I love the field of value investing because it's one of the surest ways to make money over the long run. You put in a number of search criteria into a stock screener program, see the shares that come out, and then do your due diligence to rate the shares as to their future prospects, and then invest. Value investing is based on fundamental analysis, which takes into account earnings, PE ratios, and financial ratios indicating the company's value.
I add one rule to this set of value investing steps. Before I invest in a stock which came from a valuation screen, I check its Factor Seasonals for the probable low time of year and how it usually does in the current economic environments. Then I change my investment decisions accordingly. If you have any edge due to market timing, of course you would do this, and our seasonal analysis software provides the key.
I don't want to be getting in a stock near a seasonal top. Since value investing means waiting two or three years (Ben Graham often said that his records indicated that the interval required for a substantial undervaluation to correct itself averages approximately 1 1/2 to 2 1/2 years), getting in just this moment is not a criteria either since the stock can stay undervalued for a long period of time. Hence I can do my Factor Seasonal technical analysis and determine an optimum time to get in.
If the stock passed my criteria for value, that means it is depressed somewhat. In that case, I CAN DELAY MY INVESTMENT DECISION for a better price if my seasonal analysis suggests so since there is no criteria urging me to buy at the moment. There's always another stock, so don't force it.
Let's take two examples of value investing criteria to see how the Factor Seasonals might help in the purchasing of shares.
The Later-in-Life Benjamin Graham Value Investing Rules of Fundamental Analysis
First, I want to go over a set of Ben Graham rules that I have photocopied from an interview he gave entitled "The Simplest Way to Select Bargain Stocks" by Medical Economics in September 1976. This is important as a background because you'll see the Ben Graham criteria.
Q: What about the conventional yard sticks like a company’s projected earnings or market share for evaluating stocks ?
A: Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. The only thing you can be sure of is that there are times when large numbers of stocks are priced too high and other times when they’re priced too low. My investigations have convinced me you can predetermine these logical “buy” and “sell” levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.
Q: That kind of thinking – ignoring fundamentals – would be branded as heresy by many analysts today.
A: Maybe so, but my research shows it works. What’s needed is, first, a definite rule for purchasing which indicates a priori that you’re acquiring stocks for less than they’re worth. Second, you have to operate with a large enough number of stocks to make the approach effective. And finally you need a very definite guideline for selling.
Q: Can a doctor or any investor, like me, do all that ?
A: Absolutely.
Q: How should I start ?
A: By making as large a list as possible of common stocks currently selling at no more than seven times their latest – not projected – 12-month earnings. Just look up the price-earnings ratios listed in the stock quotation columns of The Wall Street Journal or other major daily newspapers.
Q: Why a P-E ratio of seven instead of, say, nine or five ?
A: One of the ways to determine what you should pay for stocks at any given time is to look at what quality bonds are yielding. If bond yields are high, you want to buy stocks cheaply, meaning you will look for relatively low P-Es. And if bond yields drop, then you can pay more for the stock and accept a higher P-E. As a rule of thumb in pricing stocks this way, I select only those issues whose earnings-to-price ratio – simply the P-E in reverse – is at least twice the average current yield on top-quality (triple-A) corporate bonds.
Q: Okay. So, as of today, your formula says to consider only stocks with a P-E of seven or less. Is that all there is to it ?
A: Well, that group alone should provide the basis for a pretty good portfolio, but by using an additional criterion you could do even better. You should select a portfolio of stocks that not only meet the P-E requirements but also are in companies with a satisfactory financial position.
Q: How do I determine that ?
A: There are various tests you could apply, but I favor this simple rule: A company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.
Q: Are there stocks around today that meet these requirements ?
A: Oh, yes. Not nearly as many as in the market decline of 1973 and 1974, but there are still plenty.
Q: Once I’ve gone through the screening process and settled on my “buy” candidates, how do I go about structuring a portfolio ?
A: To give yourself the best odds statistically, the more stocks you have to play with, the better. A portfolio of 30 would probably be an ideal minimum. If your capital is limited, you can deal in “odd lots” – less than 100 shares of stock.
Q: How long should I hold onto these stocks ?
A: First you set a profit objective for yourself. An objective of 50 percent of cost should give good results.
Q: You mean that I should aim for a 50 percent profit on every stock I buy ?
A: Yes. As soon as a stock goes up that much, sell it.
Q: What if it doesn’t reach that objective ?
A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.
Q: What do I do with the money when I sell off a stock ? Reinvest it in other issues that meet your requirements ?
A: Usually, yes, with some flexibility dictated by market conditions. In times like the 1974 drop, when you find many good companies whose stocks are selling at low P-E levels, you should take advantage of the situation and put up to 75 percent of your investment capital into common stocks. Conversely, in periods when the market as a whole is overpriced you’d have trouble finding stocks to reinvest in that meet my criteria. In such periods you should have no more than 25 percent of your funds in stocks and the rest in, say, U.S. Government bonds.
Q: Using your strategy what kind of results can I expect ?
A: Obviously you’re not going to get a 50 percent gain on every stock you buy. If your holding-period limit on a stock expires, you’ll have to sell it at a smaller profit or even take a loss. But in the long run, you should average a return of 15 percent a year or better on your total investment, plus dividends and minus commissions. Over all, dividends should amount to more than commissions.
Q: This is the return you’d have gotten over 50 years according to your research ?
A: Yes, and the results have been very consistent for successive periods as short as five years. I don’t think a shorter period gives the strategy a really fair chance to prove itself. In applying the approach every investor should be prepared financially and psychologically for the possibility of poor short-term results. For example, in the 1973-1974 decline the investor would have lost money on paper, but if he’d held on and stuck with the approach, he would have recouped in 1975-1976 and gotten his 15 percent average return for the five-year period. If we get a repeat of that situation, the investor should be prepared to ride out the downturn.
Q: With the Dow around 1000 and many issues at their five-year highs, is there a danger of the kind of drop that followed the overpriced markets of the late 1960s and early 1970s ?
A: I have no particular confidence in my powers – or anyone else’s – to predict what will happen with the market, but I do know that if the price level is dangerously high, chances are you will get a serious correction. In my own tests there were a number of periods of overvaluation, and the number of stocks available at attractive prices was very small; that proved a warning that the market as a whole was too high.
Q: Can you summarize the key to making your approach work ?
A: The investor needs the patience to apply these simple criteria consistently over a long enough stretch so that the statistical probabilities will operate in his favor.
In general summary, the Ben Graham rules for this fundamental analysis value investing system are:
Rule 1. Select shares with a P/E of 7. Many others use a P/E of 10 or 12 today.
Rule 2: Companies must have a stock holder equity to assets ratio of 50% or more
Rule 3: Hold a portfolio of 30 stocks meeting this criteria
Rule 4:
Sell when stock increases 50% ... 2 years pass ... the company gets bought ... or the stock splits.
Now Yahoo Finance did an interview with Bob Auer, portfolio manager with the Auer Growth Fund that uses a combination of valuation and growth screening to select shares from among EVERY STOCK THAT TRADES IN THE UNITED STATES which is about 8,000 stocks. He's looking for the GOOGLEs, APPLEs and RIMMS in the world when they are really on sale or don't have a lot of coverage. In the interview Bob stated that the Auer Growth fund only buys stocks that meet the following value criteria:
- 20% quarterly year-over-year revenue growth
- 25% quarterly year-over-year earnings growth
- Trades at a P/E ratio below 12
You can see that this is a screening system as well, but for growth stocks that have low P/Es, and thus are undervalued somewhat. It combines value with growth criteria. When I saw the interview the criteria reminded me of Graham's interview, so since the Auer's started their investment fund by building a track record in their own accounts, I decided that it would be cool to investigate this approach with seasonal market timing.
Let's see how we can put Factor Seasonals on top of this strategy or any such long term investment strategy for better portfolio returns.
Yahoo noted that this value-growth strategy produces some volatile returns. While Auer's long-term track record on his personal accounts -- verified by an independent auditor — has outperformed the S&P 500 over the last 20 years in 2008 it lost more than 50%.
So let's see how the Factor Seasonals might help in the investment purchase decision of some of the recommendations that came out of this interview, which is remindful of the Ben Graham criteria for selection. Then we'll walk forward in time, and you decide:
Finance.yahoo.com reported on June 19, 2009:
Auer is currently hot on Cubist Pharmaceuticals (CBST). The company sells Cubicin, an antibiotic that treats the methicillin resistant Staphylococcus aureus (MRSA). It currently trades at around $18 per share with a P/E ratio of 7.
He also likes fertilizer stocks including Potash (POT) and Mosaic (MOS). His favorite of the bunch is Intrepid Potash (IPI). This was a high-flying IPO in 2008, trading as high as $76 before the market crashed. Today, it sells for a more modest $27 per-share - a price tag more to Auer’s liking.
Here are the charts for these shares which you can produce with our Factor Seasonal program. Ask yourself, "Even though you like these shares, would you get in these shares at this moment?"
If not, look for some other stock meeting your valuation criteria and check the seasonals when it passes the screening criteria. If you absolutely want to get into some stock but want to limit the chances of a portfolio drawdown, that means you want to buy it at a base or retracement low, so you'd use seasonals to help find those points. You'd keep producing charts every month until the actual prices and the seasonals converged, or you get a MACD BUY crossover signal or trend line break around the time you expect your seasonal bottom.
Let me illustrate some of the many ways to use seasonals with value investing with the first three of these stock picks because there isn't enough IPI data from Yahoo for seasonal analysis.
First CBST. The stock is mentioned by Auer and checking the seasonal chart, it's still in seasonal low territory so you have a chance to buy. No further seasonal analysis is necessary. They probably got in during the March to June period because that's when the price would have dropped and triggered a great low PE ratio on their stock screens. So we'd be looking for a 50% pop using Graham's rule, which we'd expect in September at the earliest, or November-December after that.
How'd it turn out? The peak is around $22 in September, exactly as seasonals predicted. Moral: stock screening for value shares can get you in at a low, and the 50% price target together with seasonal expectations can help on the sell side.
Okay, now for POT. Let's look at the seasonal chart ...
When announced we can see it's already run up a lot, so the good buying period is over. However, if you absolutely must buy it for your portfolio -- perhaps to add on to positions -- then this is the approximate time period within a few days.
However, since you aren't buying at your seasonal low where the PE ratio is perfect, don't expect to get your Ben Graham 50% pop because it might require a longer holding period. The seasonal expectation is for a November or December high.
How did it turn out?
If they bought at the low then the June high is when they should have gotten out, not held. In fact, anyone who bought in Feb-April should have gotten out in June but there was a second chance in Nov-Dec, just as predicted.
The last stock we have data for is MOS, Mosiac:
This is not a stock to be buying right now on the announcement date -- the best time is seasonally over and there's a chance the stock will even fall before it rises. I'd look at it again in October, but by then it might not meet my valuation criteria and there might be better candidates out there.
The moral here was that the best time to get in was earlier than the announcement, which was probably the time of the screening and simultaneously the time of a seasonal low, and then you could make the 50% gain Graham recommended. If you waited until October you might have picked the anticipated seasonal low at $44-45, but this stock didn't give 50%. You just had to be in a little earlier at the time of the stock passing the initial screening test.
Look at where all these stocks were being purchased -- usually during their seasonal low. So if you screen for value and find a share and it's near it's seasonal low, that might be the good time to buy. It might be that low simply because people overreacted to some bad news or something else, and so you get it at a steal; knowing that the price is in seasonal low territory should help you calm your nerves and convince you there isn't anything fundamentally wrong.
If you purchase it at any other time except its seasonal low, you might still make the 50% target, but the chances are less.
And as to how long to hold it...we randomly picked on this Yahoo interview and found that Ben Graham's rule worked for this set of value growth fund recommendations. PLUS, we found that it worked time wise according to seasonal expectations even though the projection charts used were created months before the final outcome.
As we always warn, seasonal charts are only most accurate for the near term projections of 1-3 months but even with periods of time far further out in the future, it often still works in spades.
You can use seasonal charts many ways in your investing, and I just wanted to introduce Graham's concepts to you, the track record of a firm that combines PE picks with growth criteria (this fund started out with the Auers buying stocks for themselves for their own account, so you can do it too), and how seasonals are uncanny in helping you anticipate the lay of the land. You can definitely use them to help your investing. |
