I recently came across this book called “The 52-week low formula” (highly recommended) written by Luke L. Wiley, who is a Senior vice President-Wealth management at UBS Financial Services. He has 15 years of experience in the Financial Services Industry and after years of research, mistakes, reading, refining, perfecting, Luke has finally dissected and condensed all the info into a simple formula called “The 52-week low formula.”
He is convinced that as an investor, you ONLY have to look at 5 key filters before investing in any stock. To test the soundness of his assumptions, Luke asked MorningStar to conduct a comparison research against the S&P 500. A portfolio of 25 companies are picked using his 52-week low formula and they are all re-evaluated annually to ensure all criteria are still met. His results? The 52-week low portfolio is less volatile and has outperformed the index consistently from time to time.
There is no “secret” to investing, it just comes from having a good investment system/strategy, buy low, sell high, don’t follow herd, practice discipline and don’t let your emotions cloud your judgement, THINK! Be hawkish when it comes to debt, there is no perfect pitch, strategy, only higher probability, forget about buying at all-time low and selling all-time-high, always insist on MARGIN OF SAFETY, be CONTRARIAN!
The reason why this formula is hard to apply is because NO ONE buys a stock at its 52-week low, downgraded by Analyst, has low momentum and a sluggish outlook. But in contrary, the 52-week low point represents the maximum financial opportunity to jump on the wagon, if the 5 filters are met.
I will provide a summary of this book as well as the 5 filters of the 52-week formula (over the subsequent few posts) and attempt to apply its concepts in real-companies using SATS as an example. SATS is a company that I have been eyeing on for quite a while and it is trading near its 52-week low right now. Hope you will find the information useful, toy the idea around, dissect it and apply it in your own analysis one way or another if you find anything applicable.
2 Types of Thinking (Thinking fast and slow)
Firstly, there are 2 types of thinking in life and in investing: System 1 thinking: Reactive, instinctive, intuitive, thinking along the least path of resistance. Following the general sentiment, herd mentality, spontaneous and emotive thinking.
Then we have System 2 thinking: which requires you to seek out input, consider data, extrapolate consequences, providing detailed analysis of how, what, why, cost vs benefits, charts comparison e.g. A more rigorous academic approach that requires a certain degree of effort and hours put in to research.
I have realized all along, I am guilty of using system 1 thinking when making investment decisions, unconsciously. And the truth is majority of the crowd are also using system 1 thinking in making judgement. Whenever, there is a new stock pick, analyst recommendations, news of record-high share price, hot discussions, we instinctively want to get into the game for the fear of missing out.
We now form a optimistic bias and proceed on to dig a few info from the website, read through briefly to reinforce our rationalization, see what other people do, say, looks good, feels good, and hit the BUY button without much thought. This is what is meant by system 1 thinking, its emotive, instinctive and we just follow the herd because we feel safe and secure, its cognitive ease and our subconscious mind are influenced by the opinions of others (especially so called “experts, analysts or the media”).
Example: the first REIT I purchased was Ascendas. Why did I purchase it? Because it’s the largest REIT in Singapore by market Cap, net income increasing trend, dividend yield increasing trend, solid management, strong sponsors, diversified tenants, and that applies for Mapletree Logistics too. This is as far as my analysis and thinking goes. I am guilty of system 1 thinking in the past because i had no idea what to look out for, but now I have a system, a framework which requires more financial rigour and deeper level of thinking.
That’s the reason why when Mark Twain said if you find yourself on the side of the majority, it is time to pause and reflect, because this is where we STOP THINKING and grow complacent. So it’s time to stop herding!
What are the 5 filters of the 52-week Formula?
Filter #1: Economic Moat
This describes the porter 5 competitive forces: threat of new entrants, bargaining power of buyers, threat of substitute products or services, bargaining power of suppliers, rivalry among existing competitors, barriers to entry, network effect, branding, durable competitive advantage etc.
I have came up with a radar chart to analyse the different components and get a better visualization of how strong is its economic moat. The scoring are based on the following qualitative analysis. Let’s have a look:
SATS has a very strong economic moat as it has already monopolized the gateway services and food solution market. There is not so much worry on competitors, threats of price war, new entrants etc. The main concern is RISING COST which forces SATS to invest in new technologies or distribution networks that drives innovation and efficiency in order to reduce cost savings in the long-run. All in all, SATS have passed Filter #1 nevertheless.
Filter #2: Free Cash Flow (FCF) Yield
This is interesting because it avoids using net earnings, net income financial metrics/ratios as it can be often distorted through accruals, depreciation, capitalizing expenditures, making judgement on depreciating policies etc. Cash flow is a better measurement as it represents REAL cash outflows and inflows, non-cash factors in accrual accounting are taken off the equation making it less susceptible to accounting manipulations.
Free cash flow (FCF) can be computed by taking Cash flow from Operations – capital costs of maintaining current capacity (CAPEX)
FCF is essentially what you as a business owner could take out from the company’s CASH register and put in your pocket while still ensuring that the company is maintaining its operations (hence, capital expenditures are deducted in the formula)
The next part of the equation is finding the Enterprise Value (EV) of the business which is computed by taking Market Cap + Debt – Cash & Cash Equivalents
Enterprise value can be thought of you “taking over” the company in your own hands, hence you are liable to pay whatever debts owed to creditors and this is net off by whatever cash the company has.
Now that we have calculated free cash flow and enterprise value, we can calculate FCF Yield by taking Free Cash Flow / Enterprise value
How to interpret FCF Yield?
FCF Yield gives you a sense of how good an investment it is in real cash return versus what you could receive in cash owning a 10-year risk-free treasury bond. Looking only at a company’s P/E multiple can be misleading because it does not include the debt side of the business or earnings yield which is the invert of P/E ratio.
The margin of safety can be calculated by taking the free cash flow yield multiple over the 10-year treasury yield. The higher the number the better as that means the risk we are putting in is justified by the returns we are getting. What we don’t want to see is that the multiplier is 1 or hovering marginally above 1. That means we are getting exactly the same cash return from a risk-free investment!
Applying this concepts, let’s now put it into a real company (SATS) and see how it turns out:
What can be observed is that the margin of safety is decreasing and is relatively low. For example, for the previous year end, an investor is better off investing in a 10-year government bond, receiving cash giving the exact same yield (almost guaranteed 100%) without taking on the risk of any catastrophe, economic downturn, competitive forces, political issues, supplier disputes etc.
The main concern is to see free cash flow sloping downwards reaching the same yield as a 10-year SGS Bond. It is generally not a good sign to see free cash flow decreasing. We have to dig further and understand if its revenue dropping or capital expenditures increasing? If it’s the former then that is even a worse sign as the company might be losing market share. In this case, the reason is the latter as seen from their cash flow statement, CAPEX has been increasing over recent years to drive innovation and cut operational costs. The key question then is to ask, how efficient is management in generating returns on assets? The best metric to do so is to use Return on Asset and Return on Invested Capital.
Looks pretty consistent to me. At least we can gain a higher assurance that these new investments would be beneficial to shareholders in the longer-term. However, if we follow the 52-week formula, SATS would NOT have passed filter #2 because the margin of safety is too low and an investor would be better off avoiding the risk and invest in a risk-free bond.
HOWEVER, if you are a growth investor that looks at capital appreciation and couldn’t care less about dividend payouts, then this filter may not be as relevant to you as a dividend investor.
We have covered filter #1 and filter #2 so far. In applying the 52-week low formula, if any of the companies have failed any one of the filters, it would be avoided as an investment until it is re-evaluated again. To complete the whole picture of the formula walk-through, i will still use SATS as an example for the next 3 filters. So do keep a lookout for the next post!