Excess Returns

Excess Returns
Excess Returns

This is the home page for our analysis of Frederik Vanhaverbeke’s book “Excess Returns”

Excess Returns: A comparative study of the methods of the world's greatest investors

It has links to each of the articles on the book, and a summary of the conclusions drawn in each case.

Here are the links to the individual articles:

  1. Philosophy and Psychology
  2. Styles and Strategies
  3. Finding Bargains
  4. Stocks to Short and to Avoid
  5. Fundamental Analysis
  6. Company Culture
  7. Valuation
  8. Process
Beating The Market
  1. The EMH says that it’s impossible to beat the market, but an analysis of the track-records of dozens of successful investors suggests that the opposite is true
  2. There are four ways to beat the market
    • trading using technical analysis and price action
    • trend following or momentum trading
    • macro investing using global economic conditions, and
    • fundamental investing using the data on a specific company – valuation, management, accounts and sector prospects (Excess Returns focuses on fundamental Investors only)
  3. Stock price fluctuations are unpredictable in the short-term, but in the long-term, prices revert to (and may overshoot) the Intrinsic Value of the stock – the fair value (FF), which can be calculated using the discounted cash flow (DCF) formula
Styles and Strategies
  1. The human brain has two competing systems for problem-solving:
    • the reflexive (fast) system – driven by instinct – which often takes short cuts
    • the reflective (slow) system  – the rational and conscious process of reasoning and thinking
  2. The stock market involves high emotions and difficult problems, which impact the effectiveness of the slow system, and leads to a large number of systematic psychological errors, known as cognitive biases.
  3. Cognitive biases in turn produce two situations which can be exploited to deliver excess returns:
    • the boom-bust cycle
    • popular and unpopular stocks
  4. There are three “easy” approaches to investing that the typical UK Private Investor can use:
    • Value investing
    • Growth investing
    • Venture Capital (VC) and Private Equity (PE)  – there are easily accessible investment trusts and ETFs for exposure to PS, and tax-advantaged VCTs for VC
  5. And there are two more advanced approaches that can be adopted:
    • pairs trading is reasonably straightforward to implement with spread betting (or CFDs or options)
    • top-down investing can be used to trade indices, commodities and currencies (eg. via spread bets), but this is not easy
  6. Successful investors need some skill in estimating the fair value of companies
    • how much estimating skill is open to debate
    • you don’t need to be the best in the market, just better than most of the market, or willing to put in more work than most of the market
    • it can be argues that that private investors managing relatively small pots have a built-in advantage over institutional fund managers with mandate constraints and large pots
  7. Successful investors also need the right mindset – important psychological aspects include:
    • independent / contrarian thinking
    • patience / long-term thinking
    • discipline (sticking to the process)
    • emotional detachment (calmness in the face of irrational markets, lack of attachment to stocks they own etc.) to limit the impact of cognitive biases
    • successful Investors are the true rational participants assumed by theory to make up the entire market
    • in fact they are a rarity, and rather than drive the market, they take advantage of its deviations
Finding Bargains
  1. Successful investors usually have a systematic approach to finding bargain stocks
  2. The most attractive opportunities for UK private investors are in:
    • dull and unfashionable companies
    • small companies
    • spin-offs and parent companies of a spin-off
    • privatisations
    • guru and fund manager investments
    • insider buying (directors)
    • stocks with under-appreciated catalysts
    • stocks that are removed from an index
  3. The kinds of stocks to ignore are:
    • Stocks in the spotlight
    • IPOs, apart from privatisations and de-mutualisations
    • Companies associated with new trends, and the incumbents affected by them
    • Tips and analyst recommendations
    • Stocks added to an index
    • Blue-sky companies
    • M&A situations (unless you react very quickly)
  1. To go further and short the stock, you need more evidence, because the downside risk in shorting is theoretically unlimited. Things to look for include:
    • poor management – dishonest, greedy, exuberant or weak
    • poor financials – weak balance sheets, poor returns on equity, poor cash flows and flawed business models
    • growth saturation coupled with plans for expansion into new territories or lines of business
    • companies in declining industries, or supplying to one
    • high prices in a competitive market
    • high float, with high institutional interest and medium short interest
  2. Some types of company should not be shorted:
    • Over-valued but good companies
    • Tech firms
    • Stocks that have already fallen in price
  3. Shorters also need a catalyst to make the share price fall quickly. Candidates include:
    • insider (Director) sales, especially after bullish announcements or an IPO
    • resignation of the Chairman / CEO / CFO
    • change of auditor / late filing of accounts
Fundamental Analysis
  1. There are three parts to fundamental analysis:
    • quantitative analysis
    • qualitative analysis, and
    • management analysis
  2. Quantitative analysis is the ratio analysis of financial statements that we’ve come across before:
    • income statement analysis looks at profit, dividends and return on capital
    • the balance sheet tells us about liquidity and solvency (leverage)
    • the cash flow statement looks at operating and free cash flows, which should match reported earnings
    • always look for improving trends and favourable industry comparisons
    • watch out for accounting manipulations
  3. Qualitative analysis is used by fewer investors, and this can be a source of competitive advantage
    • The main factors in qualitative analysis are industry structure, business model and competitive forces
  4. A favourable industry has the following characteristics:
    • barriers to entry
    • opportunities for product differentiation (not a commodity industry)
    • stability and low rate of change (not a “hot” industry, not technology)
    • no barriers to exit, avoiding overcapacity and price competition
    • no substitute products
    • low capital requirements
  5. A favourable business model will:
    1. not be complicated
    2. involve lots of repeat business
    3. have been proven over at least one business cycle
  6. Competitive forces act between a firm and its customers, suppliers and rivals
  7. Customers:
    • do they need the product under all economic conditions (defensive products)?
    • can they switch easily to a competing product, or are they locked in?
    • is the company the cheapest provider at a given quality level?
    • does the company have a strong brand?
    • does the company provide excellent service?
    • does the company have many customers, or is it reliant on just a few?
  8. Suppliers (including labour):
    • when suppliers can raise their prices, the company has a weak position
    • when there are lots of suppliers or substitute inputs, the supplier’s position is weak
    • if the company is a large part of the supplier’s business, then the supplier’s position is weak
    • if the input component is critical, the supplier has more power
    • low-skilled labour has a weak position, especially when unemployment is high
    • entrenched unions make it difficult to switch labour inputs
  9.  Rivals:
    • market leaders usually make the best investments
    • duopolies are okay
    • avoid industries with lots of equally sized players who will compete against each other
  10. A strong competitive position is supported by the ability of the company to maintain that position – to control its destiny
    • investors should avoid companies with regulatory risk
    • and those that rely on government support
    • R&D and fashion are risky areas
    • leverage, geographical and weather dependence are also risks
    • cyclical companies and those dependent on commodity prices, interest rates or FX rates have macro risk
  11. Growing companies make the best investments
    • early stage growth is risky
    • historic growth can predict future growth
    • growth should be driven by more units or higher prices
    • growth mean reverts and all companies reach saturation eventually
Company Culture
  1. Company culture and management are important to fully understanding and valuing a firm, but this is an area where good information is not readily available to the private investor
  2. Six internal functions help a company to maintain its competitive position:
    • Culture
    • HR
    • Structure, organisation and process
    • Marketing
    • Research and development
    • Operations (back office)
  3. The role of management in a company’s success is generally overstated
  4. The things to look for in management are:
    • personality
    • experience and track record
    • skills (capital allocation, strategic thinking)
    • focus
    • allegiance to the company
    • passion and energy
    • value promotion
  5. The board of directors defend the interest of shareholders
    • they need to speak up when management underperform
  6. Measures of a good board include:
    • experience – each board member should have unique expertise and knowledge
    • independence
    • board size <= 7
    • management compensation and director pay
    • separation of Chairman and CEO
    • good decision-making process
    • director shareholdings
    • small number of other directorships
    • regularity, frequency and attendance of meetings
  7. Information in many of these areas is difficult to come by
  8. Sources of public information include:
    • official regulatory documents (financial statements etc.)
    • broker reports
    • company websites
    • annual meetings
    • bulletin boards
    • Twitter
    • brokers and platforms
    • commercial sites like Morningstar and Digital Look
    • investor shows
  9. Investors can also make use of scuttlebutt – “everything else”:
    • visiting shops or other premises
    • using the products and services
    • talking to employees, customers, competitors and suppliers
    • this can provide juicy information, at the expense of lots of leg work
  1. Keep the valuation model as simple as possible.
    • Restrict the number of parameters that are used
    • Avoid DCF where possible.
    • Focus on:
      • PE (with PEG)
      • P/FCF
      • EV/S
      • EV/EBIT (with PEG-EV/EBIT)
      • P/BV
  2. Be conservative.
    • Use a margin of safety.
    • Prefer balance-sheet based multiples.
    • Use normalised and trailing values for income and /or cash flow-based ratios.
  3. Be sceptical of growth and competitive advantages.
    • Always double check valuation results since the markets are not stupid.
  4. Use comparisons with peers and with historical multiples.
  5. Limit errors through triangulation.
  6. Look for quality at a fair price.
  1. If you don’t have a coherent strategy, get one and stick to its rules
  2. To maintain independence, cut out the noise
    • Some top investors (eg, Buffett) are located far away from the markets
  3. To counter psychological biases, pay special attention to the bear case (or if you are planning to short, the bull case)
    • always look for information that disproves rather than confirms your investment thesis
    • sell those stocks where you become aware that you are biased / attached (or indeed, simply “spring clean” your portfolio on occasion)
  4. Limit your attention to (changes in) stock prices
    • don’t check your portfolio every day
    • frequent checks lead to the identification of spurious patterns and to anchoring to historical prices