4. Watching for Ex-Dividend Dates.
Dividend payments, which are not considered in the published results, are an important source of income.
It is a general assumption that, when a stock goes ex-dividend (the day after those who hold the stock are entitled to the next dividend payment), the value of stock is reduced by the amount of the dividend. For example, if a stock's price is $40 and it pays a dividend of $1, at the time of the ex-dividend date the inherent value of the stock is reduced by the dividend amount $40 — 1 = $39.
This reduction in the stock's market price is logical. In our example, the corporation paid out $1 of its value and the corporation's worth is reduced accordingly. This is even accounted for in stock quotations. As in our example, if the stock closed at $40 the day before the ex-dividend date and closed the next day at $39, its day-to-day price change would be printed as no change.
Our experience with the stocks we monitor has been that, in depressed conditions (when we often are doing our buying), the market price of the stock does not always descend by the amount of the dividend payment. Our reasoning as to why this occurs is purely theoretical. We suppose that, because of the superior quality of the issues on the Master List, during depressed market conditions when many people are frightened, there is a "flight to safety," which can function to prop up our stocks. In other words, buying demand picks up in our stocks relative to the broadly based market because of their image of safety created by their demonstrated fundamental quality.
For whatever reason, when two stocks appear equally attractive for purchase, some advantage in total return can often be achieved by selecting the one with the nearest ex-dividend date.
5. Combining the Time Overlay Models.
The three methods of specific stock selection (earnings, yield, price) function independently. One of the reasons for this is academic—to demonstrate that each method by itself is valid in determining stock selection.
In the actual implementation of the Time Overlay modeling, we have found that better results can be obtained by concentrating purchase on stocks that qualify best in all three categories. For example, a stock may qualify very well for the yield method, but may be well down the priority list in the price method. In combining the methods we do not take the average of a stock's rank in each category, which might appear to be the most logical approach. The reason is that there is too much weighting to the earnings and yield selections which often overlap. What we do is rank each stock for each method and then take the lowest rank for each issue. Then, we concentrate on the stocks with the highest low rank. To date, we have found that this combining can add to both profit consistency and expanded return.
6. Loss Reduction.
As previously discussed, the weekly Report, which applies the Time Overlay portfolio modeling to current market conditions, functions in a purely mechanical format. There is no allowance for subjectivity because it could function only to invalidate the results.
The losses, which at the time of this writing comprise only around 4 percent of the concluded positions, are often forced because of the mechanical structure, and we have found that this losing percentage can be significantly reduced.
Keeping in mind that the Report's structure only allows for changing positions in the model portfolios during outright buy/sell indications, recall that losses occur for two reasons.
At the time of a sell indication:
- The specific stocks selected for sale to reduce investment level appear the most overvalued relative to the stock selection method but still might return high probabilities for future appreciation.
- The stocks have been deleted from the Master List, which causes them to be sold first irrespective of their ranking when compared to the other holdings.
When incorporating rotation, quite often when a stock has been deleted from the Master List, it will have already been sold profitably between the predetermined buy/sell points in the published portfolio models. In other words, the published models are holding the position because an outright sale indication has not occurred, but the rotational application has sold the position profitably and now will not repurchase the stock because of its elimination from the Master List.
The Master List is extremely selective, and sometimes a stock is deleted because of only a very minor change in underlying fundamental quality. In fact, in some instances a stock can be kicked off the list briefly for a closer look at its condition and then be reinstated, in a sort of probationary period as its quarterly Report is reviewed. Under these circumstances, there is no reason to abandon the stock even though the Report's mechanical modeling will automatically kick it out. In actual theory, we will retain the stock as a holding (but not purchase any more of it) when it is close to qualifying for the list and compare it to the others when selling as though it still qualified for the list. This is significant in eliminating the forced sale effect.
We will not, however, wait forever for a stock to remain in a probationary phase. If the stock has not requalified for the list after two consecutive quarterly Reports, we will sell it.
Note that, of the very few positions the mechanical structure of the Report sold at a loss, 75 percent have so far subsequently doubled in value after being sold from the Report's selling price. In our own experience in actual Time Overlay portfolio management, which has involved many times the number of individual stock positions in the published models, at the time of this writing we have experienced only 12 losses, and most of those have been minimal (less than three points).
Although we find the basic Time Overlay method satisfactory in achieving our objectives of profit consistency and return, several factors can significantly increase return in actual market endeavors.
1. Rotation.
The published models are very strict. They will only change positions during outright buy/sell points that can only occur on the Report's publication date. The models completely disregard price movements between the predetermined, published mechanical buy/sell periods. Almost invariably, better prices are available at times other than the instant of a published buy/sell indication.
We know, by the results derived over the many years of the modeling's publication, what the average percentage return per position is by strictly adhering to the published buy/sell points. We also know that each stock selected has an equal chance of concluding profitably irrespective of price fluctuations between the predetermined buy/sell points. If we can get equal or better prices than those of the published models between buy/sell points, there is no reason not to capture gains before an outright sell signal.
Knowing that prices fluctuate, we can attempt to take advantage of the intervening price movements by rotating our positions. For example, let's say there is a buy indication and two stocks (A and B) appear equally suitable for purchase, and both are selling at 20. We purchase stock A. Rather than wait for a sell signal, we decide that we will take our profit if we realize a 10-percent gain. The 10-percent profit would capture a return greater than that averaged by the published models for individual positions. (Any parameter can be used, it is a matter of personal preference). Now, let's say that our stock (A) advances to 22, meeting our 10-percent objective, and that stock B has stayed at 20. We do not want to reduce our investment level because there has not been a sell indication. We sell stock A, taking the profit and move to stock B. Then, let's say stock B goes to 22 providing us our 10-percent profit, and stock A has fallen back to 20. We sell stock B and rotate back to stock A, and so on, until there is an indication to sell out entirely and/or reduce the investment level.
In actual managed accounts, the rotational process is utilized and, to date, without exception accounts incorporating rotation have outperformed the published Time Overlay models. During exceptionally volatile periods, the incorporation of rotation can create very active trading. However, during such periods and/or during extended market cycles, the use of rotation can dramatically improve results.
2. Optimizing Rotational Selections.
In the previous rotation example, the rotational selections were made from stocks selected at the time of buy indications without consideration of the other issues on the Master List.
This is an unnecessary constraint. It is possible that, at the time a purchase is warranted because of a rotational sale, there might be a stock on the Master List that is a better bargain than any of those selected at the time of a buy indication. In actual rotational trading, we move to whatever stock appears most undervalued from all those on the Master List, irrespective of whether they are being held as open positions in the published modeling. This wider selection generally expands return.
3. Delaying Buying.
The published modeling is designed to be early. That is, lower prices are available after buy indications and higher prices are available after sell indications. As discussed, this is necessary to assure that compensation has been made for transaction costs and to provide sufficient price latitude so that the method can be duplicated in actual trading.
At the time of a buy indication, each specific stock selected has an equal chance of concluding profitably. Price fluctuations between the predetermined buy/sell points are of no concern to the strict models because nothing is going to happen between the buy/sell points.
Price fluctuations (both up and down) between the predetermined buy/sell points can be significant and, since each position has an equal chance of concluding profitably, there can often be some advantage in waiting until after a buy signal and then selecting issues that are demonstrating relative discounting. For example, let's say that there is a buy signal and two stocks (A and B) are selected, each at a price of $20. Instead of buying one immediately, we wait and see that stock A is remaining at $20 and stock B has declined to $18. We then buy B because it is relatively discounted, having an equal chance of being above its initial published purchase price as does stock A when specified to be sold.
In our real time application of the Time Overlay portfolio modeling, we do not wait until after a buy indication to begin expanding the investment level. Although better prices become available after the buy indication, we usually get them anyway because of the rotational aspects. In fact, because of the rotational advantages, we are often a bit more aggressive in our investment level than the Report. However, for those wishing to avoid the sometimes rapid trading associated with rotation and/or the added analytical time, delaying buying and emphasizing the most discounted issues can often significantly increase return.
The proponents of LBOs, usually the managements involved and those who are paid fat fees to construct the deals, point out that shareholders benefit by getting to sell their stock at a substantial premium relative to what the stock would be worth if there was not an LBO offer. They also point to somewhat hazy theoretical benefits including (but not limited to) concepts that the nonpublic corporation will be more competitive and thereby benefit the economy as a whole. In addition, they contend that those who provide the financing (usually through junk bonds) are pro. vided higher interest rates than they could otherwise obtain.
Critics of LBOs contend the only true value is to those who construct the deals and the management that takes over the corporation, in that they are provided very large profits with relatively low risk. They maintain that the added debt burden to the corporation detracts from its financial stability, using the high default rate of junk bonds as proof. Their criticism also includes a couple of accusations: For one, the junk bondholders are not properly appraised of the risk involved. Also, when banks are involved in the financing, the taxpayers (because the bank's deposits are insured by the federal government) are subsidizing a process that does nothing except make a select few enormously rich and destabilize the overall economy, as the U.S. savings and loan debacle clearly attests.
Irrespective of the arguments, one aspect is clear. The managements who are buying the stock from stockholders (the owners) are, in effect, competitors thinking they are buying the stock cheap (at least relative to their risk). Otherwise, why would they want the stock all to themselves? Our main point is to demonstrate that the objectives of management and shareholders (for whom management presumably works) can often bedivergent and directly competitive.
Corporate Raiders
Corporate acquisitions can take one of two forms: friendly or hostile. In riendly arrangements, the buyer and the corporation to be acquired agree
on the terms involved and all proceeds (usually) rather smoothly. In hostile situations, the management of the corporation resists the buyer's actions. The buyer in such instances is usually termed a raider.
For a variety of reasons, including the possibility of loss of employment, managements do not like raiders. They want the raider to go away. To entice the raider to leave, they may offer incentives, such as buying the raider's stock in the corporation at a price significantly above the free market price, providing the raider high paying preferred stock/bonds, or any other enticement that leaves the raider with a profit sufficient enough for him to promise not to return. These payments are called Greenmail. In a greenmail arrangement corporate management has paid off the threatening party without the permission of shareholders (or owners). The shareholders have not even been given the choice as to whether they want to take the raider's presumed offer.
Thus, once again, corporate management and shareholder objectives can diverge and, in effect, place management and shareholders in direct competition.
Some raiders have perfected their activities to an art, getting paid off repeatedly without ever really making a serious attempt to takeover the "threatened" corporations. Other raiders have been known to buy stock in a corporation, then announce (or imply) that they might takeover the corporation at a price higher than the current market price. Speculators might rush in and push the stock higher. The raider then "changes his mind" and sells his stock into the buying demand (higher prices) created by the speculation. Such activities turn ethical stomachs. They are mentioned to reinforce the true nature of the market, which includes avoiding the assumption that corporations are automatically investors' friends.
Taking a Corporation Public
In taking a corporation public, instead of management buying stock from the public, it is selling its stock to the public. The sale may take the form of new stock issues, selling stock held previously taken private by means of LBOs, or simply large blocks of stock held by management in corporations already trading publically. Whatever the form, the implication is clear that management is selling because the price of the stock is too high. Again, the managements of corporations so involved have placed themselves in direct competition with other investors.
Avoiding competitive abuses from corporations entirely is not possible. Slimy types have been known to work their way to the top of some of the finest corporations. Once identified as the unethical types that these individuals almost always are, they can be avoided by staying away from the corporations with which they are involved. To reduce the possibility of being victimized by unscrupulous corporate managements, we confine investment interest to the issues that meet the selection criteria where shareholders concern plays an important role.
Stock Splits Versus Stock Dividends
Many texts and financial publications differentiate between stock splits and stock dividends. There is no real difference. Stock dividends are nothing more than small splits. For example, if a corporation has a
3-percent stock dividend, someone with 100 shares would be issued 3 (or 3 percent) new shares.
Almost all articles state the reason for stock splits and stock dividends is so that the stock will be at a lower price level, which makes the stock attractive to a wider range of investors. Because of wider appeal, the assumption is that the stock's price will be more easily supported and consequently will rise more easily. Although this theory might get nods of approval in ivory towers, in the actual market it is not always true. In fact, many stocks literally get smashed after stock splits. This is because of a combination of naive investors bidding up the price too high in anticipation of the split, and professionals shorting in the knowledge that the price is inflated because of irrational buying demand.
The most important realistic aspect of stock splits to corporations is thatthey increase the number of outstanding shares. The more outstanding shares there are, generally the more trading and eventually the moreshareholders. The more shareholders there are, the more difficult their communication with each other and thereby the lower the chance of a concentrated effort by shareholders to oust management. The end result is to make management more secure in its position. This can effectively place the management in a situation of perpetual control, without its ever owning any of the corporation's stock.
Insider Trading and LBOs
New issues and stock splits are the result of overall corporate policy. Competition from corporations can also be from individual officers and directors who have access to information concerning the corporation thathas not been made available to the public—an obvious advantage. Those having such positions within a corporation are called insiders.
The existence of illegal insider trading abuses is obvious, as demonstrated by publicized arrests and indictments. However, the large majority
of corporate insiders (probably) adhere to the law and report their buying and selling to the Securities and Exchange Commission, which is required in an effort to ensure they are not basing their decisions on information not available to the public. These reported trades (often after a significant time lag) are available to the public and provide the basis for a wide range of analytical methods and financial advisory services.
The reasoning behind monitoring reported corporate insider trading is simply that the group's knowledge of corporate events will result in their trading being profitable. Studies indicate that this assumption is basically true. However, the results of these studies of reported insider trading fall well below those considered acceptable by the methods. Insider theories fail to provide acceptable results apparently because the insiders themselves do not understand the market as well as they should. (The topic of corporate insiders is expanded on in Chap. 6.)
The most notorious abuses of insider information (by both corporate managements and others) involves mergers and acquisitions, primarily leveraged buyouts (LBOs). The term leveraged buyout simply means that leverage (or borrowed capital) is used to buy the stock of so many stockholders that the corporation involved is no longer public. Control is transferred to a relatively few individuals who have arranged through borrowing, to purchase the stock. The process is often described as taking the corporation private.
Because of the large amounts of money involved, the fees paid to those who construct the LBOs (although usually a small percentage of the total) can be huge with relatively minor risk. The buyers often include members of corporate management, who also stand to profit dramatically with very little risk. The risk is taken by those who put up the borrowed money to effectuate the purchase of the stock.
To entice shareholders to sell their stock to the LBO group, the buyers will offer a price that is at a significant premium above the usual market price. Those involved in the LBO know that a higher price is going to be offered before there is public announcement. In the United States, trading stock with such insider knowledge is illegal. However, a large number of people are involved. Corporate managements, lawyers, bankers, underwriters and their staffs are aware that a higher price is going to be offered, and the temptation to cheat is obviously great. By buying the stock before the announcement of a higher price is made, huge profits can be obtained with minimal risk. As a long list of arrests and convictions, involving hundreds of millions of dollars in illegal profits (most taken from ethical shareholders), clearly demonstrates that such insider trading can be pervasive.
Corporations Role on Stock Market
Most of the investing public fail to view corporations as direct market participants. They usually assume that the relationship of a corporation to the trading of its stock is an arm's length situation. The corporation, they reason, is consumed by business activities, and the stock exchange is independently judging the relative merits of the corporation's activities.
Yet corporations and the stock market are intertwined on both a theoretical and practical basis. It is widely presumed, and generally true, that the goals of the corporation's management and the stockholders are identical: to maximize the corporation's profitability and consequently to optimize the value of ownership (that is, the common stock). Corporationsare established because of money and the stock market is established because of money.
However, in some instances the objectives of management and stockholders conflict. In these cases, the corporation is both a direct market participant and a direct competitor.
The Dangers of New Issues
Such a conflict is clear, for example, when corporations offer new issues of stock during seller's markets.
The sale of common stock allows access to money without any guarantee it will be returned, and without having to make interest payments. In effect, it is a source of cheap capital. Many corporations, keenly aware of stock market activity, have a genuine desire that their stock command a high market price. The more people are willing to pay for the stock, the higher the (paper) valuation of the entire corporation and the more money available through the sale of new stock.
Thus, when the market is high and a euphoric atmosphere prevails, corporations (both new and established) will come to market to sell new issues of stock. In effect, they are taking advantage of the elevated stock pricing to generate more money through the sale of new stock than would be available if stock prices were lower. In other words, they are selling high—to the corporation's owners!
This type of corporate activity is usually a clear warning signal of impending decline. The corporations, by rushing to sell themselves through new stock issues, are effectively advertising that stock prices are too high. Yet few investors heed the warning. On a more elementary basis, the new corporate stock offerings are increasing the supply of stock and dissipating buying demand over a larger number of shares. Both factors add to a curtailment of price advance and a consequent lessening of buying demand, with the eventual result of supply outweighing demand, causingprices to decline.
Stock Splits
Corporations might also take advantage of high prices with stock splits. The effect of a stock split is simply to expand the number of outstanding shares. Although attractive to naive investors, the effect of a stock split is usually meaningless to the real value of the stock.
For example, let's say a corporation has 1000 shares outstanding and earns $4000. The earnings per share would be: $4 per share.
Now let's say there is a 2-for-1 stock split. The company exchanges two new shares for each old share. The per share earnings change to: $2 per share.
The end result is that the investor has twice as much of what is worth half as much. In other words, if the stock was worth $50 per share before the2-for-1 split, it would be worth $25 per share after the split with twice as much outstanding stock.
The stability factor can be clearly demonstrated in open-end mutual funds where the investors can add money (that is, buy mutual fund shares) or withdraw money (through mutual fund redemptions) at any time. Mutual fund sales are highest during periods of euphoria when the public's greed has been stimulated after seeing stock prices advance significantly. The fund manager is forced to invest the monies coming in because that is what those investing expect. In effect, the manager is being forced by the institution's structure to buy at high prices. When prices falter and the investors become fearful and/or disgusted, they want to redeem. To meet the investor's demand for cash, the institutional manager is forced to liquidate stock positions at low prices. In effect, through no fault of personal investment ability, the manager so placed is forced to buy high and sell low—the precise formula for disappointment. Even without net redemptions, this basic problem is further compounded by the fact that there is more money to be invested when stocks are overpriced than when stocks are underpriced.
The Sheep Syndrome
Irrespective of the stability aspect, almost all institutional managers are under pressure to achieve acceptable relative performance. That is, the manager does not want to look bad when compared to other managers. This results in what we term the "sheep syndrome," which is the predictable herdlike behavior of the majority of managers who make identical judgments as to their movement into, out of, and within the market. As with their animal counterparts, those who stray or straggle behind are easy targets for the crafty predator. And the herd itself, relatively defenseless because of predictability, has no great strength in numbers when attacked.
To understand this phenomenon, try to empathize with the institutional manager. He or she has certain goals and needs, among which survival through job preservation is of prime consideration. Most portfolio managers, although tending to exhibit little individuality, believe themselves to be in a very competitive environment and are keenly aware if they are over- or underperforming their peers. As long as everyone is doing about the same thing, the status quo is maintained and all proceeds relatively smoothly. The manager who does not stay with the crowd is easily singled out and comes under the scrutiny of others. The manager who demonstrates exceptionally profitable performance has effectively shown up the others and, as a result, may be resented rather than applauded. A manager who underperforms only draws attention as being inferior to the crowd.
In the market, it is mathematically impossible to be correct all the time. Therefore, when a maverick manager (even though consistently doing better than others over time) does make a mistake, it attracts inordinate attention. The result can be analogous to a baboon like cuffing when one of the adolescents gets out of line. In a more civil context, it is peer pressure. This pressure can intimidate a manager into thinking that the investing public is focusing attention on the error and into magnifying the imagined detrimental effects to his or her image.
This real and/or supposed pressure can make even the most original manager fall into line with the others. In other words, the manager may be forced into what may be considered a herd of other managers. But not all managers choose the herd because of peer pressure. It is also a convenient place to disguise incompetence or lethargy. Just do what the others do and you will never be singled out as less capable. This also reduces the possibility of being disliked, which enhances the chances of obtaining alternate employment if it should become desired or necessary.
Our observation of the effects of peer pressure among institutional managers is far from theoretical. It is not unusual to see institutional managers have their personal funds managed under strategies far different from those employed by the institution itself.
This group consists of pension funds, mutual funds, mutual insurance companies, bank trust departments, brokerage firms that accept discretionary accounts, and any other entity that invests monies on behalf of those who have entrusted their funds. The institution may use pooled monies (mixing together the monies of many different individuals) or invest for others on an individual basis.
There is a significant difference between institutional money management and most other professions. Doctors can (sometimes) bury mistakes. Attorneys can befuddle their clients about why their case was lost. Administrators can attribute mistakes to staff. Politicians can cast blame on predecessors. But institutional money managers have nowhere to hide: Either they have made money or they have not.
To check institutional results, all you need to do is see how the money under management performed relative to some predetermined standard, the most popular standard being major market averages. Many investors might be surprised that most institutions are unable to outperform the market and/or profit consistently.
This is not to imply that institutional managers are ignorant, for many of them are quite competent. The difficulties, even for the most astute manager, can be inherent in the structure of the institutions themselvesand the market.
The primary advantage of institutions is their financial power. Because of the large amounts of money at their disposal, their investment actionscan significantly affect the supply/demand balance and consequently price changes.
The Problems of Institutional Investing
This financial power can also function as a disadvantage because of a lack of maneuverability and liquidity. Dealing with large dollar volumes, institutions often find themselves with very large stock positions. When the time comes to sell, there might not be enough buyers to purchase the large amount of stock unless the price is lowered significantly. In such instances, institutions can be forced to accept lower prices when they sell. Conversely, when they buy, they can be forced to pay higher prices because of the large amounts of stock involved. Of all investor groups, institutions are the mostpredictable, and as such they are frequently preyed upon by true professionals.
In isolating the institutional characteristics that afford profit opportunity, it is possible to categorize institutions as to type (pension funds, mutual funds, etc.), ethical standards (high, low, none), investment strategies (fundamental, technical, etc.), method of funding (constant or variable), and taxation (immediate or deferred).
The institutional manager is, by definition, in the business of investing the monies of others and consequently is influenced by both the attitudes and actions of clientele. The source of the capital can have a significant influence on performance. The greater the stability of the funds that are being added/withdrawn, the easier the task of management.
In the middle to late 1980s, the restructuring binge financed by junk bonds resulted in many previously superior corporations degenerating to bankruptcy. Despite past records of earnings predictability and growth, we usually delete corporations that have restructured with excessive debt because they are less likely to meet earnings projections.
Inordinately high compensation (in the form of salary or options) to senior management and/or their families and friends is another managerial practice that can disqualify a corporation from our list of issues suitable for investment consideration.
Many corporations have various classes of common stock. The most important differentiations among the classes are usually concerned with rights involving dividends and/or voting. The various classifications are usually distinguished alphabetically—Class A, Class B, and so on. Note that alphabetical positioning is not necessarily indicative of the merit of the class of stock. For example, Class A may be nonvoting and Class B voting.)
Of particular concern is the restriction of the voting right and/or preferential right to dividends to a class that is not available to the public. This characteristic is usually found when a family or other tightly knit group is able to sell the public the lower classes of stock. The public is, in effect, capitalizing the holders of the preferential stock and accepting disproportionate risk. Although such "class" issues are defended rather vigorously, those most vocal in the defense are those holding the preferential stock.
It is a general policy of ours to disqualify such stock issues, but not because of the voting right. As discussed in Chap. 1, the vote is relatively meaningless to the vast majority of stockholders. Our objection is to the basic attitude of the issuing corporation. The motivation demonstrated by any corporation selling "ownership" (via common stock) and then not allowing the stockholder even the gesture of a vote, carries the implication of pomposity at best and hypocrisy at worst. Neither of these traits is desirable in any form and the avoidance of such issues is prudent.
Family-held/publicly-traded situations are similar to those involving stock classes, except that all outstanding stock has voting privileges and equal rights to dividends. The majority of outstanding shares, however, remain under the control of one family. Thus, nonfamily stockholders are effectively as powerless as if their stock has no voting rights.
Such circumstances, although quite common, are not an automatic reason to disqualify the stock issue from investment consideration. Almost all publicly traded corporations will eventually fall under the control of a few individuals whether or not they personally control the majority of outstanding stock.
Family-controlled corporations must, however, be closely monitored to isolate those instances in which management is passing from one generation to the next.
Managerial ability is not a genetic trait. Quite often, when the second and/or successive generations become dominant, the intelligence and drive that initially allowed the corporation to prosper tend to lessen. Another potential problem is sibling rivalry, which can result in effective stagnation of corporate growth.
In summary, the basic intent of our criteria is to select corporations that are stable and predictable. We want to minimize "surprise" from fundamental corporate events. By doing so, the process of actual market participation becomes greatly simplified because attention can be focused on intrinsic market mechanisms (timing and the other aspects of trading that are most affected by internal market structure).
Also important is the fact that our filtering process is a search for the quality of two elements: the corporation's business and its record in conducting that business, as well as the individual managers directing the corporation.
3. Dividend Protection and Growth.
Dividends play a role both in added income and in risk reduction. To maximize these benefits, a corporation's dividend policy must be established and stable. The decision as to what portion of earnings will be paid to shareholders in the form of cashdividends, relative to the amount retained to finance future corporate growth, must be reasonable.
A consistent dividend policy, providing adequate assurance that the dividend will continue to be paid (protection) as well as increase (growth), reduces the possibility of unpleasant "surprises." It also reduces the number of stocks we find suitable for investment consideration.
4. Liquidity.
One of the primary advantages of common stock as an investment type is maneuverability; theinvestor can buy or sell quickly with very low transaction costs. This ease of movement is termed liquidity.
Liquidity involves two elements, which vary as to the characteristics of individual stocks:
- The number of shares a stock trades daily. This is the standard measurement of liquidity. It is only reasonable to confine interest to thoseissues that provide sufficient trading volume so that orders can be accommodated without disrupting price.
- The "mix" of investors in the stock's market. To us, the liquidity factor also involves an aspect largely ignored in conventional analysis. Professional participation mandates the realization that success depends on the actions of other investors. It is only logical, therefore, that the more varied the market participants interested in a particular security, the more areas of potential profit.
We will detail that market participants can be isolated and categorized (public, institutional, market makers, etc.) as to their repetitive behavior, which can provide us opportunity. The more varied and abundant the prey, the easier the task of the predator. Consequently, our liquidity requirements provide a dual function in filtering for both the number of shares traded and the number of different participants. Accordingly, the list of qualifying stocks is decreased.
5. Shareholder Concern.
Unfortunately, a corporation's fundamental (earnings) success does not automatically translate into the success of shareholders. In a variety of ways, management can intervene to block owners (shareholders) from experiencing presumed benefits. Greenmail is the corporate acronym for blackmail. The usual form is a "hostile buyer" (supposedly independent of management) who purchases a relatively small amount of outstanding shares and then threatens to buy controlling interest. The connotation is that with such control it will oust current management and ravage the corporation's assets.
To avoid the greenmailer's threat (and retain their paychecks), a common reaction is for the management to deem it "wise" to buy the green- mailer's stock at a price above "market." That is, "pay off" the greenmailer at prices higher than those available to other owners (shareholders).
Although greenmail could conceivably be justified in some instances, in general we question the credibility of managers that engage in such practices, thereby disqualifying their corporations from investment consideration.
The capitalization structure of corporations (that is, the monies the corporation utilizes to fund its activities) involves two basic sources: equity (monies contributed by and/or earned for stockholders) or borrowings (debt). The capitalization "structure" is simply the ratio of debt versus equity.
To avoid "hostile takeovers," greenmail and other activities that could interfere with management's security, a popular maneuver is to restructure. The general pattern of restructuring is for the corporation to add debt to the point that the new debt load makes the corporation less attractive to potential buyers. The excessive debt has the net effect of reducing the corporation's fundamental quality, with the excessive interest charges detract from earnings and making it more difficult for the corporation to survive adverse economic conditions.
In our method of stock selection, we first determine which specific stocks warrant investment consideration. Qualification for consideration does not necessarily translate into actual investment. Consideration is only the first step. The actual implementation of purchase and sell decisions depends on a number of other factors which will be described after we have determined the general group of stocks we want to utilize. The qualification process is a filtering technique, through which thousands of different stocks are condensed down to a manageable number. This is not a hypothetical process. It is the actual method we use, and it is the basis from which our extraordinary high degree of accurate price forecasting was developed.
While very logical, the stock selection procedure is possibly too lengthy for the average investor. Do not be alarmed. After explaining the long method, we will describe a greatly simplified approach that is easy and quick, and that approximates the results of the longer method. The following lengthy explanation, however, is necessary for an understanding of the logic of the selection process.
The Criteria
The following qualifications are considered mandatory for the stock of any corporation to be of sufficient quality to warrant possible inclusion in our market strategy.
1. Earnings Predictability.
If you are involved in a serious hunt for a dangerous prey, your primary concern is the reliability and working condition of your weapon. Our weapon is common stock, and its specific selection is a serious (core) concern. The probability of error must be minimized to help assure survival.
Earnings are generally the most important factor in the value of a corporation. It was also mentioned that earnings generally are not easily predicted. Some corporations, however have demonstrated a consistent record of earnings predictability. Because of the existence of such corporations there is no need to rely on corporations whose earnings are less predictable.
As a rule, we consider the earnings predictability factor acceptable if the corporation has managed to meet earnings projections ±15 percent during each of the previous seven years. Disqualifying corporations that have not demonstrated a satisfactory past predictability as to earnings helps to eliminate fundamental surprises, as well as about 80 percent of all common stocks.
2. Earnings Growth.
Predictable earnings does not mean acceptable earnings. Because of the availability of corporations with demonstrated patterns of earnings growth, it is only logical to direct investment toward these issues.
The reason for this criterion is deeper than psychological reassurance. Corporations with demonstrated earnings growth get wider publicitywithin the investment community, and consequently they are considered for investment by a larger number of investors, both individual and institutional. It is from other investors that profits are taken. The greaterthe number and different types of investors involved, the easier the task of prey identification.
Keep in mind, however, that past earnings growth in itself is not enough. Future earnings projections must also indicate a pattern of growth. Themarket is most influenced by anticipation of the future. Limiting investment to corporations with both earnings predictability and earningsgrowth concentrates attention on quality, which can (but won't necessarily) help in supporting market price.
This earnings growth criterion generally halves the number of issues that were able to survive the test for earnings predictability.
