Value-Stock-Plus

by David Opoku

Investors employ a multiplicity of techniques in choosing shares. What is common amongst the various methods is that they don’t always work. The suggestions made in this discussion combined with common sense and good judgment should help to hone your stock selection skills.

The first step in the selection process is asking yourself a few questions to help clarify exactly what you want and expect from your investment. It is immensely necessary to endeavour to find out the amount of risk you are prepared to take. Look back, and recall how you felt when you incurred some financial losses. Such memories, with some amount of honesty should help you to find out your level of risk tolerance.

Companies on the stock market are grouped on two main basis: in terms of similarity in size, and on grounds of carrying out the same activities (sector grouping). If your analysis shows you are risk-loving, then your focus should be on smaller companies or growth companies which are generally riskier, with potential for higher returns. If you happen to be the risk averse type or you want a share with minimum maintenance, then you want to consider large organisations, which have a lower tendency to go bust and can also serve as more reliable source of income. Such firms are known as ‘blue chips’. Target shares in industries or sectors that will be positively impacted on my political ventures and economic trends.

After considering the category of companies you want to deal with, you should begin inspecting the dividend yields and P/E ratios of the companies. It is a good idea to be on the look out for companies with reasonably high dividend yields. A P/E ratio between 7 and 10 is very much recommended. Remember that a P/E ratio is only useful when compared to others. Consider companies with P/E ratios that are lower than those of competitors in the same industry, and also lower than the previous years’ figures. The yearly sales and earning per share figures should ideally be increasing over the previous years. It’s a good idea to consider growth companies that have fallen on hard times, but shows signs of future recovery.

You should also decide how long you will be holding the share for. You will thus be on the alert, when it is time to get rid of the share. Higher returns will be earned when a share is held for a minimum of 5 years, with substantial savings in dealing expenses. This, nonetheless, does not mean that duds should not be turfed out before their planned disposal dates. Accordingly, a winner should not be gotten rid of just because it has had a decent run. Tact should be exercised before selling shares and it is good technique to keep an eye on the next share to grab, once the old one is gone.

Do not catch a falling knife. Although it is good practice to buy cheap shares, some shares suffer a free fall in price, and stay cheaper and cheaper with the passage of time. These should be avoided. Also eschew shares recommended by newspapers and tipsheets. The explanation for this is that market makers also read newspapers, and by the time you lay hands on the share, every advantage it has would have been already siphoned out by professional investors, especially, if you’re considering a blue chip. If you want to try your luck in securing a winner you may have to rummage financial statements of companies that have capitalisation less that £100 million. Such companies do not attract professionals, hopeful you can beat the market here.

It is almost impossible to outperform the market extensively. What you want to avoid is losses. A long-term goal of tracking the market, or better still performing slightly better than it is quite realistic and dignified. You should decide to what extent you want to get involved with the management of the share. If you want to be mildly involved, you will be better off investing in mutual funds or investment trusts rather than picking your own shares. Be prepared to buy investment management, when necessary.

Year 2007 is drawing to a close & our markets are entering into 5th year of the bull market. So, now is the time to look into retrospect, and have a close look at our investing triumphs & failures. And, what could be better than learning from the Master Stockpicker, Warren Buffett himself.

Here are some of his best quotes:

1. If past history was all there was to the game, the richest people would be librarians.
2. In the business world, the rearview mirror is always clearer than the windshield.
3. It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
4. It’s better to hang out with people better than you. Pick out associates whose behavior is better than yours and you’ll drift in that direction.
5. It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
6. Let blockheads read what blockheads wrote.
7. Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
8. Of the billionaires I have known, money just brings out the basic traits in them. If they were jerks before they had money, they are simply jerks with a billion dollars.
9. Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
10. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
11. Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful”.
12. Wide diversification is only required when investors do not understand what they are doing.
13. You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.
14. You only have to do a very few things right in your life so long as you don’t do too many things wrong.
15. Your premium brand had better be delivering something special, or it’s not going to get the business.
16. Only when the tide goes out do you discover who’s been swimming naked.
17. Our favorite holding period is forever.
18. Our favourite holding period is forever.
19. Price is what you pay. Value is what you get.
20. Risk comes from not knowing what you’re doing.
21. Risk is a part of God’s game, alike for men and nations.
22. Rule No.1: Never lose money. Rule No.2: Never forget rule No.1
23. Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
24. The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective. The first rule is not to lose. The second rule is not to forget the first rule.
25. The investor of today does not profit from yesterday’s growth.
26. The only time to buy these is on a day with no “y” in it.
27. The smarter the journalists are, the better off society is. For to a degree, people read the press to inform themselves-and the better the teacher, the better the student body.
28. Time is the friend of the wonderful company, the enemy of the mediocre.
29. Value is what you get.
30. We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’
31. We enjoy the process far more than the proceeds.
32. We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
33. When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
34. A public-opinion poll is no substitute for thought.
35. Chains of habit are too light to be felt until they are too heavy to be broken.
36. I always knew I was going to be rich. I don’t think I ever doubted it for a minute.
37. I am quite serious when I say that I do not believe there are, on the whole earth besides, so many intensified bores as in these United States. No man can form an adequate idea of the real meaning of the word, without coming here.
38. I buy expensive suits. They just look cheap on me.
39. I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.
40. I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.
41. If a business does well, the stock eventually follows.

…and here comes my favorite!

* There seems to be some perverse human characteristic that likes to make easy things difficult.

Can market timing generate excess returns? This article argues that excess returns are possible as long as assets price our idiosyncratic behaviour such as loss aversion. A portfolio manager should follow time diversification strategies to capture such idiosyncrasies and follow strict money management rules to control risk.

B. Venkatesh

Asset prices are galloping at a fast pace in the Indian market. Many investors have not participated in the recent uptrend for the fear of a sharp turn in prices. Market timing is, hence, a relevant topic in the current environment.

Professor Javier Estrada’s paper “Black Swans and Market Timing: How not to generate alpha” concludes that “market timing is an entertaining pastime but not a good way to make money.” He argues that if a portfolio manager misses the ten best days in the market, the portfolio annual returns reduce by 3 percentage points.

Likewise, avoiding the ten worst days increases the annual returns by 4 percentage points. As no portfolio manager knows the best and worst days’ ex-ante (before the event), Estrada states that market timing is a wasteful exercise. This article argues that disciplined money managers following time-diversification strategies can generate alpha from market-timing.
Alpha Generation

Alpha is the excess returns that the portfolio generates because of manager skill. Alpha will be 5 percentage points if the portfolio generates 25 per cent when the Nifty moves 20 per cent. Alpha can be generated through market timing or by holding stocks that outperform the market. Some argue that alpha returns will decrease with the proliferation of institutional investors and hedge funds; for more funds will chase alpha-generating assets.

But this argument may not be entirely true. Why? The total available alpha is unknown.

So, even as new funds emerge to harvest alpha, newer sources for alpha generation will evolve. The argument is the same as in the case with oil. As crude oil prices climb, the world is working hard to develop alternative sources of fuel.
Market timing

Generating alpha from market timing involves using technical analysis, which trades on human behaviour.

Take Essar Oil. The stock hit Rs 70 this September and declined to Rs 49. The next time the stock hit Rs 70 in November, it jumped to Rs 250 in 16 days. Why? Experts in behavioural finance have shown that we suffer from loss aversion. That is, we tend to keep losers in our portfolio too long and sell winners too soon. Perhaps, that is what happened with Essar Oil. This stock failed to move past Rs 70 early this January; investors who bought then saw the stock decline to Rs 46. So, the next time the stock moved to Rs 70 in September, most investors sold. The higher supply of shares at Rs 70 pushed the stock price down yet again. Technical analysts would call Rs 70 as the “resistance level”.

After naïve investors offloaded their supplies in September, smart traders gathered critical mass and eventually pushed the stock beyond Rs 70, which now becomes the “break-out” level. A money manager can generate alpha from market timing as long as we all suffer from loss aversion and other idiosyncrasies.
Pareto Principle

Estrada is right. Only a few trading days contribute substantially to portfolio returns. But you know that Pareto Principle holds true in all walks of life. Eighty per cent of your work gets done in 20 per cent of the time that you spend in the office! In the markets, 20 per cent of the stocks in your portfolio contribute nearly 80 per cent of your total returns. Likewise, 20 per cent of the total trading days account for 80 per cent of the positive returns in the market.

Money managers, hence, follow time-diversification to minimise the risk due to loss aversion. Understand that loss-aversion leads to selling winners early and losing the best 10 days in the market. It could also lead to carrying losses and staying in the market during the worst 10 days. Time diversification means that the portfolio manager has exposure across various time horizons. The portfolio will have stocks for the short-term (5 to 30 days), some for the medium-term (30 days to 12 months) and some for the long-term (over 12 months).

This ensures that the manager is engaged in active trading through the year and so does not take profits too soon. Remember, we take profits too soon because we need to see cash flowing into our account at regular intervals. Time diversification also ensures that the portfolio rides through the 20 per cent positive days in any year.
Black swans

Black swans refer to extreme events, such as a market crash. If a money manager does not manage the ten worst days effectively, she is likely to lose all the profits. Professional money managers, hence, follow strict money management methods, such as stop-loss rules to control portfolio risk. The problem is that all managers are not disciplined — they suffer from loss aversion too! And that is when market timing leads to negative alpha.