Tuesday, 13 November 2007

The little book that makes you rich: what is really going on?

In my last post I questioned the long term relevance of some of the fundamental factors outlined in the Navellier's Little Book that makes you rich. However, I also noted that all eight of these factors only add up to a 30% weight in his final analysis. The other 70% is given to what Navellier calls his quantitative stock grade. He describes this as a measure of buying pressure amongst institutional investors.

However, he also tells us exactly what this measure actually is. On page 88 he says "In basic form, we divide a stock's alpha (the return independent of the stock market that typically comes from buying pressure) by its standard deviation. We measure this over a 52-week period".

The 'alpha' Navellier calculates comes from a simple CAPM model. However, as we show in Chapter 35 of Behavioural Investing, the simple CAPM model is deeply flawed. It just doesn't work. In fact in general there seems to be a negative relationship between beta and return, rather than a positive one.

Of course, Fama and French suggested a revised multifactor model of asset pricing - based on size, and price to book as well as the normal market factor. To help reduce the pricing errors in this model a momentum term was introduced by Cahart. A very recent modification has been proposed by Hirshleifer
. This adds a new factor to the equation of repurchases minus issuers (labeled UMO). This again reduces the significance of the alphas calculated from the FF4 model. In general the alphas become statistically insignificant under this five factor model.

So effectively, Navellier is running a semi reduced form model, not specifying which factors matter, but rather taking the alpha as a catch all term (which could be broken down into more understandable elements - such as size, value, issuance and momentum). However, Navellier demonstrates that these alphas have persistence. He estimates them over the past 52 weeks, and then uses them going forward.

To my mind this is consistent with recent work on style momentum. Chen and De Bondt have shown that style categories have a degree of persistence. They show that if you buy styles that have done well in the last year (in terms of size, price to book and dividend yield) they continue to do well over the next 12 months (but not beyond). The return achieved from a long short position based around this style momentum is around 7% p.a. using a 12 month holding period, and style past returns calculated over 12 months. In long only space a style momentum strategy generates a return of around 17% p.a. over the period 63-97. So Navellier's idea of alpha persistence certainly gets some support from this viewpoint.

Some final thought

I found much to agree with in Navellier's Little Book such as the over-reliance on stories, and the meeting with company management being a waste of time. His reliance on numbers based analysis echoes very much my own views on evidence based investing. However, ultimately I found the book couldn't stick with its own discipline. For instance, Navellier can't help but eulogize over the wonderful outlook for stocks that deliver out future. Despite his pronouncements that his eight factors and his quantitative grading system are really all you need to invest, he spends a considerable amount of time telling you to read the newspapers, whilst simultaneously ignoring the noise. Such overtly contradictory advice can do little but confuse the reader.

Personally I am not convinced that Navellier puts together a coherent defense of growth investing. But then again that won't surprise those of you who know me!

Wednesday, 7 November 2007

The little book that makes you rich: A critical analysis of the fundamental factors

Firstly apologies for the recent lack of posts, I've been enjoying a sojourn visiting some of my family in New Zealand. I've recently been reading Louis Navellier's 'Little Book that makes you rich' subtitled "a proven market beating formula for growth investing".

I'm generally skeptical of the benefits of growth investing. All too often growth investing simply seems to be a cover for buying the latest fad or fashion in the investing world. So when I saw a book purporting to offer a numbers based approach (what I have called evidence based investing) to growth investing I was intrigued.

Navellier starts out by listing out his eight criteria for fundamental investing.
1. Earnings revisions
2. Earnings surprise
3. Sales growth
4. Operating margin growth
5. Cash flow to MV
6. Earnings growth
7. Earnings momentum
8. ROE

When I looked at this list I was somewhat surprised. Many of these factors struck me as odd. For instance, I have never come across a single paper claiming that sales growth had any kind of positive relationship with returns, nor ROE. Others such as earnings revisions and surprises were less shocking.

I decided to run a quick check on each of these factors, using a variety of sources ( I will run a full set of tests once I'm back at work, but for now I'll rely on others results). For each factor I tried to find the study with the longest history. The table below presents the results showing how much each factor added to a long only portfolio vs the market.

1. Earnings revisions 4.8% p.a
2. Earnings surprises 2.7% p.a.
3. Sales growth -13% p.a
4. Operating margin growth N/A
5. Cash flow to MV 4% p.a.
6. Earnings growth -2% p.a.
7. Earnings momentum 0% p.a.
8. ROE 0.8% p.a

In fairness to Navellier, he does note that the importance of each of these factors waxes and wanes over time. However, with a number of his factors appearing to add no value over a consistent time horizon, one must wonder what these fundamental variables bring to the party?

Interestingly, one of the best fundamental factors turns out to be a value factor! Although Navellier dresses up his use of cash flow as a growth variable, nothing can alter the fact that it is really a value variable. This is consistent with work that I have done which showed that value strategies did well within a growth universe (see Chapter 31 of Behavioural Investing).

It is also noteworthy that despite spending around two thirds of the little book of these variables, they only get a 30% weight in the final system....so what is the this little book really doing? I'll examine this in my next post.