30-Sep-2005

>Valuation: Reverse the Thumbnail

By Jim Gillies

I have a confession to make: I love valuation. It doesn't matter if it's discounted cash flow valuation, projected future valuation, or relative valuation against a firm's own history or against its competitors. I love 'em all.

First comes caution
There are pitfalls to valuation. You can get caught up in numbers and actually ignore the underlying business. You can make one or two systematic errors in your model, which, in turn, can give an erroneous buy or sell signal. Finally, valuation is largely dependent on future, unknown numbers that have varying degrees of uncertainty.
The future may not reflect the past, but then again, past records are all we have.

Still, I'm firmly in the valuation camp for the simple reason that it can help you avoid losing money foolishly. You might miss a few highfliers or a perpetually "overvalued" company , but you'll also avoid a lot of risky duds.

Yet while thumbnail valuations can be useful for projecting prospective annual returns, I contend that there is another "hidden" use.

If we turn the process around into what I call a "reverse thumbnail," we can predict the percentage a company must grow it's free cash flow (FCF) to justify a target return.

When to buy? When to sell?
The reverse thumbnail can also help investors determine good times to buy shares of a company -- and this is particularly helpful when analyzing small caps because they tend to be more volatile than the broader market. Buy decisions are even more difficult to make when a stock has been beaten down, even if we intellectually know that's precisely when we should be buying.

Vitals today
  1. Stock price
  2. Net cash and equivalents
  3. Debt
  4. Free cash flow
  5. Shares outstanding
Those are the vitals today. Now we can use the reverse thumbnail to determine how much a co. have to grow FCF to justify various potential annualized returns:
  1. Desired annual return 15.0% 20.0% 25.0%
  2. Price in five years to achieve desired return
  3. Total FCF in five years to achieve desired return
  4. Required FCF growth to achieve desired return
To gain a 15% annual return and double our money in just less than five years,co.will need to grow free cash flow by a little more than 15% annually.

Getting into the habit of doing a reverse thumbnail can simplify buy or sell decisions and help you determine which stocks in your portfolio are best for new money now.

Remember Peter Lynch's words:
"The best stock to buy may be the one you already own."
But if your desired 15% annual return can only be accomplished through 30% or greater annual FCF growth, you should probably wait for a better price.

Nevertheless, it's always worthwhile to revisit your investments and their valuations.

26-Sep-2005

>When to Sell?

Some issues associated with the decision to sell.

  1. The process of deciding to sell a stock is a difficult one at best unless an investor has developed a discipline or methodology and adheres to it faithfully to avoid inevitable internal mental battles.
  2. When a loss is involved, the sell decision is even more difficult because the issue of pain avoidance is now present. It is human nature to seek self-preservation, and pain signals to us a danger to our well-­being
  3. Some investors may be obsessed with safety, while most are reasonably bal­anced in their tolerance of the risks involved in seeking to earn a profit. But every investor has some threshold at which pain must be avoided, sometimes at ridiculous cost.
  4. One of the most convenient ways to avoid the pain of loss - or even of profit squandered - is denial.
  5. Dealing with an investment or trading loss involves not only financial pain but also ego pain, a blow to our self-sense of value. A majority of stockholders at some point attempt to avoid both pains by failing to deal with the reality of their losses. They prefer not to think about it, or they minimize it. When specific stock positions go bad, the pain avoider becomes a longer-term holder, who is more accurately a collector of stocks. He has no real investment motive or astuteness of value judgment and is, in fact, simply denying the pain of potential (or already apparent) loss.
  6. Unfortunately, most investment brokers are of very little or no help to their clients in dealing with losses - they are unwilling or unable to break down client denial or avoidance behavior. Part of brokers' inability to help stems from the bias of their training, which is strongly focused on gathering new assets and then persuading clients to buy, not sell, securities. But the broker problem goes much further.
  7. The broker, too, as a human being is a pain avoider. He or she needs to re­main on cordial and constructive terms with clients. A successful sales person must listen to customers and act on all resulting feedback. So, naturally, when a customer indicates an unwillingness to deal with losses, his or her broker hears that message loud and clear-and heeds it. An unspoken contract between investor and broker develops: "I will not complain about my problem if you will please do me the favor of not reminding me of it."
  8. There are several rationalizations that investors use to deny losses, or the im­portance of their losses. One relies on the rubric of the U.S. Tax Code. Investors are well aware that, for tax purposes, no loss is recognized as having occurred until a closing transaction actually takes place (and the 31-day "wash-sale rule" is not vio­lated). Using this tax reality as a psychological crutch, many investors actually talk themselves into believing that they do not have a loss until they actually take one. On objective examination, of course, such reasoning is absurd. Few such investors, holding a pleasant 200 percent paper gain, would say they have no profit!
  9. It is, of course, possible that price might recover and today's paper loss might be reduced or recovered-or might even become a paper (or real) profit in the fu­ture. But the truth is that if the stock is quoted below what was paid, there is a loss of capital because wealth is measured by the current value of assets less liabilities. Liquidate investments under duress, value an estate, or switch investments to obtain maximum current income from available assets, and reality prevails. A stock is cur­rently worth only what it can be sold for now-not what it was bought for, what the owner wishes it would be, or what he thinks it should sell for. If current price is be­low cost, a loss exists. Period.
  10. If an investor is too smart or too logical to attempt self-deception with the "paper-loss-isn't-real" farce, he may rely instead on a less disprovable assertion: the stock will come back given enough patience. Hope springs eternal, and once in a great while a terrible loser does reverse and rise phoenix like from the ashes. Then, the investor who has sold out at a loss and later sees the price recover says, "See, if only I'd been smarter or more patient and followed my instinct and held on, I would not have had that loss."
  11. Closing out a position, especially when at a loss, represents the process of coming to closure. Optimistic by nature, we prefer to see our options remain open rather than have them closed off. Buying a stock involves the grand opening of new possibilities, but selling closes the final chapter. Many clo­sure processes in our lives carry sadness: graduating from and leaving our alma mater, admitting a failed marriage via divorce, burying a departed friend, cleaning out great-grandmother's attic. These represent some pretty heavy baggage, of a kind we'd prefer to avoid lifting if possible. Selling a stock conjures up such feelings, at least at a subconscious level. Holding it allows us potential for greater profit or re­claiming a current loss. If our stock is down, selling brands us with a sign of failure, which we'd like to avoid.
  12. Actually placing a sell order and taking the loss on a final basis goes even further in that it sets up our investor for a second source of pain by being "wrong again": watching the stock move higher without being on board for its recovery. This possi­ble double horror show can be avoided by refusing to take the loss in the first place, says the denier.
  13. What psychologists call denial is, in the investment arena, an umbrella de­scription for a variety of rationalizations and self-deceptions. All are designed to al­low possessors of losing investments to justify doing nothing about them.
  14. There are several variations on the denial theme. One springs from the mem­ory of the purchase price, the highest price ever reached, or the best achieved since purchase. Old best price levels can each act as a high-water mark that becomes a once-was, a could-be-again, a should-be, then a will-be, and all too often a gotta-be. It does not matter how many months or years ago that high-water mark was made. It does not matter that the company's fundamentals or general market psychology has been eroded seriously. It does not matter that a rise of several hundred percent from current prices may be necessary for full recovery. To avoid accepting and dealing with the loss, the denier waits (and waits and waits some more) for recovery, denying the long adverse odds.”

>Beautiful Quotes

Peter Lynch
  1. The person that turns over the most rocks wins the game. And that's always been my philosophy.
  2. The key to making money in stocks is not to get scared out of them.
  3. I think you have to learn that there's a company behind every stock, and that there's only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.
  4. In this business if you're good, you're right six times out of ten. You're never going to be right nine times out of ten.
  5. You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets.
  6. When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30. You just don't know when you can find the bottom.
  7. I've found that when the market's going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy.'
  8. Go for a business that any idiot can run - because sooner or later, any idiot probably is going to run it.

Warren Buffett
  1. Wide diversification is only required when investors do not understand what they are doing.
  2. Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.
  3. We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
  4. Why not invest your assets in the companies you really like? As Mae West said, "Too much of a good thing can be wonderful".
  5. Your premium brand had better be delivering something special, or it's not going to get the business.
  6. Our favourite holding period is forever.

Milton Friedman
  1. The only way that has ever been discovered to have a lot of people cooperate together voluntarily is through the free market. And that's why it's so essential to preserving individual freedom.
  2. Nobody spends somebody else's money as carefully as he spends his own. Nobody uses somebody else's resources as carefully as he uses his own. So if you want efficiency and effectiveness, if you want knowledge to be properly utilized, you have to do it through the means of private property.
  3. The most important single central fact about a free market is that no exchange takes place unless both parties benefit.
  4. My major problem with the world is a problem of scarcity in the midst of plenty ... of people starving while there are unused resources ... people having skills which are not being used.
  5. The most important ways in which I think the Internet will affect the big issue is that it will make it more difficult for government to collect taxes.
  6. The black market was a way of getting around government controls. It was a way of enabling the free market to work. It was a way of opening up, enabling people.

Alan Greenspan
  1. I have found no greater satisfaction than achieving success through honest dealing and strict adherence to the view that, for you to gain, those you deal with should gain as well.
  2. The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake.
  3. I do not deny that many appear to have succeeded in a material way by cutting corners and by manipulating associates, both in their professional and in their personal lives. But material success is possible in this world and far more satisfying when it comes without exploiting others.
  4. It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making
  5. Any informed borrower is simply less vulnerable to fraud and abuse
  6. To succeed, you will soon learn, as I did, the importance of a solid foundation in the basics of education--literacy, both verbal and numerical, and communication skills.
  7. It is decidedly not true that "nice guys finish last," as that highly original American baseball philosopher, Leo Durocher, was alleged to have said.
  8. I was a good amateur but only an average professional. I soon realized that there was a limit to how far I could rise in the music business, so I left the band and enrolled at New York University.

Charles Schwab
  1. I consider my ability to arouse enthusiasm among men the greatest asset I possess. The way to develop the best that is in a man is by appreciation and encouragement.
  2. I have yet to find the man, however exalted his station, who did not do better work and put forth greater effort under a spirit of approval than under a spirit of criticism.
  3. The man who does not work for the love of work but only for money is not likely to make money nor find much fun in life.
  4. I quickly learned that if I kept at it and plowed right through the rejections I would eventually get somebody to buy my wares.

23-Sep-2005

>Market and Lifes Paradoxes

In a great book “Sun Tzu on Investing”, the author, Curtis J. Montgomery, writes about paradoxes in life and in the stock market.

“The emphasis on the advantage of enigma pervades Taoist thinking. You may have heard the sayings, "A good merchant hides his treasures and appears to have nothing," and "A good craftsman leaves no traces." These sayings were adopted by Zen Buddhists from Sun Tzu's Art of War concepts.

An investor cannot avoid being confronted by paradox. Do any of these situations sound familiar?

  1. Making a concerted effort to identify investment-grade businesses, while at the same time understanding a good business will not necessarily make a good investment.
  2. Feeling despondent as a portfolio of stocks sinks in a bear market, while at the same time feeling excited about new bargains to be had.
  3. Rejoicing when selling a stock to realize a substantial gain, while worrying about where to invest the proceeds to achieve higher returns compared to holding the divested stock.
  4. Checking stock prices several times each day, while at the same time being disciplined to seldom make trades.
  5. Buying insurance (risk aversion) and a lottery ticket (risk seeking) the same week.
  6. Sipping a $5 Starbucks latte each day while calculating the compounded value of just another $5 per day invested in the stock market over a lifetime.

Paradox: The Ultimate Creative Expression

Historically, few ambitious Emperors who have set out to control a vast kingdom, or even the world, have come close to succeeding in their quest. Ancient Chinese warlords, Machmud of Ghazni, Genghis Khan, the British Empire, Napoleon, and Hitler all fell short of their goals.


=>Master Sun's teachings were addressing the futility of war, but doing so while standing alongside the generals on the battlefield, not marching in protest or demanding attendance at the negotiating table.

=>Master Sun's creative genius was to protest armed conflict from the position of an accomplished strategist of armed conflict.
=>To demonstrate the evil of war, Sun Tzu helped his generals first survive the slaughter of a pitched battle by arming them with effective tactics.
=>Once the generals were proficient in battle skills, he then enriched them with the philosophy that true greatness is achieved only by one able to avoid such armed conflicts with superior forethought, preparation and wisdom.

The greatest general is not interested in winning wars, but avoiding them.


Sun Tzu educated a generation of generals that "to win without fighting is best, "thus preventing more war than all war protestors combined.


Peter Lynch is one of the most accomplished fund managers of our generation, but he retired after just 13 years as lead manager of America's largest mutual fund to publish three books that challenge the entire concept of managed funds.


John Bogle
, founder of the Vanguard fund family has also published several books and made numerous speeches chiding his own profession, and encouraging investors to choose low-cost Index funds as the most intelligent "managed" investment. Lynch and Bogle didn't enlist in anti-fund associations, but fought from a point of strength from within the industry, where they were able to make first-hand observations of the strengths and shortcomings, and establish inside knowledge and reputation that made others more willing to accept their criticisms. Paradoxically, protest is most effective when those performing the very activities they believe to be objectionable voice it.

If you make a historical study of the true stock market giants of the last 100 years, you will surprisingly find, with few exceptions, they lived rather humble lives. At the same time, you will find many flamboyant speculators who usually achieved only temporary success and made sure everyone knew about it. They lived in splendor beyond compare. They loved money, and their investing methods were a means to accumulate wealth to support their greed, accumulate possessions and live like kings. None of them were able to endure. Paradoxically, enduring wealth comes to those who do not covet it.

Generals have a goal of being so well prepared for battle they preempt battle. Great investors have a goal of knowing selected business economics so thoroughly that they have the courage to make bold purchases when others hesitate. Their market savvy is not driven by greed, but by intellectual challenge. The vast wealth they accumulate is not wasted for trivial pursuits, but simply compounds as a measure of their ability. Becoming a millionaire, or even a billionaire is often the end result, but seldom the initial goal. They enjoy the investing process more than the proceeds.

Sun Tzu obviously had no desire to conquer the world, or even carve a personal territory from among the warlords of ancient China. There are few plausible explanations for his passion in teaching the ways of war, other than to help avoid war. His keen understanding of human psychology helped him avoid the ineffective war-protestor approach. Much like the jesters in Shakespearean plays who disguised serious messages in foolish riddles, Sun Tzu fostered an anti- war sentiment from the improbable guise of teaching war mastery.”

>Buying Pessimism?

""" Successful investing involves development of two sets of tools-one set to decipher strong business franchises and another set to interpret business valuations-and no investing craftsman will be very effective if either tool set is missing.
"""

“In 1981, popular business guru Tom Peters authored a best selling book called, In Search of Excellence, which profiled several businesses that exemplified the author's defined characteristics of excellence. Several years later, Michelle Clayman, a finance academic from Oklahoma State University, examined the stock market performance of the companies profiled by Peters and compared it with a matched group of "less-than-excellent" companies using the same criteria. For the five-year period following the book's publication, the less ­than-excellent companies outperformed the excellent companies by an amazing 11 % per year. This provides a lesson no Sun Tzu paradox fan should ever forget:

Paradox: A good business does not usually make a good investment.

=>Because a key component of your future investment returns are dependent on your initial purchase price of a stock, buying low­-priced stocks enhance your probability of achieving superior future returns.

=>Of course, low prices are usually offered only on less-than ­excellent businesses, or, at least those businesses currently perceived to be somewhat less-than-excellent by other investors and analysts.

=>Since the majority of investors and analysts regularly and predictably overestimate the value of businesses perceived to be excellent, and just as regularly and predictably underestimate the value of businesses they perceive to be less-than-excellent, Sun Tzu-style investors learn to intelligently discern victory as they investigate these low-priced out-of-favor stocks.

=>A good place to begin your search is a list of low Price-to- Earnings (PE) stocks.

Regarding Warren Buffett's bold purchase of Coca­Cola stock in 1988, Buffett had obviously identified the Coca-Cola Company as a sound business. It had been a wonderful business almost from its inception more than a century before Buffett's timely purchase, and it is unlikely Buffett only noticed the company's endearing qualities suddenly during 1988. Buffett wasn't satisfied with simply owning a wonderful franchise, even one like The Coca-Cola Company, until it was offered to him by a fickle stock market at an attractive price.

While a portfolio full of excellent businesses is something to initially be proud of, it has a low probability of producing market­ beating returns if the initial purchase prices were never considered.

=>Excellent businesses typically attract optimistic analysts and investors who drive the share price to rich valuations.
=>A high initial purchase price reduces your probability of making future gains. Undoubtedly, some excellent businesses like General Electric and Wal-Mart have produced market-beating returns for many decades.
=>Unfortunately, for every high-return, excellent business there are many unsustainable, over-hyped, soon-to-be-leapfrogged, temporarily excellent businesses that turn a once proud portfolio into regretful market laggards.

Optimism and pessimism don't restrict themselves to single stocks, but regularly infect the overall business environment and economy.

In 1929, the US entered a time of tremendous optimism. Commerce and daily living were being revolutionized by technological marvels including automobiles, telephones, aircraft and electrical power. Standards of living were rising rapidly, and so was the stock market. Now, fast-forward just three years to 1932 and the depths of the Great American Depression. One third of workers were jobless, the Gross National Product (GDP) had fallen by almost 50%, and membership in the American Communist Party had reached an all- time high. Economists, who were so optimistic about the future just three short years earlier, were now predicting continued doom and gloom.

Had an investor purchased stocks at the brightest moments in American history, in September 1929, and held them until 1960, they would have earned7.76% annually, turning each dollar into $9.65. Not bad, but not spectacular.

But if the same investor waited just three years to buy the same stocks in June of 1932 at the depths of the depression and held them until 1960, they would have earned an annual return of 15.86%, turning each dollar into $58.05.

Buying pessimism is a paradox that pays.

14-Sep-2005

->John Templeton on Investing


In an investment classic “The Passionate Investors", the author, Madelon Devoe Talley, writes about the great investment legend, John Templeton.

“I first saw John Templeton at a lunch for Templeton College at the Racquet Club in New York. He was sitting only two places away from me, and I overheard his con­versation. He asked the president of Purolator, "If you were not allowed to buy Purolator shares, what other com­pany's shares in that industry would you buy?" And the reply was, "Federal Express."


Searching out such infor­mation from secondary sources is one of Templeton's fa­vorite techniques. He always learns more, he believes, when he asks a businessman about others. Businessmen will go right to the heart of the matter and put their fin­gers squarely on the problems or the advantages of their competitors, their suppliers or their customers. It is only when businessmen discuss their own companies that they filter information.


At Yale, with $300 surplus from his earnings, he bought stock from his roommate, a broker: the $7 (dividend) pre­ferred stock of Standard Gas and Electric. In the Twen­ties, there had been many mergers of electric utility companies. With the Depression, most of those utility holding companies failed, including Standard Gas, en­abling Templeton to buy a $7 preferred for about $12 a share. Utilities, he reasoned, would continue to have good earnings in the long run. Templeton did get an immediate psychological return on his first choice; it rose immedi­ately, and he ended up by quadrupling his money. Mod­estly, he remarked, "It did happen that way, but that's not always wise for a young man starting out in investments; it's much more educational if he has a failure to begin with instead of a success."

Perhaps he is right, perhaps a failure would be more educational, but the rewards of the glow from the psycho­logical effects of quadrupling one's money can instantly boost self-confidence and the eagerness to continue. Tem­pleton was more than able to handle such successes.


When the Germans and Russians invaded Poland, Tem­pleton saw that there was going to be a widespread world war. Since there had been a great worldwide depression, a war meant that demand for goods would pick up: During wartime, everything is in demand. There were over a hundred stocks, then, selling below one dollar a share on the New York and American stock exchanges, so, from Texas, he called Fenner and Beane and gave the order to buy $100 worth of every stock at a dollar a share or less. There were 104 of these stocks and 100 of them turned out to be profitable. The most spectacular investment was the $7 preferred stock of Missouri Pacific Railway. It had been offered to the public at $100 per share, paying a $7 cash dividend. The railroads had had a particularly rough time in the Depression, and this one had gone into bank­ruptcy. The preferred stock had gone down to 12 cents a share, or 1/8 point. For his $100, therefore, Templeton was able to buy 800 shares of stock that were each supposed to pay $7 in cash dividends. After the war, the stock moved from 1/8 to 5 a share or forty times what he'd paid for it. Templeton said, "I thought how wonderful it was and took my profit, and within two years it went to 107."


After Oxford and before starting at Fenner and Beane, Templeton had gone with a friend on a trip around the world. One of the countries he visited was Japan, where he was impressed with the hard work of the Japanese and the quality of their products-a great contrast with the perceptions of Americans back home, for whom "made in Japan" in the Thirties was an indication of a junk product. He observed also that Japanese accounting understated true earnings. So, with his own money, he began to buy small amounts of shares in Japan, about two years before money could be taken out of that country. What he ob­served on his barebones grand tour eventually led to a significant commitment to the Japanese market, as Japan's economy exploded after the war. When Templeton bought them, the finest companies' shares sold for three times earnings, and Westerners still believed that Japan only made poor imitations.


Templeton found all these bargains before he opened those Rockefeller Center doors. To him, a good invest­ment is nothing more than finding a bargain; these are superb examples of him at work in his best bargain-hunt­ing period.


One of my favorite questions of other investors con­cerns their mistakes or some investment they made that might in retrospect seem foolish. For years, the Temple­ton group kept a record of what happened when they took their clients out of one stock and put that same money into another one. In studying that record a year later, they found out that, a third of the time, it would have been better to have stayed with a stock they had sold. But even that doesn't seem foolish to me. To be right two thirds of the time is to be tops in the investing field.


Some of Templeton's tips:


Rule 1: Make an investment plan, commit a certain percentage of your income to it each year, and don't spend the capital you've put aside, for that would defeat your invest­ment plan.

When they married, Templeton and his wife agreed to set aside half of their income each year for a personal investment portfolio. He has always followed that plan, even in the early years when it was difficult, but his pro­pensity towards thrift saving was extremely strong. He actually did what many counselors advise their clients to do, though they don't always suggest 50%. He went into debt only once: when he borrowed $10,000 from his boss to buy the 104 stocks under a dollar. But he soon repaid it from his profits of $40,000.

Rule 2: Enjoy making capital gains and paying taxes on them when you sell securities; for long-term investors, there is only one objective: maximum total real return after taxes.

Templeton finds that many people spend too much time trying to avoid paying taxes. They would do much better if they concentrated on making money with their invest­ments.

I agree. I have been amazed at how difficult it is for some people to sell a security and pay capital gains taxes -a problem, surprisingly, for some of the richest and savviest families. A friend once asked my advice about the trust department that managed her money. She lamented their poor performance record and wanted me to recom­mend another manager. I reviewed her portfolio and found that 80% of her money was in one stock that she had received when her family company was bought with shares of that corporation. "Oh!" she said in a shocked tone, "I can't sell that. The capital gains would kill me." Still, the bank that managed her money could not perform well unless her one big position was in an uptrend. An­other family I have known just rode stocks up and down over the years rather than pay capital gains taxes.

Rule 3: Diversify your investments.

Templeton believes that the best investor is only right two thirds of the time and that it is only prudent to protect yourself, because you will make mistakes. He developed his theory of prudent diversification to minimize risk; he thinks that an investor in stocks should own at least ten companies of 100 shares each. Some of his large mutual funds even have over 100 names.

He followed his diversification theory in applying to Yale. It was necessary to take a qualifying entrance exam for Yale, and there were two ways to do it. Applicants could take a comprehensive exam covering the past three years, at the end of their third year in high school, or take an exam for each course the year they completed it. John chose the latter, considering the former option too risky: Something might happen on that one all-important exam day to keep him from doing his best job. His aim was to get accepted at Yale. To bet everything on a one-day exam when he had another choice was not a worthwhile risk.


Rule 4: Look for bargains when you buy a secu­rity.

By this, Templeton means not just any bargain but those that have true value. And he does not have a magic for­mula that can help others in their search. Each position in a company or industry is distinct; for instance, he focuses on earnings per share for grocery chains, and depletion of minerals for mining companies. He does use a large vari­ety of yardsticks for value: how high the price is in relation to earnings, to potential earnings, book value or net work­ing capital after subtracting the debts, to sales per share, to prices of other stocks in a similar industry or a similar situation and so on. "These yardsticks of value are never very reliable or very accurate, for that matter," he added, "but if you know enough about them, you can come out with an estimate of the value of the company and then you can price the companies once a month to see which is the cheapest." Perfection is to divide the total value of the company by the number of outstanding shares, and find that the market price is less than that figure. Then it is attractive.


Rule 5: Learn the art of decision-making.

Research the company, weigh all the factors and make a judgment. Anxiety accompanies any new path, but if the research encourages strong convictions, don't delay too long before acting.

I think that many investors form a judgment after sound analysis but then vacillate about taking action. A successful investor must do both.

Rule 6: Decide which risks are worth taking and which are not.

To secure admission to Yale, Templeton weighed risk in deciding how to take his entrance exam. As an investor, the one risk he refuses is to invest in socialized countries, where capital cannot be taken out, or, for that matter, even in countries where there are price controls. The cli­mate for capital accumulation is best in an open society


Rule 7: Let the numbers tell you whether manage­ment is good or not.

The numbers will tell how well management is doing. In interviews, most managements sound enthusiastic; it is hard to manage a company without being optimistic. Visits to companies provide a little information, primarily that most of the managements are composed of intelligent peo­ple. But only the numbers reveal what you need to know. Measure management by quantities, not qualities.


Rule 8: Keep a flexible, open-minded and skepti­cal attitude as an investor.

This is one of Templeton's two most famous axioms. The second: Focus on value, rather than on outlook or trend-in-the-making. To Templeton, everything has a sea­son and he is suspicious of anything that blooms longer than four years. He also believes that when a particular industry or type of security becomes popular with inves­tors, that popularity will always prove temporary and will not return for many years when lost. In a world where people like to label investing styles, Templeton thinks that no investment approach should be graven in stone, be­cause no selection method will ever be permanent. To stay ahead of the competition, an investor must experiment with methods that no one else, or very few others, are looking at. At any given time, Templeton is trying six or seven or eight different methods.

He remembers one time, thirty years ago, when he was not flexible or skeptical enough. When his group was or­ganizing its funds, one of the underwriters on Wall Street persuaded them to bring out a new fund called Nucleonics Chemistry and Electronic shares; at the time, these new buzzwords excited the public. Templeton says that his firm appointed a board of scientific advisers from all these fields, and at the offering, the fund was very popular. But they stayed with the fund too long. They should have known that new buzzwords are just a fashion, their popu­larity temporary. Once Templeton's group realized its mistake, the fund was folded into one of its larger mutual funds. But the delay lost money for their shareholders.


Rule 9: Be positive.

This rule applies to everything in life, according to Templeton. Negative thoughts are psychological poison that may distract investors from important goals. If an investor keeps dwelling on mistakes, it becomes harder and harder to take the next risk. To add to that, Temple­ton then developed his theory of the extra ounce. He has observed in all fields that outstandingly successful people always do that marginal extra bit; they practice more, they recheck their research, they make just one more telephone call. And their results are dramatic-as they clearly have been, year in, year out, for Templeton.”

10-Sep-2005

>20 Rules for Swing Trader

20 RULES FOR THE MASTER SWING TRADER
By Alan Farley

Swing trading can be a great way to profit from market upswings and downswings, but it’s not easy. Mastering the swing- trading techniques takes time and effort.

Rule 1: If you have to look, it isn’t there.
Forget your college degree and trust your instincts. The best trades jump out of nowhere and create a sense of urgency. Take a deep breath, then act quickly before the opportunity disappears.

Rule 2: Trends depend on their time frame.
Make sure your trade fits the clock. Price movement aligns to specific time cycles.Success depends on trading the right ones.

Rule 3: Price has memory.
What happened the last time a stock hit a certain level? Chances are it will happen again. Watch trades closely when price returns to a battleground. The prior action can predict the future.

Rule 4: Profit and discomfort stand side by side.
Find the setup that scares you the most. That’s the one you need to trade. Don’t expect it to feel good until you take your profit. If it did, everyone else would be trading it. Wisdom from the East: What at first brings pleasure in the end gives only pain, but what at first causes pain ends up in great pleasure.

Rule 5: Stand apart from the crowd at all times.
Trade ahead, behind or contrary to the crowd. Be the first in and out of the profit door. Your job is to take their money before they take yours. Be ready to pounce on ill-advised decisions, poor judgment and bad timing. Your success depends on the
misfortune of others.

Rule 6: Buy the first pullback from a new high. Sell the first pullback from a new low.
Trends often test the last support/resistance before taking off. Trade with the crowd that missed the boat the first time around.

Rule 7: Buy at support. Sell at resistance.
Trend has only two choices upon reaching a barrier: Continue forward or reverse. Get it right and start counting your money.

Rule 8: Short rallies, not selloffs.
Shorts profit when markets drop, so they start to cover. This makes it a terrible time to enter new short sales. Wait until they get squeezed and shaken out, then jump in while no one is watching.

Rule 9: Manage time as efficiently as price.
Time is money in the markets. Profit relates to the amount of time set aside for analysis. Know your holding period for every trade. And watch the clock to become a market survivor.

Rule 10: Avoid the open.
They see you coming, sucker.

Rule 11: Trades that work in hot markets destroy accounts in cool ones.
Stocks trend only 15% to 20% of the time. Price ranges cause grief to momentum traders the rest of the time.

Rule 12: The best trades show major convergence.
Watch for the bull’s eye. Look for a single point in price and time that points repeatedly to a trade entry. The market is trying to tell you something.

Rule 13: Don’t confuse execution with opportunity.
Save Donkey Kong for the weekend. Pretty colors and fast fingers don’t make successful careers. Understanding price behavior and market mechanics does. Learn what a good trade looks like before falling in love with the software.

Rule 14: Control risk before seeking reward.
Wear your market chastity belt at all times. Attention to profit is a sign of immaturity, while attention to loss is a sign of experience. The markets have no intention of offering money to those who do not earn it.

Rule 15: Big losses rarely come without warning.
You have no one to blame but yourself. The chart told you to leave, the news told you to leave and your mother told you to leave. Learn to visualize trouble and head for safety with only a few bars of information.

Rule 16: Bulls live above the 200-day moving average, bears live below.
Are you flying with the birds or swimming with the fishes? The 200-day moving average divides the investing world in two. Bulls and greed live above the 200-day, while bears and fear live below. Sellers eat up rallies below this line and buyers come
to the rescue above it.

Rule 17: Enter in mild times, exit in wild times.
The big move hides beyond the extremes of price congestion. Don’t count on the agitated crowd for your trading signals. It’s usually way too late by the time they act.

Rule 18: Perfect patterns carry the greatest risk for failure.
Demand warts and bruises on your trade setups. Market mechanics work to defeat the majority when everyone sees the same thing at the same time. When perfection appears, look for the failure signal.

Rule 19: Trends rarely turn on a dime.
Reversals build slowly. Investors are as stubborn as mules and take a lot of pain before they admit defeat.

Rule 20: See the exit door before the trade.
Assume the market will reverse the minute you get filled. You’re in very big trouble when it’s a long way to the door. Never toss a coin in the fountain and hope your dreams will come true.

09-Sep-2005

>Coin Tossing (money mgmt. contd..)

A more detailed cut into the question asked in the previous post.

In a coin tossing game you have rs. 100. You are free to put in any amount from 1 rs to 100 rs in betting.

if you put 50 rs..
if u win you get 50*2 = 100 more rupees.
if you loose you loose just 50 rs.

amount in hand after win if 50 rs betted = 100 + 50*2 = 200
amount in hand after loss if 50 rs betted = 100 - 50 = 50.
you have to play this game for a minimum 100 times.

the question is
How much would you bet as a % of amount in hand on every coin toss?
============before you look down.....think and calculate.........
ready??
but wait..
qus: whats the use of such childish puzzles on an investment/trading related blog?
ans:
most trading systems however accurate become lame due to lack of money management.

qus: How is coin tossing related to trading? are they not hugely different.?
ans:
yes they are different in some ways but similar in more ways..!!
  1. The outcome is uncertain in both.
  2. Risk of loosing money is there in both.
  3. Coin tossing appears purely random, while when trading we "feel" we are experts and have some "control" on what the outcome would be.
  4. My View: The people who can remove this bull shit "feel" and use class Xth maths are kings.
Thus some ways to allocate money to each trade is required.
One has to dig into his system or trading style. See what kind of trades you get.
How often do you succeed/loose. How big is your win and how huge is your loss.

In the coin tossing context.
profit is 200% while loss is 100% of invested amount.
The equation to be optimised for 100 trials of which 50 would be win and 50 looses is..
amount left = 100*(1+2x/100)^50 * (1-x/100)^50 and .... x works out to be 25%.
(it wont be 25% for other setups and has to be recomputed)


It doesnot matters in which order you win or loose. you could loose 50 times first and then win the rest 50. (assume you can invest the smallest of amounts)

This exercise has to be done for every trading system.
Only looking at indicators, exit and entry would not do.
Knowing how much to allocate given a particular risk/reward profile of some trade setup would be the =>
Biggest Sustained Competitive Advantage. (a term i like to use often)

(open image in new window to enlarge)
In the image below note that the trading strategy did not change at all.
The win/loss ratio or the pay-off/penalty didnot change.

The **"ONLY"** change was HOW MUCH was invested.
So when we know how to trade, the next question to aks is how much to trade?

>Money Management-I

(i can assure you, only the best traders would be able to read to end or understand this post completely :-)) )

The description of blog has the words risk and money management.
Its time we had a look at it, after all EagleEye has a focused brain behind the sharp eyes. ;-)

You see, if we’re flipping a coin, heads has a 50 % chance of turning up on each flip of the coin and so does tails. But, each flip is independent of the last. The last coin toss has nothing to do with the one before it, each flip is a random event. This means it’s possible to get a hundred heads in a row if you do it long enough.

Trading is the same. A percentage of your trades will not work out. A certain percentage will not go in your favoured direction, and the next trade has nothing to do with the last one. Even if you have the world’s most accurate method, over time you will go broke if you don’t practice good money management.

Money management rules include defining

  • your trading float
  • setting your maximum loss
  • calculating your stop loss
  • and most importantly learning how to choose your position size.

Once these rules are in place

  • it’s important to stay with them.
  • They will keep you from making snap decisions, and playing the odds longer than you should.
  • This is why money management rules are a critical part of any effective trading system.
O.K. I have heard this shit many times over? any details? yes....>

what & why money management?
  • The mathematical process of increasing and decreasing the number of contracts/shares/options..
  • The purpose of utilizing money management should be to increase the profitability during positive turns and protect those profits during darw downs of any trading system or method.
  • oh.. i see... sounds good.. but what the big deal...duhhh..!!
an example please? why not...>
Take a coin, toss it in the air 100 times.
The ratio of heads to tails landing up should be very close to 50/50.

If you were to win Rs. 2.00 every time the coin landed heads up and lose $1 every time heads landed face down, you should have won approximately Rs. 50 by the end of 100 tosses.
This is a positive expectation situation. The odds of you winning are heavily in your favor.
Further say you have Rs. 100 to bet with.

The question is, what percentage of your money should you risk on each flip of the coin?
What would you say is the best percentage to reinvest on each flip? 10% 25% 40% of 51%?
This means that if you begin with Rs. 100 and choose to risk 10% of your capital on each flip, you begin by risking $10 on the first flip. If the coin lands heads up, you win $20. You would then risk $12 of the new $120 total on the next flip of the coin. If you lose, you lose $12 and if you win, you win $24 and so forth the game goes. Would it make a difference which % you used? If so, how much? Remember, you make twice as much when you win than when you lose. The odds of you winning are 50% every time.

The answer may surprise you.

By risking 10% of your money on each of the 100 flips (a Rs.10 bet on the first flip) you will turn your Rs. 100 into Rs. 4,700! Money management increases your return from 50% to a 4700% return!

Reinvesting 25% of your money would have turned Rs. 100 into Rs. 36,100! An increase of just 15% per toss increases your total return from 4700% to 36,100%.

It looks like it gets better the more you invest. ??But wait. ..

Increasing your risk another 15% every flip to a total of 40% being risked on each flip would turn your $100 into $4700. This time by increasing your risk, your return dropped drastically.

What if 51% of your money is invested? With this scenario, you actually lose money even though the odds are statistically in your favor. Your $100 decreases to $36. A loss of 64%.

The point? USING THE RIGHT OR WRONG MONEY MANAGEMENT CAN MAKE OR BREAK YOU!

Notes:
  1. In the example above, it would not matter in what order heads or tails were achieved.
  2. The great thing about money management is the fact that money management is purely a function of math. A hundred years ago, two + two = four. Today, that same equation yields the same answer. Therefore, money management IS predictable unlike trading strategies or systems.
  3. Money management is more powerful than any trading system that it can be implemented to.
  4. It is more logical to implement proper money management to a trading system than to trade that system without it. Money management will take you farther with less.
  5. The wrong money management applied to your trading could actually hurt the end result.

a little thinking on a different question....
=> suppose you have 55,000 rs in your account.
one contract of nifty takes 20,000 rs and one contract of sbi takes 50,000 rs.
(assume nifty and sbi are same in every other imaginable way, only difference is in amount to buy one contract)
what would you trade? Nifty or SBI and why? (assume you are a godly trader and you never loose)

If you use Nifty you can buy only 2 contracts and 15,000 would be idle.
If you use SBI you can buy 1 contract and only 5,000 would be idle.

Now think what would you trade?
I would trade Nifty, since its more granular. I can rapidly increase the number of contracts I trade while its more difficult to do so in SBI.
To trade one more lot of SBI, I would need 50000 more Rs every time.. while for Nifty I need only 20000. So profits can re reinvested more easily trading Nifty than with SBI..
Thus I would be trading a more fuller part of my portfolio with Nifty then with SBI and over time Nifty trading would grow my portfolio faster than SBI trading...!!! (startled?? ) (incase its not clear leave a comment).
Dont forget the above point.. This is one thing which would give one trader a sustained-competitive advantage over another.

Some say money management is simply a matter of preference and that it is going to be different for every trader (risk apetite.. ehhh). To some degree, this is true.

But if you take the same account size with the same risk tolerance and the same profit goals, there is only one "best" money management application for that set of circumstances. In geometry, the definition of a line is the shortest distance between two points. There are other ways to get from point A to point B, but there is only one way that is most efficient to achieve the same results. That is the same way with money management.
It is a matter of mathematics(class 10th). Keep in mind.

need to read on risk management?? click me.
-----
leave ur comments.. praises and slaps.. :-)

08-Sep-2005

>Bad Investment? Blame Your Brain?

Bad Investment? Blame Your Brain ? by Amanda Gardner for HealthDayNews

Scientists may have found a way to quantify the legendary balance of greed and fear that is said to drive investment decisions. New research appearing in the Sept. 1 issue of Neuron identifies two brain regions that are activated before people make certain types of investment mistakes.

The upshot seems to be that, for better or for worse, emotions play a larger role in financial decisions than is currently recognized.

"These areas of the brain are fairly deep and not associated with math and taxes. They're more associated with emotions or how people feel before they're about to do something," says senior author Brian Knutson, an assistant professor of psychology and neuroscience at Stanford University. "Anticipatory emotions may have some role in decision making and even financial decision making."

Knutson conducted the study in conjunction with Stanford doctoral candidate Camelia Kuhnen, whose specialty is finance. "This research suggests that we're understanding different parts of the brain in relation to decision-making and emotions," adds Paul Sanberg, director of the Center of Excellence for Aging and Brain Repair at the University of South Florida College of Medicine in Tampa. He says there's been a trend toward this type of research looking into the neurological roots of human behavior.

Anticipatory emotions are only rarely included in economists' calculations of how people make decisions, Knutson says. And though the murky area of human feelings is starting to factor into some economic models, economists still lack a way of understanding how emotions might influence choice.

The current study revolved around two basic questions: how people make decisions, especially in financial situations; and whether brain activation is used to predict what decisions they might make, especially when it comes to risky decisions.

Study participants, all of whom were Stanford Ph.D.s, were asked to pick between two stocks and a bond several times over. Just like the stock market, the stakes were real dollars. Before the transactions began, the researchers randomly designated one stock a "good" one (more likely to make money) and one a "bad" stock (more likely to lose money). The bond paid $1 no matter what.

The participants did not know which stock was good, and which was bad, but they could learn which was which by watching the market.

"That's how we figured out if they were behaving rationally or not," Knutson says. "Did they pick according to all the information they had previously?" Participants' brain activity was scanned with real-time functional MRI as they made the decisions and then learned the outcomes of the decisions. The volunteers tended to make two types of mistakes: selecting a stock when the bond would have been better, or going for a bond when a stock would have been wiser.

Before participants made "risk-seeking" mistakes (such as investing in a stock with a "bad" history), an area of the brain called the nucleus accumbens (NAcc) was activated.

On the other hand, before participants made "risk-averse" mistakes (such as investing in a safe bond when a "good" stock would have been better), an area of the brain called the anterior insula was activated.

"That seems to push people in the direction of avoiding risk if activated too much," Knutson says. The NAcc is an area that's rich in dopamine and is involved in drug seeking and other risky behaviors, Sanberg says.

On average, the participants in the study made rational choices 75% of the time and made mistakes 25% of the time, Knutson says. And the brain areas lit up even when rational choices were being made, just not as much.

These findings may also explain why casinos employ "reward cues" such as free drinks and surprise gifts as anticipation of other rewards that may activate the NAcc and lead to changes in behavior, Knutson adds. Insurance companies might employ the opposite strategy, using strategies that would activate the anterior insula, he says.

The bigger message may be a common sense one: Whenever you're facing a big decision, step back a moment and think it over.

"This is evidence suggesting a mechanism that might help you see things differently," Knutson says. "The lesson is that emotions may have an influence on decision making.

The information, he adds, could be used to improve models of how people make decisions. And to understand more extreme behaviors.

"The next step is what happens in people that have some kind of alteration or damage to that part of the brain," Sanberg says. "Does that explain why some people are addicted to the stock market and make the wrong choices all the time?"

Link: http://www.forbes.com/2005/09/08/cx_0908health_ls.html?partner=lifestyle_newsletter