The 52-Week Low Formula: Book Review

52 Week Low Formula

The 52-Week Low Formula: Book Review by David Merkel CFA of the Aleph Blog.

I usually don’t like reviewing books that say, “Follow this formula, and you will make lotsa money.  Thus it was with some hesitance that I requested this book.  I did it partly off of Tweedy, Browne’s study, which is aptly titled, “What Has Worked in Investing.”  For those reading at Amazon, Google “Tweedy Browne What has Worked” for the link. Stocks that hit new 52-week lows on average are ready to rebound.  So why don’t people buy them?

Are you kidding?  Look at that chart!  Do you really want to catch a falling knife?!  You want to throw good money after bad!?  Why do you want to buy that dog, anyway…

Shhh.  The competition is gone.  There are no friends of failure.  But made some companies get unfairly tarred as losers, when it is simply a good company that made a few mistakes.

That is the idea behind this book.  Analyze companies from which most market players  have fled.  Look for those with  the following characteristics:

  1. They must have a durable competitive advantage.
  2. They must must a strong free cash flow yield.
  3. They must have a return on invested capital that exceeds the cost of that capital.
  4. They must not have too much debt relative to free cash flow.

I Had Troubles Getting to Solla Sollew

But here’s the big problem, and advantage, of the book.  He does not give you the “secret sauce.”  He gives you the principles.  Indeed he can’t give a formula, because many of his criteria don’t admit an easy formula.  You can’t calculate free cash flow from looking at GAAP accounting — you would need to know what portion of capital expenditure is to maintain existing assets, and that is nowhere disclosed.  Typically, when you see free cash flow in screening software, all capital expenditure is deducted from cash flow from operations, producing too conservative of a figure.

Thus we can’t replicate points 2 & 4.  What about 1 & 3?  Companies do not comes with tags saying “Durable Competitive Advantage” and “No Durable Competitive Advantage.”  That is a judgment call.  You could use Morningstar’s Moat Ratings, or Gross Margins as a fraction of assets.  The author does not give explicit guidance.  As to point 3, the main problem is that we don’t know what a company’s cost of capital is.  There are a lot of assumptions lying behind that, and they matter a great deal.

The easiest of his five criteria to calculate is the price vs the 52-week low.  Still, he doesn’t give us a threshold.

So What Good is This Book?!

Unless you are an expert, not much good, unless you simply want to play the 52-week low anomaly.  That said, actionable strategy would be to review the 52-week lows, and analyze companies with low debt and high past profitability that seem to have a franchise that is not easily attacked.  I think the theory is solid.  That said, it does no give a lot of the details, not that most readers would understand it if they did.

This book is good, in that it is realistic.  Though not explicit, it informs you that it is very difficult to choose superior stocks, and it it does not give you a cut-and-dried method.

So If You Can’t Do It Yourself, Then What Is This Book?!

Though the disclosure at the end says otherwise, this book is an advertisement for the author’s method of money management.  In none of his five criteria does he get sharp.  The general principles are correct, but you aren’t given the tools to use them.  That means if you want to use them, you must go through the author.

Verification

They have a website – 52weeklow.com, but it is not laden with data as the book intimates, as of the day that I write this.  That would be worth seeing.

Quibbles

On pages 74-75 he gives a strained view of margin of safety, comparing free cash flow yields to the 10-year Treasury yield.  Margin of safety is more of a balance sheet construct, asking how likely is is that a company will get into financial stress.  What he is actually measuring here is valuation.  What he is doing is not wrong, but it is mislabeled.  Also remember, you can estimate free cash flow, but you never know for sure.

Also, as mentioned before, we have no idea of what his thresholds are and how he actually implements the strategy.

Thus after this article are two attempts to work out the strategy.  What should not be surprising is that there are no companies on both lists.

Summary

This is a good book, but average investors should not buy it, because they can’t implement it.  If you still want that, you can buy it here: The 52-Week Low Formula: A Contrarian Strategy that Lowers Risk, Beats the Market, and Overcomes Human Emotion.

Full disclosure: The PR flack asked me if I wanted the book, and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Application Attempt One

These were the companies selected — Morningstar Wide Moat, 5% Free Cash Flow Yield, Less than 20% above the 52-week low.

52-week low

And here is the second try: Gross margins as a ratio of Assets over 13%, free cash flow yield over 5%, Long-term debt as a ratio of free cash flow greater than five, less than 20% above the 52-week low.

52-week low formula

Not one alike on the two lists.  Tells you that his book would be very difficult to implement.  *I* don’t know how I would implement it.



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.