Wednesday, May 14, 2014
Wiley, The 52-Week Low Formula
Wiley does not advocate buying a stock just because it has made a 52-week low. Each stock that is a candidate for his “buy” list is subjected to a five-question filter: (1) Does it have a durable competitive advantage? (2) What is the purchase value of the company relative to its free cash flow? (3) What is the return on invested capital of the company? (4) Can it pay off its long-term debt quickly with free cash flow? And, only then, (5) Is it trading close to its 52-week low? Wiley’s strategy is “a logic-based, disciplined approach to narrowing down the 3,000 publicly traded companies in the market to the 25 that represent the best opportunity for creating real value in the coming months.” (p. 13)
Each chapter of the book begins with an inversion, as Wiley tries to follow in the footsteps of Carl Gustav Jacob Jacobi, the nineteenth century mathematician, and Charlie Munger, one of the chief proponents of the process. Jacobi suggested, in Wiley’s not quite historically accurate interpretation, that “when it comes to problem solving, we start by understanding the desired outcome and then identify all the factors that will ensure it can’t be reached. Through the process of identifying the ways we won’t succeed and eliminating them, what are we left with? The building blocks of a strategy for success.” (p. 17)
Wiley doesn’t make especially good use of his interpretation of the inversion process. For instance, in the second chapter on herding and the bandwagon effect he begins with a quotation from Howard Marks’s The Most Important Thing: “If you want to achieve above average outcomes you must be willing to take an unconventional approach. If your approach is conventional and commonly used then you guarantee average results.” Wiley’s Jacobian inverse is: “I would prefer to invest alongside the masses to ensure I achieve average results. It feels comfortable, as there is safety in numbers. I realize there is no use to thinking differently than the investing public, as it is much easier emotionally to be one of many versus one of few. We will all win and lose together.” (p. 19) Unfortunately, the inverse doesn’t provide new insights or clarify Marks’s statement.
A more useful description of inversion in the investing context comes from Tim Richards’ Psy-Fi blog: “Always look for reasons to do the opposite of what you’re considering, because then you’re pushing against your biases, even if you don’t realize it.” For instance, to disrupt an ingrained bullish mindset, ask how you can lose money rather than how you can make money.
Wiley devotes five chapters to his filters and nine chapters to more general thoughts on investing, some from behavioral finance. Because, let’s face it, it’s very difficult to buy 52-week lows, even if the candidates have emerged unscathed from the other four filters.
Wiley is quick to admit that the 52-week formula is “just that: a formula, a recipe, an approach. When you are cooking at home, you follow a recipe and expect certain results. … But a proven recipe is not a promise of a good meal. … Any number of things can go wrong and ruin the meal. Does that make it a bad recipe? No. It just shows that recipes, like stock formulas and investment strategies, represent a path toward a desired outcome, not the outcome itself.” (p. 180)