How then do we go through the structured investment process that I speak of? We may resort to a three-pronged investment process for value or growth investing:
1) Stock screen and research equities
2) Find intrinsic valuation ranges for companies in conjunction with
3) Technical analysis for favorable entry point
Beside going through the investment process, we must resort to scrutinizing the fundamentals. Below, I have outlined five assumptions (non-exhaustive) which appear to be misnomers at first glance:
1) Low PE ratio stock does not a cheap company make. Either the company may be very risky (thus higher required rate of return) or have low earnings growth. However, most hedge funds will use PEG ratio < 2 as an attractive valuation indicator (source: Jim Cramer's Mad Money: Watch TV, Get Rich). By screening for low PEG ratio, you will reduce the probability of overpaying for stocks.
2) High dividend yield may be misleading. A company that invests in low NPV projects (or if the firm reinvests profits at ROE less than required rate of return — think franchise value formula! i.e., intrinsic PE = tangible PE + franchise PE) may mask their poor performance by high dividend compensation
3) A value investor should not solely rely on high dividend yield strategies. Three drawbacks, most notably: The company is shrinking its asset base (dividend as capital leakage) thus reducing its capacity for future growth.
Second, book value of equity will be reduced. It is instructive to note that sustainable growth rate, g = RR retention ratio*ROE return on equity, indicates that if actual growth forecasted is greater than sustainable growth rate, the firm will have to issue equity unless it increases its PRAT components (profitability, retention rate, asset turnover and financial leverage).
Third, high dividend yield is unsustainable in the long run, especially for a firm that has a high dividend payout rate. For the dividends to be truly sustainable, we may turn to a residual dividend model that implies the firm will only pay dividends if out of residual earnings, i.e., if planned capital expenditure < (A/E)*(increase in equity from 100% reinvestment of earnings) equation holds.
4) A stock trading at less than its book value is NOT a steal! Re: point one above, the company is either highly risky or at its nascent stage (biotech stocks), thus has low or no earnings. Many penny stocks appear cheap for these reasons. Book value or liquidation value is not usually applicable for most penny stocks after discounting for the high risks involved (illiquidity, paid pump and dump, high bid-ask spread for AMEX, OTC and pink sheets) etc. It is only the expectations of being the next biotech blockbuster, i.e., DNDN that will propel the stock higher. But that’s another story for another time.
5) Contrarian strategy. Mean reversion theory asserts that extreme earnings tend to revert or normalize over time. How do we know that we are not catching a falling knife as contrarian investors? As Keynes put it, “Markets can remain irrational longer than you can remain solvent” that alludes to psychological mass dynamics.
Second, there is George Soros’ interpretation on price reflexivity that implies a self-reinforcing boom and bust pattern, i.e., prices, do influence the fundamental and change expectations thereafter through price dynamics. Thus, investing in stocks that have made their 52-week low for example may be a highly risky strategy, i.e., the company is exposed to default risk.
Like academics, there is usually banter vis-à-vis market pundits on the above-mentioned. One may be long-term bullish on China like Jim Rogers or take the opposing view of Jim Chanos. This is what makes the market. Clearly investing is never easy, which makes reaching the ranks of the coveted 5% all the more gratifying.
About the author:Graduated with BA Economics from National University of Singapore. Passed Level 1 of the CFA examination and CAIA Level I Candidate. Long-biased US equities, with strong focus on small to mid-cap stocks (NYSE, NASDAQ, AMEX, OTC & ADR) utilizing fundamental and technical analysis.
Agnostic investor, trader, writer and perpetual student of the market.