Last month we discussed a number of share selection techniques
(i.e. buying and owning "smaller" or
"neglected" shares, "under-valued" shares,
shares with the highest price "strength", etc.) that
have each been shown to outperform the market average.
Unfortunately, combining several of these techniques into a
comprehensive share selection criteria is not a simple task.
Furthermore, once you have decided upon using one or more of the
share selection techniques, it is also necessary to develop a
"Portfolio Management Strategy" - turning your analysis
into actual decisions to "buy", "hold" and
"sell" particular shares.
There are several "problems" in attempting to
combine various share selection methods into a comprehensive
share selection criteria.
One major difficulty is that criteria can be correlated. Another
is that they can be uncorrelated.
Examples of the former (i.e. "correlation") would
include the "small company effect", sharebroker
"neglect" and institutional "neglect".
"Smaller" company shares (as a group, over the medium
to long term) outperform the market, shares "neglected"
by brokers outperform the market and shares "neglected"
by institutions (i.e. with low levels of institutional ownership)
outperform the market. However, combining these criteria (i.e.
"smaller" companies, "neglected" by brokers
and by institutions) does not yield higher investment returns.
The reason? Companies that qualify under one of these criteria
will often qualify under the other two. So each of these three
criteria will select a very similar group of companies - and
combining similar criteria adds little to the value of these
share selection methods.
Similarly, shares with low Price/Sales ratios tend to outperform
the market, as do shares with low Price/Earnings ratios, high
Dividend Yields or a low Share Price to Net Asset Backing. Again,
however, combining several or all of these criteria will make
only a small improvement in these selection methods. All of these
statistics measure "under-valuation" and a share that
is "under-valued" by one criteria will likely be
"under-valued" by most of the others. Combining several
"valuation" statistics therefore adds little additional
information.
An example of the "problem" of uncorrelated criteria
would be high "relative price strength" and criteria
for finding "under-valued" shares (i.e. low Price/Sales
ratios, high Dividend Yield). For a share to have high relative
price strength it must have risen strongly over the last 6-12
months (and that "strength" has a tendency to continue
into the future). However, having risen strongly, such shares are
never the most "under-valued" on the market.
You cannot, therefore, buy shares that rate in the "top
10%" by price "strength" and the "top
10%" by "under-valuation". Few - if any - shares
would ever meet both criteria. The rising price necessary to
qualify under the first criteria will remove the extreme of
"under-valuation" necessary for the second criteria.
Nevertheless, these two techniques can be profitably combined -
by reversing one of the criteria! For example, a very successful
combined criteria would be to buy the "strongest"
shares with a Price/Earnings ratio under 20 and a Price/Sales
ratio under 1.00 (i.e. the "strongest" shares,
excluding those that are already too "over-valued").
Another very successful way to combine these two criteria would
be to buy the shares with the lowest Price/Sales ratio but with a
positive strength rating (i.e. the most "under-valued"
shares, excluding "weak" shares that are declining in
price).
"Insider" trading (i.e. buying and selling by directors
and senior management) can be a very reliable indicator of future
share price performance - but significant transactions can be
rare. (Note: Directors' transactions are not even reported in NZ
- but are in Australia.) One director buying or selling $10,000
worth of shares is not enough to justify a decision for an
investor to buy or sell shares in the company. Several directors
each investing a few hundred thousand dollars would be very
significant - but this may happen only rarely.
So "insider" trading - by itself - does not offer
enough investment opportunities to develop a useful share
selection method (i.e. it will not offer enough investment
opportunities to be able to maintain a properly diversified
portfolio). However, "insider" trading information may
yield the occasional investment opportunity and can be valuable
in choosing between shares that look relatively equal under other
selection criteria.
In addition, there is little or no research or information on the
relative importance of the various selection criteria that we
have been discussing. A "neglected" share may be more
attractive than a "moderately followed" share, and a
share trading on a P/S ratio of 0.25 is more attractive than one
on a P/S ratio of 0.80. But is a "neglected" share on a
P/S ratio of 0.80 more attractive or less attractive than a
"moderately followed" share on a P/S ratio of 0.25? We
don't know - and to find out would require a major research
project following hundreds or thousands of individual shares over
three or four decades. Unfortunately, that historical data just
isn't available.
Finally, all of the share selection methods we discussed last
month can be evaluated objectively. That is, you can measure the
criteria with a number and rank shares from most attractive to
least attractive - and those criteria can be accurately measured
and duplicated in the future or by other investors.
Many factors (e.g. the future "growth" potential of a
company or an industry, how that growth will be financed, a
company's future cash flow and dividend policy and any
"competitive advantage" over current - and future -
competitors) do need some consideration, but can only be
evaluated subjectively by an investor or analyst. In other words,
there are some companies that we may choose to avoid even if they
scored well on the objective criteria - and similarly some
companies that we would tend to favour.
Combining different share selection methods requires
considerable subjective decision making. In the absence of
empirical research studies, one must subjectively decide upon the
"weighting" of the various techniques (i.e. the
relative importance of each selection method), the formation of
various indicators (e.g. should an "insider" statistic
measure the net number of buyers and sellers over the last six or
the last twelve months, and should those transactions be
"weighted" to reflect the dollar value of buys and
sells?), and set a "level" at which a share becomes
attractive enough to qualify as a "buy" (and
unattractive enough to warrant a "sell").
However, sharemarket studies have demonstrated two useful facts
that can probably be used as guidelines for combining any share
selection methods:
1. Most indicators "work" across their full range -
differentiating between the most attractive shares through to the
least attractive shares. So in a combined share selection
criteria, individual methods can be used to include the most
attractive shares (i.e. the "strongest" shares,
"under-valued" shares, "neglected" shares,
shares being bought by "insiders") or to exclude the
least attractive shares (i.e. the "weakest" shares,
"over-valued" shares, "widely-followed"
shares, shares that "insiders" are selling).
2. The best combinations consist of unrelated selection methods.
For example, combining "fundamental" methods (i.e.
based upon valuation) with "technical" methods (i.e.
relative price strength) offers significantly higher returns and
lower risks than using just one of these selection techniques.
A comprehensive share selection criteria should therefore favour
"smaller" companies and/or "neglected"
shares, which are "undervalued" (the Price/Sales ratio
has, surprisingly, proven to be the most reliable indicator,
followed by the Price/Earnings ratio and then the Dividend Yield)
and whose prices are in uptrends (i.e. with high relative price
"strength").
Similarly it should generally avoid the very largest companies
which are widely followed by sharebrokers, trade at high
valuations and where the share price is declining.
Formulating "Buy", "Hold" and
"Sell" Criteria
It is easy to formulate a "buy" criteria for any share
selection method (i.e. buy the "strongest" shares with
P/S ratios of less than 1.00), but to manage a "real
money" portfolio in "real time" it is just as
important to formulate a "hold" criteria and a
"sell" criteria.
Some "tests" of share selection methods assume that a
portfolio of perhaps ten or fifty of the most attractive shares
are purchased on January 1st of each year. The following year -
on January 1st - those shares are sold and replaced with the
current most attractive.
This theoretical method involves several real life problems.
Firstly, the only reason for this "once per year"
review is that the portfolio does not have a "sell"
criteria and so more frequent reviews could generate excessive
trading and brokerage costs. A major problem with a "once
per year" review is that it cannot exploit information in a
timely fashion. If several directors suddenly started selling
large quantities of shares in February then a review of whether
or not that share should be sold and replaced will not be made
for another eleven months.
In the real world, a "hold" criteria and a
"sell" criteria are just as important in a share
selection method as the "buy" criteria.
For example, in the original work on "relative
strength", each week Robert A Levy ranked shares from
"strongest" to "weakest" based upon their
return over the previous 26 weeks. A simulated portfolio using a
"buy" criteria that a share be in the top 5%, and held
until it fell out of the top 70% (i.e. the "sell"
criteria), yielded returns 2½ times greater than the stockmarket
average.
To achieve our goal of formulating a comprehensive Share Selection Criteria we shall next month review some of the important research supporting each share selection method. These studies will form the basis for our subjective selection and "weighting" of the various techniques - and to determine appropriate "buy" and "sell" rules for Portfolio Management.