Know your Strategy

buy

Before I start with the topic I want to introduce via this article, I’d like you to note that this article is a rewrite of an article called “Strategies of Investment Gurus”, which was published in Economic Times weeks ago. I’d like to decode it for you, the ED Way!

Warren Buffett once said “Be greedy when others are fearful and fearful when others are greedy.”  After all, the most terrible investing mistakes are made during bull runs, while the most profitable investments happen when the markets are down in the dumps.
Does this mean that you should stay away from the stock market during a Bullish phase? Not really.
Despite the high rates it is possible, to make profitable investments in stock. You just need to choose the right ones. But how do you do that? Fundamental Analysis can be performed, which helps the investor judge the stock on the basis of certain Ratios. However, the only problem is that no single ratio is applicable in all the situations. The most common ratio, the Price-Earnings ratio (PE Ratio) can’t be used while evaluating loss making companies. Believe it or not, the leading investment gurus also use this fundamental analysis in order to pick their stocks. However, the ratios and combinations they choose might be different. How different are they? Let’s find out.

All the investment gurus believe that no matter how volatile a market is during the short term; the price of share moves towards the intrinsic value during the long term. Therefore, it might be advisable to buy a stock that has a lower market price than the intrinsic value of the share.
Before you follow any guru’s strategy, keep in mind that a stock picked up by a celebrity investor is not a substitute for own research. They also might get their bet wrong; one should follow the strategy of the investor, not the stock they are investing in. At the end of the day it’s your money and you are responsible for it.

Before you read any further please note that these strategies were derived for developed markets, and they might not fully be applicable in case of developing Markets like of India. And these strategies are only for those who are willing to invest for a long duration. Short term investors might not be able to derive benefits from them.

Buy with great care and hold for a long, long time – Warren Buffett, Chairman, Berkshire Hathaway

Warren Buffett follows a conservative policy. As he says, his favorite holding period is “Forever”. He prefers to invest in straight forward business which manufactures products which people can’t live without. Buffett’s primary concerns include the financial stability, quality of management and simplicity of business. He also checks whether the company has the ability to pass on any rise in its costs to its consumers. A company should have the ability to adjust the prices of its products to inflation because this enables it to make profits in varying economic climates.

To identify solid companies that are worth investing in, Buffett uses a series of fundamental indicators, such as stability of earnings, level of long-term debt to earnings, return on equity (ROE), return on total capital (ROTC), free cash flows, and return on retained earnings.

One of Buffett’s abiding principles is that stock price volatility, even year-to-year fluctuations, is caused by irrational investor behavior that can’t be predicted. Therefore, he is concerned more with the percentage change in per share book value instead of the stock price.
His basic rules of stock selection are as follows, the earning per share should’ve consistently risen for the past 10 years with no Negative EPS in any year. The long term debts in the current year should be equal to less than 5 times its earnings. Their 10 years average return on equity should be at least 15%. 10 years average return on capital should be at least 12%. Return on retained earnings should be higher than or equal to 12%. Free cash flow in the current year should be more than zero.
One must try to invest in a company who’s USP is such that it makes almost impossible for it competitor to overtake it. Coca Cola, a long term holding in Warren’s portfolio is the best example for this. Buffett also feels that Market share is a dominant factor; he likes the firms that enjoy ‘consumer monopolies’ due to an overwhelmingly dominant market share, which gives them the power and leverage in the marketplace.
He only trades in his few hand chosen stocks. Since his mindset is for a long period, day to day market movements do not bother him too much. So, I suggest this strategy is great for long term investments.

To buy stocks successfully, you need to price them based on causes, not results – Kenneth L Fisher, Chairman & CEO, Fisher Investments

Kenneth L Fisher pioneered the price-to-sales approach of stock selection. He believes that investors raise expectations to unrealistic levels for companies that display strong growth in the early years. When earnings drop or the companies fail to keep up with investors’ lofty expectations, the stock prices fall because people overreact. Fisher believed that companies with sound management have the ability to identify the problems, resolve them and move forward. As they do, the stock prices and earnings begin to rise again. Based on this concept, he devised the price-to-sales approach to identify companies that have the ability to rebound.

The idea was radical. For decades, the PE ratio had been the most widely used parameter and many investors relied on it to determine whether a stock was overvalued or undervalued. However, Fisher thought that there was a major flaw in the utility of the PE ratio. The earnings or profits of a company can be highly volatile. The earnings of a good company do fluctuate from year to year.

A change in the accounting method can also turn one quarter’s profit into next quarter’s loss. While earnings can fluctuate, Fisher found that sales are more stable. He therefore advocated the use of price-to-sales (PS) ratio to analyze stocks. The ratio compares the total price or market capitalization of a stock to the total sales of the company.

Fisher’s rules of stock selection are as follows. Identify stocks with low price to sales ratio. Pick stocks with price to sales ration less than or equal to 0.75 in the current year. Also ensure that the total debt to equity ratio of the company shares in less than equal to 40%. The 3 year average net profit margin should be greater than or equal to 5%.

A low PS was obviously the first parameter for Fisher’s analysis. However, he warned not to rely exclusively on this variable. Terrible companies can also have low PS ratios because the market knows that they are facing financial distress. He applied several other fundamental indicators, such as inflation adjusted EPS, free cash flow and net profit margins to identify the winners. An unorthodox approach, but effective.

Stick with a strategy, even when it performs poorly relative to other methods – James O Shaughnessy, Chairman & CEO, O’Shaughnessy Asset Management

James O’Shaughnessy is a firm believer of the buy-and-hold approach, but unlike Buffett, he doesn’t hold stocks for several years. Instead, he holds them for a year and then rebalances his portfolio. By doing this he makes sure that he does not hold the stocks that do not match his criteria.
His strategy is actually a combination of Cornerstone Growth Model & Cornerstone Value Model. In order to identify stocks using the Cornerstone Growth model, Shaughnessy targets large-cap market leaders with above-average sales. The next step is to calculate the number of outstanding shares of the company and the sales revenue of the company. Both of them should be more than the market average, and then he checks the cash flow of the firm. The higher it is, the better is the firm.

Under the Cornerstone Growth model Shaughnessy’s rules of stock selection dictate that first we should look for midsized stocks (mind it, large capitals and midsized stock) . Their Earning per Share (EPS) should’ve risen consistently over the past 5 years. Their price to sales ratio should be less than 1.5.

Under the Cornerstone Value model his rules dictate that one must look for large capital stocks. The cash flow per share and outstanding shares should be greater than market average. Also one should ensure that the previous 12 months sales of the firm are 1.5 times greater than the market average.

Once the stocks are passed through the filters, they are ranked on their dividend yield.  He found that dividend yield was an excellent predictor of success. Large-cap stocks with high dividend yields outperform during bull runs and don’t fall too much during bear phases.

The Cornerstone Value model looks at stocks with low price-to-sales (PS) ratios. Shaughnessy looked for stocks with a PS ratio of less than 1.5. To avoid weak stocks, he applied the earnings criteria. According to him, the EPS of a stock should have consistently risen in the past five years. Finally, he ranked the stocks that passed all other criteria on the relative strength that measures how a stock has performed on price compared to all other stocks over the past 12 months.

Shaughnessy asserts that the more one trades, the higher the chances of loss. Therefore, have a strategy and stick to it.

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