This is really another in the Value Investing Series, but also an 80/20 Investing idea. To reiterate 80/20 investing is my value investing concept that attempts to get 80% of a solid return with 20% of the work. Not sure if it is really viable, although I am thinking of starting a test portfolio. But it is also the result of finding the website I mentioned in yesterdays blog about Empirical Finance Research.

The important distinction between Value Investing and speculating is that Value Investing involves research, and some analysis. Mostly, it is about properly valuing a company and buying at a discount to intrinsic value. Speculating requires you guess the correct direction of a market, stock or commodity. Within that statement I am not sure that this concept actually falls within the simple concept of value investing I just laid out. The paper is called The Asset Growth Effect in Stock Returns by Cooper, Gulen, and Schill. You should read it. It is not hard to follow. And they do a better job than I do of explaining their own findings. However for the 80/20 people…

Here is the concept: take all non financial, US stocks and look at their growth in assets, Total Assets( t)- Total Assets( t1)/ Total Assets (t1). Then you arrange then in deciles (10% groups) from highest to lowest. The lowest deciles of Asset growth stocks beat the highest decile by more than 20%/year. This equals a return of 23.28%. Not too shabby. But this is another typical value investing idea that is sort of like Einstein’s theory of relativity. The more you explore the more it defies the world that you know. This research seems to imply that hi ROA companies are likely to experience sub par returns while low ROA companies will likely have outsized returns. Isn’t that contrary to everything we learn in Investing 101? But if you look at Table 1 of the study, the high asset growth companies have an average ROA of 21%. Sounds great, right? The low asset growth rate stocks averaged -3.1% ROA.

There are actually a couple of problems for the practical investor. First, the strategy seems to require a relatively large outlay of stock purchases, which is simply not feasible for the small time investor. If you are required to buy 10% of the stocks evaluated that is hundreds and hundreds of stocks. Second, the What is wrong with Back Testing phenomenon is also important to take note of here. Any back tested concept that requires a specific purchase date and rebalancing time frame, has the potential to buy and ineffective or unprofitable times, when a less inflexible model might not. But who knows. I am still reeling from the concept that low ROA may be good.

2 Responses to “Easy Concept, Potentially Profitable Investing Strategy”

1. Parker Bohn
   March 5th, 2010 @ 2:37 am

   Here’s one that blew my mind when I first encountered it: Stock markets in countries with low GDP growth outperform markets in countries with high GDP growth.

   For instance, here is data to that effect:
   http://www.brandes.com/Institute/Documents/Case%20for%20Emerging%20Markets%20071105.pdf

   And a quote: “The professors’ findings demonstrated that the highest returns were associated with countries in the lowest quintile of GDP growth”

   My takeaway here is that both high GDP growth and high ROA are positives, but that attractive assets with high growth rates are often over-priced, and thus underperform going forward.

2. chroma
   March 5th, 2010 @ 12:06 pm

   It is a given that high ROA is a good thing, right. I am not sure that the findings are mutually exclusive since this all refers to growth. The question for me is is there any advantage to a high ROA stock with low Asset growth over a low ROA stock with low asset growth. What do you think. The GDP growth study is also very interesting. How do we captialize (pun intended) on this research? Parker, thanks for coming by and for the thoughtful contributions.

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