Screening for Value: A Unique Mindset

How do we decide what investment strategy to follow? For many of us, there is an element of chance involved. Perhaps a particular investment strategy is popular during our formative investing years. Or maybe we were inspired by an early mentor, or read a famous book describing winning ways. Once we start pursuing an investment strategy, however, we rarely stop to think about whether it is a good fit for our unique circumstances. Of course, if we invest for long enough, we may gravitate towards a strategy that suits us, but it often happens through trial and error rather than conscious thought.

When it comes to adapting their strategy, investors are often their own worst enemy. The average investor has poor market timing instincts. Investors tend to jump into something after an extended period of positive returns, switching out when they just can't take the pain of underperforming investments anymore. The problem is that over periods of a few years, investments tend to suffer from mean reversion. As a result, the top quartile funds over three years are more likely to be in the bottom quartile than the top quartile in future years. Investors make the switch just as the outperforming funds start to underperform. The same happens with individual stocks. In a 1999 study of around 50,000 individual investor trades, Terence Odean found that the stocks that investors sold outperformed the ones they bought.

Every successful investment strategy is hard, either analytically or psychologically. It has to be; if there were an easy way to beat the market, we would all do it, and it would stop working. The best strategy is, therefore, one that you can follow consistently, through periods of underperformance, without switching at the worst possible moment. We will find it much easier to stick with a strategy if we find one that matches our unique personality.

While there are many different models of personality, the most widely accepted is called the 'Big Five' consisting of the following, mainly independent, traits:

Agreeableness represents how inclined to share and co-operate with others we are. It measures how willing we are to "go with the flow" and accept the opinion of others.

Conscientiousness is how thoughtful and detail-orientated we are and is often related to strong impulse control.

Extraversion can be described as the extent to which the company of others energises someone. Extraversion is often mischaracterised as how out-going someone is. However, this is a poor proxy for this trait. Plenty of people are naturally gregarious but require time on their own to re-charge after meeting other people.

Neuroticism is reflected in our moodiness or level of emotional instability.

Openness is how eager we are to learn and experience new things.

You can find many free 'Big Five' personality tests online to get your own assessment, such as this one.

Most successful stock-pickers are likely to have an above-average level of conscientiousness and a low level of neuroticism. Without conscientiousness, they won't be willing to put sufficient work into analysing stocks. If they have high levels of neuroticism, they will fail to cope with the emotional roller-coaster that the market can induce. Those who find themselves without these inherent qualities, and haven't put in place mitigation strategies, may be better off being passive investors rather than choosing their own investments.

While some personality traits are important for all investors, there is one that marks out value investors: low agreeableness, also known as disagreeableness. In general, disagreeableness is not considered a particularly desirable trait; those who are disagreeable can sometimes be difficult to get along with. However, being disagreeable is a positive when it comes to value investing. Disagreeableness enables value investors to go against the flow and not be overly influenced by the opinion of others. As a result, value investors are often described as being contrarian.

Value investing works because, given a choice, every investor would like to buy rapidly growing companies with great products, and excellent management, that are well-financed and have high returns on capital. However, because everyone prefers this type of company, they are in great demand, and the price gets bid up until they are often overvalued. Conversely, no one wants to own shrinking companies with poor products and management that are barely profitable, so they become undervalued on average.

If that were the only factor impacting returns, then the gains from buying the unloved would be slight. However, there is something else at play: the forces of capitalism. Companies that currently generate high returns on capital tend, on average, to see it decrease over time as competitors seek to share in those supra-normal profits. Conversely, companies that currently generate a poor return on their invested capital tend to see it increase over time. This is because they are pushed by their owners to improve their efficiency, reduce their working capital, invest in better products, or shut down unprofitable business lines. As a result, return on capital is one of the most mean-reverting series in finance, as the following graph from a Michael Mauboussin paper shows:

The same effect is seen in earnings growth rates. Highly-rated stocks do grow faster in the near term. However, over several years, the earnings growth rates of both the high-rated and lowly-rated stocks end up at the same value. Investors will likely generate superior returns if they own the same earnings stream growing at the same rate but pay a much lower multiple for it.

Sometimes it doesn't even require these changes in corporate performance for a re-rating to occur. For example, looking at the historical revenue and EPS of UK semiconductor company Iqe (LON:IQE), there is no sign of why the share price went from 20p in July 2016 to 180p in November 2017 and then back down again to 20p by March 2020. The only thing that really changed during this period was the market’s perception of the company.

It is psychologically hard to buy something like IQE when everyone views it as a capital-intensive, no-growth business fairly valued at a P/E of 7. On the other hand, it is equally hard to sell when everyone is excited about the prospects and considers it one of the most exciting growth stocks. Only those disagreeable enough to go against the crowd are willing to buy what everyone else hates and sell what everyone else loves.

Screening for Value: 52 week lows

So how can we go against the flow and find unloved, undervalued investments? One of the simplest ways is to look for stocks trading close to their 52-week lows. Legendary value investor Walter Schloss used this method to find many of his investment ideas. The idea of buying stocks at 52-week lows has some academic rigour to it as well. In a 2009 paper, Steven Huddart, Mark Lang and Michelle Yetman found that buying a basket of stocks that hit 52-week lows outperformed those that didn't. [Interestingly, buying stocks trading at 52-week highs also showed outperformance, although an investor possessing a value mindset will struggle to buy that set of stocks!] The authors also found that the excess returns were focused on the smaller stocks, suggesting that our search should also be there, where the market is less efficient.

Using the Stockopedia screening function, it is easy to find companies trading at their 52-week lows. Unfortunately (or perhaps fortunately for the value investor), in the current markets, a simple screen of stocks trading on the Main Market and AIM, within 15% of their 52-week lows, between £10m and £600m market cap, yields 482 stocks. This is far too many to look at in any detail, so we need to narrow our universe down with some additional criteria:

Value Rank > 80 This is a value screen, after all, and the Stockopedia Value Rank does an excellent first-pass job of identifying where value may lie.

Current Ratio > 1.5 Since successful value investing requires giving companies sufficient time to turn around their prospects, we need firms to be financially strong enough to weather short-term setbacks. The current ratio is a measurement of balance sheet strength. A value of 1.5 means that current assets exceed current liabilities by a wide margin. This may exclude companies, such as retailers, that can operate safely for many years with low current ratios. However, given the weak economic outlook, having some margin of safety here is wise.

Excluded Industry Segments: Banking Services, Investment Banking & Investment Services, Residential & Commercial REITs, and Collective Investments. While investors can find value in these segments, they require different skills to analyse than the typical trading business. So, for this simple screen, we exclude them.

Applying these constraints leaves 28 results from the screen. Unlike some value investors, I don't automatically exclude mining or oil companies. Investors need to be careful with these sectors, but often these can be businesses that generate high free cash flows, something a value investor may be interested in owning. Here are the results:

In next week's article, I will look at these companies in more detail to see if they may be attractive to the value investor.