Wednesday, January 17, 2007

Value Investing - Part 2 - Stock Picking

Last Wednesday, I wrote a piece about the long term outperformance of the value investing style and I wanted to follow it up with some specific ideas for leveraging this investing style. Before I do that, I want to clarify that there are generally two types of investors:

  1. Passive - Buy and Hold strategy, buys mutual funds, has others manage investments, does not have time to devote significant time to research and trading.
  2. Active - Buy and Monitor strategy, buys individual stocks and bonds, manages own investments, devotes a significant amount of time and resources to research and trading.

Most people fall somewhere between these two types but will tend toward one or the other. This is probably one of the most important distinctions that a person can make when understanding what type of investor he or she is. For example, a passive investor who attempts to pick his own stocks without devoting enough time to research and monitoring will likely fail in his strategy. Also a word of caution to the active investor; an active investor who attempts to build a portfolio without sufficient funds (at least more than $100,000) will likely spend an inordinate amount of money on transaction fees and commissions thus reducing the total rate of return. Ideally, an active investor, in addition to having an aptitude for research and analysis, should have more than $300,000 to build an appropriately diverse portfolio.

Assuming all of the above is taken into account, the following guidelines would apply to an active value investor. I will discuss solutions for a passive investor next week in Part 3. The following guidelines are a synopsis of Benjamin Graham's investing guidelines from his book: The Intelligent Investor. These guidelines are extremely generalized and form a basis for evaluation but not all encompassing. Please augment this knowledge with your own readings.

  1. Look at the average current yield on top-quality (triple-A) corporate bonds. Say 4.5%
  2. Multiply that by 2. =9%
  3. Divide 100 by the number found in (2). =11.11
  4. The number in (3) gives you the highest acceptable P/E ratio of the stocks that you can choose from. P/E = 11.11
  5. Note: Generally, don't go for stocks with P/E ratios greater than 10. P/E ratios of 7 or lower should preferrably be chosen.
  6. The ratio of stockholders’ equity to total assets should be at least 50%. For example, if a company has stockholders’ equity of $30 million and total assets of $50 million, the ratio is 60%. Since that is over 50%, the company passes the test.
  7. Form a portfolio of at least 30 stocks: this is the ideal minimum.
  8. Hold onto the stocks until you make a 50% profit. As soon as the stock goes up that much, sell it.
  9. If a stock has not met your objective profit of 50% 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 2002, you would sell it no later than the end of 2004.
  10. When times are bad for the stock market, i.e., when stocks are selling at low P/E levels, take advantage of the situation and put 75% of your investment capital into common stocks. In good times, when the market is overpriced, when you have trouble finding stocks with low P/E ratios, you should have no more than 25% of your funds in stocks and the rest in other less risky assets.

I would also say that an active investor should devote a significant amount of time to developing his or her analysis skills and into researching potential investments and monitoring his or her current investments. 15 to 20 hours per week for a portfolio over $300,000.

I'll have some more to say about value investing next week for the passive investor or investors who have less than the funds required to build an adequately diverse portfolio.

What do you think? Is Value Investing the way to go? Are you a passive or active investor?

16 comments:

Pondering said...

Great Blog!

I think it is the way to go and without actually having heard the term, I am managing my investments in that manner.

Keep up the good work!

mohican said...

Are you a passive or active investor? Do you use mostly ETFs, Mutual Funds, or do you pick your own stocks?

loki said...

I've been a passive investor, having only mutual funds & gic's in my rrsp, but I'm interested in becoming more active. I was interested in using a self-directed rrsp through etrade canada(any reccomendations for a better online broker?).

I was surprised to see you say an active investor should have $100-300k to start. I only have $20-30k. Is it your opinion I should stick to mutual funds or is there a 'good' way to start being more active with $20-$30k?

littlemanrenter said...

I'd have to agree and say I'm a bit dismayed by the 'must have >100K' statement. That rules out a lot of people. Given the nature of this blog, if most people have 100K to work with, then talk of a housing affordability problem is kinda off key.

That being said, I too am working myself to become knowledgable about stocks. I would only plan that <10% of my portfolio would actually be stock investing. The rest being handled in accordance to a financial plan with an experienced planner - albeit moderate to conservative.

However, while I know I won't buy high priced stocks, I do believe that given the nature of the market, when its done, thats the entry point for new people. Things rise and fall, buy low and sell high.

dingus said...

Great post, great blog. A great evolution from the housing blogs for those that have been around and around on the discussions there on the lack of value in that market and are trying to figure out what to do with funds they have if they don't have a mortgage to pay down.

I haven't checked, but likely almost nothing meets the value test in this market. That's not a comment on the methodology, but a comment on the market. Personally, I'm pretty lazy and tend to focus on tried and true dividend earners that have a history of dividend increases. Recent price performance and comparative P/E is thrown into the mix too. But if you're getting 3% dividends, after taxes you're about where a savings account will get you. Add even modest cap growth and it's a no-brainer. Then factor in dividend growth over time, and bob's your uncle. But this greatly helps refine that crude 'strategy', so thank you.

And I know at least half a dozen renters with well in excess of 100k to manage. They are fairly typical folks who for one reason or another don't own and refuse to buy in the current market, seeing it as a one way trip to long term financial indentured servitude.

mohican said...

I will have some great stuff next Wednesday for passive investors or aspiring active investors with less than $100k-300k.

A note: Many renters have significant savings and choose not to purchase a house for 'value' reasons not for lack of affordability.

For those of you asking about whether you can start an 'active' portfolio with less than $100k, you certainly can. You must be mindful of transaction fees and compare that to say a value index fund or a well managed value mutual fund. To be diversified enough you should own 10+ Canadian stocks and at least 20+ outside Canada. For a portfolio of 40 stocks with only $40k you would only have $1000 in each stock and paying $10-$30 per trade to buy and then again to sell. By my calculations that would probably run you 3-6% per stock just for trading. If you traded half your portfolio per year you would be paying 2-3% for trading fees. Management fees on good mutual funds are less than that so unless you have enough money to reduce transaction costs by holding more money in each name then I don't suggest holding individual stocks for portfolios less than $100k. You also need to weigh the time element of managing your own portfolio and how much that is worth to you.

There is definitely a point where buying your own stocks makes more sense than mutual funds and you need to do the math for yourself.

dingus said...

Well, I think the point of individual sock picking can actually be with fairly low portfolio or position values, depending on risk tolerance (as diversification is harder to achieve). But if you don't intend on trading actively, ie a true value buy and hold strategy, then even very small positions will warrant the the fees. A $1000 position will incur $20 to get into, or 2%. That's still a less than most management fees for mutual funds, and it is one time, not an annual skimming off the top. If you hold that for at least a year, you've beaten the fees on a mutual fund.

Resources like Moneysense's top 200 may help cut a lot of the time element. They've rated the major Canadian stocks, using both value and growth filters. You should be responsible for your own judgement ultimately, but tools like that can help you have confidence in your own picks. Or you could simply pick a fund you like, research their top holdings, which they disclose, and buy them yourself and save the fees.

Freako said...

If you are interested in very low brokerage fees, I have used Interactive Brokers for a number of years. Their minimum fees are rock bottom, U.S. $1 for U.S. markets and $2 CDN for the TSE.

Initially, the interface was intimidating at first (professional trading screen), but I think they have added more user friendly ones. They do hit you with a $10 monthly fee for something or rather.

The actual trading service is probably above and beyond what a regular broker would do (it allows you to route your order in very specific ways, and it accepts complicated orders such as trailing stop loss. I swear by it, but that is just my opinion.

dingus said...

Of course "sock picking" can be done with very little money. "Stock picking" takes probably a bit more.

Freako said...

"A $1000 position will incur $20 to get into, or 2%. That's still a less than most management fees for mutual funds, and it is one time, not an annual skimming off the top. "

If you are looking for rock bottom MER on index funds, TD's E-fund fees are very low, something like 0.33% on domestic funds, and .55% on U.S.

rentah said...

mohican, thanks for all this.

By the way I think 'Divide the number found in (2) by 100.' should read 'Divide 100 by the number found in (2).'
Minor point but I'm making it because i value what you're doing.

----
PS freako: good to see you posting where you're appreciated (here, VHB, etc). The exchanges at rob's blob got so ugly I've stopped taking it seriously.

mohican said...

Thanks Rentah, I never caught that.

solipsist said...

I am an active "investor" (small potatoes - about 5K right now).

I pick my own, but do take tips from a couple of people whom I respect. I like venture capital for a plethora of reasons. I've won, and I've lost, but it has more to gain in the long run than buying lottery tickets.

I take a long view, and research my choices. Some are hell-for-leather though.

ReductiMat said...

Freako,

Do you have to pay extra to play on different markets on IB? (Say the wild wild west, aka the TSX-V?)

OnTheIsle said...

Great blog mohican, good to see a place to discuss investing while we wait out the RE market.

I'm not playing with anything near $100,000 either but my theory, after going to the school of hard knocks in the market the last several years, is to have a combination of a good broker,as well as a self directed account and use a good chart system to spot the new trends and stocks breaking out and to save your ass when the the red flags say sell. I have had winners and losers but are now more winners and avoid the losers in the early going and not believing the "story".

Diversifying by splitting into 40 stocks is extreme and lowers your odds of success,where as playing a handful is much easier to manage when doing it yourself.
Mutual funds are great if you have low expectations but I personally don't like them and will take the risk of higher gains with a stock any day as long as it is fully researched from the industry trend to the management to the chart. The trend is your friend as they say.

Freako said...

"Do you have to pay extra to play on different markets on IB? (Say the wild wild west, aka the TSX-V?) "

Don't know for a fact (don't like to play against the house (AKA TSX-V), but I believe they have a seat on the exchange, and their fee structure quotes:

"CAD 0.01 per share, minimum CAD 2.00, maximum 0.2% of trade value plus exchange, ECN, regulatory and specialist fees"

I was very skeptical at first, but it peformed exactly as promised. It is essentially a day trading account, with very cool tools. It even has scripting capabilites so that very advanced traders could create their own automated trading system.

For layman, it allows one to achieve amazing diversification with limited funds. Even $400 purchases are economical. Heck, it beats gambling anytime. I have on occasions taken a small position (say $1000) on a volatile momentum stock just to entertain myself while killing time. On Nasdaq, a $10 stock only needs to climb two cents to cover the commission. I generally decide to get out by the end of the day no matter what. On a volatile stock you can make (or lose) $50 within a short time, even on such a small investment. Cheap entertainment. Generally, I like to sell on the news and short hyped stock on big news once volume starts cooling off. A prime example would be Apple after the i-phone. My bigger positions are less spontaneous and more long term. Shorting is of course a risky proposition, but with IB you can take very small positions and maintain a nice hedged position. I think it is easier to find overpriced companies than underpriced. But I would NEVER go net short.