Mechanical Value Investing: Your Best Path to Investing Success

 What's up everybody!  Today I have a stocks and stock market related post for you.  I love me some stocks talk, and especially when the convo revolves around value investing and beating the market!  My guest, Evan Bleker, is a Benjamin Graham (father of value investing) disciple.  He's going to show you the advantages that a small, independent investor has when it comes to investing and why value investing is a perfect fit for you!  Let me tell you, chasing growth (Tesla-TSLA, Netflix-NFLX, Facebook-FB, etc.) continuously might work for now, but it will not work forever!  So pay attention amigos.  Evan is about to break things down for you.

Mechanical Value Investing: Your Best Path to Success

For decades, Wall Street has pushed the idea that investing is best left to the professionals, but is it really impossible for the layman to get ahead?  As we will see, the small, independent investor may have a significant advantage.

Is The Stock Market Rigged?

We all know that the stock market is a hyper competitive space, filled with the smartest minds and funds equipped with billions of dollars worth of the most advanced trading technology.

This is exactly what drives the, "Efficient Market Hypothesis."  If the best and brightest are constantly buying and selling stocks, then the current price of a stock must reflect everything already known!  Moreover, if the current price of a stock is the perfect reflection of all known information, then logically there is no way to make excess profits in the markets, especially if you are a regular, independent investor.

Every year we see reports drawing attention to the chronic underperformance of individual investors vs. their benchmarks.  However, there are a select group of independent investors who are not only matching the index, but in many cases are beating them!

First Advantage: Small and Nimble

Smaller doesn't mean worse.  In fact, in the investing world, companies with small market capitalizations (the size of the company) historically outperform their larger cousins.  This well documented phenomena is called, the small cap advantage.

Numerous theories have explained why these small companies have outperformed.  Some believe it is a premium on the risk investors take, betting on smaller companies that may be more likely to fail.  This sounds credible, but when you look at companies such as Enron or Bear Stearns, you begin to wonder how true that is.

Another theory is that it's simply more logical for these small companies to grow at a faster rate.  A well established company like Apple (AAPL) will find it nearly impossible to double its sales from its current gargantuan size.  A small company, on the other hand, might only be operating in a single state or place, and will find it much easier to expand and grow.

So clearly, investing in small cap companies can lead to outperformance.  Our advantage as small, independent investors is that those genius, well-funded institutions for the most part can't invest in these companies!  Most of them have a set of guidelines that their investors agree to call a mandate, and in most cases, small cap stocks aren't on them.  These institutions do deep dives into individual companies, oftentimes paying someone to just track every minute change in the business.  The universe of small cap stocks is enormous, with far more stocks than any one fund could possibly track with the level of diligence that is required.

For these institutions, it just isn't worth the time to track the thousands of businesses out there.  What's more, even if institutions want to invest in a small cap company, they wouldn't be able to!  Most of these small businesses have such little trading volume and shares outstanding that it would take a large fund months (or years) to exit a position.  They would most likely drive the price against them as they do it.  For these reasons, most institutional investors avoid the small cap market entirely.

What does this mean for us?  Less competition! With less competition you get more mispricing and deals that you'd never see with large Fortune 500 names that everyone in the world is following.

Second Advantage: Patience

The second major advantage we have is that we are independent!  We may hear about the amount of money some funds manage (Assets Under Management-AUM) and get a bit jealous.  In reality, answering to investors 24/7 comes with a myriad of issues, specifically around patience.

Institutions are under constant pressure to perform every single quarter.  For many that don't yet have an established reputation, a few bad quarters in a row can spell their doom.  What often ends up happening is that most funds make very speculative bets hoping for a moonshot that will catapult their performance results.  Or, they hop on the bandwagon of a trendy growth stock, hoping the momentum keeps driving the price upward.

At the other extreme, we also see many funds crowd into the same boring, stable companies simply because the risk is minimal.  Similarly, investing in these stable brands is easy to explain to investors.

This is why oftentimes institutional investors can't take part in the second well known premium in the market: the value premium.  Businesses are considered to be value plays when they have stocks that are worth more than they are currently trading for.  A good value investor finds a bargain, researches it, buys it and waits for the price to rise to what is should be.  You get bonus points, so to speak, if that fair value is actually growing as well.

An institution however, is going to have a hard time explaining to its clients why it's buying a business at the low.  It will be even harder to explain why it's holding a business that appears to be failing.  The small, independent investor need not worry about this.  Value stocks tend to be long-term investments, and certainly longer than the single quarter metric by which institutions are measured.  This allows us, the small investors, to invest for the long haul and enjoy the well documented outperformance that has historically been seen in value stocks.

A Better Approach: Ben Graham's Basket

Benjamin Graham, the father of value investing, and Warren Buffett's mentor, figured all this out a long time ago.  He devised a simple, no-fuss strategy to maximize the advantages that were available to the small, independent investor.

He'd look for extremely undervalued businesses he called, "net nets."  These businesses would be trading below their Net Current Asset Value (NCAV), meaning, they were trading at such steep discounts that if the business were to close down today, they could theoretically sell all of their assets, cover their debts, and still have cash left over to payback shareholders!

This huge discount provided investors with tons of downside protection.  Unfortunately, most of these companies would have to have been facing real issues to trade at such low valuations.  That is why Graham advised buying around 30 of them, to diversify, and reduce the volatility and risk any individual net net had, leaving the investor to enjoy the massive upside benefits.

Best of all, this approach doesn't require investment or brilliance.  It's what investors refer to as mechanical strategy: you buy a pool of stocks that meet a strict set of criteria, hold for a period of time, and then replace them.  The performance of the lot determines your portfolio's performance - you're not relying on any one company.  Rather, the sheer cheapness of the companies propel your stocks on average higher over a number of years.

There are a number of value factors you can use to achieve success.  Some value investors like to look at a stock's Price to Earnings (i.e., PE) ratio.  They like to pay a low price relative to what a business could earn.  Others look at book value, the accounting value of a company's net assets (assets less all liabilities).  There are a number of good approaches for the small investor.  But, each approach is characterized by its own return profile.

Coming from Net Net Hunter, is should be no surprise that I'm biased towards net nets.  To this day, this simple strategy has been one of the best performing for decades, historically providing a compound annual return around 20-30% per year, handily beating both the benchmark and institutional investing.  The strategy has also been good for nearly 100 years, and has ample academic evidence for its success.

That is why we believe that the small, independent investor isn't at a disadvantage at all to Wall Street.  Quite the opposite, being able to remain independently minded, adopt a sound value strategy, and buy tiny, illiquid firms is a major advantage when billions of dollars on Wall Street are fighting over a few hundred mega companies.  We believe that independent investors owe it to themselves to realize this, and start beating the indexes in order to attain financial freedom.

Evan Bleker is a small investor, author, and founder of Net Net Hunter, a community focused on Ben Graham's net net stock strategy.  He recently published Benjamin Graham's Net-Nets through the UK Publisher Harriman-House.  When not combing the stock list for dirt cheap companies, Evan enjoys getting beaten up at Brazilian Jiu-Jitsu class, riding motorcycles, and traveling around the ring of fire.