6 posts tagged “master list”

Yield

There is a widespread belief that a corporation's growth is enhanced by a low dividend payout, based on the logic that the money not paid out in dividends can be reinvested in the corporation thereby facilitating its expansion. This is logical and essentially true, but is not as important as many believe. As we will clearly demonstrate in a later discussion of actual results, the total return (capital appreciation plus dividends) of the stocks on our Master List is about the same irrespective of perceived growth rates.

We like money in any form, and if it happens to come from dividends, that's just fine. In fact, it is so fine that dividend yield can be valid stock selection factor all by itself.

The problem with selecting stock simply on the basis of the highest dividend yield is that dividends (as with earnings) are not constant. A fat dividend yield could suddenly go poof if the dividend is lowered or omitted. This risk is reduced by the construction of the Master List, which attempts to confine interest to issues of demonstrated superior fundamental quality, affording both above average dividend protection and dividend growth.

In employing this method of stock selection, all you need to do is, at the time of a buy indication, review the Master List and select the issues that have the highest dividend yield and that have experienced a price decline over the chosen comparison time period. In the publication of this type of portfolio modeling, the Report uses a four-week price comparison to match that associated with the primary criterion and several of the ancillary criteria. As previously discussed, the actual time periods compared depend on individual preference.

Price

Although most elements of the financial media and analytical community are quick to dream up reasons to justify any price change, the fact is that many price shifts have no fundamental basis and are simply natural imbalances in demand/supply. Since our objective is to buy low and sell high, it seems logical to review the Master List at the time of a buy indication and select the issues that have experienced the sharpest percentage price decline over the chosen comparison period. This percentage price shift is so significant that price change in itself can be considered a valid method of stock selection.

In the published portfolio modeling, again using a four-week comparison period, at the time of a buy indication the issues on the Master List are reviewed to isolate those that have experienced the greatest percentage decline. Those issues that are down the most are chosen for purchase.

Again, the importance of the Master List comes into play. If a corporation turns into garbage, its stock is going to go down. If a corporation reaps fantastic profits, its stock is going to go up. In such instances, the price changes are the result of not a basic demand/supply price dislocation creating over/under valuation; the price shift is based on true underlying fundamentals. The Master List's design is to confine interest only to those issues of demonstrated superior fundamental quality, thereby allowing clearer focus on price changes that are not related by true underlying fundamental change. In other words, the Master List is a conscious attempt to isolate stocks that become more attractive as their prices drop.

Oversimplification?

The initial reaction to determining specific stock selection by these three methods might be that it is too simple to really be valid. No complex mathematical formulas are involved. There is no need for computer assistance. Neither is there a need for a staff of analysts or heeding the predictions of puffed-up gurus. And there is not even any need to pay much attention to the financial media beyond acquiring the necessary data to determine if a buy/sell point has been established as well as the specific stocks involved.

The fact of the matter is that we have found the market to be quite simple. It is often presented, and consequently perceived, as complex, but we have found its core to be nothing other than a straightforward, repetitive, man-made business.

Recognizing this basic, underlying simplicity and comparing it to the rantings of many analysts and media sensationalism, you can gain insight as to why the simplicity is widely overlooked by the majority and always will be. The majority within the analytical community will always attempt to present a reason to justify any price change, after it occurs, in the context of the reasoning being most easily accepted by clientele. Because of the assumed, widespread belief that all price changes are based on fundamental change, the consensus among analysts repeatedly ignores structural and/or psychological pressures that can create prices that are extremely divergent from underlying fundamental norms.

To understand how an erroneous consensus can develop, place yourself in the position of an institutional analyst, keeping in mind that job preservation provides some nice things, such as food and shelter. Now let's say the market makes a significant move because of psychological and/or structural pressures that move prices well away from underlying fundamentals. You are asked to explain why. If you say you don't know, you look stupid to clientele (after all, you are being paid to know everything), and you risk loss of employment. Your image, as well as your future, might very well depend on providing an answer that is most easily accepted by your clientele, which have been conditioned by you and/or other analysts to believe that every price change is justified by a purely fundamental factor. Looking about at what the other analysts say is the cause of the price change, you simply repeat what they are saying and join the consensus. You are one of the group. Even if absolutely wrong, your retaining employment is enhanced because you are in full agreement with your peers (they can't fire everybody).

The sentiment among analysts is reinforced by most elements of the financial media which (in its attempt to generate sales) stresses uncommon events.

The sales structure of the securities industry is also a powerful force that is bolstered by the consensus among analysts and concentrated media attention. It is elementary logic that a sale is made easiest when the customer is predispositioned to making a decision.

The consensus among analysts plus media concentration plus the sales structure of the securities industry combine to create tremendous pressures that can make the exception appear to be the rule. Consequently, chasing price after the fact of price change creates a lure that ignores the market's underlying simplicity. It also ignores the basic logic that profit. ability requires being properly positioned before the fact of price change.

Keep in mind that our stock market participation is limited to the very select group of stocks on our Master List. In effect, we are dealing in our market within the overall market.

At any given time, each stock on the Master List will vary as to its relative over- or underpricing when compared to the others. When a buy indication occurs, we do not want to buy the entire list. We want to choose from the list the specific issues that appear to provide the highest probabilities for appreciation.

To accomplish this objective, as well as to demonstrate valid factors that can be utilized in specific stock selection, three separate methods (earnings, yield, price) are incorporated into our portfolio modeling and each method is followed in detail in the published weekly Report.

Earnings

The most fundamental value of most corporations is earnings, which can be measured relative to stock pricing by the price/earnings ratio. The higher the P/E is, the higher the relative pricing. Conversely, the lower the P/E, the lower the relative stock pricing will be.

Lagging P/E ratios (the current stock price divided by the last full year of reported earnings) are provided in the daily stock quotations published in most major newspapers.

The problems associated with using the published P/Es are twofold.

1. The earnings of most corporations are erratic and basically unpredictable. What looks like an attractive low P/E could suddenly skyrocket with lower earnings. To overcome this, one of the conditions for inclusion on the Master List is an established record of earnings predictability. Only by confining interest to stocks with demonstrated earnings predictability can the P/E selection method be viable.

2. The published P/Es are associated with past earnings and earnings change. This is why we use earnings projections that are somewhat time-consuming to generate. To repeat, although we continue to use earnings projections in our P/E selection technique, over the many years of this technique's publication there is not a significant difference in the results obtained using either lagging earnings or projections.

Having made a reasonable attempt to overcome the obstacles associated with P/E valuations, our objective during buy indications is to purchase issues that are trading at the most attractive (lower) P/Es. Each stock on our Master List has a history of P/Es; that is, the past P/Es are available, and you can see the high and low P/Es (the P/E range) that the stock has experienced. We go back seven years in determining the range.

Not all stocks or stock groups trade in the same range. Stocks that are viewed as having superior growth will trade in a higher range than those viewed as stodgy.

During a buy indication, we want to purchase issues that are trading in the lower portion of their P/E range, thereby providing higher probabilities for appreciation than those that are trading in the upper portion of their range.

In the published portfolio model concentrating on the P/E method, generally, during buy indications, a wide variety of stocks with different P/E ranges are selling at a similar low level. Since only a very limited number of stocks are selected, a mechanical technique to determine which issues are selected from among those in similar P/E ranges is employed. You simply select those with the lowest P/E, irrespective of the range. Consequently, this selection method tends to concentrate in low-P/E stocks. In addition to the selected stocks being in the lower portion of their P/E range, they must also be selling below their price four months ago.

Everyone wants a system, and there are hundreds of analysts who clamor for attention as they lay claim to having found the fail safe road to riches.

Mastering the market through hindsight is easy. Just look back at what has occurred, copy the consensus, or make up your own reasons why the price changes occurred, and, presto, you have a foolproof system. The process of developing "the great system" is therefore fairly simple. Sift through the mounds of data the market has accumulated throughout its 200-year history and see what would have worked. Then, going back over the data, tabulate the results and claim that, because this is what happened in the past, it will surely repeat in the future. You can then claim to have achieved the past results.

This is a very common practice among system seekers, and in some cases the underlying analytical search is valid. However, in most cases the discovered system is nothing other than what would be a normal bell- shaped curve created by random results. In other words, something can be derived that looks wonderful, but it is really only a random variable that has no real validity in future investments. Another thing about this group's "discoveries" is that they almost invariably point to results obtained in hindsight. They are concerned in proving their merit by listing what could have happened after the "system" was discovered. They did not acquire their results through real time foresight by making their forecasts known and presenting them in a format prohibiting any form of hindsight or omission.

This lack of foresight is extremely clear when you take a careful look at the hundreds of entities (ranging from independent analysts to brokerage firms, to pension funds, to mutual funds, to anybody else wanting to manage others' money). They all claim they can do it better because they have the best system, when actually their results are a function of hindsight or tainted by selective memory loss.

The line of system sellers is dramatically shortened when confined to those who have documented results that eliminate any possibility of hindsight or omission. Some entities (such as mutual funds) are forced into full disclosure (and by their results most would probably prefer otherwise), but most system sellers have not really presented their work in a credible format requiring documented foresight.

Our concern is with reality, not hindsight or hypocrisy.

The Time Overlay Concept

Keep our objective in mind: to extract profit from the stock market through the buying and selling of common stocks. Although risk can never be eliminated from stock market participation, the goal of profit consistency requires that a conscious, rational effort be made for risk minimization.

Beyond developing a realistic understanding of the nature of the market, our risk minimization involves two distinct, specific elements. (1) We want to confine investment interest to stocks that are of superior fundamental quality and that therefore are less likely to present any nasty fundamental surprises. (2) We would prefer to have the overall movement of the market on our side by means of a market timing technique.

By confining our interest to the Master List, it is helpful to reinforce the concept that we are dealing with a market within a market. At any given time, each individual stock we monitor will vary as to its over- or underpricing with the others in the group. At the time of a buy indication, we only want to invest in the issues on the Master List that appear relatively discounted to the others. In effect, by being so selective we are employing an aspect of market timing through our selection process.

Relative to overall market timing, we will not buy or sell in the published portfolio modeling unless the primary and ancillary criteria are in agreement. Although the stocks on our Master List generally parallel the major market averages, because of the small number of issues we monitor, it is possible that our list will not always be directly aligned with the popularized averages.

Our method of participation involving market timing involves two distinct and separate analytical elements: specific stock selection and market timing. We term this combination Time Overlay: one analysis combined (or overlaid) with another analysis.

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:

1. 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.
2. 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.

1. In an attempt to eliminate the effect of extrinsic factors, our Master List criteria stress predictability and quality. We are not part of corporate management. We cannot make corporate decisions. The fundamental activities of the corporation are not within our direct control.

We do have some control over intrinsic factors, those that determine stock price change because of market structure. As market participants, we must compete and (hopefully) profit within this inner world. By attempting to confine interest to corporations with demonstrated predictability, we have some assurance that matters beyond our control will not catch us unexpectedly. We can therefore concentrate attention on those aspects over which (by our actual buying and selling) we do have some control, including discretion as to whether we will even participate. As functioning professionals, we exist in the market, not within the corporations whose stock we are using to acquire profit.

The result of this reasoning is that we are involved with stocks whose prices are more a function of the market than a function of some particular corporate event that may (or may not) occur. Since corporations have been selected on a basis of both earnings predictability and earnings growth, the unexpected has been minimized. Price changes of the stock, therefore, will be more affected by overall changes in the market than by events within the corporations themselves. Consequently, the benefits associated with market timing become more easily attained.

4. As the investor may perceive, by limiting our interest to the Master List, we are shifting the entire investing situation to our favor. The variables that concern us most are those involved with internal market structure. Since we have a reasonable understanding of the earnings and dividend traits of our stocks, we can easily evaluate them as reasonable or unreasonable relative to market price.

As a result, we can do two things. First, we can make a disciplined determination as to which individual stocks appear relatively over- or underpriced, thereby allowing us to concentrate on the undervalued stocks as buying possibilities and the overvalued stocks as potential selling possibilities. Second, by determining if the entire list is overpriced or underpriced, we can develop a method of market timing. Both facets (relative positions within the list and the relative position of the list as a whole) are interrelated. The combination of the two (Chap. 9) forms the basis of Drach Market Research as being able to predict price change with an accuracy of 95+ percent for specific common stocks over many years and in a wide variety of market conditions.

The value of confining interest to stocks appearing on the Master List, therefore, goes far beyond the rather simplistic criteria used in the List's construction. We not only have concentrated attention on specific potential investments, but have taken an important step in constructing a method of market timing. The timing aspects are not limited to common stocks. They can be applied to a variety of investment types including closed-end funds.

Condensing the List

The more stocks there are on the list, the higher the probability of success, simply because of the greater number of individual stocks from which selections can be made. However, the list can be substantially reduced without any significant loss of accuracy. For those who desire to work with fewer stocks, the elimination of specific issues depends on individual investor's circumstance.

For U.S. investors, Canadian issues may hold disadvantages because of the added taxation on dividends and potentially added costs/risks associated with currency exchange.

If you do not work closely with over-the-counter stocks, the sometimes excessive spreads, the possibility of double charging (commissions plus markups/markdowns), the lack of accounting for order priority, and other factors can make this market less desirable than listed stocks.

This leaves the New York and American Stock Exchange issues. From these, the process of elimination becomes one of personal preference. If you do not like the name of a corporation, never heard of it, dislike an industry, then go ahead and scratch it. Throw darts. Let the kids decide. It is a matter of whim because the criteria used in developing the list are such that it mathematically makes little difference in the long term which stocks are selected.

Only two things must result after this condensation.

1. The list should contain a minimum of 20 issues.
2. The list should not be altered except to more issues from the Master List. No subtractions should be made unless they have been deleted from the original Master List. To do otherwise injects after-the-fact emotion, which can seriously detract from the probability of success and effectively destroys objectivity.

Whether you choose to follow all stocks or the minimum, the most important aspect is clear recognition that this is now your market. The principles and methods can be employed with the stocks selected.

Expanding the List

Some investors might feel that condensing the entire market to under 100 individual stocks is overly restrictive. Others might feel that the list should be altered to more closely duplicate the specific stocks comprising popular averages.

The statistical fact is that, in our method, the addition of issues that fail to meet the fundamental quality standards results in a net loss of accuracy as to both the percentage of individual positions including profitably and annualized return.

Changes in the List

Although additions and deletions to the Master List are rather infrequent, over time the list does change. Takeovers, buyouts, mergers, and the loss of fundamental quality reduce the number of acceptable issues, while the list can expand via corporations establishing the characteristics required by our criteria.