How to profit with the square root theory
Legendary investor Sir John Templeton once said that If you want to have a better performance than the crowd, you must do things differently from the crowd.
Templeton, who is regarded as the greatest global stock picker of the 20th century, revealed in the book “The Templeton Touch” that one of his investing secrets was following stock price fluctuations as proportional to the square root.
Known as the golden key, the square root theory assumes that the magnitude of a stock’s volatility is directly related to its share price.
The theory works by adding or subtracting a constant number to the square root of a stock price to predict a future value prior to its high or low.
For example, when Megawide started to recover after making a historic low at P14.02 a share in October 2018, we could predict the stock’s future price using the square root theory.
First, we can compute the square root of the stock price, which is 3.74. Then add a standard factor, which is the number 1 for this exercise. After we get the sum of 4.74, we can square it back to get the projected price of P22.47 a share.
Seven months later after the pivot low, in May 2019, the stock’s recovery indeed achieved its target price at P23 a share, resulting in a 64-percent gain.
As share prices move in a square root relationship, we can also use the same number factor 1 to project target price of a falling stock.
When Metrobank began to correct in January 2019 after reaching a high of P75.04 per share, we could predict how low the stock can fall.
By simply following the same process again, only this time we shall be deducting, instead of adding, the factor 1 to get the target price of P59.03 per share.
Again, in 10 months after the pivot high, in October 2019, the stock eventually bottomed out at P57.96 and it is now up by 18 percent.
The use of the number 1 as a factor may not be accurate for all stocks. Some stocks may need less than 1 while others may need more.
An alternative way to derive the factor objectively is by observing the implied factor from the historical performance of a stock.
For example, when the stock of DM Wenceslao fell from a high of P12.46 to a short-term low of P9.20 early this year, we could compute the implied factor by getting the difference between the square roots of its high and low prices, which is 0.50.
If we get the average of square root differences of several highs and lows of the stock for the year, we can derive the factor of 0.46.
By using this into the square root equation, we can project the short-term price target of the stock at P11.56.
Over at the PSE, the average factor of companies with market cap of P1 billion and below is about 0.55. For companies with market cap over P1 billion up to P10 billion, the average factor is 0.67.
Note that the average factor increases as the market cap of the stock increases.
For companies with market cap with over P10 billion up to P100 billion, the average factor rises to 0.91 while those with over P100 billion, the average factor is 2.10.
The square root theory is applicable not only in forecasting prices from a pivot high or low but is also useful in projecting IPO stocks with no historical price reference.
For example, Fruitas Holdings, which is about to list this weekend, has an offering price of P1.68 per share.
If we use the average factor of 0.67 for companies under P10 billion, we can project that the initial target price of the stock over the next 12 months should be P3.87 per share.
How about the stock market? Well, the PSE index had at least pivot highs and lows in the last 52 weeks, which yields an average implied factor of 3.91.
Given the market downtrend, if we will use the square root theory, we may see the PSE index falling further toward 7,522 support. INQ
Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 80th batch of RFP Program this January 2020. To register, e-mail [email protected] or text at 0917-9689774
