If your analysis is wrong, don’t wait, get out.
In setting up a trading strategy and portfolio you need to consider a balance between technical triggers and fundamental issues that influence markets and shares. The first relates to portfolio structures, asset allocation, and your rules for entering and exiting stock positions; and the second relates to an understanding of risk-reward factors, financials and corporate structures, and governance. I would like to add a third factor, which I call Streetwise Fundamentals.
These are issues that assess managerial capabilities, shareholder rights, understanding the reflective mood of traders, and economics and politics which are issues that cannot really be quantified. These are factors that make the astute investor more streetwise.
Therefore, in building a strong strategy it is essential to have a sound understanding of all three factors. The analysis of financial data and technical triggers are set out in out later volumes and, therefore, the following text deals with issues relevant to streetwise preparedness. This is followed by variables that will assist you to build a better benchmark for yourself.
The Streetwise Trader
Over time, if the investor is wise, he or she will gain experiences in understanding how people behave in the market and what such behavior influences trading patters; at times rational and then completely illogical. After all, there are many traders who have no understanding of financials, yet they make buy and sell decisions on gut feel and sentiment. These decisions, in turn, affects overall investor mood and thus share prices. There is however a real thread of logic that can be applied to understanding the masses of faceless traders.
The following text points out some nonmathematical methods and issues to consider when taking investor sentiment into account.
Management
For most traders, getting hold of the managers or directors of a listed company is near impossible. Since speaking to them is difficult, there must, therefore, be an alternative method to assess the effectiveness of these directors.
In 2014, a stockbroker and I interviewed the directors of a Cape Town-based food listed company. The directors said that “everything is positive,” and “we can achieve 25 percent growth this year.” Despite their attempts at conveying a positive message, they seemed uneasy.
After the discussion, my colleague turned to me and said that he was going back to the office to advice clients to continue to accumulate the share. He then asked me for my advice.
This is what I said: “I believe that the company is about to be delisted, with head office using this company to reverse list another operation, possibly the Johannesburg-based holding company.”
He looked at me, slightly confused and, shaking his head, asked me how I had concluded that scenario. Simply, the directors had avoided any question relating to head office, which immediately made me suspicious. In addition, having gathered the necessary information on the company prior to the interview I knew:
• Head office was planning to move other food operations into Africa. They would need a listed vehicle to fund such a venture.
• Head office was not content with the bad publicity that the Cape Town-listed company had received in the recent past.
• Part of the holding company’s plans (announced in the press) was to “take greater control over our subsidiaries to unite us in a single, focused mission.”
Within 3 weeks of my statement to my colleague, the holding company announced a delisting of the Cape Town firm. I had proved my statement to institutional clients, yet all it took was gut feel and listening closely. In other words, try to know that people often say more by not speaking at all.
If you are “listening” you can get an investment edge or, stated differently, learn to read between the lines.
IPO and Long-Term Strategy
Here is a truism. An IPO has no trading history, so the masses of traders need to be convinced that your share price is fair and has a chance of providing them with reasonable capital growth over the next 12 months.
Forecasts are set out in the IPO’s prospectus and, subsequently, in annual reports.
An important part of the prospectus or annual report is the mission statement, often ignored by traders. The directors use this statement to bring traders, investors, and staff together with a focused, common ideology and direction.
Your assessment of the mission statement must look at two issues:
• Is this statement too broad? A statement should be broad enough to allow an understanding that the company is focused and driven with a common goal or mission.
• Is this statement focused? It should be focused enough to provide individuals with clear understanding of the company’s future direction. Often these statements ignore the labor force. A solid mission statement can keep workers and employers united and avoid strike action, loss of productivity and avoid a falling share price.
A broad statement is effective blue sky planning or brainstorming. A statement that is too restricted foregoes future opportunities.
However, trading in IPOs is seriously misunderstood and also massively missed opportunities. If you can place a value on the share from the prospectus info, then you could acquire the share as a short-term strategy.
• The share price stated on the prospectus is not the share price at listing. So, if you assess that the current trend in IPO offers is twice oversubscribed, then make an offer for twice what you want. For instance, if you want to buy $10,000.00 of the IPO, then offer $20,000.
• The listing price is determined by the book building method of listing. So, if the prospectus offer price is $10 per share, if the mutual and other funds bid the share to $20, then the broker will calculate a price on a formula. In this case the listing price would be about $15 a share.
• Understand that you received the shares at $10.
• The first 3 days of an IPO listing often sees a price move by 25 percent. This is called Abnormal Initial Return. A system to entice mutual funds to acquire the share.
• If you invested $10,000 at $10 per share, you would have received 1,000 shares.
• At listing these go up by 25 percent, giving you a share value of $18.75.
• You have effectively bought the share at $10 and now it is $18.75. This is a profit of 87.5 percent.
• See Appendix for further explanation.
Whether you hold the share for the future or not, trading in IPOs can be profitable. There are numerous strategies that can be adopted, so send me a message if you are interested: [email protected]
Market and Industry Characteristics
Another nonmathematical method of determining whether a company has a suitable strategy is to conduct fundamental research and analysis that a company faces in the environmental factors within which it operates; including, politics, economics, finance, global threats and opportunities, technology, social change, and labor issues.
The dilemma traders and investors face is what factors to include and exclude when setting up key criterion for trading decision making. One approach is to create a filter system; set out in later volumes.
Among the research techniques used by analysts are: understanding key value triggers, SWOT analysis of the industry and of the company, Pestle analysis, and conducting Porters Five Forces (see Appendixes for an explanation of the latter two).
Some key filters include an assessment of overall markets, peer analysis, market fragmentation, director entrepreneurial flair, and possible synergies arising out of acquisitions, merger, and expansion of product range or region. Stated differently, a company must show in its performance that it is meeting and complying with its mission statement.
Identifying Winners at a Glance
If it is assumed that the board of directors is responsible for the direction, growth, and future prospects of a company, it is fair to assume that a comparison of that company relative to its sector index—for a set period—is valid. This test of management’s ability is extremely broad.
For instance, not all pharmaceutical companies within the sector of an exchange buy, sell, or produce the same products. One company may be strong in the export market, another may be labor intensive and yet another may have a spread of divisions to include hospitals.
In addition, not all pharmaceutical companies listed on an exchange would be listed in the pharmaceutical sector. Some may be listed under the services sector, because it has logistical transport services.
The most effective way to identify winners in a sector is to create your own sector. Database these companies and create an index using these companies’ market cap. The total market cap becomes the index. So, if you have 10 companies in this “created” sector, you will find that movement in the companies that make up the Index will have a different comparable movement to that shown in the official statistics.
These would be different, but would provide you with information that is unique to your trading strategy.
Analyzing the Winners: Random Theory Approach
Is it possible to conclude that companies that beat the sector averages are wise and others are not? By extension, can the people who invested with companies that outperformed the indexes also claim to be winners? Is it possible that these winners could have been predicted? A truism in statistical analysis is that probability theory will always account for a number of winners and losers in any random series of events.
The example often used to demonstrate probability theory is, if one person tosses a coin 100 times to get “heads,” is it likely that he will succeed 50 times? Actually, there is no guarantee that the more times the coin is thrown, the greater his chances are of getting the desired result. Every time he throws, he has an equal chance of success, but also an equal chance of failure.
If it is assumed that markets are efficient, it can be expected that a random distribution of results will show there are some winners and also some losers. Therefore, how does an investor know which director to trust, who to follow, and how much to invest in that company?
The answer is never easy and there is a multitude of ways to assess the situation:
• In an efficient market there are large numbers of buyers and sellers, which means that market perception of a directors’ ability is reflected in the share price. For instance, if the company does not perform, or the directors are involved in a scandal, investors are likely to sell the shares. A large volume of sales often sends the share price downwards. After all, nobody wants to invest in a company that does badly.
• To offset the problem of number distortions, use growth averages rather than direct comparisons. For instance, instead of comparing the 2017 profit growth rate of Food Company Ltd against the 2017 Food Index growth rate, use a period of time, that is, a 3- or 5-year period. This means that the average growth rate of Food Company Ltd would be compared to the average growth rate of the index.
• Use a “constant performer” counter system to determine the best of the best. The following example highlights the best performers for investor Robertson. Remember that this is the random approach and does not take a multitude of factors into account, namely track record, new acquisitions planned for the new financial year, or specific types of food industry the following companies operate under.
• Investor Robertson believes food companies will benefit from economic growth, higher purchasing power, and demutualization.
• There are 10 companies (fictitious) listed on the food sector of the NYSE.
• The growth performances for the last 3 years of trading of these 10 companies is outlined as follows:
Companies and index (% growth on previous year) |
Year 1 |
Year 2 |
Year 3 |
|
Index |
+12.0 |
+14.5 |
+16.9 |
|
Companies |
|
|
|
|
1 |
A Ltd. |
+33.9 |
+36.7 |
+39.7 |
2 |
JJ Ltd. |
−10.0 |
+10.0 |
+0.8 |
3 |
KK Ltd. |
−4.0 |
+3.0 |
+1.5 |
4 |
KM Ltd. |
−9.0 |
−12.0 |
−45.0 |
5 |
BW Ltd. |
+4.2 |
+5.8 |
+22.5 |
6 |
GG Ltd. |
+32.7 |
+21.0 |
+43.0 |
7 |
HH Ltd. |
+11.9 |
+14.0 |
+15.5 |
8 |
PH Ltd. |
−44.4 |
−11.9 |
−1.0 |
9 |
LG Ltd. |
−31.0 |
+18.4 |
−32.0 |
10 |
TF Ltd. |
+1.1 |
−9.0 |
−90.0 |
Here are some investment options:
Option 1: Buy shares in companies that constantly achieve positive annual growth rates.
LIST A |
BW Ltd. |
A Ltd. |
GG Ltd. |
HH Ltd. |
Option 2: Buy shares in companies with positive growth only during the past 2 years? These companies could have turned problems around and could continue to perform well in future.
LIST B |
JJ Ltd. |
KK Ltd. |
Option 3: Buy shares in companies with rates that surpass the previous years?
LIST C |
A Ltd. |
BW Ltd. |
HH Ltd. |
Assuming that investors want winners, which are expected to continue to perform in the future? There are a number of options:
Conclusions
From List A: A Ltd. and HH Ltd.
• A Ltd. has outperformed the market and shown constant growth, while BW Ltd. may have performed well, but the question remains whether the past year was an aberration and more history is needed before an investment decision can be made. GG Ltd. has outperformed the market, but growth is erratic and it too needs to prove itself to investors. HH Ltd. has shown constant growth over 3 years and its average rate is close to the sector growth rates. From List B: None.
• JJ Ltd. is too erratic and KK Ltd.’s growth is far too low to be considered to be a viable investment option.
From List C: A Ltd. and HH Ltd.
• A Ltd. and HH Ltd. prove themselves again.
So, from three preset options, two companies, A Ltd. and HH Ltd., appear. In this case, the investor has shown that two companies have the high probability of future growth success and are thus the best options for the investor.
Track Records and Other factors
If management skills add value, can past performance give an indication of how these directors will perform in future? How successful will investors be if they only buy shares with the best past 3-year track record?
There is no guarantee directors will repeat past performances, nor is there a certainty the company will continue to outperform the index. It is up to the investor to keep personal records of directors’ performance during the financial year.
Winners Often Keep Winning
In an efficient market, it would be difficult for the same winners to keep winning, as investors have a multitude of choice and can become extremely particular in their investment decisions. Yet, over two year periods, shares that rise in price tend to repeat such trends.
Many portfolio managers suggest that chasing last year’s winner does nothing more than position your portfolio with next year’s potential loser. After all, it is easy enough to pick last year’s winner, but not so with next year’s winner.
Chapter 11 is the start of the establishment of your portfolio rules.