Cover Story, by Mark Robertson, Managing Partner
Posted on September 1st, 2005
Keep your eye on the pendulum.
Echoing these words from last month’s issue and Graham and Dodd’s Security Analysis, “We return to firm ground in the [time-honored] wisdom that WHEN TO BUY AND SELL is as important as WHAT to buy.” Projected Annual Returns are the barometer for decision-making.
In The Intelligent Investor, Benjamin Graham comments that “common stocks, even of [high quality] are subject to recurrent and wide fluctuations in price, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings.” There are two ways by which we may try to do this: by way of timing [and outguessing momentum trends] or by way of pricing [or effectively using projected returns to our advantage.]
Our quest is to buy at the right prices, avoiding paying too much for our stocks. We achieve this by vigilant attention to the persistent variation in projected returns, seeking to buy when projected returns are sufficiently high and sell when projected returns are too low to support our objectives. Keep your eye on the pendulum.
Stock prices fluctuate. Period.
Many of you know that I believe respecting this reality is Rule #1 in investing.
Seeing the pendulum and trusting “gravity” holds a powerful promise for the vigilant investor. “This materializes in either the form of long-term appreciation of a portfolio held relatively unchanged through successive rises and declines, or in the possibilities of buying near bear-market lows and selling not too far below bull-market highs.” — Ben Graham.
You may feel that Ben was getting a little idealistic with those aspirations, but I think we’ve experienced what he means. The actual annualized rate of return since inception for our family investment club has remained in a fairly narrow range (19-24%) for the last several years, despite the challenges of the 2000-02 bristling bear market. We’ve seen evidence of this very potential with the Tin Cup model portfolio and how it reacted to the same adverse market.
Vigilant attention to projected returns is the key to success in stock selection and it holds the elusive answer to the When/What-to-Sell question.
The successful long-term investor makes a focused effort to identify stocks that are undervalued. Although a simple effort on the surface, we know that relying exclusively on current P/Es as a gauge can be misleading and in some cases, even dangerous.
Relying on a comparison of current P/Es relative to some trailing average of historical P/Es can be equally uninformative. This strikes me as the act of driving one’s car using only the rear view mirror for navigation.
I also question the wisdom of a fixed target (for example, 15% return) over the long term. If the overall expected return for stocks is 20%, targeting 15% as the criteria of selection is — by definition — settling for less and compromising returns. At other times, seeking 15% when overall returns are 8% can be a path to frustration or calamity.
Stock prices fluctuate. So do the projected returns of the stocks which make the market. The successful long-term investor recognizes these realities and while we emphasize long-term holding of stocks with sufficient merit, regular stock selection and portfolio design and management must be done with “an essential minimum of attention to market levels.”
Once again, those are Graham’s words. He’s suggesting that investing should be generally guided by overall market characteristics. National Association of Investors Corp (NAIC) co-founder George Nicholson, Jr. warned investors that “…results may be very erratic if investors go into lower-quality stocks as a bull market progresses.”
The warning is extremely important to avoid the speculation and temptation of exorbitant projected returns. Those who bought lower-quality stocks in early 2000 probably suffered heavy casualties to their portfolios and long-term actual returns. It’s too bad that very little guidance is offered as to what a bull or bear market actually looks like.
We define quality with the MANIFEST quality rating. But how might we define what a bull or bear market looks like? How might it guide our general research and stock selection efforts?
The answer lies in (1) projected annual returns (PAR) for individual stocks, and (2) the collective, median PAR for all stocks followed by Manifest Investing — now over 2400 companies.
It’s a natural extension of Rule #1.
It’s a given: IF “Stock prices fluctuate,” (and they do) THEN “Projected Annual Returns fluctuate.”
We build PARs for all companies based on some core characteristics and forecasts. PAR is the combination of price appreciation and projected dividend yield for any company. Price appreciation is, quite simply, the annualized change between the current price and a projected price. (We use five years as the time horizon.) The future price is projected based on current sales, a sales growth forecast, projected net margins and average P/E ratios.
By using these core projections (assumptions and judgments) we build an expectation for nominal conditions in the future.
If we believe that the individual projected returns have merit for decision-making, what might the collective projection of all stocks we follow tell us? How might this be used to implement Graham’s insistence that “general attention to market conditions” matters. The big picture matters. It really does.
Manifest Investing tracks, on a daily basis, the median PAR for all stocks currently covered in the Solomon database. Although company fundamentals (forecasted sales growth, current sales, profitability forecasts, shares outstanding, projected dividend yield and projected average P/E ratio) only change every 91 days, 1/3rd of Solomon changes every month. With all other characteristics constant, when stock prices fluctuate, PARs fluctuate. You monitor these fluctuations with your Portfolio Dashboards and the PARs displayed by Fundamental Forecasts.
The Manifest Investing Median PAR (MIPAR) replaces VLMAP in the methodology effective 9/1/2005. The long-term range has been 8-20%.
The “collective projection” matters too. Going forward, we’ll routinely display the median PAR for all MANIFEST stocks, dubbing it MIPAR. It’s function will replace our use of the Value Line Median Appreciation Projection (VLMAP) if for no other reason, VLMAP doesn’t include the total return component from dividends. MIPAR will also be more dynamic, granular and timely.
How is this incorporated into the MANIFEST methodology for stock selection and portfolio design and management?
If stock prices fluctuate, and PARs fluctuate, THEN “Sweet Spots” fluctuate. We had defined the sweet spot as a 5-10% range greater than VLMAP. We’ll now substitute MIPAR for VLMAP in the strategy, yet continue to seek the 5-10% incremental advantage. In practice, with MIPAR currently at 10.9% (9/1/2005) our purchase target range would be 15.9-20.9%. Assertive and risk-tolerant portfolios might target a minimum portfolio PAR of 15.9%. (Tin Cup is at 16.2% overall.) Our search for an “attentive measure of market levels” leads us to MIPAR, our powerful market barometer.