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Benjamin B. Taylor Investment Manager | 51 JFK Parkway First Floor West Short Hills, NJ 07078 phone: 973-313-1220 toll free: 888-BRICK-10 |
November 2005 Client Letter
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December 6, 2005
Dear Clients, Partners and Friends,
Our Portfolio Average advanced 4.4% in November due to strong performance in the Choice model portfolio. The Relative Value model portfolio returned 2.5% and the Choice model portfolio returned 8.9%. The gross returns for both model portfolios versus relevant stock market indices (including reinvested dividends) as of November 30, 2005 follow.
Portfolio | November | YTD 2005 | 2004 | 2003 | 2002 | Since Inception |
Relative Value | 2.54% | -2.47% | 33.54% | 44.09% | -2.09% | 83.74% |
Wilshire 4500 | 4.67% | 9.50% | 18.10% | 43.84% | -4.21% | 78.17% |
Multi-cap Mutual Funds | 3.51% | 5.72% | 11.05% | 29.89% | -5.39% | 44.27% |
Choice | 8.86% | -1.77% | 15.31% | 22.31% | 38.54% | |
S&P 500 | 3.78% | 4.88% | 10.88% | 32.87% | 54.51% | |
Large-cap Mutual Funds | 3.75% | 4.70% | 7.79% | 25.59% | 41.74% | |
Port Average | 4.37% | -2.26% | 28.07% | 37.31% | -2.09% | 68.29% |
Wilshire 5000 | 3.99% | 6.23% | 12.48% | 31.64% | -5.54% | 48.59% |
All Equity Mutual Funds | 4.02% | 6.20% | 11.96% | 32.44% | -5.46% | 48.88% |
It was a good month
The market had one if its best months of the year in November. Our portfolios benefited from this rise as well. In the Choice model portfolio our largest positions performed extremely well. eBay rose 13.1%, Amazon rose 21.6%, Autozone rose 10.1% and Radian rose 8.6%. Even Anheuser-Busch which has been flat most of the year rose 6.7%.
The Little Book
Instead of getting into the details of our portfolios this month, we thought we’d change things up a bit with this letter. Recently, a neat little book hit bookstores. Written by hedge fund manager, Joel Greenblatt, The Little Book That Beats the Market explains value investing in (mostly) layman’s terms. The book touts a “magic formula” that Greenblatt says will help any investor beat the returns of the market. A review from the University of Western Michigan Library states:
“Using basic math skills and simple concepts, Greenblatt shows you how to achieve investment returns that beat the pants off even the best investment professionals and the top academics… Through entertaining anecdotes and practical pearls of wisdom, the book explores the basic principles of successful stock market investing and reveals the secrets to buying good companies at bargain prices automatic… The (magic) formula has been tested over hundreds of different periods and thousands of stock picks and has been proven extremely profitable for those who are willing to stick with it...”[1]
Good companies at bargain prices
The book is of particular interest to us and the clients of Brick Financial because it so clearly lays out basic value investing principles that we follow every day. Basically the book is about how to find superior companies at bargain prices. Greenblatt’s magic formula helps investors identify those companies.
Following the formula requires caution
Greenblatt goes to great lengths to explain to the reader that the magic formula is not a panacea. The formula is bound to lead to some years of underperformance. [Even proven investors have down years.] Those that don’t have the conviction or where-with-all to stick with it are bound to abandon the approach. Thus, following the formula requires faith in the underlying principles of value investing. It requires the ability to endure the long-term. And it requires, as Warren Buffett has stated, a “quality of temperament…not a high IQ”.
He is also adamant in saying that you should not be investing directly in stocks if you do not know the principles of accounting, forecasting, and basic financial principles. If you can not confidently work your way around a company’s financial statement then, according to Greenblatt,
“You have no business investing in individual stocks on your own!”
He goes on to say,
“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
Some of the main points of the book, and those that are most relevant to clients of Brick Financial, follow:
There is a place where they sell businesses for half price all the time. And it doesn’t take a genius to figure out where to find them. The trick to finding these one dollar bills for 50 cents is that you as the investor must believe that these “dollars-on-discount” exist.
Everyone should endeavor to save money. There are places an investor can put his money – under a mattress, in the bank, in government bonds or in corporate bonds. Some investments are better than others though.
Buying a stock means buying a percentage share in a business which entitles you to your proportional share of that company’s future earnings. Estimating the current value of the business requires guessing what the future earnings of the business will be. Your investment in any company should offer you more of a return than you might get in “safer” alternatives like the mattress, bank, or bonds.
Most stock investors are irrational and speculative which is one reason why the prices of stocks swing wildly in short periods of time. For instance, GM’s stock price can go from $30 to $60 in just a few months. It is improbable that the value of the GM would double in that time. Does this phenomenon make any sense? No! But all we as investors need to know is that it occurs and attempt to exploit it. We don’t need to know why it occurs.
Even though it is difficult to value business, we must make our best guess. And when we do decide to invest, we are best served to wait for the moment when the stock price of the company is below our guess of the business’ intrinsic value. Benjamin Graham coined this action as buying with a margin of safety.
It is better to buy a company that earns more money relative to the amount you paid for it. In other words, if company A earns $2.40 per share per year and company B earns $1.20 per share per year, yet both companies cost you $12 to purchase, which is the better buy? Company A of course. You’re getting more earnings for your money. Company A’s earnings yield is 20%, while company B’s is only 10%.
An investor would also be keen if he bought only good business. How do you tell which are the good business? As an example, let’s say it cost both company A and B $400,000 to build each of their widget stores and get up and running. Let’s further say that company A earns $200,000 but company B only earns $10,000. Which is the better business? Company A once again. Company A’s return on invested capital (ROIC) is 50% while company B’s ROIC is a paltry 2.5%.
If an investor stuck to buying good business (high ROIC) at cheap prices (high earnings yields) he’d do well with his investments.
Buying good businesses at bargain prices works as an investment strategy. Not only has it worked in the past but because its principles are sound, it will work in the future. There will always be better business than others and there will always be better values than others. But the investor must have faith in the principles.
The “magic formula” as well as any well reasoned investment strategy will occasionally fail to do well in the short-term. The short-term can often mean years, not days or months. It is extremely hard to stick with a strategy that may not work for several years in a row. Which is a good thing. If the formula worked all the time, everyone would use it and it would eventually cease to work. The trick is to have a long-term mindset. Long-term in this case means three, four, or even five years or more!
Although you want an investment strategy that has worked in the past, a good track record will not ensure results in the future. A good track record will not keep you following if the results are not as good. You should follow an investment strategy if the principles are sound. Buying good businesses at bargain prices is a sound principle and is the definition of value investing.
If an investment strategy is sound, the longer the time horizon, the better the chances for success. Time horizons of 5, 10 or 20 years are ideal. Such a time horizon will give an investor a large advantage over most other investors.
As much as 95% of the trading that occurs in the stock market is completely unnecessary and meaningless.
The stock market offers the best possibility for high investment returns over time. However, most people that should invest should not invest on their own. So it is difficult to know where to start. Stockbrokers generally have NO idea how to help investors. They’re only trained to sell products at the investor’s expense. Mutual funds would be fine but the vast majority of mutual never beat the market. A hedge fund may be a viable option but their high fees are usually not justified by their performance.
Since there are so few good avenues for investors to participate in the stock market, the best choice is most often an index fund. Or he may use an easy to use “magic formula” like the one in the book.
We have our own magic formula
We think that is a pretty thorough summary of an excellent book.[2] The book describes a process that is very similar to the one we go through when selecting investments for our portfolios at Brick Financial.
We have our own magic formula in the form of an approach that is grounded in the value investing philosophy first espoused by Benjamin Graham and practiced by many other great investors. We too are looking for good companies at bargain prices. We rely heavily on computer based models, but we inject our own judgment as well. We realize that our approach will not always work in the short-term, which is why we maintain a long-term mindset. And, although our approach has produced exceptional results in the past, this is not why we continue to use it. We continue to use it because the underlying principles are sound.
You (can) benefit from Brick Financial’s magic formula
One other point we would like to address is Greenblatt’s dismal picture of the investment alternatives most investors are left with. He says that most investors have two viable choices for investing in the stock market – an index fund or his magic formula. Well, let us suggest that there is a better alternative than either of the choices he touts.
An investor would be well served by placing their funds with an investment manager that follows value investing principles, charges a low fee, and does so in separate accounts. Such a manager has many inherent advantages over most other options. Brick Financial just happens to be one of those investment managers.
Finally, we encourage you to read this book. You can click the link below to pick up a copy:
You can also view a review by The Wall Street Journal here.
And lastly, we would like to ask for your referral. We would like you to be aware that nothing has as much cache or is as important to Brick Financial Management’s business success as your seal of approval. As always, thanks for your confidence in us. Please don’t hesitate to call us at (973) 313-1220 or 1-888-BRICK-10 or email us at info@brickfinancial.com.
Sincerely,
Benjamin B. Taylor
Brick Financial Management, LLC
51 JFK Parkway
First Floor West
Short Hills, NJ 07078
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[1] url: http://www.wmich.edu/~ulib/news/2006/ebook022006.php
[2] Let us also say that we have no affiliation with the author, his investment firm, or the publisher of the book.
Notes: The returns of the Relative Value and Choice model portfolios and the Portfolio Average are determined using a technique known as “time-weighted return on investment” and include all capital gains and reinvested dividends. They do not represent actual trades or returns of client portfolios although client portfolios are based on the model portfolios. Client portfolio returns may be higher or lower than the model portfolios’ returns. The model portfolios are presented here for informational purposes only. Although Brick Financial believes the information and data in this report were obtained from sources considered reliable and correct, we cannot guarantee their accuracy or completeness. Neither this commentary, nor any opinions expressed herein, should be construed as an offer to sell or a solicitation of an offer to acquire any securities or other investments mentioned herein. Persons associated with this firm may own or have an interest in securities or investments mentioned in this presentation. Their positions may change from time to time and they may buy or sell such securities or investments. Past returns are no guarantee of future performance. The Relative Value and Choice model portfolio data is maintained at Foliofn.com. The index and mutual fund data comes from several sources including Wilshire, Standard and Poor’s and The Wall Street Journal (Lipper Mutual Fund Averages).
The inception date for the Relative Value model portfolio is 12/6/2002.
The inception date for the Choice model portfolio is 4/4/2003.
The Portfolio Average is meant to represent the weighted average of the Relative Value and Choice model portfolios. Returns for the Average are determined as follows: A split investment (70% in the Relative Value, 30% in the Choice) is assumed to be made at the beginning of each calendar year and rebalanced every subsequent calendar year. Inception date for the Average is 12/6/2002.
© Brick Financial Management, LLC, PhatKnot Media, LLC, Benjamin B. Taylor, all rights reserved. No material that appears here can be reproduce without express written permission. However, permission is hereby granted to electronically link to, forward or quote passages as long as source is attributed to "Benjamin B. Taylor, President of Brick Financial Management, http://www.brickfinancial.com."
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