I'm going to start from the point that an asset manager would start at. The client service representative (or you, if your doing it alone) would have already determined your risk/riskfree split based on your risk aversion and investment horizon. The discussion from here on out will be an approach to investing in risky assets without horizon constraints and with a reasonable risk appetite constraint.
Wind at Your Back
The first point of research to be done is entirely macro, and then you get into looking at specific assets. You need to figure out where the general economy is going, where the future risks may lie, and what industries are likely to be favorable in the future, then which companies will capitalize on the environment. This involves a lot of reading, I would suggest checking out some of the research reports that are put out by banks and information agencies, there are a lot of links in my "must have links" post. The general process is:
- Where are we in the economic cycle? If interest rates are high moving investments over to low risk, debt could be very prudent. Recall that as interest rates fall bond prices rise, but you only will receive this benefit if you are in bonds before the market anticipates a shift to lower interest rates. Also bonds have two major risks, interest rate risk and default risk. Unless you plan on buying CDS insurance on your debt investments you will want to be invested in firms (or governments) that are both liquid and solvent, as interest rates usually only fall in market crashes.
- Obviously it feels as though we are at a bottom now, but we have already had a good rally. I would say that in a long term view there are still plenty bottom buying opportunities to be had, but there is a good chance we will find ourselves lower than we are today over the next 3 years.
- Where are industries in their business cycles? Oil and gas in North America both have a lot of inventory in waiting. Dot-com has been roaring ahead for a long time now and there is a lot of talk about another internet bubble forming. Paint this picture for each of the major industries by using economic data and research reports. Banks and government bodies often have very good free reports. The Economic Intelligence Unit (the data side of The Economist) is a good source as well. When you see a industry that you think is bottoming you are likely to find Value opportunities. When you see an industry that has bottomed and is growing strong you are likely to find Growth opportunities. Industries that are nearing their top or are falling will have short strategy opportunities (puts). This the first big area asset managers really add value, being able to spot a difference in the true business cycle and the one priced in by the market can make a lot of money for the long term investor.
- So now that you have your industries classified as value, growth, or short you can start looking at actual stocks OR you can make the appropriate plays with indexes. This could be as basic as buying the value and growth industries and not buying the short industries, or as exotic as finding ETF's that give you exposure to high Book Value / Market Value stocks in the value industry and low Book Value / Market Value stocks in growth industries. (MV/BV is a value/growth measure typically used in the Famma French Four Factor Model).
- Finding value stocks is done many ways, and this is the second major area that asset managers make their pay check, finding the diamond in the rough. A very simple way of identifying these assets is to look at comparable multiples. A multiple is generally a market derived item divided by a financial statement item (or sometimes vice versa). Examples include: Price/Earnings Per Share, (P*Shares Outstanding)/EBIT, EV/EBIT, P/(E*G), MV/BV. Multiples are always compared to the median value of the firm's closest peers (companies generally do not form normal distributions when grouped by multiple and so means are skewed by outliers). How many you choose is a bit discretionary but usually more than 10 and less than 50 is common. From a value standpoint you want to find companies that have low [market/book] multiples and investigate further. Sometimes these companies will have justifiably low ratios - they might be poor businesses. These can still be candidates because poorly run firms can be bought up by another firm, leaving shareholders with a sizable premium, but this can take a long time. If you find a stock that has a low multiple and it seems to be a solid business with low default risk and growth rates comparable to its peers then you might have found yourself a value stock to buy. An efficient market theory is that all firms will revert to the mean, your low multiple firm should converge to the median multiple over time, which means that either the numerator (price) will grow, or the denominator (assets/earnings) will shrink. Firms love to get bigger so usually it is the price that moves.
- Finding growth stocks is similar, look for high multiple candidates. This is less in line with EMH principles but there is research that suggests firms who have performed well in the past seem to enjoy persistence in their performance, and yield higher returns compared with their peers longer than theory would suggest. This is almost always because they hold a scarce resource their peers do not, (think Apple and Google). There is some evidence that these growth stocks although desirable, are not the true winners. The real high flying stocks will be "value with growth characteristics". Value stocks with the low multiples are usually your blue chip businesses, but everyonce in a while a low multiple company will take off as a growth stock and become a high multiple company. This transition is very profitable and finding these companies is the explicit goal of many Bottom Up investment approaches.
- Valuation. You can do it easily with the multiple approach briefly described above by taking the firms denominator item in the multiple and multiplying it by the median multiple to find the expected Price or EV (enterprise value) if the company were to revert to the mean. The second major way is to create a discounted cashflow model of a company. I plan to discuss both of these valuation methods at length in a future post, but for now here is the coles notes of a DCF. A stock is a fractional ownership of a company. A company is made up of assets (buildings, machines ect) that make money. This money belongs to two entities, debt holders, and the companies owners. A firms worth can be considered the sum of all future cash flows it will make by doing its business discounted at the firms cost of borrowing the money to do business. This discount rate can be thought of an opportunity cost of the owners and the debt holders. Subtract debt from this sum and you are left with the value of the company that belongs to the owners; divided by the number of shares an you have a share price. DCF valuations require a lot of assumptions because they are computed off of future figures, so they are fairly useless in business that have a lot of uncertainty in their future cash flows, but can be very valuable in very stable businesses. If you price derived from valuation is higher than the market price, buy baby buy!
- Highly priced firms (highly priced relative to their firms using multiples, the actual stock price has absolutely nothing to do with it) which you suspect to fall in price are good targets for short strategies. You can identify these through multiple analysis (high multiple stocks), or just through economic intuition. The safest way to short is to buy puts on the security you think will fall. You will pay a premium up front for the opportunity to make money if the stock falls, or if volatility in the stock increases. If the stock rises in price you don't lose any more money (like you would if you actually shorted the stock).
- The key point to all of these strategies is you have to have information that the seller of the security does not. If the stock was definitely going down, who would want to buy it? If it was definitely going up, who would sell? Most of the shares in the market are traded by institutional holders who put a lot of time into being on the right side of the trade. There is some "dumb money" in stocks, so your chances of playing someone for a fool are at least not 0, but the option market is almost exclusively written by institutions so when you are buying that put you are calling some quant jock at Goldman a fool. The good news is that historically the markets go up, so if you are net long your playing a game where everyone will win.
- Now it's time to buy the stock. You need to put on your portfolio analysis hat now and think about how the security will affect your diversification. How much should you buy? Should you sell something that holds a similar market niche as this company to make room for it? How will it change the risk profile of your whole portfolio. You also might want to get your technical analysis hat on too. EMH theory, valuation, and economic analysis can find you good stocks to buy, but there is no denying that there are some optimal and less than optimal times to buy. Look for events in the stocks future like earnings announcements. Take a look at momentum indicators and make a play at the fools game of bottom picking. If you're even a little successful you could have just added 5% onto your yearly return. A way to avoid this task is to simply scale into the stock over a moderate period of time. The law of averages should make sure you aren't totally screwed on entry.
- Or don't buy the stock. Maybe it's not the best way for you to make money. If through your economic reading you've found a stock that you think has a great opportunity to make money over a short period of time, you could consider event play strategies. These involve calls and puts and include, bull spreads, bear spreads, straddles, strangles, and lots more. Each has their purpose and don't require that much background knowledge to understand. Pay attention to the break even points, and remember, you are trying to beat a bank, don't do it on a whim.
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