Trades and observations from a British contrarian stock investor

This blog is not intended to give financial advice. Before investing, do your own research and consult your financial adviser if appropriate. The accuracy of any information included is not guaranteed and may be subject to conjecture or interpretation by Contrarian Investor. Therefore visitors should validate all facts using alternative sources where possible.

Sunday, January 17, 2010

EDUCATION SEGMENT - Contrarian Investor's Guide to stock picking

DECIDE YOUR INVESTMENT STYLE
Investors make money in several ways:

1. Long term value investors in the ilk of Warren Buffett “the sage of Omaha”. They buy and sell stocks on the basis of perceived value in the price based on fundamentals and tend to hold as long term investments.

2. Trading investors, who look for short to medium term opportunities in stocks, currencies and bonds. They can hold for hours or even minutes looking for quick profits on fast changes in valuations.

3. Stock picking investors have several approaches. They either go for:

-- A Game Changing pick which is going to change the landscape of an industry e.g. Apple with Ipod,. Investors can profit in these stocks by doing research and buying in before the crowd and especially the investment community get the stock on their radar.

-- Inflection Point stocks have poor business model that they’re aiming to turn around and fix. Buyers find a turnaround early often when sentiment is at its weakness and make very large gains albeit it at some risk.

-- “Under the radar” stocks are stocks no one is talking about , but can produce explosive growth if the fley blossom

4. Income seeking investors looking for solid and preferably growing dividend payments

5. Contrarian investing

The greatest profits are there to be had if you manage to find that out of favour stock which is due to a significant re-rating before the City or Wall Street Analysts rediscover it. Warren Buffett once said “Be fearful when everyone is greedy, and be greedy when everyone is fearful". When the Sunday Newspapers are talking about the stock market on the front page its often a strong signal to sell or buy. If the headlines are full of stories about “All time highs” then it might be a time to slim down the portfolio and conversely if the papers talk “Crisis in the markets. Depression looms!” then its normally a sign that bargains are there to be had. Another sure sign indicator of problems ahead in a particular sector is large amounts of fund manager advertising for a particular fund just at the time the sector peaks. A classic illustration of this was the launch of several emerging markets funds in the Spring and summer of 2007 and early 2008 often in highly specialist markets such as the Middle East and Africa or Commercial Property Funds. These funds have fared particulary poorly in the subsequent period during 2008 and 2009

The markets and particularly private investors behave like a flock of sheep. Selling their holdings at the bottom because according to the press there is no light at the end of the tunnel. In the case of small capitlisation stocks under £50 million in value this can be particlaularly problematic since the number of sellers can be relatively large and the number of buyers is very small. Hence the price drops dramatically. Those with stop losses that trigger an automated sale if the price drops below a certain level also join the chain reaction and within a short period of time a company with a reasonable market value has dropped to below its cash in bank value.

Well known contrarian investors like Warren Buffett looks for under valued investments that are “out of fashion”. His company Berkshire Hathaway has been one of the success stories of the investment community and made Buffett one of the richest men in the world by investing in companies which can deliver long term growth in profits or earnings per share. He famously avoided the technology boom and bust in 2000/2001 since he only invests in companies he or his team can fully understand and have a history of sustainable profitability. He chooses stocks on the basis of metrics such as % gross margin,return on equity, return on capital employed


CHECK OUT THE FUNDAMENTALS

First of all ask yourself a few questions.

How does the price/earnings (p/e) look? – The FTSE 100 currently trades at an average P/E of 18, the DOW Jones Industrial Average trades at just over 18  and the S&P 500 trades at close to 91. But rather than looking at a P/E in isolation to ascertain the valuation of a share, you need to look at it in comparison to its sector.

e.g. let’s look at the historical and forecast p/e’s of pharmaceutical stocks in the U.K.

                                                                Latest p/e            Forecast p/e
Glaxo Smithkline (GSK)                            11.9                10.4
Astra Zeneca (AZN)                                    9.6                 7.8
Shire (SHP)                                                  61.9              21.0

So based on expectations of the forward p/e Astra Zeneca Looks cheaper than GSK, whereas Shire looks expensive , probably due to a an expectation of a takeover at some point which drives a sector premium.

Is the balance sheet OK? -  check the cash and short term investments on the balance sheet versus the debt of the company. This can be easily fond on the internet using sites like www.yahoo.com  or www.digitallook.com .When is the debt due for repayment? Could there be a fund raising to raise cash to bring down debt? If you divide the cash the company has by the number of shares in issue, this will give an indication of cash per share. Some of the big tech names in the U.S. have significant cash on their balance sheet, e.g. Intel, Apple, Google which gives support to their share price.

Have directors been buying or selling shares? – Consistent buying or selling of shares by directors can be indicative of a company’s prospects but take this with a pinch of salt e.g. a company director may need to sell stock to meet a personal obligation rather than because of an issue with the company. Again, many web sites have information about director deals including the ones cited above.

Broker recommendations – How many brokers are saying that the share is a buy, hold, strong buy, sell. If every broker is selling a stock is a buy this can often be a contrarian indicator because expectations are universally high. With such a company, one earnings disappointment can drive a stock much lower. The converse is true with a company which everyone advises to sell, but any surprise on the upside can cause broker reratings and a large move up.

               
2.   WHAT IS THE INVESTMENT THESIS?
Why are you buying the shares of this company and why are you devoting your assets to buying it versus another company? You should always have an investment thesis for buying a stock e.g. because it pays a good dividend, because it’s launching a new product, because its a consumer recovery play, because its earnings are growing faster than any other company in its sector.

3.    WHAT IS THE NEWS FLOW?
Ask yourself, what are the catalysts for a change in the share price. Although overall market sentiment and the sector the company operates in is a significant shifter of the price, it is often news flow that drives a share price change either up or down. This particularly impacts oil and gas or  mining companies where asset valuations can change rapidly on the announcement of a discovery. Biotech and pharmaceutical companies can also see a dramatic change in share price, particularly in the case of small cap shares. Look at historic news flow, particularly regulatory announcements to ascertain what is likely to come up in the near future, either good or bad.

4.    WHAT IS THE MOMENTUM OF THIS STOCK?
There is an excellent adage, “never catch a falling knife”. Looking at a company with depressed share price can give the illusion that it is cheap based on the historical share price. Make sure you check the fundamentals, particularly earnings estimates before jumping in because the stock can get cheaper still! Timing the purchase of a stock is everything. Often the share price chart of a share looks frightening because it been up and up over a period of time. But you should ask yourself the questions, what are the fundamentals and what is the news flow to check whether its the right time or definitely the wrong time. For companies who are still not making profits, then clearly future news flow is the primary concern and then the strength of the balance sheet.

5.    WHAT IS THE OVERALL MARKET SENTIMENT LOOKING LIKE?
Probably 50% of the likely direction of a stock is dictated by the overall market sentiment. If the market is likely to be heading in a certain direction, investors will Sector Rotate. That is:

Examples of Sector rotation:
Defensive stock rotation: Tobacco, pharmaceuticals, utilities, Consumer staples, Defence
Growth stock rotation: Technology, Consumer products, Property, Commodities

For example, it may be a bad time to buy a tech stock if the overall market is heading for recession. Conversely, a tobacco company may be a good buy.

6.    DO YOU GO LONG OR SHORT?
With the advent of Spread Betting and Contract’s for Difference (CFD)’s through providers such as IG Group, it is easy to either sell a stock short and make money if the stock price falls or go long and make money if the price appreciates. The benefits of either CFD’s or spread betting is that they are leveraged vehicles i.e. you can buy a substantial amount of shares using margin (more than you could if you just bought the stock with the same amount down), which can accelerate your gains or your losses.

If you believe a stock is significantly over valued, then sell short. For example I was looking at the Cinema Company IMAX in the U..S. last weekend which had risen by close to 50% over the last few weeks as Avatar 3D fever gripped the cinema sector. Directors starting to sell as the valuation got into the stratosphere. After hitting $14 earlier in the week, I was tempted to go short. In fact, it dropped before I could get the position in but it is around $12.50 now.


DIVIDEND POLICY
The U.K.in particular has a strong dividend payment culture in contrast to some of other countries such as the U.S. where companies are increasingly less focused on the this shareholder payment mechanism and instead tend to reward share holders through share buy backs which have the effect of boosting earnings per share by reducing the number of shares in circulation - the profit in effect is split around a fewer number of shares. A high dividend yield is often sought by so called “income investors” which look for quarterly or annual dividend payments. The dividend yield is calculated by diving the dividend payment by the share price. A company with a solid and growing dividend payment gives support to a longer term holding in a particular stock and when combined with earnings growth can be a powerful formula for above average investment returns. Pharmaceutical, Tobacco and Utility stocks, the classic defensives tend to pay above average dividend and usually have a progressive dividend policy where payments are increased annually above inflation.

No comments:

Post a Comment