3 posts tagged “selection”

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.

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.