Michael Lauer: The Wisdom Of Value, The Folly Of Fad
Michael Lauer is well known for managing funds with outstanding returns coupled with low risk. Since January 1993, Lauer's flagship fund has realized a net 72% average annual compounded return (CAGR). He has achieved these exorbitant returns keeping losses both small and short-lived.
Lauer believes in concentrating his portfolio into a small number of holdings (fifteen stocks typically account for 75% or more of assets). He believes broad diversification is very mediocre because it makes your performance similar to that of the market. Research shows that 80% of the diversification benefits can be achieved with just 15 different stocks. To achieve the goal of exceptional performance and low correlation, too much diversification is not required.
To cut down the universe of U. S. stocks to a mere fifteen requires a very restrictive selection process. Lauer has six screens that must be met by security to feature on his shortlist:
- It must be a company/sector that he fully understands.
- The price of that stock must have declined by more than 50% relative to the market average. This means that the stocks which have experienced wholesale/institutional liquidation are his area of focus.
- The company must have a reasonable cash flow and a strong balance sheet.
- There must be either insider buying or a repurchase program or both.
- The stock must represent convincing value (e.g., price near book value, large revenues relative to total capitalization).
- There should be a catalyst to ensure that the stock moves shortly. Otherwise, although the preceding four conditions will limit declines, the stock could just sit where it is for years, reserving the capital.
Lauer will typically liquidate his stock despite knowing that it will move higher. This is because he believes that he will get other opportunities for a better risk/return profile.
He goes on to explain that short positions differ from long positions in two ways:
Firstly, the holding period for short positions is much shorter than for long positions (a week compared to three to eighteen months). Stops are employed in short positions to limit losses because of potential upside loss.
Second, the size of major fund holdings provides important information. For example, if major funds hold a large number of shares and they start liquidating their position, then the stock will probably undergo relative pressure for months.
One similarity between long and short positions is that they both require a catalyst. For short positions, it is a supreme issue because timing is motivated by an expected event (e.g., a disappointing earnings report).
Lauer explains two more important concepts. First, a great performance requires not only picking the correct stock but also having the conviction to implement trades in meaningful size. For example, a small position in a great stock is just an add-on to one’s mistakes. He firmly believes that any investment approach that depends on stock market direction for profitability is destined to mediocrity. Similarly, any approach that relies on accurate forecasting or involves high expectation stocks is extremely risky.
He summarizes the market philosophy by saying that the business does not involve investing in great companies but by profiting from inefficiently priced stocks. He explains that the fundamentals are not bullish or bearish in a vacuum; they are bullish or bearish only relative to price. The greatest company in the world may prove to be a terrible investment if its price rise has already over-discounted the bullish fundamentals. Conversely, a company that has been blasted with negative news could be a great buy if its price decline has over-discounted the bearish information.