Crossing The Street – Walk! Don’t Run!

Drama. Mr. Cramer has given us a half-dozen of his practical investment rules, or things that we might think about, when tackling Wall Street (The Street, August 30, 2013, Cramer’s ‘Mad Money’ Recap: Demystifying Wall Street). These ideas seem to be pretty familiar and since there are millions of individual investors – and thousands of how-to books and websites on investing – it’s probable that tens of thousands of investors will be applying one or another, or several, of these rules at any time, allbeit that the market is dominated by institutional investors who don’t really think about companies, but whole markets, all at once, framing an hypothesis and then seeing which companies, or investors, might be effective in it.

Crossing The Street
Courtesy: Abbey Road Studios

So how do we cross the street if we’re not famous, or well-heeled enough, to stop the traffic?

For example, Mr. Cramer tells us that Wall Street thinks about the market in terms of just two groups of stocks called “secular” companies that supply basic materials or services that are always required (such as retail necessities, pharmaceuticals, food or groceries) and “cyclical” companies that need a strong economy, or demand, in order to grow, such as industrial commodities or feed stocks of all sorts (chemicals, iron ore and metals, wood, and so forth, although restaurants and luxury goods might also fit).

Moreover, even though there is always an economy, it might not be strong enough to encourage “cyclical” producers to leverage their plant & equipment and labour by producing more not destined for inventory, and, therefore, earnings will falter; or, the long term prognosis is that no more is required in the foreseeable future, and, therefore, there’s no point in further development against the long horizon for better returns; notwithstanding that there are also “wild cards” of new companies that want to bring their newly discovered production into play and displace the old timers with new discoveries or better technology.

The Perpetual Bond

That idea – secular and cyclical – would explain why the S&P TSX “Hangdog” Market is so “hangdog” this year because a lot of resource-based commodity stocks are traded there – about 80% with the balance in financials and retail, and some manufacturing – but it doesn’t explain how we’re able to run a portfolio of about 80 companies in that market and get a return of +75% so far this year, or an even smaller portfolio of just forty companies that has returned +40% so far this year. And we know how to keep everything that we get.

Possibly, secular and cyclical are not that powerful an investment idea, even though its the bread and butter of hedge funds (ibid, The Street). But they’re playing for the short term – loading up on secular companies and shooting up or down the cyclicals as time demands, plus other strategies based on long/short positions, leveraged positions, volatility, and macro economics. Of course, we have to wonder who gets shot? Other investors? Because we don’t see any more sales or production coming out of these “money companies”.

In defence, Mr. Cramer suggests that “buy and hold” is not a good strategy, but that we need to be prepared to “buy and sell” more frequently, and that we need to buy the “good companies” but be ready to sell them when the market goes against them in the struggle between secular and cyclical, and the unpredictable actions of hedge funds which are also trying to get a return on several trillions of dollars.

“Good companies”, he says, have “best of breed” managements who are almost guaranteed to successfully execute a plan to grow the earnings and that we should try to buy them when the price to earnings ratio (P/E) is low, such as 20×, indicating a yield of 5% which we can’t get in bonds.

On the hand, we might not get it in cash either because dividend yields tend to be steady but in the range of 1% to 3%, most commonly, but could also be zero because this is supposed to be a “growth” stock. But, on the plus side, good earnings growth will tend to attract more investors to the stock, bid up the price, and we might get capital gains – if we sell – and let the new guys hold the stock at a P/E similar to one that we had when we bought it, if the earnings are good and the price is bid up enough, while we go off in search of more low P/Es, profits in hand.

That’s confusing isn’t it? If the stock price and the company’s earnings are rising in lock-step, that’s two “goods” and might encourage us to hold on to stock so that it might become even more “expensive” to buy. And when the stock price is rising faster than the earnings, that’s also a “good” if we already own the stock; all that we need to do is “protect” the price by setting a stop/loss or taking some of our profits off the table and buying a “put” to protect the rest, if and when the market decides that a “correction” is called for or that the earnings growth is unlikely to be what is hoped for, absent some other “surprise”.

Crossing The Street Safely
The RiskWerk Company

In order to prove this hypothesis about stocks, earnings, and investor preferences, one would have to show that the stock price that is calculated as:

“Stock Price” = [P/E] × EPS

where EPS is the “earnings per share”, is a “discriminant”. That is, if we only buy stocks that are trading below the calculated “Stock Price” and sell them only when the stock price rises above the “Stock Price” (or the “Stock Price” drops to below the ambient stock prices), then our portfolio will be successful and tend to provide a non-negative return.

To be convincing, however, as “scientific evidence”, we would also have to show that the portfolio of stocks that we buy at prices above the “Stock Price” and only sell when the stock price falls below the “Stock Price” (or the “Stock Price” rises to be above the ambient stock prices, bringing us back to the first case, in which we buy the stock, but it’s now in that portfolio) tends to provide a zero or negative return. And to avoid a “selection bias”, every stock in the market should be one or the other at all times, although there is no reason to insist that the calculated “Stock Price” should remain constant, and, in fact, we expect it to vary.

For example, the expected [P/E] that we might apply to a stock might be typical for a company or its industry, or even just a constant such as 14× reflecting the oft asserted notion that the long term gains in a diversified portfolio of stocks should be 7% per year (please see our Post, The Wrong Tools Eventually Strip All Nuts).

Moreover, Mr. Cramer suggests that “earnings per share” (EPS) is a measure of “risk aversion” – that investors will tend to buy companies that have increasing earnings per share, and sell or not buy companies that have decreasing, or not increasing, earnings per share. In that case, the calculated “Stock Price”, as above, is a risk-adjusted price of Sharpe-Markowitz type.

Of course, we know that none of this works on a portfolio basis although it might help an investor to make money in the stock market from time-to-time, and tilt the odds slightly in their favour in the same way as looking left, and then right, might help us to cross the street more safely (but right, then left, on Abbey Road) assuming that there’s nothing in the blue sky above us, or a sink-hole underfoot.

For more information, please see our Post, Earnings Don’t Matter.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond™“
Alpha-smart with 100% Capital Safety and 100% Liquidity”
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.