Friday, April 29, 2011

RIM Update

Speaking of earnings revisions - overnight RIM, according to the Wall Street Journal, has cut it's first quarter earnings outlook by 12 percent.  If we apply that same 12 percent reduction to the annual estimate of $6.91, then we end up with $6.08.  At the same time the shares, as I write this, have dropped to $46.25.  Using our P/E ratio of 10, we get a price target of $60.80.  $60.80 - $46.25 = $14.55.  $14.55 / $46.25 = 31 percent.  For the shares to go from where they are now to my new price target of $60.80, there would have to be an increase of 31 percent in the current price.  As long as I can believe the annual estimate to be accurate, RIM, from a fundamental point of view, still would be attractive. 

Fundamental Analysis - Research In Motion

Price = Earnings X Avg. P/E Ratio
Fundamental Models
I love how analysts will go to incredible lengths in trying to figure out what the stock of a company should be worth.  They use mathematical  models that would give a genius pause.  These models are usually the product of decades of research into market behaviour.  Most are proprietary - they wouldn't want anyone else to steal their secrets gleaned from day to day experiences in the markets.  How could we, for even a second, believe that we could ever hope to understand prices when it has taken them a lifetime?  Why even try?  Until, that is, we read the line that says, "Past results cannot be used to predict future performance."  Huh?!?

The truth is, nobody has ever developed a model that works in every type of market every time.  In fact, nobody has ever developed a model that works in most markets most of the time.  I believe the reason these models are so complicated is because every time something goes wrong with the model, it has to be updated and amended so that, next time, they won't make the same mistake.  Still, there is no forecasting the markets.

Having said that, we need to understand that trends develop in the markets.  After all, markets are the product of human interaction, and we know how people can develop a herd mentality.  What that means is while prices may be affected by people's perceptions of different events as they occur, prices tend to follow a trend for periods of time.  This is huge when it comes to technical analysis, but it can also be used in fundamental analysis. 

Calculating Price
I have blogged earlier about Price/Earnings ratios as a means of calculating a fair price for any stock I might want to own. Studying the trend in RIM's Price/Earnings ratio over the past number of years, I feel comfortable using a value of 10.  If anything, 10 would appear to be low, given the growth rate of the company in recent years.  By using a value of 10 I am saying that I am willing to pay 10 times annual earnings for a share in RIM.  For a company growing at the rate that RIM has, and is, most people would normally be prepared to pay much more.  Using the guideline of never paying more than twice the growth rate of the company, that would suggest RIM is only going to grow somewhere between 5 and 10 percent next year.  Given the company's past performance, this is clearly a conservative estimate.

Annual mean earnings for the fiscal year ending February 2012 are estimated to be $6.91.  Earnings of $6.91 times an estimated Price/Earnings of 10, gives us a price of $69.10.  Given the current price as at the end of April 28, of $53.83, that would give us a potential up side of $69.10 - $53.83 / $53.83 = 28 percent!

That's It?
Can it really be that easy?  What about management, products, cash flow, and all that stuff?  Think of it in this way.  Let's say we want to buy a new car that is reliable and has better than average gas mileage?  Should we pay more than a similar car that is not reliable?  Should we pay more than a similar car with poor gas mileage?  Should we pay more for a car that is popular - one which people are happy to own?  While there are other considerations (whether, or not, the company is going broke), we can see in this case that we are looking at a company which can offer a better car, hopefully at a fair price.  What we need to know about the company is baked into it's history of being able to offer a better vehicle at a better price - one which people enjoy owning (assuming that is the case).

Would the company continue it's favourable history if it was poorly managed?  Would that likely be the case if they had poor quality control?  Would that likely be the case if the company was not offering value to it's customers?  I'm from the school that says if it quacks like a duck, it looks like a duck, and it acts like a duck, then it is probably a duck!

How fast the company is growing is reflected in the earnings estimates and the historical Price/Earnings ratio.  The same for management, and competition, and financing, and inventory, and on, and on.  What that also means is I only buy reliable companies (one's with a consistent history of earnings - which also means they are making money).  Still, I don't just blindly follow earnings estimates.  They will be too high going into a market correction.  I watch for earnings revisions on any company I own, or want to own, and know that analysts don't usually anticipate future market corrections.

So, with a potential, conservatively estimated gain of 28 percent, then RIM is a buy, right?  Well, not so fast.  Next time we look at the trend in RIM's price before I put in my order.

Can you see how I use earnings and Price/Earnings ratios to help establish a price target?  Do you use price targets? 

Monday, April 25, 2011

Research In Motion

Who Is Right?
It seems Research In Motion (RIM - TSX) is in all of the Canadian media these days.  With the release of its new Playbook tablet, there is no end of debate as to the future of this company.  It seems there are strong arguments to be made both for and against owning stocks in this company.  In fact, there seem to be as many opinions as there are analysts who follow this company, and there are over 50 who do.  Despite all of those opinions, sentiment seems to be split pretty much down the middle, for and against.  Does that mean investors should just let the dust settle before deciding whether or not to own shares in RIM?

Fundamental, or Technical Analysis?
I am not a professional, so, as I keep saying, I cannot advise people as to which companies they should own, or not.  However, I think this would be an excellent opportunity for me to reveal the process I follow when evaluating a stock for my own portfolio.  Some people prefer to rely on fundamental analysis, where the company financials are dissected and numbers crunched.  Others prefer a technical approach, instead, analyzing charts of price patterns. 

Why Not Both?
Personally, I have never understood why it has to be one, or the other.  Why would anyone try to do their best work by, first, tying one hand behind their back?  I understand why some people prefer one method over the other, but something I learned a long time ago was to solve a problem using one approach, then check the result using a different approach.  This can create a situation which reinforces the old proverb that a person with a watch knows what time it is, while a person with many watches can never be sure.  In other words, what to do if the fundamentals and the technicals do not agree?  My advice is the same as any situation when there is too much uncertainty - don't buy!

What To Buy and When To Buy
In fact, I use both approaches because I am actually trying to determine the answer to two different questions.  The first question is what should I buy, and the second question is when should I buy?  I do not simply buy stocks in fundamentally good companies and wait for something to happen.  I use the price charts to determine whether the stock is in an up trend, or not.  I don't believe in purchasing a stock where the share price is losing money, because my first priority is preserving capital.  Neither do I like to have money sitting in stocks that are not performing.  There is an opportunity cost to tying up money that could otherwise be earning a return.

When To Sell
Buying a stock with a price that is in an up trend is fine, but how do we know how long to hold it?  We can simply hold the stock until the trend breaks, but there is a chance of leaving money on the table.  Stocks rarely rise in a perfectly uniform trend line.  The purpose of having a price target is to increase my probability of selling at the best time.

Next Time
Next time I will describe the process I use to determine my price target.  Whether the analysis is fundamental, or technical, the principle is to buy stocks when the price is low and to sell them when the price is higher.

Do you have a preferred process in determining what stocks to add to your portfolio?  Do you have a sell strategy?

Tuesday, April 19, 2011

S&P Downgrades U.S. Credit Outlook

Click here to play the video
Standard and Poors rating agency has downgraded their outlook on the U.S. government's credit rating (as opposed to downgrading the actual rating). 

When asked in the interview if he thought we would see a downgrade, Mr. Collender said, "No, I don't."  I find it interesting how he calls the rating agency's record into question because of it's failure to downgrade mortgage backed securities until after the fact.  I would agree Standard and Poors has lost integrity.  To my way of thinking, that is likely the reason they are the first rating agency to call the U.S. government on it's poor record of debt management - especially in light of all of the recent political wrangling.  If the government actually believes that was Standard and Poors' role in the financial crisis, then why has nobody ever been held accountable? 

Mr. Collender also asks, then answers, his own question, "Does this change anybody's mind, and I suspect the answer is no."  Again, I find it interesting how this news creates a significant wobble in the stock market, but the politicians continue to shrug this stuff off as old, irrelevant, news.

In my case, it isn't the threat of a downgrade, as much as it is the continual denial by politicians that they have anything to worry about that concerns me.  It is their inability to even articulate, let alone begin to implement a solution, that made me bearish on the stock market quite some time ago.  Why should we expect anything to change when nobody is being held to account?

Do you trust these guys with your money?  Do you think the situation is going to get better before it gets worse?   

Friday, April 15, 2011

Is Goldman Sachs Correct?

Click Here To See The Video
Earlier in the week Goldman Sachs issued a recommendation for their clients to sell Canadian equities.  It would appear it is based on the correlation between the price of oil and the Toronto Stock Exchange index.  Goldman clearly thinks the price of oil is close to a short term high.  Shown below are charts of the TSX and Oil (Light Crude). 

Do you agree with the Goldman prediction that oil, and Canadian stocks are headed lower?

TSX Index (Click to Enlarge)
Light Crude (Click to Enlarge)

Wednesday, April 13, 2011

BEAR Markets

Click To Enlarge
I mentioned in my previous post that I did not believe we have started another bull market.  There are a couple of reasons for this.  I posted a while ago about Mr. Craig Alexander's (Senior VP and Chief Economist at TD Bank) take on the economy.  During his presentation, he said something I found of great interest.  He said in assessing our recovery we had to compare it,  not to other recessions, but to other financial events of the past.  In that regard he felt we were on track as far as a recovery from that type of event was concerned.  Whether we are or not, it made me realize there is a difference between what we should expect during this recovery and one that follows a normal bear market. 

Incidentally, research has shown bear markets occur on average every four years and last for an average of one year.  If you look at the data, however, you will see the frequencies and durations for bear markets are all over the map.  They can be only a couple of years apart, or they can be ten years apart.  They can last for a few months, or they can go on for years.

If Mr. Alexander is correct, and we are not looking at the average recovery after an average bear market, with which I would have to agree, the above chart becomes rather fascinating.  What makes it particularly interesting is the fact the percentage in change in weekly index values is derived from inflation adjusted numbers.  What that means is the recent markets peaked in the year 2000, and not 2007, as we might otherwise believe in observing unadjusted charts.

While not the same indexes each time, two of the three indexes combine to create definite up and downward trends.  If that continues, then most of the next two years in the stock markets, starting almost any time now, will be lower, rather than higher, as most of the academics and vendors of equities would have us believe.       

Do I think we are headed lower?  In the short term, yes.  It doesn't make a whole lot of difference in my case.  I play a trend until it ceases to be one.  So, even while the longer term trend may be down, there could be opportunities for me to take advantage of a shorter up trend.  For people with a longer term investing horizon, the decision as to what to do is more complicated.  In 1998 I had a rather large (for me) pension adjustment which I wanted to invest.  I put the whole thing into a good mutual fund at the beginning of the year.  By the fall I had lost almost one third of my investment.  Nobody had suggested to me that was even a remote possibility!

Based on my experience, I would not invest any of my money in mutual funds today.  Mutual fund managers will try to minimize losses in a down market, but they cannot avoid them.  For the longer term, I would only invest in a broad index based Exchange Traded Fund (ETF) like XIU and watch it very closely.  I would set a maximum daily, weekly, and monthly loss limit and sell if I attained any one of them.  I would only try to reenter the market once the market direction regained an upward trend.  The problem with this approach is my portfolio could end up dying a death of a thousand cuts - enter the market, lose, sell, enter the market, lose, sell... .  Since I have little faith in the longer term, what I would most likely do is shorten my investing horizon to a much shorter term.

I am not an investment professional, so I cannot advise you in what to do with your money.  What I would recommend is being very careful.  History would seem to indicate things could get a lot more worse before they get a lot more better.

Do you think we are currently in a new bull market?

Monday, April 11, 2011

Stock Market Volume

Dropping Stock Market Volumes (Source: Bloomberg)
Dropping Volume
We can see from this chart from that stock market trading volumes are almost one half of what they were at the beginning of this rally.  Some would call what we are experiencing a new bull market.  Me, I remain unconvinced.  While the volumes have dropped off, many, if not most, have put much of their cash to work.  Fund managers are at record levels of  participation in the markets.  So, if so much cash is actually in the market, why are volumes so low?  While we can't tell for sure, it would seem people are prepared to stick with what they have, as long as the market continues to climb.

The problem with everyone sitting on their hands is it increases volatility.  When there is no shortage of buyers and sellers it is easier to get our price.  Fewer participants translates into greater variation between what sellers want and what buyers are willing to pay.  Think of the real estate market.  In times when there are fewer sellers and we need to buy a house, we can end up paying a lot more than we might otherwise want to.

It also means it is easier for the big guys to defend their gains.  Market index values and portfolios can be maintained by purchasing fewer shares in favourite names than would otherwise be the case.  Still, market breadth as measured by the number of companies reaching new highs continues to be strong.  Weaker volumes do not signal an impeding implosion of the stock markets, but moves not accompanied by strong volumes tend to be shorter in duration.

All In (Or Out)
There is no level of volume at which one could predict a reversal in the stock market.  If that were the case we would likely be able to determine the peak or bottom.  The thing to remember, and what makes a reversal so hard to call, is they come when everyone is in, or out, who wants to be.  Either buying dries up at a top as new buyers refuse to pay higher prices, or sellers are exhausted at a bottom.

As for me, I have already taken my profits.  Are you all in, or all out?

Wednesday, April 6, 2011

Expect To Pay More For Health Care

I say we need to make more in the future just to be able to afford some of what we mostly take for granted today.  I am of the opinion that expectations for future economic growth are too optimistic.  Government debt levels worldwide are limiting our options.  The best way to regain control of our personal future is to get our own finances in good order.  There is little hope the government or the financial services industry will be of any help!

Friday, April 1, 2011

March Portfolio Update

Click To Enlarge
We saw a minor correction in the stock markets during the first couple of weeks in March.  While commodities are still down from the highs, they have not broken the upward trend.

My attempt to play technology stocks as they come down from their high has not paid off, yet. Seasonally, April/May is not the best time to own them, so that opportunity may still exist.  This also tends to be the case for Canadian financial companies. 

Meanwhile I would not bet against the energy and materials sectors at this time of year, although the energy sector does not look like a great buy to me since it has been without any real correction since late last summer.
Three month return for TSX @ Mar. 31, 2011 = 5.21 percent
Three month return for Basic Timing Model using XIU = 4.27 percent
Three month return for Advanced Timing Model (my returns) = -3.34 percent
Money for charity = $411.27