Does it Pass the Sniff Test?
Pick winners.
Prevent losses by staying away from the losers.
Easy.
Well.. no.
A quick way is to first eliminate a lot of the junk out there with a sniff test.
A sniff test is the same as a simple checklist.
The purpose is to build guardrails so that you don’t step into dangerous territory.
It doesn’t work out as well because value investors get attracted to cheap stuff and growth investors get attracted to charismatic managers and glamour stories.
One big area of improvement and a big plus to my own sanity and workaholic nature is applying the principles of the Action Score as my sniff test.
Speaking from the position of a busy investor, I sought after hardcore value to show and prove to people that I was a value investor.
But in terms of an edge, I had neither informational or time edge.
The dedicated finance pros are putting in long and hard hours combing through documents, data and other information.
By seeking complex value stories, I was playing on their field, at a disadvantage.
Not only that, I was limiting my stock universe to choppy waters that requires a lot of effort to work through. And my failed investments certainly reflect the lack of work.
I concluded and acknowledged a few things.
- I love being a value guy
- I don’t have the time to search the entire ocean for value fish anymore
- I needed a simple yet strict process
- I wanted to remove bias from over-research and overconfidence
I’ve been able to do with with the help of Old School Value.
There are plenty of ideas that gets passed up by the Action Score criteria, but for a busy person, it cuts out the potential for devastating losses by sticking to a process and spreading my bets.
Joel Greenblatt on diversifying
Minefield of Biases
Before you place an order, you’re somewhat ok.
As soon as you are invested in a company, your position changes and you put yourself in the middle of a minefield full of biases.
As you read more, and as you find yourself liking a company and management, you are priming yourself with an incredible amount of bias.
- Consistency and commitment bias
- Extra vivid evidence bias
- Past correlation bias
Munger presents 19 biases you fall for.
Not picking on Ackman (I’m using my own recency bias), but all the noise related to Valeant and Ackman in 2016 is a good example.
On his 2016 performance, Ackman told CNBC:
“It’s almost entirely been driven by Valeant. I’ve never owned a stock down 90 percent,”
“[Valeant] is now a more traditional Pershing Square investment” now that it’s been pummeled, he said. “We normally invest when shareholders have lost confidence in management. And that’s what happened here. It was not just management, shareholders lost confidence in the numbers. The financial statements were delayed. There was a potential default.”
“We never normally get to meet the management of a company before making an investment. [And] we never invest in really complicated companies you can’t figure out from just reading the 10K [filing],” he said.
Without using the exact words, you get a feel for how many biases Ackman lost to.
I look back at many of my failed investments and I know that I fall into the same category.
Check out this table of the top 20 hedge fund managers of 2016.
Top 20 Hedge Fund Manager 2016 – H/T Valuewalk
You likely haven’t heard many of these names.
In fact, unlike Ackman who publicizes his stock picks and shorts for the public to scrutinize, they don’t subject themselves to the same biases.
Valeant still fails my sniff test and I’ll let Ackman and other hedge funds hold.
With so many stocks available in the stock market, is it the best use of your time to go after Valeant or lower hanging fruit?
Valeant Historical Action Score
I want to sleep better at night and not worry about a single position wiping out years of gains.
Proper portfolio allocation helps limit losses, but the best use of my time and for other busy investors is to look for opportunities in pristine waters.
Not in muddy ones.
Take a look at GPRO which reported recently. The Action Score does not reflect the latest results as I took the screenshot based on Q3 2016 data.
GPRO Action Score Q3 2016
Here’s a side by side look at the three scores that make up Quality, Value and Growth.
GPRO Action Score Make Up | Click to Enlarge
In less than 10 second, I know it’s a pass.
If I wanted to dig further, I would question:
- do I know why the business is putting up such numbers?
- do I know how the business will fix these numbers?
Most of the time, the answer is no, because if the insiders don’t know themselves and continue to misfire in their execution, what chance do I have of knowing how the company will make it out.
Therefore, it’s an easy decision to pass instead of getting swallowed up in the potential value (trap) as I show in this image.
Action Score Borderline Stocks | Click to enlarge
Investors tend to gravitate towards one of these broad categories.
The stock market is beautiful because you don’t have to settle for second best. You can search for companies that score high on all QVG or at least two out of three.
I get asked a lot about Amazon (AMZN), which is now available for free on the demo.
Amazon Stock Grade | Click to enlarge
The Action score is currently 74.8.
Borderline between B and C. Once a stock gets above 75, it’s a good stock to consider.
The frequent question I get is whether it’s a buy considering how expensive the stock is.
I like to respond by simplifying the question.
Is Amazon more likely to stay as a C stock, fall to a D or move into the B category?
- Their Quality is awesome.
- Their Growth is unbelievable.
- Their Value by the numbers is expensive, but hides intangible factors like having more than 30% of ecommerce market share and their determination to chip away at the retail market share, which is much bigger than ecommerce.
By focusing on the big picture first before diving into the details, it makes the process much easier and allows you to focus on companies with potential.
This type of sniff test not only saves you time, but saves your portfolio from a single point of failure due to something like overconfidence.
Iradimed Corp (IRMD)
On a different note, Iradimed is a company that was an A grade stock at the beginning of the year, and is included in the 2017 model portfolio.
2017 Portfolio Viewable Here
It has fallen to a B and is down 23.66% YTD.
Iradimed passed the initial sniff test but it represents what can happen.
- As Greenblatt said, spread your bets if you don’t put in a lot of work for specific positions. With the 2017 model portfolio, it’s a mechanical portfolio following the rules of the Action Score stocks.
- Don’t anchor on price. Don’t anchor on the direction using historical stock charts. If you believe Amazon is overvalued, do you also ask yourself why something is undervalued and why you should buy?
IRMD Stock Summary
- Piotroski Score = 7
- FCF/S = 25.8%
- CROIC = 29.7%
- P/FCF = 11
- EV/EBIT = 6
- P/B = 3.3
- TTM Sales Growth = 33.8% (latest reports show it has fallen)
- Gross Profit to Total Assets (GPA) = 0.82
What About Goldfield Corp (GV)?
From a value investing point of view, this is not a company you buy.
Here’s the anchoring effect I’m going to throw at you.
3
2
1
For traditional value investors, this chart is scary.
Surprisingly it is one of the winners in a very short month.
What does this mean?
Price is not an indicator.
A company that looks undervalued can go down, a company that looks overvalued can go up.
Goldfield is not a company I own in my personal portfolio, and that’s because it may have passed the initial sniff test, but it didn’t make the final cut when I manually go through my own list.
Companies like GPRO, FIT, VRX didn’t make it to the list either.
Good.
Define Your Sniff Test
We cover about 5000 “clean” companies. And there are only 296 A-B rated stocks.
This is only 6% of the universe.
Include C’s and it jumps to 1042, but still only 21% of the stock universe.
By implementing a sniff test, I’ve been able to automatically weed out 79% or 94% of stocks. Apply the same principles and you’ll be able to filter down your universe depending on your taste.
You can use the Piotroski Score, Altman Z score, Beneish M score, Sloan ratio, and more to define your sniff test.
Fail to use one and you could end up with a company like Valeant in your holdings.
Summary
Use a sniff test to:
- boil down your stock universe
- create a strict and objective process
- eliminate bias
- eliminate devastating pitfalls
Disclosure
No positions at time of writing.
