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?

The TSX Example

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Market Opportunities
Before posting my last trade, I decided I would illustrate the typical opportunities the market creates.  These charts of the Toronto Stock Exchange show a period of one year chosen at random.  The charts are courtesy of StockCharts.com.  In addition to great, flexible charting, there is also a ton of learning resources regarding technical analysis and various indicators and overlays at that website.  I am not going to get into detail about the indicators shown here, I am only looking at the trend illustrated by them.

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The Charts
The green lines illustrate an uptrend; the red downtrends.  Both charts are of the period December 7, 2007 to December 7, 2008 (one year chosen at random).  In the section which shows the price candles, the first line indicates weekly, or daily.  The indicators used are the same on both charts.  The moving averages are adjusted for the time period.  For instance, the 200-day moving average for the daily chart becomes the 40-week moving average (40 weeks being the same as 200 week days).

Same, But Different
Overall, the time period shown represents less than one complete trade per month (one buy, one sell) on average.  The trend lines are, for the most part, the same between the two charts.  There are a couple of divergences, however.  If we look at the end of April, the indicators on the daily chart show a break in the uptrend, while the weekly indicators do not.  Also, in October, it is arguable as to whether, or not, all of the indicators reflected a trend change.

Disclaimer
This is the point where I am required to point out that I am not a certified market analyst, so what I am about to say describes what I do, and should not necessarily be taken as advice as to what you should do in your portfolio.  Any time we try to take an approach which is new to us, I recommend trading on paper without risking real money until we are more comfortable over a longer period of time.  How much of  your portfolio to put into any particular methodology is an important decision with which you should involve the advice of your professional advisor.  Every portfolio should be unique to the owner's situation (including risk tolerance) and experience. 

Taking Profits
When all of the indicators are in agreement, then we have a trend we can trade.  I know a lot of people will point to the fact that anyone can look at the historical charts and see where they could have executed a trade.  I am not suggesting we would have bought into the market right at the bottom, or gone short at the top.  What I am suggesting is when we have a long position, and the indicators look like they are beginning to top out, why not take at least some profits, by selling?  Normally at that point, the market begins to go sideways, and most of the gains have been made.  After we have taken our profits, we watch for all, and I mean all of the indicators to begin to show a new trend as the old trend-lines are broken. 

Price/Earnings Ratio
An additional method for assessing the upper boundaries of a trend is to value the companies we hold, either individually, or those held within Exchange Traded Funds (ETFs).  By using historical values for earnings and price, we can determine when stocks are on sale and when they are selling at a premium.  Next time I will talk about a previous trade of mine.  One of the reasons for believing the market would correct, was the Price Earnings ratio for the market as a whole.  At the peak of the market earlier this year, the S&P 500 market index attained a value in excess of 1,360.   The average inflation adjusted annual earnings for the market as a whole was $53.50.  The resulting Price/Earnings ratio was over 25.  The average all time ratio for that market is 15.9!  While we can't use that ratio to tell us when to buy and when to sell, it is useful in telling us when we are paying too much!  By the way, the S&P 500 would be trading at 850 for it to be at the average P/E ratio of 15.9.  It is currently around 1,200.

Next time I will discuss my previous trade in July/August where I anticipated the correction in the S$P 500.

Questions?

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? 

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.