Ways to invest in stocks

July 19, 2018

There are thousands of  investors who want to own ‘good’ companies that avoid ‘trouble’.

  • they invest in stock shares [stock shares are equal units of part ownership]
  • a good company
    • operates a profitable, growing business
    • avoids financial distress and regulatory penalties

Investors purchase and sell shares in the stock market.  They hope to sell their stock at a desirable price and may also receive cash rewards from companies that pay dividends.  Investors earn a profit (called a capital gain) when the sales price is above their cost of investment or lose money (called a capital loss) when the sales price is below cost.  

Stock Analysis

Two ways of evaluating a stock are called technical analysis and fundamental analysis.  Technical analysis measures the performance of share prices and share volumes in the stock market.

  • Shares are units of part ownership which are traded in the stock market.
  • Price: the price of a share in the stock market.
  • Volume: the total number of shares traded in the stock market 

Fundamental analysis evaluates the business performance of a company by way of searching through its quarterly and annual filings.  The business description, financial statements, and CEO’s annual letter to shareholders are important sections of the filings.

  • CEO: Chief Executive Officer; top manager of the company.
  • Filings: periodic reports to shareholders that are required by the U.S. Securities and Exchange Commission (SEC).

Business performance is also assessed by the company’s market share and competitive advantage within its industry.  This information is available online.

Investment Strategies

The most common investment strategies for stocks are swing trading, value investing, and growth investing.  

Swing trading (cyclic trading) uses brief upward or downward trends in share prices to determine when to buy or sell stocks.  The typical holding period is from one day to several weeks.  The investor hopes to earn a capital gain (–if seeking a profit–) or capital loss (–if seeking to reduce the short term capital gains tax–).  The investor uses either a technical analysis or guesswork to judge the price trend.  The main risks of incurring a loss are due to price volatility and taxation of returns.

  • Hold: to own.
  • Short term: one year or less.
  • Short term capital gains tax: the taxation of a capital gain at the regular income tax rate.
  • Price volatility: the random fluctuation of prices based on the market forces of supply and demand.
  • Return: the profit or loss from an investment.

Value investing seeks a capital gain by purchasing the stock at an unusually low price (e.g., 60% of intrinsic value) and then selling it at approximately double the purchase price.  The holding period depends on the length of time for the stock price to become profitable. During the holding period, an investor will receive any dividends paid by the company.  The informed investor uses a fundamental analysis to assess the quality of the company and the intrinsic value of its stock.  The causes of an unusually low price include a market downtrend (e.g., economic recession) and poor company performance.  The main risks of incurring a loss are due to an eventual delisting of the company and taxation of returns.  

  • Intrinsic value: the share price calculated by a professional analyst’s secret formula.  However, you can estimate the intrinsic value as the net worth of the company (book value) per share, based on the idea that a wealthy investor could acquire the company at its intrinsic price by puchasing all shares of stock at the book value per share.   
  • Dividend: a cash reward paid to share holders from the company’s profits or cash reserves.
  • Delisting: removal of the stock from the stock market for various regulatory reasons, including bankruptcy of the company.    

Growth investing is a long term strategy for using the upward momentum of share prices to earn a capital gain. The capital gain is earned by simply holding the stock and reinvesting all dividends.  The rule of 72 estimates the holding period needed to double the purchase price of the stock at an assumed rate of annual return.  The growth investor uses a fundamental analysis of the company and market valuation to judge the fairness of the stock price.  The main risks of incurring a loss are due to deterioration of the company, decline in market value, and taxation of the returns.

  • Long term: after one year.
  • Momentum: an upward trend of share prices.
  • Rule of 72: [ Years to double the price = 72/percentage annual rate of return ] For example, a 15% annual rate of return will double the share price in 4.8 years. 
  • Annual rate of return: a constant percentage change in value every year that accelerates the growth of an investment; CAGR is an acronym for the annual rate of return.
  • Valuation: the art of judging if the price is low (discounted, undervalued) or high (expensive, overvalued). 

disclaimer: this article may not increase your investment profits.

Copyright © 2018 Douglas R. Knight


Investment styles

June 14, 2015

An investment style describes the way an investor earns a total return. The many possible investment styles can be characterized by the holding period (i.e., length of ownership) and method of valuation. Individual investors typically choose between the cyclic, growth, and value styles. Day traders hold stocks less than a day to earn small change from each share. This style is favored by a group of professional speculators and will not be discussed in this article.

A stock investor’s total return is an accumulation of dividends and capital gains. Dividends are the company’s occasional cash distributions to shareholders. Dividends can be withdrawn from the investor’s brokerage account, saved in the brokerage account as cash, or reinvested in stock. Capital gains (‘price appreciation’) are the increase in market value of a stock as calculated by the change in price since purchase multiplied by the number of shares owned. Conversely, capital losses (‘price depreciation’) are the decrease in market value caused by a price change. Capital gains(losses) are realized or unrealized cash flows. The realized gain(loss) produces an actual change the investor’s cash balance resulting from a sale. The unrealized gain(loss) is a theoretical change in cash balance at the moment of accounting.

Investors generally expect capital gains to exceed dividends. Capital gains are only earned by selling shares above the purchase price [this is the principle of ‘buy LOW’, ‘sell HIGH’; remember that a trading fee is charged for each transaction]. The following chart illustrates 3 strategies for earning capital gains:

styles

The “share price” (built into the Y axis) is what traders quote for one share of stock at a particular moment in time. The smooth curves show 3 different trends as the share price moves into the future (along the X axis). In reality, the share price oscillates throughout the trading day as a result of various market forces. However, the curves are drawn as smooth lines for the purpose of forecasting the share price. The future price can’t be predicted with absolute certainty. It’s always true that the further into the future, the less certain an investor can be about predicting the price. Investors can choose to manage the uncertainty in different ways as illustrated by the position and shape of the curves in the graph. The first way (red curve) is to earn a quick profit from a cyclic market. This method requires a gift for timing the market so that the investor can buy at a low price and sell at a high price in a relatively short time period of weeks to months. Second (blue curve), the investor can place a future value on the stock by forecasting the long term growth of company earnings in the belief that stock market participants will pay a higher price for the growth of earnings. If the investor’s analysis is correct, the future selling price will be higher than the present purchasing price. Third (black curve), the unit price may be ‘beaten down’ by a market panic or by other mechanisms causing market participants to lose interest in the stock. The analyst may find that the economic value of the company is worth more than the value of the stock by an amount called the ‘margin of error’. If that margin of error is 50%, then ‘value investors’ are fond of describing their stock purchase as buying a dollar for 50 cents. They will hold the stock as long as it takes for market participants to restore the stock price to the intrinsic value of the company. They are taking a risk that the stock price continues to fall as the company goes out of business.

Analysts make a distinction between the economic value of a company and the market value of that company’s stock. The cyclic investor pays more attention to market value. Growth and Value investors analyze the relationship between company and market value. They believe that over a period of years, the market value of the stock will rise with the economic value of the company. During the holding period they will accumulate any dividend payouts in their cash account or reinvest the dividends in more shares of stock. The accumulation of dividends and capital gains is called compounding the returns.

The future is uncertain. Many unexpected events can affect the share price following the initial purchase. Re-valuation of the company and its stock are essential to managing the risk of a long-term stock investment.


Book review: The Little Book that Still Beats the Market, by Joel Greenblatt

September 28, 2013

(9/30/2013 update: The American Association of Individual Investors tested the performance of the magic formula described in this book. The test results are published in the AAII.com stock screens web site. 4/5/2016 update: A ‘revisit’ is added to General Comments)

about the author

Joel Greenblatt is a celebrity among formula investors for devising the “magic formula” to screen stocks. Greenblatt received his bachelors and MBA degrees from the Wharton School at the University of Pennsylvania in 1979 and 1980. He is the founder and managing partner at Gotham Capital, a hedge fund, and is the author of several books on investing. He is an adjunct professor at the Columbia University Graduate School of Business.

General comments

For the benefit of the reader, Greenblatt attempts to explain to his young son a method for earning profits by investing in a portfolio of 20-30 stocks. His method depends on using a magic formula to select ‘good’, ‘cheap’ stocks for purchase and annual replacement. Greenblatt’s method is designed for ordinary investors who commit to the plan at least 3-5 years. It solves the perennial problem of deciding when and which stocks to trade. As of this year, 2013, Greenblatt provides free access to an updated list of screened stocks on his website.  Shortcomings of the method and book are described at the end of this review.

Revisited in Apri, 2016:  Greenblatt’s book reminds us that buying stocks on pure speculation is likely headed for a loss.  Instead, good buying decisions need research and measurements.  His method is to condense the company’s financial statements to 2 measurements in the belief that earning cash from customers is the key element of a successful business: 1) “Earnings yield” is a measurement of market valuation that shows how highly the earned cash is valued by investors in the stock market; higher is better.  2) “Return on invested capital” is a measurement of management efficiency that shows how much earned cash is derived from the company’s assets; higher is better.  Greenblatt claims that a new basket, every year, of high-scoring stocks will collectively beat the stock market after 5 years.  About 50-60% of the purchased stocks will outperform the remainder of 20-30 stocks in his baskets.  Greenblatt’s method is not designed for dividend reinvestment plans and other long term strategies for buying smaller baskets of stocks.  I’m inclined to believe that more than 2 measurements are needed for making small-basket, multiyear investments.

What is a good business?

Jason was an 11 year old business man who sold sticks of gum at school for a huge profit. Suppose Jason opened a chain of gum stores after graduation from high school and achieved success. Now he wants to sell half the business for $6 million. He plans to split the ownership into 1 million equal pieces, called shares, and sell ½ million shares at $12/share (Jason will keep ½ million shares for himself). Is that a good price for the investor? According to Jason’s income statement from last year:

Gum sales   from 10 stores $10 million
Cost of gum $6 million
Other   expenses (rent, salaries, etc.) $2 million
Profit   before taxes $2 million
Taxes (40%   tax rate) $0.8 million
Net profit $1.2   million  ($1.20/share)

One share costing $12 today earned $1.20 last year. That earning, called an earnings yield, is 10% of share price ($1.20/$12.00 = 10%). The 10% yield is better than a risk-free return of 6%, so the share price seems to be acceptable. Will Jason’s earnings grow? That depends on how well he operates the business. Here’s Jason’s return on capital:

Cost of   property and equipment (capital) $4 million
Profit   before taxes (return) $2 million
Yearly return on capital 50%

Jason’s 50% return on capital is better than if he invested $4 million in U.S. government bonds for a risk-free return of 6%. He has a very good business. Good businesses attract competition that may eventually reduce profits. Until then, a high return on capital for one year shows temporary success and reflects a competitive advantage. Warren Buffet, a stock market master, buys stocks of good businesses at bargain prices that show signs of growth in value over time.

Stock Market Master

The stock market master earns higher returns than otherwise earned from risk-free U.S. government bonds (assume the minimum U.S. government bond rate is 6%). The classic method is to buy stocks of good companies at bargain prices. Benjamin Graham was a stock market master who invested with a “margin of safety” by paying less than the company was worth. Graham, who knew that market prices fluctuate according to moods of pessimism and optimism, sold his holdings when an optimistic market was paying more than the company was worth. The success of Graham’s method depended on the availability of many bargains during the era of the Great Depression. Today, very few stocks fit Graham’s requirements.

Greenblatt claims that a revision of Graham’s method will beat today’s market, and future markets, with low risk to the investor. His revision, called the magic formula, is to buy stocks of profitable companies when they are trading at low prices.

Magic formula

All businesses need working capital and fixed assets for successful operation. So, why not rank businesses on the effective use of those assets? The magic formula ranks stocks according to two criteria: return on capital and earnings yield –Greenblatt defines the earnings yield and return on capital differently from the generally used inverse of the price-to-earnings ratio (E/P) and the return on assets (ROA)–.

Good companies have high returns on capital; the higher, the better. The return on capital should exceed the return from a risk-free investment; otherwise, the company is better off investing in the risk-free U.S. government bond. Stocks with high earnings yields offer bargain prices, and higher yields are better bargains. The earnings yield should also exceed the return from the risk-free U.S. government bond.

A stock market index measures the average price of the average stock, but the magic formula selects the above average stock at a below average price. Therefore, it’s a good bet that a basket of magic formula stocks will beat the market. To test this bet, Greenblatt created a portfolio of 30 top-ranking stocks among 3,500 U.S. stocks screened by the magic formula. He used a 3-step screening process: First, all stocks were ranked from 1 (highest return on capital) to 3,500 (lowest return on capital). Second, the same stocks were ranked from highest to lowest earnings yield. Third, the combination of scores were ranked from best to worst (e.g., a ranking of 385 (232 + 153) was better than a ranking of 1,151 (1,150 + 1)). The test portfolio was replaced with a new set of top-ranked stocks every year during the 17 year period of 1988-2004. The market value of the test portfolio grew by 30.8% per year compared to the 12.4% annualized growth of the S&P 500 index. Greenblatt created other test portfolios derived from 2,500 U.S. stocks with market caps above $200 million and 1,000 U.S. stocks with market caps above $1 billion. Both test portfolios grew by 23.7% or 22.9% per year depending on the stock universe.

Did the magic formula make a few lucky picks? Greenblatt opined that a few lucky picks could not bias the outcome.

Will bargain stocks eventually disappear? Greenblatt divided the universe of 2,500 U.S. stocks into 10 subgroups of 250 stocks according to the magic formula’s rankings (i.e., the first subgroup had the highest rankings and the last subgroup had the lowest rankings). The first 6 subgroups of highest ranking stocks (a total of 1,500 new stocks each year) outperformed the S&P 500 during the 17 year test period, indicating a plentiful supply of bargain stocks.

Did subgroup returns correlate with subgroup rankings? It seems so since the returns from subgroup 1 beat the returns from subgroup 2, and so on; however, Greenblatt did not report the correlation.

What if everyone uses the magic formula? Greenblatt opined that they won’t. New participants eventually quit at the first sign of short-term bad news (most investors want to own the most popular stocks, but the magic formula finds less popular stocks!).

What is the risk of losing money over the long term? The good news is that the plan doesn’t lose money and always beats the market during rolling 3-year periods (rolling refers to the calculation of a previous time period every month).

Conclusions

The magic formula offers high returns at low risk based on the simple logic of screening stocks based on the earnings yield and return on capital. The earnings yield helps to sort the universe of stocks for companies that earned a lot last year compared to today’s stock market price. The return on capital is used to identify companies that earned a lot last year compared to the cost of operating the business. The advantage of using the magic formula is to screen for a number of undervalued stocks on a regular basis.

The disadvantage of the magic formula portfolio is the demand for frequent, long-term attention. There are repetitive screenings, many trades, and numerous tax records.  The portfolios described by Greenblatt have a 100% turnover that incur 2 trading fees per stock per year. Since the book does not discuss the potential impact of trading fees on investment return, I estimated the effect of trading fees (see chart) on one of Greenblatt’s test portfolios.  Don’t expect high returns unless you invest at least $15,000 in the portfolio.

magicformualcost

Click on the following links for additional book reviews: 1. A listing of returns from this and other formula investing plans.  2.  Why You Should Take Joel Greenblatt’s ‘Magic Formula’ Stocks Seriously.  3. video, What’s Joel Greenblatt’s Magical Investing Formula?

Joel Greenblatt. The Little Book that Still Beats the Market. John Wiley & Sons, Inc. 2010.


Book Review: The Little Book of Value Investing, by Christopher H. Browne

August 21, 2012

Summary

There’s a simple distinction between momentum investing, which is buying when prices are rising, and value investing, which is buying when prices are falling.  The entire book is dedicated to the art and science of value investing.

About the author

Christopher Browne is a career broker at his father’s firm of Tweedy, Browne, and Knapp.  The founder, Bill Tweedy, made a fortune by marketing shares of obscure stocks that frequently sold at bargain prices.  The famous Benjamin Graham was one of Tweedy’s clients and advisors.  Graham championed the method of appraising the auction value of a stock in the same way that a banker appraises a loan.  Loan appraisals are based on the borrower’s annual income and the value of the underlying asset.  Graham’s stock appraisal was based on the company’s earnings and net worth.  If the stock of a good company was valued below its net worth with an added margin of safety, then Graham bought the stock.  Many readers consider Graham’s book, Security Analysis, to be the best book on investing.  Christopher Browne’s book is a close runner-up.

Christopher Browne’s core message

The goal of value investing is to outsmart other investors by purchasing stocks at bargain prices for resale at handsome profits.  Market sell-offs (i.e., decline in prices) create opportunities for buying good stocks at prices below their intrinsic value (synonyms: fair value, book value, net worth).  Intrinsic value is determined by a statistical and fundamental analysis.  The statistical model is a set of financial ratios aimed at screening stocks for bargain prices.  For example, the author’s screening criteria are a price-to-book ratio (P/B) of no more than 1.4 and a market capitalization value of at least one million dollars.   The fundamental model is an appraisal of the company for its auction value.  Buying a stock at intrinsic value offers no margin of safety for protecting the investor’s future profit.  Some stocks recover slowly from a sell-off (or never at all!) and the stock price drifts below the investor’s purchase price.  The investor’s principal margin of safety is a market price discounted well below the intrinsic value of the stock.  For example, Benjamin Graham sought stocks that were priced one-third below their intrinsic value in anticipation of profiting from a 50% rebound in price.  The stocks of solid companies with strong balance sheets usually recover from sell-offs and are likely to increase in price at some future date.  An extra margin of safety is achieved by:

  1. Excluding stocks with a high ratio of debt to net worth.  These are likely to liquidate from declining earnings.
  2. Diversifying the stock portfolio to protect from unpredictable adverse conditions.  The diverse stock portfolio inevitably holds winners and losers in any given year.  The idea is to hold more winners than losers.
  3. Avoiding stocks in emerging economies, where speculative earnings reduce the margin of safety.

 “Due diligence” is the examination of financial health to determine if the company has dependable earnings.  Three signs of dependable earnings:

  1. SEC filings of insider trading.  Buying is a sign of confidence that operations are improving and that there will be future gains
  2. Corporate buyback of discounted stock is a sign of future gain.
  3. Activist investors who accumulate at least 5% of outstanding shares must file with the SEC and state whether they are investing or lobbying for change.  Taking an investment position with discounted stock is a sign of future gain.

Conclusions

Browne identified six peer-reviewed studies which show that lower ratios of P/E and P/B outperform higher ratios over holding periods of 14-46 years.  Fewer studies of global stocks also show that low-ratio stocks outperformed high-ratio stocks.  The short chapters of this book present clear descriptions of value investing and financial analysis.  It is well worth reading.

The Little Book of Value Investing, Christopher H. Browne, Forward by Roger Lowenstein, John Wiley & Sons, Inc., Hoboken, 2007.


%d bloggers like this: