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How do you sleep better at night with factor based investing? We explain with one currently undervalued stock

Irving Soh
Irving Soh

If you’re invested, you’ve probably experienced this once or twice.

It’s 2am, you wake up with a jolt, reach for your phone and blearily open sleepy eyes now stung by the sharp blue light to look at your stock prices (if you invest in US, markets open at 10.30pm Singapore time, varies depending on daylight savings).

If you invest in Singapore, this same phenomenon is likely to happen when you go to the loo or when you’re at lunch with colleagues and when you should really be talking to them not staring at your stocks hoping the magical power of your eyeballs make the share price go up.

I call this the “Bad Approach to Investing” Syndrome.

In either of the above cases, investors feel ill at ease and uncomfortable with the stocks they pick. There might be some lingering doubt. Some unknown fear. Some random thing they feel they might have missed out on.

Most of it is due to the fact that they feel ill prepared for the choices they made, and they feel some doubt.

  • Is it really ok…?
  • Did I do it right….?

And while its common to feel doubtful and even healthy to be sceptical of your own work from time to time, doing it too much leads to madness.

  • How can you ever grow confident in your own ability as a stock picker if you cannot ever learn to trust yourself?
  • And if you want to trust yourself, how do you ever learn to sidestep human biases and remove uncertainty from the investing process?

Enter Factor Based Investing.

What is Factor Based Investing?

Image result for factor based investing

Believe it or not, factor based investing was around quite a long time ago. The seminal paper on it was the paper titled, “The cross sections of expected stock market returns“.

Yeesh, what a mouthful. I know it sounds boring already, but hear me out.

At its core, Factor-based investing is about finding what has worked in the past, and then applying it.

Simple right?

In case its still not clear what factor based investing is really about, I shall leave you with the following excerpt from the above book (go buy it please…it’s cheap).

“If a poll was taken asking investors to name the greatest investor of all time, it is safe to say that the vast majority would likely respond, “Warren Buffett.”

Thus, we would say that a goal of investors the world over is to find Buffett’s “secret sauce”. If we could identify it, we could invest like him – assuming we also had his ability to ignore the noise of the market and avoid the panicked selling that causes so many investors to incur the higher risk of stocks while ending up with lower, bond-like returns…

This book is in part about the academic community’s search for that secret sauce-specifically the characteristics of stocks and other securities that both explain performance and returns (above market)….
such characteristics can also be called factors..which are properties or a set of properties common across a broad set of stocks…

What you will learn is that while Buffett is considered by many to be a peerless stock picker, we now know that his success has not been due to such skill. Instead, it is attributable to his ability to identify certain key characteristics, or factors, that would deliver above-market returns.

Your Complete Guide to Factor-Based Investing

This picture tells you how closely mirrored Buffett’s style is with Factor Investing.

Replicating Berkshire Hathaway via a Factor-Mimicking PortfolioReplicating Berkshire Hathaway via a Factor-Mimicking Portfolio

Okay, but why does Factor-Based Investing let me sleep well at night?

I mentioned above and have shown evidence of how Factor investing just works.

Conceptually, this may be difficult to digest. But I would ask you to entertain the following questions if you can.

  • How does your phone charge? How do you know it works?
  • How do you trust a bunch of guys, driving giant steel constructs across roads to stay organised and not smush people randomly at a frequent rate?
  • How do you know an airplane will take off successfully?
  • How do you know you will wake up tomorrow?
  • How do you know your heart will continue beating ten minutes from now?

The answer to many of these questions, is not “we don’t know”, but rather, “there is a process it follow”.

There is a science behind it.

  • If you’re a phone repair specialist – you know how phones work and how it charges.
  • If you’re a driver, you know how the driving code works.
  • If you’re a pilot/airplane mechanic, you know how a plane operates.
  • If you’re a doctor, you know how circadian rhythms and brain activity functions to allow waking and sleeping hours.
  • If you’re a heart specialist you know in general how long more a heart can function after studying it. You can diagnose heart health.

The thing about investing is that everyone seems to think they can do the jobs of the above specialists. The phone repair men. The driver. The pilot. The mechanic. The doctor. The heart specialist.

People weren’t made to be naturally good investors. Investing has a numerical science behind it. Just as much as any of the professions above.

Just as investors know the process behind factor based investing.

An example of the process with the Value Factor: Playmates Holdings

Many of you already know “Value Investing”.

It is worth noting that all investing is “value” investing, in that undervalued stocks has value that is not realised now, and growth stocks has value that can be realised in the future. In this specific example, we’re talking about undervalued stocks when we talk about value investing.

Note the financial details of Playmates Holdings (HKSE:0635) currently.

Look at the cash hoard currently vs the total liabilities of the company.

$1, 479,188,000 vs $978,902,000.

Next look at the Investment Properties + lands and buildings, normally properties bought and rented out for income or basically…well…for investment purposes.

Total: $5, 844,058,000 + $171,680,000

Taking the sum of cash and properties alone, less total liabilities, less minority interests would give you an exacting value (call it X) of the company (we don’t count other assets such as inventories etc cetera, because they do not hold full value in a sale as opposed to cash and land/buildings).

So if we use the value of X divided by total share capital found in the annual report, we can easily find the real value of the company per share.

Currently that value stands at $2.865 per share.

The current share price is $1.13.

That means the company is undervalued by $1.735 currently. Note that $2.865 is currently a Conservative value, because we do not include the values of inventories, receivables, etc cetera.

$1.735 potential profit is more than 100% in terms of potential gains since the entry price is currently $1.13 and our target price is $2.865.

Thus, we know the company, comfortably, conservatively, is undervalued. What are items are on our checklist?

I’ve mentioned it before but I will do so here again for posterity.

  1. large insider ownership (playmates has 63.1%, a fairly large number) to reduce risk of shareholder destruction actions taken
  2. if no large insider ownership, large insider recent purchases (signalling their confidence and their likelihood of knowing more than you).
  3. no excessive debt
  4. no excessive cash burn
  5. no current running short reports
  6. no annual report number manipulation

Conclusion

Your ability to sleep well at night, is therefore, a product of how stringent your investment process is.

  • Is it based on mathematics or opinion or tips?
  • is it based in logic?
  • is it grounded in research as factor-based investing is?

On “But Cheap can always get cheaper what, what if I buy and it goes down even more?”

I had a fun meeting with a friend of mine who shared that his stocks were getting beaten. He’d bought undervalued stocks in Hong Kong prior to when all of the protests started. And as the portfolio got pounded, he sold out, desperate to protect his capital, suffering minimally 20-33% losses across all his positions.

His argument was that cheap can always get cheaper, and it was better to sell out and protect capital then sit and absorb losses.

My argument was different.

Imagine I told you today you could buy $10 with $5. You’d do it in a heartbeat. Now imagine if the next day, I come back to you, and tell you that you can buy that same $10, except now at $3.

You don’t say no to that sweeter deal if you are logical and rational. But somehow, when it comes to the markets, no one seems to think this way. Yes, I get that the simplification might be over simplistic, but if the fundamentals of the companies have not changed, and the share price has gone down, the market is merely offering you further discounts. You can take it, or if your portfolio allocation for that stock/sector is used up, just ignore it.

Besides, what do you think management is going to do if the market is undervaluing their shares? Do you think majority insiders are going to just sit by and twiddle their thumbs?

These companies, which you previously checked to be in great financial health, undervalued, with decent management teams – what do you think they do?

They do what EVERY OTHER GOD DAMNED MANAGEMENT TEAM DOES.

They take the chance to;

  1. buy back shares as quickly and as efficiently as possible, hopefully without notice from fund managers and investors with large followings
  2. quickly increase their own insider purchasing

Or like Challenger (attempted, failed, hah! Score one for value investors!), or San Teh or any of these guys.

Go check and find how many of them had cheap stocks. I guarantee you, delisting, meant they were cheap, or were cheap to someone else.

No one just goes out there and buys up shares on the open market to force delisting. There must be value for the person/team/company doing the delisting just as there is value for the person/team/company doing the IPO.

Once the buybacks start, share prices tend to rise, and voila, your chance to sell has arrived.

Lesson?

If you want to sleep better at night, use a proven process. If you want to see us explain the process more and do the calculations live on the 19th (noon). Come if you want to find out more about the process. [Here’s a later one on the 25th, night]

If you’re an expert, feel free to skip it. It might not be very informative for you (though I’ve been told otherwise).

You can even throw stock ideas for us to value.

We’ll do it on the spot. In five minutes.

If not, I hope you’ve learned the value of having a process baked into your investment approach, and how that can translate to a better night of sleep.