Thursday, May 26, 2011

My Comment to Interactive Investor's Latest Blog Post

Below is my comment to Interactive Investor's latest blog post: "Mines flood Nifty Thrifty screen". The author worries that "if next year is a bad year for resource companies, it will be a bad year for the Nifty Thrifty", though I think this is just the normal Sector Rotation phenomenon. I think my comments is informative so I just repost it here.

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Thanks for the post. I have similar experiences.

I also have a ranking system similar to Magic Formula. Roughly speaking, Magic Formula has two components: valuation and return on capital. I added one more: financial condition. I tweaked a little bit the formulas within valuation and return on capital, though.

Although I traded my ranking system for only a couple of months, I see the same thing you discussed here. One month ago, all the top names are mining companies, including RIO. But not anymore. I think some bad fundamental numbers entered the earnings reports during this earnings season. As a result, the ranks of top ranked mining companies dropped abruptly.

Nonetheless, I believe it is normal that certain sectors / industries are favored at certain phases of a business cycle. This is actually the well studied Sector Rotation phenomenon. I don't have predictive power so I worry less what's going to happen one year down the road. But I believe I'm in good hands as long as my ranking system tracks the fundamentals closely. If commodity price crashed in the future, the fundamental numbers will crash, too. My ranking system will reflect the changes and I'll exit the positions. In fact this already happened with my ranking system. As mentioned before, now the mining companies are not top ranked anymore and I don't have any of them in my portfolio.

One key point I'd like to mention is: How often do you update the ranks. I insisted to update the ranks every week with my ranking system. Fundamental numbers change slowly, but the changes are usually abrupt. For example, the rank of RIO dropped about 20% one month ago. I think if I don't update the ranks frequently, I'll miss big profit or get caught by big loss.

Another thing is I'm not sure which EY are you using. Some value investor will use 10 year average. But I'll use ttm number. For one, ttm is more popular so it's going to have bigger impact on price, at least in short term. For two, ttm is more sensitive to changes. There will be fluctuations, but I think it pays to follow the fluctuations in the long run.

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