Big Picture Strategy for Investing in Stocks

Everyone invested in the stock market wants to make money – the more the better. There are many approaches to that end. Below, is an overview of your choices. Whether one approach makes higher returns than another is debatable. Investors have been successful using all of them. The reason for their success is not so much the approach taken, it is the discipline imposed by the method. By specifying a ‘method’, emotion is taken out of the decisions. It is emotion that will kill you. (See page Emotions Destroy Returns.)

This website reflects mainly the value investor using top-down portfolio selection based on heuristic stock picking. But if you have no interest or enjoyment in ‘playing the market’ it is widely accepted that you should passively hold and grow a large cap, cross-industry, index fund. Certainly this is true if you are not willing to learn the necessary skills or put in the time. Do an honest assessment of yourself – really honest.

OBJECTIVES

There are three ways to make money on the stockmarket.

1. You can choose companies for large dividends or distributions. Usually investors with this objective buy large-cap companies with a proven track record of stock price stability and dividend growth, to buy and hold. But smaller-cap companies can also be bought (e.g. income trusts) as long as they are closely watched for stock price declines. Companies can either retain their profits for growth, or pay them out as dividends. Since the rate of return generated by assets within an operating business is generally higher than investors can realize in the secondary market (see page Understand Equity), stocks paying dividends will trade at cheaper valuation metrics than ‘growth stocks’ – hence the term ‘value stocks’. With few exceptions, the rate of return from dividends is not sufficient in itself for assuming equity risk. If you want a 10% return from a stock paying a 4% dividend you are implicitly presuming 6% growth. Too often, investors focus only on the dividend and ignore the difficult analysis for predicting that growth. Investors may think the dividend strategy does not require complicated financial analysis. After all, the important metrics (dividend yield, payout ratios) are simple and widely quoted. But care should be taken to ensure the dividends are not an illusion funded by increasing debt, additional share issues and DRIPS, or running down assets. The sustainability and growth of the dividend resides in the future profits. Financial analysis is still need to assess those. Theoretically share buy-backs are exactly the same as the payment of dividends. But investors have a different emotional response for many good reasons. So companies using buy-backs tend to be bought by growth investors (No.2 below) whether or not they realize it is only their ownership interest that is growing and not the company as a whole.
2. You can choose companies whose stocks will grow along with the company’s growth. Analysis emphasis is placed on the company’s operating margin, leverage, return on equity and top-line growth. This investment can be a long-term play with established companies (buy and hold), or a play on the short-term, isolated growth spurts of a small cap business. You may either buy growth at a reasonable price (GARP), or a momentum investor will willingly pay a high valuation for the expectation of exceptional growth. The payment of dividends does not disqualify a company for this investor, but higher growth always comes from reinvesting profits within the business, at high rates of return.
3. You can choose companies for short-term stock price correction. All investors using technical analysis fall in this camp. If using fundamental analysis, you buy undervalued (cheap) stocks and sell when the market recognizes its error (over-valued). All companies are worth something. The stocks of bad companies are just as likely to be mispriced by the market as good companies. Detractors will claim that research shows you cannot “time the market”.

TACTICS

A: The process of finding appropriate stocks can be either top-down or bottom-up. This choice defines the process of whittling down the universe of stocks to a possible few.

• The top-down investor’s first decisions are macro-economic. What countries promise the greatest growth? What sectors? What industries? It is believed that stocks are governed most by overarching industry-wide economic factors. Competition between companies is of much less importance.This process explicitly addresses asset allocation and diversification within the portfolio. It also allows investors to avoid specific industries. E.g. If you know nothing about fashion you can avoid retail. E.g. If you believe that airlines have never earned a profit (in total over time) then you can chose truckers or shippers instead.
• The bottom-up investor thinks there are good companies within all sectors and geographies. His first decisions weed out companies by technical or fundamental metrics specific to the company.

B: Investors will often narrow their search by restricting their universe of possible purchases to either growth stocks or value stocks. There is some evidence that over long periods, value stocks have higher returns. But this changes in cycles. There is a natural tendency for investors buying value stocks to hold for long periods and be interested in dividends (objective #1 above). But there is not a necessary correlation.

C: There are two camps with opposite opinions on whether higher returns result from buy-and-hold patience or from market timing.

• Buy-and-hold investors believe the market always goes up in the long-run, that trying to determine market tops and bottoms along the way cannot be done. They believe “You cannot time the market”. They enter the market using dollar-cost-averaging to offset the normal exuberance of a rising market. They cash out some percentage of a holding when it grows into an over-weight position. This tactic cannot be used when your objective is to benefit from market mispricing (objective #3 above). It is only rarely the philosophy of the growth investor (objective #2) because companies do not experience great growth on a sustained basis. It most frequently believed by indexers and investors looking for income from large-cap established companies (objective #1).
• Market timing can be applied differently. Investors looking for price corrections using (e.g.) technical analysis, will apply it on a stock-by-stock basis with very short term holds. An investor looking for growth will try to time the beginning and end of the growth period for a longer term holding period. Even investors wanting income from stable dividend-paying stocks will identify business cycles and exit the market-as-a-whole during down-drafts. It has certainly been shown that active stock picking can reduce portfolio volatility, even if returns are no higher. And individual managers can outperform for long periods. There are also the many undocumented privately managed trust portfolios that outperform for decades, probably because they are not under pressure to benchmark their returns annually. Benjamin Graham, the father of value investing, advocated rational selling. His idea was: by buying stocks at a price low enough to provide a margin of safety, you could sell, when bad things happened and the margin was lost, before the market price collapsed below the company’s ‘worth’ .The existence of sector ETF’s has opened up the possibility of timing the market by sector rotation. It is too early to say whether this can add value. The evidence against stock-picking (which is essentially market-timing) is the fact that mutual funds on average, underperform the index benchmarks. But that comparison is unfair. Mutual fund results include a management fee of about 2% that is a function of the legal structure, not a cost of active management. Fund managers also cannot use the basic tools of active management – cashing out in downdrafts, hedging foreign currency exposure, selling options, moving to other asset classes, etc. Fund managers also need to keep unproductive cash balances in order to be able to fund the daily movements in and out by investors. To top it off, fund managers must invest unwanted cash inflows from investors pouring in at the top of the market. And the reverse at the bottom. Another argument against market timing rests on the statement of true fact “A whole year’s returns happen in only the (say) ten best trading days in a year” therefor you have to stay invested. But the argument is false because it STARTS with the convenient presumption that the market timer has accomplished the exact opposite from what he intends. See the discussion previous. A third argument against market timing comes from analysis of retail investors’ trading records in discount brokerages. It is found that a greater frequency of trading correlates with lower portfolio returns. But is the conclusion from these fact correct? Do they measure the returns from different portfolio strategies, or do they measure the returns from different levels of investor expertise? Most everyone would agree that novice investors do not know how to do fundamental analysis or how to read financial statements. They trade off the headline news and stock price momentum. They trade very frequently, and lose a lot of money. At the other extreme are experienced investors using fundamental analysis for stock picking. They trade less, but still trade, and generate fine returns. The research did not split the results by ‘trading’ vs ‘never-trading’. Their results were on a gradient of trading frequency. You cannot conclude, just because VERY frequent trading showed poor results, that NO trading is the best strategy.

STRATEGY

The process of evaluating stocks (companies) can be classified as either passive or active.

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PASSIVE INVESTING involves buying exposure to large market indexes. You can do this with index mutual funds, exchange traded funds (ETFs), or futures contracts. The investor is buying into the general market. He is not concerned with the attributes of individual companies. You can search using
US, Cdn and GB funds
GlobeInvestor (security = ETF)
ETFconnect
Yahoo Finance
MarketWatch

This investor appreciates that active managers have not proven they can beat the average market return. This investor is happy to do ‘just as well’, without the risk of doing worse. He does not want the cost of management (2% to a manager or in his own time) to further reduce those returns. He recognizes that investors in actively-managed funds chase past returns, switch funds at the worst time, thereby losing 1/3 to 1/2 the market’s return. Ditto for stock pickers. He buys the index that covers the largest number of companies, in the most industries, from the most countries.

Define the mechanics:

• An index can be derived :
  1. by weighting each company according to its market capitalization to mimic the economy. Any market-weighted index that covers both large and small caps will not be noticably different from just the large-cap index, because the weighting of the small-cap inclusions are so small. This is the way the S&P500 index is weighted.
  2. by equally weighting the dollar value of each company. Rydex offers equal weight ETFs on major indexes.
  3. by equally weighting the number of shares from each company. Companies with higher priced stocks will have a larger impact on results. This is used to calculate the Dow Jones Industrial Average.
  4. by practicalities. With the blooming of ETFs there has been a shadow blooming of indexes they are intended to track. This is a case of the cart coming before the horse. Fund managers decide how it is possible to construct a certain portfolio, and then devise the index to mimic it. Take a look at the length of this list of indexes on Stockcharts
• Diversify by geography: Since holding foreign companies exposes you to exchange risk, most investors are more secure staying in their home country. Because international markets are now closely correlated, you get very little reduction in risk from diversifying internationally. But you do gain from the different rates of growth experienced in different countries. All countries’ markets may go up and down at the same time, but the percent changes will be different.
• Limit by sector: Even when the investor is a stock picker, he may find himself underweight specific sectors of the economy. He can use the sector index to reduce this risk.

There is a problem with the increasing use of index ETFs and the closet indexing by ‘active’ managers. It can be argued that as a result, the extra returns from stock picking are growing smaller. Stocks have started to move very much in tandem with their indexes. Money flowing in/out of the index impacts all its constituents equally, even when distinctions should be made. This has the insidious effect of reducing the incentive to find market inefficiencies. A spiral effect results. The more people index, the lower return from stock picking, resulting in more indexing, etc. See this academic paper measuring stock-picking volumes over time.

Active stock picking in the small cap universe has a much better history of beating the indexes. The small cap universe is an untested swarm of wannabe’s. The discipline of the market has not yet weeded out the losers. Good portfolio managers outperform indexers by doing the weeding-out that the financial markets have not yet had a chance to do.

This article by the creator of indexing warns that the following uses of index funds predominate, while only 20% of owners are the ‘true’ buy/hold indexers. But don’t get too dogmatic. There is a place for all strategies.

• buying Exchange Traded Notes (ETNs) which guarantee against loss,
• using indexes that are weighted by fundamental metrics of the companies (e.g.growth vs.value).
• using index funds in combination with derivatives,
• trading in/out with technical analysis,
• cherry picking industry sectors to underweight/overweight, or
• rotating from one industry sector to another based economic predictions. It has been proven that investors cannot ‘time the market’ by going in/out of asset classes, but a lot of people feel it will work with ETFs. There is not enough history to back-test (if you accept that as proof).

ACTIVE INVESTING requires the investor to make the decision that one stock (or sub-index) is a better bet than another. There are four methods: technical analysis, absolute valuations, relative valuations and heuristic stock picking. And then of course we should not forget all those people who buy stocks based on some gurus’ recommendation.

1. TECHNICAL ANALYSIS: uses only market information – the stock’s (or index’s) price, its volatility, trading volumes, money flows, long/short ratios, earnings estimates, analysts’ recommendations, etc. The investor is buying stocks, not companies. He considers all fundamental analysis a waste of time because all the available information is already incorporated in the stock’s price. Day Traders are the quintessential technical traders. They pick a stock to trade based on liquidity, volume and wide price swings. They play a price trend within a day and close out their positions each night. Beginner investors are drawn to this method because it does not require a knowledge of financial statements or finance or the economy. But it is widely accepted that relying solely on technical analysis is not a successful way to invest. Witness the lack of mutual funds managed by technicians. See this short discussion of the basics of technical trading that most beginners never learn. The presumption behind technical analysis is that market prices are determined by grunts doing all the work of fundamental analysis (absolute and relative valuations). It is their knowledge that the stock’s price reflects. But what happens when momentum investors pile into a stock whose trend was initially determined by fundamentals? They can drive the price way too high and way too low. The presumption is wrong in many cases. Charting is concerned only with the stock’s price relative to its past price and relative to the behavior of similar stocks. The shape of a stock chart represents the owners’ emotional responses and expectations. The patterns repeat, over time and for different stocks, because human emotion is universal. Technical analysis tries to detect trends and shifts in those trends. It is used to determine buy/sell decisions, not to determine any ‘true value’ of the company or its stock. It deals in relative prices, not absolute values. See this summary of the different systems used. The default 1-year chart can be very misleading without context, so immediately start with the 5-year, or better the 10-year. Use a logarithmic scaled graph to prevent distortions. Steady growth shows up as an exponential hockey stick over long periods without a log scale. BigCharts gives you a 10-year log chart with the accompanying charts of EPS and P/E and MACD.Technical analysis does not work on ALL stocks. Beware of thinly traded stocks. They can move sharply when only a small number of investors change sentiment. Also understand that there is the market of ‘smart’ money and the market of retail investors, who may not be so smart. Decide which market controls the particular stock. The reality is that most retail investors hear a good/bad ‘story’ in the media, and buy/sell the stock at whatever $ they can get. Because they consider it ‘a buy at any price’ (or ‘a sell at any price’) they push the stock in extremes in both directions. Some charting metrics MUST be considered simply because many other people use them. Remember the Beauty Pageant Analogy. E.g. the ‘golden cross’ of moving averages. E.g. parallel price channels that remain intact for years. Other metrics have validity because they represent human nature. Support and Resistance Levels are real emotional hurdles for human investors.
2. ABSOLUTE VALUATIONS: Investors using absolute and relative (below) valuations consider they are buying into individual companies, not their stocks (as a separate phenomenon) or the market in general. All the methods to pinpoint a specific value on a company use the “Net Present Value of Future Cash Flows” or “Discounted Cash Flow”. This is a bedrock technique of finance for valuing projects and assets. It has three basic inputs: the cash flow values, the timing of those cash flows, and the rate of return demanded. There is a detailed discussion of this valuation strategy in the section called “The Cash Flow Debate” on the Discounted Cash Flow page. Absolute Valuation can result in finding NO company worth the investment – in contrast to relative valuations. And it forces the investor to confront and specify his presumptions explicitly. Buy-and-hold investors get less benefit from all this work because they will not be selling when the market closes the value discrepency. There are problems with this strategy.
   • It is A LOT OF WORK. The analyst must know the size of the market and growth, the company’s market share and growth, the timing and cost of replacement assets and restructuring costs, the ability to defend profit margins, etc, etc. Some retail investors have the conceit to think they are valuing companies when they plug analysts’ earnings estimates and growth rates (from public websites) into simplistic models. This process only reverse engineers the current stock price. It does not value the company.This method of stock valuation ignores market sentiment – fine for long term decisions, but not in the short term. Remember the phrase: “The market can stay irrational longer than the investor can stay solvent”. Just because you determine the stock to be undervalued does not mean the rest of the market will eventually agree with you.Stocks are never ‘undervalued’ per say. It makes more sense to consider your different valuation to be the result of your assumptions about the future that differ from the assumptions of everyone else. The assumptions differ, not the value.The results of this process tend toward a portfolio of companies with low P/E and high dividend yields: a result that can be obtained with much less work, directly.The model has no inputs for dilutions of ownership or non-cash transactions, or the benefits from new share issues. The companies are always analysed on an ‘entity’ basis, which assumes no change in ownership %. This is a serious drawback in this age of stock options. It is the use of these valuation models that has caused many people to dismiss non-cash transactions as irrelevant. It would be more correct to conclude that the models need modification.There is a problem defining the cash flow to be measured. Too frequently you hear people capitalizing “cash flow from operations” instead of some portion of Earnings – a much smaller part of CFFO.
   There are three general methods: A) dividend discount model, B) discounted cash flow and C) residual income.
   1. Dividend Discount Models: The investor faces only two cash flows; the dividends received, and the resale value recovered. But trying to predict the resale value brings you right back to the original problem – valuing the shares. Even the amount of the dividends is hard to quantify. The model requires that all the excess cash is paid out to investors, without accumulating inside the company, without being used to buy back shares. The dividends must be earned – not paid for with debt, or by delaying the purchase of assets, or by refinancing debt to capitalize its interest. In order to be perpetual, enough cash must be left in the company to replace assets and increase working capital as required by inflation. Just because the dividends are currently being paid does not prove they are sustainable over the long term.
      1. Dividends Forever: You can ignore the future resale value of shares if you presume the dividends continue forever, and the next investor will himself value the stock at their present value. This is essentially the same way investors value bonds. This is how investors valued Canadian Income Trusts, despite being warned that these did not conform to the model. The simple math involved is given in this spreadsheet.It should not be hard to convince you that markets have never actually used this theoretical model. Dividend payments are very static, but stock prices are very volatile. Even adjusting the value of dividend payments for current factors like interest rates does not produce the necessary variability to explain stock prices. For an academic’s look at this see Shiller’s Irrational Exuberance, 2ndEd, pg263.
      2. The Gordon Model: builds on the above by including a presumption of growth in the dividends. Because the rate of growth is presumed “forever”, minor changes in that presumption will have huge impacts on the resulting Present Value purchase price.
      3. Two Stage Growth: The Gordon model can be refined for a stated period of excess growth followed by steady-state growth equal to (e.g.) inflation.
   2. Present Value of Free Cash Flow or Discounted Cash Flow (DCF): Since dividends are now such a small part of the total return from owning stock, a new model was devised to measure the cash flows within the company that could be considered ‘potential’ dividends. Called “Free Cash Flow”, this is not a thing that can be measured directly. It is a theoretical construct. There is no agreement on its calculation. Even if you accept the general definition of its calculation, it includes all the problems listed for the Dividend Discount Models (replacement assets, increases in working capital, barter transactions and share buy-backs).The data required to develop the inputs is extensive and time consuming to calculate. Since it predicts an unknown future, there is a large variability of possible values and it requires many subjective assumptions. Since its complexity is known, some people claim to use this method in an attempt to impress others. Inevitably they are using super-simple models that ignore all the important stuff. Don’t let them impress you.A more pragmatic use of DCF does not require the investor to come up with all his own variable inputs. Instead, the market price is accepted as a given, and a model of assumptions is reverse engineered to create that result. The investor then decides if those assumptions are reasonable.
   3. Residual Income : This method prices stocks by discounting future excess earnings and adding them to the present book value. It deducts from accounting income a charge for the cost of equity capital, resulting in residual income. Here is a download that explains things simply.
3. RELATIVE VALUATIONS: Screening for stocks makes sense for investors who plan to stay invested through ups and downs (buy and hold), without timing the market, without indexing because they hope to beat the market. No matter how bad the markets are, some companies will always rank higher than others. No attempt is made to determine any intrinsic value for each company. Instead different metrics (financial ratios) are compared in an attempt to rank businesses for risk or growth or income or the cost of its stock, etc. A great benefit of this method is the extent to which it is ‘objective’. It can be automated to ignore all subjective opinion. This results in a portfolio that can be maintained in the face of adversity, because less ego and emotion is involved. See Screening Stocks. Investors must decide what metrics to use, and which companies are similar enough to be compared. At this point investors split between preferring ‘growth’ stocks or ‘value’ stocks. The two camps put different importance on different metrics. For more details, look at this academic’s presentation on the various valuation metrics and their pros and cons. Various strategies require greater and lesser amounts of work.
   1. Complicated multi-variable mathematical algorithms are modeled in-house for professional money managers. The retail investor has no hope of replicating their sophistication. Exchange Traded Funds are available that screen for different metrics (dividends, P/B, ROE, etc).’Dogs of the Dow’ and other simple rules of portfolio selection are widely public. But because they are widely known, it is believed their effectiveness has been reduced. Other portfolio rules based on screening for specific metrics (e.g. J. Piotroski, O.Shaughnessy) have been validated by back-testing.
   In practice screening may not work for the retail investor because:
   • It is too expensive to execute because of the excessive trading or large number of stocks involved.
   • Investors will not strictly abide by the rules for the original selection. They allow emotions to overcome their best intentions.
   • Investors do not appreciate the difference between ‘mean’ and ‘median’. It is common for the research to conclude that while the average return beat the index, the mean return underperformed. That means the return of any individual stock chosen by that criteria will be more likely to UNDERPERFORM. The method works only ‘as a basket’.
4. HEURISTIC EVALUATION: Half-way between absolute valuation and relative valuation are the investors who do not want to stay invested through market downturns. They believe markets overshoot on the upside and downside. They believe timing their entry and exit from the market will lower risk and preserve capital. This strategy was promoted by Benjamin Graham in his 1934 classic Security Analysis.He did not believe investors could or should determine a business’s intrinsic value because:
   • The future is unknown and history does not repeat itself without variations. A business’s future is a hazard. The objective is to guard against it more than profit from it.
   • Markets behave irrationally because they are driven by speculation, by neglect and prejudice, and by excess optimism and pessimism. The market is a voting machine where individuals register choices based partly on reason and partly on emotion. It is not a weighing machine on which the value of each security is measured and recorded
   • Any determination of value would depend on available data that may well be incorrect through accounting artifices and management concealment.
   • Knowing the value of a business will not help you in the execution of an investing strategy because no matter what lip service they give to the contrary, all investors care about the market’s value of their holdings. And the market can stay irrational longer than the investor can stay solvent. And emotions WILL lead to non-optimal trades.
   Graham presented the argument that “It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age.” In other words “It is not necessary to value a stock at $20 or $40 in order to decide the shares are attractive at $8.” What is needed is only an approximate measure of value so that stock picks have a sufficient margin of safety, that they meet minimal requirements.When the requirements are no longer satisfied, the investor sells. His sell signal comes before the market has over-corrected because of that margin of safety. This prevents the common situation where the investor refuses to sell because he feels the market has already over-shot on the downside.Graham’s criterion were financial ratios with rules of thumb benchmarks. They needed to be
   • metrics that are measurable in advance,
   • the acceptable value of it indicated by definite and well established standards,
   • dependent on price, the business and the economy,
   • measured using the worst reasonably likely circumstances (he discounted the Great Depression which had just passed as unlikely to be repeated), and
   • supported by legal rights (even though he discounted legal enforceability and cautioned that performance would always depend on the business’s financial capacity).
   The strategy can be applied top down using computer screens to sort through all the market for ‘ideas’. Or a bottom-up process can be used to analyze any stock that peeks the investor’s interest. This investor is more likely to buy ‘growth at a reasonable price’ (GARP) stocks.
5. GURUS’ RECOMMENDATIONS: There does not seem to be anything remotely complementary to be said about this choice of strategy. It is unfortunate how many people do not understand the difference between advice and entertainment. The people at CXOAG have tracked the recommendations and results of many internet Gurus (last updated 4/24/09 before they stopped tracking) . They find their outcomes are no better than the 50:50 chance you would expect. There are legions of neophytes who listen to Cramer and BNN’s MarketCall Top Picks (Canadian business TV station). It is not unusual to see price and volume spikes on the stock within a few minutes. Sure sometimes these programs bring to your attention investment ideas you had been ignoring. And sometimes the expert will offer an original analysis. But you have to listen for about 20 hours for each analysis that is not already being spouted from all the media. You also find these investors on the Discussion Forums suggesting a stock on which they have done NO analysis; asking for other people’s opinion as if either they expect others to do their work for them, or else they make their decisions based on popularity. When challenged they claim to be sophisticated investors who will do their own analysis “of course”. The sad part is that they probably truly believe it.