prelims
4/3/02
4:36 pm
Page i
INVESTOR’S GUIDE
The Empowered Investor Manage Your Investments the Way the Professionals Do
MARK HARRISON
An imprint of Pearson
Education
London · New York · Toronto · Sydney · Tokyo Singapore · Hong Kong · Cape Town · New Delhi Madrid · Paris · Amsterdam · Munich · Milan · Stockholm
prelims
4/3/02
4:36 pm
Page ii
PA RT O N E . S t r a t e g y f o r t h e i n d i v i d u a l i n v e s t o r
PEARSON EDUCATION LIMITED Head Office: Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 London Office: 128 Long Acre London WC2E 9AN Tel: +44 (0)20 7447 2000 Fax: +44 (0)20 7240 5771 Website: www.financialminds.com
First published in Great Britain in 2002 © Mark Harrison 2002 The right of Mark Harrison to be identified as Author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 65943 X British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1P 0LP. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. 10 9 8 7 6 5 4 3 2 1 Typeset by Northern Phototypesetting Co. Ltd, Bolton Printed and bound in China The Publishers’ policy is to use paper manufactured from sustainable forests.
This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, investing, or any other professional service. If legal advice or other expert assistance is required, the service of a competent professional person should be sought. The publisher and contributors make no representation, express or implied, with regard to the accuracy of the information contained in this book and cannot accept any responsibility or liability for any errors or omissions that it may contain.
prelims
4/3/02
4:36 pm
Page iii
About the author
Mark Harrison joined www.iii.co.uk, the financial website, as Chief Investment Editor in 1999. In 2000 the site won the Bradford & Bingley Personal Finance New Media Site of the Year and in 2001 it won the Investors Chronicle Best Online Content Award. Mark trained as a securities analyst at Credit Lyonnais Laing before spending three years as part of a team managing £20 billion of assets for Guardian Asset Management. Mark is a Member of the Association for Investment Management and Research in the US and an Associate of the UK Society of Investment Professionals. He was educated at Lincoln College, Oxford.
iii
prelims
4/3/02
4:36 pm
Page iv
prelims
4/3/02
4:36 pm
Page v
Contents Preface Acknowledgements 1
ix xii
The information wheel Jump onto the information wheel The information chase New information on the wheel How can the individual private investor beat the professionals? Individual private investors can beat the market Buy companies forecasting growth Buy small firms Watch your ratios Watch the pros Timing effects Buy on investment announcements Beat the index trackers at their own game
9 9 11 13 14 17 20 21 21
2
The noise trading revolution What is noise trading? Internet bulletin boards: the noise trading revolution Professionals vs. individual investors Who gets the information first? Know thyself Frames – it’s the way you tell ’em The way we find things out The information wheel can turn The individual investor advantage
27 29 31 33 34 35 38 39 40 42
3
Fundamental analysis Part One: Picking a good stock A qualitative decision How can we detect a company’s growth? Yikes, numbers: ratio analysis Hidden assets
45 47 47 48 50 53
1 4 5 7
v
prelims
4/3/02
4:36 pm
Page vi
Contents
vi
Selecting stocks using P/E models Shells and penny shares Picking a good management Big ideas: behavioural finance and mean reversion Market timing Part Two: Picking a good industry Looking at different industries Detecting earnings quality Corporate events: mergers, takeovers and IPOs
53 54 55 56 57 58 60 63 65
4
Technical analysis What is technical analysis? Let’s start with the basics Volume and the Dow Theory Support and resistance levels Breakouts and moving averages Candlesticks Point and figure charts Easy patterns to detect Triangles Rectangles Flags Reversal trends: double tops and head and shoulders Mathematical indicators Relative strength indicators (RSI) Rate of change (ROC) indicators of velocity MACD Bollinger bands Fibonacci retracements Elliott waves Market indicators Contrarian technical analysis rules Breadth of market indicators Kondratieff and Coppock Buy and sell signals Indicator tips
71 73 75 76 77 78 80 80 81 82 83 83 83 85 85 86 87 88 89 90 91 91 91 92 92 94
5
A more professional portfolio Step 1: Your portfolio and your needs Step 2: Pick a benchmark
95 97 100
prelims
4/3/02
4:36 pm
Page vii
Contents
Step 3: Understand risk vs. return Step 4: Designing the portfolio universe Step 5: Bonds vs. equities Step 6: Combining shares
101 102 106 107
6
Winning online portfolios Portfolio case studies Case 1: A UK growth portfolio Case 2: A UK value portfolio Case 3: A UK income portfolio
117 119 119 129 135
7
Mastering your age Samuel Jones Lloyd: a Victorian multimillionaire John Maynard Keynes: playing the world markets after the crash Jim Slater: figuring out the best stocks Nils Taube: getting the big picture right Warren Buffett Peter Lynch
143 145
8
Crashes and bubbles What is a bubble? Tulipmania The Mississippi bubble 1720 South Sea Company joint stock bubble 1720 Wall Street crash 1929 Monday 19 October 1987 The Japanese catastrophe The internet bubble The UK internet bubble Anatomies of a price bubble
167 169 170 171 173 174 178 180 182 183 186
9
Doing your research The information problem Primary sources Secondary sources How to do research Research case study 1: the housebuilding industry Research case study 2: The Berkeley Group plc
191 193 194 194 196 196 208
10
Online resources survey Selecting stocks
215 217
148 152 154 157 163
vii
prelims
4/3/02
4:36 pm
Page viii
Contents
Index
viii
Broker research reports UK broker rankings Independent analysis Other research sites Stock screening tools Helpful broker and fund manager sites IPOs Economic angle Official resources Technical analysis Sectoral research resources Pharmaceuticals and biotechnology Property Media Chemicals, industrials and oils Banks and financial services Technology Selecting other assets Portfolio monitoring Financial news Newswires UK data and market prices
217 218 218 218 218 219 220 220 221 222 222 223 223 224 224 224 225 225 226 227 228 228
Appendix: Voices from the bulletin boards Tipsters The bubble Risk Technical analysis Shareholder democracy At the height of the UK bubble: February 2000
229 231 233 236 237 238 238 240
prelims
4/3/02
4:36 pm
Page ix
Introduction
Preface
At the height of the boom in technology shares in 1999, one of the leading stockbrokers took a call from a client. ‘I want to buy a thousand of whatever that bloke on the telly just tipped,’ he said. ‘Don’t know the name of the share, just buy me a thousand shares quick.’1 I haven’t written the book for him since he may well be beyond hope. I have written it to help investors exploit the opportunities of the stockmarket, to realize the benefits of the latest technologies and to take intelligent decisions for themselves. The technology stock boom has created many new investors. Some have been disappointed, but many have caught the bug. There has been a huge growth in trading, especially over the internet which now accounts for one in five trades in the UK. Equally many private investors have become disenchanted with the fund management industry, which has a habit of heavily promoting sectors just before a downturn. These new active investors and traders are becoming a force to be reckoned with around the world as they already are in the USA. They want to be on equal terms with the institutions by having access to all the best information. ‘They do not accept that there should be a charmed circle of brokers, analysts and institutional investors with privileged access to corporate data.’2 Individual private investors now demand a level playing field to furnish them with enough independent information to take their own decisions. My object in writing this book is to empower private investors to build and manage a portfolio of investments. Portfolio might seem a forbidding word suggesting ancient, leather-bound binders full of papers. Nothing could be further from the truth. If you have more than one share then you have a portfolio. Everyone can have a portfolio. With new technology you can manage it entirely without the burdens of accumulating piles of paper and expensive administration costs. By your portfolio I don’t mean your house, your pension and any cash you have for emergencies. Since your home is not real spendable stuff, you ix
prelims
4/3/02
4:36 pm
Page x
Preface
should not account for that in the same way as you do your shares. The same applies to your pension which, although a portfolio of assets, is designed to match a set of liabilities to provide for your retirement. I am talking less about the selection of individual shares, but rather about the deliberate combination of shares into a portfolio. To do this you can learn to use all the tools of the fund managers’ trade and to think just how the professionals think. I have at one time or another been a stockbroking analyst, part of a team managing a £20 billion institutional fund and a financial journalist so I suppose I have been around the block and back. One thing is certain: no professional investor would invest a penny on the back of a tip he saw on TV. There is a world of difference between a tip and an analysis. For a start, analysts are regulated for the protection of investors and journalists are not. Analysts cannot ‘front run’ or buy shares for themselves before tipping them. If they do then they risk losing their licence to practise and damaging the reputation of their firm. No such binding restrictions apply to journalists. A tip in a newspaper could be a one-liner made up in the bath. It could be founded on nothing more substantial than the fact that it sounds clever. Analysts who are, as I am, members of professional bodies are bound to have a reasonable and objective basis for their conclusions. So how do analysts analyze? The results of a survey of 185 US investment managers and bankers are shown below. Fundamental analysis and technical analysis are clear favourites. But we shall look at all three in turn. Favourite professional techniques of investing3 Fundamental analysis Portfolio analysis Technical analysis
74 per cent 30 per cent 35 per cent
I feel that the best place to start is by first exposing the way information flows about the stockmarket. The next step will be to examine ways to profit from inefficiencies in the flow of information. Then we can journey through the professional toolkits of fundamental and technical analysis. After that we will be ready to tear apart the myth that building a winning portfolio is the preserve of investment managers. Finally, we can learn something from how investors such as John Maynard Keynes, Warren Buffett and Jim Slater mastered their age and achieved fortunes through x
prelims
4/3/02
4:36 pm
Page xi
Preface
investing in both bull and bear markets. For your entertainment and instruction I have also included a few pages on the great bubbles and crashes.
xi
prelims
4/3/02
4:36 pm
Page xii
Acknowledgments
Just to prove I didn’t write all this off the top of my head, I should like to credit Fred Wellings for his acute analyst-training seminars at Crédit Lyonnais Securities, the Association for Investment Management and Research whose CFA program helped organize my thoughts on portfolio analysis, and the many users of iii, the financial website, particularly during that brief spring of 2000 when it seemed we had discovered a new eternal truth and shaken old prejudices. Robert Barrie of Credit Suisse First Boston, Clyde Lewis and Julian Marshall of HSBC Securities, Anil Raval at Ample Interactive Investor, Tom Stevenson at Hemscott.net, staff at the UKSIP, City Business and Guildhall Libraries and the custodians of the Keynes literary estate all win mentions for promptly dealing with my queries. Rafael Gómes Rodriguez reminded me that simple English words are always best. Jonathan Agbenyega and Richard Stagg, my publishers, showed commendable faith in the appetite for knowledge of private investors. I owe grateful thanks to Penelope Allport for unflappingly managing this project through production and to Susan G. R. Williams for accurate and vigilant proofing. Enjoy the book and best of luck in your investing. Mark A. Harrison Clerkenwell, London December 2001
NOTES 1 2 3
xii
Justin Urquhart Stewart of 7 Investment Management, a division of Killik & Co. Howard Davies, Chairman of the Financial Services Authority, in a speech to the Investor Relations Institute, 9 July 2001. R. C. Carter and H. Van Auken, ‘Security analysis and portfolio management: a survey and analysis’, Journal of Portfolio Management, Spring (1990), p. 82.
chap 1
4/3/02
4:38 pm
Page 1
1 The information wheel Jump onto the information wheel The information chase New information on the wheel How can the individual private investor beat the professionals? Individual private investors can beat the market Buy companies forecasting growth Buy small firms Watch your ratios Watch the pros Timing effects Buy on investment announcements Beat the index trackers at their own game
1
chap 1
4/3/02
4:38 pm
Page 2
chap 1
4/3/02
4:38 pm
Page 3
chapter 1 . Why the stock market?
I’d be a bum on the street with a tin cup if the markets were efficient. (Warren Buffett)1 I have noticed that everyone who ever told me that the markets are efficient is poor. (Larry Hite)2 Not long ago information flowed smoothly around the small, clubby world of the City of London. News about takeovers, profitability, new products or management incompetence was divided among a small circle of perhaps a couple of thousand brokers and fund managers on a daily basis. The London Stock Exchange motto, ‘My Word is My Bond’, was to a large extent true and anyone who dared to break the rule was unceremoniously exiled. This world was brought to an end by liberalization of the ownership rules of the London Stock Exchange in the late 1980s. This ‘Big Bang’ prompted a rash of wheeling and dealing by US and overseas banks to buy up the European financial capital. There is still an interdependent clubbiness in the City, of mutual favours and informal contracts. Companies who want to raise loans or issue shares have to rely on investment banks. For example, an investment bank will guarantee (or underwrite) the success of a rights issue, where a company sells its stock to existing stockholders, charging a fee of up to 15 per cent. In turn the investment bank will pass on the risk that stock may not be sold to sub-underwriters, often the investment managers who already own the stock. Again a fee changes hands. Investment banks rely on investment managers to buy their loans and stocks and all rely on analysts and salesmen to convey and interpret information. A large investment bank will have not only a corporate department but also analysts, a stockbroking and an investment management arm.
3
chap 1
4/3/02
4:38 pm
Page 4
The empowered investor
JUMP ONTO THE INFORMATION WHEEL The stock market can be thought of as a gigantic information-processing machine. Information will make or break your investment: information not so much about the past as about the future earning power of a stock. With a computer terminal we can now see prices reflecting almost instantly whatever is happening in the most distant corners of the world. When there is a legal ruling against a tobacco manufacturer in Los Angeles, the prices of tobacco makers around the globe reverberate. If there is an explosion in a refinery in Brazil, the share price of speciality chemical manufacturers of the product in England who will gain from the misfortune are instantly marked higher. It is important to distinguish between stale information and new information. Past information is already impounded in the price of a stock. New information about future growth feeds change in the share price. Informed by our own It is important to information and analysis, millions of investors distinguish between stale information and continuously vote as if in a gigantic opinion poll new information. where the result is the market price of a stock. When new information appears there is a scramble to profit from it and the price adjusts to a new equilibrium. So the stock market is a kind of competition among investors for the very best information. If there is no new information then the stock market will become stagnant. Then as pulses of new information appear, their energy will be consumed to fuel change in the market. Better information allows superior analysis and higher profits from the anomalies between the market price and potential price you foresee. By your own buying or selling you will remove the opportunities for the less perceptive to arbitrage a profit for themselves as you and others rush to drive prices to the point where profitable opportunities do not exist. This is not so much of a zero sum game as a positive sum game because the trend of earnings and prices is generally upwards. Other things being equal, company profits and stock prices will trend up with general economic growth. But that does not make it any easier to select stocks. In order to arrive at an investment decision to buy and sell you need to build up a mosaic of information to give you the confidence to do so. If you look at fundamental information you may have been following company announcements, bulletin boards or economic indicators. If you are interested in charts, you could well have noticed a pattern or a trend.
4
chap 1
4/3/02
4:38 pm
Page 5
chapter 1 . The information wheel
Whichever way you invest, you will have acquainted yourself with significant facts. You will be able to give concrete reasons if someone asks you why you did the deal.
THE INFORMATION CHASE Where does information come from and what is important? Information is not the same as market gossip. Information is what really determines the true or intrinsic value of a stock. It says something significant about the future earnings power of a stock. When as an analyst I talk about intrinsic value or economic value I am thinking of something entirely different to market value. A market value can be unduly influenced by the day-to-day fluctuations in the liquidity of a stock. For example, when an institution sells a large line of stock, the market price jumps about all over the place, whereas a theoretical value will be more stable. A small illiquid stock can be severely damaged by the attempt of a large shareholder to sell up, even if they are selling for some genuine technical reason. Intrinsic value is unaffected by such short-term consideration and can be calculated yourself or taken from independent experts such as investment analysts. In fact anyone can calculate the theoretical value of a company. You can use ratios from accounting information, look at the quality of management, scrutinize market share or do your own assessment of a company’s products. If you are mathematically inclined you can calculate a present value of future cash flows, though that is beyond the scope of this book. There are two families There are really two families of information of information opportunities available for investors to exploit. opportunities available The first is under-reaction and the second is overfor investors to exploit. The first is reaction. Good news can lead to over-reaction. In under-reaction and the which case you can profit by selling. But if news is second is good, prices may under react and then keep trendover-reaction. ing up and develop momentum. Momentum, where the price just keeps on going in one direction, is a longer term consequence of the price under-reacting to news in the short term.3 All these sorts of news announcements provide measurable changes in value. Imagine a world where stock prices changed instantaneously in response to information alone rather than to market noise. In such a world 5
chap 1
4/3/02
4:38 pm
Page 6
The empowered investor
prices would move up and down in giant leaps as soon as news was announced through the regulated channels. Active trading makes these leaps less pronounced and makes the stock market a lively and liquid place to trade. There is one difficult notion that we are going to have to get out of the way first. This is the notion of markets being efficient. When the investment experts and academics talk about efficiency they don’t mean quite the same thing as ordinary folk. We might think our new car is very efficient in doing 50 miles to the gallon when our neighbour’s car does only 30 miles. Stock market efficiency is a little different. It is all about the way stock prices absorb news and adjust to it. If stock prices always reflect all the available information then they are always right, they are always efficient. But as we all can guess this is an unrealistic and rather academic theory. I don’t know what it is about academics, but they always seem to take extreme positions and occupy opposite poles. In one corner these efficient marketeers hypothesize that market prices are supposed to adjust to all publicly available information on its release instantaneously preventing any possible trading opportunities. They call this the Efficient Markets Hypothesis (EMH).4 EMH is in turn based on the more primitive idea that people behave rationally at all times to maximize their own benefit or utility and are able to process new information correctly. The argument of this book is that for one reason or another they basically do not, and I am in good company. According to George Soros, a speculator of some note: ‘The theory [of efficient markets] is manifestly false – I have disproved it by consistently outperforming the averages.’5 Soros believes that participants themselves distort the efficiency of markets by reacting to information in unexpected ways: ‘Nothing could be further removed from reality than the assumption that participants base their decisions on perfect knowledge. People are groping to anticipate the future with the help of whatever guideposts they can establish.’6 What is the Efficient Markets Hypothesis? In a perfectly efficient market, prices are held to adjust to all publicly available information on its release instantaneously preventing any possible arbitrage trading opportunities.
6
chap 1
4/3/02
4:38 pm
Page 7
chapter 1 . The information wheel
NEW INFORMATION ON THE WHEEL In the modern stock market, new information about companies first flows out from the company around a tightly knit circle of analysts, journalists, public relations and investor relations firms and finally to institutional and smaller investors (Figure 1.1). Companies PR/IR firms
Analysts
Journalists
Fund managers Small investors
Figure 1.1
New information on the wheel
New information such as the figures on the sales of a new product first has to get through the company’s management structure. You can easily imagine the product being introduced on your local high street and thousands of other high streets around the world. It may take time for a company to know whether the product is selling well in one region or another. They may have manufactured too much stock or have faulty products recalled. In a large company with many management layers, managers may disguise the failure of products from their bosses perhaps until after a bonus appraisal. Eventually the information will percolate to the office of the chief executive and a decision will be taken on whether the information is price sensitive and how and when to release the information to the outside world. All major news announcements such as results, mergers, acquisitions or new contracts have to flow through formal stock exchange channels. In the UK this is the London Stock Exchange Regulatory News Service (RNS), while in the USA the official channel is the Securities and Exchange
7
chap 1
4/3/02
4:38 pm
Page 8
The empowered investor
Commission (SEC). They contain what is described as material non-public information. This is news that will likely influence the share price when it becomes known. These news announcements are simultaneously delivered as press releases to journalists and investors. On the day of announcements the managers of the company make themselves available first to investors (usually in order of size), then to securities analysts and lastly to journalists. These formal channels are only the tip of the information iceberg. Firms of investor relations have grown up to provide a far more informal means of information flow. They arrange company visits for analysts and investors and massage expectations between the news announcements. While journalists and company managers have been around for centuries, analysts are a relatively young profession. In the USA they developed on Wall Street in the 1920s, often as statistical departments of stockbroking firms. In London they arrived in the 1960s and have expanded in number as stockbrokers and investment banks have merged. More recently investment management companies have developed their own analyst departments. The job of a securities analyst is basically to form and communicate investment recommendations to their clients or employers. Because of their close access to institutional investors and influence on public opinion, analysts are given privileged access to companies and company managers. They are given ‘clues’ as to how the companies are faring. Increasingly companies have been under pressure to provide equal access to new information and to appear transparent. The distribution power of the internet has made instant simultaneous information distribution easy. But there remain marked differences in the information that companies make available on their eponymous corporate websites. There are seasonal patterns for news flow with lots of announcements after the end of the tax year. Bad news often flows out when markets are shut or on a Friday after the close of trade. Takeover news also has a tendency to develop over the weekend, described in the trade as the ‘Friday night drop’. When markets are shut, foreign markets can reflect market sentiment through foreign listings which most large companies maintain abroad.
8
chap 1
4/3/02
4:38 pm
Page 9
chapter 1 . The information wheel
HOW CAN THE INDIVIDUAL PRIVATE INVESTOR BEAT THE PROFESSIONALS? With thousands of analysts and professionals scouring the market for bargains every day, you might think that there are not many overlooked opportunities around to exploit: ‘The more skillful analysts there are, the harder it will be for the average practitioner to “beat the market”.’7 Even the fund managers are complaining. For professional fund managers at the giant fund management firms, it is hard work to find profitable information and getting harder still as their funds grow. With competition for information becoming ever more intense, professionals have a tough time in trying to outperform one another. According to one: ‘We could not beat the market because we were rapidly becoming the market.’8
INDIVIDUAL PRIVATE INVESTORS CAN BEAT THE MARKET ●
●
●
●
●
Understand your own investing behaviour – know the great bubbles, understand overconfidence, overtrading and misleading frameworks. Understand the investing behaviour of the professionals – learn from the master investors. Jump on the information wheel – know when you have spotted really new information. Know the market anomalies – growth stocks, small firms effect, ratios effects, calendar effects. Build a winning, balanced portfolio using professional tools – broker research, online information, screens and online portfolios.
Understanding your investing behaviour The diversity of our opinions does not proceed from some being more rational than others but solely from the fact that our thoughts pass through diverse channels and the same objects are not considered by all. (Rene Déscartes)9
9
chap 1
4/3/02
4:38 pm
Page 10
The empowered investor
How is it that with equal access to the same information two investors will probably come up with completely different conclusions? In recent years a rather frighteningly named group of theorists, Behaviouralists, have been trying to find patterns in such things. What they suggest is that people behave in predictable ways in their investing and that these explain the way share prices move. Behaviouralists are basically taking commonly observed patterns such as avarice, aversion to risk, impatience and the formation of habits and slapping categories on top of them. Once we have got to grips with a couple of these categories, then we will be better able to spot shares that are trading at the wrong market price. Professional investors live in a rather more rarefied world. They have the experience and the Behaviouralists are basically taking time to allocate all their resources to working out commonly observed how particular stock prices will respond to the patterns such as various categories of information. Private avarice, aversion to investors are less well informed and have less risk, impatience and time. There is always the temptation to oversimthe formation of habits and slapping categories plify, reducing investment into a couple of investon top of them. ment techniques and maxims such as: ‘Always invest when directors are buying their own shares or when the P/E ratio is low.’ While these are both sound principles it is advisable to study the detail before relying on a rule. We shall look at behavioural finance in some more detail later.
What is a P/E ratio? This is the price per share divided by the earnings per share, i.e. if price is 100 and earnings are 10 the P/E is 10. So you are paying up ten years of today’s earnings if you buy it.
Markets are not efficient Find out the inefficiencies and profit from them Between the autumn of 1929 and 8 July 1932 the US stock market lost over 90 per cent of its value. It didn’t all happen in one go, although it had a violent beginning. On Thursday 24 October, the first day of the crash, a syndicate headed by Mr J.P. Morgan and executed by Richard Whitney thought it was getting a bargain when it bought US Steel stock at 205. They had recently traded as high as 258 that very summer. By 5 Novem-
10
chap 1
4/3/02
4:38 pm
Page 11
chapter 1 . The information wheel
ber 1929, US Steel was 165. On 8 July 1932, US Steel was trading at only 22. Doesn’t look like the price was very efficient in reflecting anything other than the panic of those years. Why were stock prices in London 11 per cent less valuable on one particular day, 19 October 1987, than they were the day before? Can it happen again? The huge change in prices from one day to the next is pretty good evidence that prices are not really that efficient. They sometimes respond not to new information, proper news, but rather to noise and dealings. Some would argue that the irrational influences would cancel each other out, but markets do not seem to be as efficient in pricing stocks as we might hope. Following directly from this is the useful suggestion that we can hope to find predictable aspects of inefficiency. If you can find out where and why the market is not effective If you can find out at pricing in information then you can profit from where and why the the anomalies. According to the experts who market is not effective at pricing in (unsurprisingly) have been swarming to discover information then you the market’s secrets for the last fifty years, here can profit from the they are: anomalies. 1. 2. 3. 4. 5. 6. 7.
Buy growth stocks. Buy smaller companies. Watch your ratios (low P/E and low Price/Book). Watch the pros. Timing effects. Check out the investment announcements. Beat the index trackers at their own game.
You may be familiar with some of these successful strategies from your own investing, but it is always nice to be proven right and have some concrete evidence provided by experts.
BUY COMPANIES FORECASTING GROWTH Should we buy growth stocks – after all they have already gone up? Earnings announcements are really central to the valuation of companies. They convey information about current and future prospects. This is where expectations and reality about growth coincide. Prior to the release of earnings, the market will have built up expectations on the likely figure 11
chap 1
4/3/02
4:38 pm
Page 12
The empowered investor
represented in the consensus earnings forecast. The magnitude of the reaction is determined by the extent to which earnings meet investors’ expectations. Undershoot expectations and your share price may promptly nosedive. What is the consensus earnings forecast? This is just the average forecast of all the stockbroking analysts of the earnings of a company in the coming year. If there are only two brokers, one forecasting 10p and the other 20p, the consensus will be 15p. Investors look to the earnings per share (EPS) as the key information output and the main measure of past and future growth. Growth is important and becoming more so in a world where inflation is low. Because EPS is an input into the other key ratio used by investors, P/E, its importance to investors cannot be exaggerated. Of course general information about the economy, the firm’s markets and products will be widely available long before the release of final results and annual reports. There will be reports from competitor firms, management announcements and the interim report to provide updates in between. So wide-awake observers like the analysts can guesstimate future earnings changes. One study by academics of the link between earnings and price returns found that the market price of shares does anticipate the direction of reported announcements on profits. According to this around 80 per cent of the attributable price Investors look to the change comes before the release of the annual earnings per share report and 20 per cent after.10 One explanation of (EPS) as the key market under-reaction on the release of information output and the main measure of announcements is that old habits die hard. Conpast and future fronted with new information about a company, growth. investors have to relate it to their existing views. They tend not to react as much as the information warrants because of their instinctive conservatism. At the same time, when investors are bombarded with good news they not only drop their old conservatism, but adopt a frame of mind that underestimates the possibility of failure.11 The implications are that we should pay up for growth particularly if we spot a positive change in the trend of announcements. The fact that the share price anticipates the direction and amount of earnings is key evi-
12
chap 1
4/3/02
4:38 pm
Page 13
chapter 1 . The information wheel
dence against the theory of perfectly efficient markets since, according to that, price changes should occur only after the release of results and not a moment before.
BUY SMALL FIRMS Another major opportunity is the fact that smaller firms tend to outperform the market even when returns are adjusted for risk. This suggests that investing in a portfolio of smaller sized firms is a good investment strategy. Six good reasons to buy small firms are as follows: 1. Profits and dividend growth can be faster than with larger companies because they are starting from a lower base. 2. There are no bureaucracies to stifle bright ideas in small companies. 3. They are small and nimble enough to adapt flexibly to fast-changing market conditions. 4. Over the long term, studies show a premium over normal returns of 8–17 per cent, persisting over long periods and after transaction costs in many countries.12 You could have had an extra $1m if you had invested $1000 in smaller rather than larger US companies in 1926 and let the money grow to 2000. 5. Good small companies may fall below the radar screens of the big investors and analyst coverage is shallow, resulting in many neglected opportunities. 6. Takeover activity is likely to be more common in smaller companies. There are several possible explanations which confirm that small companies are fertile hunting grounds for bargains. One is that the costs of investing in smaller stocks are higher due to wide dealing spreads, so you would expect returns to be better. However, the magnitude of the premium over normal returns is so large (8–17 per cent) that transaction costs from wide bid/ask spreads are dwarfed. Another explanation argues that smaller firms are more risky and that the return is merely compensation for risk that is difficult to compute. But even adjusting for risk, returns from smaller companies are still abnormally large. Another possible explanation focuses on the neglect of some companies by analysts. This results in poor availability of high quality information. It is common sense that if you have less information you can demand a higher return. 13
chap 1
4/3/02
4:38 pm
Page 14
The empowered investor
WATCH YOUR RATIOS Buy on low P/Es If you remember nothing else about P/E ratios, remember to avoid stocks with excessively high ones. You’ll save yourself a lot of money if you do. With few exceptions, an extremely high P/E ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse. (Peter Lynch)13
Many investors use P/Es and nothing else because they are easy to calculate and allow stocks to be quickly compared. But to my mind there is there is no right or wrong P/E. When you do the calculation of dividing price by earnings per share, you just get a number that is a starting point to work with. The more you know about the individual company, the less informative it is. You can use past earnings or more realistically you can use future earnings to calculate the ratio. But you must be sure to be comparing like with like. Looking at the whole market over time, P/Es are up and down like a yo-yo. Take the US stockmarket. Since 1926 the P/E has averaged 14.4 and ranged from a low of 5.9 in 1949 to a high of 35 in 1999. A dollar of earnings could be worth $5.9 a share or $35.14 This is a wide disparity. In the early 1970s stock prices of a group of large companies known as the Nifty Fifty, which included Sony Corporation and McDonald’s, traded at 60–90 times earnings. At this time the market as a whole had a P/E of 18. In 1961 the P/E had risen from its post-war low to 22 and then fell down to 7 in 1980 before accelerating to its recent high of 35. Which one was the right level? The answer is that they all seemed pretty right to investors buying stocks on the day. Buying low P/E stocks is one of the oldest ways of discriminating in favour of stocks. The idea is that stocks with a low P/E or conversely high earnings to price are likely to be undervalued and earn future excess returns. Benjamin Graham, the Buying low P/E stocks founder of modern security analysis, used P/E is one of the oldest ways of discriminating ratios as a screen to identify undervalued stocks in favour of stocks. in his classic, Security Analysis: Principals and Techniques (1934). The performance figures seem to back him up. From 1967 to 1988, US firms in the lowest P/E decile earned an average return of 16.26 per cent, while those with the highest P/E ratios earned only 6.64 per cent. These excess returns are mimicked worldwide.15
14
chap 1
4/3/02
4:38 pm
Page 15
chapter 1 . The information wheel
The excess returns from stocks with low P/E ratios cannot be explained as a compensation for extra risk because most low P/E stocks have low growth, large size, high assets and stable businesses. These are characteristics of dull and safe businesses that diminish risk. Obviously a rule of buying on the basis of a low P/E excludes many companies of merit that are not yet in profit or whose earnings have been disrupted by cycles or corporate events. The other problem with investing on the basis of low P/Es is what is known as ‘aggressive accounting’, where companies deliberately adopt an accounting practice to flatter their earnings. Other perfectly proper accounting practices distort earnings such as by restructuring charges or the amortization of goodwill. Overall buying on P/E ratios sounds like a pretty good bet providing you check out the company and its earnings in more detail.
Buy low Price/Book It is not size that counts in business. Some companies with $500,000 capital are making more profits than other companies with $5,000,000. Size is a handicap unless efficiency goes with it. (Herbert N. Casson)16
If you take a look at the balance sheet in the accounts of any company, you will see that there is a line called shareholders’ funds or equity. This is what is known as book value (BV). It is not money that shareholders can have back if they ask politely; nor is it money that the company can splash out on anything it likes. Book value is exactly Book value is exactly what it says, just the value what it says, just the value in the company’s in the company’s book of its net assets. The true book of its net assets. value may be lower because an asset such as machinery has worn out, or higher because land or technology has gone up in value. The ratio of price to book is simply the price per share divided by book value per share. The price to book anomaly captures the outperformance of firms whose underlying assets are a high proportion (or even larger) of the market value. So you buy low Price/Book and sell high Price/Book. Book value is always a fairly stable number. It will not chop and change as much as earnings and high book value will be a characteristic of relatively low risk firms.
15
chap 1
4/3/02
4:38 pm
Page 16
The empowered investor Table 1.1
Excess annual returns of low Price/Book stocks, 1981–9217 %
France Germany UK USA
3.26 1.39 1.09 1.06
Source: Asweth Damodaran (1996) Investment Valuation, New York: Wiley, p. 177.
What is Price to Book (P/BV)? This is simply the price per share divided by the book value per share or the shareholders’ funds divided by the total market capitalization. If the price is 100 and the book value is also 100 the P/BV is 1. Information on book value can be found in the annual report of a company. A bank may have a Price/BV of around one while an industrial company would be more likely to be greater than one. But because book value is calculated on the basis of historical cost of the assets, an industrial company may overstate the true value of worn-out machinery. Benjamin Graham used P/BV to select stocks and was particularly keen on stocks with P/BVs above two-thirds, i.e. more than two-thirds of the share price could be covered by book asset value. While this may have helped Graham to avoid investing in too many duds during the Great American Depression, it seems a conservative strategy in a time of low inflation and more professionally managed economies. We should not forget that assets attract maintenance and upkeep expenditure for their owners. Buying low Price/Book stocks seems a winning strategy since you are investing in mostly stable and low risk stocks. But it is probably a good idea to check out that all the book assets in which you are investing are actually producing cash flow. Double-check that the dividends are covered and not a relic of some bygone era of prosperity.
16
chap 1
4/3/02
4:38 pm
Page 17
chapter 1 . The information wheel
WATCH THE PROS Buy on insider-director dealings and fund manager trades With enough inside information and a million dollars you can go broke in a year. (Warren Buffett)18
A whole industry has grown around tracking director and institutional dealings. The reasoning for this is that directors and large institutional shareholders are privy to important private information, or at the very least able to react to public information before the rest of us have the chance. Fortunately in most countries such trades have to be reported to the local stock exchange. In the USA, corporate insiders, as they are called, have to report their transactions in their employer’s shares to the SEC each month. In the UK director’s dealings and share trades by holders of more than 3 per cent of an issue are reported as soon as practicable. So we can monitor the trends in these purchases or sales. With director’s dealings we are just seeing the tip of the iceberg. There are all manner of reasons why a director may be buying. They may be exercising a stock option; they may just have been appointed and want to demonstrate commitment to their new employer; they may be making a minor adjustment to a huge shareholding. But the evidence is that corporate insiders consistently enjoy above average returns, especially on purchase transactions.19 It seems that transactions by the chairman and CEO are the most useful to follow. Because of investor interest in these data the Wall Street Journal in the USA and the Financial Times in the UK publish columns discussing the largest insider trades. I must admit that this is one of my favourite strategies other than buying small firms. I always check what the directors are doing and I suspect that sometimes they use their dealings to signal to the market. Occasionally they may attempt to send out false signals. I find the fund manager dealings less useful, except in some smaller companies where the presence of a good fund manager can also prompt his following to buy.
Buy or sell on analyst recommendations Analysts operate at the core of a matrix of information flow between the companies they analyze and the stock market. They use both publicly available and private information to formulate and issue buy and sell
17
4/3/02
4:38 pm
Page 18
The empowered investor
recommendations. As you might expect, there is evidence that both buy and sell recommendations affect the prices of stocks (Figure 1.2). Analysts have come in for a lot of flak recently. The problem is that analysts are part of giant investment banks with both corporate financing and analyst departments divided by ‘Chinese walls’. The suspicion is that they are not immune to pressures from elsewhere in their institution, which may be a sizeable shareholder in the company being analyzed or may have a corporate finance relationship. It turns out that only about 3 per cent of analyst recommendations lately have been sells. In their favour, analysts are anxious to be seen as independent and there are moves afoot to restore the reputation of analysts and their employers.20 Another allied issue is the analyst neglect effect that it is believed to contribute to the low valuation of many smaller companies. The fewer the number of analysts covering a stock, then the bigger the adjustment when new information finally appears.
Back the fund managers?
Figure 1.2
Cumulative abnormal returns (%)
If markets were perfectly efficient, then there would be no need for fund managers to chop and change their portfolios to try and outperform the index. Stockmarket prices would always fully reflect the available information and outperformance would be impossible. So in an efficient market you might as well buy an index fund. 3.5
Cumulative abnormal returns (%)
chap 1
–2
3 2.5 2 1.5 0
1
0
1
2 3 4 Time in months after analyst Buy recommendations 2
3
4
5
6
5
6
–4 –6 –8 –10 Time in months after analyst Sell recommendations
Share prices respond to analyst Sell recommendations more than Buy recommendations Source: ‘Do Stockbroking Analysts Earn Their Bonuses?’, Professional Investor, May 2001, p. 16. With permission of UKSIP
18
chap 1
4/3/02
4:38 pm
Page 19
chapter 1 . The information wheel
You would think that, if there were any market anomalies to take advantage of, money managers would be in a better position than most to exploit them. However the facts are that by and large they do not outperform. One famous study by Jensen21 showed that of 115 fund managers, only 26 outperformed the market. But this is not overwhelming evidence of efficient markets because in a truly efficient market no funds at all should be able to outperform.
Gurus and investment systems The obvious follow-on from looking at analyst recommendations is to identify some analytical techniques that are better than others. In the USA, studies have been done on Value Line to test this. Value Line is a large financial information advisory service that has built a model with four elements to it – a four-factor formula model. This divides around 1700 common stocks into five ranked groups. The model assigns weights based on the four factors: ●
P/E relative to other companies
●
price momentum
●
year-on-year earnings changes
●
the difference between actual and forecast earnings (earnings surprise).
The results are illustrated in Figure 1.3. One study shows that the top ranked group in this model outperforms the bottom ranked group by 20 40,000% 20,000% 10,000% 5,000%
Group 1: Group 2: Group 3: Group 4: Group 5:
15,915% 7,430% 2,743% 959% 193%
Group 1 Group 2 Group 3 Group 4
1,000% 500%
Group 5 100% 0% –50% –75% 1965
Figure 1.3
’70
’75
’80
’85
’90
’95
2000
’05
The success of Value Line’s stock selections Source: ‘Value Line outperforms the DOW® by 20 to 1’, www.valueline.com July 2000. Reproduced with permission of Value Line Inc, 220 East 42nd Street, New York, NY 10017
19
chap 1
4/3/02
4:38 pm
Page 20
The empowered investor
per cent.22 However, Value Line’s own Centurion Fund, which invests in stocks in the top-ranked Value Line group, has underperformed consistently over the past decade. Spot the dodgy system! Watch out for: ● transaction costs – which can eat away profits. ● survivors’ bias, where stocks that go bankrupt are screened out to leave only the winners. ● misleading graph scales showing the results. ● size of the universe of data – is it so big it could prove almost anything? ● whether the system claims credit for the successful strategy of yesteryear. ● whether the assumptions of the system are fully disclosed.
Surveys of equities analysts by Womack in the USA and AQ in the UK are similarly inconclusive. There is rarely evidence of consistent success by an individual analyst. Womack does however find greater accuracy in regard to sell recommendations than buy recommendations. Even if an analyst is inaccurate, this is not to say that they are not influential. So it is worth finding out who are the most influential analysts in surveys of analyst rankings according to fund managers and companies analyzed. These are produced annually as the Reuters Surveys and also by Extel.
TIMING EFFECTS Another oddity is the tendency for markets to perform well during the first month of the tax year. This is because investors engage in selling to establish their liability to tax at the end of the tax year. After New Year there is a rush to re-acquire those stocks that look attractive. So if you buy stocks in the last month of the tax year you should beat the market.23 There is also evidence of a weekend effect where market prices tend to open at lower levels on a Monday than they closed the previous Friday.24
20
chap 1
4/3/02
4:38 pm
Page 21
chapter 1 . The information wheel
BUY ON INVESTMENT ANNOUNCEMENTS Many people think that a surefire way to make money is to buy on news announcements, but this is more of an art than a mechanical science. You have to ask yourself, ‘What informational advantage do we have over other traders?’25 Intuitively we can guess that if a firm invests in something, then there is a possibility that the project will succeed. If we own the stock the day before the announcement of new investment, we can rightly demand that, if we sell that stock the day after, it reflects a premium for the possibility of the new project succeeding. There is evidence that joint venture formations, expenditure on research and development and capital expenditure projects all have an appreciable effect on share prices (around +1.5 per cent in the month of the announcement).
BEAT THE INDEX TRACKERS AT THEIR OWN GAME An increasing percentage of the market is now controlled by index funds, which mechanically invest in all the constituents of the chosen index without any input from analysts or fund managers. By and large these do the job they are supposed to do – one study reports the earliest US index funds have tracked the S&P 500 with a correlation of 98 per cent. From zero in 1971, when Wells Fargo set up the first index tracker, the amount involved in index funds exceeded $1 trillion a few years ago. What this means is that a large sector of the market is investing in the success or failure of one particular index. Stocks outside the index or stocks moving in and out may find themselves undervalued or overvalued purely because of the buying and selling by index trackers to keep up with the index. This creates obvious arbitrage opportunities for investors keeping an eye on stocks at the fringes of indices. Since fund managers are paid to outperform the indices, many have basically given up stockpicking and in reality keep their funds closely matched to the benchmark index. This is referred to as informal or ‘closet’ index tracking. An example of the absurd situation that both formal index tracking and informal index tracking can produce was when the UK’s Vodafone
21
chap 1
4/3/02
4:38 pm
Page 22
The empowered investor
merged with a large US operator, Airtouch, instantly increasing its technical weight in the index. According to one fund manager, ‘I’m surrounded by people who are all buying Vodafone in the wake of the Airtouch announcement. We all think it is expensive, but we’ve got to buy it to maintain our weight in the sector. The more we buy it, the more the price rises, so we have to buy more.’26
SUMMARY AND CONCLUSION The arbs We are not the only people to know about these anomalies and inefficiencies. There are thousands of hedge funds around the world that can also borrow money to invest in market inefficiencies. In a perfectly efficient market these arbitrageurs would ensure that all opportunities for a quick profit were instantly arbitraged away. However, the arbs (short for arbitrageurs) cannot know everything and it will always take time for them to catch on. There is often difficulty in effectively and cheaply shorting stock. Shorting is selling stock you do not own in the hope you can deliver it in settlement by buying it back at a cheaper price in the future. (Don’t worry if you can’t get your head around shorting or arbitrage – you are not alone.) Then there is the problem of finding substitutes to exercise an arbitrage between two like but mispriced assets. There are currently over 2000 US hedge funds worth about $175bn and thousands more elsewhere.27 Occasionally they go bust. In August and September 1998 it emerged that Long Term Capital Management (LTCM), a fund known for its large size, high leverage and the employment of the Nobel Prize winning academics Myron Scholes and Robert Merton, lost nearly half of its $3–4bn of equity. The default of Russia on its debt had triggered a market collapse that floored LTCM and several other hedge funds. A rescue of LTCM was then coordinated by the Federal Reserve Bank of New York, an intervention justified by Alan Greenspan, Chairman of the Fed, in these terms: ‘A fire sale may be sufficiently intense and widespread that it seriously distorts markets and elevates uncertainty enough to impair the overall functioning of the economy.’ In other words the financial system had been brought to the brink of collapse. One other problem involving arbitrage is that mispricings which should not be there just are – and persist for long periods of time. For
22
chap 1
4/3/02
4:38 pm
Page 23
chapter 1 . The information wheel
example, many investment trusts in the UK and closed end funds in the USA trade at very different values to their underlying assets for long periods of time. Royal Dutch and Shell are independently listed in the Netherlands and the UK. This is a structure that grew out of an agreement in 1907 between Royal Dutch and Shell by which the two companies merged while retaining their separate lists, on a 60:40 basis. Royal Dutch got 60 per cent of cash flows and Shell got 40 per cent. So in theory Royal Dutch should trade at 1.5 times Shell. In fact there are enormous deviations from this theoretical value that persist over long periods. If markets were truly rational and efficient, such problems would not arise. There would be no profits for arbitrageurs to arbitrage away. To my mind all of these, particularly the outperformance of small firms, ratios effects and analyst recommendations, are compelling evidence against efficient markets. The last irony is that there is evidence that the market may be getting more inefficient because those who believe in efficient markets are investing in index funds, which distort the share prices of many stocks.
NOTES 1 Janet C. Lowe, Warren Buffett Speaks: Wit and Wisdom from the World’s Greatest Investor (Wiley, New York, 1997), p. 93. 2 Attributed to Larry Hite, Mint Investment Management Company. 3 Andrei Shleifer, Inefficient Markets (Oxford University Press, Oxford, 2000), p. 18. 4 The framework of efficient markets theory is that prices are the sum of all available information and seamlessly adjust to all new information instantly. This can be thought of as a formal academic model. You have your inputs of various kinds of information and then you have your outputs in that prices respond measurably. It was in fact an academic physicist, Eugene Fama, who tied this together as the Efficient Markets Hypothesis (EMH). Fama classifies information into three sets corresponding to a weak, semi-strong and strong form of EMH. The first is an information set that includes only the past stock price information. This implies that past prices cannot be useful in any shape or form in predicting future prices. Technical analysis, which arrives at chart patterns and trends from past price data, is consequently a waste of time. We shall explore some of the evidence against this later. The second set of information is all publicly available information such as company accounts and government statistics. According to EMH, this is instantly reflected in the price as soon as it is known. Fundamental analysis is thus a waste of time. The final set of information includes all public and privately held information. This would include secret takeover talks and the like. Prosecutions against insider dealers such as Ivan Boesky are evidence against the last set of information.
23
chap 1
4/3/02
4:38 pm
Page 24
The empowered investor 5 6 7 8 9
10 11 12
13 14 15 16 17
18 19
20
21 22 23
24
George Soros, The Alchemy of Finance (Simon and Schuster, New York, 1987), p. 47. George Soros, The Alchemy of Finance (Simon and Schuster, New York, 1987), p. 45. Peter Bernstein, Capital Ideas (Free Press, New York, 1993), p. 161. Peter Bernstein, Capital Ideas (Free Press, New York, 1993), p. 140. Rene Déscartes, ‘Discourse on the method of rightly conducting the reason’, in The Great Books of the Western World: Déscartes and Spinoza (Franklin Library, Franklin Centre, PA, 1982), p. 69. Ray Ball and Philip Brown, ‘An empirical evaluation of accounting numbers’, Journal of Accounting Research, autumn (1968), pp. 159–78. Andrei Shleifer, Inefficient Markets (Oxford University Press, Oxford, 2000), p. 112. In the USA, R.W. Banz, ‘The relationship between return and market values of common stocks’, Journal of Financial Economics, 9, 1 (1981), p. 3–18. Marc Reinganum, ‘Misspecification of capital asset pricing’, Journal of Financial Economics, 9, 1 (1981), pp. 19–46. In the UK, Dimson and Marsh 1955–84 found outperformance of 7 per cent. For France, Bergstrom, Frashure and Chisholm reported a premium of 8.8 per cent over the period 1975–89 and a slightly smaller effect in Germany. Hameo 1989 reported a small firm premium of 5.1 per cent for Japanese stocks between 1971 and 1988. Peter Lynch, One Up on Wall Street (Simon and Schuster, New York, 2000), p. 165. C. Barry White, ‘What P/E will the US market support?’, Financial Analysts Journal, 56, 6 (2000), p. 30. Asweth Damodaran, Investment Valuation (Wiley, New York, 1996), p. 175–6. Dean LeBaron and Romesh Vaitilingam with Marilyn Pitchford, The Ultimate Book of Investment Quotations (Capstone, Dover, NH, 1999), p. 332. Table adapted from Damodaran (1996), p. 177. Other studies show that there is an excess monthly return of 1.83 per cent in the 1963 to 1990 period for stocks with low P/BV; i.e. E.F. Fama and K.R. French, ‘The cross-section of expected stock returns’, Journal of Finance, June (1992), p. 436. Janet C. Lowe, Warren Buffett Speaks: Wit and Wisdom from the World’s Greatest Investor (Wiley, New York, 1997), p. 189. H. Nejat Seyhun, ‘Insiders’ profits, costs of trading, and market efficiency’, Journal of Financial Economics, 16, 2 (1986), pp. 189–212. Study of period 1975–81, covering 59,148 trades, showed purchases were followed by price rises of 4.3 per cent while sales were followed by falls of –2.2 per cent. In early 2001 the Association of Investment Management and Research (AIMR) established a task force to examine the issue of recommendations. Many investment banks have also issued internal guidelines to reinforce ‘Chinese walls’ between analysts and corporate financiers. Michael C. Jensen, ‘The performance of mutual funds, 1948–1967’, Journal of Finance, 23, 2 (1968), pp. 389–416. Clark Holloway, ‘A note on testing an aggressive investment strategy using Value Line Ranks’, Journal of Finance, 36, 3 (1981), pp. 711–19. According to one study using past data from the NYSE, if you buy on the second to last day of the tax year and sell on the fourth day of the tax year you would have gained 6.9 per cent each and every year and more for smaller companies. You might have thought arbitrageurs would have recognized this and piled into the market before the tax yearend, then sold after it. Prices would have adjusted to remove the benefit of the anomaly.
chap 1
4/3/02
4:38 pm
Page 25
chapter 1 . The information wheel
24
25 26 27
Some say the effect has disappeared for smaller US stocks. But apparently it isn’t universally the case; other studies indicate the anomaly persists. It may be that it is the arbitrageurs themselves who are doing the tax selling. Kenneth French, ‘Stock returns and the weekend effect’, Journal of Economics, 8, 1 (1980), pp. 55–70. French suggests that it should be possible to benefit by always selling on a Friday and buying on a Monday or going short of the same stock on a Friday and covering your short position the following Monday. This effect may be linked to the tendency of firms to release bad news when markets are closed. As did Nobel Prize winner, Myron Scholes, to the suggestion that LTCM undertake some bets on the currency markets. However, other bets were not quite as prudent. Treasury’s Smaller Quotes Companies Report, November 1998, quoted in Tony Golding, The City: The Great Expectations Machine (Pearson Education, London, 2001). Bing Liang, ‘Hedge fund performance: 1990–1999’, Financial Analysts Journal, 57, 1 (2001), p. 11. Liang uses the TASS database which although comprehensive does not cover all global funds. According to Richard Hills there were 5000 hedge funds globally worth $300bn at the end of 1999.
25
chap 2
4/3/02
4:39 pm
Page 26
chap 2
4/3/02
4:39 pm
Page 27
2 The noise trading revolution What is noise trading? Internet bulletin boards: the noise trading revolution Professionals vs. individual investors Who gets the information first? Know thyself Frames – it’s the way you tell ’em The way we find things out The information wheel can turn The individual investor advantage
27
chap 2
4/3/02
4:39 pm
Page 28
chap 2
4/3/02
4:39 pm
Page 29
chapter 1 . Why the stock market?
The stock exchanges are necessary auxiliaries of modern industry and commerce; and the services which they render to the public probably outweigh many times the evils which they cause to it. (Alfred Marshall)1 The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. (Warren Buffett)2
WHAT IS NOISE TRADING? In the bull market of the 1990s it became more apparent to me than ever before that many investors choose to react not to new facts of significance, but rather to make their trades on the basis of market rumour and noise. They follow superficial advice from ill-informed journalists or gurus and trade their portfolios more for the pleasure of seeming activity than for profit. Investors are able to convince themselves that they are making an investment, but why should their choice of security go up? The most likely answer is that they think there is safety in numbers: everyone else is buying so they should too. But of course it is not always safe for the little fish to swim with the sharks. Such investors are relying on: (a) everyone else doing the same; (b) everyone else continuing to do the same when the price has gone up. We turn later to how bulletin boards actively facilitate the formation of this crowd psychology. Many will sell winning stocks or hold onto sinking ones in the hope that they might recover. They will buy heavily advertised issues at the top of a boom and sell them in a bust. Some swear by technical analysis and spend their days looking at pictures of charts and indicators and nothing else. All of these are trading on noise rather than information.
29
chap 2
4/3/02
4:39 pm
Page 30
The empowered investor
If people invest on the basis of a random guess or a hunch, a bulletin board posting, broker gossip or a groundless tip, then they are noise trading.
Let’s start by distinguishing between noise and information.3 Responding to noise is not the same as responding to information. If people invest on the basis of a random guess or a hunch, a bulletin board posting, broker gossip or a groundless tip, then they are noise trading. This is investment on the basis of what people mistakenly think is new information.
Am I a noise trader or an information trader? A noise trader is someone who buys and sells securities on the basis of factors like commentary on bulletin boards, market gossip, newspaper tips or stale news. An information trader acts on the release of previously non-public, brand new information that is considered material for the company’s future earnings.
I should say straight up, if you haven’t already guessed, that to my mind noise investing is an act of confusion. It is a kind of prejudice against or in favour of a particular stock for which every trade is a vote in favour or against. It is trading for the sake of trading, perhaps out of enjoyment. It is certainly not information. Even so it can move prices if enough people take the same view. Following on from noise investing is herd investing: ‘the trend is your friend’; ‘running with the herd’. Whenever I hear such expressions I always run in the opposite direction. I am a natural contrarian investor. Herd investors do the oppoHerd investors are site. They are desperate to conform at any cost. desperate to conform This is particularly so when those you want to at any cost. mimic are making big profits. You fear you are going to be left out. Some people are by nature conformists. They learned that behaving themselves in class leads to praise from teachers. Obeying the rules in the office leads to promotion. If they see a queue they join it. The trouble is that price bubbles can develop when noise traders start chasing a trend. They begin reacting not to any particular information but
30
chap 2
4/3/02
4:39 pm
Page 31
chapter 2 . The noise trading revolution
solely to the fact that prices are going up. In these cases the price becomes the key information. There is nothing more irrational than a man who is rationally irrational. (Lecomte Du Nuoy)4
INTERNET BULLETIN BOARDS: THE NOISE TRADING REVOLUTION The internet has come into its own as a medium for sharing information about the financial markets and trading online. In the USA there are nearly 20 million internet brokerage accounts. In the UK there were 327,000 online accounts in the third quarter of 2001 and 20 per cent of trades are now done on the internet. Information sources have proliferated. All official US company news is filed online at the EDGAR site. All UK companies file their news with the RNS service and releases are available at financial sites such as Ample Interactive Investor and Hemmington Scott. Along with these official filings there is the output of newswire journalists and stock market pundits. The internet also offers the facility for millions of investors to share their views in open bulletin boards and forums. Typically, sites such as Raging Bull and Ample Interactive Investor offer a message board for each security allowing stock specific discussion as well as ‘off topic’ boards for particular subjects of common interest.
Do bulletin boards affect stock prices? Bulletin boards are often quick to post new information, leaked or official. SmithKline Beecham’s merger with Glaxo and the merger between AOL and Time Warner appeared on the boards prior to the event. Oracle’s stock plunged 30 per cent on false rumours spread on message boards that founder Larry Ellison had died. Experts on a topic may choose to post their proprietary analysis on the boards. Perusing the boards can be a good indicator of popular investor sentiment, certainly as good an indicator as asking one particular stockbroker what the sentiment towards a stock is like. Other indicators of pes-
31
chap 2
4/3/02
4:39 pm
Page 32
The empowered investor
simism or optimism may be hidden from investors (selling stock short may, for instance, be impossible). Boards can be vehicles for ramping a company’s share price by posting falsely positive messages in order for a ramper to sell the stock at inflated levels. In February 1999 the stock price of a small Milwaukee toy company, Alottafun Inc, soared Boards can be vehicles 382 per cent based on speculation in internet chat for ramping a rooms. In the UK, a bulletin board poster under company’s share price the name of Sixpack posted a doctored press by posting falsely positive messages in release on the Minmet plc board, causing its price order for a ramper to to fall. A hoaxer can deramp a stock in order to sell the stock at inflated short it – sell stock he does not own in order to levels. buy it back at lower prices. In the case of Minmet, the hoaxer posted a press release saying that the largest institutional shareholder had sold out. The Kent fraud squad are believed to be still investigating the case. Early studies showed that the volume of internet messages about a stock predicted changes in the next day’s stock volume and returns. In particular it was found that a doubling of overnight message volume leads to a 0.18 per cent average abnormal return.5 Another study did not find much predictive power, but on days with high message activity there was unusually high trading volume. Changes in investor opinion correlated with abnormal returns. It was also found that boards with positive opinions are very responsive to recent positive market returns. The number of messages can be predicted by the previous day’s trading volume. So the market predicts activity on the boards – not the other way around.6 Even if they do not affect stock prices, participants or other noisetraders may think that they do (see Figure 2.1). This may exaggerate the effect of any sentiments expressed on the boards. For me noise trading is also an act of confusion about what the stock market is for. In many countries an aversion to the stock market as a forum for rational investment develops in response to some national economic trauma. This happened, for example, in Germany after the inflation of the early twentieth century and in the USA after the Great Crash of 1929. To many it remains an iniquitous gambling house. John Maynard Keynes is well known for his economic theories, but he was also no mean investor. As Bursar of King’s College, Cambridge, Keynes was faced with constant opposition from his fellows to his apparently radical policy of selling properties and reallocating the proceeds into
32
4/3/02
4:39 pm
Page 33
chapter 2 . The noise trading revolution
Volume of discussion posts
Figure 2.1
01/01/01
01/11/00
01/09/00
01/07/00
01/05/00
01/03/00
01/01/00
01/11/99
FTSE TechMARK 100 index
01/09/99
chap 2
Volume of discussion postings on the Ample Interactive Investor discussion boards 1 September 1999 to 1 January 2001. There is a close match to the performance of the FTSE TechMARK 100 index of technology stocks. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
the stock market. The College Estates Committee regarded stockmarket investments as mere speculation. Keynes retorted that he would rather be a ‘speculator’ in an asset that at least had a daily price quotation and was liquid enough to be bought and sold on a stock market than an ‘investor’ in something with a largely unknown price.7 I am inclined to side with Keynes that what some would regard as speculation is in fact intelligent investment.
PROFESSIONALS VS. INDIVIDUAL INVESTORS In the USA, as in other countries, the story of the stock market in the last 50 years has been a story of the growth of professional investors. There are now over 30 companies in the USA with assets under management of more than $100bn. Once the generation of investors haunted by the Great Crash of 1929 and the bitter depression of the early 1930s had faded away,
33
chap 2
4/3/02
4:39 pm
Page 34
The empowered investor
a new crop of individual stockholders graduated. Thirty years after 1929 they numbered one in every eight adults in the USA. Against a background of immigration and a lucky escape from most of the discontinuities of World War II, the US economy has grown dramatically. Culturally the attitude to risk taking is not as conservative as in many other countries. The spoils of this growth have enriched millions of individual investors. Although there are still many private investors, the share of the US stock market held by institutions has grown tremendously; from 26 per cent in 1980 to 53 per cent in 1996 with the increase being even greater for larger stocks. The story is much the same in the UK where 12 million people now own shares. Nearly a third of the UK population has been handed shares free from demutualized financial companies. The institutions have also grown. Whereas the private investor held 54 per cent of shares in 1963, by 1998 they held only 16.7 per cent of UK shares.8
WHO GETS THE INFORMATION FIRST? The old world of cosy meetings between companies and analysts, in which prospects and information were conveyed as codes and clues, is dying. Companies are under increasing pressure to equalize the flow of information, while also being under pressure for transparency. Similarly, analysts are under presCompanies are under sure to be unbiased and independent. In the USA, increasing pressure to the SEC responded to pressure from the press and equalize the flow of information, while also investors by ruling that companies must not being under pressure favour particular groups of investors by selective for transparency. provision of information. Regulation FD (Fair Disclosure) has prompted a lively debate on Wall Street about whether it has forced companies to provide more timely information to the market or clam up.9 Warren Buffett, the legendary investor, is on hand to provide an appropriate viewpoint: Through the selectively dispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge over investment-oriented individuals. This was corrupt behaviour, unfortunately embraced by both Wall Street and corporate America. Thanks to Chairman Levitt [of the SEC], whose general efforts on behalf of
34
chap 2
4/3/02
4:39 pm
Page 35
chapter 2 . The noise trading revolution investors were both tireless and effective, corporations are now required to treat all of their owners equally.10
In some ways Warren Buffett is really the great professional individual investor writ large, except that he does not buy just a few shares, instead he buys the whole company. In the UK, the authorities have been much slower to provide official rulings in favour of equitable information distribution, relying on the fact that Stock Exchange rules already require it. Unfortunately, through sloppy practice or deliberate intent, companies continue to give selective briefings to analysts and takeover information continues to be passed to journalists over the weekend (referred to in the City of London as the ‘Friday night drop’). While official stock exchange news releases are now available in both countries, only in the USA are private briefings simultaneously distributed to all. It seems likely that before long new information will be available for everyone to attempt to try and decipher. As the technology bubble collapsed, analysts came under increasing fire in the USA and UK for their apparent lack of independence from the corporate departments of the investment banks that commonly employ them. In simple terms, they were backing the house stocks. Any company that favoured the investment bank with its business could expect favourable coverage from the same house’s analysts. In the USA, the analysts’ professional body, AIMR, established a task force in 2001 to examine the issue. At the time of writing several investment banks were enthusiastically barring their analysts from owning any of the shares they write about.
KNOW THYSELF Overconfidence: trading on noise, trading too often, confusion from appetite for profits One idle summer’s afternoon in London, I put together a poll on the Ample Interactive Investor website with the following question: In respect of your driving ability are you an average, above average or below average driver? Only 8.8 per cent of respondents said that they were below average. Of course, this cannot be true. What the poll shows is that over 90 per cent of respondents think that they are either average or above average. People
35
chap 2
4/3/02
4:39 pm
Page 36
The empowered investor
are overconfident of their driving ability and also underestimate the ability of others. A poll held at the same time, which asked people what the change in their stock market investments over the last year or so showed, revealed that a third had lost over 40 per cent of their capital. I wonder if these were the same people: the average investor evidently believes that he is smarter than the average investor.11 Overconfidence is everywhere, particularly in money matters. If people were not overconfident, fewer would start small businesses. Proof that their confidence was misplaced is the fact that a large percentage of small businesses fail. This is a harsh tale to have to tell – you are not as smart as you think, but if it is any consolation neither am I. Overconfidence can be your downfall in a variety of ways. As investors we do not assess risky gambles in a fully rational manner. We fail properly to consider the facts in hand. We sell winners too soon and hold onto our losers for too long. We put too much weight on optimistic forecasts. Men in particular are more overconfident than women. Investors remember their past records selectively and are biased in their interpretation of their own skill. Overconfidence on a wide scale can lead to an overreacting market with stocks going up too far in response to new information before investors come to their senses and the price falls back. Equally, if investors are confident that a conservative view of a stock is appropriate, then that stock will underreact to good news (Figure 2.2). How can we spot if we are overconfident investors? Telltale signs are: ●
chucking large amounts of cash into the market without knowing much about what we are investing in;
●
thinking we have a good record and only remembering the best trades we have done in the past;
●
assuming that investing in what you know is all you need for success.
And how can we learn from this discovery? ●
Stop investing on every plausible sounding idea you hear.
●
Do more research.
●
Take professional advice.
●
Like driving, you may need the occasional refresher course.
There is another area in which our appetites for certain profit can mislead us of the true odds. When given a certain gain people prefer to take the cash upfront, yet given a certain loss people will gamble. When offered a
36
4/3/02
4:39 pm
Page 37
chapter 2 . The noise trading revolution
Share price
Efficient Market
Time
Share price
Over-Reacting Market
Time
Slow-Learning Market
Share price
chap 2
Time
Figure 2.2
As the graphs illustrate there are three distinct types of market reaction to consider: efficient market, slow reacting market and overreacting market Source: Asweth Damodaran, (1996) Investments Valuation (Chichester: Wiley), p. 168. This material is used by permission of John Wiley & Sons, Inc.
test choice between getting a five-pound note for free and a one in two chance of winning a ten-pound note, most investors will cut and run. They will take the guaranteed five pounds, proving that they are averse to risk. In theory they should go for the ten-pound note because the probability of returns is mathematically equal. Most people don’t like maths.
37
chap 2
4/3/02
4:39 pm
Page 38
The empowered investor
They didn’t do well at maths at school and they never want to have to learn dull algebra ever again. Hence they can’t even do a simple probability calculation. When the tables are The moral is to let turned and you have a choice of giving someone winners run and cut losses. else a five-pound note or a one in two chance of winning a ten-pound note most investors will gamble on the ten-pound bet. In this case they prefer to take on the risk. In the markets, if you have a losing share you prefer to take on the risk that it may go down more by hanging onto it for dear life in the hope that things will turn out all right. Equally, when a stock you own has gone up, you prefer to bank the winner and lose out on the fact that the stock may go up some more. The moral is to let winners run and cut losses.
FRAMES – IT’S THE WAY YOU TELL ’EM Take two politicians with different views talking about the same thing, for example, the legalization of cannabis. One side presents the good points about it – less street crime; the other presents the bad points – encouraging addiction. If only one of the two was present you would probably walk away thinking that one point of view was very reasonable. Your view would be anchored in the frame of their argument. So it is with investing. If you just get half the story, you end up taking the wrong decision. First impressions last. For instance, a group of surveyors was given a pack of information and told that the recent asking price of a property was $120,000 dollars. They valued it on average at $114,000. A different group was given the same information but told that the asking price was $150,000. They produced a value of $129,000.12 When we are anchoring our decision we latch onto some fact and can’t get it out of our heads. For example, we may have seen Vodafone at £5 per share. When we see it next at £1.50 the price doesn’t seem right. How can you tell whether you are suffering from anchoring ailments? ●
Do you make decisions on the hoof without a moment’s thought?
●
Do you always buy your favourite brands?
●
Are you unable to sell investments for less than you paid for them?
If this is you, then you are a chronic victim of anchoring. 38
chap 2
4/3/02
4:39 pm
Page 39
chapter 2 . The noise trading revolution
What is this doctor’s prescription for anchoring? ●
Get a second opinion.
●
Do your research.
●
Don’t pay more attention to the share price than the fundamentals.
●
Forget the past, it is the future that counts.
THE WAY WE FIND THINGS OUT Heuristic rules of thumb for investing If we glance at something and it looks familiar, we instantly label it as something we already know: if it walks like a duck and looks like a duck, it probably is a duck. But we may be wrong. We may be missing some important detail. When you learn a foreign language it is often the case that you cannot find a word for something you want to describe. French, for instance, has several different categories for the word friend. So when French people are looking for an English word to describe some delicate level of intimacy, they cannot find it. Words and concepts such as illiquid, GNP, Retail Price Index or ‘beating the index’, which are in common use today, were totally unknown in popular speech 50 or 60 years ago. Words are powerful ways of defining and summarizing things and getting them under control in our minds, but in so doing we may miss the point. We may define whole categories of company as ‘quality’ stocks, ‘bios’ or ‘techs’. Dot com, an expression which once had a very positive connotation, now has the opposite. We may well be wrong. If one type of stock is so good, everybody who agrees may already have bought their fill. If a stock is so bad, those who share that view may have sold out. Investors who swallow such rules of thumb become overly pessimistic about past losses and over-optimistic about past winners. Behavioural finance is a very ambitious area. It is looking to answer the most difficult questions you can think of. For example: How do investors view and evaluate risk? Why do they gamble? It may surprise you to learn that around 1.1 per cent of US men are compulsive gamblers.13 Other puzzles include how bubbles get going and why investors trade so much. If
39
chap 2
4/3/02
4:39 pm
Page 40
The empowered investor
you could work out the answers to these questions you would be halfway to getting very rich indeed.
THE INFORMATION WHEEL CAN TURN Short-circuiting the wheel Professional investors have traditionally been passive investors. In my years in fund management there was a daily ritual of meetings with the chief executives and finance directors of large companies who once a year would devote a fortnight or so to doing the City rounds of investment institutions. They would arrive at the offices, spend an hour or so giving an update on the company and its markets, answer a few mostly illinformed questions and then leave, not to return until the following year. They would usually tell us how it was, giving us the bad news straight and making the odd promise. If we didn’t like what we heard we often sold, knowing that no one institution, even if we owned a couple of per cent, was really powerful enough to make much difference. What we were looking for was reliable and predictable growth. As Tony Golding, a City fund manager, points out: ‘Investors abhor uncertainty. They have a deeprooted desire to make world a more predictable place.’14 But increasingly, when things go wrong investment institutions have begun to get active. When British Airways failed to deliver, the Chief Executive, Robert Ayling, had to go. The same thing happened in the summer of 2001 at Marconi after a Investors abhor bungled profits warning. Institutions have been uncertainty. They have willing to step in with a demand for change in the a deep-rooted desire to make world a more interests of shareholders. In Golding’s words: ‘In predictable place. 1990 when recession hit, institutions found themselves forced to adopt a more interventionist stance towards their investments.’15 This trend has accelerated as more active foreign investors have acquired more shares. In 1963 foreigners owned 7 per cent of UK shares; at the end of 1998 they owned 27.6 per cent. George Soros, the legendary speculator who shorted $10bn of the pound sterling and broke the Bank of England’s attempt to defend a high value of sterling in 1992, takes this argument further. In his view investing is a reflexive process. The activity of investors can influence the company, just as the activity of the company can influence the investors and share price.
40
chap 2
4/3/02
4:39 pm
Page 41
chapter 2 . The noise trading revolution
The connection between the stock prices and the underlying companies is not a one-way traffic. Stock market valuations first have an immediate impact on things such as the motivational value to employees of share options. A depressed share price can undermine confidence in a company’s ability to repay its debt and make that debt more expensive to obtain. If a company wishes to issue shares, then a high share price can make it easy to do so and a low share price can make it expensive and difficult. In his biography Soros says: ‘I do not accept the proposition that stock prices are a passive reflection of underlying values, nor do I accept the proposition that the reflection tends to correspond to the underlying value. I contend that values are always distorted.’16 Soros clearly sees that the views of participants are part of the situation in which they are both observers and possessors of a voting power. They can revalue the shares up or down by their own trading activity. When this happens the information wheel can begin to turn (Figure 2.3). Instead of information cascading down from the company at the top to the investors at the bottom, the flow is reversed. The investors are in control at the top and the company is haplessly sinking to the bottom. In such cases the price has become the key item of information.
Small investors Journalists
Fund managers
PR/IR firms
Analysts Companies
Figure 2.3
The information wheel begins to turn
41
chap 2
4/3/02
4:39 pm
Page 42
The empowered investor
THE INDIVIDUAL INVESTOR ADVANTAGE Markets have a way of seeking out weakness. In the eternal competition between bulls and bears, one or the other party gives greater credence to particular items of information. They interpret the information differently. Bulletin boards are one of the subtle ways in which the different parties expose the extent of their pessimism or optimism. When there is no news, and no news really can be good news, there are always new bulletin boards to read or gossip to pass on. Individual investors, armed with the power of their personal computers, are using a level of complexity that was not available even to professional fund managers five or ten years ago. They are also furnished with a means of two-way communication. They can interrogate remote and formerly inaccessible Markets have a way of seeking out databases. They can post proxy votes electronicalweakness. ly. Most importantly private investors can now receive official news releases at the same time as the institutional investors and analysts. They can, at least potentially, short circuit the information wheel, removing the information advantage cherished by professional investors. Individual investors can create market noise, but they also have access to the tools to tune it out. Once again here is the plan of the book:
42
●
Understand your own investing behaviour. Know the great bubbles. Understand overconfidence, overtrading and misleading frameworks.
●
Understand the investing behaviour of the professionals. Learn from the master investors.
●
Jump on the information wheel. Know when you have spotted really new information.
●
Know the market anomalies – growth stocks, small firms effect, ratios effects and calendar effects.
●
Build a winning, balanced portfolio using professional tools – broker research, online information, screens and online portfolios.
chap 2
4/3/02
4:39 pm
Page 43
chapter 2 . The noise trading revolution
NOTES 1 2 3 4 5 6 7 8 9
10 11
12
13 14 15 16
Alfred Marshall, Money, Credit and Commerce (Macmillan, London, 1923), p. 95. Chairman’s Letter to the Shareholders, 2001. Peter Bernstein, Capital Ideas (Free Press, New York, 1993), p. 124. Dean LeBaron and Romesh Vaitlingham with Marilyn Pitchford, The Ultimate Book of Investment Quotations (Capstone, Dover, NH, 1999), p. 224. P. Wysocki, ‘Cheap talk on the web: the determinants of postings on stock message boards’. (Working paper, University of Michigan Business School, 1999). R. Tumarkin, and Whitelaw, R.F. ‘News or noise? Internet postings and stock prices’, Financial Analysts Journal, May/June (2001), pp. 41–51. The Collected Writings of John Maynard Keynes, Donald Moggridge (ed), Vol. XII. (Cambridge University Press, New York, 1983), p. 109. With permission of Palgrave. Office for National Statistics, Share Ownership, A Report on the Ownership of Shares as at 31st December 1998 (The Stationery Office, London, 1999), p. 7. A number of surveys have been conducted to cast light on this debate. The evidence does not produce an unambiguous verdict. A National Investor Relations Institute’s survey of 600 companies, published in February, shows an increase of information being disclosed to the public as a result of regulation FD. Another NIRI survey found that 48 per cent of companies were releasing the same amount of information as they were before, while 24 per cent were releasing less and 28 per cent more. And, according to First Call/Thomson Financial, regulation FD seems to be leading more companies to issue press releases when they want to update investors on earnings prospects. But a Securities Institute Association survey was, by contrast, less positive, suggesting a net loss of disclosure. (Howard Davies, Chairman of the FSA, Speech to the Investor Relations Society, 9 July 2001) Warren Buffett in Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 2000. Adam Smith, in his famous treatise Wealth of Nations (1776), said: ‘The overwhelming conceit which the greater part of men have of their abilities is an ancient evil remarked by the philosophers and moralists of all ages.’ John B. Taylor and Michael Woodford (eds), Handbook of Macroeconomics, Vol. 1 (NorthHolland, Amsterdam, 1999), pp. 1305–40. There is another good (and short) summary of behavioural finance: Alistair Byrne, ‘A study of how investors make stupid mistakes’, Professional Investor, Dec/Jan (2000–1), p. 13. John B. Taylor and Michael Woodford (eds), Handbook of Macroeconomics, Vol. 1, (NorthHolland, Amsterdam, 1999), pp. 1305–40. Tony Golding, The City: Inside the Great Expectations Machine (Pearson Education, London, 2001), p. 60. Tony Golding, The City: Inside the Great Expectations Machine (Pearson Education, London, 2001), p. 171. George Soros, The Alchemy of Finance (Simon and Schuster, New York, 1987), p. 48.
43
chap 3
4/3/02
4:40 pm
Page 44
chap 3
4/3/02
4:40 pm
Page 45
3 Fundamental analysis Part One: Picking a good stock A qualitative decision How can we detect a company’s growth? Yikes, numbers: ratio analysis Hidden assets Selecting stocks using P/E models Shells and penny shares Picking a good management Big ideas: behavioural finance and mean reversion Market timing Part Two: Picking a good industry Looking at different industries Detecting earnings quality Corporate events: mergers, takeovers and IPOs
45
chap 3
4/3/02
4:40 pm
Page 46
chap 3
4/3/02
4:40 pm
Page 47
chapter 1 . Why the stock market?
In the old days any well-trained security analyst could do a professional job of selecting undervalued issues through detailed studies; but in light of the enormous amount of research being carried out, I doubt whether, in most cases, such extensive efforts will generate sufficiently superior selections to justify the cost. (Benjamin Graham)1 The real accomplishment of the many thousand analysts now studying not so many thousand companies is the establishment of proper relative prices in today’s market for most of the leading issues and a great many secondary ones. (Benjamin Graham and David L. Dodd)2
Part One: Picking a good stock A QUALITATIVE DECISION When you come to select a stock for your portfolio there may seem to be an overwhelming volIn the end you are ume of detail about the various companies and going to have to make their industries. All of it may seem important. But a qualitative decision. it is a measure of your skill as an investor that you learn to discriminate. While it is useful to have lots of tables of numbers or lists of statistics, quantitative information can be superficially definitive. Numbers can get out of date very quickly. Managers of companies can manipulate accounting data by choosing one practice or another. In the end you are going to have to make a qualitative decision. It is a good idea to look at the relevant quantitative information, but that alone is not enough. Of course this may make you feel uncomfortable. We all prefer to deal in black and white. But in making an investment we are taking on a risk and while our risk should be compensated with a good return there are no money-back guarantees.
47
chap 3
4/3/02
4:40 pm
Page 48
The empowered investor
HOW CAN WE DETECT A COMPANY’S GROWTH? Many investors start by looking at the share price and its graph first, as though that conveyed all the information they needed to know. To my mind the price is merely the effect of a variety of root causes – the smoke above the fire. My own starting point is to find the basic facts, most often in the annual report. If I have a hunch that there are good growth prospects in a particular industry or subsector, I put together the reports of a group of companies for comparison. In each report I start with the chairman’s statement to get a flavour of the company’s products and current market conditions. I then turn to the cash flows and accounts to try and get some idea of the scale of the company. Last I check things like share price, yield, dividend cover, P/E ratios and Price/Book ratios. These help refine whether there is value in the share at the current price. Growth is the holy grail of stock market investment. Without growth, earnings and dividends cannot grow. Not just the fact of growth but also the direction of change in growth needs to be examined. Is it increasing or is it slowing down? We are less interested in the past than in the future and we are just as interestGrowth is the holy grail ed that a company can afford to fund its growth as of stock market investment. we are in a company producing growth for growth’s sake. Companies can quite literally grow broke if they are not careful. The individuals tasked with forecasting earnings growth are for the most part stockbroking analysts, which is quite a job as we shall see. It is worthwhile stating the obvious fact that most growth comes from increasing sales of products. So it is often useful to look at the companies’ key products and preferably a graph of their sales. As shown in Figure 3.1, we can see weekly sales of new products, such as DVDs or a new computer chip, over a number of weeks. At first the growth is very fast, but eventually it hits a peak and falls to a stable level. The accumulated sales are also visible. It should be evident that the growth curve is fairly predictable for all products of any kind. Once an analyst establishes the target maximum penetration for a product, he or she can then work out the growth rate taking into account the useful life of the device and the replacement rate. The obvious reality check is the number of households in the country. For big ticket consumer
48
chap 3
4/3/02
4:40 pm
Page 49
chapter 3 . Fundamental analysis 400000
12000
350000 10000 300000
Accumulated sales 8000
250000
Weekly sales
6000
200000 150000
4000 100000 2000 50000 0
0 1
Figure 3.1
11
21
31
41
51
61
Weekly sales of a new product (right-hand scale) and the accumulated sales of that product over time (left-hand scale). Growth rates are initially very fast but slow to a more stable level Source: Fred Wellings (1998), ‘Profits forecasting: a practitioner’s view’, Professional Investor, October, p. 28.
durables such as widescreen TVs and bagless vacuum cleaners, you are unlikely to have much more than one item per household at any one time. Forecasting profits is not quite the same as making a sales forecast because between revenues and profits there are expenses, interest, taxes and all manner of accounting. Over the years, analysts and industry watchers will develop a mental filing cabinet of pictures of all the trends and cycles in their industries.3 There is a familiar pattern of a company having a J-shaped curve of product sales when the new product is introduced which then falls off as the potential ownership or market is satisfied. Repetitive patterns are not just for the chartists. Once the industry growth rates are discovered, sales forecasting is a matter of working out market share, which is usually a function of the marketing expenditure. If you can spot that rising, then market share will usually follow. Analysts go on to calculate margins and profitability and then construct elaborate accounts using historic figures as the basis and cash flowing through from sales into the accounts.
49
chap 3
4/3/02
4:40 pm
Page 50
The empowered investor
At a product level, the success or failure of the product being sold will usually depend on whether there is differentiation or a cost advantage in the product. It may be that the company has a technology advantage or innovative designs. An example of this would be Cartier, the Swiss jewels and watches company. In this case the main threats are going to be imitation or a change in technology. If the firm has set out to be the low-cost producer in its industry, its success will depend on large scale and minimizing costs. An example would be Ford, the motor company. Threats to a company like Ford would be a competitor finding a cheaper manufacturing process or a drastic change in customer taste. Where a company is growing too fast it will need to raise capital by issuing more stock or getting new bank credit. If it is growing too slowly it can give up the ghost and return money to shareholders or acquire growth through acquisition. Growth can be as much of a burden as a badge of success. ‘It is a sad fact that almost as many companies can go bankrupt because they grew too fast as do those that grew too slowly.’4 Where can I check analyst forecasts? Individual analyst forecasts and copies of their research are now widely available on the internet. You can consult the Reuters or Extel survey to find out the most popular analysts, and then check out their latest forecasts on websites such as Ample Interactive Investor and Hemmington Scott. Finally you can download their research using the websites listed in the final part of this book.
YIKES, NUMBERS: RATIO ANALYSIS It is inevitable, even for those of us who are not mathematically inclined, that the investment process will involve taking at least a brief glance at one or two numerals. Companies report their performance over a particular period in the form of accounts. These can be easily analyzed in order to detect trends and compare with other like companies or industries. We can then build these trends and comparisons into our forecasts. Ratios are not just for analysts. They are easy to calculate and can serve as useful comparative tools. If you are stuck on which of two similar shares to invest in, calculate a couple of ratios and go for the one that comes out best. Think of ratios as only part of the picture. You cannot
50
chap 3
4/3/02
4:40 pm
Page 51
chapter 3 . Fundamental analysis
expect simply dividing one number by another to give the whole story of a complex organization, but it may help you on your way to understanding the company better (Table 3.1).
Table 3.1
Ratios are not just for analysts. They are easy to calculate and can serve as useful comparative tools.
Using different ratios – objectives, pros and cons
Type of ratio
Objective of consulting ratio
Pros
Cons
P/E
Low P/Es show you can buy the earnings cheap.
Easy to compare. Can work out with next year’s earnings forecast.
Management can flatter earnings. Different industries not comparable.
Operating margin
High margin = high profitability.
Easy to compare like companies.
‘Aggressive accounting’.
Price/Book
Low Price/Book shows you can buy the assets cheap.
More stable than P/E and easy to make comparisons.
Assets in the books at old values.
Gearing
High gearing = higher risk.
Useful for similar companies.
Some debt can be hidden.
Asset turnover
High asset turnover = good use of assets.
Useful for assetintensive industries.
Some industries don’t need lots of assets.
Return on equity (ROE)
High ROE = good return on its equity.
Easy to compare.
Value of the equity gets outdated.
P/E and Price/Book are very commonly discussed in the financial press. Price divided by earnings, the P/E ratio, is a useful comparative tool. It is also very sensitive to changes in earnings, say if a company is restructuring or experiencing a downturn. There is no right or wrong P/E. Profitability is easily calculated by working out the operating margin. Operating income (sometimes called profit before interest and tax) is divided by sales. Both the inputs into this ratio are easily found on the profit and loss account (P&L). Sales are the top line and operating income is below cost of goods sold. Take care that you are using the correct year’s figure. As with earnings, this ratio can be sensitive to ‘aggressive account-
51
chap 3
4/3/02
4:40 pm
Page 52
The empowered investor
ing’; for example, if the management does not have a conservative policy on booking in sales from its longer run contracts. Price as a multiple of book value is a more stable measure, but again there is no right or wrong P/B ratio. A lot depends on the management’s policy of valuing their book assets and lots of companies don’t need lots of assets. Compare the assets of a chemical company with those of a provider of consulting services. Leverage or gearing is also easily worked out from the balance sheet. You just find the entry for long-term debt in the bottom half of the balance sheet and divide it into the total assets line found in the middle. Asset turnover is another easy number to find. You simply divide the sales figure from the profit and loss by the total assets number found in the middle of the balance sheet. The final ratio I intend to inflict on you is Return on Equity (ROE). This is very simply the net income divided by the shareholders’ equity. Net income is on the P&L while shareholders’ equity is on the balance sheet near the bottom. These ratios are especially useful when comparing between years so that the trend is revealed. There is no one correct ratio. A judgement that a ratio is too high just depends on your point of view. For instance, a company may have high leverage because it has geared up to invest in a good project. A company may have low asset turnover because that is a typical feature of a capital-intensive industry. Margins may be low because the company is experiencing a cyclical downturn and has high fixed costs. Each ratio is particularly sensitive to both of the inputs into the equation. For instance, the intellectual property (patents on drugs and drugs in development) of pharmaceutical companies is not included as part of their equity. Although they benefit from the employment of intellectual assets, they are not on the balance sheet. So the return on equity for pharmaceutical companies is artificially higher than for other industries. Similarly the accounting choices made by management on the presentation of earnings can sharply affect the inputs of the ratios. If earnings are flattered by one device or another, then so are the ratios. There are big differences internationally: for example, US and UK companies tend to be financed by the sale of shares, whereas French and German companies tend to issue debt. This affects leverage ratios. However, comparing one company’s ratio to another within its industry provides a useful shortcut to ranking a company among its fellows.
52
chap 3
4/3/02
4:40 pm
Page 53
chapter 3 . Fundamental analysis
HIDDEN ASSETS Many private investors seem to be spellbound by assets and treat them as an investment screen, sniffing out companies with the most assets and the lowest Price/Book ratio. A lot of the blame for this In his investing, falls on Benjamin Graham, one of the earliest Graham’s insurance investment theorists. He was rooted in the dark policy was the days of the US Depression when bankruptcy question: ‘Is this lurked around every corner. In his investing, Gracompany worth more ham’s insurance policy was the question: ‘Is this dead or alive?’ company worth more dead or alive?’ In the inflationary late twentieth century this investing approach had a revival, but now even private investors are deploying a more sophisticated approach. There are hidden assets, but of course they have to be balanced against hidden liabilities. The main hidden jewels are intangible assets such as patents, brand names, copyrights, licences and leasehold assets, as well as research and development (R&D) in progress. Details of these are not usually in the accounts, although they can be guessed at from the price obtained when they change hands. Other hidden assets often sought out by investors are property and real estate companies and investment trusts. These may trade below their asset value for long periods, so do not expect an instant uplift. Part of this discount to assets could reflect higher risk from large borrowings or exposure to volatile assets.
SELECTING STOCKS USING P/E MODELS Choosing stocks can seem like hard work. We are all on the lookout for an easy shortcut and investment screens can do a lot of the hard work for you. The most common screens all use P/E ratios. Computers add up the P/E ratio of all stocks in Choosing stocks can seem like hard work. the market and sort them out with the lowest P/E stocks at the bottom and the highest at the top. They also weight them all added together to arrive at a market average P/E which is called 100. Individual stocks can then be compared relative to the market average. For instance, a stock may have a P/E 20 per cent
53
chap 3
4/3/02
4:40 pm
Page 54
The empowered investor
higher than the average. If the average is 10 its P/E will be 12 and its P/E relative (sometimes called PER) will be 120. One further elaboration of this computer-driven process is the P/E growth ratio (PEG), which just divides the P/E by the earnings growth rate (next year’s forecast compared to this year’s historic earnings). For example, the PEG is 2 for a company with a P/E of 16 and a growth rate of 8 per cent, 16/8 = 2. All stocks are then ranked and those where you get more growth for less P/E are chosen. Some investors such as Jim Slater swear by them: ‘To me, a low P/E ratio and a high growth rate has always been the right combination.’5 They buy when PEGs are below one and sell if they head up towards two. What is a PEG ratio? A PEG ratio is the P/E divided by the firm’s growth rate (for example, the PEG is 2 for a company with a P/E of 16 and a growth rate of 8 per cent, 16/8 = 2). The trouble with all the P/E models is that they are using numbers that are often very changeable. Managers can bolster earnings by asset sales or acquisitions while stockbrokers’ growth forecasts are constantly changing. Prices of stocks can also be volatile and subject to artificial swings. It is compounding flexible figures one on top of the other. The P/E itself is vulnerable to accounting manipulations – so too is the growth rate. What if the company has just bought a fast-growing company or has sacrificed current growth for investment to develop a sure-fire product? Who knows what the growth rate is going to be next year. Brokers’ forecasts are notoriously inaccurate. P/E itself is already a function of growth rates, past and future. The other big input error is the market price that obviously already reflects investors’ expectations about growth. So you could be building in several layers of inaccuracy.6
SHELLS AND PENNY SHARES Many investors become mesmerized by stocks with a low value, as though that in itself is a guarantee that the stock will inevitably go up. It is a fact that many of the best performing stocks were those that once no respectable fund manager would want to touch. Before they got better they had to get worse. When the share price hit rock bottom, a heavy-
54
chap 3
4/3/02
4:40 pm
Page 55
chapter 3 . Fundamental analysis
weight management team appeared and turned Many investors the company around, probably by injecting a new become mesmerized by business. stocks with a low It is quite true that some shell companies are value, as though that in itself is a guarantee created out of redundant floats of dead compathat the stock will nies and these are used by entrepreneurs to obtain inevitably go up. a listed vehicle and create a company. But with so many such shells about it would seem an aimless task to be guessing which one the entrepreneurs are going to target next.
PICKING A GOOD MANAGEMENT Picking a good company is to a great extent a question of avoiding a bad management. There is no point having the best factories, highly qualified employees and stacks of cash in the bank if the men at the top of the company throw it all away on living the good life or doing a dud deal. Indeed, the story of many large companies has been one of tug-of-war between shareholders and bad managements. When shareholders have the upper hand, companies are run for their benefit. When incumbent management think they can pay little attention to shareholders, then increasing the share price is not a priority. From the 1980s onwards many hostile takeovers were launched with the precise objective of forcing bad managements to restructure their companies. Investors can often spot bad More frivolous but managements by the kind of industry in which obvious signs of bad management are they operate. Prime candidates are often found in corporate excesses. mature or declining industries. With few profitable investment opportunities, managers might be expected to shrink or withdraw from the business, perhaps returning surplus funds to shareholders. But often they do not. They continue to invest in the old way. Out of loyalty to company culture or employees and in order to retain their office and prestige, they throw money at unprofitable investments. The board of directors should in theory put matters right, but is often surprisingly ineffectual. More frivolous but obvious signs of bad management are corporate excesses. Management may award themselves extravagant share options or salary packages with low performance targets. There may be a company jet or a fleet of limousines. The institutional investors, who own the
55
chap 3
4/3/02
4:40 pm
Page 56
The empowered investor
bulk of a company’s shares, would normally be expected to act as a check on this but many do not consider it their responsibility. Good managements are wide awake to change. They are not steeped in a stuffy and self-regarding company culture closed to outside influences. They are intuitive strategists, but sensitive to the detail. They have made themselves aware of what is going on in their companies. They know what the next product is and what the customers want. Managers should know all the weaknesses and vulnerabilities of their companies and have answers ready if asked how they aim to circumvent them. In an established company there may be a bureaucratic system of management, but they must know how to work it to ensure change can happen. For a growth company it is always a good sign if managers have a large personal stake in its success or failure. If managers are the founders and lack formal experience, then it is a positive signal if they surround themselves with well-qualified and experienced lieutenants. Personally, good managers should have the charisma to lead without the arrogance of high office. They must have credibility before the analysts, investors and backers and should not shirk tough questions in meetings with them.
How do I check out the management? You should be able to get a flavour of management from the annual reports, biographies and unedited interviews in the media or from providers such as Wall Street Transcript. The best opportunity for many private investors to meet them in person is at the annual general meetings. Just ring up the company secretary to ask the date of the next one.
BIG IDEAS: BEHAVIOURAL FINANCE AND MEAN REVERSION Every decade has its big ideas. Behavioural finance is an attempt to explain why investors make investment decisions in a different way to how theorists think they should. We shall be looking at the ideas of behavioural finance and the efficient markets theory in more detail through the book. It is sufficient to say here that investors are complicated animals; they are human and make mistakes like everybody else. They do not behave like a scientific model and may or may not learn from their expe-
56
chap 3
4/3/02
4:40 pm
Page 57
chapter 3 . Fundamental analysis
rience. The way we react to a situation today may or may not be the way we react to it tomorrow. The other big idea floating around at the moment is mean reversion. This comes from the notion that variable things in nature such as population growth or volcanoes Mean reversion always settle down to some average (mean). In represents the evolution of stock prices this implies that a high value is more uncertainties. likely to be followed by a lower value and vice versa. Mean reversion represents the evolution of uncertainties. For as the uncertainty continues through time it fluctuates around a constant level.7 This can be applied to stock prices, commodity prices and fixed costs. In a portfolio context it means an investor thinks that whatever a security’s value has been in the past, it will eventually revert to that mean value. When presented with competing investment choices, an investor will choose the one farthest below its average value. But mean reversion hasn’t won over everyone. George Soros argues ‘that there is little empirical evidence of an equilibrium or even a tendency for prices to move towards an equilibrium’.8 He thinks prices are basically random.
MARKET TIMING Many investors attribute more importance to market timing than the quality of what they are buying. The most obvious solution to the problem of timing is that it depends on the time period you are looking at. The issue is really wrapped up in the age-old distinction between speculation and investment.9 SpecuMany investors lation is trading on the basis of little more than a attribute more hunch. A speculation is unlikely to be based on importance to market timing than the quality any significant deduction. It is motivated by a of what they are desire to get exposure to events in the future. buying. Investment on the other hand has a more certain basis in facts. It is likely to be grounded in the question of what the stock is really worth. Investment is primarily concerned with the underlying earnings growth over time. If you are confident of the underlying value of the company you are buying, you should be prepared to pay up today for growth in future years. Speculation is more likely to be preoccupied with the price tomorrow.
57
chap 3
4/3/02
4:40 pm
Page 58
The empowered investor
You should be able to tell whether you are a speculator or an investor by the simple test of your reaction to a temporary dip in a share price. This will cause a speculator alarm but leave an investor unconcerned. Am I a speculator or an investor? ●
●
●
●
●
How long do you hold stocks for? (a) more than a year (b) I close out all my positions by 4:30 every day How many times do you trade a year? (a) less than fifteen (b) as often as I can, bathroom breaks permitting How many times have you been married? (a) < 2x (b) >2x How many children do you have? (a) 2.4 (b) I admit to 5 How much do you invest on each trade? (a) < 10 per cent of my total wealth (b) as much as I can borrow
If you scored mostly (a) then you are an investor; if (b) then you are a speculator!
Part Two: Picking a good industry Almost as important as choosing the right company within an industry is identifying which industries are going to prosper and which are in terminal decline. Even the best canal builder was a poor investment when the railways came along. If an industry contains just too many competitors, profits will tumble. If it costs too little to enter an industry, say, you can just hang up a sign, then competition is likely to worsen. There may be a problem with the supply of raw materials or specialized skills. New technologies may be copying the key product at low cost. An industry might be unduly exposed to the cost of borrowing, such as leasing, or to the price of oil, such as airlines. On the other side of the coin you should be able to identify which industries are on the up. New technologies such as the internet have 58
chap 3
4/3/02
4:40 pm
Page 59
chapter 3 . Fundamental analysis
lowered the cost base of industries with high mass distribution costs so you should expect the margins to rise of industries benefiting such as insurance and book sales. Some industries have exploited growing international demand for We are looking for brand names, for example, soft drinks and such big picture trends and seeking potential footwear. Population data show that there is a as yet unfulfilled. surge of people born after the war who are now entering retirement age, so you can expect demand for healthcare and retirement homes to boom. We are looking for such big picture trends and seeking potential as yet unfulfilled. So we might have looked at mobile telephones and pagers in the late 1980s and foreseen the potential for them to be used not just by business people, as was then the case, but by ordinary consumers. It is a useful exercise to classify industries into categories such as Pioneer, Growth, Maturity and Decline.10 1. Pioneer: This is the high-risk stage when product acceptance is questionable. 2. Growth: Product is accepted and rollout to the market begins. Execution of strategy is the main risk. 3. Maturity: The industry is stable and trends up and down with the general economy. Participants compete for market share. 4. Decline: The game is up! Shifting tastes or technologies have overtaken the industry and it goes into decline. Evidently the riskiest stage is the Pioneer stage when companies are using up cash to develop the product and get it into the marketplace. There is a high failure rate. Seven out of ten start-ups fail to survive in the USA and nine out of ten in the UK. In a speculative bubble, start-ups will multiply to feed the demand by investors for risky assets. Many small companies more usually at home in a venture capitalist’s portfolio will cash in by floating on the stock market. This was an unfortunate characteristic of the internet securities bubble of 1998 to 2000. With the Growth stage, the big questions are how far will it grow and how fast. The best growth story is one where you recognize it early and get in at the beginning. Another sure-fire winner is where the industry has created demand that did not previously exist. Twenty years ago, who would have thought they needed a mobile phone, an e-mail account or a text-messaging viewer to stay in touch.
59
chap 3
4/3/02
4:40 pm
Page 60
The empowered investor
As competition increases, attracted by profitability, you will get maturity and after that decline. The only thing left is to battle for market share and to minimize costs. Among these last two categories you will tend to find the high dividend paying stocks and contrarian plays. How do I find out which are the growth industries? Use our guide together with some of the online sources for different industries mentioned at the end of this book. Above all keep your ears open. If you get interested in the industry, find out the key statistic or indicator and follow the bellwether firm within that industry.
LOOKING AT DIFFERENT INDUSTRIES Every industry has its own peculiar characteristics and key indicators. The brief guide below covers some of the main industries. If you get interested in one of the industries, your next step is to find out which is the bellwether company in that industry and what the competition is like.
Media Media companies create and distribute intellectual property. There are three types of property produced by the media: ●
information
●
education
●
entertainment.
The mark of a successful media company is always its ability to sell creative ideas many times over. There is a tendency for some distributors to become dependent on big name talents that can exercise control. So spotting successful media companies is about finding brands where the ‘gatekeeper is king’.11 One odd characteristic about media companies is the high concentration of ownership and the enthusiasm with which wealthy men on the make seek to acquire them as publicity machines.
Industrials These mature and stable basic industries with lots of assets are prime candidates for ratio analysis and the use of P/E and Price/Book. Check out 60
chap 3
4/3/02
4:40 pm
Page 61
chapter 3 . Fundamental analysis
the broker reports for Discounted Cash Flow (DCF) analysis. While DCF has its drawbacks – it is sensitive to the discount rate chosen and to the accounting policies of management – it is a widespread method. Firms in the same subsector can be reliably compared. What is DCF? Stable cash flow in the future can be predictably discounted back using a Discounted Cash Flow (DCF) technique to arrive at a theoretical present value today of future cash flows.
Utilities As with industrials, these tend to be stable and mature businesses and are eminently suitable for P/E, Price/Book and DCF analysis. The main difference is that for all utilities you have to check out the regulatory situation, which has a high incidence in natural monopolies such as electricity or water supply; it is not so much the fact of regulation as the direction of regulatory change, whether it is getting more or less strict.
Banks and financials The unique factor with these stocks is the exposure to the interest rate cycle of firms borrowing more during economic good times and then regretting it when bad times come along. Income for banks is mainly interest income, while insurance concerns will be exposed to the cycle of insurance claims and the performance of their portfolios of assets versus the attendant liabilities. Valuations on P/E and DCF can be tempered with comparison of the bad debt levels within the sector.
Oils The chief factor to watch here is of course the price and demand for oil. Another major influence is the control and ownership of reserves, the majority of which are owned by states. An oil company must successfully replace its reserves to survive. With diversified oil companies there may be exposure to chemicals and the growth of gas. Asset value may be important, particularly if profits are not yet being generated. One problem is that the valuation of reserves can be very subjective (what is referred to
61
chap 3
4/3/02
4:40 pm
Page 62
The empowered investor
in accounting as the LIFO vs. FIFO debate) and so working out the cost and size of capital can pose difficulties.12
Pharmaceuticals Pharmaceutical companies are greatly dependent on the merits of very few drugs. Most drugs actually fail to reach the market and each successful drug will cost more than $100m to develop. Pharmaceuticals is a research-based industry so it is important to know how much is going into what and how it is accounted for. Since R&D is not usually a balance sheet asset, the return on capital of the industry is often overstated. Investors need to evaluate the scientific information in the three stages of clinical trials. Phase (i) trials are the basis of whether to proceed to human testing of products. Phase (ii) trials are the first major trials of a drug to demonstrate statistical efficacy. Phase (iii) trials are designed to demonstrate conclusively the effectiveness of a drug and provide regulatory data for government approval: ‘Valuation of prospects for a few major products, both those currently on the market and new drugs in R&D account for most of a pharmaceutical company’s stock market value.’13
Property Earnings from the rent roll of property companies may be less important to investors than the performance of the capital values of the portfolio. Quality of management can have a very direct impact on portfolios, which are often highly concentrated and illiquid. Valuation may be subjective and dependent on infrequent appraisals. Risks revolve around the cost of debt and amount of leverage. Many sectors such as breweries, transport and retail are property companies in disguise, so if you are positive on property it is worth looking at these as well.
High tech With immature streams of earnings, high technology stocks defy conventional valuation. The most popular substitute has been to value them as a multiple of their sales, a price to sales ratio that can then be compared to like companies. But this fails to account for very different types of businesses. A second approach is the DCF approach, discounting future cash
62
chap 3
4/3/02
4:40 pm
Page 63
chapter 3 . Fundamental analysis
flows by a selected interest (discount) rate to come up with a present value. This suffers from the problem of sensitivity to the selected interest rate and sensitivity to the growth rates selected for the cash flows. A final group of valuations involves sophisticated probability modelling and anecdotally these have been more successful, although difficult for laymen to understand.
Mining Assessing mining stocks is a matter of forecasting the prices of the relevant minerals. It is also a function of the quality of the reserves and the rate at which these deplete. If a company is unsuccessful in replacing reserves at reasonable cost, the long-run future of the company is in doubt. The analysis of mining stocks as a group is often a matter of valuing them all on the same basis and seeing which is cheap.14
DETECTING EARNINGS QUALITY One penny of earnings from a company may not be the same thing as one penny of earnings from another company. When managers compile accounts they make important choices as to how their accounts are compiled. Three classic examOne penny of earnings ples of accounting fiddles show how large a probfrom a company may lem this can be: not be the same thing as one penny of 1. Companies in most countries can keep certain earnings from another leases off their balance sheet and thus undercompany. state their real level of debt. 2. When companies restructure they can often take an excessively pessimistic write-off charge all at once so future earnings will be flattered by the use of assets that disappeared from the balance sheet in the restructuring. 3. Companies can acquire fast-growing companies and by consolidating the accounting records they can flatter their own records. On an international level there are distinct differences in accounting rules, which make for very different looking accounts. Some countries write off the goodwill in acquisition (the difference between the purchase price and the assets purchased) immediately against reserves. Others such as the
63
chap 3
4/3/02
4:40 pm
Page 64
The empowered investor
USA charge it to income over 40 years. Germany charges it over a more punishing 15 years, while the UK uses 20 years or the useful life of the asset. This kind of difference helps explain why, when in 1993 Daimler-Benz applied for a US listing, it had to publish two sets of accounts. The one under German rules showed a solid profit of DM600m but the one under US rules showed a staggering loss of DM1.7bn. In Japan the habit of investing excess capital into the shares of suppliers and customers has led to some very strange looking balance sheets by western standards. A further issue is the problem of aggressive accounting practices, both here and in the USA, indeed perhaps more so in the USA. I am talking of circumstances where the financial performance of a company is presented in an unrealistically favourable light in an attempt to meet market expectation, reduce tax liabilities, comply with loan covenants or meet legal or regulatory thresholds. All of these can lead to the market being misled about a company’s profitability or performance. What are the danger signals? ● ● ● ● ● ● ●
Longer depreciation lives One-off profits from the sales of office buildings, etc. Restructuring charges Accelerated recognition of revenues and deferral of costs Reversals of a reserve Sharp falls in inventories Unrecorded stock option plans
Shortcuts: EVA analysis One shortcut to discovering whether an industry or company is adding value and making profits is Economic Value Added or EVA analysis. Fortune magazine Today’s hottest describes it as ‘today’s hottest financial idea and financial idea and getting hotter’. EVA basically says that a company getting hotter. is creating value for its owners (shareholders) only when its operating income exceeds the cost of the capital employed to make the income happen. This is a powerful
64
chap 3
4/3/02
4:40 pm
Page 65
chapter 3 . Fundamental analysis
linkage since of course the owners could invest their capital somewhere else to get a better return. EVA sews all this up into some nice simple numbers which allow you to compare companies and sectors. Unfortunately, according to Merrill Lynch, the companies making the most EVA are not always the ones the market recognizes with better share prices.15 Joel M. Stern, the inventor of EVA, countermands that EVA is useful because it shows up companies that are not undertaking new investments which return more than the cost of the capital.
CORPORATE EVENTS: MERGERS, TAKEOVERS AND IPOs Corporate events come along with surprising frequency and raise a number of obvious questions. What price is the right takeover premium and are IPOs worth investing in? Mergers and acquisitions occur for a wide variety of reasons, some meritable and some not. The prime argument is usually synergy. There may be operating economies or pooling of resources that would not otherwise occur if the two companies remained separate. Examples are the merger of Lotus Development Corporation and IBM and the merger of Glaxo and SmithKline Beecham. Other motivations include getting into assets on the cheap (Gulf Oil and Chevron), diversification or tax considerations. Less healthy motives are the desire by management to gain more power and bigger salary packages. Firms may also seek to break up the acquisition and extract value from the parts greater than the cost. The evidence is that a hostile takeover will merit a 30 per cent increase in the stock price, while a friendly merger will cause a 20 per cent leap.16 Studies of the long-term benefit for the acquirer are rather less conclusive. Anecdotally in the UK it is obvious that many of the takeover vehicles of the 1980s, including Hanson, BTR and Tomkins, failed to benefit in the long run from their acquisition sprees. On IPOs we should first be suspicious of the reason behind the decision to come to the stock market. Is the management just dressing up a run of the mill company to cash in their options? Are they seeking to take advantage of excessive market optimism about their sector? Do they really need the cash and is the investment project worthwhile?
65
chap 3
4/3/02
4:40 pm
Page 66
The empowered investor
IPOs are difficult to price, given that shares have not traded before and the company may have many unique features. Brokers are also understandably concerned that the issue be seen as a success. These factors lead IPOs to be issued at a discount to the real value. According to one source the average underpricing is of the order of 15 per cent.17 But the evidence is that most of the profits from IPO companies accrue on the first day of trading and sadly most of the stock available is allocated to the big institutions. Other investors acquiring after the first day do not experience abnormal returns.
SUMMARY AND CONCLUSION In a freely traded share or commodity the price takes into account all known facts. So please do not confuse me with the fundamentals. (Sri on the Interactive Investor bulletin boards, April 2001)
The key thing to remember is that, if you use fundamental analysis, you are going to have to take a view. There are no crutches or shortcuts. You need to weigh up the evidence you think is important and come to an independent conclusion. There are of course a number of helpful tools. You can buy into services such as Hemmington Scott or Standard & Poor’s that summarize the factual information on a company and make decisions on it. You can use tipsheets and independent sources of information such as websites. By far the most obvious solution is to use broker reports and let the brokers do the legwork, assembling all the relevant industry and stock specific information. However, Of analysts Warren Buffett warned: ‘Never a word on brokers is needed. First, brokers do not ask a barber if you produce research out of charitable concern for the need a haircut.’ plight of bewildered private investors. They are part of investment banks designed to maximize profits. Of analysts Warren Buffett warned: ‘Never ask a barber if you need a haircut.’ The two problems are first that they may withhold sell recommendations and exaggerate the attractiveness of investments to help their corporate finance departments win clients among the companies they are analyzing. According to one fund manager, ‘The notion that analysts make independent forecasts is a convenient fiction that suits all parties.’18
66
chap 3
4/3/02
4:40 pm
Page 67
chapter 3 . Fundamental analysis
Second, analysts will be part of investment banks which take positions in the stocks they analyze. So if they are short or long of a stock the analyst might be pressured to make a recommendation convenient to the bank. On the other hand we should not forget that analysts work at the crux of the information food chain. They may get a bad press, particularly technology stock analysts, but they are generally very strong on detailed industry knowledge and contacts.
What turns the professionals on? We would expect fund managers to know best. After all, their job it is to deal with flows of competing investment prospects all day long so they ought to know how to sift stocks better than the rest of us. Tony Golding, in The City: Inside the Great Expectation Machine, usefully summarized the kinds of things fund managers love and loathe into hard and soft categories. Positives include solid numbers, simple company structures focused on one activity, a memorable story and obvious quality characteristics. Softer factors relate to the credibility of managers, PR and strategy. Investors like to see solid financial numbers and ratios showing growth of sales and margins, preferably double-digit growth. Investors hate to see such numbers distorted by acquisitions that are dilutive or make the numbers deteriorate. On the other hand acquisitions that are earnings enhancing are greeted with applause. Investors in the UK prefer to see a simple company structure without the confusing crossholdings common in Europe. They like a company focused on a core business so that fund managers can get pure exposure to an exciting area of operations. Stories that make the company memorable will stand out in a fund manager’s crowded mind and allow it to be categorized in the market with a ‘turnaround’ or ‘restructuring’ label. Companies benefit by linking into the world of existing blue-chip stocks in fund manager portfolios. They do this by boasting of their bluechip clients or a key contract with a fashionable name. Companies that can be regarded as commodity businesses are a major turn-off for fund managers. They favour unique businesses with repeatable long-term earning streams or unexploited growth industries. The key soft factor identified by Golding is the quality of management. Since the management are the face of the company to the all-important institutional investors, their credibility and personality is key. Institutions make judgements about whether to buy on the management promises
67
chap 3
4/3/02
4:40 pm
Page 68
The empowered investor
and sell if they do not deliver. Management also vocalize the strategy and explain it to the investors. How well they and the rest of the company’s PR machine do that job can impact the rating of the share price. So what makes a good stock? This is in the eye of the beholder. You need to be comfortable with both the industry and the stock. Above all you need to be convinced not only about the underlying company, but also that the valuation meets your measure of cheapness. Let’s just summarize the conclusions for this section (Table 3.2). Table 3.2
Indications of industry and company health
What makes a good industry?
What makes a good company?
Positive market growth trends Lots of potential markets as yet unexploited Dynamic product cycles Healthy but not excessive competition Costs contained Suppliers not too powerful
Exposed to industry growth Able to fund its growth Management switched on Good products Unexploited markets Gearing not excessive Valuation comparisons favourable
NOTES 1 In John Train, Money Masters (HarperCollins, New York, 2000), p. 122. 2 Benjamin Graham and David Dodd, Security Analysis: Principals and Techniques (McGraw-Hill, New York, 1934). 3 Fred Wellings, ‘Profits forecasting: a practitioner’s view’, Professional Investor, October (1998), p. 28. 4 Robert C. Higgins, Analysis for Financial Management, 6th edn, (McGraw-Hill, Maidenhead, 2001), p. 115. 5 Jonathan Davis, Money Makers (Orion, London, 1998), p. 168. 6 A study using the period 1982–9 was originally used to justify this effect but more recent studies undertaking annual rebalancing have not been supportive. Frank Reilly and Dominic Marshall, ‘Using P/E/growth ratios to select stocks’, (University of Notre Dame, Paris, January 1999). 7 Tom Copeland and Vladimir Antikarov, Real Options, A Practitioners’ Guide (Texere, New York, 2001, p. 262). 8 George Soros, The Alchemy of Finance (Simon and Schuster, New York, 1987), p. 47. 9 John Maynard Keynes said, ‘A speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.’ The Collected Works of John Maynard Keynes, Donald Moggridge, ed., Vol. XII (Cambridge University Press, New York, 1983), p. 109. With permission of Palgrave.
68
chap 3
4/3/02
4:40 pm
Page 69
chapter 3 . Fundamental analysis 10 Jeffrey C. Hooke, Security Analysis on Wall Street: A Comprehensive Guide to Today’s Valuation Methods (Wiley, New York, 1998), pp. 79–108. 11 Chris Gasson, Media Equities Evaluation and Trading (Woodhead Publishing, Cambridge, 1995), p. 4. 12 Nick Antill and Robert Arnott, Valuing Oil and Gas Companies, 2nd edn (Woodhead Publishing, Cambridge, 2000), pp. 110–18. 13 Andrew D. Porter and Karen Beynon, Valuing Chemical Companies, 2nd edn (Woodhead Publishing, Cambridge, 2000). 14 Charles Kernot, Valuing Mining Companies, 2nd edn (Woodhead Publishing, Cambridge, 1999), pp. 156–8. 15 Issued by Merrill Lynch, Pierce, Fenner and Smith, Merrill Lynch Quantitative Viewpoint: An Analysis of EVA, by Richard Bernstein and Carmen Pigler, London, 19 December 1997. 16 Michael C. Jensen and Richard S. Ruback, ‘The market for corporate control: the scientific evidence’, Journal of Financial Economics, April (1983), pp. 5–50. 17 B.M. Neuberger and C.A. Lachapelle, ‘Unseasoned new issue price performance on three tiers: 1975–80’, Financial Management, 12, 3 (1983), pp. 23–8. 18 Tony Golding, The City: Inside The Great Expectations Machine (Pearson Education, London, 2001), p. 62.
69
chap 4
4/3/02
4:41 pm
Page 70
chap 4
4/3/02
4:41 pm
Page 71
4 Technical analysis What is technical analysis? Let’s start with the basics Volume and the Dow Theory Support and resistance levels Breakouts and moving averages Candlesticks Point and figure charts Easy patterns to detect Triangles Rectangles Flags Reversal trends: double tops and head and shoulders Mathematical indicators Relative strength indicators (RSI) Rate of change (ROC) indicators of velocity MACD Bollinger bands Fibonacci retracements Elliott waves
71
chap 4
4/3/02
4:41 pm
Page 72
Market indicators Contrarian technical analysis rules Breadth of market indicators Kondratieff and Coppock Buy and sell signals Indicator tips
chap 4
4/3/02
4:41 pm
Page 73
chapter 1 . Why the stock market?
Many sceptics, it is true, are inclined to dismiss the whole procedure [chart reading] as akin to astrology or necromancy; but the sheer weight of its importance in Wall Street requires that its pretensions be examined with some degree of care. (Benjamin Graham and David L. Dodd)1 Those who cannot remember the past are condemned to repeat it. (George Santayana)2
WHAT IS TECHNICAL ANALYSIS? Technical analysis is really about two simple things. The first thing is the trend in a stock price. Chartists do not believe that share prices move randomly. The second is the pattern in the price chart. Whereas fundamental analysis uses information such as the company’s earnings or the state of the economy, technical analysts believe that the market itself is its own best forecaster. They think that prices move in repetitive patterns that provide a visual representation of the market psychology. If this seems hocuspocus to you it is worth bearing in mind that at the very least they have relevance because a significant body of investors think they do. Technical analysts maintain that the prices and volumes of share trades contain all the meaning you need to arrive at buy and sell decisions. They see things solely in terms of demand and supply. The market is the sum of all rational and irrational Prices move in influences. Change for technicians does not occur repetitive patterns that suddenly but in a trend. So they do not accept that provide a visual representation of the information is gobbled up by the market and market psychology. prices change to prevent profits. They consider that prices move sedately in one direction or the other. They are interested just as much in the change in the rate of change as in the direction. Once a trend develops, rather like a car changing between different gears, it has different levels. They aim to
73
chap 4
4/3/02
4:41 pm
Page 74
The empowered investor
identify shifts in the persistence of a trend and believe that trends persist for long times. We should not confuse this with trends and patterns that appear commonly in fundamental analysis, such as rising sales growth or falling interest rates. Every investor and analyst will also have a mental framework of patterns that he has seen in past industry cycles or events. The difference between fundamental and technical analysis is that technicians see prices as predictable by looking at the past price evidence alone.
Arguments against technical analysis Some critics argue that price patterns have become self-fulfilling prophecies. For example, let’s assume that technicians think a stock will rise to 100 if it breaks through a resistance line at 75, (we will examine these terms shortly). If it does go to 75 the sheer volume of trades generated by the technicians themselves will cause the stock to go to 100. Another problem is that if one rule or the other is successful, investors will adopt it in droves and neutralize the value of the technique. The major studies against technical analysis are the tests for efficient markets. One set of tests analyzed prices to determine whether they were random – a random walk. The second set of tests looked at whether a buy and hold strategy would be better than following trading rules. They found that share prices were indeed a random walk and that a buy and hold strategy outperformed trading. In fact there is a surprising lack of academic evidence in favour of technical analysis. We won’t let that stop us here because if enough people believe in something it is bound to influence the behaviour of prices. And lots of people do believe. Here a few justifications from users of the Ample Interactive Investor website: Every tipster has some hidden objective. You simply don’t know who to believe. Charts are impartial. They work particularly well in a world of massmarket manipulation and market abuse. Long live the chartists! (Richard Scarlett) Technical Analysis is the only logical way to make decisions that can be backtested on when to buy and sell. It works on any market and any timescale. (Mike Alexander) Technical Analysis (TA) is merely a consensus accepted by insiders. It does not follow any real flow being only supported by itself. It is a more complicated version of herd following. (Frederick Mole)
74
chap 4
4/3/02
4:41 pm
Page 75
c h a p t e r 4 . Te c h n i c a l a n a l y s i s
In order to provide a balanced account it is only fair to include a couple of doubters too: All Technical Analysts have 20/20 hindsight but not a Scooby Doo about the future – they would be as well gutting a chicken and reading the entrails! (Tom Watson) Following charts is for those who like playing with crayons rather than engaging in considered analysis. Of course if we all did charts it would be a selffulfilling prophecy in the short term. (Nick Beart)
Advantages of technical analysis First, it is quicker to arrive at trading signals than the laborious process of fundamental analysis. Technical analysts claim superior ability to time trades and benefit from getting in low and getting out high. Second, it is less vulnerable to the clever accounting tricks that plague ratio analysis.
LET’S START WITH THE BASICS We all remember the graph paper with boxes which we used at school for drawing elaborate shapes and bar charts of class heights and weights. This is the starting point of any technical analysis. If you plot the highest and lowest price for a particular day onto the chart and join them up you will have a range. The bars representing the daily ranges build up over time to result in a bar chart, a classic charting tool. Figure 4.1 shows a close-up of a bar chart with the day’s high/low and close indicated as a tag. Below the chart you can see the volume shaded to show the direction of the price. Under the bar chart, it is the convention to put a bar chart of the day’s volume over the corresponding period. In order to compress the chart and remove the illusion that a price goes up faster and faster as it rises higher, a special scale is used to scale down the jaggedness of changes over time (logarithmic paper). It allows for better trend and pattern analysis. You will need to select appropriate timescales to work with. The longer the timescale, the wider your horizon to spot trends and patterns.
75
chap 4
4/3/02
4:41 pm
Page 76
The empowered investor 670 665 BP PLC
660 655 650 645 640 635 630 625 620 615 610
BP PLC Volume (millions)
50 40
rising price falling price
30 20 18 21 22 23 24 25 29 30 31 1 4 May June
Figure 4.1
5
6
7
8 11 12 13 14 15 18
Bar chart Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
VOLUME AND THE DOW THEORY The price change alone does not tell us all we need to know. The volume of stock traded confirms the trend. An increase on heavy volume is a positive signal, while a price decline on heavy volume is bearish. English technical analysts used to pay less attention to volume than US technicians, who were influenced by Charles Dow, the founder of the famous Wall Street Journal and the Dow Jones Index. Dow described stock prices as moving in three types of trends analogous to the movements of water: ●
76
major trends like the huge tides of an ocean
chap 4
4/3/02
4:41 pm
Page 77
c h a p t e r 4 . Te c h n i c a l a n a l y s i s ●
middling tides that resemble waves
●
short run movements like ripples.
Followers of the Dow Theory recognize that prices do not go straight up, but occasionally go in the opposite direction. Technicians also use a ratio of the volume traded of rising shares to the volume traded of falling shares to indicate the overall momentum of a market. This is reported daily in publications such a such as the Wall Street Journal and Financial Times.
SUPPORT AND RESISTANCE LEVELS Once you have got your chart you can draw on a trendline. You may prefer to work with an ordinary line graph, shown in Figure 4.2, rather than use the daily highs and lows. The extreme bumps in the price chart, the 700 650 620 590 560 540 520 BP PLC
500 480 460 440 420 400 390 370 360 400 300 200 100 0
Figure 4.2
BP PLC Volume (millions) rising price falling price
1999
2000
2001
An upward trend line drawn on top of a line graph for BP (log scale) Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
77
chap 4
4/3/02
4:41 pm
Page 78
The empowered investor
highs and lows will tell you where to put the trendline. You should take care that your trendline has more than two points of contact with the low or high points you are illustrating. A technical analyst will believe that a trend will continue for a long time. So once your trendline is established, the strategy is to buy on the dips if the trend is upward guided by your trendline and sell on the rises if your trendline is downward. A support level is the price range at which the technician expects demand for the stock to increase. Investors are snapping up stock at lower prices. Technicians believe that if a stock has been rising and then falls slightly, it will hit a support level as all of those investors left out of the rise rush to get into the stock. A resistance level is a price range where an increase in the supply of stock will occur on a price rise leading to a rapid reversal of any price gain. People are selling into higher prices. A resistance level is more likely to occur after a stock has steadily declined from a higher level. A supply of stock is said to be overhanging the market.
BREAKOUTS AND MOVING AVERAGES It is easy enough to understand the concept of an average. The average of days in a week is seven. But a moving average may take a while to get your head around. Let’s say that instead of seven days, this week happened to have fourteen. The moving average over the past two weeks is therefore no longer seven days in the average week but 10.5. A moving average in a share price keeps track of the change in the average share price over a defined time period. The most commonly used short- and long-term moving averages are the 50-day and 200-day moving averages. It just adds up the share price for those 50 or 200 most recent days and divides by 50 or 200. This number will change over time, lagging the movement in the current share price. It makes sense that an average will trail the trend if the price is rising, and in a falling market the average will be above the current price. It is usual for chartists to overlay two moving averages – a short and a longer period moving average. If the price begins to slow down or go into reverse, then the moving average covering the shorter period will go down first. A shorter moving average is obviously a lot more volatile than a longer one (Figure 4.3).
78
chap 4
4/3/02
4:41 pm
Page 79
c h a p t e r 4 . Te c h n i c a l a n a l y s i s 1120 1100 1090 1080 1070 1060 1050 1040 1030 1020 1010 1000 990 980 970 960 950 940 930 920 910 900
BOC Group PLC 50 day SMA 200 day SMA
15
BOC Group PLC Volume (millions) rising price falling price
10 5 0
Figure 4.3
Jan 2001
Feb
Mar
Apr
May
Jun
Diagram of a line graph (log scale) with 50-day and 200-day moving average crossing over Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
When the shorter moving average slows first, it is possible that it will cross over the longer average. This is considered significant if and only if both moving averages are moving in the same direction as each other. In the event that both moving averages were rising when the crossover happened, this is a bullish signal called a Golden Cross. If the moving averages are both heading down, this is a bearish signal called a Bearish Cross. Both of these are regarded as indicating a change in the overall trend. When a 50-day moving average crosses the 200-day from below on high volume, this signals a reversal from negative to positive. On the contrary, if a 50-day moving average crosses a 200-day line from above, then this is considered a sell indicator. As always, the technical analyst will look to volume to support the conclusion.
79
chap 4
4/3/02
4:41 pm
Page 80
The empowered investor
If prices break out through a trend line, chartists consider this significant if accompanied by heavy volume. For instance, if a stock price reverses, a trend breaks through a moving average from below having been trending down and if accompanied by strong trading volume this is considered a positive sign.
CANDLESTICKS These originated in Japan and are referred to as candlesticks because of the shape of the plot, which looks like a little candle. They are plotted using the day’s high and low like a bar chart. However, if the closing price of the day was above the opening price, then the box is left empty. If the price closed lower than it opened, then the box is filled in. The vocabulary of candlesticks is one of oriental names attributing meaning to the various colour patterns that are produced. Chartists see significance in the length of the candle. A long black body is a bearish signal, while a long white body is a positive signal. Short candlesticks, dojis, where the price at open and close was similar can be seen as significant, forming tops and bottoms of a trend (Figure 4.4).
POINT AND FIGURE CHARTS Technical analysts don’t just use bar charts; they also use the strangely named point and figure charts. In these charts the price changes that are too small to register are omitted and the timescale is also left out. A rising price is represented by an X and a falling price by an O. The chart is plotted in vertical columns and only changes if the price moves outside the box in which it was last plotted. The chartist determines which movements are significant enough to be registered. For example, if you decided only to record changes of more than 4 and the stock price started at 40 and moved to 42, you would record an X in the box above 40 and do nothing else until the stock rose above 44 or dropped below 38 (a four-point reversal from its high of 42). If it dropped to 38, you would move the column to the right, indicating the direction of movement had changed, and put an O to indicate a decline to 38. If the price dropped another 4 points you add another O. Only if it moves
80
chap 4
4/3/02
4:41 pm
Page 81
c h a p t e r 4 . Te c h n i c a l a n a l y s i s 670 664 659 654 650 648 644 640 638
BP PLC
634 630 628 624 620 618 614 610 50
BP PLC Volume (millions) rising price falling price
40 30 20 18 21 22 23 24 25 29 30 31 1
Figure 4.4
4
5
6
7
8 11 12 13 14 15 18
Diagram of a candlestick chart for BP Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
another four points in the opposite direction would you move to the next column and begin again with an X. Over time you will plot what looks very like a bar chart and trendlines and breakouts can be detected. Technicians favour point and figure charts because they screen out the irrelevant sideways movements and present changes in trends starkly.
EASY PATTERNS TO DETECT A great deal of technical analysis concerns the ability to spot constantly repeated patterns. This is where technical analysis overlaps with human psychology. We can all recognize well-established patterns of constantly repeated behaviour. In technical analysis such patterns will last differing lengths of time and arise with different degrees of strength.
81
chap 4
4/3/02
4:41 pm
Page 82
The empowered investor
TRIANGLES One of the easiest and most common patterns to detect is the triangle pattern typical of a rising market. Triangles indicate a battle going on between buyers and sellers. They can be formed from a horizontal line on top and a line below the rising share price. They can have flat tops or in a market trending sideways they might have more of a ‘>’ shape. A flattopped triangle arises because the price is hitting resistance at a particular level and sellers are coming in at that point. At some point the buyers will gain the upper hand and the ceiling of the triangle will rise. The pattern is most certain when there are more than a couple of points of contact on the top and bottom lines. Uncertainty will be more likely close to the apex. Target prices can be deduced from the depth of the triangle (Figure 4.5).
55 54 53 52 51 50 49 48 47 46 45 44 43 42 41 40 39 38 37 36 3000
SABRE HOLDINGS CORP
SABRE HOLDINGS CORP Volume (thousands) rising price falling price
2000 1000 0
Jan
Feb
Mar
Apr
May
Jun
2001
Figure 4.5
Diagram of a triangle pattern overlaid onto a chart Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
82
chap 4
4/3/02
4:41 pm
Page 83
c h a p t e r 4 . Te c h n i c a l a n a l y s i s
RECTANGLES This shape is rather less common than the triangle. It occurs when a stock is trending up and down within a narrow range, the bounds of which can be drawn as two lines (hence the rectangle name) on a couple of contact points to the extreme highs and lows of the share price. What this is saying is that there is a fairly undecided argument going on between buyers and sellers. When one or other becomes exhausted, the price moves swiftly up or down through the bounds, although it might temporarily pull back. Rectangles can build up over a couple of months and may not resolve themselves for many months more.
FLAGS These formations occur in fast-moving situations. Basically they occur when a rising or falling stock price stalls. They are compacted miniature consolidations in a sharp upward or downward movement. Because the rise or fall is so steep, they look like flagpoles – hence the name of flags for these formations.
REVERSAL TRENDS: DOUBLE TOPS AND HEAD AND SHOULDERS Two of the most common reversal patterns – double tops and head and shoulders – can be described in terms of investor psychology.
Double tops Double tops occur when the market hits a peak, then sells off, then rallies up to the old peak and then falls again. So the price chart looks like the letter M. The mid-point of the M pattern is the support point. In terms of investor behaviour, this can be seen as investors initially being reluctant to accept that the high prices are wrong and chasing the share back up after its first fall. After a while though, the sellers gain the upper hand and force the price to ‘double top’ and fall. The complete opposite of a double top is
83
chap 4
4/3/02
4:41 pm
Page 84
The empowered investor
a double bottom where the chart looks like the letter W. In this case the buyers eventually gain the upper hand and the price rises. Both are regarded as powerful signals, but are very rare indeed.
Head and shoulders A more common occurrence is the head and shoulders formation (Figure 4.6). This pattern builds up when a price has been in an upward trend for some time and lots of investors are in heavy profit. The pattern develops out of three peaks. The top of the inner peak (the head) must be higher than the two outer peaks (the shoulders). In terms of demand and supply, the reason the shoulders form is that investors are inclined to take profits 1.80 1.75 1.70 1.65 1.60 1.55 1.50 1.45 1.40
NECKLINE
1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 15 10 5 0 Feb
Figure 4.6
mar
Apr
May
Jul
Example of a head and shoulders formation Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
84
chap 4
4/3/02
4:41 pm
Page 85
c h a p t e r 4 . Te c h n i c a l a n a l y s i s
around that plateau and when the price fails to break through the higher peak (the head) it settles back to the old familiar level as before, forming the second shoulder. If the price breaks through the neckline, this is regarded as a serious negative signal. In a bear market the exact opposite of a head and shoulders can form and any breakout through the upside down shoulders is then regarded as a very positive signal.
MATHEMATICAL INDICATORS Technical analysts do not produce charts full of flashy indicators just to show off. Indicators are simply a mechanism for cutting down on the margin of error. Computing power has increased the usage of complex indicators of all kinds, but the object always remains the same – to refine the signals and reduce the error.
RELATIVE STRENGTH INDICATORS (RSI) The relative part of the relative strength indicators refers to comparison with the market. It works out how your share is performing relative to everyone else so that you can see whether you are falling behind or getting ahead. Technicians believe that a trend of underperforming or outperforming the market will continue and that the trends (in this trend) can be charted just like any other. Technicians therefore compute weekly or monthly relative strength ratios, for instance, for a stock or for an industry group. They are computed relative to some index such as the S&P 400 or the FTSE 100. Relative strength indices work during rising as well as falling markets. A positive relative strength in combination with moving average lines crossing is a powerful buy signal. A change in the trend of relative strength can be a strong buy or sell signal, particularly if confirmed by successive lurches in the RSI up or down (Figure 4.7).
85
chap 4
4/3/02
4:41 pm
Page 86
The empowered investor 1950 1900 1850 1800 1750 1700 1650 1600 1550 1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 750
Logica PLC 20 day SMA
Feb
Mar
Apr
May
Jun
Jul
30 Logica PLC Volume (millions) rising price falling price
20 10 0 100
14 day RSI
50 0
Feb
Figure 4.7
Mar
Apr
May
Jun
Jul
Example of a relative strength indicator (RSI) Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
RATE OF CHANGE (ROC) INDICATORS OF VELOCITY This measure is calculated over a short time period such as 14 days and is a measure of the momentum or velocity of the change. It indicates whether the price has moved too far too fast or is speeding up. Generally this is worked out as a percentage of 100, with numbers above 50 indicating overbought and below 50 indicating oversold. It is rarely used on its own, but rather for confirmation of other trends. To calculate the ROC, you divide the latest closing price by the closing price the desired number
86
chap 4
4/3/02
4:41 pm
Page 87
c h a p t e r 4 . Te c h n i c a l a n a l y s i s 1950 1900 1850 1800 1750 1700 1650 1600 1550 1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 750
Logica PLC 20 day SMA
Feb
Mar
Apr
May
Jun
Jul
30 Logica PLC Volume (millions) rising price falling price
20 10 0 100
14 day Fast Stochastic %K %D
50 0
Feb
Figure 4.8
Mar
Apr
May
Jun
Jul
Example of a velocity indicator Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
of days ago then multiply by 100. This value is then used as the ‘reference line’ (the ‘K’ line). A smoothed version of this line (a ‘D’ line) can then be monitored for crossovers (Figure 4.8).
MACD What is it? This is the moving average convergence/divergence indicator – or MACD for short. As we know, moving average lines are constantly moving relative to each other, either towards or away from each other and even crossing each other. The moving average convergence/divergence
87
chap 4
4/3/02
4:41 pm
Page 88
The empowered investor 1950 1900 1850 1800 1750 1700 1650 1600 1550 1500 1450 1400 1350 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 750
Logica PLC 20 day SMA
Feb
Mar
Apr
May
Jun
Jul
30 Logica PLC Volume (millions) rising price falling price
20 10 0 100 50 0 –50 –100 –150 –200
MACD (12, 26, 9) (day scale) MACD line Signal line
Feb
Figure 4.9
Mar
Apr
May
Jun
Jul
An example of MACD Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
indicator measures the extent of this convergence or divergence. If two moving averages are the same, then the MACD is given a value of zero. If the shorter term moving average goes above the longer term MA, the difference is a positive value. When the shorter term moving average falls below the longer term then this is plotted as a negative value (Figure 4.9).
BOLLINGER BANDS These were developed by John Bollinger who went on to found a successful fund trading on the principle that the volatility of a share price (its
88
chap 4
4/3/02
4:41 pm
Page 89
c h a p t e r 4 . Te c h n i c a l a n a l y s i s 2100 2000 1900 1800 1700 1600 1500
Logica PLC 20 day Bollinger Bands
1400 1300 1200 1100 1000 900 800 700 30
Logica PLC Volume (millions) rising price falling price
20 10 0 Feb
Figure 4.10
Mar
Apr
May
Jun
Jul
An example of Bollinger bands Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
standard deviation in mathematical terms) should form bands above and below the actual share price. In a very jumpy market the bands will be wide. In a flat market the bands will narrow. It is said to be significant when the share price breaks through the band. This will often signal the start of a trend. Other indicators such as RSI should confirm this. A 20-day average with two ‘standard deviations’ is popular for short and medium term analysis. For longer periods a 50-day average with 2.5 standard deviations may be better, while shorter periods will find 10-day moving averages and one standard deviation sufficient (Figure 4.10).
FIBONACCI RETRACEMENTS A standard stock market pattern is where a move in one direction is followed by a retracement in the opposite direction. Technical analysts,
89
chap 4
4/3/02
4:41 pm
Page 90
The empowered investor
believing that markets are predictable, will try and predict these retracements. They have dug up Leonardo Fibonacci, an Italian mathematician whose technique was to build up a sequence of numbers in which each previous number is the sum of the two previous numbers, 0,1,1,2,3,5,8,13,21 etc. Buried in this series of numbers is the Golden Mean, which is the ratio between any two successive numbers in the sequence. It works out at about 61.8 per cent and is one of those numbers that crops up all over the place. The Greeks knew about it and called it phi. The Nautilus shell (Nautilus pompilius) grows larger on each spiral by phi. The sunflower has 55 clockwise spirals overlaid on either 34 or 89 counter-clockwise spirals, a phi proportion. It also crops up in music and architecture. In charts it seems that many retracements cease at 38.2 per cent on the way down leaving 61.8 per cent of the price intact. It is difficult to know why this might be so other than that lots of investors believe that this is the case.
ELLIOTT WAVES Ralph Nelson Elliott observed more than half a century ago that stock market movements unfold in a series of rhythmic patterns based on a natural shifts in investor mood. In Elliott’s own words: Practically all developments which result from [human] social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring serials of waves or impulses of definite number and pattern.3
Elliott believed that waves occur in three parts, a riding impulse wave of five parts followed by a corrective wave of three parts, with the relationship between them determined by various rules such as Fibonacci numbers. Corrective wave or retracements would typically be 38.2 per cent. Underlying the Elliott wave theory is the basic assumption of a long-term bull market in which there is a regular compounding accrual with occasional setbacks quantifiable as phi, 38.2 per cent.
90
chap 4
4/3/02
4:41 pm
Page 91
c h a p t e r 4 . Te c h n i c a l a n a l y s i s
MARKET INDICATORS Many technical analysts pay great attention to indicators that are reckoned to foreshadow events elsewhere in the market. Commodity prices are seen by some technicians as giving advance warning of changes or trends in the world economy. Although some individual commodities such as oil are closely followed, indexes of a number of commodities bundled together are normally used. An example is the Bridge Commodity Research Bureau futures index, traded in New York. Other chartists prefer to look at different leading indicators. Commodities may actually lag the movement of the economy as suppliers build up capacity during the boom and regret it during a downswing, building up stocks rather than mothballing capacity.
CONTRARIAN TECHNICAL ANALYSIS RULES Many technical analysts have developed trading rules based on a contrarian notion that the majority of investors are wrong as the market approaches peaks and troughs. If a technician can identify a peak or trough, then he can trade in the opposite direction. The level of cash held by fund managers is one such indicator of a market approaching its peak or trough. If fund managers are bullish, then they will have used up all their cash to buy stocks, and if bearish they will be holding lots of cash. The level of cash held by private investors is a statistic that is available from adding up cash in brokerage accounts. A decline in cash balances indicates a fall in available buying power and is a bearish signal, while higher cash balances are a bullish sign. The put/call ratio is one more such rule designed to spot market trends. If there are more outstanding call options (the option/right to buy stocks) than there are put options (the option/right to sell stocks), then that is a bearish sign indicating excessive bullishness.
BREADTH OF MARKET INDICATORS Technical analysts also pay close attention to market statistics such as daily highs and lows and the number of issues rising and falling. A tech-
91
chap 4
4/3/02
4:41 pm
Page 92
The empowered investor
nician would look for a highs/lows ratio or an advances/decliners ratio to show a divergence from the trend in the main general index of the market. That could indicate underlying trends changing.
KONDRATIEFF AND COPPOCK Very long run indicators If you accept the importance of trends then this applies over all time periods, not only the short run. Kondratieff, working in Russia in the 1920s, traced a 54-year cycle in the peaks to troughs of interest rates. He set out evidence of a cycle of interest rates using bond yields as a proxy for rates. He then used grain prices to show parallel trends in the wider economy through wars and other political and social developments. For Kondratieff, a cycle is set off by major innovations such as the railroads or the automobile. One rationalization is that cycles can reflect opposing cultural attitudes of subsequent generations. Another is that technological advances such as railways, motor cars and computers regularly come along and mop up spare capital, driving interest rates up. In the UK, for example, interest rates started to rise in 1946 and peaked in 1974–5. They have been falling more or less in a straight line to the present day. Since interest rates reflect demand and supply of loans to invest on a global basis, the rate may have significance in many areas. In the USA there is a similar interest rate cycle to the UK. Yet another long run indicator is the Coppock indicator which is featured in publications such as the Investor’s Chronicle. This is based on a mechanical system devised by Edwin Coppock, a Texan investor. The buy indicator is a function of three consecutive similar monthly changes in the direction of the indicator.
BUY AND SELL SIGNALS The object of technical analysis is really to provide buy and sell signals, to simplify stock market investment into a set of rules. A technical analyst is hoping to benefit from the major part of trends that have been identified.
92
chap 4
4/3/02
4:41 pm
Page 93
c h a p t e r 4 . Te c h n i c a l a n a l y s i s
Whether or not you accept the validity of technical analysis, it is important to understand the signals by which technical analysis works. Technical analysts will often overlay indicators and seek out confirmatory signals. The summary signals list that follows is by no means complete, but serves as an indication of what technical analysts are actually up to.
The object of technical analysis is really to provide buy and sell signals, to simplify stock market investment into a set of rules.
Buy signals ●
If the moving average line flattens following a decline and the price of the stock penetrates that moving average line on the upside, this constitutes a major buying signal.
●
When the 50-day moving average breaks through the 200-day moving average, this is a significant event. If the 50-day moving average breaks through heading up, this is a positive signal.
●
If the price of the stock falls below the moving average line while the moving average line is still going up, you should buy the stock.
●
If the stock price travels above the moving average but bounces off it when it dips lower and instead turns up again, this is a buying signal.
●
If the stock price falls too violently below a declining moving average line, a rebound is likely.
Sell signals ●
If the moving average line flattens or declines following a rise, and the stock price penetrates that line heading down, this constitutes an important selling signal.
●
When the 50-day moving average breaks through the 200-day moving average, this is a significant event. If the 50-day moving average breaks through heading down, this is a negative signal.
●
A sell signal is given if the stock price rises above the moving average line while the average line is still going down.
●
If the stock price has difficulty penetrating the moving average then that too is a sell signal, particularly after a number of a failed attempts to penetrate.
93
chap 4
4/3/02
4:41 pm
Page 94
The empowered investor ●
Where the share price spikes up above the moving average line it may have moved too far too fast and will probably head back down.
INDICATOR TIPS ●
Multiple indicators give more valid signals than individual indicators.
●
Indicators are useful to confirm that a change in the trend has taken place.
●
Momentum can be detected using indicators such as RSI, MACD and Bollinger bands.
●
MACD works well in both a trending market and a market trading in a volatile trading range.
●
Watch out for the signal line crossing over the MACD line.
●
RSI is more reliable in a trending market.
●
Bollinger bands will tighten in a flat market so a breakout will be signalled early.
NOTES 1 2 3
94
Benjamin Graham and David L. Dodd, Security Analysis: Principles and Techniques (McGraw-Hill, New York, 1934). George Santayana, Life of Reason (1905–6), Chapter 12. R.N. Elliott, Nature’s Law: The Secret of the Universe (1946), reprinted in R.N. Elliott’s Masterworks: The Definitive Collection, ed. Robert R. Prechter (McGraw-Hill, Dubuque, IA, 1994).
chap 5
4/3/02
4:42 pm
Page 95
5 A more professional portfolio Step 1: Your portfolio and your needs Step 2: Pick a benchmark Step 3: Understand risk vs. return Step 4: Designing the portfolio universe Step 5: Bonds vs. equities Step 6: Combining shares
95
chap 5
4/3/02
4:42 pm
Page 96
chap 5
4/3/02
4:42 pm
Page 97
chapter 1 . Why the stock market?
Common stock purchases obtained through purchases month-bymonth, at low prices as well as high, would have provided a very effective method of investing a portion of retirement funds. Most of the difficulties in individual investing in equities arise from lack of diversification both among shares and over time. (William C Greenough)1 The greatest safety lies in putting all your eggs in one basket and watching the basket. (Gerald M Loeb)2
STEP 1: YOUR PORTFOLIO AND YOUR NEEDS Once you have decided to build a portfolio you will need to ask yourself a number of questions to manage it professionally. ●
You need to establish what are your goals and objectives.
●
You need to establish a time horizon, how long you want to hold onto your investments.
●
You need to work out your risk level and expectations.
Because of changes in your commitments and your assets over time, your investment strategy will change over your life. The early stage, say up to your mid-thirties, will involve the accumulation of assets. There will be short-term needs such as saving for a down payment on a house, holiBecause of changes in days or car and then there will be longer term your commitments and your assets over time, needs such as establishing a pension or saving for your investment your children’s education. Because of the longstrategy will change term time horizon, you will be able to take on over your life. higher risk investments in the hope of making good gains.
97
chap 5
4/3/02
4:42 pm
Page 98
The empowered investor
Between your mid-thirties and your fifties you will be in the consolidation phase of your investment strategy. You may be at your career peak and earning a good salary. You may have paid off most of your mortgage. You may still have some commitments to pay your children’s college bills, but these are coming to an end. You will have a surplus to save and invest. Since your time horizon is still quite long, moderately risky investments will be most satisfactory. An increasing concern though will be capital preservation, as you do not want to put your capital at risk. A final lifecycle phase is your retirement when you are spending the accumulated assets. Living expenses are covered by social security and pensions. The important thing in this stage is to protect against the effects of inflation, not forgetting that retirement on average lasts around 20 years. You may initially wish just to preserve capital while drawing down a rising income. Completely different types of investments are required to accomplish this goal compared to previous strategies.
Your portfolio You will need to work out an investment strategy that offers the most suitable way forward. You should first consider your tolerance to risk, your investment goals and any constraints such as your tax status or obligations to fund a child through college. What is your investment goal – to make a lot of money? This is the obvious answer but is probably not suitable for most investors. The fact is that the market is very volatile. It can go up and down by 10 per cent in a day (or even 22 per cent on Wall Street’s Black Monday in 1987). Individual stocks can go up and down even more. Your portfolio needs to be robust enough to see out likely falls and rises in a volatile investment world, but it also needs to be designed to take advantage of changes in prices of the various assets.
25 years old At this age your investment goal is likely to be capital gains. If you hold a steady job, you are likely to see income rising. So you should be able to carry high amounts of risk. You can consider higher risk stocks and industries as well as exposure to emerging markets. Income is not a major priority.
98
chap 5
4/3/02
4:42 pm
Page 99
chapter 5 . A more professional portfolio
45 years old At this age your investment goal is becoming more conservative. You can still take on some risk, but you are looking for security of your capital and beginning to consider income.
65 years old At this age your investment focus is on getting income from your assets while preserving both income and capital from the effects of inflation.
The risk quiz How risk averse are you? 1 You have bought a stock for 100 that has doubled. Do you (a) sell half (b) buy more? 2 You win £100 in the office Christmas draw. Do you (a) pay off your overdrawn cheque account; (b) spend the lot on a riotous evening out? 3 A good description of your attitude to money is (a) save the pennies and the pounds will add up; (b) borrow as much as you can? 4 Your friends would describe you as (a) miserly; (b) always first to pay for a round of drinks? 5 When the stock market takes a tumble, do you (a) buy; (b) sell? 6 I hold stocks (a) for the long run; (b) for fun. 7 My early life was (a) a struggle for security; (b) one long party spending Dad’s money? The more (b)s you score, the less risk averse you are.
Time horizon There are some obvious constraints on your investing. One is any immediate need for cash. We will assume that these are amply covered by your current account and income. A younger person will clearly have a longer time horizon than someone older and will be able to take on more risk. This does not mean that someone older will have a zero exposure to risk. In order to preserve the real value of capital after inflation, it will be necessary to have some exposure to the stock market. 99
chap 5
4/3/02
4:42 pm
Page 100
The empowered investor
Taxes and transaction costs Investment planning is made more difficult by the different tax status of every individual in each country. Specialist advice should always be sought. Purchases and sales will both attract stock brokerage commission and suffer from the bid/offer spread. In the UK there is still a 0.5 per cent government stamp duty payable on share purchases, so frequent trading will attract additional costs. Many professional equities fund managers buy and sell the equivalent of their whole portfolio once per year.
STEP 2: PICK A BENCHMARK Your total return will need to be measured in a given time period such as one-quarter year or one year. You should calculate your total value at the beginning and end, including dividends and excluding any contribution of additional capital. Whereas a professional investor would weight the portfolio performance to account for new funds, a private investor might just as well wait until the start of the next quarter to account for new funds. As we have noted, most people want to make money from their investments. But you are not just trying to make lots of money. You are really trying to beat the market. You are not just trying All those advertisements boasting of how much to make lots of money. You are really trying to money you could have made had you invested in beat the market. a particular fund ten years ago are irrelevant. Indeed at the time of writing the UK’s regulatory authority is considering whether to ban them. To determine whether you are beating the market, you need to compare the performance of your investments to a market index or benchmark. If your portfolio consists of the largest US companies, you might choose the Dow Jones Industrial Average. If it were full of big UK stocks, you would choose the FTSE 100. If there are lots of small stocks, you should choose a wider index that covers all shares in the index. There are also special indices for technology and other sectors. Unfortunately, concentration among large international companies has made for concentration of risk in many indices that are heavily weighted towards oils, pharmaceuticals and telecommunications. These sectors
100
chap 5
4/3/02
4:42 pm
Page 101
chapter 5 . A more professional portfolio
made up 43 per cent of the UK’s FTSE 100 index in 2001, up from 26 per cent five years ago.3 Because of their dominance of the index, you cannot match the index if you avoid these sectors. Many of these sectors are also lacking long-term prospects. So you should be careful to choose an index that matches your portfolio objectives. The other problem with indices is that they are constantly chopping and changing and may need rebalancing, which attracts transaction costs.
STEP 3: UNDERSTAND RISK VS. RETURN Risk is completely relative to the individual and their circumstances, therefore risk measurements could be very misleading if people don’t interpret them properly. (Mike Embrey on an Interactive Investor bulletin board) If I’m walking along a cliff edge on a windy day, I know it’s risky, it seems odd to try and put a figure on that, say 457, what? (Keith Beef on an Interactive Investor bulletin board)
Measuring risk in your financial affairs is not intuitively obvious. Luckily the two basic premises of portfolio management have been passed on to us from the cradle. First, nobody likes risk. We would much rather avoid it and we get round this by hedging our bets and holding different types of financial assets. We don’t put all our eggs in one basket. The constitution of our economy means that high risk is rewarded. A stock market which allows us to take a small part in a big risk oils the wheels of the great economic gamble. Second, as the tired old saying goes, nothing ventured nothing gained. When things are certain, there won’t be a lot of upside. When there is uncertainty, the price you pay now will be low and reflect the possibility of downside. But if things go well it will offer plenty of upside in compensation. These are the basic premises of Modern Portfolio Theory (MPT) which informs the decision making of professional fund managers everywhere today. As we know, most investors want to make as much money as possible. But of course that does not mean that we should immediately rush out to borrow millions of dollars and speculate in the volatile derivatives markets; nor does it mean that we should buy up the gold supply of Russia in the hope of cornering the world gold market. We want to make the money while avoiding the hazard of losing the lot.
101
chap 5
4/3/02
4:42 pm
Page 102
The empowered investor
For investors, risk is not just a general negative word as in everyday speech. Risk can be quantified by putting the numbers showing the daily ups and downs of stocks through a model. It can then be used as a tool to increase the returns in your portfolio. Who is Harry Markowitz and what is Modern Portfolio Theory? Harry B. Markowitz, a graduate student in economics at the University of Chicago, developed the simple principles of ‘Nothing ventured, nothing gained’ and ‘Don’t put all your eggs in one basket’ into a comprehensive system of diversifying your investments to get an optimal trade-off between risk and reward. In 1990 he was awarded the Nobel Prize in Economics. If you know the risk for various different stocks and expect some to have better returns than others in a future year, it is a simple step to find the best one to invest in. You want the one with the highest returns to the lowest risk. The winner, according to Modern Portfolio Theory, is the one who can put together For investors, risk is the portfolio with the highest returns for the not just a general negative word as in lowest risk, the optimal portfolio that dominates everyday speech. other possible portfolios.4 If you map out on a graph all the portfolios of risk and return for different investors, many people will be below the optimal point for their level of risk. They will be taking on too much risk for too little return. Some will be above it. If you do your sums and compare the number of stocks to the level of risk, it turns out that risk falls steeply once you have about 10 or 12 stocks in your portfolio (Figure 5.1).
STEP 4: DESIGNING THE PORTFOLIO UNIVERSE What is your universe of investments? If we consider all those assets in the world that are easily tradable, the global market portfolio of assets in which we can potentially invest, we find that they add up to a staggering $58 trillion in 1998. US equities amount to 21.7 per cent of the total, Japanese equities make up 4.2 per cent and all other global equities comprise
102
4/3/02
4:42 pm
Page 103
chapter 5 . A more professional portfolio 60%
50% Risk (variance) of the portfolio
chap 5
40%
30%
20%
10%
0% 1
3
5
7
9
11
13
15
17
19
21
23
25
Number of stocks in the portfolio
Figure 5.1
The level of variance (risk) in a portfolio falls sharply as you increase the number of stocks in your portfolio from 1 to 10 and varies little once you have 10 or more stocks Source: Asweth Damodaran, (1996) Investment Valuation New York: Wiley, p. 28, Fig 3.5. This material is used by permission of John Wiley & Sons, Inc.
19.6 per cent. Most of the rest of the total, around half, is made up by bond issues. The trend is that non-US assets are growing faster than US assets as a proportion of the total. In fact the US proportion of the stock and bond market has declined from 65 per cent of the total in 1969 to 47 per cent of the total in 1998. Which bits of the collective wealth of all nations should I invest in? Let’s start by defining what there is to invest in. Not long ago, if you went along to your broker or bank manager with money to invest he would recommend a couple of local stocks or perhaps some government bonds. Now technology has made capital mobile. Investment managers, banks and stockbrokers operate globally and 24 hours a day. If you want to, you can buy Japanese bonds, US biotechnology stocks, a British telecom company or a German investment fund all at once. The universe of available investment opportunities is greater than ever before.
103
chap 5
4/3/02
4:42 pm
Page 104
The empowered investor
Different assets, different risks OK, so there’s a lot of choice, but what about risk? Returns depend on risk, don’t they?
Risk in shares There is no legal reason why you can’t lose all your investment in a stock. It is worth focusing on the fact that stocks are really an advance of capital to managers of companies in order to participate in the success of their undertakings. If they are OK, so there’s a lot of successful, you will benefit. Of course holding a choice, but what about risk? Returns depend number of stocks in different businesses and on risk, don’t they? opposing industries can rapidly reduce risk. Risk can also be measured against the average risk of the stock market. If the stock market has a risk of one and you own a stock 20 per cent riskier then you can quantify that risk as 1.2. You can thus decide a target level of risk, which we will discuss in more detail later (page 126).
Risk in bonds and cash What is a bond? Bills and bonds generally pay a fixed rate of interest. They are a contract promising payment of an unchanging interest rate at set times. Investors who purchase these are really acting as bankers to the borrower. Investors will not get any return other than their coupon and if all goes well the original principal of the bond. Bonds are clearly considerably less variable than equities and so cannot demand much of a return from issuers. As interest rates rise, the principal value of the bond will fall. Its fixed coupon will be worth less to the buyer who can find high interest rates elsewhere. It will generally fall further for longer maturities such as a 20-year bond than for shorter dated bonds. So you can take on more or less risk depending on your view of which way interest rates are heading. What is the risk of bonds compared to equities? There is less price volatility in bonds than shares but there is a different kind of risk. As J.M. Keynes pointed out: ‘An investment in common stocks is an investment in real values. An investment in a bond is an investment in money values.’5
104
chap 5
4/3/02
4:42 pm
Page 105
chapter 5 . A more professional portfolio
Because of inflation it is money rather than equities which will in the end depreciate in value, giving you less eventual purchasing power. Equities are more likely to offer protection from inflation. Corporate bonds offer exposure to the risk of the issuer. You might buy the bonds of a distressed company in the hope of an improvement in its circumstances or stick to higher quality issues. In most countries there is also a lively market in debt based on cash flows from mortgages or backed by regional governments or agencies. This will tend to offer a premium interest rate to the one offered by the central government bonds to reflect the added risk of default. What’s this about bonds going down when interest rates go up? It’s true! When interest rates go up, all assets with fixed interest rates fall in value. And when rates go down, the opposite occurs. For cash accounts you deposit money and receive interest and in doing so you lend money to the provider who lends it on to somebody else. Most likely you will have a variable interest rate unlike the fixed interest rate of a bond, so you are exposed to the risk that interest rates might fall. Because the government generally insures savings accounts, there is less risk than bonds and considerably less risk than stocks. For larger amounts certificates of deposit allow access to the interest rates available on the wholesale money markets.
Risk in other assets The last main class of investments worth mentioning is commodities. Commodities such as gold and palladium do not pay any income and may attract storage costs. You may enjoy and Their value will depend on factors such as benefit from living in your property demand and supply. Risk may depend more on surrounded by fine art considerations such as liquidity and exchange but it will not generate rates. any cash flow and will Aside from these financial assets there are real attract insurance, maintenance and assets such as property, art and antiques. Unlike appraisal costs. the financial assets, these assets are difficult to price. They may trade infrequently and prices may not be easily discovered. You may enjoy and benefit from living in your
105
chap 5
4/3/02
4:42 pm
Page 106
The empowered investor
property surrounded by fine art but it will not generate any cash flow and will attract insurance, maintenance and appraisal costs. When you sell them, typically at auction, the auction house will demand commission of up to 20 per cent.
STEP 5: BONDS VS. EQUITIES Which proportion in stocks – the asset allocation decision Most of the returns over time will not be determined by your decision to invest but by the balance between cash or bonds and risky equities. In other words whether to balance your portfolio in bonds and cash rather than equities is the key decision. If you are seeking capital preservation, you are more likely to hold more bonds than equities. Typically a growth investor will have a ratio of 70/30 of his portfolio in equities/bonds while an income investor will have 30/70. Another way of doing it is to take 100 and subtract your age. So if like me you are 29 years old, then 100 minus 29 is 71. According to this formula, I should put 71 per cent of my assets into equities and 29 per cent into bonds. One of the most comprehensive studies of the returns of stocks versus other assets is on the UK stock market. A summary of the results is shown in Table 5.1.
Table 5.1
UK market stocks returns vs. other assets
UK market returns Nominal Equities Bonds/gilts Cash (T bills) Real Equities Bonds/gilts Cash (T bills)
1918 value (£)
100 100 100 100 100 100
1999 value (£)
2000) value (£)
1,238,492 1,175,288 13,327 14,367 7,425 7,887 58,835 633 353
54,259 663 364
2000 1918–2000 return (£) return (%)
Risk (%)
–5.1 7.8 6.2
12.1 6.2 5.5
24.6 13.3 4.2
–7.8 4.8 3.2
8.0 2.3 1.6
22.9 15.0 6.5
Source: Issued by Credit Suisse First Boston (Europe) Ltd, Economics and Equity Research, 2001 Equity Gilt Study by Robert Barrie, Robert Jukes, Richard Kersley, Anna Mackman CFA, Steve Wright and William Porter, London, April 2001. With permission of Crédit Suisse First Boston.
106
chap 5
4/3/02
4:42 pm
Page 107
chapter 5 . A more professional portfolio
Table 5.1 shows that between 1918 and 2000 UK equities produced an average real return (after inflation) of 8 per cent per year compared to 2.3 per cent per year for bonds.
Different countries have different preferences The UK and US are heavily biased towards equities, while Germany generally invests a lower proportion. Institutional investors in the UK invest 72 per cent of assets in equities, in the USA 45 per cent in equities. UK investors are particularly biased against bonds, perhaps because of a history of high inflation, while the USA has developed a lively market in all manner of bonds. In Germany institutional investors put only 11 per cent of their portfolios into shares. Part of this is due to the average age of the population which is highest in Germany and lower in the USA and UK. Another reason is the ease with which companies in Germany can raise funds from banks rather than the stock market, which is the most common route in the UK and USA. Until quite recently many Germans associated the stock market with gambling and preferred the safety of investing in bonds. Table 5.2
Typical institutional portfolios: equities vs. bonds
USA UK Europe
Bonds
Equities
30 20–25 70
70 70 30
Source: Tony Golding (2001), The City: Inside the Great Expectations Machine, London: Pearson Education, p. 38.
STEP 6: COMBINING SHARES What is a portfolio? It is simply a diversified group of assets each with different patterns of returns over time.6 Hopefully the good will balance out the bad. The management of a portfolio can be efficient or inefficient, just like anything else. If you are not careful you can accumulate all sorts of stocks that have no logic to them. There may be stocks you should have sold. After all it is painful to accept you made an investment error; far
107
chap 5
4/3/02
4:42 pm
Page 108
The empowered investor
easier to hope that one day things will turn out right. There may be stocks you have investigated and know you should buy. You ought to regularly ask yourself the question: If I were starting my investments all over again today, would I really invest in the same old stocks I already have? A basic assumption is that you want to maximize your returns for your level of risk. If we take the portfolio of all your assets, we must consider how they affect returns (and risk) when added together. We should in theory include your house, pension, your car and any antiques or furniture. But since you would be homeless without your house and penniless in old age without your pension, we shall ignore these. We are only considering your basic financial investments here.
Portfolio returns added together An illustration of how and why returns on different shares go in different directions is shown in Table 5.3. You can see the profits during the year of an ice cream maker and an umbrella manufacturer. It is clear that if you held both you would be exposed to the good times all the year round. Table 5.3
Ice cream maker/umbrella manufacturer and stock prices Ice cream maker Profits Share price
Spring Summer Autumn Winter
100 800 200 100
20.0 30.0 27.5 25.0
Umbrella manufacturer Profits Share price 500 100 100 500
40 30 30 50
Portfolio risk added together Your portfolio’s risk changes markedly when rebalancing it between two basic asset classes – bonds and equities. If you have 100 per cent of your portfolio in equities, the risk will be high; if 100 per cent in bonds much less. If half and half, then you benefit from some exposure to equities at lower risk. This is not just a matter of simply weighting the risk. The key insight of Modern Portfolio Theory (MPT) is that risk of individual stocks bounce off each other in different ways when grouped together.7
108
chap 5
4/3/02
4:42 pm
Page 109
chapter 5 . A more professional portfolio
One thing you should always be on the lookout to avoid is a group of stocks going down together. A portfolio that contains too many stable and mature companies is badly diversified. They will all go down together. A portfolio that contains too many companies that are expected to be the next Microsoft is also badly diversified. They too have a habit of losing the confidence of the market at the same time. This less obvious point is that a portfolio of individually high risk assets may be less risky than a portfolio of low risk assets, providing the high risk stocks do not all move in tandem one with the other. In the language of Harry B. Markowitz, the founder of MPT, the riskiness of a portfolio depends on the ‘covariance’ of its holdings – how they interact – not on the average riskiness of the separate investments.
Choice is global The choice of investment is a global one. There is no reason why returns should be higher in your home country than in other countries. You may decide that you want to try and invest in the best companies in the world. There is no reason why you should not. In a portfolio you can achieve greater diversification by investing in other countries and benefit from a wider selection of perhaps higher quality assets. If you over-concentrate on your home country, you may be missing out on such opportunities. The downside risk is currency exposure. If your foreign assets go up but the currency depreciates you may lose out. A broadly diversified international portfolio should reduce overall risk and give you access to opportunities not available at home. The New York Stock Exchange (NYSE), the largest stock exchange in the world, offers stock issued by over 3000 companies. On the NASDAQ, where technology stocks are traded informally, another 7000 stocks can be traded, many of them from companies operating outside the USA. In London there are 2500 companies, a fifth of which are foreign. In Tokyo there are 1700 stocks. In France there are 660 and in Germany 355. The trend towards combining exchanges and computerized technologies means that the markets of the future will not be physically located anywhere – they will be global and fully automated.
109
chap 5
4/3/02
4:42 pm
Page 110
The empowered investor
How do the professionals manage money? Fund management is big business. By the end of September 1999 collectively managed funds worldwide were worth over $9.4 trillion. A staggering 30,000 separate funds around the world fulfil demand. And demand shows no signs of falling off. It is not unusual for a firm to be managing tens of thousands of millions. The largest firms, such as Schroders Investment Management, manage over £100bn. Many of the funds managed are pension funds and therefore tax free. They can be aggressively managed with no concerns about building up tax liabilities. The turnover of funds, the percentage of the fund bought and sold in a year, can often amount to 100 per cent. As fund managers have ballooned in Fund management is big business. size, so has their minimum unit of investment. A fund of £5000m with a well-diversified portfolio of a hundred stocks may have a minimum unit size ‘building block’ of £50m. Such size means that it is difficult for them to get in and out of stocks quickly and also means a whole raft of smaller companies are simply below the radar screen of fund managers. The results of this problem of size are hundreds of smaller companies that are under-researched and offer opportunities to private investors prepared to do the legwork. Typically, a fund management house will be resourced with information from an in-house team of analysts and support from brokerages that they patronize. They will have a stream of management visitors from the companies in which they invest and they will go and see companies in which they have an interest. We could not beat the Their technology will include all manner of data market because we had become the feeds, risk optimizers and stock screening and market. monitoring software. Their performance will be audited by outside firms of investment consultants such as William Mercer or Frank Russell. Fund managers themselves are typically recruited from the ranks of analysts, from accountancy or MBA programmes and from industry. They will probably have studied at good universities and may have additional qualifications such as the Chartered Financial Analyst (CFA) program or the associate exams of the UK Society of Investment Professionals (UKSIP). One key difference in the management of portfolios by private and professional investors is in the assessment of risk. Private investors rely on intuition as a rough yardstick to measure their risk. Professional investors 110
chap 5
4/3/02
4:42 pm
Page 111
chapter 5 . A more professional portfolio
need to measure and quantify their risk. They want to see a concrete number that tells them how risky their portfolio is compared to the market and they have the computer resources (optimizers) to monitor this minute by minute if they wish. If the risk is unsatisfactory, they can rebalance their portfolios to a desired level. Following on from the development of cheap computing power and the theory of efficient markets (EMH) is the development of indexation. If the market is assumed to be perfectly efficient, then what use are fund managers? You might as well just invest in the whole market portfolio rather than waste money trying to beat it. Fund managers don’t like index funds on the whole, but they delight in the fact that transaction costs prevent index funds from matching indices. The reality is that different indices underperform each other. The first such fund was put together by Wells Fargo in 1971 and invested in 1500 US stocks in an attempt to match the index. This it did tolerably well. Index funds have grown apace ever since, particularly in the USA. Index funds comprised $275bn dollars in 1995. In the UK the six largest tracker unit trusts amounted to £6bn at the time of writing (2001). One typical large US index fund is the California Public Employee Retirement System (CALPERS), which invests ‘over $20 billion dollars in stocks with one manager and two part-time traders. The traders sit in a room no bigger than a kitchen, surrounded by ten computer terminals with brightly coloured screens alive with jumping numbers’.8 Let’s hope nobody accidentally switches the electricity off.
Cutting the equities cake Once you have decided how to divide your investments between cash, bonds and equities, your next challenge is how you cut your equities cake. One strategy of traditional fund managers was to buy one stock big. When I arrived at my first fund Your next challenge is how you cut your management job, I was startled to find huge equities cake. amounts of Racal and Vodafone in all the portfolios. It turns out that one fund manager used to just pick out stocks he liked and buy 5 or 10 per cent of them. One such was Racal Electronics. So when Racal spun off its mobile telecommunication division, the portfolios received a large chunk of Vodafone, which shortly became one of the world’s largest telecom companies.9 This kind of approach – buying the best stocks in each industry paying little regard to weightings – can be successful, but also concentrates the 111
chap 5
4/3/02
4:42 pm
Page 112
The empowered investor
risk of underperforming the index. It is an approach that is more appealing for a private investor who may be looking for 15 or 20 stocks rather than the 100 in a typical fund manager’s portfolio. The private investor will be able to concentrate on a few stocks, whereas a professional will be forced to spread his or her attentions far and wide.
Sectors Keeping up with the market means keeping up with its sectors. The most obvious way to avoid underperforming the index is to buy all the shares that make up the index, in other words, to match it exactly, forming a ‘closet index fund’. This is easy for a large fund manager, although many forget to reduce their charges from those suitable for an expensively researched active fund to those Keeping up with the justified by a passive index tracker. A more realismarket means keeping tic approach would be to pick out the best stock(s) up with its sectors. in every industry. If the latter is impracticable, you could select industries that are promising or dominate an index and pick out the best stocks among them. Don’t forget that there is often a difference between an industry and the sectors that make up a stock market index and are decided by the index provider. Many investment professionals are contemptuous of the whole notion of arbitrary sectors determined by a public body which may not reflect the reality of an industry or suit the way fund managers invest. Whichever technique you prefer, you need to take a view of sectors. There are two ways of forming a view of sectors. The first is the top-down approach, which uses macroeconomic factors to determine your bias towards a sector. The second is the bottom-up approach, which focuses on the health of the companies that make up the sectors. Since I am now going to have to dwell on a little economics, I would recommend anyone who finds economics intolerably dull simply to turn to the next chapter.
Top-down sector picking To take a macroeconomic view of sectors, you need to track down various indicators of economic cycles. Leading indicators include factors that usually reach peaks or troughs ahead of the general economy. Lagging indicators normally trail the peaks and troughs of an economic cycle. Examples of leading indicators would be claims for unemployment and
112
chap 5
4/3/02
4:42 pm
Page 113
chapter 5 . A more professional portfolio
stock prices while a lagging indicator would be production of various heavy goods. There are several useful indicators published by the Office of National Statistics in the UK, the National Bureau of Economic Research (NBER) in the USA and Columbia University’s CIBCR. There are two types of basic economic changes. Cyclical changes arise when the business cycle moves from peak to trough and back again. Structural changes are more long term and reflect major change in the way the economy functions: for example, the transition of the eastern bloc countries from communist to capitalist and the emergence of new internet information distribution technologies.
Cyclical changes It follows that different sectors are impacted by economic change in different ways. Investors can rotate their exposure to benefit from industry sectors in the different stages of the business cycle. The typical pattern would be that towards the end of a recession financial stocks excel as investors anticipate better times, rising bank earnings and demand for loans. Once the economy begins to recover, businesses start thinking about modernizing their equipment and expanding services so capital goods industries such as machine tool manufacturers become attractive. Towards the peak of a business cycle, the rate of inflation increases. Basic raw materials therefore increase in price and their producers, such as oil, timber and steel, benefit. During a recession, consumer staples where demand is inflexible do best, so food, beverages and pharmaceuticals should outperform. Clearly every economic cycle is different, but the above patterns make a lot of sense. Other sectors impacted by specific factors can be identified. High inflation will benefit raw material producers and property companies, but damage consumers of these products. High interest rates will benefit banks, but damage highly leveraged sectors such as construction, hotels, retail and ship owners. A high currency will benefit importers while damaging exporters.
Structural changes Demographics are one big structural change. In the past 50 years the USA has had a baby boom, those born between the end of World War II and the
113
chap 5
4/3/02
4:42 pm
Page 114
The empowered investor
early 1960s. This has had a large impact on US consumption and in areas such as housing, social security and health care. Other demographic changes around the world include ethnic mix, the geographical location of people and the distribution of income. Government regulation can impact sectors. This applies particularly to the monopoly or quasi-monopoly industries such as gas and water supply or banks. Government also impacts on the Demographics are one pharmaceutical industry in approving new drugs big structural change. and on financial services in providing consumer protection. Another influence on sectors is lifestyle changes in how people live. This includes the increase in divorces and dwellings occupied by a single person along with changes in fashions, entertainment and working patterns. Technology changes can affect any number of sectors in different ways. For example, bar code scanning allows retailers to manage their stocks better and increase their return on capital. Smaller planes can reduce the market share of railways. The internet can provide low cost distribution.
Computer screening Rather than spend time looking at individual companies, many professional fund managers apply screens using computer databases. Screens narrow down the list of thousands of possible investments according to set criteria. An example would be stocks that have a low P/E, low Price/Book, high ROE or other attributes. Another use of computers is to determine companies with momentum or growth in earnings or share price. We will look at this in the next chapter.
Bottom-up stock picking This entails taking a view on individual companies or a group of companies within an industry. We have already covered this in Step One. Essentially you apply your analysis to the individual companies and this drives the selection of which stocks to put into your portfolio. This is usually used alongside some input from the top-down approach, for instance on the economic environment of a company, but it is basically an exercise in stock picking.
114
chap 5
4/3/02
4:42 pm
Page 115
chapter 5 . A more professional portfolio
Tactical timing You may find that you have a choice on when to time your entry into the market. If you delay, you could lose out if the market is rising or gain if the market is falling since your block of cash will buy less or more shares. It is possible to use options on the index or individual stocks to get a rough match of exposure to the change in the index if required. Futures contracts offer a rather more precise exposure. Both instruments are used to get exposure to the market or to bet against it (go short of it). Fund managers would typically use futures prior to receiving a new block of funds to invest in order to protect themselves from underperformance. They may also use futures to gear exposure up or down if the market looks like shifting in one direction or another. Recently many individual investors have taken to using derivatives to speculate, but this seems more likely to be a function of the desire of brokers to win commissions rather than any inherent advantage that private investors possess over professional investors.
NOTES 1 Charles Ellis and James Vertin, The Investor’s Anthology: Original Ideas from the Industry’s Greatest Minds (Wiley, New York, 1997), p. 161. 2 Charles Ellis and James Vertin, The Investor’s Anthology: Original Ideas from the Industry’s Greatest Minds (Wiley, New York, 1997), p. 90. 3 Issued by Credit Suisse First Boston (Europe) Ltd, Economics and Equity Research, 2001 Equity Gilt Study, by Robert Barrie, Robert Jukes, Richard Kersley, Anna Mackman CFA, Steve Wright and William Porter, London, April 2001. 4 The optimal risk return trade off for each investor lies on the efficient frontier. The efficient frontier represents the set of portfolios (rather than individual securities) that has the maximum rate of return for every given level of risk. The optimal portfolio is the portfolio on the efficient frontier that has the highest utility for a given investor. 5 The Collected Writings of John Maynard Keynes, Donald Moggridge, ed., Vol XII. (Cambridge University Press, New York, 1983), p. 247. 6 Frank Reilly and Keith Brown, Investment Analysis and Portfolio Management (Harcourt Brace, London, 2000), p. 69. 7 To calculate the efficient frontier for a 1000 share universe for all possible portfolios using Markowitz’s methodology requires no fewer than 499,500 calculations. 8 Peter Berstein, Capital Ideas (Free Press, New York, 1993), p. 193. 9 That fund manager was Tom O’Connell and when Guardian Asset Management was taken over by AXA Investment Managers, dominated by its AXA Rosenberg quantitative division, Tom took the opportunity to move on. He is now running funds at Ely Fund Management.
115
chap 6
4/3/02
4:49 pm
Page 116
chap 6
4/3/02
4:49 pm
Page 117
6 Winning online portfolios Portfolio case studies Case 1: A UK growth portfolio Case 2: A UK value portfolio Case 3: A UK income portfolio
117
chap 6
4/3/02
4:49 pm
Page 118
chap 6
4/3/02
4:49 pm
Page 119
chapter 1 . Why the stock market?
PORTFOLIO CASE STUDIES It has been a long journey, but we have now worked out how information moves around the financial world and seen how analysis can be used to select industries and individual stocks. We have looked at how portfolios are constructed and seen the way in which a top-down or industry approach can influence investment decisions. After all that hard work we can finally put the icing on the cake and gather it all together. This chapter is about building different types of portfolios using the professional tools we have encountered so far. We will be looking to build an appropriate weighting of around ten stocks in each portfolio. Different purposes require very different portfolios. While we cannot cover every single possible purpose, we shall begin with the example of a ‘growth’ model portfolio, moving on to a ‘value’ model portfolio. We can then examine an ‘income’ Different purposes model portfolio. In each case the broad motivarequire very different portfolios. tions for the overall style and individual stock selections will be explained. Finally we will compare our efforts with some professional portfolios. In each case we will risk rate the portfolios using an online risk tool. Please bear in mind that we are not making recommendations which you should necessarily follow the day you read this book. We are merely illustrating method.
CASE 1: A UK GROWTH PORTFOLIO There is a tendency to classify some companies as growth stocks as though this were a permanent condition. (Stephen Lofthouse)1
What is a ‘growth’ portfolio? A growth investor is one whose interest is in companies where earnings are growing or expected to accelerate. A growth investor will be less con-
119
chap 6
4/3/02
4:49 pm
Page 120
The empowered investor
cerned with the existing share price than with the story of a company and its likely growth prospects. To fully diversify we need to target around 12 stocks in industries that are not closely aligned. How do we pick them out? Many successful investors, such as Warren Buffett, refuse to invest in anything they have not thoroughly researched themselves. You might choose to rely on annual reports, company news releases, company webA growth investor is sites and stockbroker reports for this, employing one whose interest is in techniques described earlier in this book. But if companies where earnings are growing you can only come up with a couple of growth or expected to stocks with accelerating earnings, then you might accelerate. want to screen the whole market for ideas. Until recently stock screens were the preserve of an elite professional band of investors. More recently they have become available on the internet at sites such as StockScreener.com in the USA and Hemmington Scott (www.hemscott.net) in the UK.
Screening the market Classifying into one category or the other can sometimes be difficult. But we can apply a set of criteria to screen the market to find out which stocks are currently regarded as growth stocks. We simply look for stocks that fulfil a set of criteria typical of growth stocks. For example, growth stocks will have a high P/E ratio because the market rates them highly and expects earnings to grow. So we can look for stocks with a high P/E. Typically, growth stocks will have a low Price/Book ratio. Fast-growing industries such as outsourcing and technology rely on human capital more than assets. Capital intensive industries such as chemicals will not exhibit rapid growth. Growth stocks will almost certainly have a couple of years’ record of growing their earnings per share (EPS). Because they are reinvesting their cash to fund their growth, they will have a low dividend yield. Why pay out dividends to shareholders if you need the cash to fund your hot new product? We might also screen for momentum in the share price and sectors to find out whether share prices and sectors have been growing faster in the expectation of future growth. The basic problem with relying on screens is that they are using mainly backward-looking historical data. The challenge is to decide which of the stocks churned out by a screen will actually keep growing and filtering out those you feel will not grow.
120
chap 6
4/3/02
4:49 pm
Page 121
chapter 6 . Winning online portfolios
Using a P/E to detect stocks regarded as growth stocks should not detract from the fact that earnings are volatile and may be artificially low due to a strike, the write-off of an asset, a cyclical downturn or some other distortion. Equally, many investors regard high P/E as a negative factor since, in combination with a high expected earnings growth, it could lead to ‘earnings surprise’ if earnings do not meet expectations. Data backing up the screen may be out of date as well as misleading. So you need to use such a tool as a starting point to further research.
Stock screens chosen for the UK growth portfolio High P/E stocks (> 20) High Price/Book stocks (> 4) High 3-year EPS growth record (> 15 per cent pa) Low yield stocks (< 2 per cent) This month’s price momentum not negative (>0 per cent)
Table 6.1 is the result of a screen (using these criteria) in the REFS Online (www.companyrefs.com) stock screen of their database of stocks on the LSE.
Table 6.1
Stock screen: UK growth portfolio
Stock
Aggreko Astrazeneca Charles Taylor Consulting Chrysalis Group CML Microsystems Gullane Entertainment Hacas Group ISOFT LA Fitness Liontrust Asset Management Marlborough Stirling MITIE Group
Price
P/E ratio
(p)
Market Cap (£m)
494 3430
1,323 60,287
29.1 28.6
435 240 625 595 105 251 306
147 401 91 186 31 281 125
414 210 149
136 385 415
Price/Book
3-yr EPS growth (%)
2001 yield (%)
9.5 9.5
22.8 19.7
1.1 1.5
23.2 126 24.2 26.9 20.3 30.8 20.8
11.2 12.4 5.1 4.4 4.5 30.6 5.4
16.5 76 17.6 32.4 41.8 1059 150
1.4 0.2 1.7 0.6 1.4 0.6 0.4
49.5 34.7 24.3
26 37.1 16.9
114 229 26.1
0.5 0.5 1.0
121
chap 6
4/3/02
4:49 pm
Page 122
The empowered investor Table 6.1
Continued
Stock
Ricardo RM Royalblue Group St James Place Capital Taylor & Francis TeleWork Systems Tempus Group
Price
P/E ratio
Price/Book
(p)
Market Cap (£m)
3-yr EPS growth (%)
2001 yield (%)
522 520 940 409 583 174 419
250 487 284 1,738 492 313 313
22.2 31.8 46.1 21.4 26.7 72.9 23.5
6.6 10.8 16.5 4.3 7.7 62.6 5.9
31.5 31 29.2 24.3 35.2 49.3 16.3
1.6 0.9 0.6 0.7 0.7 0.4 1.2
Source: This screen was performed on 13/07/01 using the REFS Online subscription service found at www.hemscott.net and www.companyrefs.com. Reproduced by kind permission of HS Financial Publishing Ltd, publishers of Company REFS. Tel. 0207 278 7769.
Picks from the screen This proved to be a useful screen (Table 6.1) and produced a choice of companies that was not too large. Tempus Group was promptly taken over which reduced the group size further. Aggreko is an international supplier of temporary power, temperature control and oil-free compressed air services. ●
Pros: low exposure to slowing sectors. Growth in food processing, entertainment and oils sectors. Good first half sales growth – 2002 Winter Olympics, China and India contracts. US$ strong (50 per cent+ of sales in dollars). Restructuring benefits. Strong potential markets in Europe.
●
Cons: Chris Masters, CEO, not universally liked in the City. Taking on sales at lower margins. Competitors such as GE have so far chosen not to compete with Aggreko’s fleet of diesel generators.
AstraZeneca, the pharmaceuticals giant, is diversifying its portfolio of products away from gastrointestinal drugs which form 40 per cent of its sales. The key Losec drug is being replaced by Noxium. The cardiovascular field is also an important area with 20 per cent of sales. Key heart drugs are Zestril and Selokin. Other key areas are oncology, anti-cancer drugs and CNS. ●
122
Pros: good news on Nexium sales. Losec sales rising outside the USA. Good newsflow on Symbicort anti-asthma therapy.
chap 6
4/3/02
4:49 pm
Page 123
chapter 6 . Winning online portfolios ●
Cons: cardiovascular and respiratory areas competitive. Anti-cancer drugs are a competitive market. Margins falling due to Losec coming off-patent.
Royalblue Group focuses on selling software licences. They benefit from a high (35 per cent) repeat business rate. Their key FidessaNet for the stockbroking industry combines process automation with global execution facilities. ●
Pros: order book management is strong. A global growth story. Strong advanced order book in the financial division.
●
Cons: not immune to global slowdown in technology spending. A oneproduct company. Slowdown in UK broking clients.
St James Place Group is a UK financial service group with £5.7bn under management and a focus on selling high margin life and unit trust sales through its 1000-strong direct salesforce. ●
Pros: selling into a growth market for retirement provision. An interesting Italian venture. Avoiding the low margin stakeholder area. Management strength.
●
Cons: 60 per cent owned by the Halifax. Poor accounts visibility. Direct salesforces are a liability if they missell products.
My top picks Alkane Energy collects methane gas that accumulates in abandoned coalmines and sells it for power generation and burner tip use. When methane is burnt to generate power, the environmental benefit is to reduce this carbon dioxide impact by 87 per cent. ●
Pros: three extraction sites in the East Midlands. Portfolio of 18 exploration licences covering 300 abandoned mines. On course to roll out of 48 sites by the end of 2003.
●
Cons: still a loss-making concept stock valued using discounted cash flow.
Oxford BioMedica, the gene therapy specialist, has a pipeline of nine products in the areas of neurology, cancer and Aids. It is targeting markets with a collective current value of $7bn, although most of its products are still in the preclinical trial stage. Its key mature proprietary technologies 123
chap 6
4/3/02
4:49 pm
Page 124
The empowered investor
are in cancer, where it has products in phase (i)/(ii) clinical trials, focusing on reprogramming cells to produce therapeutic effects in situ. ●
Pros: collaboration agreement with Aventis and AstraZeneca. MetXia breast cancer remedy has successfully completed its phase (i) clinical trials. TrovaxTM remedy is generating positive preclinical data as a cancer vaccine.
●
Cons: a botched fundraising in 2000 left a stock overhang and twitchy investors. Still a loss-making company.
ARM is one of the largest global semiconductor designers and has a goal of becoming the embedded chip architecture for the digital age. Its model is to license out its chips. The biggest product is the ARM 7 family of chips, but in terms of licensing, which counts for about half of revenues, ARM 9 is now the most important and the company is benefiting from customer upgrading. ●
Pros: competition is kept at bay with a combination of technological lead and partnering. No one customer is more than 8 per cent of revenue and ARM now has more than 40 partner licencees. Microsoft is a fan.
●
Cons: US slowdown. Exposure to a slowing mobile phone market (which is consuming half the chips manufactured) as it gears up to 3G and WAP.
Royal Bank of Scotland has emerged as the fastest growing of the UK banks in recent years. Since it took over NatWest, it has one in five current accounts, 15.7 per cent of UK consumer savings and 16.5 per cent of credit card debt. It also has a significant position in banking to small businesses as well as large. ●
Pros: highly rated management skills. Cost benefits from merger. Strong UK consumer demand for financial products, conservative financial ratios.
●
Cons: large and recently expanded US exposure.
Johnson Matthey, the global precious metals and fine chemicals group, has recently acquired Meconic, a licensed supplier of medicinal opium. Its three divisions encompass catalysts and chemicals, precious metals and colours and coatings. ●
124
Pros: auto catalyst division benefitting from moves to cleaner fuel. Potential from fast-growing fuel cell market in which it is involved.
chap 6
4/3/02
4:49 pm
Page 125
chapter 6 . Winning online portfolios ●
Cons: US and Europe softening. Coating division dull, while tableware division is losing market share.
RPS Group is an environmental advisory consultancy providing environmental assessments and advice on contaminated land improvements. It has a number of areas of activity, including planning and transport consultancy, environmental impact assessment, nuclear safety and decommissioning, as well as oil and gas geosciences. ●
Pros: benefitting from stricter environmental laws. UK business strong. Labdirect web-enabled testing operation moving to profit.
●
Cons: US weakening.
SurfCONTROL is pitching for global leadership in corporate internet access control, a market in which it has a 25 per cent market share and in which there is a projected market size of $1.5bn by 2003, compared to just $30m in 1998. ●
Pros: SurfCONTROL products prevent users at work or home looking at porn sites, etc. Pushing proven product into non-US territories (only 5 per cent of current sales). Lower priced products less prone to slowdown than bigger ticket items. Improving visibility of earnings.
●
Cons: one-product company. Exposure to slowing US economy.
Wiggins is a property development company focusing on airports. It owns London Manston Airport, the UK’s fifth largest cargo-handling airport, as well as airports at Odense (Denmark), Smyrna (Nashville, USA) and Pilsen (Czech Republic). ●
Pros: strong cargo airport growth. Planning permission sought to develop Fairfield site. Innovative in seeking ways to exploit airports. New grandstand at London City racecourse.
●
Cons: poor City visibility.
Fitness First is a provider of pure health and fitness clubs in the UK with 112,000 members. It has rolled out its concept of affordable fitness to Germany and Belgium where it has another 38,000 members. It is on schedule to increase its current 126 clubs by 64 this year. ●
Pros: fast and proven ability to open new clubs. Strong business model of affordable health clubs. Taking a proven concept into Europe.
●
Cons: can growth continue so quickly? Budget clubs are less able to
125
chap 6
4/3/02
4:49 pm
Page 126
The empowered investor
extract cash from members than premium clubs. Budget providers trade at a premium to quality operators.
Risk rating Once we have made our selection we can work out our level of risk. If we know the betas of the individual stocks, we can take a weighted average and compare the portfolio beta to that of the market. For a growth portfolio the risk should be above, but not excessively above, the beta of the market (which is one). So a number such as 1.5 or 2 might be acceptable depending on your risk preference. One of the best sites to conduct a risk rating exercise is www.riskmetrics.com. On entering the UK growth portfolio it appears that the risk rating is 1.46, or 46 per cent more risky than the FTSE 100 index. The riskiest stocks are ARM, Surfcontrol and Telewest. The less volatile stocks are St James Place, Fitness First and AstraZeneca. So I would be tempted to increase or decrease the weighting of these stocks in the portfolio to suit my risk profile.
Professional growth portfolios The next step, having screened, researched and risk rated our stocks, is to compare our portfolio to the professionals. Handily, they are required to reveal their own portfolios in regular reports to unit holders or shareholders of collective investment funds. ABN AMRO UK Growth was launched in 1986 and since then has been managed by Nigel Thomas. Thomas graduated from University College, London, in 1976 with a degree in economics and geography and has been a fund manager for 20 years. The fund is one of the top performing UK Growth funds producing around 217 per cent return in the five years to 2001. Thomas manages his investments within a thematic framework. His key approach is to pick relatively few but good stocks. He looks for themes and then selects individual stocks with an emphasis on earnings growth, strong cash flow and management quality. He is concerned to locate companies with a business franchise which have high barriers to entry and he diversifies his risk among companies of all sizes.
126
chap 6
4/3/02
4:49 pm
Page 127
chapter 6 . Winning online portfolios
At the start of 2001 Thomas’s fund had 66 individual holdings worth about £550m which is highly concentrated for an institutional unit trust. His largest holdings, representing 22.2 per cent of the total, are listed below. He favoured defensive sectors such as pharmaceuticals, engineering, media and banks. Favourite shares included Porvair, which manufactures and licenses advanced materials, and Laird Group, which designs and manufactures products for the electronics, building and automotive industries. In the early part of 2001, Thomas commented: ‘It will be very much a stockpickers’ market.’ He remarked on the return of old-fashioned valuation techniques such as P/E and drew parallels with the depression and war years: We will invest in the equivalent of those growth industries in the depression and war years but obviously not the same ones. We will look for reasonably priced outsourcing companies … companies that also benefit from an ageing population – pharmaceuticals or financial services and where there are environmental concerns – in companies that produce more efficient and less polluting energy.2
His fund’s cash level stood at 13 per cent (see Table 6.2).
Table 6.2
ABN AMRO UK Growth: top ten holdings at 7 April 2001 %
Cobham GlaxoSmithKline Rolls Royce Royal Sun Alliance Compass Group Safeway AstraZeneca Vodafone Royal Bank of Scotland Royal & Sun Alliance
2.8 2.66 2.4 2.3 2.2 2.2 2.1 2.1 2 2
BWD UK Smaller Companies Trust was launched in 1991 and has been managed by Stuart Sharpe ever since. Sharpe began his career as a solicitor before gaining experience in the shares valuation division of the Inland Revenue. He was an assistant fund manager at Aberdeen’s Investment Trust division before joining BWD in 1991.
127
chap 6
4/3/02
4:49 pm
Page 128
The empowered investor
The fund has produced a five-year return of 216 per cent to the start of 2001 against 92 per cent for the sector. One advantage the fund possesses is that it is small at about £70m, so that stockpicking can make a big difference and the fund is not actively marketed so is likely to remain small. BWD is a large provincial private client stockbroking and wealth management company based in a modern building in the rejuvenated docklands area of Leeds. Sharpe is far away from the distractions and frantic rumour mill of the City. He draws from the long-term macroeconomic themes, but is not averse to taking trading positions in the latest IPO or hot stock. His portfolio is invested in smaller growth companies that have grown to maturity and are still growing, as well as riskier special situations in very small companies. Short-term profits also come from investment in AIM stocks that are the subject of an investment bandwagon or have potential. The portfolio is comprised of around 100 holdings with 19 per cent of assets in the top ten which is a well-diversified unconcentrated approach. There is an emphasis on the use of on-the-ground knowledge from regional stockbrokers and company visits. Sharpe makes 150 company visits per year. Significance is attached to the background dynamics of the company’s immediate business environment and especially the capabilities of the management. At the beginning of 2001 Sharpe preferred industries such as software and computers, support services and oil and gas. One favourite stock is Wiggins Group, a property and construction company. Torex is another favourite, operating in the supply of software for health care and retail. Torex is the largest IT supplier to the NHS. Sharpe also backs Radstone Technology, a manufacturer of robust, single-board computer systems. It specializes in supplying the defence industries around the world (see Table 6.3). Sharpe commented: Most of the small cap sectoral trends that dominated 1999 had reversed by the end of 2000 … While more defensive areas are likely to see support in the near term, we anticipate rotation into cyclicals and financials: looking towards the second half of 2001, we expect growth stocks to re-establish some leadership.3
128
chap 6
4/3/02
4:49 pm
Page 129
chapter 6 . Winning online portfolios Table 6.3
BWD UK Smaller Companies Trust: top ten holdings at 1 March 2001
% Torex Wiggins Group Sportsworld Media Minmet Simon Group Peterhouse Alphameric Radstone Technology Energy Capital Cairn Energy
3.9 2.6 2.2 2.1 2.1 1.9 1.9 1.9 1.8 1.8
CASE 2: A UK VALUE PORTFOLIO Value investing is basically based on a static analysis, a concentration on value right now. Your value investor might wear a T-shirt that proclaims ‘We don’t pay for the future’. The growth investor thinks about where the company will be in five years. (Ralph Wagner)4
What is a value portfolio? The focus of a value investor is the current share price. A value investor would become interested in a share in anticipation of an improvement in other investors’ sentiment towards the company. If a company was restructuring or had fallen on hard times, a value investor might buy in anticipation of improving The focus of a value company fundamentals. investor is the current Whereas a growth investor is mostly concerned share price. with earnings growth, a value investor is not that interested in earnings at all. While a growth investor will assume the P/E ratio will probably remain unchanged, the value investor will see the P/E as a variable and very likely to change.
129
chap 6
4/3/02
4:49 pm
Page 130
The empowered investor
Screening the market It is equally difficult to categorize stocks into the value category as into any other. Value stocks might be defined as stocks with low P/E ratios, low Price/Book, high yield and low growth. Typical value stocks will have a share price that has been punished by the market for one reason or another. They will probably have plenty of assets in comparison to price and have high and stable earnings that will sustain a large dividend. So yield will be high. The downside is that such companies will have low growth and probably be in basic industries such as manufacturing, chemicals or food production. Another screen that I have not included here, but which is often useful, is Price/Sales. A low Price/Sales per share is often a good contrarian indicator. Screens such as Price/Book are backward looking rather than forward looking. They reflect the value of assets on the books of the company, which may or may not be a fair reflection of the true utility to the company. The main distorting factor will be the company’s choice of depreciation policy. The other screens, high yield and low earnings, could throw up companies in financial difficulties. If they are paying out too high a dividend and their earnings are stagnant, they could go bust. Finally, I have applied a market capitalization screen because the spread between the bid and offer price is very wide for companies of this size in current market conditions. Table 6.4 is the result of a screen in the REFS Online (www.companyrefs.com) stock screen of their database of stocks on the LSE. Stock screens chosen for the UK value portfolio Lowest P/E stocks (<10) Lowest Price/Book stocks (<1) Lowest 3-year EPS growth record (< 5 per cent pa) Highest yield stocks (>6.5 per cent) Dividend cover (>1x) Market capitalization (>£10m)
130
chap 6
4/3/02
4:50 pm
Page 131
chapter 6 . Winning online portfolios Table 6.4
Stock screen: UK value portfolio
Stock
600 Group Airsprung Furniture API Austin Reed Birse British Polythene Burndene Investments Carclo Dawson Holdings Dewhirst Firth Rixson Fulmar i–spire Independent Insurance Kunick Lambert Howarth Linton Park London Clubs International Lookers Low and Bonar McLeod Russel Holdings Morthamber Partridge Fine Arts Portmeirion Renold Silentnight Holdings Sinclair (William) Holdings Stadium Stirling TransTec TT Electronics
Price (p)
Mkt cap (m)
P/E
Price/ Book
3-yr EPS growth (%)
2001 yield) (%)
Dividend cover (x)
75 83.5 120 122 9.25 225
42 19.9 40.6 38.1 17.8 58
7.9 7.1 4.6 6.8 5.5 4.5
0.5 0.79 0.41 0.87 0.53 0.96
–20.8 –3.6 –8.7 –3.5 –6.2 –12.6
7.3 9.6 12.7 6.8 10.8 9.4
1.7 1.9 1.7 1.9 1.7 1.2
29 114 68 65 46.5 67 22.5
26.4 59.3 42.6 86 89.7 19.9 21.9
6.3 7.2 7.4 4.5 8.8 6.6 4
0.7 0.87 –4 0.89 0.89 0.72 0.53
4.1 –17.3 3.6 –3.1 –11.9 –2.1 2.7
8.6 9.7 9.7 8.4 7.1 7.8 10.7
1.9 1.4 1.9 2.4 1.8 2.2 2.4
81.5 13.5 166 333
196 29.8 37.6 63.3
3.5 7.9 4 8
0.62 –4.2 0.79 0.5
4.6 –9.8 –0.2 –15.7
9 8.4 11.3 7.2
1.2 1 2.5 1.7
38.5 112 76
56.7 37.8 75.6
4.8 6.9 7.3
0.35 0.68 0.64
–30.7 2.9 –27.4
13.9 7.7 8.2
1.3 1.8 2
61.5 82 62 203 103 186
33.5 26.9 13.7 21 71 86.9
8.3 5.5 6.3 8.4 7.5 7.2
0.97 0.82 0.5 0.84 0.83 0.92
–13.1 –1.8 –6.8 –14.1 –26.1 0.2
7.3 7.3 7.3 6.5 9.5 7.7
1.2 2.5 2.2 1.7 1 1.7
82.5 39.5 28 6.5 148
18.7 11.1 24.6 12.3 228
7.6 3.1 3.8 1.4 6.5
0.79 0.51 0.92 0.16 0.94
–14.9 –2.6 –1.4 2.8 –10.7
7.8 14.2 8.9 43.1 7.2
1.3 2.3 1.4 1.7 2
Source: This screen was performed on 13/07/01 using the REFS Online subscription service found at www.hemscott.net and www.companyrefs.com. Reproduced by kind permission of HS Financial Publishing Ltd, publishers of Company REFS. Tel. 0207 278 7769.
131
chap 6
4/3/02
4:50 pm
Page 132
The empowered investor
Picks from the screen I must admit that of the three screens I conducted here, this was the one that I was least happy about. One of the stocks produced by the screen promptly went bust, Independent Insurance, while I had not heard of most of the others. Given the larger pool of choices in this screen and my name-recognition concerns, I will hedge my bets with eight choices. It is worth stressing once again that the evidence shows your portfolio risk is not much reduced by adding more than 12 stocks into your portfolio (see Step 3 in the previous chapter). So there is no need to spend days building a hundred-stock portfolio. Our target is to arrive at ten or so stocks quickly, mainly by a process of elimination. British Polythene Industries manufactures packaging for consumer and industrial use and makes a variety of film products designed to protect goods in transit. A recycling division produces moulded plastic products such as garden furniture. ●
Pros: £10m costs savings from restructuring. Thwarted bidder may rebid. Share buy backs.
●
Cons: declining turnover and £106m debt.
Firth Rixson, the global engineering group, makes rings, steel forgings, specialist steels and metals. Aerospace demand ‘buoyant’. ●
Pros: turnover rising. Benefits from a restructuring of the cost base.
●
Cons: impact of global slowdown.
Lambert Howarth designs and distributes footwear, homeware products and accessories. ●
Pros: looks cheap following profits warning. Management action to address underperforming divisions.
Cons: sales and margin pressure. Marks & Spencer division weak. London Clubs International owns 7 of the 21 casinos in London and a total of 11 casinos worldwide as far afield as Beirut, Egypt and South Africa.
132
●
Pros: highly leveraged to success of Aladdin Las Vegas Casino/hotel project. Trading in London casinos is good.
●
Cons: may have taken too big a bet on Aladdin.
chap 6
4/3/02
4:50 pm
Page 133
chapter 6 . Winning online portfolios
Lookers business is the sale, hire and maintenance of motor vehicles, agricultural machinery and motorcycles. It also sells tyres, parts, oil and accessories. ●
Pros: strong start to 2001. UK consumer spending robust.
●
Cons: foot and mouth disease outbreak could impact agricultural division.
Low and Bonar operates two divisions, plastics and specialist materials. ●
Pros: benefits from new products, cost reductions and capacity increases.
●
Cons: exposed to slowing US and European demand.
McLeod Russel manufactures air filtration materials and filter systems for servicing air-conditioning systems. The company also makes transportation, industrial and wood-finish products. ●
Pros: positive outlook on air filtration. Proceeds from disposals.
●
Cons: markets slowing.
Sinclair (William) Holdings manufacture a range of garden products (55 per cent of sales) and pet and household items. ●
Pros: new CEO, Roger Feaviour, reviewing dividend products.
●
Cons: garden division highly seasonal.
My top picks To the above list I have also added several stocks on which I have undertaken some fundamental analysis. Enterprise Oil is a large independent oil and gas producer. At the end of 2000 proven and probable crude oil reserves were 1045.7 mmbbls. ●
Pros: strong oil price. Strong earnings growth and cashflow generation. Diversification into Iran. Good prospects in Brazil and Mexico. It is also a potential bid candidate. Cheap relative to peers.
●
Cons: technical problems on some platforms. Crude price falling. Tax charge higher.
133
chap 6
4/3/02
4:50 pm
Page 134
The empowered investor
Centrica, demerged from British Gas, now operates four divisions: energy supply (87 per cent of revenues), home services, road services (it runs the AA) and financial services. ●
Pros: the Centrica utility business is trading well. Also growing service earnings rapidly. A defensive utility revenue stream.
●
Cons: worries about its Goldfish credit card joint venture.
Risk rating Using the www.riskmetrics.com site, the UK value portfolio is 15 per cent less risky than the FTSE 100 and 28 per cent less risky than the All Share Index. The three riskiest stocks are Lambert Howarth, London Clubs and Low and Bonar. The least risky stocks are BPI, Macleod Russel and Enterprise Oil.
A professional value portfolio Fidelity Special Values plc was launched in 1994 and is managed by Fidelity’s Anthony Bolton. Bolton has become something of a celebrity since his other Fidelity fund, the Special Situations unit trust, clocked up a 21 per cent a year performance from its launch in 1979. Fidelity Special Values has, with a little help from gearing, returned 147 per cent over the five years to July 2001 against 67 per cent in the FT All Share Index. Bolton’s investment style is aimed at uncovering companies at a price that does not reflect their potential, companies undergoing restructuring, or companies in unfashionable industries where there is room for sentiment to change. He also keeps an eye out for takeover candidates and companies that become cheap by international standards. One unusual aspect of his investing, compared to other top fund managers, is that Bolton keeps an eye on the charts and uses elements of technical analysis. With Fidelity’s formidable research resources, Bolton is able to monitor a large portfolio of 200 stocks. There is a strong bias towards medium sized and smaller companies. In early 2001 he favoured classic old-economy plays: 25 per cent of the fund was in industrials, chemicals, engineering and machinery. Another 20 per cent was in retailers and consumer staples. Financials made up 20 per cent. As a contrarian, he shunned exposure to the new economy. The only nod in the direction of the internet was indirect through companies such as Iceland, which offered internet shopping, and British Airways, which offered online booking (see Table 6.5).
134
chap 6
4/3/02
4:50 pm
Page 135
chapter 6 . Winning online portfolios Table 6.5
Fidelity Special Values: largest holdings at 31 March 2001 %
Safeway Bank of Ireland British Energy Reed International BAA Bicc Gallaher Group Carillion Royal & Sun Alliance
3 2.5 2.4 2.4 2.1 2.1 2 2 1.8
CASE 3: A UK INCOME PORTFOLIO What is an income portfolio? The focus of an income-orientated investor is the level of income and the growth of income, so it is a little more sophisticated than a pure growth portfolio. We need security The focus of an of income, but also sufficient growth to secure an income-orientated investor is the level of increase in the dividend over time. According to income and the growth the CSFB 2001 Equity Gilt Study, some 20 per cent of income. of total return over the period 1979-99 is due to dividends which are reinvested.5
Screening the market You first need to establish a universe of stocks with a tolerable yield. So you might conduct a yield screen to find stocks yielding between 2.5 per cent and say 3 per cent. Notice we have not just picked the very high yielders. We are looking for growth of income and want to avoid stocks which the market thinks are past it (ex-growth). You then need to screen for the amount of dividend cover: that is the number of times that a company could pay out its dividend from its earnings if it wanted to. If cover is below say 1.3 there may well be cause for concern. How is the company going to maintain its plant and invest in future projects if all its earnings are paid out in dividends?
135
chap 6
4/3/02
4:50 pm
Page 136
The empowered investor
We will also screen for earnings growth to make sure that it is reasonably positive. An earnings growth above inflation with a little extra added on would seem satisfactory so we will go for 4 per cent to 8 per cent. Again, the data we are using are historical rather than forward looking. We need to bear in mind that earnings quality may have deteriorated for our income stocks or it may be improving. Clearly the latter is preferable. So we should allow sufficient weight in our minds to the trends of earnings. Stock screens chosen for the UK income portfolio High dividend yield (>3 per cent) Good dividend cover (>3) 3-year EPS growth record (>10 per cent pa) Moderate to high interest cover (>5) The results of the screen using REFS Online (www.companyrefs.com) are shown in Table 6.6. Table 6.6
136
Stock screen: UK income portfolio
Stock
Price (p)
Abacus Andrews Sykes Artisan (UK) Barratt Bellway Bett Bros Boot (Henry) Bovis Homes Brewin Dolphin Brown and Jackson Christie Clinton Cards Colefax Countryside Properties Crest Nicholson Dewhurst DTZ Holdings
271 85 11.5 351 360 244 253 328 131 33 52.5 151 98.5 174 203 94 184
Mkt cap (m)
113 66.2 32.2 822 393 38.6 64.9 373 239 55.4 13.4 104 24.2 134 218 7.9 96.3
2001 yield (%) 3.5 8.1 7.8 3.9 4.1 5.7 4.6 4 3.3 10.6 6 4.3 3.7 3.9 4.3 4.5 3.8
Yield cover (x)
3-yr EPS growth) (%)
Interest cover (x)
3.4 6.6 7 3.6 4.6 3.5 3.2 3.6 3.3 4.4 3.3 3.5 3.9 4.2 4.3 3.7 3.5
24.9 11.2 48.5 28.5 21.9 11.2 10.6 22.3 33.4 182 16.9 20.6 16.6 26.2 21.1 24.7 33.5
36.5 5 11.1 17.9 13.5 14.4 17 19.1 42.7 20.4 11.5 24.9 11 5.4 5.4 45.4 1174
chap 6
4/3/02
4:50 pm
Page 137
chapter 6 . Winning online portfolios Table 6.6 Stock
Continued Price (p)
Fuller Smith and Turner 524 GET 160 Gleeson (MJ) Group 1070 Harvey Nash 213 High Point Rendel 69.5 Mallett 193 McAlpine (Alfred) 328 McCarthy & Stone 271 Persimmon 323 Pittards 62 Prowting 147 Reed Executive 237 Robert Wiseman Dairies 125 RPC Group 150 Savills 224 Taylor Woodrow 196 Trifast 87.5 Vardy (Reg) 347
Mkt cap (m)
2001 yield (%)
Yield cover (x)
3-yr EPS growth) (%)
Interest cover (x)
84.5 26.4 113 62.8 18.5 26.6 346 280 883 13.5 115 75.4 100 129 140 1135 62.4 200
3 3.9 3.3 3.5 4.1 4.3 3.4 3.8 6.1 4.8 3.2 4 4.1 4.1 3.5 4.4 3.7 3.7
3 3 3.5 4.2 4.4 3.2 4.2 3.8 3.3 4 4.4 3.4 3.1 3.1 3.9 3.3 3.3 3.7
10.6 21.7 17 23.9 98 22.5 32.3 43.1 23.8 69.9 16.9 12.1 11.9 14.8 19.3 21.7 18.3 26
7.8 10.5 5.8 11.1 23.3 5204 9.9 23.6 9.5 7.1 6.4 25.6 17.8 7 12.5 7.2 22.2 5.9
Source: This screen was performed on 13/07/01 using the REFS Online subscription service found at www.hemscott.net and www.companyrefs.com. Reproduced by kind permission of HS Financial Publishing Ltd, publishers of Company Refs. Tel. 0207 278 7769.
Picks from the screen Table 6.6 consists of more stocks than I expected, probably because of the large number of housebuilders which numbered no fewer than six/seven plus an estate agent. Once again I am taking a deeply sceptical look at the output of the screen and applying common sense to my choices. In each portfolio I am keeping the object of the portfolio at the front of my mind and looking for concrete evidence not only that the stocks fulfilled our criteria last year using the historical data in the screen, but also that they can do so in the future. Bellway is a major UK housebuilder selling more than 5700 homes, at an average price of about £106,400. More than 60 per cent of Bellway’s homes are built on brownfield sites. Bellway offers mortgage and insurance options.
137
chap 6
4/3/02
4:50 pm
Page 138
The empowered investor ●
Pros: housing market robust in the regions. UK consumers less exposed to interest rate cycle than last recession, 70 per cent of new mortgages fixed. Houses more affordable in regions than London.
●
Cons: rising cost of building sites. Possible UK recession.
Clinton Cards sell greeting cards through a network of over 700 retail outlets in the UK. ●
Pros: trading well in 2001 from revamped store portfolio. Dividend increases.
●
Cons: vulnerable to consumer downturn.
Fuller Smith and Turner is a substantial UK brewing concern trading beer, wines and spirits, catering and operating a chain of tied public houses. ●
Pros: robust, recession-proof company. Recently invested £23m in three hotels. Expanded capacity, pubs acquisition. Optimistic chairman’s statement.
●
Cons: beer volumes pretty flat.
Alfred McAlpine operates a large UK housebuilding division accounting for 55 per cent of 2000 revenues alongside construction services. They built 4000 homes in 2000, three-quarters for the private sector, with an average selling price of £133,800. ●
Pros: buoyant market conditions. Rising operating margins. Reservations up 6 per cent. Industry consolidation offers opportunities.
●
Cons: housing and construction are highly cyclical.
Reg Vardy is a motor vehicle distributor operating 70 dealerships, a number of car businesses and two commercial vehicle franchises throughout the UK. ●
Pros: expanding network. Strong consumer spending. Lower used car prices stimulate demand.
●
Cons: falling used car prices in the UK.
My picks GlaxoSmithKline is a global pharmaceuticals giant with revenues of nearly £30bn and a 7.3 per cent global market share. The three biggest
138
chap 6
4/3/02
4:50 pm
Page 139
chapter 6 . Winning online portfolios
product groups in GlaxoSmithKline are anti-infectives (a 16.9 per cent global market share, growing at 10 per cent pa), respiratory (a 16.8 per cent market share growing at 11 per cent pa) and central nervous system (an 11.6 per cent market share growing at 13 per cent pa). ●
Pros: solid defensive stock. US driving growth. EPS growing 10 per cent pa.
●
Cons: weak in HIV/AIDS.
Royal Bank of Scotland has emerged as the fastest growing of the UK banks in recent years. Since it took over NatWest, it has one in five current accounts, 15.7 per cent of UK consumer’s savings and 16.5 per cent of credit card debt. It also has a significant position in banking to small businesses as well as large. ●
Pros: highly rated management skills. Cost benefits from merger. Strong UK consumer demand for financial products. Conservative financial ratios.
●
Cons: large and recently expanded US exposure.
East Surrey Holdings supplies water to 634,000 people in South East England. The non-regulated activities include specialized aggregates, bottled water for commercial use and the provision of household emergency protection. In March 2001 the company acquired 24.5 per cent of Phoenix Natural Gas for £50.2m. Phoenix is in the process of building a network to distribute and supply natural gas to greater Belfast. ●
Pros: recently won appeal to regulatory levels. Good prospects for Phoenix.
●
Cons: dull growth prospects.
BP has major operations in Europe, North and South America, Australasia and parts of Africa. Refining and marketing accounted for 72 per cent of 2000 revenues; gas and power 11 per cent; exploration and production 10 per cent; chemicals 7 per cent. ●
Pros: higher US upstream and downstream margins. Benefits from Amoco merger still flowing.
●
Cons: US gas and refining margins could be peaking. Oil price soft.
139
chap 6
4/3/02
4:50 pm
Page 140
The empowered investor
Risk rating Using the Riskmetrics web site, the overall UK income portfolio is 27 per cent less risky than the FTSE 100. The most volatile stocks are Royal Bank of Scotland and Clinton Cards. The least risky stocks are GlaxoSmithKline, Fuller, Smith and Turner and East Surrey Holdings.
A professional income portfolio ABN AMRO UK Income was launched in 1984, has been managed by George Luckraft since 1993, and has risen by an exceptional 183 per cent over the last five years to 2001. Luckraft is head of UK Equities and a director of ANB AMRO Asset Management. He has over 20 years of investment experience and a degree in engineering and land economy from Cambridge University. His management style can be described as a flexible ‘barbell’ strategy combining high quality, higher yielding stocks with growth stocks including smaller companies that have the potential to increase dividends. It currently yields 2.6 per cent. The portfolio, which is still small at around £110m, is fairly concentrated with 83 holdings and 20 per cent of assets in the top ten stocks. At the beginning of 2001, favoured sectors were banks, oil and gas and general retailers. Much of Luckraft’s success is attributed to his stockpicking. His favourites in early 2001 included Phytopharm, United Drug and Stirling Group. Phytopharm is a leading botanical drug development company with nine potential products in clinical trial. United Drug is a wholesale manufacturer, distributor and marketer of medical and pharmaceutical products. Stirling Group designs, manufactures and sources luggage, clothing, accessories, toys and gifts (Table 6.7). Luckraft commented that 2001 ‘will be very much a stockpicker’s market and the fund will be looking for growth at reasonable rates’.6
140
chap 6
4/3/02
4:50 pm
Page 141
chapter 6 . Winning online portfolios Table 6.7
ABN AMRO UK Income: top ten holdings at 1 January 2001 %
Royal & Sun Alliance Barclays Henlys Group Hampson Industries Pendragon Bradford & Bingley Victrex Reylon Group ICI Findel
2.2 2.2 2.1 2.1 2 2 2 2 1.9 1.9
NOTES 1 2 3 4 5 6
Stephen Lofthouse, Portfolio Management (John Wiley, New York, 1997), p. 74. ABN AMRO UK Growth Fund Managers Annual Report, for the year ended 7 April 2001. David Aaron Partnership, A Guide to the Top Ten UK & European Smaller Company Unit Trusts and ISAs (David Aaron Partnership, London), May 2001. Ralph Wagner with Everett Mattlin, A Zebra in Lion Country (Simon and Schuster, London, 1999). CSFB, 2001 Equity Gilt Study, April 2001. David Aaron Partnership, A Guide to Top Performing ‘Tracker Beating’ Unit Trusts, by David Aaron and Andrew Jones, Shelton House, High Street, Woburn Sands, Milton Keynes MK17 8SD, March 2001.
141
chap 7
4/3/02
4:52 pm
Page 142
chap 7
4/3/02
4:52 pm
Page 143
7 Mastering your age Samuel Jones Lloyd: a Victorian multimillionaire John Maynard Keynes: playing the world markets after the crash Jim Slater: figuring out the best stocks Nils Taube: getting the big picture right Warren Buffett Peter Lynch
143
chap 7
4/3/02
4:52 pm
Page 144
chap 7
4/3/02
4:52 pm
Page 145
chapter 1 . Why the stock market?
SAMUEL JONES LLOYD: A VICTORIAN MULTIMILLIONAIRE Born into a wealthy English banking family in 1796, Samuel Jones Lloyd, Lord Overstone, became one of the richest men in his world. Karl Marx’s friend, Frederick Engels, writes of him in the same breadth as Rothschild and Baring.1 On his death, far from the peak of his wealth, he owned one in every 1000 acres of the UK and £1 of every £5000 earned in the UK belonged to him. We can still learn from his extraordinary talent for preserving and creating wealth in challenging times. The first source of his fortune was his income at the banking house his family ran in Manchester and London. Once Samuel joined the family bank in 1817, his income averaged out at a staggering £18,161pa until 1848.2 To convert to today’s money you can probably safely add two or three noughts. In his twenties he inherited a large fortune from his uncles, Samuel and William Jones, including considerable holdings of shares in canal companies. Presumably seeing the way the wind was blowing, he was entirely out of canal shares by 1840. His first investments were a painful learning exercise. In his twenties and early thirties he made a number of poor investments in speculative foreign securities. He bought and sold French rentes and traded in and out of New York State stock and Bank of New York bonds. But with a modest loss he appears to have learned not to invest speculatively abroad and did not do so again until 1849. One stroke of good sense and fortune was that Samuel entirely avoided the urge to invest in the main speculative mania of the Victorian age, the railway boom of the 1840s that culminated in the crash of 1845. He also refrained from investing in the whole class of financial joint stock banks, an area you might have thought he had the inside knowledge to profit from. His argument was that because the joint-stock banks were run by employees rather than partners, ‘ I think that joint stock banks are deficient in everything requisite for the conduct of the banking business.’3 He
145
chap 7
4/3/02
4:52 pm
Page 146
The empowered investor
was obviously not persuaded by the advantages of scale in spreading risk, the ease of raising capital or the benefits of employing skilled professionals enjoyed by joint stock banks. He was therefore unaffected by the frequent banking crises of the century such as the collapse of Overund and Gurney in 1866. Since a major source of income was his family bank, this shows he may have been concerned to diversify his income. His favourite investment in the major part of his working life was landed estates. Between 1830 and 1860 he sank £2,050,492 into buying them and another £47,017 into improving them. He also lent out money secured on land and was able to repossess the estates of several unfortunate aristocrats unable to keep up their loan repayments, such as the Fotheringay estate in 1842. Given the lack of stable alternative sources of investment in the Victorian world, this was a masterstroke. Samuel evidently foresaw the yearning of successful businessmen in the Victorian world to better themselves by acquiring landed estates and the rising price they would pay. He was one step ahead of his bank’s best customers. Land rose in price steadily through the century to a peak in 1874. In 1831 land was £31 per acre and by the 1870s it had nearly doubled to £53 per acre. Meanwhile the price index had dropped by 5 per cent over the period, while the value of alternative investments such as government debt rose by only 14 per cent. Samuel was buying landed estates at times when the future of agriculture was clouded by uncertainty owing to the effect of the Corn Laws. His masterstroke was the purchase of three estates in 1860 for £1,365,000 at Northamptonshire, BerkI will not throw away shire and Coldham. As he wrote to G.W. Norman what remains of Good in 1860, ‘By this dextrous land jobbing I expect to money in a desperate attempt to save the make a fortune to last into my old age.’4 And he bad. did so, with land soaring to a peak in 1874 when his lands were worth an astounding £4,800,000 – the equivalent of many billions today. By 1881 land was falling in price: ‘I will not put any more money into land on any plea … I will not throw away what remains of Good money in a desperate attempt to save the bad.’ Samuel had held on to his land too long as imports of food caused a long-term agricultural depression. But once again Samuel was one step ahead of other landowners in diversifying their portfolios. In the 1860s, at a time when railways were regarded as speculative gambling chips, he had begun to purchase huge shareholdings in the major trunk lines such as the Great Northern and the
146
chap 7
4/3/02
4:52 pm
Page 147
chapter 7 . Mastering your age
Great Western Railways. Between 1860 and 1869 he invested £283,686 in the railways. His father had picked up some scraps of railways after the speculative boom and bust in the 1840s, but by the 1860s railways were dividend paying companies. Samuel’s insight was to anticipate the change in investor sentiment towards the asset. By the 1870s other wealthy investors were also diversifying into railways and the price of stocks had soared. Once he had exhausted his appetite for railways, Samuel invested in other joint stock companies – this time speculative mining ventures. One key investment rule he usually followed was never to borrow to invest and so avoid the possibility of having to make a forced sale of the asset at distressed levels. This rule was broken for a £110,000 purchase of the Wigan Coal and Iron stock in the late 1860s. He borrowed the whole sum at 5 per cent per annum and received a dividend alone of 10 per cent per annum from the investment. Nevertheless, such speculations amounted to less than 3 per cent of his total wealth at the time and less than 15 per cent of his securities portfolio. Other key manoeuvres were a sectoral switch in 1868 out of railways and into utilities with the purchase of £70,000 in Metropolitan Water and Midland Perpetual on the advice of his London stockbroker. Further diversification into Massachusetts State stock and Italian bonds followed. By the time of his death in 1883 his securities portfolio was heaving with profits and worth millions. A contemporary, Prescott, said of him: He was perhaps too cautious a character to have created the business, but his judgement in managing the Banks which were established by his Uncles and his father was unrivalled. He used the large deposits at his disposal with good skill and while he kept free from hazardous transactions he did not shrink from large, bold transactions when they could be undertaken with a due respect of safety.5
Above all, he possessed a clear understanding of the business cycle that follows from monetary expansion and contraction. Bagehot quotes him describing the cycle in these graphic terms: ‘quiescence, improvement, confidence, prosperity, He did not shrink from excitement, overtrading, convulsion, pressure, large, bold transactions stagnation, ending again in quiescence’. With this when they could be undertaken with a due mastery of the underlying economics of his age, respect of safety. he was able to become one of the wealthiest inhabitants within it.
147
chap 7
4/3/02
4:52 pm
Page 148
The empowered investor
JOHN MAYNARD KEYNES: PLAYING THE WORLD MARKETS AFTER THE CRASH John Maynard Keynes, more famous as an economist than an investor, was appointed Second Bursar of King’s College, Cambridge in 1919 and First Bursar in 1924, a position he held until his death. In the nine years to 1 January 1938, the Chest, the name given to one of the college funds, rose by 162 per cent, an average of 14 per cent per year in capital terms or over 20 per cent per year if interest and dividends are included. Over the same period the indices of stock market prices fell by 20 to 25 per cent.6 Keynes’s first step in enriching King’s College began in 1919 when he persuaded the Estates Committee which oversaw the college assets to authorize him to invest the Chest, which was not restricted by trust deeds, into ‘foreign government and other government non-trustee securities’. Previously the convention was to invest funds in the safest cash deposits. His next key decision was to stop the policy of passive investment in real estate and to actually sell lands in favour of securities. In the 1920s, Keynes sold £200,000 worth of lands. He argued: ‘The fact that you do not know how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one.’7 Just because land does not have a fluctuating price each day does not make it a safer investment; a ‘speculator’ in securities is at least running risks which they can daily quantify. He was not entirely averse to property and during World War II he made astute purchases of £140,000 worth of lands. Initially Keynes thought that he could make money by what he called credit cycling: ‘selling market leaders on a falling market and buying them on a rising one and after allowing for expenses and loss of interest’.8 But he later admitted that it takes phenomenal skill and ‘most of those who attempt it sell too late and buy too late and do both too often, incurring heavy expenses’.9 He was nevertheless able to invest more of King’s money into shares during the bad years of 1929–31 than the good years of 1933–6. In his own early personal investing, Keynes experimented with credit cycling primarily through the currency and commodity markets. In 1919 we find him forming a syndicate with friends to sell (short) the continental currencies and buy (go long) the US dollar. He made a loss of £22,000, which by 1922 had become a profit of £21,000. Through the 1920s he developed experience as a commodities speculator at the same time as
148
chap 7
4/3/02
4:52 pm
Page 149
chapter 7 . Mastering your age
trading securities on his own account, often with huge loans. The number of securities he held was always very few, although his positions were large. In 1929 he held just four securities, including a large holding in Austin Motor Car Company that had fallen from 21s to 5s but later rose to 35s. From spring 1930 he gave up on the market and held only two securities in 1931. By 1937 he had four in Britain and three in the USA. In 1928, due to a combination of losses in commodities trading and a demand from his stockbroker for more collateral on the loans he used to finance his investing, he had to sell £45,000 worth of securities. This reduced his exposure ahead of the 1929 crash, with his securities falling from £78,500 in 1927 to £18,165 in 1929. Keynes quickly grasped the problem that the markets faced after the Crash. In a memo to the board of the National Mutual Life Assurance Society he cautions against selling at depressed prices: ‘It is only too easy to be frightened and to find plausible reasons for one’s fears’.10 He takes the contrarian view: Just as many people were quite willing not only to value shares on the basis of a single year’s earnings but to assume that increases in earnings would continue geometrically so now they are ready to estimate capital values on today’s earnings and to assume that decreases will continue geometrically.11
By 1932 he had only 29.5 per cent of his assets in English ordinary shares and 51 per cent in bonds. In 1932 he had been tempted to put 10.4 per cent of assets into US shares which grew to 26.6 per cent in 1937. By 1933 he had built his securities portfolio to £299,363, with UK shares representing two-thirds of his portfolio, and he had also started taking significant positions in American preference shares as well as American ordinaries. By 1936 he had securities worth £692,057 and loans of £300,000. In 1936, UK ordinaries represented 35.7 per cent, UK bonds were 20.3 per cent, US ordinaries were 16.8 per cent and US preference shares 21 per cent, with the balance in unlisted and UK preference shares. Some of his biggest personal gains occurred in 1933–7. He reduces his bonds positions and increased his investments in British and American shares and preference stock. But some large profits appeared to derive from highly leveraged positions taken in the commodity markets. At one stage in 1936 he was long on sufficient wheat to supply the UK for a month and was threatened with delivery. He ordered that King’s College Chapel be measured up to determine whether there was enough space to store it. Since it was too small, he had to object to the wheat quality and request that it be cleaned in order to obtain a month’s delay.
149
chap 7
4/3/02
4:52 pm
Page 150
The empowered investor
Loans of half the value of his portfolio were not unusual to finance his positions. This meant big losses when he was wrong, as with a ‘straddle’ involving pig lard and cotton oil at the end of 1937 in which he lost £27,210. After 1929, Keynes’s investments beat the Banker’s Magazine index of the stock market in 21 out of 30 years. In the seven years before 1929 he did worse in five years. There were some timely pieces of advice to the National Mutual Life Assurance Society and the Provincial Insurance Company which he advised throughout the late 1920s and 1930s. He advised both to pursue a far more adventurous policy than their competition by investing in ordinary shares, battered by the prolonged bear market. In 1933 he was advising Provincial to buy gold shares as he was doing himself as a hedge against depreciation. In December 1936 he was telling the Provincial to switch into more marginal US stocks now that the recovery was established. After the correction in the UK market in 1937–8, Keynes triggered a heated debate within the board on whether to sell equities: ‘I do not believe that selling at very low prices is a remedy for having failed to sell at high ones.’ He was adamant that: ‘I feel no shame at being found still owing a share when the bottom of the market comes.’12 On the outbreak of war, when the UK market dropped 20 to 25 per cent while the US market rose by 40 per cent, he pointed out the disparity between the valuation of the two countries’ stock markets and urged Provincial to buy Barclays, To carry one’s eggs in Imperial Tobacco, Woolworths, Marks & a great number of baskets, without Spencers, insurers and of course armament having time or shares. 13 To the suggestion that the Provincial opportunity to discover weight its sectors according to those in the index, how many have holes Keynes issued a stern rebuke: ‘Fixed percentage – in the bottom, is the surest way of particularly within each group of industry etc. – increasing risk and loss. is altogether opposed to having an investment policy at all.’14 He vigorously defended the basic tenets of discretionary investment: ‘The whole art is to vary the emphasis and the centre of gravity of one’s portfolio according to circumstances.’15 The first and most important rule developed from Keynes’s experience is the careful selection of a few investments: ‘To carry one’s eggs in a great number of baskets, without having time or opportunity to discover how many have holes in the bottom, is the surest way of increasing risk and loss.’16 He encouraged the careful comparison of likely current and potential values relative to other competing investments. The second rule is to
150
chap 7
4/3/02
4:52 pm
Page 151
chapter 7 . Mastering your age
maintain ‘a steadfast holding of these in fairly large units though thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake’.17 Finally, Keynes advocates a balanced investment position: ‘a variety of risks in spite of individual holdings being large, and if possible opposed risks (e.g. a holding of gold shares amongst other equities, since they are likely to move in opposite directions when there are general fluctuations)’.18 The best investment portfolio for Keynes is one divided between a safe and secure income from bonds and more variable equities capable of a large improvement that will offset the inevitable duds. Investment in bonds is an investment in monetary values since it is fixed, while an investment in shares is an investment in real values since companies can reinvest surplus funds and compound gains. Keynes clearly saw that picking shares was and is a relative exercise – like judging a beauty competition, where the judge has to pick out not the competitors that he himself finds most attractive but the ones he thinks most likely to catch the fancy of the other judges. He recommended ‘acting accordingly as you think them cheap in relation to other shares, with particular reference to the possibility of large relative appreciation, which means buying them on their intrinsic value when, for one reason or another, they are unfashionable’.19 By 1938, after the bear markets of 1929 to mid-1932 and 1938, he cautions against trading on the way down and attempting to buy at the bottom: ‘It is a mistake to Keynes had come full sell a £1 note for 15s in the hope of buying it back circle. He had started off thinking he could for 12s 6d, and a mistake to refuse to buy a £1 note ride the cycle and for 15s on the ground that it cannot really be a £1 ended up a stockpicker. 20 note.’ Keynes had come full circle. He had started off thinking he could ride the cycle and ended up a stockpicker. The cycles might throw up the bargains, but you have got to pick out your favourites that have a good chance of rising enormously.
151
chap 7
4/3/02
4:52 pm
Page 152
The empowered investor
JIM SLATER: FIGURING OUT THE BEST STOCKS Jim Slater is remembered for announcing, amidst the collapse of his investment empire, Slater-Walker in 1975–7, that he was a ‘near minus millionaire’. He was at that time just about the most famous stock market operator of his day, the equivalent of George Soros or Warren Buffett in today’s markets. In fact his investment thought is just as rigorous as Buffett, but he is interested in detecting dramatic share reratings rather than lifelong shareholdings. Today he is a professional private punter. In 1973 he was a financial giant. When Slater was reported in the Daily Mail to have said that the market was too expensive, it duly tumbled. SlaterWalker itself grew so large so fast that it was able to court mergers with three of the grandest City merchants of the day – Pearson, Warburg and Hill Samuel. It seems improbable that a man who started as a chartered accountant at an obscure provincial vehicle manufacturer could take on the City establishment and briefly win it over as Chairman of Slater-Walker Securities in the ten years to 1974. Unlike Buffett, who benefited from Columbia University and the tutorship of a Nobel Prize winning theorist, Slater is completely self-educated in investment. While recovering from illness in Bournemouth, he bought back issues of the Stock Exchange Gazette and Investors Chronicle and searched out a formula of investment success. After deciding on his system, he borrowed £8000 and with £2000 savSlater is completely ings put the lot into a share called Bernard Wardle self-educated in investment. that supplied parts to his factory. It was a good choice. Smaller companies with growing earnings enjoyed a bull market. Slater formed an investment club for his fellow managers and moved on to write a share tipping column, ‘Capitalist’, in the Sunday Telegraph, describing his investment system. He was soon able to start an investment advisory business which, through an extraordinary series of acquisitions, quickly became a financial conglomerate, obtained a banking licence, launched unit and investment trusts and diversified into mining, finance and property. After the oil price shocks of the early 1970s and rising interest rates, the stock markets and property prices collapsed. Slater-Walker, financed with vast quantities of debt, rapidly became a lost cause. Slater could not sell
152
chap 7
4/3/02
4:52 pm
Page 153
chapter 7 . Mastering your age
assets fast enough to pay off debts. With that experience under his belt, Slater went on to found the REFS investment information system, one of the most admired UK share selection systems for private investors. It is based on assembling key pieces of information all on one card and screening them to isolate stocks for investigation. It is a highly empirical investment system, based to some extent on the Value Line and Standard & Poor’s stock report cards. Now available on the internet, the screen is based on one professionals use daily. Slater’s screen is unusual in the weight given to one ratio, PEG or P/E divided by the growth rate: ‘To me a low P/E ratio and a high growth rate has always been the right combination, no doubt about it. That is of course what a low PEG is.’21 Slater could not sell Professional fund managers would laugh at his assets fast enough to emphasis on one ratio, just as they might mock pay off debts. Buffett’s concentrated portfolios, but it is a rigorous system in its own way. Provided you are confident of the validity of the inputs, PEGs can sometimes signal an impending market rerating, particularly in under-researched smaller companies. Since he first stated an investment formula in his Sunday Telegraph column, Slater has made a number of refinements to his investment system. Originally the criteria insisted on earnings that had doubled in the last four years, a 4 per cent dividend yield, high liquidity of assets and of shares as well as optimism from the chairman. More recently the emphasis has shifted away from dividends towards an odd mix of fundamental factors and share price momentum: If Graham was alive today, he might argue that you should simply withdraw from the market for a few years until conditions arise which offer you value for money that you are seeking. Graham might be right, but my problem is that I would get so bored waiting.22
Slater now looks for competitive advantage, a franchisable product or concept, a strong ‘story’ to give the buyers a memorable reason to buy. Clearly the emphasis on growth and management remains fairly consistent, but he is also keen on shares that are going up: as strong a sign of rerating as many fundamental factors. In essence Slater possesses a flexible but empirical approach. He cleverly used the information available to him to build a credible formula for investment success based on analysis of the facts. He is a man who is
153
chap 7
4/3/02
4:52 pm
Page 154
The empowered investor
aware of the power of a chart or a table of facts to persuade. He also has a talent for self-publicity and, even when Slater-Walker collapsed, Slater was going broke in style. While the current system may yet have to adapt to a new bear market, it will doubtless be based on strong numerical or factual evidence.
In essence Slater possesses a flexible but empirical approach.
NILS TAUBE: GETTING THE BIG PICTURE RIGHT Few outside the City would recognize the name of Nils Taube. Most would know the name of Lord Rothschild, some of whose investments Nils Taube manages. Taube remains a discreet but successful fund manager. His fund, the St James’s Place Greater European Progressive Fund, has increased its value nearly two hundred-fold since its establishment in 1969 – a compound annual growth rate of about 19 per cent. He is famously well connected, a director of one of George Soros’s funds, an intimate with the Rothschilds and friend of bankers across the world. His success can be attributable to his insight that to get the best opportunities you have to look at all the international opportunities and not just the ones on your doorstep. Taube was one of the first of the new breed of analysts helping to establish the Society of Investment Analysts in the 1950s. When he started at the City stockbroking firm of Kitcat and Aitken in 1947, there was no such thing as analysts. Taube’s first analytical coup came when he started looking at BAT, the tobacco To get the best opportunities you have group which had a large American subsidiary to look at all the called Brown and Williamson. In those days cominternational panies did not split out their overseas earnings opportunities and not and as the pound sterling was struggling against just the ones on your doorstep. the dollar, overseas earnings suddenly became very valuable. Taube got hold of a copy of an American magazine called Printer’s Ink that had a list of how many cigarettes each of the major brands was selling in the USA. Taube was able to multiply the number of cigarettes by the price to discover the total US sales of BAT’s cigarette brands. It turned out to be quite a lot – more than half BAT’s earnings were in increasingly valuable dollars. With this
154
chap 7
4/3/02
4:52 pm
Page 155
chapter 7 . Mastering your age
insight Taube was able to write a circular recommending BAT as a buy. His firm made £100,000 in commission and saw the value of letting somebody concentrate on this kind of analytical work. By 1972 Taube was earning £250,000 per year. His real interest was always in rooting out profitable analytical insights on an international level. In the late 1960s and early 1970s he was a big buyer and promoter of German life insurance companies. A friend of Taube, Shelby Davis, another early investment analyst, had worked out that it was crazy to value life insurance companies solely on the basis of dividend yield, which was the way it was done back then. Insurance companies at that time wrote off the cost of winning new business in the year the business was won. This was too conservative if you consider that the benefits of premiums come in over many years. Davis and Taube recognized the best way to deal with such costs was to charge them over the life of the policy. This insight opened up the way to much higher valuations of insurance companies. Taube prefers to look at companies and industries rather than take big bets on the general direction of the market: ‘I have always believed in looking at companies and industries rather than saying the Japanese market is about to go up, or the Spanish market will go down.’23 His other well-known preferences are for situations where management has changed and for undervalued growth companies. Taube invested heavily during the 1990s in Great Universal Stores, the high street and home shopping group. The company had been built up by Sir Isaac Wolfson but had, in Taube’s words, become very sclerotic. A new manager, David Wolfson, from a different branch of the Wolfson family, was brought in. His background was as a successful manager of the Next clothing chain. ‘David Wolfson is a very capable businessman and retailer’, says Taube, ‘and we invested solely on the basis of the regard we had for him and his business acumen.’24 Taube builds up large stakes in his investments and will stay with them for lengthy periods of time. He takes positions in His investment style companies that have fallen on hard times and are can be characterized as selling at a fraction of book value and on groups flexible response to of stocks which he feels will benefit from one or fast-changing facts. other industry or economic changes. For example, he takes note of deregulation of European savings markets or the introduction of the euro and finds groups of stocks likely to benefit.
155
chap 7
4/3/02
4:52 pm
Page 156
The empowered investor
Above all, his investment style can be characterized as flexible response to fast-changing facts. Where his friend George Soros would speak of reflex trades dominating the under-pricing or over-pricing of securities, Taube’s view is that a successful investor needs a ‘mixture of steadfastness and just a dash of cowardice as well. To be totally stubborn is dangerous’.25
What is Taube in today? At the end of 2000 Taube was extremely cautious and had 30 per cent of his trust in bonds and cash, mostly in sterling. By mid-2001 this liquidity remained at 25 per cent. He admits: ‘We will not be able to pick the bottom but now that the technology bubble has been pricked, euphoria has been replaced by gloom and the truth may lie somewhere in between.’26 Taube believes that the internet could prove a great destroyer of businesses: ‘In a few years you will be able to order a movie on the net for your 2200 2100 2000 1900 1800 1700 1600 St James’s Place Greater European Progressive Acc
1500 1400 1300 1200 1100 1000 900 800 700 1998
Figure 7.1
1999
2000
2001
St James’s Place Greater European Progressive Fund Source: Interactive Investor International (now Ample.com) 2001. Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
156
chap 7
4/3/02
4:52 pm
Page 157
chapter 7 . Mastering your age
TV. So who will need video machines and video tapes after that?’27 Taube suggests that more and more people will bypass the intermediary and go directly to the manufacturer for what they want, thus cutting out a whole layer of businesses. During 2000 he sold large investments in Psion, Ericsson and Telecom Italia and bought Bank of Scotland, BG Group, Ses Fiduc and Norsk Hydro. In the first half of 2001, Taube sold mature investments such as Bank of Ireland, Dixons and Autoliv while reinforcing holdings in Bank of Scotland and Dresdner Bank. He likes European financial services companies that will benefit from the needs of an ageing population to save, and also media stocks as pay TV companies experience rapid growth (Table 7.1).
Table 7.1
St James’s Place Greater European Progressive Fund: largest 12 investments at 31 May 2001 %
Treasury FRN 10-07-01 France 3.4 per cent 25-07-29 Lagardere Norsk Hydro Germany 3 per cent 15-06-01 Bank of Scotland Soc Europeenne Vivendi Universal Koebenhavn Lufthave Great Universal Stores Commerzbank IFI
14.31 7.09 3.37 3.04 3.01 2.97 2.87 2.4 2.3 2.24 2.03 1.93
Source: St James’s Place Greater European Progressive Fund, Report for period ended 31 May 2001
WARREN BUFFETT We have all heard of Warren Buffett who has become synonymous with one straightforward investment technique – buying a large stake in a few businesses that meet a strict set of rules and requirements. But Buffett started out as student of an investment pioneer, Benjamin Graham, the real founder of the ‘value’ school of investing. Graham believed that
157
chap 7
4/3/02
4:52 pm
Page 158
The empowered investor
investors should base their decisions on the intrinsic value of a security. A veteran of the Great American Depression, Graham was constantly aware of the risk of bankruptcy and the necessity to sell the assets. By intrinsic he meant the mathematical discounted value of all the future cash flows. To work it out, Graham prescribed diligent analysis of balance sheets and cash flows. Buffett studied under Graham at Columbia University and spent a couple of years number crunching in Graham’s investment firm, but went on to develop a highly original and profitable method of investing all his own. If you invested $10,000 in Buffett’s original investment partnership in 1956 you would have collected around $267,691 by the time it was dissolved in 1969. If you had then invested $10,000 in a new partnership, Berkshire Hathaway, you could have collected around $60 million today. His Berkshire Hathaway investment vehicle has grown into a $100bn combine and made Buffett himself the second richest man in the USA.
Buffett’s methodology A great deal of this success was a consequence of his insight that there are only a very few really good, reliable businesses. For Buffett, a good business is one protected by something unique, a franchise or domination of a particular segment that shields it from competition. The kinds of businesses he means are those that a competitor could not imitate, even with ample supply of capital. An There are only a very few really good, example is his comment on Coca-Cola: ‘If you gave reliable businesses. me $100 billion and said take away the soft drink leadership of Coca-Cola in the world, I’d give it back to you and say it cannot be done.’28 Coca-Cola is protected from competition by its unique brand and franchise. This cannot be imitated. Buffett does not accept the standard theory that diversification is the most appropriate investment strategy, or rather it is inappropriate for him. As he says: The strategy we’ve adopted precludes us from following standard diversification dogma. Many pundits would therefore say our strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.29
158
chap 7
4/3/02
4:52 pm
Page 159
chapter 7 . Mastering your age
Nor does Buffett have much time or respect for Wall Street. Indeed he has lived in the same obscure provincial American town of Omaha, Nebraska, all his life. His office there is on the top floor of a modern office block. There are no trappings of his multibillion dollar fortune. There are a couple of pictures, a bookshelf with several editions of Graham’s books and a tidy desk. He has lived in the same house in Omaha that he bought for $32,000 in 1952. Omaha itself is a plain town laid out for the purpose of facilitating commerce without any big city fripperies.30 Buffett considers his purchase of a security as the purchase of a fractional interest in a business. His first question on analyzing a security is to ask what he would pay for the whole company and what the company is likely to be worth in the Buffett has lived in future, working back from that. The very last the same obscure thing he looks at is the price of a security: ‘As far provincial American town of Omaha, as I am concerned, the stock market doesn’t exist. Nebraska, all his life. It is only there as a reference to see if anybody is offering to do anything foolish.’31 He views the stock market as too short term to properly value securities: ‘An investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behaviour from the supercontagious emotions that swirl about the marketplace.’32 Indeed, one of the stated objectives of Buffett’s early partnership fund was: ‘Our investments will be chosen on the basis of value not popularity.’33 Buffett searches out a fractional interest in companies that have a good return on capital, are intuitively understandable, cash generative and have strong franchises. With such rigorous criteria, Buffett rarely makes any investments. But when he Buffett is skilled at does, he does so in size. One fact worth mentioning finding free funds to is that Buffett’s investment vehicle seeks out situainvest in profitable tions where gearing up to invest in things can be enterprises. obtained for free. For example, one early purchase was Blue Chip Stamps which had a huge ‘float’ of unredeemed stamps. This was free money that Buffett could use to buy other businesses. Similarly, he bought several insurance companies that are obliged to hold permanent excess assets against liabilities. Essentially, Buffett is skilled at finding free funds to invest in profitable enterprises. Currently the ‘free float’ of Berkshire is about $27bn and its cost is close to zero. The actual returns on miscellaneous investments in the period 1991 to 1997 are more modest and represented, according to Grants, an outper-
159
chap 7
4/3/02
4:52 pm
Page 160
The empowered investor
formance of only 3 per cent over the S&P 500 index. The free gearing of course magnifies the return. Only if you are super-confident of what you are investing in can gearing pay off. As Buffett himself says: To understand Berkshire, therefore, it is necessary that you understand how to evaluate an insurance company. The key determinants are: (i) the amount of float that the business generates; (ii) its cost; and (iii) most critical of all, the long-term outlook for both of these factors.34
The winning investments The history of Berkshire Hathaway is as you might expect one of a series of extraordinarily successful investments. Early investments were the Blue Chip Stamp company and Sees, a candy manufacturer. In 1964, during a salad oil scandal, the price of American Express collapsed allowing Buffett to apply the majority of his funds into buying a large stake. Buffett saw that the basic strengths of the credit card operation and traveller’s cheques would be unaffected. The stock quintupled in the next five years. In 1973–4, after the oil price increases, the stock market collapsed and Buffett was able to buy big stakes in companies he liked. He bought 8 per cent of Ogilvy and Mather, an advertising agency, and 16 per cent in Interpublic, another media company. He acquired 11 per cent of the Washington Post and large percentages of the Boston Globe, Capital Cities and Knight Ridder Newspapers. He was buying companies in the media and insurance industries that were naturally dominant and had strong cash flow characteristics. One lifelong association of Buffett is with GEICO, an insurance company which only sells insurance to government employees. Buffett’s teacher, Ben Graham, was a director of GEICO and the company was one of the first stocks in which Buffett took a serious interest as a youth. Berkshire purchased a large stake in the company in 1976 and consolidated full control in 1985. In 1977, through the Blue Chip Stamp company, Buffett bought the Buffalo Evening News for $35m. He considered that such a newspaper had a natural monopoly and after launching a Sunday edition the only competitor collapsed leaving the Buffalo Evening News with a valuable monopoly. In 1985 Buffett announced he had taken a significant position in Capital Cities/ABC, a chain of newspapers that owned television stations. In 1989 he bought 6.3 per cent of Coca-Cola for $10.96 per share, one-tenth of the
160
chap 7
4/3/02
4:52 pm
Page 161
chapter 7 . Mastering your age
current value. Buffett’s enthusiasm was based on the strength of the brand name and the growth from overseas expansion of the company. Coke is a universally liked drink and its markets grow with the population. A similar large investment was made in Gillette, owner of the eponymous razor brand, in 1991. In 1990, when banks were suffering the effect of a major recession, Buffett bought a stake of 10 per cent in Wells Fargo – a grand San Francisco banking name which was founded in 1852 and had been profitable in every year of its history, even during the Great American Depression. The stock was bought at $58 and stood at $99 within a year or so. In 1997–8 Buffett amassed a fifth of the world’s total silver supply, some 129.7m ounces, paying around $4 per ounce. Buffett explained the move by pointing out that for several years the demand for silver had exceeded the supply. He reasoned that if the price of silver was near or below its costs of production when demand was healthy, then the price was too low. The price of silver rose to around $7 by February 1998.
Berkshire Hathaway, is it still a buy? More recently in 1997, Buffett bought General Re, a global insurance company, for $22bn. This brings with it free money of $20bn from the permanent excess assets held against liabilities and allows Berkshire to supply capital on which General Re can write insurance on a larger scale. A big hit from the World Trade Centre catastrophe makes this investment look rather weak at the time of writing (Figure 7.2). Of course not every investment was satisfactory. In 1987 Buffett invested $700m in a convertible bond issue from Solomon Brothers. Weak markets and a trading scandal in 1991 made this investment a poor one. There was criticism that the bond issue was made on unethical terms more favourable to Buffett than to existing stockholders in return for securing the chairman’s job. Buffett got his fingers burned with an investment in US Air in 1991. The following year half of the US top airlines filed for bankruptcy. He had miscalculated the bottom of the cycle. Today Buffett’s company looks increasingly as though it has become too big to grow. Its success can be seen as attributable to employing its assets wisely and gearing up by using insurance assets twice or more times. There have been significant occasions in which Buffett’s decision to refrain from investing because market conditions had become too bullish has paid off – 1969 and 1999.
161
chap 7
4/3/02
4:52 pm
Page 162
The empowered investor 80000 78000 76000 74000 72000 70000 68000 66000 64000 62000 60000 58000 56000 54000 52000 50000 48000 46000 44000 42000 40000 38000 36000 34000 32000 30000 20 15 10 5 0
Figure 7.2
BERKSHIRE HATHAWAY ‘A’
BERKSHIRE HATHAWAY ‘A’ Volume (thousands) rising price falling price 1997
1998
1999
2000
2001
Berkshire Hathaway ‘A’ Source: Reproduced with permission of Ample Interactive Investor. All Rights Reserved.
Finally, there is the key man problem of what to do now that Buffett himself and his business partner, Charles Munger, are getting old. Increasingly, Buffett has become an American cult. The details of his investing have become lost in the enthusiasm that surrounds popular heroes. A book of his sayings has If we follow Buffett’s been produced, along with countless biographies. own advice and shun the popular instinct, we If we follow Buffett’s own advice and shun the should avoid his popular instinct, we should avoid his company’s company’s shares. shares. Despite a revival after the technology shares collapse in 2000, these uncertainties and the exposure to a currently tough insurance cycle make Berkshire Hathaway an unexciting investment.
162
chap 7
4/3/02
4:52 pm
Page 163
chapter 7 . Mastering your age Table 7.2
Berkshire Hathaway’s investment portfolio, 31 December 2000
Holding
Shares owned ($m)
Cost ($m)
Value ($m)
151.6 200 96 1.727 55.1
1,470 1,299 600 11 319 6,703 10,402
8,329 12,188 3,468 1,066 3,067 9,501 37,619
American Express Company The Coca-Cola Company The Gillette Company The Washington Post Company Wells Fargo and Company Others Value at 31/12/00
PETER LYNCH Not many investors outside the USA have heard of Peter Lynch. They have probably heard of Fidelity, one of the largest investment management companies, and they may even have heard of Fidelity Magellan fund. This was the fund worth $22m when Peter Lynch took over and when he left was the largest mutual fund in the world, worth a total of $12bn with over a million unit holders. He was the most famous fund manager in the USA. Ten thousand dollars invested with Lynch’s Magellan fund in 1977 would have turned into $250,000 on his departure in 1990 – an average annual return of 29.2 per cent.
How did he do it? Lynch is the model hard-working professional fund manager. He was groomed in the research department at Fidelity’s Boston headquarters and after a few years became head of research. He is an indefatigable note taker and reader of inforLynch is the model mation. He visits 40 or 50 companies per month, hard-working professional fund 500 or 600 a year. In 20 years of marriage he is said manager. to have taken only two vacations. He works at least a 12-hour day.
What is his investment technique? There are a number of persistent favourable attributes that Lynch looks for. The firm’s product must not be a fad. It should be one that consumers
163
chap 7
4/3/02
4:52 pm
Page 164
The empowered investor
will continue to buy over time. Investors who spot this long before other investors will win out over the long run. The company should have some sustainable comparative advantage in its industry. If it does not then its superior growth will evaporate. The firm’s industry or product must have the potential to become a stable market resistant to new entrants so it will have to spend little on R&D. Firms must be in a position to benefit from technology and cost reductions. A company buying back its own shares, or where management are buying shares, is seen as attractive by Lynch since it indicates management awareness of the stock market’s imperatives. As the doyen of the Boston fund management community, Lynch was typically bombarded with thousands of investment proposals every day. He had access to Fidelity’s in-house research department, but insisted on seeing the management himself and doing basic spadework. He is looking for changes in key variables to spot the obvious winners and moves swiftly from one idea in one sector to the next in another. If he detects market inefficiency, he will not pause to act. His skill seems to be the breadth of his knowledge and the speed with which he can detect significant changes. He recommends placing firms into one of six categories in order to define the focus of investigation and to decide if a firm is an attractive investment.35
164
●
Slow growers. These companies are at the peak of their industry life cycle and pay a regular dividend. Investors should look out for attempts to buy growth by acquisitions or new products.
●
Stalwarts. These are stocks that have fast earnings growth, but this has already been priced into the share price. Investors should check out the P/E ratio versus its traditional level in comparison to the market or sector. Anything that might increase the growth rate is a plus.
●
Fast growers. Stocks in this category are small and ambitious firms with high potential to grow earnings. These stocks are volatile because if they do not deliver their ratings will collapse. They may also run into trouble financing growth.
●
Cyclicals. The profits of such firms go up and down with the general industry cycle, so they are fairly predictable by looking at general economic indicators. On a firm-specific level, the leverage chosen by management is key.
chap 7
4/3/02
4:52 pm
Page 165
chapter 7 . Mastering your age ●
Turnarounds. These are out of favour firms that may have the opportunity to generate a recovery. The firm’s plan to solve its problems should be given close attention.
●
Asset plays. Where a company has assets of value that are hidden from obvious numerical analysis. This might include land, movie rights and intellectual property, lists of customers or patents and trademarks.
At the same time as being a fanatic about his job, Lynch recognizes the limits of his approach. He sees an advantage for the individual investor who can take his time, concentrate and just stay put in the stock, the same way he holds on to his house.
NOTES 1 ‘If Messieurs Rothschild, Fulchiron and Decazes in Paris, Samuel Jones Lloyd, Baring and Lord Westminster in London, were to read this description of the woes of the “rich”, how they would sympathise with the good Westphalian Ram.’ Frederick Engel’s, The True Socialists. Karl Marx and Frederick Engels: Collected Works, Vol. 5 (International Publishers, New York, 2000), p. 540. 2 R.C. Michie, ‘Income, expenditure and investment of a Victorian millionaire: Lord Overstone, 1823–83’, Historical Research, 58 (1985), pp. 59–77. 3 In 1832, Lord Overstone observed: ‘I think that joint stock banks are deficient in everything requisite for the conduct of the banking business except extended responsibility; the banking business requires peculiarly persons attentive to all its details, constantly, daily, and hourly watchful of every transaction’ (Bagehot IX 11). 4 R.C. Michie, ‘Income, expenditure and investment of a Victorian millionaire: Lord Overstone, 1823–83, Historical Research, 58 (1985), p. 70, in a letter to G.W. Norman in 1860. 5 R.C. Michie, ‘Income, expenditure and investment of a Victorian millionaire: Lord Overstone, 1823–83’, Historical Research, 58 (1985), p. 71. 6 The Collected Writings of John Maynard Keynes, Donald Moggridge, ed., Vol XII (Cambridge University Press, New York, 1983), p. 162, ‘A memorandum to the Estates Committee of Kings College, Cambridge’, 8 May 1938. The wisdom of Keynes’s accumulated investment experience has come down to us in two 1938 memoranda, one for the Provincial Insurance Company dated 7 March 1938 and the other for the Estates Committee of Kings College, Cambridge, dated 8 May 1938. With permission of Palgrave. 7 Ibid., p. 108. 8 Ibid., p. 100. 9 Ibid., p. 106. 10 Ibid., p. 117. 11 Ibid., p. 17. 12 Ibid., p. 37. 13 Ibid., p. 72.
165
chap 7
4/3/02
4:52 pm
Page 166
The empowered investor 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
166
Ibid., p. 68. Ibid., p. 68. Ibid., p. 99. Ibid., p. 107. Ibid., p. 107. Ibid., p. 101. Ibid., p. 107. Jonathan Davies, Money Makers (Orion, London, 1998), p. 168. Jim Slater, The Zulu Principal (Texere, London, 2000), p. 147. Jonathan Davies, Money Makers (Orion, London, 1998), p. 77. Jonathan Davies, Money Makers (Orion, London, 1998), p. 78. Jonathan Davies, Money Makers (Orion, London, 1998), p. 89. St James’s Place Greater European Progressive Fund, Report for period ended 31 May 2001. Jonathan Davies, Money Makers (Orion, London, 1998), p. 78. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 2001. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 2001. John Train, The Midas Touch (Harper, London, 1987), p. 6. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 2001. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 1987 in Charles Ellis and James Vertin, The Investors Anthology (Wiley, Chichester, 1997), p. 89. John Train, Money Masters (2000) p. 21. Chairman’s Letter to the Shareholders of Berkshire Hathaway Inc., 2000. John Train, Money Masters (2000), pp. 192–8.
chap 8 pages
4/3/02
4:53 pm
Page 167
8 Crashes and bubbles What is a bubble? Tulipmania The Mississippi bubble 1720 South Sea Company joint stock bubble 1720 Wall Street crash 1929 Monday 19 October 1987 The Japanese catastrophe The internet bubble The UK internet bubble Anatomies of a price bubble
167
chap 8 pages
4/3/02
4:53 pm
Page 168
chap 8 pages
4/3/02
4:53 pm
Page 169
chapter 1 . Why the stock market?
But the most strange of all, perhaps, was ‘For an Undertaking which shall in due time be revealed.’ Each subscriber was to pay down two guineas, and hereafter to receive a share of one hundred, with a disclosure of the object; and so tempting was the offer, that 1,000 of these subscriptions were paid the same morning, with which the projector went off in the afternoon. (Bagehot, describing stockofferings in 1720)1 I expect to see the stock market a good deal higher than it is today within a few months. (Professor Irving Fisher, 15 October 1929)2
WHAT IS A BUBBLE? When commentators speak of a stock market mania, they are referring to a collective outburst of irrational behaviour. A bubble in the same sense is an expansion of prices that anticipates a dramatic burst. In the English language such events are the When commentators opposite of rationality. Rationality prescribes that speak of a stock individuals weigh up the facts to make prudent market mania, they are referring to a collective investments and prefer profit to loss. But ‘when outburst of irrational the rest of the world is mad we must imitate them behaviour. in some measure’.3 It can seem perfectly reasonable and rational to go with the flow. We all want to make money and will succumb to whatever seems the quickest way to do so. Speculation often develops in two distinct stages, each dependent on the other. First you need a sober stage of investing in a concrete concept. Thus, in the 1830s hard-headed Lancashire businessmen and Quaker capitalists backed specific railway projects to link up their mills and their markets. In the second phase, during the 1840s, the professional company promoters moved in to manufacture elaborate schemes and speculations to
169
chap 8 pages
4/3/02
4:53 pm
Page 170
The empowered investor
satisfy the demand from widows and clergymen for exposure to the new railway technology. Then there is the turning point. By 1845 the bubble had been pricked. Some time after, the original speculative ventures spawned solid dividend paying operators, which by the 1870s were bought up by investment pioneers such as Lord Overstone. Railways were staple investments for the portfolios of the wealthy in preference to land. In Japan in 1990 the turning point came with a rise in interest rates that pricked the bubble of land and stock market speculation. In 1929 there were the bear speculators like Joseph Kennedy and Bernard Baruch. They took to selling – ‘shorting’ – stock they did not own, betting that they would be able to fulfil their obligations on settlement day by buying sliding stocks at lower prices. In 1720 there was Thomas Guy who quietly liquidated £54,000 of South Sea stock between April and June, selling blocks of £1000 at a time. He spent some of his huge fortune endowing Guys Hospital in London.
TULIPMANIA In the 1500s, tulip bulbs imported from Constantinople began to appear in the mansions and palaces of Dutch nobles. Rare bulbs, affected by a mosaic virus that created feathered patterns, were particularly sought after. They were exceedingly difficult to cultivate. The rich of Holland and Germany began to send off to Constantinople for bulbs ‘until it was deemed proof of bad taste in any man of fortune to be without a collection of them’.4 As the Dutch economy and culture developed in the early seventeenth century there were booms in drainage schemes, shares of the Dutch East India Company, canals and trade. The fashion for tulips spread to the middle orders of shopkeepers It was deemed proof of and innkeepers. Prior to 1636 common varieties of bad taste in any man of fortune to be bulb attracted little attention, with high prices without a collection of reserved for rare varieties. In 1625 a rare Semper them. Augustus bulb sold for Fl2000, the equivalent of about $16,000.5 By 1634, however, Charles Mackay, the Victorian historian, says that the ‘rage among the Dutch to possess them [tulips] was so great that the ordinary industry of the country was neglected’.6 In 1635 it became necessary to sell tulips by weight in petits 170
chap 8 pages
4/3/02
4:53 pm
Page 171
chapter 8 . Crashes and bubbles
like diamonds. A Semper Augustus by this time was worth Fl5500, according to Mackay. In September 1636 the excitement in tulip prices that had been present in previous autumns began in earnest. Demand for rare species became so great that markets had become established on the stock exchanges of Amsterdam, Rotterdam, Haarlem, Leiden and other towns. During the autumn no bulbs are available for examination because of course they are planted to bloom the following spring so there were no hard facts to get in the way of speculation. Mackay describes graphically what happened next: The stock jobbers, ever on the alert for a new speculation, dealt largely in tulips, making use of all the means they so well knew how to employ to cause fluctuations in prices. At first, as in all these gambling mania, confidence was at its height, and everybody gained. The tulip-jobbers speculated in the rise and fall of tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich.7
With the wealthy sucked into speculation, the lower orders could not resist following their betters. In November 1636 a futures market in tulip bulbs emerged for those without capital who could only afford a down payment of ‘wine money’. For example a pound of White Crowns could be had next June for a In February 1637 prices down payment of four cows now. Other down for tulips on the stock payments included land, houses, furniture, clothexchanges suddenly ing or foodstuffs. These allowed speculation in collapsed. common varieties by ordinary folk. Some varieties increased in price by up to 25 times. In February 1637 prices for tulips on the stock exchanges suddenly collapsed. Tulip bulbs at Haarlem were unsaleable at any price. Elsewhere bulbs could not be sold for a tenth of their peak values. Semper Augustines were down to Fl300 and within a couple of years the prices of prized bulbs had fallen to 1 per cent of the peak.
THE MISSISSIPPI BUBBLE 1720 The Mississippi bubble is intimately related to the famous South Sea bubble that occurred in England at around the same time. John Law approached the regent of France, then struggling to resolve problems with farming out tax revenues, to set up a bank. This bank would be
171
chap 8 pages
4/3/02
4:53 pm
Page 172
The empowered investor
responsible for the management of the royal revenues and would issue notes, backed by the security of the revenues and lands. Law was so successful in gaining the confidence of traders that his banknotes rose to a premium, while the government’s debt traded at a discount. Grateful for the stability that Law had created, the Regent gave up monopolies for the sale of tobacco, gold and silver refining and finally nationalized the bank into the Royal Bank of France. In April 1717, Law hit on the idea of creating a company secured on the exclusive privilege of trading up the River Mississippi and with the (then French) province of Louisiana, on its western banks. At first it was unsuccessful, but by 1719 the company was the beneficiary of an edict granting to it the exclusive privilege of trading with the East Indies, China and the South Seas, as well as trade with the possessions of the French East India Company, established by Colbert. According to Mackay, this new company offered 50,000 new shares which, because they were paid for in billets d’état at a nominal value, could be effectively bought with a promise of about 120 per cent profit: ‘At least three hundred thousand applications were made for the fifty thousand new shares, and Law’s house in the Rue de Quincampoix was beset from morning to night by the eager applicants.’8 Law became ‘at once the most important personage of the state’.9 Nobles, judges and bishops besieged his house in the Rue de Quincampoix. Paris became a magnate for European nobility, all anxious to gain the ear of the brilliant financier, and the court of France sought his counsel on all matters of moment. Mississipi stock sometimes rose 20 or 30 per cent in a matter of days, while Paris became the focus of inflation in both luxury and basic commodities. Mackay ably sums up the panic: People of every age and sex and condition in life, speculated in the rise and fall of the Mississippi bonds. The Rue de Quincampoix was the grand resort of the jobbers, and it being a narrow, inconvenient street, accidents continually occurred in it, from the tremendous pressure of the crowd. Houses in it, worth, in ordinary times, a thousand livres of yearly rent, yielded as much as twelve or sixteen thousand.10
By the beginning of 1720 the warnings of parliament were becoming louder and the Prince de Conti, offended at being denied access to more stock, reportedly cashed in an enormous quantity of notes for specie. The more astute stockjobbers started sending gold abroad. Soon a trickle became a flood. Eventually, by February 1720 so much gold and silver were flood-
172
chap 8 pages
4/3/02
4:53 pm
Page 173
chapter 8 . Crashes and bubbles
ing out to England and Holland that the Regent Soon a trickle became was obliged to ban exports of precious metals and a flood. coin, imposing a limit of 500 livres per person. With that edict, the Mississippi shares and the confidence in the currency slumped. By May the convertibility of the currency had been suspended and Law had fled.
SOUTH SEA COMPANY JOINT STOCK BUBBLE OF 1720 Not to be outdone by the French, in refinancing the troublesome national debt, the English parliament voted the transfer of its national debt to the South Sea Company in February 1720. The South Sea Company had in 1717 begun to convert itself into a monetary corporation, having been thwarted in its legal monopoly trade with the South Atlantic on account of a rupture of trade with Spain. The South Sea became the rival to the Bank of England in short-term financing of the public debt. The bill to transfer the national debt to the South Sea Company took two months to go through parliament, during which time the stock rose from 130 to 300. The focus of trading was in Exchange Alley in the City of London where the stockjobbers gathThe focus of trading ered. According to Mackay: ‘It seemed at that time was in Exchange Alley in the City of London as if the whole nation had turned stock-jobbers. where the stockjobbers Exchange Alley was every day blocked up by gathered. crowds, and Cornhill was impassable for the number of carriages.’11 In April, with speculation about the impending riches of the South Seas growing, the directors issued two tranches of South Sea stock. The first was to raise £1,000,000 at 300, payable in five instalments. In a few days the stock advanced to 340, with the first instalment trading at double the value it was issued. A second subscription followed at 400 on the promise of a 10 per cent dividend and raised £1,500,000. Attracted by the huge success of the South Sea Company’s fund raising, dozens of other joint stock companies were formed to cash in on the enthusiasm for investment: ‘The highest of the aristocracy were as eager in this hot pursuit of gain as the most plodding jobber in Cornhill. The Prince of Wales became governor of one company, and is said to have
173
chap 8 pages
4/3/02
4:53 pm
Page 174
The empowered investor
cleared 40,000l. by his Speculations.’12 Eventually parliament passed an Act to ban the practice of joint stock companies and to secure the monopoly of the South Sea Company as the sole joint stock enterprise. Meanwhile, directors such as John Blunt were pulling out profits on stock they had bought with company loans in order to invest in landed estates, of which Blunt was contracted to buy six at the time the company failed. The legislation to give the South Sea Company a monopoly helped the stock rise from about 500 in May to 890 by June. When this prompted a burst of selling, the directors of the South Sea Company ordered their agents to buy the stock. At the start of August it rose to 1000. On St Bartholemew’s Day, Sir John Blunt opened the issue of a fourth subscription but ‘the old fire was missing. The books were filled but the more observant noticed that the sober clothes of the merchants and traders were scarce in the throng’.13 The stock began to decline precipitously. There was a crowded public meeting at Merchant Taylors’ Hall on 8 September in which directors and supBribes had been paid porters such as the Duke of Portland gave enthuto numerous government officials siastic speeches in the manner of sporting and nobles including champions: ‘Upon the very same evening the the Chancellor of the stock fell to six hundred and forty, and on the Exchequer. morrow to five hundred and forty.’14 The attempt to rally supporters had failed and had undermined confidence by giving the appearance of desperation. But the real blow to the bubble came from the Swordblade Company, cashiers to the South Sea Company, who stopped payment. An inquiry found that, to facilitate the company’s issues, bribes had been paid to numerous government officials and nobles including the Chancellor of the Exchequer: ‘Petitions from counties, cities, and boroughs, in all parts of the kingdom, were presented, crying for the justice due to an injured nation and the punishment of the villainous peculators.’15 To assuage public outcry, confiscations and imprisonments of numerous participants were ordered.
WALL STREET CRASH 1929 During the mid-1920s, the US economy was a genuine success story. Between 1921 and 1928 the Federal Reserve Index of Industrial Production increased from 67 to 110 and rose to 126 by June 1929. The stock mar-
174
chap 8 pages
4/3/02
4:53 pm
Page 175
chapter 8 . Crashes and bubbles
ket began to be the focus of a new optimism. The New York Times Index of 25 industrial stocks rose from 106 in May 1924 to 181 in December 1925. From 1927, the increase began in earnest with regular rises in stock prices day after day. The index had risen to 245 over 1927, up 69 points on the year. In 1928 the nature of the boom changed. Prior to 1928, according to John Kenneth Galbraith’s famous account of the crash, ‘even a man of conservative mind could believe that the price of common stocks were catching up with the increase in corporate earnings’.16 After 1928 there was an increasing gap with reality. In December 1928, Coolidge felt able famously to declare: ‘No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time.’ Radio Corporation and other communications stocks rapidly became the speculative symbols of the boom. Radio Corporation rose from 85 to 420 in the course of 1928. Chains of stores were popular too. Montgomery Ward, a chain of department stores, went from 117 to 440. The apparently ever-rising stock market was becoming a source of newspaper interest and popular debate. Volumes of trading were rising from 577 million shares in 1927 to 920 million in 1928, and by 1929 more than 5 million shares were traded regularly each day. The popular imagination became exercised by the great stock market operators of the day: John J. Raskob, William Crapo Durant and the Fisher brothers. In the minds of the growing mass of speculators, ‘somewhere around there are big men who put stock prices up and put them down’.17 Borrowing to invest There was so much became so popular that it caused a monetary crimoney going into the market that by March sis: ‘People were swarming to buy stocks on marthe financial system 18 gin.’ Margin enabled investors to put down a was running out of cash deposit as low as 10 per cent to acquire money. stocks. Between 1926 and 1928, loans on margin increased from $2.5bn to $6bn. In fact there was so much money going into the market that by March the financial system was running out of money. A meeting of the Federal Reserve which was convened in Washington went on for days as policymakers debated what to do. There were genuine concerns that there were not enough common stocks to go round. The boom had focused on the prices of chain stores, holding companies and investment trusts. In order to satisfy demand,
175
chap 8 pages
4/3/02
4:53 pm
Page 176
The empowered investor
promoters manufactured such companies at an increasing rate. In 1927 there were 160 new investment trusts offered to the public, usually at premium to the assets; in 1927 and 1928 there were 326. One such, the Goldman Sachs Trading Corporation, issued 100 million shares at $104 in December 1928, which were trading at $225.5 by February. By March they had invested $52m in their own securities. Through 1929 there was one investment trust being launched per day. The problem was that demand for money to invest had raised the cost of money; the call rate or interest rate had risen at one point to 20 per cent. Such rates were necessary because the flow of funds from abroad that had sustained the boom had been stemmed in February by the Bank of England’s decision to raise interest rates. In March 1929, with no word from the Federal Reserve meeting in Washington, the stock market feared the worst and prices fell sharply. This triggered a flood of telegrams to investors requiring them to post more margin. According to John Kenneth Galbraith, this March liquidity crisis might have been the end of the boom if not for a move by Charles E. Mitchell, head of the country’s second largest commercial bank, National City. He offered to supply unlimited liquidity to the market and did so – causing the Fed to dissolve into inaction for the crucial months ahead. The stock market had further breaks in May and September and quickly recovered because ‘when there was a break it was a good time to buy’.19 Over the summer stocks rose every day, week by week and $600m of investment trusts were launched in September, a record month. Steel went from 165 to 253; General Electric from 268 to 391. Each Friday the Federal Reserve published the weekly and monthly statistics for brokers’ loans and each Friday they had risen to new record highs. Nobody dared speak out: ‘Pessimism was not openly equated with efforts to destroy the American way of life. Yet it had such connotations.’20 There were always champions of shares available for ready money. A financial columnist of the Daily News received $19,000 in 1929 and early 1930 in return for tipping stocks in which a trader, John J. Levenson, had positions. A radio commentator, William J. McMahon, accepted bribes from David M. Lion to back favoured stocks. On 3 September most accounts agree that the enthusiasm for the market suddenly flagged. After 3 September the market never again rose with ‘its old confidence’. There was worrying news from England about the collapse of a financial group built up by Clarence Hattry. By early October, Radio Corporation had gone down to 82.5 from 114.75 in September.
176
chap 8 pages
4/3/02
4:53 pm
Page 177
chapter 8 . Crashes and bubbles
Having touched 261.75, US Steel dropped as low as 204. On 2 October, brokers’ loans hit a record high of $6,804,000,000, showing that margin buyers were far from discouraged. In the final week of October a different mood descended on the market. On Wednesday 23 October there was all of a sudden ‘a perfect Niagara of liquidation’. The Times Index fell from 415 to 384. On Thursday 24 October it became apparent that prices were falling with a violence that could only mean one thing: people were selling not just a few shares, but everything they owned at almost any price. Those who had financed their purchases with borrowed money could not afford to hold out for a bounce. Speculators who had financed on margin were selling up. Brokers’ offices around the country, which had become the focus of trading for America’s 600,000 margin traders, saw crowds gather. A mass of people waited aimlessly outside the stock exchange on Wall Street. ‘In brokers’ offices all over the country tape watchers looked at one another in astonishment and perplexity. Where on earth was this torment of selling orders coming from?’21 At noon on Black Thursday, Richard Whitney, floor broker to the Morgans, scurried around the trading floor placing bids for stocks on behalf of a consortium of bankers headed by JP Morgan and Co. Organized support had been part of the So many deals had mythology of the bull market. If the market drops, been done that the ticker machines in the big operators will surely step in – therefore the brokers’ offices had market can never go down. Now a consortium fallen behind the backed by $240m was prescribed as a remedy to trading and continued the market panic. At the close of that day a record chattering throughout the night. 12,894,650 shares had been traded and so many deals had been done that the ticker machines in brokers’ offices had fallen behind the trading and continued chattering throughout the night. Black Thursday was far from being the end of the affair. The following Monday, the Times Index fell 49 points, US Steel lost 18 and General Electric 48. On Tuesday there was another mammoth sell-off: ‘The scene on the trading floor was chaotic. Despite the jamming of the communication system, orders to buy and sell – mostly to sell – came in faster than human beings could possibly handle them.’22 A new record of 16,410,030 shares traded was set and the Times Index fell 43. John D. Rockefeller, John J. Raskob, the feared market operator, and President Hoover all made reassuring statements and speeches by the
177
chap 8 pages
4/3/02
4:53 pm
Page 178
The empowered investor
dozen, but the market never recovered. On 5 November, US Steel fell from 181 to 165 and the Times Index fell 37. On 13 November the Times Index hit 224, half of its recent level of 452. The market went on to bottom out at 58 on 8 July 1932, when US Steel was at 22, Montgomery Ward at 4 and Goldman Sachs Trading Corporation at 1.75. At that time the US steel mills were running at 12 per cent of capacity and pig iron was being produced at the lowest levels since 1896. Traditional explanations blame the economic catastrophe that beset the USA from 1929 to the mid-1930s squarely on the shoulders of the monetary policymakers. But more recent explanations have focused on industrial production which had been declining well before the Great Crash and continued to fall afterwards. The Index of Industrial Production was 117 in October, compared to 126 a few months earlier. US automobile production declined from 660,000 units in March 1929 to 440,000 in August, to 92,500 in December.23 There were senate hearings and committees of inquiry. Heads rolled – notably Richard Whitney – and legislation was passed. The Glass-Steagall Banking Act separated brokers from commercial banking. In the 1930s a Federal Reserve regulation fixed margin requirements at 50 per cent. But this requirement in effect speeded the development in the futures markets since it applied only to individual securities. By buying an S&P 500 futures contract in Chicago with a 10 per cent margin, you can basically get access to the underlying shares with a 10 per cent downpayment. More recently margin trading has boomed again, although it is interesting to note that after the 11 September 2001 catastrophe in New York several countries moved to ban short selling of stock (selling stock you don’t yet own).
19 OCTOBER 1987 By 1987, the US stock market had enjoyed a five-year bull market. Markets were exuberant over spring and summer as big bids financed by leverage and shares swept up London and New York. Dividend yields on shares had fallen to 2.5 per cent in New York with P/E ratios up to 22x. However over the late summer, interest rates began rising in the UK as well as New York. The US market peaked in August, wobbled in September and weakened as October progressed. Prior to crash day, volatility had signif-
178
chap 8 pages
4/3/02
4:53 pm
Page 179
chapter 8 . Crashes and bubbles
icantly increased. The three days of 14 to 16 October 1987 had witnessed the largest three-day percentage decline in the S&P 500 since 1940. Panic set in even before Monday 19 October. In the USA over the weekend an overhang of sell Panic set in even orders had built up. On the night of Thursday 15 before Monday 19 October. October 1987, London and the south of England were hit by the worst storms in living memory. The FTSE 100 stood at 2322. Few brokers and dealers made it into work the next day and system failures meant that no index figures could be calculated. In New York on Friday the Dow Jones fell 108 points, just under 5 per cent, to 2246. There were concerns about a rise in the prime rate from 8.75 per cent to 9.75 per cent. There were worries about weak trade figures. In London the weekend papers were full of predictions about recession and London’s likely reaction to Friday’s big fall on Wall Street. At the market open, London stocks were immediately marked down with record falls. As the New York opening in the afternoon approached, stocks did not recover. Instead, it became clear that a calamitous 500 point fall on the Dow Jones was being indicated in the futures market. At the New York opening, nearly 10 per At the New York cent of all stocks were unable to trade. opening, nearly 10 per By noon on Monday 19 October 1987, the Dow cent of all stocks were Jones Industrial Average was down 100 points unable to trade. and in the final hour the drop amounted to another 300 points. At the close the Dow Jones was down 508 points or 23 per cent. London’s FTSE 100 index was down 10.7 per cent. Volume on the US market was four times the average with $21bn of shares changing hands, mostly into the hands of market makers. The US futures index fell 29 per cent on volume of about $20 billion as investors found it easier to raise cash in the futures market than the actual stock market. The FTSE 100 fell a further 10 per cent the next day, giving a fall of 22.4 per cent in two trading days. BP, which was in the middle of a privatization issue, had fallen from £3.50 to £2.80. Many smaller and more speculative issues lost over half their value. But this was far from the end of the calamity, with the Hang Seng Index falling 41 per cent after a week’s suspension. The FTSE fell further to reach 1565.2 by 19 November, a total fall of 32 per cent since 16 October. On crash day, trading shares was difficult for both the institutional and private investor. Computer program trades designed to insure the down-
179
chap 8 pages
4/3/02
4:53 pm
Page 180
The empowered investor
side of some large portfolios were chasing each other to sell shares and themselves prompted prices to spiral lower. Private investors jammed phone lines and caused systems to crumple amid rumours that frantic brokers simply would not answer the phone. The official explanation is that the crash was due to institutions operating automatic computer trading strategies which were unable to find buyers for large blocks of Private investors jammed phone lines stock. According to the Brady Report of the Presiand caused systems to dential Task Force, the chaos of 19 October was the crumple amid rumours result of ‘mechanical, price-insensitive selling by a that frantic brokers number of institutions employing portfolio insursimply would not answer the phone. ance strategies and a small number of mutual fund groups reacting to redemptions’.24 Some explanations for the events of Monday 19 October 1987 focus on the rational background to crashes in that they amount to sudden revelations of the extent of hidden pessimism. The market is generally good at estimating optimism but sometimes makes a wrong guess at the extent of pessimism.25 This would explain the fact that, since World War II, the S&P 500 has had many more significant one-day declines than one-day rises. When actual sell trades reveal the pessimism, the market has to adjust very rapidly.
THE JAPANESE CATASTROPHE The roots of the Japanese bubble can be traced to the Plaza Accord of 1985. With the Plaza Accord, the five major nations met with the intention of ensuring an orderly depreciThe roots of the ation of the dollar against the major currencies. Japanese bubble can be traced to the Plaza This was to help US exports. It was agreed that the Accord of 1985. level of the yen was too low. The yen exchange rate had been set after the Japanese catastrophe of World War II to allow Japan to rebuild its economy by exporting.26 Now that the Japanese economy had been rebuilt, it was argued that the yen could be allowed to appreciate. In 1982 to 1985 the yen had been around 240–260 to the dollar. By 1987 it was 145 and went on to hit 128 in 1988. As the appreciating yen attracted investors, the Bank of Japan was able to cut the discount rate from 3.5 per cent in 1986 to 2.5 per cent in 1987. 180
chap 8 pages
4/3/02
4:53 pm
Page 181
chapter 8 . Crashes and bubbles
With capital flooding in from abroad and the domestic money supply expanding, there followed a remarkable increase in the price of land and stocks, building on an equally stellar post-war recovery. While the 1987 crash affected every major stock market in the world, it little affected Tokyo. The Nikkei index started at 100 in May 1949, was 5000 by the early 1970s and 10,000 in 1984. In 1986 it advanced 20 per cent, then took off in a bubble to reach 39,000 by the end of 1989. The Nikkei struggled to regain 15,000 in the early years of the twenty-first century. A price index of real estate property in six large cities started at 100 in 1955, rising to 5800 in 1980, and peaking at 20,600 in 1989. At one point it appeared that the value of all Japanese land was four times that of the entire USA and that of Tokyo was greater than California.27 At the end of 1989 a new governor, Yasuki Mieno, was appointed to the Bank of Japan. He proceeded enthusiastically to follow the international central banks’ moves to raise interest rates to control inflation. The official discount rate was raised five times from 2.5 per cent in May 1989 to 6 per cent by August 1991. The bubble finally burst in January 1990, with a host of scandals in which banks made good losses of favoured customers and cooked their books. Unlike Anglo-Saxon crashes, the agony has been prolonged by the Japanese system of financing enterprises by bank debt rather than by limited liability equity. The problem is that much of the debt held by Japanese banks is non-performing, but if this is admitted then the banking system will fail. To help take the pressure off borrowers and banks, the Bank of Japan has successively reduced the discount rate from 6 per cent in 1991 to zero in March 2001. But the Japanese consumer has refused to spend, saving 30 per cent of their Much of the debt held income. Investment has been diverted abroad. by Japanese banks is Families in Tokyo pay 13 times annual income for non-performing, but if this is admitted then their housing compared to three or four times in the banking system New York and London. The agony of the bubble will fail. deflation has been prolonged by the failure of Japan’s banking system to accept reality – many of their assets are not worth a dime. The ordinary consequences of speculative excess should be bankruptcy and forced sale of assets at realistic prices. In Japan this has not happened, so there is no way the steam can get out of the boiler.
181
chap 8 pages
4/3/02
4:53 pm
Page 182
The empowered investor
THE INTERNET BUBBLE With the memories of the internet bubble still fresh to mind, there is no need here to narrate the legend of Bill Gates and the Microsoft Corporation. After achieving world dominance of our personal computer environments in the early 1990s, it The internet captured the imagination of the was a relatively simple matter to popularize the masses. internet, which had started off as a means for academics to exchange information. From such a plausible beginning there quickly arose implausible expectations as the internet captured the imagination of the masses. Internet share trading and share information exchange came to be the focus of the enthusiasm. By 1999 there were 12 million online accounts in the USA. Internet message boards started in the USA as a way of exchanging views on individual stocks. Between April and November 1999 a discussion site such as RagingBull.com tripled its membership to 300,000 and averaged 6 million page views per day. In the UK, Ample Interactive Investor boasted a million members and 90 million page views in March 2000. Other commercial uses of the internet were soon discovered. By the end of 1998 Amazon.com, which sold books, had a market capitalization of $17bn having risen 979 per cent over the year. A year later at the end of 1999, Amazon.com was valued at $26.2bn with shares trading at $76. By way of comparison, at the end of 1999 both of America’s largest booksellers, Barnes & Noble and Borders, together had a market capitalization of $2.61bn and were producing sales of $6.5bn. Amazon.com at this time produced sales of $1.6bn and was unprofitable. At the end of 1998 Yahoo.com, a search engine which hosted advertisements, was valued by the market at $23bn, having risen by 546 per cent over that year. By the end of 1999, Yahoo.com was worth a staggering $115bn, with shares trading at $216 and was unprofitable. As a contrast, an established media giant such as Walt Disney was then valued at $60bn and producing profits of $1.3bn. At the initial public offering of eBay, an online auctioneer, the filing range was $14–16. On the first day of trading in September 1998, the price rose to $54 and hit $84, then $218 in November 1998, soon attaining a market capitalization of $12bn.
182
chap 8 pages
4/3/02
4:53 pm
Page 183
chapter 8 . Crashes and bubbles
THE UK INTERNET BUBBLE (AND MY ROLE IN THE MAYHEM) Such share performance spawned a crop of internet-related IPOs around the world. In February 2000, Interactive Investor International plc, a UK provider of financial information, offered around 50 million shares for sale at £1.50. The offering was oversubscribed by 26 times, with 82,000 private investors applying for shares and the bankers in receipt of cheques for £2bn. I had joined the company, popularly known as iii, in 1999 to beef up the equities content on the home page and centres. The company was unusual among financial internet companies in a number of ways. It was basically first in the UK, founded way back in 1995. Thus it was almost always first to implement the latest innovations. Its employees, particularly on the technical side, were unusually highly qualified, whereas other dot.coms tended to be repositories for drifters or people on gap years. Unlike the Johnny-come-lately dot.coms that appeared in 1999–2000, there were few extravagances and no dominating personalities at iii. The founder, Sherry Coutu, was a soft-spoken Canadian with an MBA-trained mind. Offices were rough and ready spaces over the meat market at Smithfield, requiring employees to wade through the mess of a morning meat market every day to get into the office. We did once splash out on hiring a Thames barge for a summer party, but that was about it. Tomás Carruthers, the CEO, sitting very democratically at the next desk to me, had a fondness for lunch at the local Berni Inn and the odd half of lager, but that was all. At the offer price, Interactive Investor, which had turnover of just £2.558m in its year to September 1999, was valued at £246m. However, within a few weeks the share price was £4.60 and the company valued at £755m, or 295 times historic revenues. At this price pretty much all the employees were millionaires many times over: ‘Kinda neat’ in the words of the founder. On the first day of trading the Interactive Investor discussion board attracted several thousand posts. Another UK company, Lastminute.com, an online travel agent, was floated shortly afterwards and was valued at £571.3m with 188,985 private investors applying for shares. Sales of Lastminute.com amounted to £9.585m in the year to September 1999 and its losses to £9.2m. Again on the discussion boards there were thousands of posts. Such a powerful
183
chap 8 pages
4/3/02
4:53 pm
Page 184
The empowered investor
medium as discussion posts quickly attracted the unscrupulous. In April 1999, a user of Yahoo! message boards posted a fraudulent Bloomberg press release that drove the stock price of PairGain Technologies up 31 per cent in a morning. In September 2000, the US Securities and Exchange Commission announced that it had uncovered a stock price manipulation scheme run by a 15-year-old boy in New Jersey. Personalities both on and off-line who had developed large followings established sites of their own to promote their views. Tokyo Joe and Whiz Kid in the USA and John Delaney and Fillyaboots in the UK are examples of this. Users of Tokyo Joe pay $200 per month for the privilege of knowing Tokyo Joe’s utterances first. Analysts at leading firms of stockbrokers became household names. Internet companies began to be manufactured at the rate of one per day. Perfectly respectable and sober businessmen flocked to lend their names to enterprises. A stock market day was not complete without some new dot.com having an IPO and going to a spectacular premium. Business plans made no attempt to disguise losses – in fact losses were a necessary badge of credibility for the aspirant dot.coms, the more losses the better. Often the business of the company was not revealed in detail for fear of imitation. Jealous of the ratings that internet-related companies could achieve, soon everyone wanted to become an internet company. Companies fell over themselves to establish their internet divisions and web credibility, often changing their Internet companies names to include the esteemed dot.com suffix. began to be manufactured at the Once upon a time new companies would decorate rate of one per day. their boardrooms with titled nobility or persuade the deputy mayor to lay a foundation stone in order to lend respectability to their enterprise. To initiate an internet enterprise no such formality was necessary. You just registered your web address and yahoo, you were halfway to becoming an instant internet millionaire. The most tiresome hurdle faced by the thousands of internet entrepreneurs appeared to be what to wear for the obligatory flotation day photograph. How dressed down can you safely appear before the world’s press? What colour to wear to avoid a clash with the logo? Trainers and tanktops soon replaced slip-ons and t-shirts. Trousers of some description remained an inconvenient necessity. In an effort to cash in on the craze for youth and scruffiness, men beyond the age cut-off point, perhaps the
184
chap 8 pages
4/3/02
4:53 pm
Page 185
chapter 8 . Crashes and bubbles
wrong side of 30, took to installing their sons into fake enterprises. As the boom wore on, the average age of directors fell until at last infant directors hardly past puberty took the helms of multimillion pound enterprises between homework and Trainers and tanktops playschool. soon replaced slip-ons and t-shirts. Before long everyone wanted to lay down their tools, punch their boss goodbye and start a new life as a millionaire day trader. And many did so, often in blissful ignorance of what they were doing. The Guardian reports: A man with his £3,500 life savings in Halifax shares rings a stockbroker because someone had advised him to sell up and put everything into Pacific Media, a technology stock whose price has jumped almost 30-fold in a month; another instructs the broker to buy half-a-dozen technology shares. When asked what they do, he says: ‘I don’t care – just buy.’28
On Thursday 29 July 1999, Mark Barton, a 44-year-old former chemist who had turned day trader, appeared in the Atlanta branch of a chain of day trader brokerages and massacred 12 people – apparently in revenge for losses from his day trading activity. Behaviouralists have a number of explanations. The obvious motivation other than greed is fear of People were trading for fun. being left out. Investors may have heard how a few people have made instant riches. There is ‘nothing so disturbing to one’s well being and judgement as to see a friend get rich’.29 They incorrectly concluded that they too could participate in the bonanza. Sounds like a case of confusing cause and effect. Another factor was ‘marketitis’ – overtrading – caused by a desire not only to profit, but also to get the buzz that comes with a trade. People were trading for fun. Investors were convincing themselves that they were making an investment, a sensible one if the newspapers were to be believed. In fact they were taking a straight one-way bet, at long odds. By July 2001, Yahoo! was valued at $17 per share with a market capitalization one-tenth of its peak, while Amazon was trading at $15 per share with a value one-fifth of its peak. Around the world hundreds of dot.coms had gone bust.
185
chap 8 pages
4/3/02
4:53 pm
Page 186
The empowered investor
ANATOMIES OF A PRICE BUBBLE In every bubble there needs to be a location, a Rue de Quincampoix, for the proverbial madness to converge from the bottom up. Discussion boards have created a brand-new, unregulated forum for the formation of crowd psychologies. We can see how, in the South Sea bubble, the transmission mechanism was the In every bubble there needs to be a location. network of coffee houses around Exchange Alley where speculation brewed. By the time of the Wall Street crash we have telephony and networks of provincial brokerage offices in which people gathered to watch the ticker tape of deals. In the internet bubble we have discussion boards accessible from any part of the world at all times of day. From the top-down perspective at the official level there are common traits in each boom of official support, tacit or direct. King George, nobles and many leading politicians backed the South Sea Company. The boom in US equities in the 1920s was justified by presidents and professors. Professor Irving Fischer most famously declared in 1929 that ‘the stock prices have reached a new and higher plateau’. In the UK’s internet bubble of 1998–2000, Prime Minister Blair of Great Britain raved about the ‘information superhighway’ and promised computers for every schoolchild and library. 3G telecom licences were sold to commercial operators for billions of pounds, leading to the near insolvency of the UK’s leading telecom operator, British Telecommunications, in 2001. Some argued that the government should have intervened. Milton Friedman considers that, if the government knows more than the speculators, it should make that information immediately and fully available. There is another explanation just for chartists. The money flow theory of technical analysis sees price movements in terms of three stages. First, you have your accumulation phase, involving the purchase of stock by well-informed investors. This is corroborated by increased volume in the stock, together with increased prices. Second, you have a distribution phase where ‘the smart people who bought it early sell to the people who bought it late’.30 Third, you have a distribution phase where prices return to fundamental values. This is familiar ground for economists too. In classic economic thought you get expansions funded by bank lending that prompt asset inflation on which is founded the creation of more credit. Then the flip side is that when confidence falls you get sliding prices of loan collateral, more con-
186
chap 8 pages
4/3/02
4:53 pm
Page 187
chapter 8 . Crashes and bubbles
servative banks calling in loans and stopping lending, leading to asset sales. Falling prices of assets lead to more liquidation and defaults until the whole cycle repeats again. In the case of the bubbles we have considered, the accumulation phase involves smarter investors supplying or creating supply of the assets to be pumped up. This role was played by the new contracts to speculate in tulips, the new securities to participate in the Mississippi bubble and the boom in investment trusts manufactured in the run-up to 1929. In the 1960s, new conglomerates increased their supply of stock, as did the internet promoters in the 1990s. The flip side of bubbles is the dead hand of legislation rushed through in reaction to the political pressure from the victims of the bubble. An attempt to support the South Sea Company in 1720 by banning rival joint stock companies led to a century-long ban on the formation of joint stock companies without parliamentary approval. Not only private bankers, such as Lord Overstone, but also a great number of thinking persons feared that the joint stock banks would fast ruin themselves, and then cause a collapse and panic in the country. The whole of English commercial literature between 1830 and 1840 is filled with that idea; nor did it cease in 1840. As late as 1845, The flip side of bubbles is the dead Sir Robert Peel ‘thought the foundation of joint hand of legislation. stock banks so dangerous that he subjected it to grave and exceptional difficulty’.31 The crash of 1929 resulted in the Glass-Steagall Act that separated banks from stockbrokers. It also hastened the formation of the Securities and Exchange Commission (SEC). Finally, there is the age-old problem of whether bubbles are good for investment and long-term advances in the economic wealth of nations. And there is the issue of the role of government – should speculative trading and shorting be restricted or discouraged by imposing taxes? I shall not attempt to answer these eternal questions. All these problems are still exercising the experts as much as the rest of us.
NOTES 1 Bagehot, Lombard Street, VI, 18. Walter Bagehot, Lombard Street, Henry S. King and Co., London, 1873, VI, 18. Additional notes and appendix, John Murray, 1915. Bagehot’s fascinating account of the events of the South Sea Bubble from a late nineteenth century
187
chap 8 pages
4/3/02
4:53 pm
Page 188
The empowered investor
2 3
4
5
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
21
22
23 24 25 26 27
188
vantage point is now available on the world wide web from the Library of Economics and Liberty: http://www.econlib.org/library/Bagehot/bagLom1.html Dean LeBaron and Romesh Vaitilingam with Marilyn Pitchford, The Ultimate Book of Investment Quotations (Capstone, Dover, NH, 1999), p. 222. John Carswell, The South Sea Bubble (Cresset Press, London, 1960), p. 161, quoted in Charles Kindleberger, Manias, Panics and Crashes: A History of Financial Crisis, 3rd edn, (Macmillan Press, London, 1996), p. 24. Mackay, 3.1. Charles Mackay, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Office of the National Illustrated Library, London, 1852, 3.I. The Library of Economics and Liberty has conveniently made the entire work available on the world wide web: http://www.econlib.org/library/Mackay/macEx1.html Peter Garber, ‘Second thoughts about Tulipmania’, The Journal of Economic Perspectives, 4 (1990), pp. 35–54. Reprinted in Charles Ellis and James Vertin, The Investor’s Anthology, (Wiley, New York, 1997). Mackay, 3, 3. Mackay, 3, 7. Mackay, 1, 27. Mackay, 1, 31. Mackay, 1, 28. Mackay, 2, 12. Mackay, 2, 30. John Carswell, The South Sea Bubble (Cresset Press, London, 1960), pp. 176–7. Mackay, 2, 30. Mackay, 2, 45. J.K. Galbraith, The Great Crash, 3rd edn, (Deutsch, London, 1973), p. 16. J.K. Galbraith, The Great Crash, 3rd edn, (Deutsch, London, 1973), pp. 17–18. J.K. Galbraith, The Great Crash, 3rd edn, (Deutsch, London, 1973), p. 26. J.K. Galbraith, The Great Crash, 3rd edn, (Deutsch, London, 1973), p. 30. Frederick Lewis Allen, ‘Only yesterday: “The Big Bull Market and the Crash” 1931’, in Charles Ellis and James Vertin, The Investor’s Anthology (Wiley, New York, 1997), p. 182. Frederick Lewis Allen, ‘Only yesterday: “The Big Bull Market and the Crash” 1931’, in Charles Ellis and James Vertin, The Investor’s Anthology (Wiley, New York, 1997), p. 182. Frederick Lewis Allen, ‘Only yesterday: “The Big Bull Market and the Crash” 1931’, in Charles Ellis and James Vertin, The Investor’s Anthology (Wiley, New York, 1997), p. 185. Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crisis (Macmillan, London, 1978), p. 61. Peter Bernstein, Capital Ideas (Free Press, New York, 1992), p. 102. Mark Rubinstein, ‘Rational markets: yes or no? The affirmative case’, Financial Analysts Journal, 57, 3 (2001), p. 26. Michael Goddard, ‘The Japanese crash 1990–?’, Professional Investor, June (2001), pp. 18–22. Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crisis (Macmillan, London, 1978), pp. 103–5.
chap 8 pages
4/3/02
4:53 pm
Page 189
chapter 8 . Crashes and bubbles 28 Heather Connon, The Guardian, 12 December 1999. 29 Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crisis (Macmillan, London, 1978), p. 13. 30 Andrei Shleifer, Inefficient Markets (Oxford University Press, Oxford, 2000), p. 169. 31 Bagehot, Lombard Street, IX, 13.
189
chap 9 pages
4/3/02
4:54 pm
Page 190
chap 9 pages
4/3/02
4:54 pm
Page 191
9 Doing your research The information problem Primary sources Secondary sources How to do research Research case study 1: The housebuilding industry Research case study 2: The Berkeley Group plc
191
chap 9 pages
4/3/02
4:54 pm
Page 192
chap 9 pages
4/3/02
4:54 pm
Page 193
chapter 1 . Why the stock market?
THE INFORMATION PROBLEM When I chat to private investors, one of the most common things that comes across is that a majority think that choosing winning stocks does not require much effort. They are willing to risk their hard-earned cash on the back of some weakly researched tip or newspaper report. If it was that easy to make money on the stock market, then why should they tell you? If only they knew how shallow is the average journalist’s knowledge of business. Under pressure of time reporters will uncritically rewrite copies of press releases knowing little of the business they are writing about. Few private investors have read official sources such as the stock exchange filings because they are written in a style that puts off most readers. Nor do most people look at sectoral information or independent sources. Occasionally they may see a broker’s report, but that event is a rarity. Television coverage is normally so simplified as to eradicate useful meaning. Even among A majority think that choosing winning provincial stockbrokers and City types, reliance stocks does not require on the media is considerable. Since the output of much effort. the news media, unlike the securities analysts, is unregulated, private investors are exposed to whatever bias the media choose to impose on the information. The lack of training and resources compounds the problem as stories go completely unchallenged. It is unusual for business reporters to have even a business degree or elementary work experience in commerce. Because of the lustre of respectability bestowed by a news article, many exaggerations, factual inaccuracies or omissions can slip through. It is true that the effort of researching a security may seem to outweigh the benefits. But that is only because few private investors have been taken aside and properly instructed in how to do the research. Many do not distinguish between the primary sources containing fairly authoritative facts and the secondary sources that put a spin on them. So the object of this chapter is to get you up to speed on cutting through the information jungle.
193
chap 9 pages
4/3/02
4:54 pm
Page 194
The empowered investor
PRIMARY SOURCES The primary sources are relatively few and can now be easily obtained on the internet. For UK companies, the compulsory company filings with the stock exchange are available on the Regulatory News Service (RNS) and distributed for convenient display to sites such as Ample Interactive Investor and Hemmington The primary sources Scott. are relatively few and The annual and half-yearly (interim) reports can now be easily obtained on the will contain accurate updates about current marinternet. ket conditions and how the firm is faring. Other essential RNS announcements such as investments or acquisitions can also be easily found. Many annual reports can be ordered online or otherwise obtained by a quick phone call to the company secretary. The other main corporate information you need in order to select a stock is some detail on the company’s products and market share. While access to management would be ideal, this can now often be found in annual reports or on a corporate website where management presentations can be downloaded. General business conditions in the sectors can be found in accessible industry websites and magazines.
SECONDARY SOURCES Digests of financial information (sales, profits, net assets, etc.) are available in the fundamental data areas of most of the big umbrella sites, although they can be difficult to find. Hemmington Scott (www.Hemscott.net) and Hoovers Online (www.hoovers.co.uk) specialize in presenting this fundamental information in an easy-to-use format. You will often find that the useful ratios such as P/E and Price/Book are readily available along with a summary of the business, financial statistics going back a couple of years and some details of shareholders and management. For US stocks the equivalent sites are Value Line and Standard & Poor’s Stock Reports, which provide comprehensive information in an abbreviated format. For more specific help in distinguishing the wheat from the chaff, there are magazines and tip sheets, broker reports and specialist websites. Tip
194
chap 9 pages
4/3/02
4:54 pm
Page 195
chapter 9 . Doing your research
sheets and magazines tend just to rewrite the basic facts and then add a rather intuitive ‘buy’ or ‘sell’ lacking any factual basis. The best investment magazines are Investors Chronicle, Business Week and Forbes. These have recently been joined by Investors Week and Shares magazines. All offer brief company-specific and sector articles, often derived from interviews with the brokers and analysts. Unfortunately the articles tend to shed a lot of the meaning in an effort to simplify complex situations. With an Infinite Tip sheets have a generally mixed record, with number of Monkeys, tracking studies showing that picking stocks at some are bound to random is a better bet. Therefore tip sheets are come up trumps. unable to charge heavily for their services and cannot afford appropriately qualified staff to research stocks properly. Ordinary private investors and bulletin boarders have contrasting views about tipsters. Referring to the common scattergun strategy of tipsters, Bri Blackdog comments: ‘With an Infinite number of Monkeys, some are bound to come up trumps.’ Matt Blacker is more of a spectator than a player using tipsters as a mere starting point: ‘We need an initial source of info about shares and tipsters are as good a way as any of bringing a share into the spotlight. This should obviously be followed up by doing your own research (DYOR) and price monitoring before buying.’ Stan Kaiser values the shortcuts some tipsters claim to offer: ‘In the end time, chance, contrary advice and every other variable makes you rely upon common sense and experience. But proven, inexpensive and quick advice is always worth it if you can get it. That is also how you run a business.’ Jamie on Ample Interactive Investor’s board is sceptical of any share being tipped: ‘The danger is that it’s only being ramped and that you might be sitting on a paper loss for some time.’ John Slade points to the prevalence of tipsters during the technology stock boom: ‘During the bull run in the market a child of twelve could have picked a string of winners. Since then they have lived off those good times. However, the tide has turned and they are now shown up as the charlatans they are. Let this be a lesson to us all.’ Of course there are alternative shortcuts for private investors. Specialist websites have now sprung up offering the expertise of highly qualified analysts to subscribers. These have the advantage of being independent of any corporate influences that may persuade a brokerage analyst to withhold a sell recommendation.
195
chap 9 pages
4/3/02
4:54 pm
Page 196
The empowered investor
I must confess that I am a fan of the research reports of securities analysts. They contain basic information and forecasts along with a wellreasoned conclusion on whether to buy or sell the stock. The reader should be aware of potential I am a fan of the research reports of conflicts of interest with the securities house sponsecurities analysts. soring the reports. First, the company being researched may be a client. Second, the objective of the report may be to generate commission or help the firm’s market makers. Analysts are also remarkably unwilling to stand out from their peers in forecasts. But as collections of important details, reports are unrivalled.
HOW TO DO RESEARCH Figure 9.1 illustrates how to go about industry research and company research.
Is sector creating demand for products?
Figure 9.1
Falling prices? Hard to sell?
Rising industry costs?
Current market conditions?
Which sector is going to grow?
Now start picking stocks …
Stock’s valuation reasonable?
Managers OK? Fans in the City?
What is its market position?
How can company sustain growth?
Key products? 10% + pa growth?
Choosing sectors and picking stocks
RESEARCH CASE STUDY 1: THE HOUSEBUILDING INDUSTRY This research case study illustrates how to use easily accessible information to do a DIY industry analysis. Once we have found an industry we
196
chap 9 pages
4/3/02
4:54 pm
Page 197
chapter 9 . Doing your research
like, we can then move on to the second stage of selecting some shares within it that look promising. Let’s start by working through an example of how to get information to build up a view of the prospects for one part of a chosen industry, i.e. the housebuilding sector. First, you have to work out what information you actually need to find. What are the questions you need to ask? With residential housing you need to work out the supply and demand for the end product (new houses.) You need to check the trends in the pricing and cost environment to consider the kind of factors that affect the profitability of the companies involved in housebuilding.
What is the demand for houses and market activity? For housebuilding the obvious key statistic of the health of the industry is house prices. I consulted the house price and affordability surveys on the Halifax Group (www.halifaxgroupplc.co.uk) and Nationwide (www.nationwide.co.uk) websites, along with government statistics (www.statistics.gov.uk) on the number of dwellings, population statistics showing the number of households and statistics showing housing market prices and mortgage completions. I then looked on the Nationwide and Bank of England (www.bankofengland.co.uk) websites for details of the trends in consumer lending. After doing that I looked at the Inland Revenue (www.inlandrevenue.gov.uk) statistics which show government revenues from Stamp Duty. What is the supply of houses? For supply of houses I again consulted government statistics (www.statistics.gov.uk) for the number of completions and starts and then compared them to the more recent data from NHBC (www.nhbc.co.uk) which is the main insurer of building works in the UK and can tell us how many homes have been registered with it recently. What are the cost trends in housebuilding? To determine housebuilding cost trends I examined the website of the government body that monitors building costs, the Building Costs Information Service (www.bcis.co.uk), and copied their graph. For trends in the costs of land, I consulted a firm of surveyors, Savills (www.fpdsavills.co.uk), and examined their graph showing the costs of residential building land. Here are the results of an afternoon’s work churning the housebuilding industry information on these websites:
197
chap 9 pages
4/3/02
4:54 pm
Page 198
The empowered investor
Step 1: Demand and supply Statistic 1: Housing stock by type Conclusion from evidence: demographic information shows that demand for owner-occupied dwellings has been increasing at a slowing rate and may now be hitting a ceiling (Table 9.1).
Table 9.1
Demand and supply of housing
Stock type
1938
March 1979
All tenures: number of dwellings Owner occupied Privately rented Local authority rented Registered social landlord (RSL) rented
10.6m 32% 57% 11% N/a
17.6m 56% 13% 29% 2%
March 2000 (provisional) 21.0m 68% 12% 14% 6%
Source: http://www.housing.dtlr.gov.uk/research/hss/hs2000/index.htm#1
Statistic 2: Household numbers Conclusion from evidence: population information shows the number of households increasing with a forecast rate of 152,000 new dwellings per year. This number excludes the replacement demand that will be required when houses fall down, fall into the sea, etc. (Table 9.2).
Table 9.2
Household numbers
Households Total number of households One-person households Average household size (persons)
1996
1999
2021 (estimated)
20.2m
20.7m
24.0m
+3.8m
5.8m
6.1m
8.5m
+2.7m
2.40
2.36
2.15
-0.25
Source: http://www.housing.dtlr.gov.uk/information/keyfigures/index.htm
198
Change 1996-2021
chap 9 pages
4/3/02
4:54 pm
Page 199
chapter 9 . Doing your research
Statistic 3: New housebuilding Conclusion from evidence: on the supply and demand front, supply of houses remains fairly weak at 137,000 completions last year, compared to 155,000 in 1991. But builders started work on 144,000 houses, compared to 134,000 in 1991 (Table 9.3).
Table 9.3
New housebuilding 1991 Starts
Private enterprise 114,000 Registered social 16,000 Landlords (RSL) Local authorities 3,000 Total 134,000
1991 Completions
2000 Starts
2000 Completions
131,000 15,000
131,000 13,000
120,000 18,000
8,000 155,000
200 144,000
500 137,000
Source: http://www.housing.dtlr.gov.uk/information/keyfigures/index.htm
Statistic 4: NHBC data new build registrations and completions Conclusion from evidence: 90 per cent of new homes are insured with NHBC with whom they register at start and finish of the new build. So we can track the trends on new homes registered and completed in the UK. In May 2001 registrations show a 6 per cent increase on May 2000. There are more registrations than completions. Completions fell by 5 per cent over the last year. This is slightly more up to date than the numbers available from the government which show that in the year 2000 completions were less than starts (Tables 9.4 and 9.5).
Table 9.4
New build registrations, all sectors
Year
Jan
Feb
Mar
Apr
May
Year to date
2000 2001
13,044 14,526 +11%
14,021 11,846 –16%
16,363 13,521 –17%
11,670 11,511 –1%
12,673 13,398 +6%
67,771 64,802 –4%
Source: www.nhbc.co.uk
199
chap 9 pages
4/3/02
4:54 pm
Page 200
The empowered investor Table 9.5
New build completions, all sectors
Year
Jan
Feb
Mar
Apr
May
Year to date
2000 2001
11,886 11,447 –4%
11,487 9,806 –15%
13,278 12,379 –7%
11,909 11,792 –1%
13,541 12,887 –5%
62,101 58,311 –6%
Source: www.nhbc.co.uk
Step 2: What’s going on with house prices and affordability? Statistic 5: Halifax house price index Conclusion from evidence: prices are rising above the average long-term rate (Table 9.6). According to the Nationwide: ‘The long-run trend in annual house price growth is around 5–6 per cent in London compared to 4–5 per cent in the UK as a whole.’ The City and the large number of company headquarters in London create an unusual market (Figures 9.3, 9.4, 9.5). Table 9.6
Halifax house price index
Halifax house price index 1983 June 2001
Monthly change
100 298.2
1.6%
Annual change
9.7%
Source: http://www.halifaxgroupplc.co.uk/view/housepriceindex/hpi_historic_data.xls
200
Average house price £30,898 £92,122
chap 9 pages
4/3/02
4:54 pm
Page 201
chapter 9 . Doing your research
(% change, year on year) 16 12 8 4 0 –4 1995
Figure 9.2
1996
1997
1998
1999
2000
2001
The Halifax publishes the annual rate of house price inflation on its website Source: http://www.halifaxgroupplc.co.uk/view/economicview.asp
400 350 300 250 200 150
South East
Figure 9.3
2001
1999
1997
1995
1993
1991
1989
1987
100
UK
Halifax house price index, South East – Quarter 1, 2001 Source: http://www.halifaxgroupplc.com/view/housepriceindex/press/images/south_east_2.gif
201
chap 9 pages
4/3/02
4:54 pm
Page 202
The empowered investor (Initial Repayment/Income) 45 40 35 30 25 20 15 10 83
86
89
Actual
Figure 9.4
92
95
98
01
Ave (83–00)
Housing affordability, South East Source: http://www.halifaxgroupplc.com/view/housepriceindex/press/london.asp
(Initial Repayment/Income) 45 40 35 30 25 20 15 10 83
86 Actual
Figure 9.5
89
92
95
98
Ave (83–99)
Housing affordability, Greater London Source: http://www.halifaxgroupplc.com/view/housepriceindex/press/london.asp
202
01
chap 9 pages
4/3/02
4:54 pm
Page 203
chapter 9 . Doing your research
Statistic 6: Private housing market statistics Conclusion from evidence: the statistics show prices rising and first time buyers dropping out. In 1979 they were 45 per cent of completions. In 2000 they were 42 per cent of completions (Table 9.7).
Table 9.7
Private housing market statistics
Average house price: England Mortgage completions (UK) Of which first time buyers Average mortgage rate (UK) at end of period
1979
2000 Quarter 1
2001 Quarter 1
% Change 2000–01
£20,000
£102,000
£113,000
+11.1%
715,000 323,000 11.9%
218,000 102,000 7.06%
204,000 86,000 6.73%
–6.4% –16.0% N/a
Source: http://www.housing.dtlr.gov.uk/information/keyfigures/index.htm
Step 3: Underlying market activity Statistics 7 and 8: Government and Bank of England lending data Conclusion from evidence: lending is at an historic high while savings are at lows. Recently Bank of England statistics show that lending growth has tailed off (Figures 9.6, 9.7).
203
chap 9 pages
4/3/02
4:54 pm
Page 204
The empowered investor
%
£bn
14
18
12
16 14
10
12
8
10
6
8
4
6 4
Savings ratio
2
2
Net mortgage lending
0
Figure 9.6
2000Q2
1999Q1
1997Q4
1996Q3
1995Q2
1994Q1
1992Q4
1991Q3
1990Q2
1989Q1
1987Q4
1986Q3
1985Q2
1984Q1
1982Q4
1981Q3
1980Q2
0
Mortgage lending and savings ratio Source: Nationwide, ONS
10
Per cent
9
8
7
3 mth arg.
Figure 9.7
12 mth
Growth rates of seasonally adjusted lending secured on dwellings Source: http://www.bankofengland.co.uk/mfsd/li/010531/sadw.jpg and http://www.bankofengland.co.uk/mfsd/li/010531/lendindi.xls
204
2001 Apr
Feb
Dec
Oct
Aug
Jun
2000 Apr
Feb
Dec
Oct
Aug
Jun
1999 Apr
6
chap 9 pages
4/3/02
4:54 pm
Page 205
chapter 9 . Doing your research
Step 4: Geographical market activity Statistic 9: Inland Revenue regional Stamp Duty Conclusion from evidence: by using the Inland Revenue data on Stamp Duty payable each time a property transacts, we can see significant activity in the South East of England over other areas which appear to be stagnant. Of course a large part of this will be related to the fact that higher rates of Stamp Duty will be payable on higher value properties (Table 9.8).
Table 9.8
Inland Revenue regional Stamp Duty
England and Wales North East North West Yorkshire and Humberside Midlands West Midlands East London South East South West Wales UK
1996–7
1997–8
1998–9
625 10 45 30
800 15 50 35
1,015 15 60 40
30 45 70 165 150 65 15 675
35 50 90 235 200 80 20 875
40 60 110 320 255 95 20 1,110
Source: http://www.inlandrevenue.gov.uk/stats/table15_3.htm
Step 5: The industry cost base Statistic 10: Building costs index Conclusion from evidence: costs are rising only slowly and present no immediate threat to the industry (Figure 9.8).
205
chap 9 pages
4/3/02
4:54 pm
Page 206
The empowered investor
BCIS All-in TPI
BCIS General Building Cost Index
Forecasts
250
200
Index
150
100
50
2000
1995
1990
1985
0
Year
Figure 9.8
Building and tender price trends Source: www.bcis.co.uk. With kind permission of BCIS Limited
Statistic 11: Land prices Conclusion from the evidence: year-on-year growth in land prices and house prices corresponds with land prices rising and falling at a far faster rate. The recent fall in land prices indicates that house prices may follow (Figure 9.9).
206
chap 9 pages
4/3/02
4:54 pm
Page 207
chapter 9 . Doing your research 40% Land prices
House prices
30%
20%
10%
0%
–10% 1992
Figure 9.9
1993
1994
1995
1996
1997
1998
1999
2000
2001
Land prices and house prices Source: www.fpdsavills.co.uk. With permission of FPD Savills Residential Research Department
Decision time The statistics show a sector with strong fundamental characteristics of demand and supply. It is at a mature stage in its recovery from the lows reached in the early to mid-1990s. Short-term signals are that the market has run ahead of prices that are acceptable in the London region, but elsewhere the picture looks fairly stable. Costs appear to be stable. The key growth area is currently the South East with the likelihood that prices in other regions may catch up. We shall now look at a housebuilder in more detail.
207
chap 9 pages
4/3/02
4:54 pm
Page 208
The empowered investor
RESEARCH CASE STUDY 2: THE BERKELEY GROUP PLC What are the alternative companies in the sector? If we look in the share price pages of the Financial Times we find that there are 14 or so housebuilders, including names we are all familiar with such as Barratts, Wimpey and McAlpine. However, because of the evidence in our case study we decide to focus on the South East so we consult the property supplements of national newspapers and look for a company that is advertising heavily in the South East. Berkeley Homes fits the bill. It is focused on high-value homes in London and the South East.
What is the company’s key product? The company’s product is obviously new houses. But what type and where? We consult the company’s website www.berkeleygroup.co.uk. For The Berkeley Group plc the key product appears to be premium, highvalue homes in London and the South East of England. We next look at the investor relations section of the company’s website which contains news releases for the last two final and interim results. We ring up the company secretary and ask for a copy of the annual report. In the meantime we download the most recent results from both the website and the RNS filings on the Ample Interactive Investor website. In the Results statement we find the Chairman’s comments and detailed financial results, all of which we download. There are lots of useful nuggets of information, including the fact that the company’s average selling price is £251,000 with 2915 units sold in 2000.
Is it growing? To answer this question we need to consult the basic facts. We could use the annual reports or a service such as Hemmington Scott’s REFS. But since the company website conveniently contains all the information we need, we shall use that. We can see the record from the company’s investor relations site and annual reports. In the last year profits are up 24 per cent. They show three-year earnings per share growth of 62.6 per cent or 17.6 per cent pa.
208
chap 9 pages
4/3/02
4:54 pm
Page 209
chapter 9 . Doing your research
From the results statement on the website, the actual number of units sold in 2001 appears to be falling. However, this is because of the company’s strategy of focusing on higher value units at higher margins. The same results show the average unit price in 2001 has risen to £278,000 from £251,000. This much is stale news. What we want to know is whether Berkeley can keep up the pace (Table 9.9).
Table 9.9
The Berkeley Group plc growth
The Berkeley Group plc
1996
1997
1998
1999
2000
Turnover/sales (m) Profit before tax (m) Earnings per share (p) Dividend (p)
334.3 43.4 33.3 8.0
485.3 75.1 49.3 9.1
599.6 100.3 60.6 10.3
697.3 110.4 62.9 11.2
798.9 143.6 80.2 12.9
Source: www.berkeleygroup.co.uk. With permission of The Berkeley Group plc
We next look at the consensus earnings estimates in Ample Interactive Investor’s quote for Berkeley stock. This is under the Broker Forecasts tab. We find that earnings growth of 9 per cent is forecast. Then we turn to the Chairman’s statement to determine how things look from his perspective. Apparently all is going well: The housing market in the past 12 months has been very solid … Early in 2001 there were some concerns about the impact on the housing market of the ‘dot com’ shake-out and the falls in the stock market. Any such effect was offset by falling interest rates, however, and the market has remained healthy for the first half of 2001. Many factors interact to determine the buoyancy of the housing market and one of these is the house price/earnings ratio which, in London and the South East, is relatively high. Equally, interest rates are low, which makes homes more affordable, while employment is high. The feel-good factor, so important to the confidence of our purchasers, continues to be strong. Sales reservations in May and to this point in June have been at record levels.
The Chairman goes on to comment on the current level of sales: The year has started strongly with the level of sales reservations ahead of previous years and also at excellent margins. We now have a number of very large schemes under construction and these will make meaningful contributions in the current year. We believe that the Group is excellently
209
chap 9 pages
4/3/02
4:54 pm
Page 210
The empowered investor placed to make further progress in the medium term. As long as the housing market remains satisfactory, we look forward with confidence to another successful year in 2001/2002.
Can it sustain growth? The key factors for sustaining growth in a housebuilder are obviously the availability of land on which to build and capital to sustain growth. According to the Chairman’s statement the company now controls 19,400 plots of land, which represent around seven years of supply: i.e. 19,400 divided by this year’s units sold of 2915. Again in the Chairman’s statement it was revealed that planning was obtained on 7000 plots in 2000 alone. So there seems no problem on that front. What about costs? How do the company’s financial numbers and ratios shape up? We again look at the accounts. The margin (PBT divided by turnover) has risen from 15.8 per cent in 1999 to 17.9 per cent in 2000 and is flirting with 20 per cent in the interim results. The gearing (long-term debt divided by net assets) is modest at around 28 per cent with interest cover very high. In the financial year ending 30 April 2000, the return on equity (net profits/shareholders equity) was 13.4 per cent against 11.8 per cent last year.
What is its market position? According to Chairman’s statement downloaded from the website: During the past five years, we have placed increasing emphasis on urban regeneration and have built up the skills and expertise to undertake the more difficult and complicated schemes which this involves. With the Group’s commitment to sustainability, such schemes, we believe, will be the thrust of our development in the future and reinforce Berkeley’s status as one the country’s leading urban regenerators.
We go to the broker research website Multex Investor (www.multexinvestor.co.uk) and consult an analyst’s report, ‘Berkeley Group, strongly positioned in a healthy market’, by Clyde Lewis of HSBC. We find that The Berkeley Group is viewed by the analyst as a market leader in urban developments, particularly in the South East. There are two free recent broker reports, one by Merrill Lynch and the other by HSBC on the Multex website. The HSBC report is a buy recom-
210
chap 9 pages
4/3/02
4:54 pm
Page 211
chapter 9 . Doing your research
mendation. It reveals that earnings growth of 18 per cent is forecast for the next year. According to the HSBC analyst: ‘We continue to see Berkeley as a well-positioned stock in a cheap subsector. Its long land bank and focus on inner city, mixed use schemes should ensure its growth rate exceeds the sector in the medium term.’ There is some useful detail in the report on the historical margin trends and the long run average selling price. A useful piece of information contained in the HSBC report is that, by type of property built, apartments now account for 70 per cent of completions. A full accounts spreadsheet gives a detailed breakdown of where the profits are coming from. A different view is contained in Merrill Lynch’s update, where they rate the company a ‘long term neutral’. Earnings growth of 13.8 per cent is forecast for the coming year: ‘Forward sales at secure high margins and the breadth of revenue sources including unlocked commercial property profits, underpins 10 per cent plus growth in the next 2 years.’ Different reports have different styles. The Merrill Lynch report comes with a complicated rating system that it is probably safe to ignore. There are rafts of complicated numbers including EV/EBITDA, EV/Sales. EV stands for enterprise value. But most of the numbers can be easily translated. For instance, Price/Book is the price divided by the book value and is 1.09, indicating the price is close to the book assets. CFPS is cash flow per share and for Berkeley it is £1 per share. This is clearly a very cash generative business at the moment, well supported by asset value. The HSBC report is much more enthusiastic and points to the recent sales records in May and June along with the fact that the company has strengthened its land bank in the past 12 months to secure future sites. Both reports stress the modest P/E ratio relative to the entire sector. Berkeley is trading on a P/E of 7.2x 2001 earnings whereas the sector as a whole is said to trade on 7x 2001 earnings. Merrills has a useful number indicating that the 2002 P/E is 40 per cent of the home market 2002 P/E. Since the 2002 P/E for Berkeley is stated at 6.7x the whole market must be trading at 16.75 2002 earnings. Either way the company is trading at a huge discount.
Management quality We look on the website and see a list of impressive biographies of nonexecutive and some long-serving internal candidates, including the cofounder of the company, Anthony Pidgely, who is Group Managing
211
chap 9 pages
4/3/02
4:54 pm
Page 212
The empowered investor
Director. We check the latest news announcements to the stock exchange whereby companies must reveal any director changes. These are listed in the ‘News’ tab in the price quotation for The Berkeley Group on the Ample Interactive Investor website. We find that the founder’s son (Tony K. Pidgely) is leaving the company. The annual report contains details of director shareholdings and reveals that collectively they own 5.395 million and have options over 3.3 million shares. There is comfort for the City in having Fred Wellings, who wrote the book on how to analyze the sector, on the board as a non-executive director. According to Merrill Lynch: ‘If visibility, deliverability and sustainability are the golden rules of success then Berkeley certainly scores 2 out of 3.’
Are the pros buying? We again check the ‘News’ tab in the Berkeley quote on the Ample Interactive Investor website for stock exchange announcements. There has been a flurry of buy and sell deals around the end of the US tax year by the founder, A.W. Pidgely, alongside the exercise of an option. Since they seem to net out at little change we shall assume that they are tax related. Among the institutions, Aegon and Fidelity have been selling a little on recent weakness while Morgan Stanley and Legal and General have been buying. All retain significant stakes with Morgan Stanley taking advantage of weakness to buy a 3 per cent stake from a zero position.
Is the share price reasonable? We conclude that it is:
212
●
P/E for the coming year is at a discount to the sector while the exposure to growth areas indicates it has a higher quality exposure to the sector’s underlying favourable prospects.
●
Growth seems assured by favourable market conditions and a long pipeline of sites on which to build.
●
Company finances are strong enough to support growth and conservative enough to withstand a downturn.
chap 9 pages
4/3/02
4:54 pm
Page 213
chapter 9 . Doing your research
Risks? 1. The HSBC broker report highlights the following risks. The housebuilding sector has traditionally boomed when interest rates were falling and bust when they were rising. With rates turning up, there is a risk of bust. However interest rates are not likely to rise as much as in past cycles and so the risk may be overstated. The biggest risk is of a full-scale economic downturn that hits confidence. But this is not currently a strong likelihood. 2. The Merrill Lynch report highlights the same risks, pointing out that exposure to rising interest rates is less than in previous cycles because of the higher prevalence of fixed interest rate mortgages. But it argues out that ‘70 per cent of new mortgages last year were fixed rate, for terms of up to five years’. In 1989 some 64 per cent of net earnings of a first-time buyer went on mortgage repayments; now the figure is 35 per cent. In London the corresponding figure was 74 per cent in 1989 and is 44 per cent now. So the exposure to changing interest rates is less pronounced than in previous cycles.
213
chap 10
4/3/02
4:55 pm
Page 214
chap 10
4/3/02
4:55 pm
Page 215
10 Online resources survey Selecting stocks Broker research reports UK broker rankings Independent analysis Other research sites Stock screening tools Helpful broker and fund manager sites IPOs Economic angle Official resources Technical analysis Sectoral research resources Pharmaceuticals and biotechnology Property Media Chemicals, industrials and oils Banks and financial services Technology Selecting other assets Portfolio monitoring 215
chap 10
4/3/02
4:55 pm
Page 216
Financial news Newswires UK data and market prices
chap 10
4/3/02
4:55 pm
Page 217
chapter 1 . Why the stock market?
Online resources have expanded at such a pace that they may appear to be overwhelming. It has never been truer that you have to look hard to find what you need and rigorously pick out material of quality and utility. So this guide has broken down the most useful sites to tune into the way you actually need to use them as tools to find the necessary facts in order to make profitable investments.
SELECTING STOCKS Fundamentals Offers free annual reports on thousands of companies in dozens of countries, not just the UK. Increasingly you can download them in a PDF file rather than getting them by post. www.hemscott.net Strong on basic accounts, director and advisor details and institutional shareholders. You have to subscribe to get many of the details. www.hoovers.com/uk Well-processed arrangements of financial data and useful links. www.ir-soc.org.uk The Investors Relations Society maintains a list of links to hundreds of investor relations sites maintained by the companies themselves. Companies’ investor relations sites vary sharply in their usefulness, but are always worth checking. www.wilink.com
BROKER RESEARCH REPORTS The only site offering a comprehensive selection of broker research to the investing public. It stocks tens of thousands of reports on over 2500 companies and from 50 research providers. Also stocks international companies.
www.multexinvestor.co.uk
217
chap 10
4/3/02
4:55 pm
Page 218
The empowered investor
Free summary research from the analysts of both Merrill Lynch and HSBC for account holders.
www.mlhsbc.com
UK BROKER RANKINGS Publishes an annual survey of the analysts as the Reuters Survey of UK larger and smaller companies. Also covers other geographical areas. www.primarkextelsurvey.com Primark Extel publishes a rival survey of much the same thing. www.tempestdirect.co.uk
INDEPENDENT ANALYSIS This excellent site offers specialized technology research from an entirely independent perspective by top-ranked former brokerage analysts, Anne McIvor and Judith Allen. www.moneyguru.com This subscription site offers company-by-company analysis and model portfolios. www.breakingviews.com Set up by Hugo Young, an FT journalist, this subscription site writes in the style of the Financial Times LEX column. www.equityinvestigator.com
OTHER RESEARCH SITES www.equity-development.co.uk
Focuses on smaller companies on the main
market. Set up by former City analyst, Gareth Evans, this focuses on smaller and OFEX quoted companies. www.unquoted.co.uk This site focuses on OFEX companies. www.itruffle.com This site focuses on smaller companies in the main market and offers some company interviews and investor presentations for free. www.equitygrowth.net
218
chap 10
4/3/02
4:55 pm
Page 219
chapter 10 . Online resources survey
STOCK SCREENING TOOLS Hemmington Scott’s REFS is to my knowledge the most comprehensive screening tool available in the UK market and is modelled on those available to professional investors. At over £700pa it does not come cheap. www.bridgefinancialsystems.com This is the institutional version of Hemmington Scott’s stock screens, although a version is available for retail customers. www.stockscreener.com This American site has free screens for US stocks. www.stocksearch.com Another American site with free screens on US stocks. www.zachs.com Has a number of limited screening tools. www.thescreener.com A subscription site that has a global screener which pulls out stocks using a mixture of technical and fundamental analysis. Some bits are available free on Yahoo Finance. www.hemscott.net
HELPFUL BROKER AND FUND MANAGER SITES Beeson Gregory, a specialist investment bank, currently makes available all its research for users of its site who register for free. www.charles-stanley.co.uk Has a research section that offers some useful economic and sector weight information as well as stock screens on yield, Price/Book and PEG. www.collins-stewart.co.uk Offers smaller company research from its team of analysts and a technical analysis product from Chris Chaitow, a wellknown technical analyst. www.durlacher.co.uk Durlacher, a technology and internet specialist, offers research and sector reports on its site. www.redmayne.co.uk Includes stock picks and daily market comment from Redmayne Bentley, a national chain of retail brokers. www.mlhsbc.com Free summary research from the analysts of both Merrill Lynch and HSBC for customers. www.baring-asset.com If you go into their private clients section, you can find updated news and views on the bond and equities markets from their research teams. www.beesonresearch.co.uk
219
chap 10
4/3/02
4:55 pm
Page 220
The empowered investor
If you go into the institutional section you can find their excellent market focus outlining Deutsche Asset Management’s views on the equities and bond markets. www.chasefleming.com In the asset management area you can find weekly updated news and views from Chase Fleming’s strategy department. www.deam-uk.com
IPOs Backed by Durlacher, the specialist technology brokerage, this offers access to IPOs with a brokerage facility. www.eo.com A site with a European angle allowing you to apply for IPOs online for a wider than usual range of issues. www.issuesdirect.co.uk Another site with a facility for applying for IPOs. www.ipo.com A big US site with the same aims as its UK equivalents and a team of journalists covering the market. www.nothingventured.com
ECONOMIC ANGLE For fans of both the top-down and bottom-up approach to stock selection, economists are always worth consulting. There is solid economic coverage on the sites of Chase Fleming, Deutsche Asset Management and Baring Asset Management. Best official sources for the UK are the Bank of England and HM Treasury. For US economic information, the best source is the Federal Reserve Bulletin, which is the monthly digest of the board of governors of the Federal Reserve System. The Economic Intelligence Unit (EIU) publishes reports on 160 countries, while The Economist looks at 100 countries. The United Nations publishes useful information for most UN countries. www.economist.com A subscription site offering the contents of the weekly magazine and some useful archives and international data. www.hm-treasury.gov.uk A compact and well-designed government website with access to economic forecasts and indicators, budget details and statistics such as the National Asset Register. www.bog.frb.fed.us Site of the US Federal Reserve System which has detailed coverage of the US economy including the monthly bulletin.
220
chap 10
4/3/02
4:55 pm
Page 221
chapter 10 . Online resources survey www.chasefleming.com
Contains updated information on markets and
strategy. Has some very high quality downloadable quarterly research from the company’s strategy and research departments. www.bankofengland.co.uk The Bank of England Quarterly allows you to follow events in the economy and financial markets in as much detail as you can take. Good summaries on page one. www.lombard-st.co.uk Forecasts and coverage from Prof. Tim Congdon, a monetarist economist and former government advisor. www.dam.com
OFFICIAL RESOURCES UK The main source for compulsory filing of accounts and information relating to all partnerships and companies in the UK. Useful for researching directorships. If you are interested in investigating whether that obscure company listed in the accounts really owns vast property assets or a hidden stake in the next Microsoft, this is the place to find out. www.statistics.gov.uk The main government website for UK statistics. Includes a cumbersome three-level database arranged by themes. The numbers you want are probably there if you look hard enough. www.hm-treasury.gov.uk The Treasury site contains access to lots of aggregate numbers such as the GDP and money supply numbers. www.londonstockexchange.com The official LSE site contains a useful database of statistics about sectors and individual stocks. It also has lots of detail on indices and listing procedures and rules. www.open-gov.uk This is the gateway to all the main UK government sites. www.ofex.co.uk The site is maintained by brokers JP Jenkins to display the prices at which they believe you can trade stocks that are members of the UK off-exchange facility (OFEX). OFEX is part of JP Jenkins. www.companies-house.com
221
chap 10
4/3/02
4:55 pm
Page 222
The empowered investor
Non-UK The site of the European version of the NASDAQ overthe-counter market for high technology exchange offers prices and information on all EASDAQ stocks. www.europa.eu.int The site for the European Union has access to plenty of statistics. www.nasdaq.com An exceptional website offering stock selection aids as well as pricing and information. It was one of the first sites with streaming self-updating information and is now offering a very good free stock screen. www.nyse.com The website of the largest stock exchange in the world. Contains (cumbersome) pricing information and some educational material. www.edgar-online.com One of the best examples of the use of the internet to my knowledge, although poorly designed. All US companies have to file their stock exchange documents here. Particularly useful once you work out what the document codes stand for, i.e. the 10K are the full year annual reports, the 9K is the interim unaudited half yearly report, while the 8K is filed each month and shows any change which affects debt or equity capital in issue. www.easdaq.com
TECHNICAL ANALYSIS Has free charting on 24,000 securities and some free features such as 52-week highs and lows, momentum, stocks being shorted and other interesting indicators. www.sta-uk.org UK professional body of technical analysts. www.mta.org World professional body of technical analysts. www.mta-usa.org US branch of the world body of technical analysts. www.trend-analysis.co.uk UK subscription site for charting ideas. www.traders.com A US site with lots of trading ideas on US stocks. www.elliotwaves.com A site devoted to the Elliot Waves technique of technical analysis. www.bollingerbands.com One of a group of sites devoted to the theories of John Bollinger. www.bigcharts.com
222
chap 10
4/3/02
4:55 pm
Page 223
chapter 10 . Online resources survey
SECTORAL RESEARCH RESOURCES Most of the major accountancy firms (Coopers, KPMG, etc.) provide sectoral reports on trends within the sectors, while several companies produce product and markets research. www.ey.com/uk Ernst & Young produces regular surveys by its in-house experts on the state of the UK corporate world, often providing useful sectoral views from a bean counter’s vantage point. www.mintel.com Lots of regularly updated consumer reports. www.datamonitor.com A flow of large, well-researched reports with good graphs and predictions.
PHARMACEUTICALS AND BIOTECHNOLOGY www.biochemsoc.org.uk The Biochemical Society of the UK. www.fda.org The website of the Federal Drugs Administration which
must approve all new drugs. Approvals are published on the website. www.sturzas.com Provides specialist biomedical research to subscribers. www.newscientist.com New Scientist is a popular weekly scientific maga-
zine that provides easily understandable explanations of current issues and discoveries.
PROPERTY This is the site of the property industry weekly, Estates Gazette, and includes plenty of information and links. www.propertymall.co.uk Propertymall includes links to sites of the large firms of surveyors. These often contain downloadable research and information of high quality. www.rics.org This site of the property industry professional body contains some useful price indices and information about the profession. www.fpdsavills.co.uk Like many of the sites of large professional firms of surveyors, Savills’s website includes some of the output of its research department on market conditions. www.weatheralls.co.uk Produces some useful research on the state of the market. www.estatesgazette.co.uk
223
chap 10
4/3/02
4:55 pm
Page 224
The empowered investor
MEDIA Provides weekly news and comment on the media, internet, advertising and marketing worlds. www.abc.org.uk The Audit Bureau of Circulation carries a wealth of information on sales trends for the printed media. www.nma.co.uk
CHEMICALS, INDUSTRIALS AND OILS www.chemweek.com
Chemicals Week is the weekly magazine of the chem-
icals industry. An umbrella for the global manufacturing industry with lots of useful links. www.cia.org.uk The site of the Chemical Industries Association has a range of industry information. www.oilandgas.com An umbrella site with links to many useful industry sites. www.eia.doe.gov The UK government department site (Environment) has lots of useful industry information. www.miningnews.net An excellent subscription site for researching resources stocks employing a team of award winning journalists and analysts. There are sections for gold, coal, nickel, diamonds and other resources with regular reports on sectors of interest. www.manufacturing.net
BANKS AND FINANCIAL SERVICES www.americanbanker.com
Site of the American Banker, an American bank-
ing magazine. The Building Society Association has useful information on lending and the state of the housing market. www.fsa.gov.uk The site of the UK’s super-regulatory body for financial services. www.bsa.org.uk
224
chap 10
4/3/02
4:55 pm
Page 225
chapter 10 . Online resources survey
TECHNOLOGY A leading US site focused on technology stocks providing market news, analysis and discussion boards. Parts of the site are for subscribers only. www.redherring.com Red Herring is a breaking news and information site for the technology industry with a US focus. Parts of the site are subscription only. www.siliconinvestor.com
SELECTING OTHER ASSETS Fixed interest securities (bonds) The kind of information required to pick a bond is of course very different from equities. There is less emphasis on fundamental analysis. Bond investors need information on: ●
the direction of interest rates
●
the inflation rates
●
the features of the bonds.
Some of this information is available in the economic sources listed above but there is also specialist information available from the leading credit rating agencies, Standard & Poor’s, Moodys and Fitch. Information on bond prices can usually be found in the Financial Times or on Bloomberg. www.bloomberg.co.uk Has a number of sections covering the bonds market and interest rates. www.psa.com The site of the US Public Securities Association shows how far ahead the USA is in popularizing bond investing. www.bondsonline.com A comprehensive site for the US-oriented bond investor with news and commentary, tools and calculators. Has useful sections on the various categories of US bonds, along with coverage of yield spreads for US corporate bonds. There is even a chat room. www.fitchibca.com The site of rating agency Fitch IBCA contains news of changes in ratings.
225
chap 10
4/3/02
4:55 pm
Page 226
The empowered investor
Venture Capital Website of the British Venture Capital Association. Useful to both entrepreneurs and investors. www.3igroup.com 3i Group is one of the largest UK venture capital funds. Useful for finding out what the professionals are investing in right now. www.jpmhq.com Hambrech and Quist are a large international technology-oriented fund. Again useful to know where the professionals are directing their investments. www.venturedome.com A news site aimed at professionals in the venture capital industry with good stories on the latest industry events. www.bvca.co.uk
Hedge funds HedgeFund.net is a listing of hedge fund information and performance that currently encompasses 31 different strategies. It includes over 1800 of the world’s most talented hedge fund managers. www.tassresearch.com This database of some 2000 hedge fund providers collects information on the types of strategies followed, along with details of the managers. www.hedgefund.net
Alternative assets www.trend-analysis.co.uk
This site is focused on foreign exchange and
commodities research. A US-focused site looking at alternative assets. www.sothebys.com Site of the leading international auction house. www.christies.com Another leading auction house. www.assetalt.com
PORTFOLIO MONITORING Risk assessment This is by far the most useful and important site for checking out your portfolio’s risk characteristics and is provided by an offshoot of JP Morgan, the Wall Street investment bank. You load up your details and it comes up with a risk grade relating your portfolio risk to market risk. It also suggests changes in your portfolio to reduce
www.riskmetrics.com
226
chap 10
4/3/02
4:55 pm
Page 227
chapter 10 . Online resources survey
risk and goes some way to quantifying your downside exposure. Works for UK and global shares, bonds and funds. www.finportfolio.com An excellent US site allows you to risk rate your portfolio and check out its overall risk characteristics. www.thomsonfn.com Has a number of tools to compare risk versus returns. www.barra.com An institutional site with a number of useful pages explaining risk. www.efficientfrontier.com An excellent educational oriented site on risk versus return. www.wsharpe.com Has the latest views of the Nobel Laureate and risk theorist, Bill Sharpe.
Insider trades Monitoring trades by directors and officers of companies is popular in the USA where sites such as www.insiderscores.com rank directors on the success of their previous trades. www.thomsonfn.com also focuses on the trades of institutional investors, who are believed to be worth following because they are close to companies. No UK sites currently exist which track these trades so closely.
FINANCIAL NEWS These sites provided by UK newspapers and magazines online need no introduction. For an interesting global perspective look at the sites of the Wall Street Journal (www.wsj.com), recognized as the prime source of financial information in the USA and the website of Barrons (www.barrons.com), a weekly digest of US stock market events. Local newspapers in each area often provide sharply focused coverage of local businesses, for example, the Liverpool Echo and Daily Post (www.liverpool.com) covers local transport businesses in the UK port of Liverpool, while the San Francisco Chronicle (www.sfgate.com) provides coverage for local software companies in San Francisco. The list below covers the major UK national newspapers. There are particularly good search engines on the Financial Times and Guardian sites.
227
chap 10
4/3/02
4:55 pm
Page 228
The empowered investor www.economist.com www.telegraph.co.uk www.financialnews.co.uk www.ft.com www.newsunlimited.co.uk www.investorschronicle.co.uk www.investorsweek.co.uk www.scotsman.com www.sharesmagazine.com www.thisismoney.com www.the-times.co.uk
NEWSWIRES www.afxexpress.com www.bbc.com www.bloomberg.co.uk www.breakingviews.com www.bridge.com www.citywire.co.uk www.cnnfn.com www.moreover.com www.reuters.com www.digitallook.com
UK DATA AND MARKET PRICES www.advfn.com www.freequotes.co.uk www.ftmarketwatch.com www.iii.co.uk www.moneyextra.com www.proquote.net www.sharepages.com http://finance.yahoo.co.uk
228
appendix
4/3/02
4:56 pm
Page 229
Appendix: Voices from the bulletin boards Tipsters The bubble Risk Technical analysis Shareholder democracy At the height of the UK bubble: February 2000
229
appendix
4/3/02
4:56 pm
Page 230
appendix
4/3/02
4:56 pm
Page 231
chapter 1 . Why the stock market?
TIPSTERS With an Infinite number of Monkeys, some are bound to come up trumps!! Bri
[email protected]
18-Oct-2000 We need an initial source of info about shares and tipsters are as good a way as any of bringing a share into the spotlight. This should obviously be followed up by your own research (DYOR) and price monitoring before buying. Sunday newspaper tips are the worst IMHO written by journalists and not analysts. Bulletin boards have their critics, but I am a big fan, especially when you find those with serious posters who can link you into other shares that you may not have considered. Stockbrokers, like travel agents and other intermediaries, must be getting a little worried by the power of the internet. Matt Blacker
[email protected]
5-Aug-2000 I would rather pay for a service which (like the professionals have in the City) gives me almost instantaneous info, refs, trades, prices, etc. This would allow me to make up my own mind about what action to take and would be especially attractive for active traders. For long-term traders, the City boys have already hit the price by X% (insert your own guess) before you can buy into the stock – so you have to hang on there a bit longer to realize a gain, with of course the danger that its only being ramped and that you might be sitting on a paper loss for some time. jamie
[email protected]
20-Oct-2000
231
appendix
4/3/02
4:56 pm
Page 232
The empowered investor
Naturally any sensible investor will pay a reasonable amount for quality tips. However, most are also Gardeners and they know that gardening advice tells them to put the plant in the shade but not the sun, put it into ventilation but not a draught, keep it damp but not wet. They also know that to do these things they must stand over the plant all day and do nothing else. Same with investment advice. In the end time, chance, contrary advice and every other variable makes you rely upon common sense and experience but proven, inexpensive and quick advice is always worth it if you can get it. That is also how you run a business. Stan Kaiser
[email protected]
18-Oct-2000 After paying TW for access to his tips, I find each and every one has tanked. Wiggins, InterX and others are now way below what I paid. Hell, I bought InterX at £9 and then doubled up when it fell to £6 because of his recommendations. From now on I will Do My Own Research and not rely on other ‘more experienced’ people to do it for me. Next fun bit is telling the wife on Valentines Day that all our savings have gone:-( Steve
[email protected]
19-Feb-2001 I do not normally buy any shares recommended by anyone. The tips give me a lead to further my research. And then subsequently after thorough scrutiny of the companies I will then decide whether to buy or not. This is just pure common sense. Anyone who just buys on tips given is trading on dangerous grounds. Robert Wong
[email protected]
12-Mar-2001 I would keep away from these analysts … they are nothing but bunch of glorified salesmen and retail investor are the last one to gain if lucky from their tips … once their clients and chumps have bought the shares. Just ignore this Kavanagh, Winnifrith etc etc donkeyholes!!!
232
appendix
4/3/02
4:56 pm
Page 233
chapter 11 . Tipsters
A Norris
[email protected]
11-Mar-2001 Thought for the day: If tipsters were any good at tipping, they would be rich men instead of advisers to rich men (or should that now be ‘poor’ men!) Grister
[email protected]
6-Mar-2001 The danger comes from treating these people as ‘experts’ and following their recommendations slavishly. However, when combined with good practice such as setting and activating stop-losses, they can be a useful source of investment ideas – but only that! It is the investor’s responsibility to manage his/her portfolio properly. However, there is great difference across the tipsheets and tipsters. Some are professional and are frank about their mistakes; the other extreme are rampers who I suspect to be on the criminal margin, i.e. ramping for self-gain. IMHO, of course. John Page
[email protected]
26-Feb-2001 During the bull run in the market a child of 12 could have picked a string of winners. Since then they have lived off those good times. However, the tide has turned and they are now shown up as the charlatans they are. Let this be a lesson to us all. Crooked Tipsters
[email protected]
19-Feb-2001
THE BUBBLE An analyst is someone who is too bullish when a company is doing well, and too bearish if the company does not reach their expectations.
233
appendix
4/3/02
4:56 pm
Page 234
The empowered investor
Oldiron
[email protected]
2-Apr-2001 I feel really sorry for people who have lost money, with the so-called experts tips, I am very surprised that these guys did not tell you to sell and bail out shares like InterX, there was no sign of them going back up, I basically run a stop loss, and wait for some evidence of the shares going back up even if I pay more for them than what I sold them for. If a share goes down more than 25 per cent, there is something wrong, those guys know this, why did they not tell us? Strange! Craig Wyper
[email protected]
6-Mar-2001 What really annoyed me was that if you opened an investment magazine last year about a hundred inserts imploring you to get ‘Tip top profits from top tips’ would fall out on the floor. Hopefully this collapsing market will see an end to this. Realistically, the same people attacking the tipsters are the same people who would have lost their shirts at Lloyd’s Insurance. Read the small print! GrimReaper
[email protected]
21-Feb-2001 At the time the chiefs of BT were bidding for the G3 licences the share price was? (Around £12–15) If that were to be sustainable the company had to become global, almost at any cost. They had a tiger by its tail and could not let go, hence the overspend during the last twelve months? A.Dyer
[email protected]
18-May-2001 Greed! I have worked within the internet arena and it is now clear that unless a business can reduce costs or improve revenue then it does not make sense to make a large investment. Old Economy Rules still make sense. However do not be pessimistic as good use of the internet can provide both of these benefits.
234
appendix
4/3/02
4:56 pm
Page 235
chapter 11 . Tipsters
Oma
[email protected]
7-Aug-2001 It is unbelievable to think that any company could be worth several billion pounds when its revenues for the year were less than 30 million and its losses were even more, and profits were years away. (Baltimore and all the other 90 per cent fallers). Get real people and invest in reality, not hype. Everyone is to blame, the hypers, the grabbers, the greedy. Martin Lawlor
[email protected]
7-Aug-2001 This is a classic example of people not being prepared to take responsibility for their own actions. If a stock went up it was the investors who claimed it was their brilliant choice and they deserved the rewards – if a stock went down the investors claimed they were badly advised and they wanted compensation. Human nature – isn’t it wonderful! nick 6-Aug-2001 The bigger companies just take everyone else to the cleaners by manipulating the market with their comments and trading power. Having faster (mis) information just makes the problem worse as the private investors are likely to have a quicker reaction to the news in terms of buying and selling. Who knows – net companies might actually be worth something after all, but they’re so volatile that no one can get a good valuation. Happy day trading! Shifty
[email protected]
6-Aug-2001 A wise trader would try to understand all methods of stock picking; for what is important to other market participants necessarily affects their decisions and therefore should by default be important to anyone who wants to understand why shares move the way they do.
235
appendix
4/3/02
4:56 pm
Page 236
The empowered investor
Tom
[email protected]
11-Apr-2001
RISK Risk is completely relative to the individual and their circumstances, therefore risk measurements could be very misleading if people don’t interpret them properly. Mike Embrey
[email protected]
23-Apr-2001 If I’m walking along a cliff edge on a windy day, I know it’s risky, it seems odd to try and put a figure on that, say 457, what? Keith Beef
[email protected]
21-Apr-2001 On what basis are the risk judgments to be made? Empirical, analytical, evidential? A relative measure of risk is not a measure of total risk. Seems a useful but limited first step. Gerald Rosenberg
[email protected] 20-Apr-2001
Well known ‘fact’ that no one admits to being a bad driver, bad lover or bad manager. Honest Al
[email protected]
6-Jul-2001
236
appendix
4/3/02
4:56 pm
Page 237
chapter 11 . Tipsters
TECHNICAL ANALYSIS In a freely traded share or commodity price takes into account all known facts. So please do not confuse me with fundamentals. sri
[email protected]
5-Apr-2001 Following charts is for those who like playing with crayons rather than engaging in considered analysis. Of course, if we all did charts it would be a self-fulfilling prophecy … in the short term. Nick Beart 4-Apr-2001 Every tipster/tip sheet has some hidden objective. You simply don’t know whom to believe. Charts are impartial and work especially in a world of mass-market manipulation and market abuse. Long live the chartists. richard scarlett
[email protected]
3-Apr-2001 All Technical Analysts have 20/20 hindsight but not a Scooby Doo about the future – they’d be as well gutting a chicken and reading the entrails! Tom Watson
[email protected]
2-Apr-2001 Technical analysis is the only way to make logical decisions that can be back tested, on when to buy and when to sell. It works on any market and any timescale.
237
appendix
4/3/02
4:56 pm
Page 238
The empowered investor
Mike Alexander
[email protected]
2-Apr-2001 TA is merely a consensus accepted by insiders. It does not follow any real flow being only supported by itself. It is a more complicated version of herd following. F.C. Mole
[email protected]
18-Mar-2001
SHAREHOLDER DEMOCRACY The big boys in the City have all the say at meetings. A couple of questions from the floor are taken normally from some shareholder who has bought in at a bad price. As the law stands, to get an EGM to stir things up you need 10 per cent of the shareholders to agree to get a meeting – very hard to get that amount. I have tried three times to do this and normally you can only get 4 to 7 per cent. Ed Fits
[email protected]
AT THE HEIGHT OF THE UK BUBBLE: FEBRUARY 2000 The price of Baltimore on Nasdaq at the moment is $177 which is about £118 if the share price is directly comparable. Like I suspect most investors only have a vague idea of what Baltimore does. However, internet security seems to be vital and more important it must be highly specialised and thus pose a significant barrier to entry insofar as competition is concerned. Last week the results showed an annual turnover of £23m and a market capitalisation of about £4bn which scared some investors. However, Freeserve’s interims reported a turnover for 6 months of £7m and it has a capital value of nearly £8bn. Which company would you rather invest in? I agree with Mr Hutchison’s wise words. Stop reading too much into
238
appendix
4/3/02
4:56 pm
Page 239
chapter 11 . Tipsters
some fluctuations and look at the bigger picture. This is a major company for the future and you will really kick yourself in a few years’ time if you sell out now. I bought in at £48 when the price graph was pretty steep and I daresay similar discussions were taking place about whether or not the price was too high then. Sit tight, this company looks like a real winner. AlyB 28/02/00, 21:13
239
new index
4/3/02
4:57 pm
Page 240
Index
ABN AMRO UK Growth 126–7 ABN AMRO UK Income 140–1 accounting practices 15, 51–2, 63–5 acquisitions and mergers 65 Aggreko 122 aggressive accounting 15, 51–2, 63–5 Airtouch 22 Alfred McAlpine 138 Alkane Energy 123 Allen, Judith 218 Alottafun Inc. 32 alternative investments 105–6, 226 Amazon.com 182, 185 American Express 160 Ample Interactive Investor 31, 35, 50, 74–5, 182 analyst neglect effect 18 analysts Chartered Financial Analysts (CFA) 110 consensus earnings forecasts 12, 50 independence of 35 recommendations 8, 17–18, 20, 66–7 see also research anchoring 38–9 annual reports 194, 217 AOL 31 AQ 20 arbitrageurs 22–3 ARM 124 art and antiques 105–6 asset allocation decision 106–7 asset plays 165 assets book value (BV) 15–16, 51, 52, 120 hidden assets 53 intangible assets 53 intellectual assets 52
240
turnover ratio 51, 52 AstraZeneca 122–3 Austin Motor Car Company 149 Ayling, Robert 40 balance sheets 15, 63–4 Baltimore 238–9 Bank of England 197, 203 banks 61, 224 joint-stock banks 145–6, 187 bar charts 75–6 Barnes & Noble 182 Barton, Mark 185 Baruch, Bernard 170 BAT 154–5 beating the market 9–11 Beeson Gregory 219 Behaviouralists 10, 39, 56–7 Bellway 137–8 benchmarks 100–1 Berkeley Group plc 208–13 Berkshire Hathaway 158, 160–3 Bernard Wardle 152 betas 126 Big Bang 3 biotechnology companies 223 Blue Chip Stamps 159, 160 Blunt, Sir John 174 Bollinger bands 88–9, 94 Bolton, Anthony 134 bonds 104–5, 151 asset allocation decision 106–7 online resources 225 book value (BV) 15–16, 51, 52, 120 Borders 182 Boston Globe 160 bottom-up stock picking 114, 115 BP 139, 179 brands 59, 158 breadth of market indicators 91–2 breakouts 80
British Airways 40, 134 British Polythene Industries 132 British Telecommunications 186, 234 broker recommendations see analysts brokerage accounts 31 BTR 65 bubbles and crashes 169–87, 233–6, 238–9 Internet stocks xi, 182–5, 186 Japan 180–1 Mississippi bubble 171–3, 187 October 1987 Crash 178–80 railway shares 146–7, 169–70 South Sea Company 173–4, 186, 187 Tulipmania 170–1 Wall Street Crash 10–11, 174–8 Buffalo Evening News 160 Buffett, Warren 3, 17, 29, 34–5, 66, 157–63 Building Costs Information Service 197 bulletin boards 31–3, 42, 184, 195, 231–9 business cycle 112–13, 164 Business Week 195 buy signals 93 BWD UK Smaller Companies Trust 127–9 California Public Employee Retirement System (CALPERS) 111 candlesticks 80, 81 Capital Cities 160 capital expenditure projects 21 Carruthers, Tomás 183 Cartier 50 cash accounts 105
new index
4/3/02
4:57 pm
Page 241
Index cash balances 91 Centrica 134 Centurion Fund 20 Chaitow, Chris 219 Chartered Financial Analysts (CFA) 110 Chase Fleming 220 chemical companies 224 Chevron 65 Chinese walls 18 Clinton Cards 138 Coca-Cola 158, 160–1 combinations of shares 107–15 commodity markets 91, 105, 149 Companies House 221 competition 158 computer screening 114, 120, 219 consensus earnings forecasts 12, 50 see also analysts contrarian indicators 91 convergence/divergence of moving averages (MACD) 87–8, 94 Coppock indicator 92 corporate bonds 105 corporate events 65–6 corporate excesses 55 corporate websites 194 Coutu, Sherry 183 covariance of holdings 109 crashes see bubbles and crashes credit cycling 148 crowd psychology 29 currency exposure 109 cutting losses 38 cyclical companies see business cycle Daimler-Benz 64 Davis, Shelby 155 DCF (discounted cash flow) analysis 61 declining industries 59 demographics 59, 113–14 deposit accounts see cash accounts depreciation 63–4 derivatives 115 Déscartes, Rene 9 Deutsche Asset Management 220 director dealings 17, 227
discounted cash flow (DCF) analysis 61 diversification 108–9 dividends 120, 135 Dodd, David L. 47, 73 double tops 83–4 Dow Theory 76–7 Du Nuoy, Lecomte 31 Durlacher 219 earnings forecasts 12, 50 see also analysts earnings per share (EPS) 12 earnings quality 63–5 EASDAQ stocks 222 East Surrey Holdings 139 eBay 182 economic cycle 112–13, 164 economic information websites 220–2 Economic Value Added (EVA) 64–5 Economist, The 220 EDGAR 31 Efficient Market Hypothesis (EMH) 6, 10–11, 37, 111 Elliott waves 90, 222 Ellison, Larry 31 Enterprise Oil 133 equity investments 33–4, 106–7, 238 EVA (Economic Value Added) 64–5 Evans, Gareth 218 Extel 20, 50, 218 Federal Drugs Administration 223 Fibonacci retracements 89–90 Fidelity 163 Fidelity Special Values plc 134–5 financial companies 61, 224 Firth Rixson 132 Fitness First 125–6 flags 83 Forbes 195 Ford 50 Fotheringay estate 146 France 109 Friedman, Milton 186 Fuller Smith and Turner 138 fund managers 18–19, 67, 110–11 cash balances 91 websites 219–20 fundamental analysis xii, 47–68
behavioural finance 10, 39, 56–7 corporate events 65–6 discounted cash flow (DCF) analysis 61 earnings quality 63–5 Economic Value Added (EVA) 64–5 growth stocks 11–13, 48–50, 164 hidden assets 53 industry selection 58–68, 112–14, 223 management quality 55–6, 67–8, 211–12 mean reversion 57 penny shares 54–5 qualitative decisions 47 shell companies 54–5 stock selection 47–58 timing markets 20, 57, 115 websites 217–20 see also ratios futures contracts 115 Galbraith, John Kenneth 175 Gates, Bill 182 gearing 51, 52 GEICO 160 General Electric 176, 177 General Re 161 Germany 107, 109 Gillette 161 Glass-Steagall Banking Act 178, 187 Glaxo 31, 65 GlaxoSmithKline 138–9 goals and objectives 97, 98 Golding, Tony 40, 67 Goldman Sachs 176, 178 goodwill write-offs 63–4 government bonds 105 government regulation 114 government statistics 221 Graham, Benjamin 14, 16, 47, 53, 73, 157–8 Great Universal Stores 155 Greenspan, Alan 22 growth industries 59, 60 growth portfolios 106, 119–29 growth stocks 11–13, 48–50, 164 Gulf Oil 65 Guy, Thomas 170 Halifax Group 197, 200–1 Hanson 65 head and shoulders 84–5
241
new index
4/3/02
4:57 pm
Page 242
Index hedge funds 22, 226 Hemmington Scott 31, 50, 66, 120, 130, 194, 217, 219 herd investing 30 heuristic rules of thumb 39–40 hidden assets 53 Hite, Larry 3 Hoovers Online 194, 217 housebuilding industry 197–207 IBM 65 Iceland 134 iii (Interactive Investor International) 183 income portfolios 106, 135–41 Independent Insurance 132 index tracker funds 21–2, 111 indices 100–1 individual investors see private shareholders industrial companies 60–1, 224 industry sector selection 58–68, 112–14, 223 inflation 105 information flows 3–8, 40–1 equitable distribution 34–5 news announcement channels 7–8 seasonal patterns 8 information sources 31 information trading 30–1 initial public offerings (IPOs) 65–6, 220 Inland Revenue 197, 205 insider information 17, 227 institutional shareholdings 33–4 insurance companies 155 intangible assets 53 intellectual assets 52 Interactive Investor International (iii) 183 interest rates 176 and bond prices 104–5 cycles 92 international investing 109 Internet 156–7 brokerage accounts 31 bulletin boards 31–3, 42, 184, 195, 231–9 corporate websites 194 information sources 31 online resources 215–28 Internet stocks xi, 182–5, 186
242
intrinsic value 5 investing and speculating 57–8 investment banks 3 investment magazines 195 investment systems 19–20 investment trusts 23, 53 Investors Chronicle 92, 195 Investors Relations Society 217 Investors Week 195 IPOs (initial public offerings) 65–6, 220 J-curve 49 Japan 64, 109, 180–1 Jensen, M.C. 19 Johnson Matthey 124–5 joint venture formations 21 joint-stock banks 145–6, 187 Kennedy, Joseph 170 Keynes, John Maynard 32–3, 104, 148–51 Kitcat and Aitken 154 Knight Ridder Newspapers 160 Kondratieff cycle 92 lagging indicators 112–13 Laird Group 127 Lambert Howarth 132 land prices 206–7 landed estates 146 Lastminute.com 183 Law, John 171–3 leading indicators 91, 112–13 Levenson, John J. 176 leverage 51, 52 life insurance companies 155 lifestyle changes 97–9, 114 Lion, David M. 176 Lloyd, Samuel Jones (Lord Overstone) 145–7, 170 London Clubs International 132 London Stock Exchange Big Bang 3 foreign shares listed 109 Regulatory News Service (RNS) 7, 194 Long Term Capital Management (LTCM) 22 Lookers 133 Lotus Development Corporation 65 Low and Bonar 133 Luckraft, George 140
Lynch, Peter 14, 163–5 MACD (moving average convergence/divergence) 87–8, 94 McDonald’s 14 McIvor, Anne 218 McLeod Russel 133 McMahon, William J. 176 magazines 195 Magellan Fund 163–5 management quality 55–6, 67–8, 211–12 Marconi 40 margin trading 175, 178 market indicators 91 market value 5 markets commodity markets 91, 105, 149 Efficient Market Hypothesis (EMH) 6, 10–11, 37, 111 over-reacting 5, 37 slow reacting 37 stock market returns 106–7 timing 20, 57, 115 see also bubbles and crashes Markowitz, Harry 102, 109 Marshall, Alfred 29 mathematical indicators 85 mature industries 59 mean reversion 57 media companies 60 Mercer, William 110 mergers and acquisitions 65 Merrill Lynch 65 Merton, Robert 22 Metropolitan Water 147 Microsoft Corporation 182 Midland Perpetual 147 mining companies 63 Minmet 32 Mississippi bubble 171–3, 187 Mitchell, Charles E. 176 Modern Portfolio Theory (MPT) 101–2, 108–9 momentum 5, 77, 94 Montgomery Ward 175, 178 Morgan, J.P. 10, 177 moving averages 78–80 convergence/divergence (MACD) 87–8, 94 Multex Investor 210, 217 Munger, Charles 162 NASDAQ 109 National City 176
new index
4/3/02
4:57 pm
Page 243
Index Nationwide 197, 200 New Scientist 223 New York Stock Exchange (NYSE) 109 news announcements 7–8, 21, 227–8 newspaper tips xii, 193 NHBC 197, 199 noise trading 29–31 objectives 97, 98 October 1987 Crash 178–80 OFEX companies 218 Ogilvy and Mather 160 oil companies 61–2, 224 online resources 215–28 operating margin 51 options 115 Oracle 31 over-reaction to information 5, 37 overconfidence 35–6 Overstone, Lord (Samuel Jones Lloyd) 145–7, 170 Overund and Gurney 146 Oxford BioMedica 123–4 P/E growth (PEG) ratio 54, 120–1, 153 P/E (price/earnings) ratio 10, 12, 14–15, 51, 53–4 passive investing 40 Peel, Sir Robert 187 penny shares 54–5 pharmaceutical companies 62, 223 Phytopharm 140 pioneer industries 59 Plaza Accord 180 point and figure charts 80–1 portfolio construction xii, 97–115 asset allocation decision 106–7 benchmarks 100–1 combinations of shares 107–15 covariance of holdings 109 currency exposure 109 diversification 108–9 goals and objectives 97, 98 growth portfolios 106, 119–29 income portfolios 106, 135–41
industry sector selection 112–14, 223 lifecycle phases 97–9, 114 Modern Portfolio Theory (MPT) 101–2, 108–9 number of stocks 103 returns 108 risk and return 101–2, 104–6 risk tolerance 97, 98–9 taxation 100 time horizons 97–9 transaction costs 100 universe of investments 102–6, 109 value portfolio 129–35 weightings of stocks 111–12 portfolio monitoring 226–7 Porvair 127 price/book (P/B) ratio 15–16, 51, 52, 120 price/earnings growth (PEG) ratio 54, 120–1, 153 price/earnings (P/E) ratio 10, 12, 14–15, 51, 53–4 primary research sources 194 private shareholders 33–4, 42, 110–11 products 50 professional investors see fund managers profit forecasts 49 profitability ratios 51 program trading 179–80 property companies 62, 223 see also housebuilding industry put/call ratio 91 qualitative decisions 47 Racal Electronics 111 Radio Corporation 175, 176–7 Radstone Technology 128 Raging Bull 31, 182 railway shares 146–7, 169–70 random walk theory 74 rate of change (ROC) 86–7 ratios 14–16, 50–2 asset turnover 51, 52 gearing 51, 52 operating margin 51 P/E growth (PEG) ratio 54, 120–1, 153 P/E (price/earnings) ratio 10, 12, 14–15, 51, 53–4 price/book ratio 15–16, 51, 52, 120
profitability ratios 51 return on equity (ROE) 51, 52 rectangles 83 Redmayne Bentley 219 REFS information system 153, 219 Reg Vardy 138 Regulatory News Service (RNS) 7, 194 relative strength (RSI) 85–6, 94 research 193–213 housebuilding industry 197–207 online resources 215–28 primary sources 194 research reports 195–6, 217–18 secondary sources 194–6 sectoral research 58–68, 112–14, 223 see also analysts research and development (R&D) spending 21 resistance levels 77–8 retirement 98 retirement homes 59 return on equity (ROE) 51, 52 return on portfolios 108 return and risk 101–2, 104–6 return on stock markets 106–7 Reuters Survey 20, 50, 218 reversal trends 83–5 rights issues 3 risk 97, 98–9, 101–2, 104–6, 236 RNS (Regulatory News Service) 7, 194 ROE (return on equity) 51, 52 Royal Bank of Scotland 124, 139 Royal Dutch 23 Royalblue Group 123 RPS Group 125 RSI (relative strength indicator) 85–6, 94 running winners 38 Russell, Frank 110 St James Place Greater European Progressive Fund 156–7 St James Place Group 123 sales forecasts 49 Santayana, George 73 Savills 197, 223 Scholes, Myron 22
243
new index
4/3/02
4:57 pm
Page 244
Index Schroders Investment Management 110 screening 114, 120, 219 seasonal patterns for information flows 8 secondary research sources 194–6 sectoral research 58–68, 112–14, 223 securities analysts see analysts Securities and Exchange Commission (SEC) 7–8 Sees 160 sell signals 93 share investments see equity investments shareholder democracy 238 shareholders 33–4, 42, 110–11 Shares 195 Sharpe, Stuart 127–8 Shell 23 shell companies 54–5 short selling stocks 22 Sinclair (William) Holdings 133 Sixpack 32 Slater, Jim 152–4 slow reaction to information 37 small companies 13, 65 SmithKline Beecham 31 Society of Investment Professionals (UKSIP) 110 Sony Corporation 14 Soros, George 6, 40–1, 57 South Sea Company 173–4, 186, 187 speculation 57–8 Stamp Duty 197, 205 Standard & Poor’s 66, 194 start-up companies 59 Stern, Joel M. 65 Stirling Group 140 stock market returns see markets stock selection 47–58 StockScreen.com 120 support levels 77–8 SurfCONTROL 125 Swordblade Company 174 systems 19–20 takeovers 65 Taube, Nils 154–7
244
tax year effect 20 taxation 100 technical analysis xii, 73–94, 237–8 advantages 75 bar charts 75–6 Bollinger bands 88–9, 94 breadth of market indicators 91–2 breakouts 80 buy signals 93 candlesticks 80, 81 cash balances 91 commodity prices 91 contrarian indicators 91 Coppock indicator 92 double tops 83–4 Dow Theory 76–7 Elliott waves 90, 222 Fibonacci retracements 89–90 flags 83 head and shoulders 84–5 Kondratieff cycle 92 leading indicators 91, 112–13 market indicators 91 mathematical indicators 85 moving averages 78–80 convergence/divergence (MACD) 87–8, 94 patterns 73, 81–5 point and figure charts 80–1 put/call ratio 91 rate of change (ROC) 86–7 rectangles 83 relative strength (RSI) 85–6, 94 resistance levels 77–8 sell signals 93 support levels 77–8 tests and criticisms 74–5 timescales 75 trends 73–4 reversal trends 83–5 triangles 82 velocity indicators 86–7 volume of shares traded 75, 76–7 websites 222 technological changes 114 technology companies 62–3, 225 Internet stocks xi, 182–5,
186 online research 218 Thomas, Nigel 126–7 time horizons 75, 97–9 Time Warner 31 timing 20, 57, 115 tips xii, 193, 194–5, 231–3 Tomkins 65 top-down stock picking 114, 115 Torex 128 transaction costs 100 trends 73–4 reversal trends 83–5 triangles 82 Tulipmania 170–1 turnaround situations 165 UKSIP (UK Society of Investment Professionals) 110 underwriting fees 3 United Drug 140 universe of investments 102–6, 109 US Air 161 US Steel 10–11, 176, 177, 178 utility companies 61, 147 Value Line 19–20, 194 value portfolio 129–35 velocity indicators 86–7 venture capital 226 Vodafone 21–2, 111 volume of shares traded 75, 76–7 Wall Street Crash 10–11, 174–8 Walt Disney 182 Washington Post 160 websites 215–28 see also Internet weekend effect 20 weightings of stocks 111–12 Wells Fargo 21, 111, 161 Whitney, Richard 10, 177, 178 Wigan Coal and Iron 147 Wiggins Group 125, 128 wilink.com 217 Wolfson family 155 Womack 20 Yahoo.com 182, 185 Young, Hugo 218
