Tax Loss Selling Approaches

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I am watching for the effect of tax loss selling this year.  Since the markets have been down since May, it will likely have more of an effect than last year when the markets were strongly higher.  It could significantly dampen any year end rally as it has the effect of depressing prices during the month of December.

Dale also talks about reasons other than tax loss selling for removing stocks from our portfolios.  I sell if the stock breaks the upward trend, especially after it has met my price target.  My price target is based on the earnings per share times the price/earnings ratio that is consistent with the rate the company is growing.  Of course, downward revisions in the earnings estimates could also be a reason for selling.  

What do you use for a sell strategy?  You do have one, right?

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 http://ianbrennan.blogspot.com/2011/03/price-earnings-ratio.html 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? 

Analyst Ratings

Analyst ratings are not useful in helping us determine if we should buy a stock.  A buy rating by itself means nothing.  How and when an analyst changes their rating can be informative, but I never go by ratings.

Analysts are real people too.  They only have so much time in the day, just like you and I.  There is no possible way an analyst can provide ratings for hundreds and hundreds of stocks.  Jim Cramer on CNBC's Mad Money recommends we spend at least an hour a week on each stock we invest in.  The point is even an analyst can only rate a limited number of companies.

Buy-side analysts research companies for fund managers.  The purpose of a sell-side analyst is to provide a compelling case for owning particular stocks.  If there is only so much time in the day, then some of that time can be used to rule out some of the candidates, but the remainder of the time has to be spent building a case for buying others.  In a finite universe of companies, some will always be sells, some holds, and others buys.  In other words, it is less about absolute performance, and more about relative performance - how one company will perform compared to another.  If we are in the middle of a bear market and the prices of stocks are plummeting, it is cold comfort to know that my stock has crashed to a lesser degree than a competing stock.

Yet, the analyst always has to have a buy recommendation.  That is their job!  In addition, analysts work for firms that have business relations with companies that want to go public, or issue new shares, or raise money using their services.  When an investment firm provides money to a company for an initial public offering (IPO), the investment firm needs to find buyers for the stock.  Have you ever received one of those calls where some advisor you have never met before wants you to buy the hottest stock since, well, ever?

Analyst ratings affect the price.  Watch for times when an analyst has it wrong and continues to raise their target price despite not liking the stock.  At some point that same stock could get so strong relative to their other ratings, they have to change from a sell, or a hold, to a buy.  When that happens, it will normally be good for the price of the stock.  Watch for any change in earnings estimates.  That is a good time to reevaluate our own target price and how many shares of a stock we might want to own, if any.

I aggregate the earnings estimates to determine a fair price for a company's stock.  If there is a herd instinct among buyers, it can also be said for analysts.  When everyone is saying the same thing, I check for alternative scenarios.  I would never buy on somebody else's say-so, and especially not on an analyst's buy rating.

Do you use analyst ratings?

Price Earnings Ratio

Price = earnings times average p/e ratio

Personally, I would never consider buying stocks in a company simply based on the recommendation of someone else.  Still, I get questions from friends about buying this stock, or that, based on a phone call they received from some "well-intentioned advisor".  Usually the story is pretty compelling, and there is always a sense of urgency to get in before it is too late.

While I struggle to comprehend the value provided by sell-side analysts, I suppose their value is not lost on firms trying to engineer the case for buying the next hot stock.

There is one piece of information those analysts provide which I do use.  It is the annual earnings number.  These people know and follow their companies better than I ever could.  They crunch the numbers and come up with an estimate for company earnings for the end of the next year.  I don't rely on any one estimate, but I do look at the average of all of the estimates for a company.

For that reason alone, if a company does not have an analyst following it, I won't buy it.  I am only interested in owning companies with a long enough track record and sufficient size to have analyst coverage.  How else can we put any probability on what the company is going to do in the future?  How many times have I seen people lose money in the stock of companies that never made a single cent?  Never mind the hype and the hyperbole, show me the money!

Did you pay full price for the vehicle you are currently driving?  If so, why?  They want our business, and will make concessions to get it.  Do you buy groceries and pay full price when you know there is a sale coming up for the same items, or a coupon which is good at a future date?  Why should we purchase any stock unless it is on sale?

Any company I would be interested in, has to have a track record, have a couple of analysts covering it, and it has to have made money for, at least, a few years.  I have no desire to own penny stocks, or hopeful wannabe's.  The companies I want to own have a great, if not the best track record in their market.  Since I know the future earnings numbers and I also have historical price to earnings ratios, I can calculate what the price of a single stock is worth.  Earnings per share multiplied by the historical average for the price/earnings ratio equals what the stock is worth.  If that is the current price, why would I buy it?  The lower the current price is below the result of my little calculation, the more interested I become.

Don't take the recommendations of other people, especially those trying to sell something.  We need to do our own homework, and calculate what the stock is worth.  Myself, I still wouldn't run to the computer and buy it without, first, doing some technical analysis to figure out a good point in time to buy.  Regardless, unless it is on sale, I won't even consider it.