Do You Know These 3 Secret Spots Where Pirates Dig for Treasure in the Stock Market?
”Life’s pretty good, and why wouldn’t it be? I’m a pirate, after all.” – Captain Jack Sparrow, Pirates of the Caribbean
Pirates that didn’t get caught by the good guys or catch any of the dozens of terrible diseases of the time had it pretty good – life on the open seas, debauchery, and treasure.
Lots of treasure.
Treasure and pirates are as inseparable as Captain Jack Sparrow and his ship The Black Pearl. Or Captain Hook and his… well, hook.
So how do pirates find treasure? One simple answer is that they know where to dig.
Picture yourself with the map above. If you were to search for treasure, where would you go looking for it?
I’m guessing you be right, matey!
The big red X is where you would go to dig. The reason why is simple: It’s where the treasure most likely lies.
Now what if I told you that there are places in the stock market marked with big red X’s, waiting for pirates like you and me to pick up our shovels and dig?
3 places to dig for treasure in the stock market
Would you find it hard to believe that these spots exist?
While common sense seems to suggest that they would long since have been discovered and plundered, research and human nature indicates otherwise.
Luckily for you and me, these excellent digging spots are neither hard to find nor likely to go away anytime soon.
So where are the big red X’s?
Let’s take a peek:
1. Valuable, ignored treasure grounds
The place to start digging is where most pirates successful investors find gold selling at closer to the price of fool’s gold.
You see, there are several measures of value that have been proven to beat the market by a significant margin for generations, and probably worked even when us pirates ruled the high seas.
Here are the main measures of value:
- Low price to earnings
- Low price to book value
- Low price to sales
- Low price to dividend yield
- Low price to free cash flow
- Small cap stocks with any or all of the above characteristics
Investing in a hull’s full of such companies is proven to bring home the booty, even if some of them spoil on the return trip.
How much booty?
Would you believe from 5%-10% above the market return, when investing in the cheapest 1/10th of all stocks ranked by any of the above measures of value?
And this isn’t just one year of outperformance – the research seems to indicate that the outperformance lasts for at least three years.
Of course, these methods don’t always work – so called value investing goes through periods of underperformance, sometimes lasting for years.
But on average, over the long run, these measures give booty-liscious returns.
If you find this hard to believe, so did I and everyone else who later converted to value investing when we first heard about it.
After all, these ‘secrets’ have been widely known since Ben Graham published Security Analysis: The Classic 1934 Edition, when he introduced the investing world to value investing.
So wouldn’t too many people knowing these methods have killed their effectiveness?
For a full accounting, you should check out the 44 studies that Tweedy, Browne Company LLC compiled in What Has Worked In Investing (warning: PDF).
For a more story-like but equally convincing account of why value investing still works, check out Warren Buffet’s famous article, The Superinvestors of Graham and Doddsville.
So there’s plenty of proof that value investing worked for generations after Ben Graham taught the methods to people like Buffett.
But it gets better, because there ways to find more booty in the markets.
2. The pirate’s magic formula
Yes, there is a magic formula for beating the market – and it is one that real pirates should know well. So how well does it work?
By as much as 10-18% per year above the market return, over time!
The return depends on which sized companies you rank with this magic formula – the smaller the company, the higher the return.
While the formula has been in hiding for ages, it was not discovered until the master pirate investor Joel Greenblatt dug it up, dressed it up, and wrote it down in The Little Book That Beats The Market.
Joel even shares the results of the formula freely at www.magicformulainvesting.com, which you can use as a screen or hunting grounds for your own self directed portfolio.
It’s magic because it combines the best aspects of value investing and business evaluation in the simplest way possible – by ranking all companies according to earnings yield and return on invested capital, and adding the two together for a new, magic ranking.¹
In giving an equal weighting to price and business quality, the magic formula might be the best stock screen out there.
All of this means that there is almost no better place to look for hidden treasure in the markets than in the chests of companies that the magic formula reveals.
Or is there?
3. Spin offs
In You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits, our pirate friend Joel Greenblatt shows us special situation investing methods that might work even better than his magic formula.
But they take lots of hard work.
Luckily, he makes clear that there is one kind of special situation investing that isn’t too hard to dig into – spin offs.
Here’s the good news: Spin offs outperform the market by an average of 10% per year for their first three years as a separate company – and they show their largest gains in the second year after the spin off!²
It stands to reason that applying basic value investing principles like the ones above will help you find spin offs that do even better than the average. And if the spin off is also caught in the net of the magic formula, watch out!
But why do spin offs work so well?
Wait… where do pirates actually dig?
Okay, I’ve got to admit: All of the ‘places’ above are not places at all, but rather methods for finding companies that fatten your booty. Investing booty, that is.
The answer to where pirates actually dig, not surprisingly, is wherever the greatest treasures lie. For intrepid pirates, this means sailing out into uncharted waters – going abroad in search of fame and fortune.
And that, me matey, is the next topic in this series of Investing Secrets of Pirates, where you will learn why you should plunder world stock markets today, and which countries be hiding the most treasure.
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The return on invested capital is measured as EBIT/(Net Working Capital + Net Fixed Assets)
The results of the study come from 17 years of compustat data (1988-2004) and are based on a one year holding period of the top 30 ranked stocks. For the top 30 companies with a capitalization of $50 million or greater the average compound return was 30.8% per year versus an S&P return of 12.4% per year (Market average of 11.7% per year). Returns for the top 30 rated stocks among the largest 1000 stocks were 22.9% per year. All information from Joel Greenblatt's The Little Book That Beats The Market.
² Based on a 25 year study ending in 1988 at Penn State: Patrick J. Cusatis, James A. Miles, and J. Randall Woolridge, "Restructuring Through Spinoffs," Journal of Financial Economics 33 (1993). Abstract here.