Readings: Week 2 - 8 Oct 2017

Selling Is Harder Than Buying

The Psyche of Selling: Selling is harder than buying, so when and how do I sell?

Your “gut feeling” is normally right because it’s the sum total of all your perceptions. When you know you should be selling it’s normally too late. Through the years I’ve found that when I start to see cracks form in my investment thesis, I should be selling. When I start thinking about selling, I should be selling. When I start to rationalize holding a position, I should be selling. When I feel management has lied to me, I should be selling. Listen to your gut.

For my strategy, it’s just a waste of time to have such rules because my position size will ultimately grow with my confidence level. Just because a stock doubles or triples doesn’t mean it’s a sell. I’ve been in many stocks whose situations were far better and even less risky after their stocks doubled.

Here are 4 reasons why I would sell:

  1. Sell when you find something better. You want to always evaluate new opportunities against what you already own. When you find an investment that is much better than a current investment you sell.

  2. Sell when the story changes, and I try to know the companies better than anyone so I can spot the changes before anyone.

  3. Sell at the first sign of management incompetence or unethical behavior. Sometimes management teams make a decision that is so bad you have to sell. The reason is because of the cockroach theory. When you see one bad decision there will be more that follow.

  4. Sell when the company gets very overvalued. I’m a long-term investor but there are cases where the stock price gets way too far ahead of the business. Evaluate the current valuation against your three or five year expectations-estimates.

UWJ’s rules to picking VALUE stocks

Common traits of value stocks include a high dividend yield, low price-to-book ratio and low price-to-earnings ratio.

When looking for a value stock, you’re looking for a stock that the market has valued incorrectly and doesn’t like. You’re buying a stock that is cheaper than it’s really worth in the faith that the market will reprice the stock. The problem with this type of investing is that you might be waiting years for the market to recognise its true value. The share price might also fall further before rising. Then there is the likelihood that you may have missed something and the market has valued the stock correctly. A cheap stock is usually cheap for a reason.

10 Value Rules

  1. Intrinsic Value – Use Thomson Reuters intrinsic value. Only buy when the stock’s market value (share price) is less than its intrinsic value.

  2. PE ratio – The P/E ratio shouldn’t be above the market’s PE. According to Benjamin Graham, invest in companies with a PE ratio of 15x or less.

  3. ROE – ROE is more than a measure of profit, it’s a measure of efficiency. A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital. So check to see if next year’s forecast ROE is higher.

  4. EPS Growth – Look for companies with positive EPS growth during the past five years.

  5. Current Ratio – Ensure ratio is over 1.50. This makes sure the company has enough cash and other current assets to see out any shocks in the economy.

  6. ROE – Must be greater than 15%.

  7. Market Capitalisation – Must be greater than $100m

  8. Dividend yield – Should be at least two-thirds more than the 90 Bank bill swap rate.

  9. Debt to equity ratio – There should be no more debt than equity (D/E ratio < 1).

  10. Free Cash Flow – Which is simply the earnings of the company, before financing costs and depreciation but after tax, working capital changes and capital expenditures. You want to see positive free cash flow.

Momentum Investing: Buying Winners and Selling Losers

Momentum stocks are typically defined by relatively strong price performance over the past 12 months, or relatively strong recent earnings. One way to explain the existence of the momentum premium through time is behavioural, in that investors tend to show herding behaviour and have a “fear of missing out” on stocks that have been appreciating in value.

Momentum portfolios can be volatile and subject to “momentum crashes”. As such, it is important to dynamically manage allocations to these high momentum stocks. To do this, we look at three broad indicators. Whilst valuation is a key decision-making input for any investment decision, it is also important to consider where we are in the economic cycle as well as gauge market sentiment.

Most investors, subconsciously or otherwise, are momentum driven. They are eager to jump on board, and to stay on board, when a share price is on the rise. Their view changes when this is no longer happening.

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