Last key factors in stock selection

Last Friday’s run-up on Wall Street seems to be the result or an example of investor action riding on the principle of momentum investing to “buy high, sell higher”—a rather imaginative innovation of the old trading strategy to “buy low, sell high.”

As reported, US investors bought quite freely into the market as they “turned their attention to corporate earnings last Friday, once again” and chose to shrug off some not-so-satisfactory economic reports along with heightening geopolitical concerns that certainly caused the sharp selloff on Wall Street just the day before.

The theory behind the practice of momentum investing is that it’s not a bad idea to buy even at the higher end of a stock’s price band so long as there is still room to sell higher—a notion arising from the principles of trends.

Documentary basis

The strategy is not without any sound basis. As documented by its authors (Narasimhand Jegadeesh and Sheridan Titman) more than 20 years ago, stocks that are performing well are more potentially reliable to do better than stocks that are down and doing poorly.

In particular, they observed that “strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods.”

In present-day situation, take for example the often cited story of an investor deciding to buy a stock because a few months back, said stock was selling for P250 a share and is now trading at P150 a piece or for P100 less.

From personal experience, when shopping for clothes this may make sense. But trading and investing in stocks is different. If the price of the stock has ranged from P50 to P150 a share and it’s currently trading at around P55, it doesn’t mean that it’s a bargain. To ascertain that it is, as stressed by all of the successful stock investors and money managers I’ve featured in this column in the past, the decision to buy must first satisfactorily hurdle the principal question in a stock’s price of whether “Is it selling at a good value?”

This simple question will all alone explain why “buying stocks that are near or at yearly lows” may not be actually beneficial to your investment positions or holdings but may rather even put it at more risk. As observed, beaten down stocks may either never reach their previous highs or they may take a very long time to go back to their highs.

We have many of these stocks in the industrial and mining sectors. A few years back, they were soaring. But after they crashed following market shifts and pending government policy changes, these companies have yet to recover from their pre-crash prices or values.

When the price of a stock doesn’t recover relatively fast enough, the opportunity cost of holding this stock increases over time on account of the principle on the time value of money.

More than the above observations, the authors added, picking the bottom of stocks or buying stocks that are out of favor is a very difficult and problematic proposition, for while they are luring as they give a sense of security, “they are cheap for a reason.”

This makes the new strategy to “buy high, sell higher” another good idea, if not better, to their conclusions.

Consider the following reasons: You are buying a stock that is trending upward, not downward. You are not hoping or waiting on a turnaround story or a buyout. And as they claim, “chances are, your stock has proved its value before you buy it.”

Also, a stock that is at or near its high is moving along the law of demand and not against it. One reason for it is because it is most probably the preferred or target stock of big market investors like institutional buyers. Conventional wisdom dictates that “institutional money moves stocks.” Retail investors hardly can cause it unless when they move as one power that produces a “bull run.”

Unlike cheap stocks that tend to trade less frequently, higher-priced stocks trade actively. Chances are you will have less difficulty finding buyers at your desired price. Stocks that lack volume often don’t have institutional patronage and interest. And as observed, institutional money determines stock prices most of the time.

Lastly, cheap stocks tend to trade less frequently and you might have difficulty finding buyers at your desired price.

Bottom line spin

Some inexpensive stocks could be actually “true value plays.”  Buying them may indeed result in substantial gain. But, again, buying cheap stocks is not a risk-free strategy. They could increase your risk of losing money when they either continue to lose value or fail to rebound to your expectations.

As their study showed, “buying relatively expensive stocks could be buying on strength.” The potential for upside by expensive stocks is observed consistently better than bottom fishing for inexpensive stocks. This brings us to the last two key measures in fundamental valuation we have been reviewing in connection with bottom-up investing. These are market capitalization and enterprise value and the concept of free cash flow (FCF), the liquidity and solvency ratios.

Market capitalization or market cap is simply the total value of a company calculated by multiplying the number of shares of the company by its current share price. Enterprise value, on the other hand, represents only the value of the ongoing operations or business of a company. It is calculated as the total of market cap plus preferred shares capital and minority interest, minus cash and cash equivalents.

FCF is the amount of cash left after paying off all expenses, including investments. It is also known as operating cash flow minus capital expenditures. Obviously, the bigger it is the better is the financial health and stability of the company.

The standard metrics for liquidity and solvency are the “Acid Test Ratio (current assets minus inventory divided by current liabilities), Current Ratio (current assets divided by current liabilities), Debt-to-Equity or D/E Ratio (total liabilities divided by stockholders’ equity).

As such, these metrics show the ability of a company to meet its debt and other obligations, both short- and long-term. A lower liquidity or solvency ratio is indicative of a company’s greater profitability of default on its debt obligations.

As a last word on stock selection, making any investment decision solely on one method is not a good strategy. The combined use of at least two methods is recommended. The application of bottom-up and momentum investing can be forceful. They both in the end reinforce each other in answering the basic question: “Is the stock selling at good value?”

The writer is a licensed stockbroker of Eagle Equities, Inc.  You may reach the Market Rider at [email protected], [email protected] or at www.kapitaltek.com