BIG PICTURE INVESTING STRATEGIES
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 kills you. (See page Emotions Destroy Returns.)
This website reflects mainly the growth at a reasonable price GARP preference 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 (see page Tools and Training.), or put in the time. Do an honest assessment of yourself - really honest.
There are three ways to make money from stocks. There are no boundaries between the choices. The profits from any one position may come from one objective, or a combination of all three. Investors may prefer one type of profits over another, but need not limit themselves. With experience you may find that you do better with one type of situation.
- 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 high dividends will trade at cheaper valuation metrics.
With few exceptions, the return from dividends only is not sufficient 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, share buy-backs 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 investors with a growth objective (whether or not they realize that share buy-backs grow only their ownership % interest, not the company as a whole).
- You can choose companies whose stock price will grow along with the company's growth. The emphasis of analysis is placed on the company's operating margin, leverage, return on equity and revenue growth.
The investments can be a long-term play with established companies. These investors look for growth at a reasonable price (GARP), intending to (buy and hold). They may be a passive investors with large-cap index funds or stock-pickers looking for steady growth. Or, the investments can play on the short-term, isolated growth spurts of a small cap business, or a sector benefiting from transient economic trends. These investors look for a stock's momentum. They are willing to 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. Investors interested in the 'Dividend Aristocrats' are in this camp. Their dividend yield is not huge and returns come mainly from growth.
- 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. All companies are worth something. The stocks of bad companies are just as likely to be mispriced by the market as good companies. Detractors claim that research shows you cannot "time the market", but anyone with this objective will disagree.
Mispriced stocks may fall within the classification of either 'growth stocks' or 'value stocks'. Both types can become mispriced. A 'value stock' is not necessarily 'undervalued'. See the discussion below at Tactics : Growth vs Value. Investors owning a growing company often also benefit/lose from re-pricing when the market changes its opinion of the future growth rate.
Notice that the term 'objective' is not being used here to answer the questions .. ."Why do you invest? What do you want to accomplish by investing? What is your personal objective?"
Top-down vs Bottom-up
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.
Growth vs Value
Investors will often narrow their search for individual stocks by restricting their universe of possible purchases to either growth stocks or value stocks. The distinction between the stocks is determined by metrics. Originally there was only one metric used - Price/Book. But now each has its own set of metrics. If a stock has a score high above the average for the growth metrics, it will be classified as a growth stock. If it scores high above the average for the value metrics, it is a value stock. About a third of stocks either score well or poorly on both sets of metrics.
The metrics used change but it is common to use for growth : a) Momentum, b) Sales growth and c) Earnings growth. The metrics for value are : a) Price to Earnings, b) Price to Sales and c) Price to Book. See S&P paper for discussion. The point here is that Growth and Value are not the extreme ends of the same metric.
There is plenty of evidence that value stocks outperform growth and the index average. But these are only averages. The US markets cycle between favouring one then the other. Growth stocks outperform in strong economies and value stocks are defensive in recessions. Growth investors are confident they can exit the stock before any correction. Active investors are more likely to beat their benchmark index when they buy growth stocks with their higher Beta.
It is natural to think of small-cap stocks as growth stocks, if only because it is easier to grow when you are small (the law of large numbers). But small-caps can be split between value and growth by the same metrics. The excess returns earned by small-cap value stocks are more extreme than the differentials found in large-caps.
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. There is some evidence that the outperformance of cheap stocks requires frequent portfolio changes. As the bad situation that prompted the stock's original decline in price gets resolved, the stock needs to be removed from the portfolio.
The terms 'Growth Investors' or 'Value Investors' are very confusing. It may describe their objectives (see above). Or it may describe the universe of stocks from which they pick (what is being discussed here).
For example. A 'value investor' may be looking for under-valued stocks - ones with a 'Margin of Safety'. His objective is a price correction in either the long run or the short run. He will sell when the stock becomes over-valued. Another 'value investor' may willing pay full price as long as the stock qualifies as a 'value stock' (eg. a Utility with a large dividend). His objective is more likely a long-term hold and grow while clipping decent dividends.
There should be no assumption that 'growth investors' are risk seekers who ignore valuation, and 'value investors' the opposite. The growth strategy 'Growth At A Reasonable Price' (GARP) explicitly cares about value. And the value strategy called 'Bottom Fishing' can be very risky. It is better to distinguish between the types of investors as ...
Value investors look for the mispricing of existing assets, while growth investors look for mispricing of assets that will be created by future investments - the mispricing of growth potential.
Buy-and-hold vs Trading
There are two camps with opposite opinions on whether higher returns result from buy-and-hold patience or from trading.
- 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 is most frequently believed by indexers and investors looking for income from large-cap established companies (objective #1).
Buy-and-hold has NEVER meant is "buy and forget". There are underlying presumptions behind all stock purchases. When circumstances change the investor must use judgement to distinguish between black swans, fundamental long-term changes, and market noise. No one makes investing decisions based on the 1 percent chance of catastrophe. E.g. retired people withdraw 4% a year even while knowing that a repeat of the 1930s depression or the 1970s inflation would wipe them out at that rate. E.g. the father of value investing, Benjamin Graham, wrote in 1934 that a repeat of the depression should NOT be considered in valuation models.
Individual companies must also be monitored for permanent change - they lose their monopoly, or a new technology makes their product obsolete, or the founder dies without a succession plan, etc. Investing requires you to evaluate the probabilities of different outcomes, weigh the probability of your upside against your downside to determine a purchase, monitor for changes in your expectations and SELL if things don't pan out as planned.
Warren Buffett is famous for saying "“Our favourite holding period is forever". Most people mistake this for saying "We hold forever". Think about it. Who would disagree with his statement? Everyone would love to find the perfect company and just walk away and forget it. But stuff happens. A comparison of Berkshire Hathaway's 13F SEC filing shows that 28% of the Sept 2007 holdings were either sold or half-liquidated two years later. This despite his access to the decision makers of the companies, that retail investors don't have. Granted this is VERY low turnover, but it shows the 'hold' concept is relative, not absolute.
The media frequently ask portfolio managers what their average holding period is. When answered with something like "we expect a 3 to 5 year holding period", retail investors get the impression that a specific time frame should be an objective - that the manager who answers with a longer period is a better manager. That is all a misinterpretation. The manager is referring to his historical average turnover - a fact - not an objective or policy. He sells a position when the stock becomes soooo overpriced (in his opinion) that it must surely correct downward significantly. Or he sells because the situation has changed for the worse and no recovery is expected.
The stocks of large companies covered by 1000 analysts rarely get sooo overpriced, so managers see no reason to sell. On the other hand, the manager of a small-cap fund whose stocks get little attention from analysts, will face an over-priced situation frequently, and so trade frequently. The decision to sell is NEVER made 'because the stock has been held 3 years'. Nor is any 'plan' ever made to sell a stock in 5 years time.
- Trading or 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. He argued that when bad things happen to a company, once the market price falls below the owner's perception of its 'true value', the owner may refuse to sell - thinking "... but the company is worth more ... the stock must surely recover". Graham's idea was that, by buying stocks at a price below your idea of their true value, the margin of safety gives you the necessary time to get out before you freeze up emotionally. This argument does not really stand up to scrutiny. A cheap stock can get still cheaper when bad things happen - so you freeze up just like everyone else. Just because every talking-head may claim that "the bad news is already built into the stock price" don't presume the stock won't tank when the bad possibility becomes a reality.
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. This strategy makes money in trending markets and get killed when trends reverse.
The primary evidence against stock-picking (which is essentially market-timing) is the fact that mutual funds on average, underperform the index benchmarks. The problems of generalizing from this sub-set of investors is discussed on the Active vs. Passive page.
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 on the Why Bother? page.
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 trends. 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.
Not everyone has free choice between buy-and-hold vs trading.
- You can only have a long horizon if you face no liquidation deadlines. Retirees need ongoing withdrawals, mutual fund managers need cash to fund daily unit re-purchases, parents saving to fund their child's tuition will liquidate in a specific year.
- The inability to trade will force you into a longer horizon. This is why Bogle recommends index mutual funds over index ETFs. Any investor going on vacation out of internet reach positions his portfolio with a long horizon before he leaves.
- Your investing horizon is impacted by how your performance is measured and rewarded. A mutual fund manager with a one-year contract whose performance is compared to his peers and a benchmark, will have a much shorter horizon. Similarly when you feel like your spouse is judging you by monthly or yearly returns.
- The ability to diversify a portfolio between asset classes helps investors take a longer time-frame. As one class does well, it cushions losses of another class. Many retail investors have little opportunity to fully diversity. Most professional managers are constrained to one asset class.
Investing vs Speculating
There is a false dichotomy implied by the terms investing and speculating. To some extent it refers to buy-and-hold vs. trading. But a much broader interpretation is meant. The word 'speculating' is always used by those calling themselves 'investors'. It is meant to be derogatory. It is meant to put the investor on some holier-than-thou moral high ground. Traders never call themselves speculators.
Supposedly the stock investor considers himself an owner of a business. He is 'in it for the long haul' while the speculator cares only about the short-term, to the detriment of long-term viability. The reality that retail investors have absolutely no say in the running of the business or even the election of directors, is forgotten. The reality that company executives run businesses more for the short-term and investors would be foolish to do the opposite, is ignored. And this whole argument is forgotten when the justification for investing in 'sin stocks' is asked for.
The investor is supposedly 'serious', willing to do the hard work of analyzing companies, while the speculator is just gambling with play-money, relying on hot-tips and charts for his decisions. The investor believes he will earn market-profits while the speculator will lose money.
Some make the distinction according to trading frequency, as if one group of people turn over their portfolio once every five years, while the other group trades 10 times each week. This is a false dichotomy.
- There is a full spectrum of trading frequencies represented by investors at each point.
- Individuals are perfectly free to trade more frequently in some economies and less frequently in others.
- Individuals can trade some securities more frequently than others depending on where they see the value surfacing.
Maybe the term 'speculator' is best applied to those who play the market without any strategy at all. Invariably these neophytes use charts to identify trending stocks. They only buy after a rising trend is identified, and continue buying as the stock rises further. They sell only when the down trend is clear, and continue selling as the price gets lower and lower. This could be called 'band wagon jumping'.
The problem with this is that stocks trend - until they don't. By the time a trend becomes obvious, the probabilities are high it will reverse. These speculators end up 'buying high and selling low'. This poor lack-of-strategy should not be confused with the accepted momentum strategy. They differ in that the momentum strategy uses rules for force the investor to go 100% long close to the start of a not-yet-clear up trend, and to go 100% short close to the start of a not-yet-clear down trend.
The process of evaluating stocks (companies) can be classified as either passive or active.
PASSIVE INVESTING - Indexing 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 for ETFs using
US, Cdn and GB funds
GlobeInvestor (security = ETF)
BMO's site but includes all Canadian ETFs
ETF Database - US listed
This investor believes 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:
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.
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.
- An index can be derived :
- by weighting each company according to its market capitalization to mimic
the economy. The effect of this is to increase your exposure to stocks that have already done well. Any market-weighted index that covers both large and small
caps will not be noticeably 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.
- 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.
- by weighting according to the market value of securities outstanding in the market. If a bond index weights its holding toward those companies with the largest public debt you get an index with more exposure to leveraged businesses and more risk.
- by practicalities. With the blooming of ETFs there has been a shadow blooming of indexes they are intended to track. This is putting the cart in front of 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
- by weighting the chosen attributes of a company that measure its economic footprint - rather than its market value - its sales, cash flow, book value and dividends. (E.g. FTSE RAFI). Using each countries' GDP as the weighting for bond indexes solves the problems in 3. above Some people argue these indexes are simply cheap ways of actively choosing stocks you think will outperform - they do not fall under the 'passive' strategy. This BlackRock paper argues that the weighting metrics are a proxy for choosing 'cheapness' (as in 6. below).
- by weighting the chosen attributes of a company that measure its market valuation relative to company metrics like earnings and dividends. Most are like WisdomTree who select for cheapness in the belief cheap stocks outperform. This methodology is NOT passive investing. It automates an active stock-picking strategy.
- by equally weighting the dollar value of each company. Guggenheim offers equal weight ETFs on major indexes. You would expect different returns from an equal weight index a) because of their higher weighting in smaller-cap stocks, b) because of their different industry-sector exposure and c) because of their perpetual rebalancing. A good analysis of returns is in this S&P pdf.
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).
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.
- 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 fundamental analysis a waste of time because all the available information is already incorporated in the stock's price or market sentiment indicators. 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. But technical traders don't necessarily trade a lot. Some play seasonal industry cycles. Some play year-long stock price movements.
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.
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 charting 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. A concise argument of the factors favouring Technical Analysis over Indexing is presented by MinyanVille
Some charting metrics must be considered no matter what strategy you use, 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.
Momentum investing has gained great credibility recently . Momentum has even been included as a risk factor in the Fama-French model that measures a portfolio's alpha. This strategy chooses portfolios of stocks based on the past year's (or 6 month's) stock price gains. A stock that has performed well in the past has been shown to continue to outperform in the following year. But this is little different from using moving averages to exit/enter stocks. The lengthy look back period exposes the strategy to huge drawdowns. See the historical chart at Item #9 on the Backtesting page. Researchers are finding that since 2008 this strategy has not worked. Rather, past high flying stocks have produced negative alpha. Asness, et al (2014) gives a spirited defence of the strategy in "Fact, Fiction and Momentum"
- ABSOLUTE VALUATIONS:
Investors using absolute 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 for 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 discrepancy.
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 differing 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,
- The model has no inputs for dilutions of ownership or
non-cash transactions, or the benefits from new share issues. The
companies are always analyzed on an 'entity' basis, which assumes no
change in ownership %. This is a serious drawback in the 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.
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.
- Dividends Forever: divide the current yield by a discount factor to generate the stock's value. 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.
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,
- 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. The simple math of the Gordon Model is given in this spreadsheet.
Stage Growth: The Gordon model can be refined for a stated period of
excess growth followed by steady-state growth equal to (e.g.)
Value of Free Cash Flow or Discounted Cash Flow (DCF): Since dividends
are often only a small part of the total return, a new
model was devised to measure the cash flow within the company that
could be considered 'potential' dividends. The 'potential' dividends are capitalized just like dividends. Called "Free Cash Flow",
it cannot be measured directly from the available data. Theoretically
it represents operating cash profits less spending necessary to replace existing assets. There is no agreement on its calculation - commonly it is the Cash Flow From Operations less the Investments in Property. 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).
Using DCF, actual cash flows (not Free Cash Flows) are modeled year by year into a projected future. Each year's residual cash increase is discounted to the future. Then the market value of the stock at the end of this period is also discounted to the present. The sum equals the stock's value.
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
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
- 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.
- 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.
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. Various strategies require greater and
lesser amounts of work.
- 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).
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. See Screening Stocks.
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.
will not strictly abide by the rules for the original selection. They
allow emotions to overcome their best intentions.
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'.
- 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.
- 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. 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 ideas you would otherwise have missed, and sometimes the expert will offer an original analysis, but you have to listen for about 20 hours for any original analysis.
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.
Decision-Making for Investors by M.Mauboussin (Legg Mason)
Ruminations on Risk by Credit Suisse (Beta vs Margin of Safety)
Thoughts on Valuation by Credit Suisse
Interview with William Sharpe