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How To Pick Value Stocks

I find it ironic that more research is being done today than at any point in time in the past, yet a lot of value investors are failing to beat the market. Ironically, the mountain of articles on popular investing websites just aren’t helping. Part of the problem might be due to the “more brains” problem Graham cited years ago. Since everybody on Wall Street is so smart, all those brains ultimately cancel each other out. This glut of brain power, investment research, and investors clamoring for bargains does not mean that you can’t beat the market. But, knowing how to pick value stocks is a key requirement, along with having a good strategy and being prepared to do things that most other investors aren’t. Where You Should Hunt When Picking Value Stocks One core piece of the puzzle is leveraging your biggest competitive advantage as a small investor: your size. Let me explain… Professional money managers manage billions of dollars each year. In fact, the entire mutual fund industry in the USD in 2012 amounted to $13 Trillion and the size of the average mutual fund was a staggering $1.72 Billion. Legal regulations make owning more than 10% of a single company, or having a single company make up more than 5% of assets, a real burden for a fund company. Given that managers want to keep positions below 5% of their fund, the pool of investment candidates open to money managers is tiny. These restrictions essentially limit a manager’s universe of stocks to firms that are $860 Million in market cap or larger. That means focusing on roughly 500-600 of the largest companies in the US. With that much money sloshing around the markets, small, medium, and large cap companies are, understandably, extremely picked-over. This suggests a powerful advantage that small investors can leverage: investing where the pros aren’t investing. That really comes down to investing in micro cap and nano cap companies. It’s in this universe, among the thousands of tiny publicly traded companies available, that a small investor can pick the most promising value stocks. What Value Stocks to Concentrate On 15 years of experience in investing has taught me a few very valuable lessons. The first is that, despite your research, you’re probably not as important to the end result as you’d like to think you are. Sure, you can conduct an analysis and your stock can go up just as you predicted, but it may not have advanced for the reasons you thought. Sometimes the stocks that you assume that will work out well… don’t. And, at other times, the stocks you thought were real dogs will advance in price. Another core insight I’ve had over the previous decade is that I (and likely you, as well) am not Warren Buffett . Small investors can’t bring the same amount of skill and experience to investing as he does, and blindly following how he invests today is what I call falling into the Warren Buffett trap . Luckily, a small investor doesn’t have to have Buffett’s investing prowess to know how to pick value stocks and succeed as an investor. Investing is a probabilistic exercise, and I’ve found leveraging a statistical investment strategy (i.e. “Mechanical” investing style), extremely rewarding. Leveraging them means being able to earn the same investment returns that drew you to value investing in the first place… without you having to be an investing guru. By simply buying a basket of stocks that are undervalued relative to some value metric, you can leverage those statistical returns to propel your portfolio to large profits. What Sorts of Strategies am I Talking About? The sorts of strategies that I’m talking about fall into the “classic value investing” or “deep value investing” categories. These are the value strategies that Benjamin Graham talked about years ago when he taught his students how to pick value stocks. These strategies have been extensively tested, and used successfully in practice for decades. Low PE – One of these strategies is the classic Low Price to Earnings strategy. This strategy has been employed successfully by contrarian managers such as David Dreman , whose funds returned 16-17% per year over decades. In general, as reported by Tweedy Browne , a Low PE strategy is good for an average annual return of 16%. Low PB – Low Price to Book value is another classic value metric that yields market beating results. Using the strategy investors should expect to bag a CAGR as high as 14.5%. That’s a fat 45% in excess of the market return over the course of your life. Low PC – One of the more recent classic value strategies, and focuses on finding stocks low relative to Cash Flow. This strategy performs a bit better, recording a CAGR of just over 18% . High Dividend Yield – Mario Levis at the University of Bath conducted a study called, “Stock Market Anomalies: A Reassessment Based on the UK Evidence.” He found that the highest dividend yielding stocks returned 19.3% on average. Not bad for a basket of cheap stocks! Net Nets – But the king of these strategies is Ben Graham’s famous net net stock strategy. This strategy has consistently beaten the market both in studies and in practice by roughly 15% per year. That amounts to a 25% CAGR, and you can achieve even higher returns with a basket of net nets by screening for other key characteristics . And, my own portfolio has done very well using this strategy. Of course, the catch is that while you can always find enough stocks to fill a portfolio using the first 4 strategies, during bull markets domestic net nets dry up, making it almost impossible to use the strategy. At least, that’s what popular websites will tell you — which tripped me up years ago. By expanding your universe of investment candidates to include friendly international markets you can fill your net net stock portfolio under all market conditions. How to Pick Value Stocks Once You’ve Nailed Down a Core Strategy This is where hunting for tiny stocks comes into play. When picking value stocks, you’re going to find your best opportunities within the universe of small companies. I’m going to come at this from the perspective of a net net stock investor, since this is where I’ve chosen to specialize. That being said, the process is the same for any statistical value strategy. As it turns out, not only do small stocks offer the best opportunities for value investors, but statistical portfolios of the smallest value stocks also offer the best portfolio returns. When it comes to net net stocks, Xiao & Arnold found that a portfolio of the smallest net nets returned significantly more than the largest net nets studied, 30.6% per year vs. 17.2% per year. That’s a staggering difference in return. The same trend is found among other sorts of classic value stocks. Tweedy, Browne found that the smallest 1/5th of Low PE stocks outperformed the largest, 19.1% to 13.1%. So, no matter what strategy you use, go small. Go tiny, in fact . This is where major investing websites really start to trip up investors. The focus on large investing sites is almost always on large stocks, and that causes small investors to give up a much more promising universe of investment opportunities in favor of trying to compete against the pros. Plus, you can only take advantage of a net net stock strategy if you’re buying tiny companies. Once I’ve narrowed down my list of possible investment candidates to the smallest, I like to look for additional metrics that are highly correlated to outperformance versus the benchmark. For net nets, one of those characteristics is a Debt to Equity figure below 20%. Companies with low Debt to Equity ratios drastically outperformed the benchmark in Tweedy, Browne’s study, What Has Worked In Investing , recording a CAGR of nearly 35% compared to their universe of net nets which returned 28.8%. That’s 6% per year of extra return! I also avoid firms with major Chinese operations, due to the flood of reverse merger scams , as well as resource exploration companies, pharmaceutical companies, real estate companies, and companies in regulated industries such as finance. None of these make for the highest quality net nets, and I’m after the highest possible returns. In the end, you have to stick to the most promising industries, and this usually means focusing on your domain of competence. How to Craft Your Portfolio If you do a good enough job using additional criteria to screen out the less promising candidates, building a portfolio really takes care of itself. At the end of the process you should be left with a very manageable number of firms. From there, spend time ranking the firms from most to least promising and then spend an equal dollar amount on the 20 most promising investments. That’s it. ….sort of. There are also nuances in portfolio construction and management that can really impact your returns, but that’s not the focus of this article. I’ll write that article at some point in the future. By now, you should have a great idea of how to pick value stocks for your own portfolio. Investing is really not as difficult as you think it is but, ironically, a lot of people try to make it more difficult than it needs to be. The hardest part is really sourcing the investment ideas and then narrowing down the pool of investment candidates you pick from. At Net Net Hunter, we start with over 450 statistical international net nets but then narrow the pool down to the 30 most promising, which gives you some idea of the amount of work to do if you want to buy the best investment opportunities. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Time To Invest In Emerging Markets? 5 Mutual Fund Picks

Slowdown in the Chinese economy, wild swings in currencies and tumbling commodity prices are dragging emerging markets down. Brazil and Russia have already entered recession. Most of the investors fear that the financial crisis in emerging economies is a bigger issue than Eurozone concerns and a hike in interest rates in the U.S. Emerging markets witnessed capital outflows faster than ever in the fourth quarter of 2015. They are now facing a wide range of risks that might weigh on their sovereign, corporate and bank ratings. However, in the face of insurmountable odds, emerging countries have remained relatively resilient for the last couple of years. What protected them from a full-blown crisis was perhaps their beefed up foreign exchange reserves. Macroeconomic headwinds notwithstanding, emerging countries are also projected to grow at a steady rate in the near term. Moreover, fears that have resulted in selling, deleveraging and down-sizing emerging economies also now work in their favor. Bargain-hunting investors should look for investing in this oversold market. Hence, if an investor is willing to stay invested for the long term, then emerging market funds can be a good bet. Investors Pull Money from Emerging Markets Investors pulled $270 billion from emerging markets last quarter that surpassed withdrawals during the financial crisis of 2008. China led the outflows, with about $159 billion pulled out of its economy in December alone. Barring China’s outflows, the emerging markets could have witnessed inflows in the quarter, according to Capital Economics Ltd.’s economist William Jackson. Concerns about weakness in China’s currency led investors to dump riskier assets. Last year, China surprised investors by devaluing its currency, which eventually led to a rout of $5 trillion in the nation’s equity markets. Subsequently, China plunged into bear market territory last month, with its manufacturing activity contracting at the fastest pace in January since August 2012. Separately, according to the Institute of International Finance, investors pulled $735 billion from emerging economies in 2015, the first year of net outflows since 1988. Emerging Markets Risk Intensifies Higher interest rates in the U.S., a stronger dollar, declining commodity prices and a rise in geopolitical tension are adversely affecting credit ratings in emerging countries. Fitch Ratings downgraded Brazil’s and South Africa’s sovereign ratings in December. These macroeconomic headwinds are also negatively impacting emerging markets’ corporate and bank outlook. Meanwhile, private sector debt turned out to be a key challenge in emerging markets. Private sector debt has surged in emerging markets in the last 10 years. Seven large emerging nations including Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey witnessed a collective rise in their private sector debt to an estimated 77% of their GDP in 2014, significantly up from 46% in 2005, according to Fitch’s analysis. Is It All Over for Emerging Markets? On an individual basis, however, most of these emerging economies haven’t added much debt compared to the size of their economies. India’s and South Africa’s private debt-to-GDP ratio increased by 17 and 11 percentage points, respectively, according to Capital Economic Ltd. The private debt-to-GDP ratio for Malaysia and Indonesia also came in at 18.5 and 12.5 percentage points, respectively. Meanwhile, growth in emerging market economies slowed down to a pace of 3.7% in 2015, according to the World Bank. A year earlier, the pace was around 4.5%. However, the World Bank expects growth in emerging economies to rise by 4.2% this year followed by a steady increase of 4.8% and 4.9% in 2017 and 2018, respectively. Moreover, Russia’s GDP, which constitutes a major part of emerging market GDPs, is also positioned to contract less, eventually having a positive impact on the overall growth of the developing nations. Russia’s GDP of around $1.2 trillion is about 4% of emerging markets’ $28 trillion economy. According to Alberto Ades, head of global economic research at Bank of America Corporation (NYSE: BAC ), the pace of contraction in Russia’s GDP this year will slow down to 0.5% from last year’s contraction of 3.7%. In 2015, Russia was responsible for reducing about 15 basis points from overall emerging markets’ economic growth. This year, it is expected to shave only 2 basis points. Separately, Daniel Hewitt, a senior emerging-markets economist at Barclays PLC (NYSE: BCS ) said that emerging economies will expand at an average rate of 4.3% in 2016, higher than 4.1% last year. He believes easing of economic contractions in Russia along with Brazil and Venezuela will help emerging markets to grow in 2016. 5 Emerging Market Funds to Buy Emerging markets have shown remarkable resilience, banking on adequate foreign exchange reserves. For example, India accumulated reserves of $325 billion by 2014, while its reserves were merely $5.6 billion in 1990, according to the World Bank data. Indonesia and Thailand too piled up $112 billion and $157 billion, respectively, by the end of 2014. As many developing countries are in a much sounder shape than they appear, investors might have a look at emerging market mutual funds, keeping in mind a long-term view. These funds generally tend to do well over the long haul due to their higher risk content. However, they may stand out in the short term as well. Emerging market funds had tanked almost 50% during the global financial crisis in 2008, but quickly recovered, gaining more than 65% in 2009. Also, it will be prudent to invest in such emerging mutual funds that have less exposure to the beleaguered Chinese economy. We have shortlisted the top five emerging market funds. They have an impressive five-year annualized return, a minimum initial investment within $5000, low expense ratio and a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy). T. Rowe Price Emerging Markets Bond Fund (MUTF: PREMX ) provides current income and capital appreciation. PREMX invests a large portion of its assets in government and corporate debt securities of emerging nations. PREMX’s 5-year annualized return is 3.5%. PREMX carries a Zacks Mutual Fund Rank #1 and the annual expense ratio of 0.93% is lower than the category average of 1.16%. As of the last filing, Argentine Republic 7% was the top holding for PREMX. Fidelity New Markets Income Fund (MUTF: FNMIX ) invests the majority of its assets in debt securities of issuers in emerging markets and other investments that are tied economically to these markets. FNMIX’s 5-year annualized return is 4.7%. FNMIX carries a Zacks Mutual Fund Rank #1 and the annual expense ratio of 0.84% is lower than the category average of 1.16%. As of the last filing, US Treasury Bond 3% was the top holding for FNMIX. JPMorgan Emerging Markets Debt Fund (MUTF: JEMRX ) seeks high total return and normally invests a large portion of its assets in emerging market debt investments. JEMRX’s 5-year annualized return is 4.4%. JEMRX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 0.77% is lower than the category average of 1.16%. As of the last filing, Argentina Rep 8.28% was the top holding for JEMRX. Fidelity Advisor Emerging Markets Income Fund (MUTF: FMKIX ) seeks capital appreciation. FMKIX invests a major portion of its assets in securities of issuers in emerging markets and other investments that are linked economically to these markets. FMKIX’s 5-year annualized return is 4.6%. FMKIX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 0.88% is lower than the category average of 1.16%. As of the last filing, US Treasury Bond 3% was the top holding for FMKIX. Franklin Emerging Market Debt Opportunities Fund (MUTF: FEMDX ) seeks high total return. FEMDX invests the majority of its assets in debt securities of “emerging market countries” that the World Bank considers to be on the developing curve. FEMDX’s 5-year annualized return is 2.3%. FEMDX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 1% is lower than the category average of 1.16%. As of the last filing, United Mexican States 4% was the top holding for FEMDX. Original Post

ETF Trends For 2016: Part 3, Management Fees

In part 1 of this series, we reviewed the growth of the ETF market in 2015 and introduced the series by covering currency-hedged products. In part 2 , we took a look at robo-advisors, a well-covered topic that could have a huge impact on the way ETFs are utilized. In this final piece in the ETF Trends series, we will cover management fees and the competition it causes between issuers, and a conclusion on the potential for the ETF Industry in 2016. The ETF Fee War While some issuers are creating funds for specific market niches, other issuers are taking a different approach when looking to stand out in the sea of possible funds, as articulated by Crystal Kim for Barron’s : Early this November, BlackRock (NYSE: BLK ), the largest exchange-traded fund provider by assets, trimmed fees by two to three basis points (two to three one-hundredths of a percent) on seven iShares Core ETFs. The expense ratio of the iShares Core S&P Total U.S. Stock Market (NYSEARCA: ITOT ) was taken down to 0.03%, winning the crown for cheapest ETF on the market-briefly. That is, until Schwab (NYSE: SCHW ) matched it by lowering fees by one basis point on four large-cap ETFs. The Schwab U.S. Large Cap fund (NYSEARCA: SCHX ) now stands toe-to-toe with its counterpart at iShares, fee-wise. For every $10,000 invested, the rival funds cost a mere $3. That’s cheaper than a copy of Barron’s at the newsstand. There are pieces covering the ETF price war going back to 2010, so this is by no means a new discussion topic for ETF investors. However, price wars continue to play a role in the ETF investment scene as a way to attract retail investors. The Trefis Team lays this relationship out for us: The largest avenue of growth for ETF providers over the coming years is expected to be the retail investor market, which remains extremely under-served. As retail investors are much more sensitive to expense ratios, asset managers have been trying to attract them with a string of low-cost ETFs. The following image is another from the ICI 2015 Investment Company Fact Book, showing the growth in ETF AUM by retail investors. Assets in ETFs accounted for about 11% of total net assets managed by investment companies at year-end 2014 and net issuance of ETF shares reached a record $241 billion. Click to enlarge While there are a number of funds digging deep to keep costs low in an effort to attach larger clients, the average ETF expense ratio is still 0.44%. This is mainly due to the number of active and narrow-focused funds that can still afford to charge investors more, because they are the only ones currently available in the space. But as market saturation continues, being the only player may not be a given. This is great news for investors interested in these niche offerings but aren’t willing to foot the bill at this time. For reference, the average mutual fund expense ratio is 0.70% (down from 0.90% in 2000 before ETF competition started to take hold), so it is no small feat that ETFs are as cost effective as they are today. But as issuers continue to fight for retail investors in the coming year, we should expect to continue to see expense ratios slashed. This slashing is not just good news for institutions, but the individual issuers who get to enjoy cheaper management fees as well. Concluding Thoughts For 2016: ETFs Continue To Grow When asked about the ETF industry in early 2015, Amy Belew, Global Head of ETP Research at BlackRock stated : The global ETP (Exchange-Traded Product) industry continues to grow at a double digit pace as ETPs attract a broader base of global investors than ever before. ETPs are being used by capital market participants looking for deep liquidity, to investors seeking precision exposures, to a growing segment of the market using ETFs as buy and hold investment vehicles. We are forecasting global ETP assets to double to $6 trillion over the next five years. While future trends within the ETF industry are impossible to perfectly predict, I believe this an industry that will only continue to evolve and grow to meet investors’ needs in 2016.