Part 2 Chapters 3 to end.
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Synopsis of Business Models
Business Models is different from other investment books because it breaks new ground. It deploys 129 business models to empower an outside investor to analyse the internal competitive advantage of companies and sectors.
Strong competitive advantage is only achieved by having low costs and/or doing something different from the competition. This must add value to the customer, who then pays a premium price. He is glued to the company, which will earn dependable revenue streams and be in the profit zone.
· 64 company business models are scored for competitive advantage. They include moats, recurring revenues, product differentiation, bolt-on acquisitions and bargaining power.
· 65 sector business models are scored for competitive advantage. They include recession resistance, must-have products, sticky customers, toll bridges and megatrends.
· The economic cycle is the ultimate arbiter of investment success or failure.
· Other important tools are growth at a reasonable price, technical analysis, scuttlebutting, accounting for growth and investment axioms.
· Conclusion Business Models unearths the best companies to outperform in a bull or bear market, giving investors a real advantage. They can correctly evaluate a company or sector in 15 minutes and emulate Warren Buffett, who uses business models to invest in companies with strong competitive advantage.
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First published in Great Britain in 2005
Copyright Harriman House Ltd
The right of David Watson to be identified as the author of this work has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. 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, copying, recording, or otherwise, under any circumstances. © 2004.
Stock market investments can go down as well as up and the past is not a guide to future performance. Securities or shares mentioned in this book are for illustration purposes only and are not a recommendation. Prices, valuations, analysis, business models and competitive advantages were at the time of writing. They are no longer up to date because prices, profit forecasts and business models continually change. What may be attractive today can be unattractive tomorrow and vice versa. Seek your own professional advice before dealing in securities. Neither the Publisher nor the Author accepts any legal responsibility for the contents of this book or for any errors, inaccuracies or omissions. The liquidity of some securities may be poor and this should be evaluated before making any investment, particularly in smaller companies.
No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Author, or by the employer of the Author.
About the author v
Summary of this book xiv
1. Business models: investing in companies 1
with strong competitive advantage
1. Competitors 10
2 Customers 18
3. Economics 30
4. Management 44
5. Products 56
6. Suppliers 72
2. Business models: investing in sectors 75
with strong competitive advantage
1. Competitors 80
2. Customers 84
3. Economics 89
4. Management 100
5. Products 102
6. Suppliers 116
7. Sectors to avoid 118
3. Shifting deck chairs on the Titanic 125
1. The economic cycle 126
2. The cycle of opportunity 136
4. Which sectors to buy and sell during the 139
5. Growth at a reasonable price 181
1. Growth statistics 182
2. Value statistics 185
3. Further considerations 187
4. Trading 189
6. Technical analysis 191
1. A useful tool to improve performance 192
2. A chartist’s view 193
7. First-hand experience of the product: 207
8. Accounting for growth 219
1. Broker forecasts 221
2. Cash flow 224
3. Dividends 227
4. Goodwill 231
5. Share options 236
9. Investment axioms 239
1. Example of a company’s business model: Radstone 264
2. How Microsoft triumphed because of its business model 272
Further information 282
Chapter 1. Company business models 7
Chapter 2. Sector business models 77
Chapter 4. The economic cycle of opportunity 144
Conclusion Company scoring using all six tools 260
Appendix 1. Company business model 270
Appendix 2. Company business model 279
About the author
David Watson read a bachelor’s and master’s degree in economics and finance at Manchester University. He is a Fellow of the Institute of Chartered Accountants, qualifying with Price Waterhouse in London. He has extensive UK and international business experience, principally in financial services and media, and was Deputy Editor of Investing for Growth, an investment newsletter first edited by Jim Slater, author of The Zulu Principle. He welcomes comment and feedback and can be e-mailed at email@example.com.
‘Draw a circle around those businesses you understand and then eliminate those that fail to qualify on the basis of value, good management and limited exposure to hard times’.
We now examine the competitive advantage of individual sectors, like beverages, rather than business models, such as moats and recurring revenue, that cut across numerous sectors, as discussed in chapter 2. We then discover which individual sectors to buy and sell during a typical economic cycle. The starting point is to consider UK and international competitive advantage.
The UK initially secured international competitive advantage with the advent of its industrial revolution in the nineteenth century. This gave it first mover advantage but this waned when the rest of the world industrialised and began to catch up on the UK’s first mover advantage. Other factors which strengthened its competitive advantage included language, geographical position, natural temperament of the population, reputation, history and perceptions of value. Today, the UK’s international competitive advantage is in various sectors that tend to dominate the top of the FTSE 100. They score highly in the table that follows and are beverages, pharmaceuticals and health, tobacco, food and drug retailing, oil and gas, and banks. These are followed by food producers, utilities, aerospace and defence, and life insurance. This does not mean that these sectors are attractive at all times, or that each company therein is attractive. Gems can be discovered in unattractive sectors. However, it is a useful reminder of where the competitive advantage lies and which have long-term potential. Those sectors that lack power have a low score in the table below and, unsurprisingly, include chemicals, electronics, electrical and engineering.
‘While you’re negotiating for a 35 hour week, remember that they have only just got 66 hours in Taiwan and you’re competing with Taiwan.’
Victor Kiam, of ‘I liked the shaver so much I bought the company’ fame.
Asia is fast becoming the powerhouse of the world. This megatrend can be expected to last for decades and will probably intensify. From an economic point of view, the West and Asia will benefit if each specialises in those activities
where it has competitive advantage and trades goods and services with other countries where it does not. China and its billion people on low wages have a powerful competitive advantage in manufacturing, not only in low cost but, increasingly, in quality too. Southern China has reached the stage of development where costs have risen and production is shifting to the north, where they are still low. Japan has competitive advantage in high-quality goods, such as consumer electronics and cars, although its manufacturing heart is being hollowed out as production shifts to low-cost countries.
Companies that can transfer production to low-cost countries have little choice but to do so or they will be beaten by the competition. If the value created can be captured by the sector, then profits will benefit accordingly. If however, they are frittered away in ruthless competition then the consumer will benefit but this may, nevertheless, increase overall demand and perhaps provide critical mass. Some sectors are unable to benefit from this megatrend and they include general retailers, transport and oil.
Intense international competition has meant that the fat in businesses is not just being cut out but is being fried out in a pan. This reflects the megatrend towards the ‘Wal-Martisation’ of the world. Price is increasingly the main, if not the only, matter that counts in selling goods. Wal-Mart piles them high and sells them cheap, as evidenced by sales that have reached $1 billion in a single day. Increasingly, if the correct price point is hit then customers ring the phone off the hook. Miss that price point by just a shade and the phone is silent. The internet has aided and abetted this extreme price consciousness.
Another megatrend is the dumbing down of jobs that take out the skill with easy to learn and powerful personal computers. There is great demand for cheap and cheerful bodies but much less demand for expensive middle and senior managers. This has thinned the ranks of the prosperous middle classes that spent freely and those that catered for them have seen business suffer, for instance expensive, four-star hotels in Austrian ski resorts. The cheap and cheerful chalets down the road that manage to produce a Wal-Mart type product that hits the price point remain packed. Therefore, it is increasingly important to differentiate products that add real value to the customer in order to achieve premium pricing. The alternative is to be in the Wal-Mart business with an ultra-low cost base and a very keen sense of capturing market share on a continuing basis that keeps the competition at bay. This is a difficult job to do indefinitely without hiccups. There is, however, little middle ground.
There will be a place for niche producers in the West for the likes of up-market
car manufacturers, such as BMW, that have immense image and prestige. However, the long-term outlook for manufacturing is bleak. It has been shrinking faster in the UK than Germany, France and the US since 1997. It has fallen from 21% of GDP to 17%. Services, for example leisure, are difficult to import and are largely immune from overseas competition. In some sectors, like telecommunications, banking, software and engineering consultancy, the back office and call centres can be transferred to low-cost countries.
The economic cycle of opportunity table, which follows, starts with the asset class to hold over the cycle, namely cash, bonds, shares and property, and this was discussed in chapter 3. Each sector is scored for its recession resistance and competitive advantage. The annual profit growth over the last five years and the profit margin is also specified.
There is a time to buy and sell various sectors, as illustrated in the table. Non cyclical sectors are: beverages; food producers and processors; pharmaceuticals; health and personal care; tobacco; food and drug retailers; telecommunications; and utilities. They should ideally be bought in the third year of the cycle when share prices are depressed but demand for these goods is robust, as they are needed in good and bad times. Consequently, they tend to have strong recession resistance. They can then be held until near the end of the cycle and sold around year nine. Alternatively, they are candidates for holding if an investor decides to have an exposure to shares regardless of the cycle, as explained in chapter 3.
Cyclical sectors are resources, basic industries, general industrials, cyclical consumer goods, cyclical services, information technology and financials, which includes real estate. They should be bought later than non cyclicals in year five when their prices are rock bottom. Share prices then begin to increase, as the market will anticipate the end of the recession by approximately nine months. Demand will recover and will boost profits enormously. These sectors are sold earlier than non cyclical sectors, in around year eight. An investor will then be partly or fully out of the market before it begins to discount the top of the cycle when it will de-rate these recession-prone sectors harshly.
Note that the sector headings and order correspond to the FTSE Actuaries Share Indices classification for ease of reference, as this details performance, dividend yield and cover, PER and total return in summary form. This classification is also used to group all of the individual shares into sectors. Both are listed daily in the
Financial Times. Thus, an investor can track sectors that are of interest and then
drill down to see individual shares in that sector from a quick perusal of the paper.
There are likely to be shares that will do well in any sector and a stock picker will focus on these, rather than be swayed by sector moves. However, the job is made harder without a reasonable sector tailwind. Note that this chapter analyses each individual sector and thus complements chapter 2, as that examination of competitive advantage cuts across numerous sectors. For example, sector consolidation discussed in chapter 2 applies to banks, pharmaceuticals and oil. Each of these sectors is assessed below individually to see what competitive advantage they possess.
The economic cycle of opportunity table, overleaf, scores the recession resistance and competitive advantage of each sector over a typical ten-year economic cycle. Although these scores are subjective, they should provide a reasonable guide. The competitive advantage points are awarded in the same manner as for sector business models in chapter 2, namely the power of the sector to achieve low cost and/or differentiate itself so that it adds value. Above all, it is crucial to be able to control revenues streams.
The Economic Cycle of Opportunity can be viewed on the following link
or on page144 here:
We now look at each of the sectors in detail. The score for recession resistance and competitive advantage is 1 for highest and 5 for lowest, with an average of 3. Note that this does not score them as attractive sectors on valuation or technical analysis grounds since these change daily. The sector’s capitalisation as a percentage of the UK stock market at the end of 2004 is also shown. This is also the date used for the profit and growth margins in the table.
Beverages: recession resistance 2, competitive advantage 1. Percentage of stock market capitalisation 3%.
‘Diageo. Based on the Latin word for day and the Greek word for world. Diageo captures what this business is all about – bringing pleasure to consumers every day around the world.’
The logic behind the new name for the merged Guinness and Grand Metropolitan.
Beverages is an attractive sector as it offers defensive growth. It is essentially a tried and tested, simple business, although changing tastes and fashion are important factors. There has been consolidation amongst the players, as economies of scale are significant so that products achieve critical mass, for example, in distribution networks.
Its resistance to recession is above average because beverages are low-ticket items and there is high compulsion to consume. People are reluctant to give up their tipple when they need cheering up in hard times. However, there will be some fall-off in demand and trading down to cheaper brands when consumers are forced to tighten their belts.
The sector has high international competitive advantage, driven by the power of leading brands, heavy advertising and global reach. This enables its claim on disposable income to remain steadfast. However, it is not all plain sailing as the market is mature and there is tough competition from overseas brands, as well as from supermarkets’ own label drinks. Although the sector does supply own label, the margins tend to be lower. Other downsides include heavy ‘sin’ taxes and a trend towards a healthy lifestyle. Overseas developing markets are attractive as incomes rise and consumers can start to afford such high status products. Please also see leisure and hotels below.
The profit growth of the sector over the last five years was 6% per annum, compared to 9% for the stock market as a whole, and the 19% profit margin is above the stock market’s 15%. The dominant player is the peculiarly named Diageo, with Allied Domecq a long way behind. Diageo is a gorilla and the world’s number one seller of spirits with long-proven brands like Johnnie Walker, Smirnoff and Guinness. Market segments have been established with new products like alcopops. This has driven growth, although demand can be fickle and some new launches have failed. Both Diageo and Allied Domecq are exposed to US dollar weakness. The temptation for the gorillas has been to diversify to boost profit. This has resulted in mountainous goodwill and expensive failures, such as Diageo with Burger King and Scottish & Newcastle with Center Parc. The key, then, is to buy when the sector is cheap, as the share price will more likely be driven by a re-rating rather than profit growth. The niche players lack powerful brands and have less competitive advantage than the gorillas.
Food producers and processors: recession resistance 1, competitive advantage 2. Percentage of stock market capitalisation 2%.
Like beverages, food producers and processors is an attractive, defensive sector. It is a stable but mature market, with sales stimulated by flair and new product launches.
Demand is robust in a recession because the products are staples of life and are low-ticket items. Brands are important to achieve premium pricing and strong product differentiation, established over many years through reputation, value for money and advertising. Supermarkets’ own brands are a threat and supplying this market has to be at keen prices and top quality. This is a tough space to occupy, as Northern Foods has found.
It has above average competitive advantage overall and is dominated by gorillas like Unilever and Cadbury Schweppes, which have significant economies of scale after extensive takeover activity but has resulted in high levels of goodwill. Nevertheless, there is strong competition from overseas giants like Nestlé, which also has been acquisitive. Generally, the space to occupy is selling the brand to the consumer and capturing that value, like Cadbury Schweppes, rather than being squeezed into producing commodity products like sandwiches and milk for supermarkets, like Geest and Dairy Crest. Such minor players struggle to pass on higher input costs to powerful supermarkets and have to resort to cost cutting.
Nevertheless, gorillas can struggle in this regard too and Unilever has embarked
on an expensive, five-year restructuring programme to reduce the ‘noise’ of having too many brands and to focus on the most promising 400. Likewise, Cadbury Schweppes has announced a somewhat similar restructuring programme. In such cases, share performance can be at the mercy of meeting restructuring targets.
The profit growth over the last five years was 10% per annum and the margin is 13%, which are both similar to the stock market as a whole. Niche players like Richmond Foods and Inter Link Foods have sound business models, in spite of supplying to powerful supermarkets, are growing fast and are more attractive than the gorillas. They both have low costs and differentiated products, with Richmond’s Nestlé brands and Inter Link’s customer relationships and new lines. Both have avoided the trap of being overly reliant on too few customers.
Pharmaceuticals, health, personal care: recession resistance 1, competitive advantage 1. Percentage of stock market capitalisation 9%.
‘What good is health? You can’t buy money with it.’
Charlie Munger, Vice President of Berkshire Hathaway.
Pharmaceuticals, health and personal care is the first of only three sectors to earn the maximum score for recession resistance and competitive advantage. The sector was riding high in the mid-1990s to the end of the decade, as the market was growing, new blockbuster drugs were launched, prices were increasing and regulatory approval times were falling. This lead to overvaluations based on the lure of defensive growth. This optimism then hit the realism of a high cost base, few new drugs and a weak pipeline, strong generic competition as important drugs came off patent, longer regulatory approval times, worsening economic conditions and opposition to prices from government and healthcare bodies. Visibility of earnings dropped sharply and emphasised the high operating risk. The next few years offer little respite from these problems so an investor should be wary in spite of the strong recession resistance and competitive advantage.
The strong recession resistance reflects the fact that drugs are ‘must-have’ products, are low-ticket items and typically free or subsidised for the end user. Therefore, demand and growth are never ending. Demographics favour the business, as the population is ageing, and drugs are much cheaper than hospital stays. It rides the tailwind of governments spending more on health and this is a Chapter 4 – Which sectors to buy and sell during the economic cycle
main objective in some cases, such as in the UK. However, various health reforms over the years have played their part in holding down the cost of drugs. Personal care includes household products and the gorilla Reckitt Benckiser dominates this sub sector. It has an impressive list of brands, like Dettol, that helped to increase margins in this very defensive play. Warren Buffett likes this sort of company because it has a strong consumer franchise and is similar in this regard to Gillette, in which he has a large holding.
International competitive advantage is very good and the gorillas are GlaxoSmithKline, the fourth biggest UK company, and AstraZeneca. There has been significant consolidation to cut costs, an example being the £5 billion Amersham takeover, and the amount of goodwill on the balance sheets is significant. There are very high barriers to entry due to the massive economies of scale that are needed to fund the enormous research and development expenditure, trials and the long time it takes to bring a blockbuster to market. However, once this has been achieved, the company can enjoy that most wonderful of competitive advantages, a monopoly, for years and the super profits roll in. Eventually, the drug comes off patent, which lasts up to 20 years, and generic competition leads to price-cutting. It is a race, therefore, to bring out new products from a long pipeline more quickly than old ones lose patent protection and such a race has similarities to the oil sector. It is preferable to concentrate on a few blockbusters rather than be an average competitor in many products, as the development costs for each are comparable.
The profit growth over the last five years was 10% per annum, just above the market’s 9%. The margin is an impressive 20%, five points above the overall stock market. Niche operators are more attractive than the gorillas, examples being Celsis, which provides contamination testing and Synergy Healthcare that offers sterilisation services.
Tobacco: recession resistance 1, competitive advantage 1. Percentage of stock market capitalisation 2%.
‘We’ll all be jockeying for position in Playboy and Penthouse.’
RJ Reynolds, on new tobacco advertising bans.
Tobacco is the second sector to score maximum points on the recession resistance and competitive advantage yardsticks. It is a unique product as it is highly addictive and is the only legal product sold that can be lethal if used in the
manner intended. Advertising bans and smoking restrictions become ever tighter and tobacco is on the black list of ethical investors. The market is stable and there is no product obsolescence.
It is difficult to imagine a product that has a stronger resistance to recession. The addiction means that customers are hooked, so demand is extremely robust and insensitive to the high price charged. Although the developed world is a mature market, there is growth in the developing world, which feeds off rising living standards that increasingly enable such products to be bought. Young populations and per capita incomes are the most significant growth drivers.
It has very high international competitive advantage. This is a remarkable testament considering it is achieved by a commodity product where little value is added in production. It is strongly cash generative, creates value for shareholders and the cost of production is very low compared to the high selling price, which is mostly comprised of punitive taxation. There is an old saying: what other products are like tobacco that cost a penny to make and sell for a dollar? The high price encourages consumption by both legal and smuggled importing from low tax countries. Brands are important as consumers respond to status and health messages. The profitability of the sector has been undermined in the US due to price-cutting by generic brands. The PER is usually low and the yield generous, reflecting the dullish growth. The latter has been boosted by numerous takeovers and goodwill is material.
The profit growth over the last five years was 11% per annum, slightly above that of the market, but the profit margin is the highest at 28%. The strong cash flow encourages high, tax-efficient gearing. The risk of litigation is high and awards in the US are astronomical, from both the civil courts and the government, which aims to extract $280 billion in a settlement with tobacco companies. Litigation news has a major bearing on sector share prices and can provide buying opportunities. Therefore, it is important to avoid British American Tobacco, as it has US exposure, whereas Gallaher and Imperial Tobacco do not. The latter two are smaller players and takeover potential is good. This is a very popular sector in a bear market but is ignored in a raging bull market, when high growth is the mantra, so sell in the former and buy in the latter. Profit warnings are rare, which is a major advantage.
End of extract from Chapter 4.
‘It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price’.
We have seen how important it is to consider both the business model of the company and the competitive advantage of the sector, and how they fare in the economic cycle. The next step is now to analyse shares that have made it thus far in the sieving process. The objective for the investor is to have control over the share and choose those that offer growth at a reasonable price. This provides a margin of safety to minimise the risk that is inherent in investing. Overpriced shares can easily be de-rated and are a sitting duck if there is a profit warning. There are many books on this subject, such as Benjamin Graham’s The Intelligent Investor and Jim Slater’s Beyond The Zulu Principle. The statistics below are easy to evaluate using REFS, or Really Essential Financial Statistics, which was developed by Jim Slater. REFS also allows companies to be sieved using various criteria, such as growth rates and profit margins, and the whole market can be searched for the best opportunities.
The following four growth statistics help to see the future, as they estimate a company’s financial progress over the next 12 months.
The price earnings ratio (PER) is usually regarded as the most important measure of a share, as it represents the number of years that the earnings per share (EPS) will repay your investment. Thus, a PER of 10 means that over 10 years the earnings will equal the cost of the share. The PER can be for the last set of results but it is more useful to look forward over the next 12 months, based on broker forecasts. Be wary of buying any share on a high PER, as all the good news is likely to be in the price and it can be very exposed if there is bad news flow or if there is a de-rating in the share or in the overall market. A PER of 10 or less is a good target and up to 15 is also acceptable, as long as the story is very good. The margin of safety is eroded if it is above 15 and it was difficult to find low PERs in the stock market mania that ended in 2000. Indeed, PERs of 70 and higher were common. That was a clear sell signal. Look at the PER over the last few years and see if the forecast PER is in the lower range, as it implies a reasonable
entry point. When a sector becomes ‘hot’, other sectors may become neglected and that is often where value and opportunity lies. For example, in the TMT mania, solid sectors, like mortgage banks and tobacco, were very cheap and subsequently rebounded strongly when there was a flight to safety.
‘Earnings are the engine that drives the share price.’
The brokers’ forecast growth rate in earnings per share (EPS) over the next 12 months is a vital tool. Ideally, this should be in the mid teens to the high twenties. Beyond that and the growth rate is unlikely to be sustainable. Increases in broker forecasts can be an important share price driver. Also, be alert for forecasts which are accelerating over the next two years, as this demonstrates that the pace of growth is escalating. This improves the margin of safety and implies the competitive advantage is strengthening. Look at the past growth in earnings and the aim is for this to be increasing with no erratic years where they fell significantly or losses were incurred.
There should ideally be three or more broker forecasts to provide a consensus view. A single forecast is less reliable and the house broker’s forecast should be taken with a pinch of salt, as there is a potential conflict of interest since they are paid by the company. On the other hand, it is reasonable to expect that it is closer to the company than the other brokers so the forecast may be more incisive. The forecasts should not be widely different or materially reduced recently. Forecasts are not a panacea and can swiftly be overtaken by profit warnings. However, they are better than flying blind. It is because they are unreliable that this book emphasises additional investment analysis tools, namely company and sector business models, the economic cycle, growth at a reasonable price, technical analysis and scuttlebutting. These provide the real margin of safety.
The PEG system was popularised by Jim Slater and is simply the PER divided by the growth rate in EPS. Therefore, a PER of eight divided by a growth rate in EPS of 16 produces a PEG of 0.5. A PEG of 0.6 or under is attractive for a growth company. A value company is chosen for attributes, such as a high dividend and asset backing, and PEGs of under 1.0 can be considered. The PEG is awarded if there are four years of growth, so there could be three years of historic growth
and one year of forecast growth. House builders need five years of growth in EPS to qualify for a PEG due to their cyclicality. An investor is spoilt for choice in a booming economy, as PEGs will be plentiful. A bear market results in many companies having an interruption in profit growth and so fewer qualify for a PEG. However, the principle is still valid and calculating a PEG ratio for the next 12 months is a useful yardstick even if the four requisite years of growth are absent.
End of extract from Chapter 5.
‘Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.’
Dennis Gartman, trader.
This book is primarily about the fundamentals of a company, with particular emphasis on business models, sector competitive advantage and the wider economic backdrop. It is not a book about technical analysis but, nevertheless, the fundamental approach can gain extra performance if some simple technical analysis is borne in mind. This chapter looks at this world and some of the tools which supplement fundamental criteria. The one-minute guide to this chapter is to buy shares that are rising and sell shares that are falling, bearing in mind the fundamentals. Also, the relative strength of a share is a good proxy for technical analysis and is easy to use, as it is a single number to consider rather than numerous lines on a graph.
Technical analysts, or chartists, study the share price graph. They ignore the fundamentals of a share, such as its competitive advantage and growth rate, as they assume that that this is all known to the market and is reflected in the price. They believe future performance can be forecast by looking at patterns that have indicated success in the past. For example, a fundamental investor might have thought that Marks & Spencer was a buy in 2000 when the price was 190 pence, reasoning that the net asset value was 220 pence and so was cheap. The point is that the market knows that too. Therefore, a fundamental investor may think he is being smart with some shrewd information but, in fact, the market has already discounted it and it is reflected in the chart.
The problem with fundamental investors is that they can become convinced that they are right about a share and the market is wrong. It is, unfortunately, very expensive to argue with the market. Dennis Gartman expressed this as follows: ‘The market is the sum total of the wisdom and the ignorance of all of those who deal in it; and we dare not argue with the market’s wisdom’. Technical analysis can take out the emotion by objectively telling an investor it is time to buy, sell or do nothing. Chartists emphasise that you should be dispassionate about shares and never fall in love with them, as that clouds judgement, and they are definitely not in love with you.
Sometimes the stock picker is right but he needs a very powerful argument to hold or buy a share that the market dislikes. It is therefore risky. It is generally
better to have a strong feeling about a share and have the market momentum behind you. That is why a fundamentalist approach is powerful when combined with technical analysis, so an investor has the best of both worlds. Neither is sufficient on its own.
Note that technical analysis applies to any graph and, in addition to shares, it can be used on sectors, funds, currencies, commodities, bonds and stock market indices. One rule of technical analysis is that shares are never too expensive to buy or too cheap to sell.
‘Buy low, sell high’. This advice seems obvious, but investors always ignore it. The demand curve for investment assets is like that for a luxury good-the higher the price, the greater the demand.’
Edward Chancellor, author of Devil Take the Hindmost.
Economics states that a price will be established where demand and supply are equal and the product will be sold. Normally, if the price rises then demand will drop and vice versa. This rule is sometimes reversed and increased prices can lead to increased, not reduced, demand when the emotional public take part and logic is replaced by greed and fear. It is a peculiarity of human behaviour that the demand for products, such as shares, which seem to promise a change in wealth, are subject to violent swings. This is not true demand in the sense of wanting to consume the product but the coveted asset is, instead, a store of wealth, which is to be maximised and then sold to a greater fool. Speculators extrapolate the past and think that price rises will continue so they buy more, not less, as the price rises. Houses are an example of demand increasing as prices rise because they become items of speculation to increase wealth, rather than places in which to live. Likewise, speculators extrapolate in a bear market and, thinking that prices will continue to fall, the result is that lower prices lead to lower demand.
Share trading is not determined, therefore, by existing prices but on expectations, resulting in the stock market producing trends rather than stability. When the trend is established, it will continue because the speculation increases until eventually it runs its course. This allows manias to flourish and it becomes a game of outwitting the enemy and anticipating what it will do under various scenarios. An
understanding of this can be gained by looking at the master strategists of war, such as Napoleon or Sun Tzu in The Art of War.
‘Trying to sell an illiquid stock in a down market brings to mind the galley slaves in Ben-Hur, chained to their bench while the ship sinks.’
The key principle is the ‘trend is your friend until the bend’ in the share price chart. Investors should thus follow the line of least resistance, buying shares in an up trend and selling those in a down trend. Do not attempt to sell at the top or buy at the bottom. This cannot be done except by occasional fluke. For example, a speculator could have tried to catch the bottom of Marconi at any time from its height of £12 in the TMT mania as it spiralled downwards. Indeed, some may have thought it must be a raging buy at £2 because it was so recently ‘worth’ £12. The share carried on down to a penny. Instead, wait until the market has bottomed out and there is sustained recovery. Picking bottoms is foolhardy because a share in an established down trend will likely continue in that down trend for an unknown period and you will be dragged down with it. Let that fate befall the existing, hapless shareholders and do not volunteer to suffer their fate.
A typical scenario is as follows. The trend starts but is not initially spotted. Buying then begins and reinforces the trend. The trend holds true and is confirmation to those testing the market. Confidence grows and the public jumps on the bandwagon. Prices then become far out of kilter with any valuation yardstick. Eventually, all that want to buy are in the market and, with no more demand, prices falter. This is the reversal point and it is unknowable because it depends on the actions and minds of the many. The same reinforcing process now happens in reverse with many sellers but few buyers. The trend has been your friend on the way up when speculators bought and vice versa on the way down. The long-term investor seeks value and will buy when prices are cheap. Thus, they will tend to be successful because they buy around the bottom before the trend is fully established. However, they do need to take profits when the party is over.
‘Investment results largely depend on how one behaves near the top and near the bottom.’
John Maynard Keynes, economist and renowned investor.
The trend examples, which are graphs, can be viewed on the following link on page 195 onwards:
There are up trends, down trends and sideways trends. Two points are needed for a trend line and a third confirms it. The trend line is shown in the line below. Note that in the up trend chart for Richmond Foods, the share price is making higher highs and higher lows, keeping the trend intact. Falls in the price are soon reversed. Buying on such a retrenchment is a wise strategy. The chart may start to increase in steepness in an up trend and further lines can be drawn confirming that the shorter-term trend lines are increasing.
In the down trend chart for Vodafone, the share price is making lower lows and lower highs, also keeping the trend intact. Rallies in the price soon fail and new lows are reached. Buying on a rally and hoping the down trend is over is not a wise strategy.
The sideways trend in the Tesco chart below is a market for a trader who attempts to profit by buying near the bottom support line and selling at the top resistance line, since there is no real direction in the overall share.
‘A picture is worth a thousand words.’
Fred Barnard, advertiser.
The market has a memory and is illustrated in the Tesco chart above. There are three groups of sellers when the price hits the upper resistance line at 270 for the second time. There are those that bought previously at the lower support line at 240 and want to realise the profit, those that previously bought at 270 and want to get their money back, and those that did not sell before at 270 but now can. These sellers cap the price and provide a resistance level at 270.
There are three groups of buyers when the share price then falls back again to 240. The first is investors who bought at 240 previously, then sold at 270 and want to repeat the profitable experience. The second is investors who previously sold at 240, then saw the price zoom up to 270 and now want to buy at 240, as they anticipate the share will go back to 270. The third is investors that did not buy at 240 but can now do so. These three groups buy at 240 and this becomes a support level.
The price holds at 240 but the rallies begin to fail as the buyers fade away. The price then falls through the 240 support, as all the investors at that level have already bought, and the price drops to 230. This is a good point to put your stop loss, as it should be placed just below the support level. The price rises to 240 again for the last time. This triggers selling because those that bought at 240 have a chance to get their money back and they take advantage of the opportunity. The rally fails, therefore, and the price drifts south again. Once the 240 support level is breached, it then turns into a resistance level. Note that the share makes numerous bottoms at around 240. This is bearish, as another attempt to fall through 240 is eventually successful as investors lose confidence in the share’s ability to perform. The price then quickly drops below 200.
When a share breaks out above its resistance level, which is 270 in the example, this brings in waves of buyers who anticipate making a profit. All the existing holders are in profit so there is no forced selling to get their stake back and the share can carry on rising. Conversely, when a share gets into a down trend, any rally is hit by waves of sellers taking advantage of the now higher prices to get out. The down trend then continues.
A support level can be made by reference to previous lows and a resistance level by reference to previous highs. These are 230 and 270, respectively, in the above
example. They can also be set by round numbers, e.g. buyers emerge when the FTSE 100 falls to 4,000. The levels can also be because of retrenchment of previous moves. A share can often bounce ahead of the support level as buyers are eagerly waiting in the wings and buy a little too early before it hits the support level. Very strong support is shown when a share has a steep ‘V’, as the reversal in the share is sudden. Where support levels are broken, especially over a long time frame, it is a very strong indicator that you should get out or short the shares. A sound strategy is to add to a winning share that is channelling upwards by buying when it bounces back up from its support line.
When a share hits a double top, or numerous tops, as at 270 above, the implication is that it is having difficulty breaking out as the sellers have the upper hand. This is a very strong sell signal and is definitely not the time to buy. Every failure to break out is a warning. If a break out is achieved, then buy quite early on to capture most of the up trend but not too soon, as you seek confirmation that the breakout is real. Continue to buy as successive breakouts are achieved. Never do the opposite and average down when support levels are successively broken, as that just reinforces investment failure. The trend here is a deadly enemy.
End of extract from Chapter 6.
‘Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company’s affairs from those who have some direct familiarity with them.’
Philip Fisher, author of Common Stocks and Uncommon Profits.
The term ‘scuttlebutt’ describes the chatting that would take place round the scuttlebutt, the name of a water barrel or butt on a ship. In investing terms, it means assessing a company by testing it for yourself through empirical observation. Philip Fisher brought this method to prominence and suggested talking to company employees, suppliers, customers, company management and knowledgeable people within the industry. This way you can try to assess the real company and its strengths and weaknesses. This can involve much work and not everybody will be willing to discuss the company so it does have limitations.
Scuttlebutting can be carried out more easily in some sectors than others and are principally those with consumer products that can be readily accessed and tested. Visiting retail outlets and discussing the business with the staff is often a very good source of information. Scuttlebutting is less useful when the product is more technical and sold to businesses. Suitable sectors include: telecommunications; insurance and life insurance; media and entertainment; banks; some support services such as estate agents; general retailers; transport; real estate; food and drug retailers; leisure and hotels; utilities; tobacco; food producers and processors; beverages; and some information technology software and hardware that is consumer-orientated, rather than business-orientated.
The people most knowledgeable about a company are its management. There are several ways to gain access to them and ask questions.
Management may normally be reluctant to spend time answering investors’ questions but a prime time to quiz them is at the AGM. After the formalities of the meeting, there is usually some refreshment and the directors can mingle freely. However, if an investor asks a pertinent question and is fobbed off with a ‘reassuring’ but unconvincing answer then do not be surprised. Your question has, in fact, been answered and the shares should be avoided. Most people gain an impression of what someone is like very quickly and a chat with a number of directors should enable an assessment as to whether they are honest, trustworthy and capable. Also, assess them when they make their presentations and see if they have a tendency to ‘spin’ the company’s progress. Unfortunately, this is very likely to be the case, as evidenced by the fact that almost all companies employ financial public relations firms to interface with the City and investors. Indeed, if you find one that does not, like Morrisons Supermarkets, then that is a point in its favour. Even so, an investor should try to see if the directors are presenting a true and fair view.
‘Always tell the truth. That way you don’t have to remember anything.’
If you have the opportunity to speak to any member of the board, then the best one is typically the finance director. He will usually have the most complete and accurate picture, as he is responsible for the entire financial operation. He will be highly trained, intelligent and hard working and been used to the concept of true and fair when he cut his teeth in the auditing profession. Once working outside the profession for a company, he will have carried on providing a true and fair view of the company’s performance to the board and, hopefully, the same to shareholders in the audited annual accounts. An institute of accountants regulates him so he will have professional integrity to bear in mind. He will be disinclined to run the risk of being reported to the institute and perhaps struck off. In other words, you are more likely to get a better answer from the finance director than any other director. The next best bet is the CEO but they can have a salesman’s optimism or be ‘colourful characters’, without the professional restraints of the finance director. Often, they have a weaker grasp of operations and sometimes are plain wrong. Finance directors are not a panacea, however, as they can sometimes be ‘economical with the truth’ and occasionally they lie blatantly, although this is very much the exception rather than the rule. A list of sample questions to the finance director might include the following. Please see chapters 1 and 2 for a more detailed explanation of some of these terms.
What is the business model, how has it changed and what plans, if any, are there to change it?
Are customers glued to you?
Does the company improve the economics of the customer’s business?
Why should a customer deal with you rather than a competitor?
How many customers do you have?
What is the percentage of turnover from the top five and ten customers? Are there recurring and long-term revenues and what is their percentage of turnover?
How big is the order book as a percentage of turnover?
Are customers locked in and, if so, are they happy to be so? Why are contracts not renewed, why do customers not return and why are new sales pitches lost?
How many sales pitches turn into contracts?
What is the contract renewal rate?
Are contracts lumpy?
How will demand fare in a recession?
Are customers long-term or transactional?
Is there resistance to a sales model, e.g. buy versus rent? Do they have superior channels to market, i.e. how do they sell: clicks and mortar?
What is the competition for each product in the UK and overseas?
How do you compete: price, service, unique selling point?
Is the competition intensifying?
Whom do you most fear?
Is there an emphasis on training staff, especially sales and customer care?
Is there a board member dedicated to customers?
How well do the board members and senior management know the customers, pay site visits and obtain feedback?
What is his shareholding in the company and changes thereto?
What does he feel about the share price?
When and why did he join the company?
Who would he like to work for if not this company?
Do you have a superior or must-have product?
Do you have patents?
Do you have a differentiated product – e.g. is it perceived as offering better value?
What is the percentage of the overall market for each product?
Which of the products has greatest potential and why?
What are the margins in each product and trend compared to competitors? When is the revenue recognised? This is particularly relevant to software companies.
Who has the power in the sector? Is it the supplier, producer, distributor or customer? How much power does your firm have? Is it changing? What are the sector economics and are they changing? What effect does technology have on your business – inputs, production, distribution and channels to market?
What special problems are there in your business and the sector?
Is there takeover potential?
What is the policy towards acquisitions?
What are the biggest threats to your company and the sector?
What are the barriers to entry and exit?
Scuttlebutting is not a panacea but it is a good check. If you are keen to buy but have poor scuttlebutting then that is a warning sign. You should be keen to buy and have positive scuttlebutting. The opposite is true if you want to sell. Scuttlebutting can provide a unique insight into the company before the market wakes up to the positive or negative story.
End of extract from Chapter 7.
‘Company accounting is a jungle with many species of animal – some benign, some carnivorous – and its own rules. Anyone who believes this is an exaggeration should read one of the entertaining studies of the securities industry, most notably Liar’s Poker.’
There is a tremendous amount of spinning in reporting company results. This is unlikely to lessen in an age where moral standards have dropped alarmingly at all levels of authority and society. There has been widespread adoption of base, rather than higher, values and greed is endemic. It is difficult to think of any part of the ‘Establishment’ that stands in higher regard than it did two decades ago, as each segment has blotted its copy book in turn, like politicians, or become marginalised, such as the church. Businessmen live in this ‘brave new world’ and bring this lack of values with them to their work. Remnants of the ‘old school’ are rare, although they are discernable in some companies like Hardys & Hansons and Morrisons Supermarkets. The old concepts of ‘my word is my bond’ and settling deals on a handshake have long gone. ‘Caveat emptor’, meaning let the buyer beware, is now the watchword. The directors’ motivation is simple. They are selling their performance and the company’s prospects to the reader and, with huge share options at stake, they have an added conflict of interest in putting on the rosiest gloss possible. Therefore, investors are right to be suspicious of not taking part in a mug’s game and the utmost caution is needed.
Terry Smith’s book in 1992 Accounting For Growth opened the lid on how companies resorted to various tricks to increase their profits and is still a classic today. The backlash from companies was so intense that he sought alternative employment, which indicates that it hit upon the truth, rather than being an academic exercise. The areas he covered were: pre-acquisition write-downs; disposals; deferred consideration; extraordinary and exceptional items; off balance sheet finance; contingent liabilities; capitalisation of costs; brands; depreciation; convertibles; pension funds; and currency mismatching. This chapter examines five further areas that should be understood before buying any share. They are broker forecasts, cash flow, dividends, goodwill and share options.
End of extract from Chapter 8.
‘There is nothing we receive with so much reluctance as advice.’
Joseph Addison, poet.
Investment axioms, or rules, are very helpful as they examine the minds of gurus who have vast experience of being successful investors. Some axioms are the trademark of a single or select number of gurus, whereas others are widely shared. Sometimes they are contradictory. The lessons to be learned should be invaluable. They generally support the ideas in this book and, where they do not, it recognises that investors have different systems. For example, a few gurus pay little heed to the macroeconomic view or technical analysis. The investment world is a broad church and accommodates the whole range of investment styles, so select those that most appeal to you. There are many ways to make a profit, depending on such aspects as attitude to risk, skill, experience, time, financial objectives and personal characteristics. The first two axioms are arguably the most important: cut losses and run profits, and the trend is your friend until the bend.
‘Great stocks are extremely hard to find. If they weren’t, then everyone would own them.’
The distilled wisdom of 35 gurus with an estimated 1,000 years of the very best experience has been summarised. This approach is different as it is an amalgamation of gurus’ ideas on each topic rather than each guru’s individual philosophy. This is likely to be more powerful, as this collective wisdom reinforces the credibility of the axiom. The gurus include: Anthony Bolton; Warren Buffett; Phillip Carret; David Dreman; Stanley Druckenmiller; Philip Fisher; John Galbraith; Dennis Gartman; Benjamin Graham; Stanley Kroll; Leonard Licht; Jesse Livermore; Peter Lynch; Michael Moule; John Neff; William O’Neil; Thomas Rowe Price; Jim Rogers; the Rothschilds; Ian Rushbrook; Ed Seykota; Jim Slater; James O’Shaughnessy; George Soros; Michael Steinhardt; Nils Taube; Sir John Templeton; Larry Tisch; and Ralph Wanger.
Some gurus share common personal characteristics and it is likely that these contributed to their success. These characteristics have included the following in several cases. They had an early tragedy, such as the death of a parent, and many were poor as a child. They know the bitter experience of a crash that has wiped
out the family coffers and made them aware of the threat of disaster. Their natural innocence and naivety were eliminated early and thoroughly. They have a strong craving to be financially secure and this drives them hard. They prefer to live modestly, even after being successful, probably reflecting the saying that ‘the dumbest thing you can do with money is to spend it’. They are important philanthropists with charitable foundations. Being loners allows them to think independently and go against the herd instinct. They trade their own money and are convinced that they will succeed in the long-term. Many have found a system, have remained loyal to it and are disciplined with an unyielding approach to controlling risk. They are very serious traders and, although decisive, they are not particularly academic. In short, they love their job.
‘Some people automatically sell the winners and hold on to their losers, which is about as sensible as pulling out the flowers and watering the weeds.’
Cut losses and run profits is simply the best advice that the gurus offer, as it is imperative not to incur large losses. This also reinforces the second best piece of advice that ‘the trend is your friend’, as discussed in the next axiom and in chapter 6. A share that has risen will be in an up trend and run the profits. A share that has fallen will be in some down trend and should be earmarked for cutting. Selling a winning investment and hanging on to a losing one is a cardinal sin. Cutting losses recognises that mistakes are often made and action must be taken swiftly, decisively and objectively. This is a rare gift and, to be a winner, learn how to lose and do not be afraid to take a loss. Profits take care of themselves but losses never do, especially in a bear market. The key is not to lose money so avoid the big losses.
Cutting losses is difficult because of ego, as investors do not like to admit they made a mistake. The pain of a loss is much more than the pleasure of a gain. There is the problem at what point to cut the loss, i.e. 10%, 20%. This is subjective but it easier and preferable to take a small loss rather than a large one. Also, should the loss be absolute or in relation to the market? If the market falls 10% and the share falls 10%, does that mean the loss should be cut? An investor must try to minimise absolute losses, so if a share has fallen by the predetermined amount it should be cut, notwithstanding what happened to the rest of the market.
There is the fear of regret that the cut position will then turn into a winner. This
does hurt but such sudden reversals do not happen often. It feels wrong to abandon an investment but this is less painful with practice. Accept small losses cheerfully and expect to experience several while awaiting a large gain. Automatic stop losses can remove emotion. Stop monitoring the share once it has been sold, as it is no longer a relevant investment and, if it does recover, then unhelpful and stultifying regret may take hold. However, you might want to monitor the share if you want to re-invest later. Learn how to lose and thus avoid hostile feelings.
It is a great mistake to average down by buying more of a losing investment, rather than cutting it. Instead, consider if you would purchase it now on its own merits rather than because you hold the dud anyway. If the conclusion is no, then do not average down and, if it is yes, beware you are not kidding yourself. The very idea itself can be a comfortable but dangerous reason for avoiding decisive action.
Running profits also needs discipline. Hold winners for the longer term, i.e. three to five years, providing that the story does not change or if it hits your profit target and is sold. Do what is right, not comfortable, so avoid the temptation of selling sure winners and resist the urge to take the cash now. Many people trade well with good timing but they make little profit because they go in and out of the market. The big profit is made by remaining invested in a bull market until it falters. You never go poor by taking profits but neither do you grow rich by making small profits in a bull market. Many get doubts or become impatient and do not give their investments sufficient time to prove themselves. The market does not beat them as they beat themselves. It is not difficult to be right about the markets but to have excellent timing and remain invested is very rare. It is the major move in the market that is important and trying to trade in and out can be a grave mistake. It is far more important to spend time considering when the bend in the market trend is going to happen than worrying about individual shares. The bull market ends before there is a general drop in the index and is evidenced by some shares starting to come off their highs.
‘The trend is your friend most of the way, trend followers only get hurt at inflection points, where the trend changes.’
George Soros, billionaire trader and philanthropist.
The chapter on technical analysis also covers this subject. For some, a trend following or momentum approach can work amazingly well, compared to any
other trading system. Wait until a major trend is clearly established and the broader the market trend the better. The real inside reason is unknown but you should climb on board by following the line of least resistance by buying an up trend and selling a down trend. The trend usually continues in the same direction and, by following it, an investor will not ‘buck the markets’, in the words of Margaret Thatcher. Do not be necessarily discouraged by the price, as a share is rarely too expensive to buy or too cheap to sell, although they may well look that way at the time.
Buy after a rise, even though you missed part of it, because catching the midrange, broad momentum is fine. If you buy on the first correction of an up trend, then again on the next correction you buy less and carry on doing this. You have restricted the amount bought near what may be the top. This tests the market and verifies its strength so that if there is a loss, even briefly, then you know the timing was premature. You may thus incur a small loss but the main firepower is ready when the time is right. Therefore, do not be afraid of buying a rising market so that each purchase is at a higher price and profitable each time. As you buy more, you can raise the stop loss so that profit is locked in if the trend reverses. You should be going with the flow of the market and thus, for a share in an up trend, there will be other buyers out there and thus buying should not be too easy for you. Be wary if it is too easy, as it means that the sellers have the upper hand. The reverse is the case for a falling share, as there will be other sellers out there too and thus selling should not be too easy. This strategy does not make a few, big, high-risk gains but numerous, small, low-risk gains. Maximise the amount of gains, not the number of wins. Being right is more important than being a genius, so aim to ride the trend. Arguing with the markets can be very expensive. Being a trend follower means being bullish in a bull market and bearish in a bear market, the opposite of a contrarian.
Selling a share when it hits its peak would be a pure and unrealistic fluke. Instead, an investor can sell before the top or wait until the market weakens and there is no bounce back, thus selling shares that are in a down trend. This means forgoing a very elusive and difficult part of the profit that was available at the top but you will get out near the top, easily bagging most of the profit. Many investors have no fear and do not recognise that unrealised gains can disappear, as they never become a profit until you sell. Down trends can also be used for shorting, although this should be left to experienced investors.
Bottom fishing for bombed out shares, before an up trend is established, is a high risk gamble. That does not stop amateurs, speculators and stock pickers from trying. They want to squeeze the last percentage of profit from a trade and are
reluctant to buy if a share moves up a little. However, if they overcome their reluctance and buy, then the results are often good, which is unsurprising as the trend is more established. Bottom fishing takes a special feel for the market and if an investor just does not have this then it should be avoided.
Avoid guessing the breakout in a sideways trading market. Establish your limits in either direction and when the market moves through one of them then trade and ride the trend. This is much safer, as you trade from a position of knowledge, now that the direction is established rather than guessing. A few gurus disagree and suggest forgetting about technical analysis. They may have been unable to find anyone who makes consistent profits and point to institutions which have poured fortunes into technical analysis ‘black boxes’ only to discard them. Other gurus are more forgiving and recognise that a chart can be a useful forecasting tool in the hands of an expert. The average technical analyst erroneously thinks that is all he needs to know about investing.
‘I avoid fads like the plague.’
Philip Carret, described by Warren Buffett as the person with the best long-term investment record.
Avoid popular shares, fad industries or anything that is ‘hot’. If you buy what everyone else is buying you will not enjoy a superior return. If you buy when everyone thinks a popular share is cheap, it is probably overvalued, since all the growth and good news is in the price. Glamour shares are the same and are overpriced. This also applies to shares receiving short bursts of enthusiasm. The best shares are often odd, uncomfortable, obscure and seem more risky. The best insurance is to check that very little has been written about it for a good while, nor are there recent broker reports. Never follow speculative crazes and often the best time to buy a security is when nobody else wants it.
To buy greedily when others are selling in despair and to sell determinedly when others are stampeding to buy requires great nerve and self-confidence but offers the highest return. Not everyone can outperform the market and if investors jump on a bandwagon of a share selection methodology or a way of evaluating the market then these tools will cease to work, just when the winning formula seems guaranteed. Once a country, sector or type of share is pursued by the masses, there will be a boom and the subsequent bust may be long-lasting. For those with
an appetite for risk, booms can be ridden with momentum investing on ‘the trend is your friend’ basis but stop losses are essential. A buy and hold strategy will be very painful.
One way to spot a bubble is to watch the multitude of new funds launched to chase the far receding bandwagon. Also, there will be glowing and reassuring articles in the media. Another pointer is if a company’s price jumps on news that it proposes to enter the hot area, for example anything with Net or .com in the name during the TMT mania.
Avoid official growth shares, as they tend to be overpriced. Hot new issues will not do well and avoid turnaround loss makers. Avoid quirky products that are difficult to understand, expensive to run and have uncertain value, such as derivatives and tax efficient investments. Avoid venture capital, as this is a high risk area where bankruptcies are frequent and amateur outsiders will play second fiddle to the professional insiders, who may have conflicts of interest. Warren Buffett, for example, says why take such an unproven risk, with promoters getting fat fees when, in a recession, you can pick up superb companies selling for less than net assets? Avoid blue chip companies in dying industries, such as metal bashing and chemicals, because they are cyclical with poor economics. Their size seems to promise safety but they deliver death by a thousand cuts.
Disregard the consensus opinion, as it is probably wrong, and think matters through for yourself. The media relentlessly emphasises that the majority is right and so it can feel unnerving to hold a contrarian view, which can undermine your determination. Be alert to this, unlike amateurs who are ignorant of it, especially during manias. It is more often the case that reality has dawned on the few rather than the many. However, do not be stubborn and just do the opposite of the majority for the sake of it but have an objective mind which constantly questions their influence instead of acquiescing to it.
‘In my 70 years of looking at markets, I have known a lot of people who went bankrupt, many of them because they ignored the need for diversification.’
It is important not to have all the investment eggs in one basket, so diversifying by country, asset class, sector and company increases the margin of safety, since the future is uncertain. Investing worldwide greatly increases the choice of finding the best opportunities compared to just your own country. Currency considerations do increase the risk of investing worldwide, however, and investing in a fund is a sensible approach rather than an investor buying individual shares. Countries should be avoided which discourage investments, such as those with left wing governments, depreciating currencies, high taxation and inflation. Instead, choose those that are stable, flexible and responding to international competitive advantage and lend support to business. Spread a single asset class, such as cash, shares and gold, across a number of accounts in case of default or fraud. Bonds do not preserve capital and shares are much better over the long-term.
‘If you have a harem of forty women, you never get to know any of them very well.’
Always invest significant amounts and avoid over-diversification. Large stakes can really make a difference but small ones will not, as they will be drowned out by other small under-performers. You also spread your time too thinly with many holdings and inertia is the result. Twelve holdings is a good size for a portfolio and will diversify 90% of the risk. Spread them across at least five sectors and be very knowledgeable about a few shares. Aggressively monitor your investments, especially any that are struggling, since change is ever present. There are no shares that you can just buy and forget. Avoid having long-term investments, where you pay no heed to performance as it is held for its dividend. Such investors are lazy and are the real risk-takers. Also, high yields are often a sign of trouble rather than opportunity.
‘Buy when most people including experts are overly pessimistic, and sell when they are actively optimistic.’
Benjamin Graham, author of The Intelligent Investor.
Please see chapter 3 for more detail. Invest from a top-down macro level by taking into consideration the economic cycle, interest rates and currencies to give country weightings and then choose the shares. Thus, an investor can then take advantage of the economic cycle and the mistakes of others. You can make exceptional profits by buying growth shares in a market wash-out, so time the market by raising cash at the end of a bull market and sell high beta shares, as they are more volatile than the index. Identify cyclical sectors and invest at the correct moment. The best time to buy is in the depths of a recession, rather than when the consensus says the outlook is encouraging, because bull markets begin when the clouds appear darkest. Buy those shares with the biggest prospective rebound and sell after the rebound.
Avoid the losing years and invest heavily in a few, really good years. There is nothing wrong with being out of the market in order to preserve capital, as it is your choice whether to participate or not. Spot the broad and most important megatrends in social, political and economic factors and buy shares that ride those trends. Some gurus do not take into account macroeconomics or try to time the market, as they are long-term investors. Others trade opportunistically, profiting from the public’s emotions.
‘The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do.’
Fear induces pessimism and greed induces optimism. They are the raw emotions that fuel the stock market, as fear causes the bear market and greed causes the bull market. Be most afraid when there is no fear. Conversely, fear and pessimism of others greatly reduce the risk of investing. The best time to buy is when pessimism is at its greatest and the best time to sell is when optimism reigns supreme. The surest and greatest profit opportunity is when the masses are panicked into selling. They buy during a boom and sell in a bust, so there can be
no value in the former, only in the latter. If you can spot a bandwagon then it is too late. To be contrarian and buy at the bottom is easier said than done, as bottom fishing is a risky strategy. This is because the bottom will only be proven in hindsight. Those who have a great fear of the market make the best traders. However, long-term investors should not be pessimistic too frequently, as shares rise in line with the long-term growth in the economy. Have the thought of what you can lose uppermost in your mind rather than what you can gain. Consider gearing up on crises, such as war, a government coup, terrorism and economic turbulence.
Greed and optimism greatly increase the risk of investing. You expect the best but need the self-assurance to deal with the worst. Do not trade if you are just merely optimistic. Optimists tend to assume ‘if’ is ‘will’, so keep hope and lucky thoughts out of your investments but, instead, be realistic about losing. Many amateurs are unrealistic and are wiped out. The professional is not optimistic but confident due to employing pessimism constructively. Assume a dire situation is exactly that, rather than kid yourself. We naturally prefer being optimistic rather than pessimistic, as it is a psychological boost. Therefore, there are more bulls than bears. Optimists also make better press, as the media likes to sell its wares and the public likes to hear positive stories. Therefore, beware the media’s partiality that also infects broker forecasts and recommendations. When optimism is most abundant, it is least helpful, whereas when pessimism is most abundant it is very helpful. This is because bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.
Greed means demanding more than you should expect. Determine at the outset what profit you expect from a trade and you should sell when that point is reached. As the trades are profitably concluded, the subsequent ones become starting points again, rather than ending points, and you have moved away from what was originally expected. Eventually, it may be very hard to sell out for the anticipated profit, as you are expecting too much. Set a sell price on all your shares and thus determine the end of the trade, rather than having it determined for you because of forced selling or a takeover. If a trade has no set ending then the share may wallow aimlessly in the portfolio. There will be times when shares take off but you do not know when or for how long so sell, locking in a decent profit.
End of extract from Chapter 9.
This book sets out six tools to choose shares that outperform. In summary, the business model methodology ascertains whether the company and its sector have strong competitive advantage. This results from low-cost activities/and or doing something different from the competition which adds value to the customer, who is then prepared to pay a premium price. Thus, costs are minimised and revenues are maximised, as is profit, which is the difference between the two. The company is then analysed according to how it will perform in the economic cycle; whether it offers growth at a reasonable price; and if the technical analysis and scuttlebutting are positive. These tools can be wrapped up in a simple table, as set out below, to rate a company’s attractiveness overall, using some sample scores.
Company business model
Sector business model
Growth at a reasonable price
* 1 is highest, 5 is lowest.
Examples of actual company business models scores are given in appendix 1 and 2 for Radstone Technology and Microsoft, which score 2.0 and 2.2 respectively. Next, a company might score the maximum 1 for its sector business model, if it had, inter alia, high barriers to entry and sticky customers. It fares less well, say, against the backdrop of the current stage of the economic cycle, as its recession resistance is only average, so scores 3 on this count. It is attractive, as it offers good growth in profits at a reasonable price, scoring 2 on this measure. The share price is in a strong uptrend, that looks set to continue, and scores the maximum 1 for technical analysis. Scuttlebutting proves to be limited and only scores 4. In this example, the overall score is 2 and the company is a candidate for buying.
Obviously, the scoring is subjective but it should be relatively straightforward to form a gut feeling about a company. To make it easier, an investor can express
the scores of 1 to 5 in the following broad terms: very good, good, average, poor, and very poor. Such an exercise would be a very useful aid to decision-making, so that an investor can conclude that a company scores 2, or ‘good’, in this example. Equally important is to stay well clear of companies that score 4 or 5. The most likely time for there to be a good choice of companies scoring the maximum 1 overall should be at the end of a recession, when the green shoots of recovery are evident. Consequently, such an ideal buying opportunity can be expected to reap the greatest rewards. Lastly, always bear in mind the investment axioms of the gurus and profit from their wisdom.
‘To write it took three months; to conceive it – three minutes; to collect the data in it – all my life.’
F Scott Fitzgerald, author of The Great Gatsby.
Many of the gurus in chapter 9 on investment axioms have said what books most influenced them. The following two classics feature repeatedly.
Reminiscences of a Stock Operator, Edwin Lefevre
The Intelligent Investor, Benjamin Graham
Beyond the Zulu Principle, Jim Slater
Common Stocks & Uncommon Profits, Philip Fisher
Competitive Advantage, Michael Porter
Contrarian Investment Strategies, David Dreman
Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay
Investing With The Grand Masters, James Morton
Letters to shareholders by Warren Buffett, at www.berkshirehathaway.com
Manias, Panics and Crashes, Charles Kindleberger
Market Wizards; New Market Wizards, Jack Schwager
One Up On Wall Street, Peter Lynch
The Alchemy of Finance, George Soros
The Art of War, Sun Tzu
The FT Global Guide to Investing, James Morton
The Great Crash, John Galbraith
The Money Masters; The New Money Masters, John Train
The Prince, Machiavelli
The Profit Zone, Adrian Slywotzky and David Morrison
The Templeton Touch, William Proctor
The Zurich Axioms, Max Gunther
What Works on Wall Street, James O’Shaughnessy
Investorease (www.investorease.com) for narrative on companies.
REFS (Really Essential Financial Statistics) (www.companyrefs.com) for company and sector sieving.
Sharescope software (www.sharescope.co.uk) for charting.
The Serious Investor Groups network (www.signet.org.uk). John Lander, Chairman, Waterdale House, Chequers Lane, Waterdale, Watford, WD25 0GP.
Toby Keynes, National Secretary, BM UKSA, London WC1N 3XX
Telephone: 020 8249 5923
Centurion House, 24 Monument Street, London, EC3R 8AQ.
Telephone: 020 7220 1730
The Economist, The Financial Times, Investors Chronicle.
There is a bewildering choice of websites to aid the investor. The following selection is worth noting.
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