Category: Stocks

Why you should not decide which stocks to buy

In my previous article on regression to the mean I touched upon the reason for why we should not simply let our intuition guide us in making investment decisions (or any decision, for that matter). Rather, it is best to have some sort of formal decision-making process.

Why is it so much better to use a formula than to simply think holistically? Is not our thinking better? Can we not adapt our thinking to any extenuating circumstances if we think holistically? Consider a stock with a low P/E ratio but a high short ratio. It might be a good idea to avoid the stock, right? Quite simply, no. The P/E ratio is probably ten times more important than the short ratio in determining whether to buy or sell a stock. Sure, the short ratio is correlated with stock market returns, but a lot less so than is the P/E ratio.

When making intuitive judgments it is easy to be led astray by such salient but marginally important information. It is true that our feelings and intuition can be highly useful, such as in our estimation of the quality of a company’s management. However, a formula can incorporate that subjective, holistic information as well. There is no reason why we cannot use intangible information in a formalized investment decision process. We could have a part of the formula where you enter in a ‘1’ if the management is good, ‘0’ if mediocre, or ‘-1’ if bad. In the case of a company with an ongoing proxy fight, we could run the computation twice, with different inputs depending upon who wins. Comparing the two possible outcomes to other investment opportunities would give us a means of deciding whether the possible benefits outweighed the risks. This can prevent emotions and unimportant information from leading us to the wrong decision.

For a further discussion of the problems we humans face in making decisions when faced with complicated and conflicting information, I suggest reading Psychological Study of Human Judgment: Implications for Investment Decision Making by Paul Slovic (1972). (Unfortunately, no free full-text version of this paper is available online.)

It’s a topsy-turvy upside-downsy world

Normally, short sellers have alpha, or skill. Highly-shorted stocks underperform stocks with low short interest. In January, however, the most-shorted stocks have done better than other stocks. See the article by the Bespoke Investment Group over at SeekingAlpha.

One explanation for this reversal (thanks to the reader at SeekingAlpha who pointed this out in his comment) is that because the markets are down so much in January, short covering in the highly-shorted stocks (realizing profits) is adding significant upside pressure, but only to the highly-shorted stocks.

My (Optimistic) Prediction for 2008: It Will “Suck”

In response to a reader comment on my prediction of financial Armageddon for 2008, I have another, more optimistic prediction. As I said before, I am not a fan of predictions per se. It is, however, useful to outline possibilities. This possibility is more likely than financial Armageddon. As you can surmise from my title, I do not believe the economy will be all roses and sunshine this year.

What everyone seems to ignore is that recession is necessary from time to time. Mal-investment must be corrected. Profligate spenders must be chastened. The economy has invested too much capital into housing and it needs to reinvest that capital into other sectors. Unfortunately, that will cause pain. But to try like the Fed to avoid the pain will only delay it and worsen it. That is exactly what happened in 2001 as the Fed cut rates drastically to avoid pain from the stock market crash. The easy money went into housing and caused the current problems.

February: Lenders and counterparties give up on ACA Capital Holdings, the smallest and weakest monoline bond insurer. It declares bankruptcy. The bailout of the other bond insurers succeeds, barely. Ambac [[abk]],  and MBIA [[mbi]] survive in run-off mode. New competitors such as Berkshire Hathaway’s [[brka]] subsidiary take over 100% of the municipal-bond insurance market. Harry Macklowe loses much of his real estate empire when he fails to refinance his short term debt. Rents decrease in Manhattan for the first time in years.

March: The stock market continues to stagnate.

April: Towards the end of the month, the homebuilders report more huge writedowns. Several see their stocks drop another 80%. One or two small public builders declare bankruptcy. The largest all survive. On a personal note, the author of this blog sells his house, which he had owned for almost four years, for a 20% loss.

May: Losses to banks from the failure of ACA alone top $20 billion. Bank stocks continue going down, but losses look like they won’t increase further. House prices in St. Louis are down 25% from their peak. In parts of California, house prices are down over 30%.

June: No bank runs, surprisingly.

July: Numerous small companies declare bankruptcy. The default rate on junk bonds approaches an annualized 7% for the year.
August: By this time house prices have fallen over 40% in California from their peak prices. The worst seems over, although house prices will stagnate for the next four years at least.

September: Mortgage insurers Radian [[rdn]] and PMI Group [[pmi]] are bailed out by banks and vulture investors, and none of the mortgage insurers declare bankruptcy. The carnage in the financial sector appears to be over.

October: Google’s profit increases 80%. Citigroup continues to flounder after losing several more top executives.

November: Barack Obama or John McCain wins the election. His (and Congress’) plans to help the economy do nothing for the economy while wasting taxpayers’ money.

December: The unemployment rate hits 5% in the US and the country enters a recession.

Disclosure: I am long BRK-A. I think Barack Obama is naive at best (and a corrupt scoundrel at worst; see his land dealings in Chicago) and John McCain is a fool who has no regard for free speech (as shown by McCain-Feingold).

Update on my stock picks and pans

My bearish calls have been pretty accurate over the last couple months. Life is not too good right now if you were an investor in Cellcyte Genetics (OTC BB: CCYG), Noble Roman’s (OTC BB: NROM), or Octillion (OTC BB: OCTL). After having almost doubled since I wrote about it, Cellcyte has now fallen 90%. Noble Roman’s is down over 40% since I first wrote about it. Octillion is down over 60% since I wrote about it.

Home Solutions of America (OTC: HSOA) is down over 80% since I first highlighted questions regarding fraud. Skinns (OTC BB: SKNN) is down 30% since I called its whole business ‘silly‘ while praising the quality of management. My old favorite, Continental Fuels (OTC BB: CFUL), is down 25% since the most recent time I mentioned how overvalued it was.

My recent positive calls have been few and far between. I was positive on TSR Inc. [[tsri]] and I still am. It is down only slightly since I wrote about it in mid-December, about in line with the market. Also, my positive call on Tecumsah [[tecua]] has been a good call.

While basking in my glory, I should also highlight my painfully bad call on ACA from last August, after which it fell 90%. (I blame this on my call being on video and not in writing.) In my defense, I did say that I did not understand the company enough to invest in it.  IDO Security (OTC BB: IDOI) has also been a bad call. Since I wrote about its promotion by junk fax the stock is up over 40%. It will eventually go back down, however.

Disclosure: I am long TSRI and have no other position in any stock mentioned. I have an iron-clad disclosure policy.

My Prediction for 2008: Financial Armageddon

I’m not much for predictions (because they are usually bad), but I thought I’d give it a try. Here is how financial Armageddon could come to pass this year. I do not think it will happen, but it is possible.

February: Lenders and counterparties give up on ACA Capital Holdings, the smallest and weakest monoline bond insurer. It declares bankruptcy. The bailout of the other bond insurers fails. Ambac [[abk]], already in run-off mode, is downgraded to junk. MBIA [[mbi]] survives a bit longer. Harry Macklowe loses much of his real estate empire when he fails to refinance his short term debt. Rents decrease in Manhattan for the first time in years.

March: Ambac becomes insolvent. MBIA is downgraded to junk.

April: MBIA declares bankruptcy. Towards the end of the month, the homebuilders report more huge writedowns. Several banks surprise everyone by calling loans on a teetering Standard Pacific Homebuilders [[spf]]. It declares bankruptcy. Several smaller, private, homebuilders are likewise pushed into bankruptcy by their lenders.

May: Losses to banks from the failure of ACA alone top $20 billion. Analysts estimate that the major banks will have to write down $250 billion as a result of the failure of the other bond insurers. Citigroup’s [[c]] stock is now down over 50% in the last 6 months alone. The Bank of America [[bac]] acquistion of Countrywide Financial [[cfc]] falls through and Countrywide declares bankruptcy. On a personal note, the author of this blog finally sells his house, which he had owned for almost four years, for a 25% loss. House prices in St. Louis are down 30% from their peak. In parts of California, house prices are down over 50%.

June: Several regional banks based in California are paralyzed by bank runs. They declare bankruptcy. The FDIC estimates that the bailout of their depositors will cost $30 billion.

July: Forgotten by almost everyone, pushed to collapse by banks’ unwillingness to refinance its debt, Chrysler declares bankruptcy. Several small companies join it there.

August: By this time house prices have fallen over 60% in California from their peak prices. It is now impossible to obtain a mortgage with a FICO score below 600, a smaller than 20% down payment, or an income at least four times the mortgage payment (including insurance and taxes).

September: A large insurer reveals write downs due to mortgage-backed security losses equal to its book value. Its stock drops 90% in one day, leading the S&P 500 down 8%. Mortgage insurer Radian [[rdn]] declares bankruptcy. It is joined in bankruptcy by competitor PMI Group [[pmi]].

October: Google’s profit increases 70%. Citigroup’s book value is now down 50% over the last two years.

November: Hillary Clinton wins the US election even though 80% of the population hates her. She decides to play the role of Franklin Roosevelt and her policies look to drive the US into a depression.

December: The unemployment rate hits 6% in the US and the country continues a recession that started back in the spring.

Disclosure: I have no position in any stock mentioned above. I hate Hillary Clinton. I am actually not pessimistic enough to believe that much of the above will occur.

Past profits are no indication of future profits

We like to think that past profits are a good predictor of future profits, and that past growth is a good predictor of future growth. As “The Level and Persistence of Growth Rates” by Chan, Karceski, & Lakonishok (2003) shows, that is not the case. Growth rates are not persistent. In fact, they appear to be random. In other words, companies with high earnings growth rates have no greater chance of continuing to grow earnings quickly than those with low growth rates. Sales growth rates do tend to persist, but it does no good for the investor if a company such as Pets.com can generate 200% sales growth if it fails to ever make a profit.

There is little indication that anything can really predict which companies will grow earnings at fast rates in the future. Nothing correlates with future earnings growth: not analyst forecasts, not past growth, and not P/E or other valuation metrics. That last thing can be good for us, though—companies we buy with low P/E ratios can turn out to be growth stocks!

Does anything predict future growth? A couple things might—companies with high dividends tend to grow more quickly (if we count the dividend yield as part of growth) than non-dividend paying companies. Also, companies that spend a large portion of revenues on research tend to grow more quickly. I will investigate both of these findings in more detail in the future.

Because of the unpredictability of earnings growth rates, those companies that are priced cheaply are the best investments, while those with high prices (high P/E ratios, high P/BV ratios) are poor investments. If you need more confirmation of this fact, see The Predictability of Stock Returns by Fluck, Malkiel, and Quandt (1997). Unfortunately I could not find a full-text version of their paper available free online.

Monoline bond insurers need $200 billion to retain AAA credit rating

According to Egan Jones, the 4th largest credit rating agency in the US. Unlike the other rating agencies, Egan Jones is paid by money managers and not by the companies whose bonds it rates. Egan Jones has already downgraded MBIA [[mbi]] 13 notches below AAA.

Independent studies I have seen indicate that Egan Jones is generally faster and more accurate than S&P, Moody’s, and Fitch. If Egan Jones is right in this case, any planned bailout will fail and the monoline bond insurers will be bankrupt in under a year.

Disclosure: I have no relationship with Egan Jones and no position, long or short, in any bond insurer mentioned, although I do own shares of Berkshire Hathaway, which has recently started a competing bond insurer. I have an iron-clad disclosure policy that has a AAAAA rating (or its equivalent) from Fitch, Moody’s, Egan Jones, S&P, A.M. Best, and The Slovenian Institute for Rating Blog Disclosure Policies.

Discounted cash flows for dummies

Performing a DCF analysis is a subject about which I have meant to write for some time. It is the culmination of the search for an objective means of valuing companies based on the total profit they will produce in the future. Various equations exist for calculating a company’s net present value. I will present one of the simpler equations for two reasons: it is easier and it involves fewer assumptions that could be wrong.

For a handy spreadsheet to calculate the present value of future cash flows, given expected growth rates and current cash flows, see this workbook (Excel format).

Performing a DCF analysis is relatively simple. We take the current profit per share (as measured best by free cash flow to equity, FCFE). Free cash flow to equity can be difficult to calculate, so free cash flow (FCF) can be used instead. If you wish to perform a quick and dirty DCF, you can use earnings instead of FCF, but this is generally not a good method.

The standard means for conducting a DCF is to take the present profit per share and then project assumed changes in that profit into the future. We use an interest rate as the discount rate to account for the time value of money (there are many different approaches for selecting the correct discount rate). Therefore, the further in the future a dollar is earned, the less it is worth today. This is because time has value. In the workbook I use 8% as the discount rate. Many people use the rate on the 10-year treasury bond. If you do that, use a long-term average of yields, otherwise your calculations of current value will change drastically over short time periods as the interest rate fluctuates. Also, you should add a risk premium onto the risk-free rate if you use it as the discount rate. A simple and theoretically defensible method would be instead to just use the long-term return on equities as the discount rate, or even the expected return given current valuations (see Rob Arnott’s work on expected returns given valuations). If we can expect the stock market over the next 50 years to appreciate around 8% per year, we would not choose an individual stock over the index unless that stock could be expected to return greater than 8% per year.

A DCF analysis is often conducted out towards infinity. In other words, given our assumptions, we figure the present value of the company infinitely far in the future. If a company were to increase its profit every year at the risk-free rate, than its profit in today’s dollars would remain the same infinitely far in the future. This never happens, so besides a period of relatively quick growth, we introduce a final growth rate for each company that is less than the risk-free rate. For this final growth rate I use the long-run inflation rate. In essence, we assume that after a period of growth the companies do not grow except in nominal returns.

‘Growth’ investors like to say that if you buy a really great, fast growing company, it really does not matter how much you pay for it. They are actually right. As I will discuss later, the faster a stock grows, the more important its growth rate becomes to its investment value. At the extreme, a company that will forever grow earnings at a rate at or above the risk-free rate will be worth an infinite amount of money, and thus its price will always be less than its true value. Conversely, the investment value of a company with zero growth will be determined purely by its current price.

There is much more to DCF analysis than this. We can model changing leverage (debt) rates, changing ROC rates, and just about anything else we want in a DCF analysis. One key, however, is to remember that a DCF analysis is only as good as our assumptions. As I will showed in the article Regression to the Mean, our assumptions are often more inaccurate than we believe.

Disclosure: This article was originally published elsewhere.

I Matter!

The mark of someone who is making a difference is that they make enemies. I guess someone thinks I’m making a difference! Dan said this to me in response to my article on CytoCore (OTC BB: CYOE):

Your article on CytoCore was total [bull feces]. Seems a little odd to have picked
it out of the blue. A virtual unknown company that you decide to short.

Seem to be trying to gain financially off the article. Best watch your [derrière].
Front and back.

Dan, if you had bothered to research me you would have found out that almost all the companies about which I write are tiny and unknown. Also, watching my tush “front and back” makes no sense. Oh, and I have never shorted Cytocore.

Disclosure: I have never shorted Cytocore. My disclosure policy, though high on life, is far more lucid than Dan.