How Can You Beat the Market?

Hard Competition

Investing world is full of hard competition. In order to get better results required hard work. Many times not even hard work is enough. If you are looking for investment opportunities in the same places as all the other it’s difficult to get the competitive advantage. Looking for only S&P 500 stocks you definitely meet the world’s smartest minds. It doesn’t mean that you should completely avoid to invest in any S&P 500 stock. After the stock market crash or heavy correction, it’s often possible to find quality blue chip stocks at discounted prices. If you have a right kind of contrarian mind and strong nerves to invest heavily in high quality businesses during the time of fear and panic, you can compound your money successfully over the long run. I have done one of my best long term investment for Wells Fargo (NYSE:WFC) after last financial crisis. Hindsight I should have used more money but after the panic my mental fear was too big to overcome. Unfortunately we are not all like Warren Buffet who was able to put over 50 % his asset to the most promising investment when all the odds were in his favor. I was happy to find Bank of America (NYSE:BAC) and AIG (NYSE:AIG) soon after WFC. After making my own deep fundamental analysis I have to admit that knowing Bruce Berkowitz e.g. was investing heavily for these companies helped me to cross the first mental obstacle.

 

Nordic Markets

At other times, you probable find best opportunities from less followed frontier markets. I’m living in Finland and all the Nordic countries (Finland, Sweden, Norway, Denmark) are more or less periphery to big market players. Sometimes you can find little unknown underpriced quality companies and smaller growth companies for reasonable price. For real bargain hunter Nordic markets are normally tough area. You can hardly find any net-nets and most of the cheap stocks are bargain for a reason. However, after the market storms small markets (typical for all Nordic markets) suffer often more than leading markets.

This can easily lead to strong undervaluation and you can find unbelievable cheap high quality companies. There are also some opportunities in a special situation sector. At this point I have to mention famous Seth Klarman (the founder of Baupost Group) who profits from Finnish Biotie Therapies (OHEL:BTH1V) buyout. Mr. Klarman purchased Finnish Biotie ordinary shares June 2015 on the Finnish securities markets before company released its initial public offering to American Depository Share.

 

Sun is Shining Far Away

Also some other more unstable markets can offer special situation opportunities. Latin America is good example. Political situations can be rapidly changing. Also business conditions are many times far from the level of Western Europe or United States. This means that risk level is higher, but if you do your homework well or you have some local knowledge, and you are careful enough (remember sufficient margin of safety) opportunities for high profits are more than enough. The same applies more or less for Far East markets. Of course there are big differences between different countries like Hong Kong, Singapore, South Korea or Malaysia, Vietnam, Philippines. Anyway you need a little bit market knowledge and you should look after companies, management and accounting principles. Quantitative investing doesn’t necessarily work so well, because in Asia many stocks that are selling cheap are more likely to be in a lousy business. Qualitative deep knowledge of the management and the company is needed.

One famous Finnish fund manager Petri Deryng (Pyn Elite Fund) has been working successfully for a long  time in Far East region. Though last year we got a good example of investing risks there. After the traiding suspension of Chinese lottery company REXLot Holdings (HKSE:00555) Pyn Elite Fund had to make a big write-down. Deryng was not the only one and it was by no means an unusual surprise on those markets. Before we condemn investing in Far East as too risky we should remember what has happened recently in the most reliable market with Valeant Pharmaceuticals, Horsehead Holdings and SunEdison. Some famous and traditionally very respected big names have burned their hands. And I suppose you also remember Enron and WorldCom – not so long time ago…

I have had a couple of interesting positions from Far East. At the moment Nam Lee (SGX:GOI)(net net from Singapore) is an example of good bargain stock in solid market. Basically family business that designs and manufacture metal products. Because of challenges in metal industry they have had couple of difficult years behind. It’s a boring but sound business. Company is very cheap (last price 0,30 SGD, net current value 0,36, book value 0,53) and profitable. I bought it for a price of 0,28 SGD. The quality of their reported earnings seems to be fine and the ROA is even 9,18 %. Owner’s also appear to be shareholder friendly by paying out a decent percentage of income as dividends. The biggest risk of Nam Lee is maybe their customer concentration and difficulty to name any special catalyst which will raise the stock price soon.

I’m also looking for troubled economies in emerging markets. Big crash, financial or political distress can spell opportunity. I’m prepared for them following 5-10 stocks from couple of different markets. Once an opportunity has been identified I can buy basket of undervalued stocks from that particular country (I think this is little bit like legendary Templeton way to invest in emerging markets).

 

Very Special Case

Then Russia is its own special case. Most of western or US investors think that you should avoid Russia in all cases – and maybe for good reason. I do not entirely agree. Here in Finland we have learned to live  ”Big Bear” as a neighbor (a horrifying thought for somebody?) and we have learned to make business with them – and even make profitable business in Russia. From Finnish markets you can find quite a many companies doing part of their business in Russia. Key word is part of their business. Then the risk remains moderate and you still have a good upside possibility. I have positions in Nokian Tyres (OHEL:NRE1V), Tikkurila (OHEL:TIK1V) and Neste (OHEL:NESTE). I have done all these investments long before Russia / Ukraine crisis. After the crisis and political sanctions, I have taken the positions even in Gazprom  (OTCPK:OGZPY) and Sberbank (OTCPK:SBRCY) because of their ridiculously cheap valuation (Gazprom P/E 3,5 – P/B 0,3 – EV/EBIT 3,75 and Sberbank P/E 10 – P/B 0,7 – EV/EBIT 1,5) combined with as stable business background as possible in Russia. I know that political risk is often impossible to value, but when I saw that military and political situation began to stand still, I assessed that possibility of the worst case is no longer a large. It’s easy to say afterwards that this time valuation meant more than political risk. I have to admit that the opposite outcome was also possible.

 

Small is Beautiful

Last but not at least Small-Cap and Micro-Cap markets offer the most opportunities to small investors. This is true everywhere in developed markets. Smaller companies are not so followed by analysts, often easier to understand and can creates unique opportunities. You just have to do well your fundamental analysis and remember the importance of margin of safety, then you can successfully go against the big crowd.

Many Economical studies confirm that small equities as a group have offered attractive and better than average returns over the long period of times. These results can differ based on the time periods examined, but in the big picture small stocks outperform large stocks by a statistical significant margin over the time. Without going too deep to analysis small stocks there’s some basic things you should take into consideration.

Avoid too tiny illiquid stocks. Trading could be difficult and bid-ask spread is wide. Sufficient daily trading volume (varies greatly from market to market) ensures the correct formation of stock prices. Annual and quarterly reports (United States SEC filings) should be up to date. It’s appropriate to require collectively Insiders owning to be at least 1 percent of company’s stocks.

The small stock space is enormous. The most effective way to narrow down the field of potential investments is often screening. For me the most interesting small cap area is net nets stocks trading at a discount to their net current asset value. Net nets can offer best investment results for small investor. Even if you use simple mechanical screen, and buy and hold strategy, results can be outstanding. Basically all the net nets stocks are very, very cheap. When you have found one, you should concentrate more on the business than focus solely on the balance sheet. Of course balance sheet value comes in cash is more favorable than value which is in receivable or high level of inventory. That’s why Benjamin Graham used net net working capital formula where net net working capital = Cash and short-term investments + (accounts receivable x 0.75) + (inventory x 0.50) – total liabilities. And finally remember once again margin of safety. Father of value investing and margin of safety Ben Graham purchasde basket of net nets which were valued at a discount to their net current asset value by 33% or more. More about net nets in the near future.

 

 

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