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Investment Practice Discussion

Last night I made a presentation to a local investment club.

They provided me with a list of questions that they wanted answered so that they could compare what we do to how they manage their portfolio as a club.

I thought you might find some it interesting, so I am posting it here to share with you.
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Mark, attached is our latest monthly report, showing stocks in our current portfolio and a summary of activity over the last 13 months. We have made very few purchases and very few sales over the last year or
two. We are not looking for specific recommendations on each of these holdings, but this will give you an idea of our type of holdings. We have done fairly well versus the market until the last 2 or 3 years.

On the attachment you sent, I have listed our proprietary rankings for your holdings.

Our ranking system is based upon the theory of Growth At Reasonable Price – a sheet that explains the components of our ranking system and its performance track record is also included. [ for you readers, I have excerpted the information immediately below ]

BankChampaign Earnings Growth Model

    Ranking System Components

30% Earnings Per Share Ranking: based upon announced earnings surprises

20% Technical Ranking: based upon stock price performance

40% Valuation: based upon earnings growth rates and cash flow ratios

10% Industry Leadership: based upon operating margin and return on equity calculations

This set of ratios and performance numbers weighted in this manner has proven over the years to provide the best predictive value of future stock price performance of company, and helps guide us in our equity selection process.

earnings-growth-model-returns

This graph shows the average annual return for the various rankings compared to the S&P 500, since 2001. Further discussion about the rankings and returns is below.

I’ve developed this system beginning in the 1980’s and with the advent of technology that provides the data, it can now cover a wide range of publicly traded companies. It has its roots in my Master’s Thesis on the Efficient Market Hypothesis from the mid-80’s and has been expanded with the advent of technology and access to information over the years.

We receive a data download of information on over 5,000 publicly traded equities. The data includes information on their balance sheet, income statement and price performance.

On an annual basis, I retest the system to make sure that its predictive value is sound. I will change the weightings and add/subtract other data points and then back-test the system to see if any tweaks need be made. I’ve always thought that the system should intuitively include a debt-to-equity component, but in all testing that ratio did not improve the predictive ability of the system.

The system calculates the various ratios to rank the companies from 100 (the top rating) to 0 (the bottom rating) on a bell curve. This indicates that there are fewer companies with very high and low ratings than companies with mediocre ratings. As you can see on the graph above, those stocks with the highest ranking performed on average well above the S&P 500, and those with the lowest ranking performed on average well below the S&P 500.

When we buy companies, we tend to buy them rated 90 and above as those companies have the strongest balance sheets, earnings growth, and price momentum/investor sentiment.

If companies drop below 60, we view them as sale candidates because historically they underperform higher rated companies due to weaker balance sheets, stagnant or falling earnings, or neutral to negative investor sentiment.

One item of note is that deep value companies in turn around situations will almost always be rated poorly by this system.

Also here are some questions we would like to discuss with you. I am sure many of these are common questions for many investors in these times. Many do not have objective answers, but are the basis for good
discussions.

1. What sectors of the market do you think will do well in the next year or so?

We currently have a barbell approach in our domestic equity portfolios:

My favorite sector is Agriculture, so having a core allocation to the fertilizers and the machinery makers is key, as well as to the commodities themselves through ETF’s like DBA and CORN.

I am also a big fan of the industrial commodities required for much of today’s technology as opposed to those required for industrial uses. China has a 97% market share in commodities that are required in the production of cell phones, alternative energy, defense systems, computers, etc. There are a few companies outside China that produce some of the remaining 3% and they are in the early stages of a major bull market cycle.

Gold, Silver, Platinum and Palladium should all do well in coming years as the dollar is weakened by our fiscal imbalances.

I also believe that you need to look at where the mergers are happening to see where corporate America sees value. Today, the people that operate successful business are paying premiums for companies that operate in Agriculture, Technology, Biotech, Energy and Commodities (ag, base metals, rare metals).

However, I believe the US Market will be in a trading range for an extended period of time as the battle between inflation and deflation plays out. To be successful and beat the broader market, an investor must have a strategy to deal with a market that is stuck in a narrow range over a long time.

We could easily see the market move up and down within a range much as it did in the 1970’s. On October 11, 1973, the S&P 500 Index was 116.03. On August 31, 1982, it was 119.51. Between that time, it moved up and down within a range, but buy and hold investors spent a decade going no where.

Today’s market is in a similar position, if you look at this graph:

sp-500-long-term-range

Secular bear markets like the one we have been in since 2000 generally last from 13 to 18 years. My best guess is that we will not break out of the range for several years. In fact, we will remain in the current cyclical bear stage until we break above the moving average line. At the moment, the market is consolidating around the midpoint of the range.

Conversely, what sectors do you think will not do well?

Unemployment will be high for a long time to come. Avoid any sector that relies upon consumers for its earnings growth. Avoid housing related investments as my gut feeling, based upon the shadow supply of houses that banks have in OREO across the nation, is that we won’t see a significant rebound in housing prices for a long time.

Government regulation will continue to burden much of corporate America. Any sector that sees the likelihood of increased regulation (think banking, health care – particularly health insurance – and domestic energy production) will have significant headwinds. It’s not to say you can’t make money in them, you just have to understand that you are pushing the stone uphill as in investor.

Fixed Income investments will also have difficult times in the years ahead – too many people have rushed into bonds paying negligible interest or have assumed too much risk by moving too much money into junk bonds. This generally means that REITS will also have trouble along with preferred stocks.

2. What are your thoughts on foreign investments– are there some specific countries or areas of the world we should be looking at?

Traditionally, the developed world was the safest place to have money invested and the developing world was a speculative investment. No longer. The levels of debt in the US and Europe make those areas less desirable than the developing markets that are loaning them the money.

Much of it is due to demographics – the US, Japan, and Europe put significant resources into social safety nets as their populations approach retirement age. The US is better off than Japan and Europe and more likely to weather its financial problems as its birth rate is only slightly below the replacement rate. Japan is in the worst shape with Europe somewhere between. There just are not enough young people entering the workforce to pay for the needs of the growing elderly populations in the developed world.

Post WWII, demographics in the US and Europe allowed those regions to flourish as a wave of births brought new consumers into the middle class. Today, that is happening in the developing world. A rising middle class population drives production and home ownership. A falling middle class population leads to falling GDP.

I think to be successful, you have to look at the economies of the world that are drawing investment money to them based upon their sound financial position, sound currency, and GDP growth prospects (much of which comes from positive demographics): Chile, Taiwan, South Korea, India, Brazil, and Poland.

Then, you have to look at the countries that are on the cusp of joining the group above based upon desirable demographics and significantly improved fiscal situations: Vietnam, Indonesia, Turkey, South Africa and Columbia.

For developed markets, overweight your positions in Canadian, Australian, German, and Swiss index funds as well as individual companies in those countries. Canada and Australia have abundant resources that they can export to the counties with growing middle class populations. Germany is an export driven economy that focuses on those growing middle class populations. Switzerland is fiscally prudent, wealthy, and will have a strong currency.

We use the country specific ETF’s for these countries to gain exposure to their stock markets.

3. How can we make the most of the growth that is happening in China and other emerging markets without taking a monumental amount of risk?

We use the country specific ETF’s to gain exposure to their stock markets. Start with small positions in a number of countries but have in mind a percentage of your portfolio that you want invested in this sort of strategy. Use significant technical levels to add to the positions and build up to your desired levels. Don’t view it as something you have to accomplish all at once.

One caveat – China’s one child policy will have a significantly detrimental demographic impact at some point in the future and they will resemble Japan in terms of the number of elderly to young. That is a generation away, but given their size it will have a major impact on the rest of the world.

4. What is your overall forecast for the stock market– do you see another massive correction coming?

We will be in a trading range for a significant period of time. Near-term, look for swings on the S&P 500 between 960 and 1250 – a roughly 30% range.
We have adopted a strategy of selling weaker positions as the market approaches 1150 (we will be hard pressed to get to 1250 until after the November elections, and maybe not for some period of time after that) and buying as the market nears 1040 (with the Fed adopting an easy money policy and stating they will do whatever it takes, getting to 960 will require some very dire exogenous event).

There can always be a massive correction based upon some dire exogenous event – 9/11 terrorist attacks, the government allowing the bankruptcy of Lehman Brothers to shake faith in the entire financial system, etc. But, absent one of those things and with the Fed in liquidity mode, I think the trading range scenario is most likely.

Longer-term, look for us to swing within the wider range shown in the chart above. Given the liquidity that the Federal Reserve has pledged to be available, we hope not to see a return to the bottom of the range but those exogenous events can occur at any time.

5. What are your broad thoughts and recommendations on the stocks in our current portfolio?

Overall, our rating system shows you own, in general, solid companies.

[specific company comments have been deleted]

6. What publications/web sites/analysts do you follow regularly, and whatdo you recommend for us? What weekly/monthly reports are most significant to investors?

Most individual investors should follow Jim Jubak. His writing is easy to understand and he has a world view similar to my own.

You can also find good global information at CBS Marktwatch with their opinion writers.

The Street.com can also be a good source of writing – but you need to be careful to sort through the fluff and hype.

Standard and Poors has very good stuff that your brokerage may provide, and if they are a full service brokerage they may have their own proprietary information that you can use.

I read Goldman Sachs and Morgan Stanley stuff, plus the Economist and Wall Street Journal can provide clues to things happening in the world that will eventually become investment trends. However, for the most part, we do not use analysts from the brokerage houses for information, preferring independent data collection and our own systems/analysis for decision making purposes.


7. What criteria/analysis do you personally use to determine when it’s time to sell a stock, and at what price to sell it?

I don’t use analysts from the major investment houses to tell me when to buy or sell.

I use the news reports, earnings releases (relative to meeting, beating or missing expectations), and my own ranking system that keeps me abreast of changes to their financial health.

For individual investors, I always recommend you set up your portfolio on MSN Investor and follow their ratings. Their ratings are pretty good and if you adopt sales a methodology centered around the ratings, it will give you a discipline to adhere to that will work better than average.

As with all systems, nothing is perfect and it is not a substitute for actual decisions on your part, but if you use it as a tool it can help you make good decisions.

8. What criteria/analysis do you personally use for selecting stocks to buy, and at what price to buy them?

I don’t use analysts. I use my own analysis and ranking system.

Some of it is macro determined (sectors, timing of the market within the range, etc., will it provide exposure to an underweight area or make me overweight in an area and increase my overall risk)

Some of it is company specific things I look for:

1. Always start with the fundamentals – is the company performing the way it should –OR- am I looking at a turn-around situation and has this company turned the corner?

2. Then I look at the technicals: does the chart tell me the timing is right:

a. Where is it in relation to its moving averages? Is it trading above, below or between them?

b. What does the volume look like compared to price levels and moving averages?

c. What does the money flow look like – are the institutions pushing it higher?

d. Where is its relative strength?

This is the chart format and indicators I use the most:

ppdi

• The Relative Strength on this chart shows that it is above 70 – statistically when the reading is above 70 the stock will pull back

• The stock price is having difficulty breaking through the 50 day moving average.

• At $26, you have a significantly greater number of previous buyers than sellers – those buyers will be looking to break even on their trades so they present an overhead resistance to the stock pushing above that until equilibrium is reached.

• Volume compared to the moving average is low.

• The On Balance Volume indicator is relative flat showing that the recent price advance has been on low volume – a weak trend for this money flow indicator

• The Stochastics indicator shows that short-term momentum has reached a peak – readings over 80 generally present short-term tops that have to be worked out either by a stagnant price for a period of time or by a falling price in a short time.

• The MACD indicator shows that intermediate term momentum is rising but hasn’t gotten above the 0 line. The good news is that the black line is rising faster than the red line

• The money flow indicator at the bottom shows a change to positive but the Accumulation/Distribution line is relatively flat – another weak trend for money flow that confirms the On Balance Volume indicator.

    Summary of this chart

: I would not be a buyer at this time. I’d want to see the Stochastic reading nearer to 20 or the relative strength between 50 and 70. I’d wait for the price to challenge the $26 level to see how investor psychology reacts – will all of those previous buyers hold or buy more or will they try to break even once the price comes back to them. I might also wait until the money flow indicators shows a change in the institutional buyers mentality – its hard for stock prices to push higher without support of the institutional markets.

9. What is your opinion of ETF’s in a portfolio?

ETF’s have a definite place in a portfolio as discussed above

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I hope you’ve found this helpful – the investment club seemed to like it although it may have been a bit overwhelming.