 1500 index. Portfolios are formed every 4 weeks and held for 1 year from June 1999 to June 2015. 

While the annually rebalanced portfolios of Financials stocks averaged an annual return of 6.75%, portfolios of stocks with a modified Piotroski score of 5 or 6 (out of 6) returned an average of 8.64%, portfolios of stocks with scores of 3 or 4 averaged 6.54%, while portfolios of stocks that scored 2 or less only returned 4.20%. This suggests that there is a good way of systematically choosing stocks in the financial sector. There might be other systematic methods, and some other criteria should likely be applied, namely the nature of the business, low valuation in relation to earnings or book value, etc. But this is a good, simple starting point for researching financial stocks and is the first criteria I use for selecting and recommending companies in that sector.