Top analysts or stock pickers, (On the New York Stock Exchange, they refer to these successful stock pickers as “Wall Street Gods”!) tell us that to pick a winning stock you need to do the following:
- Find a listed company you think is doing well.
- Analyse the company, its financial statements and its share price behaviour intensely, interview the company’s management, even talk to the company’s management. This way you get an idea of what deals they have coming in over the next period (quarter, year, five years etc).
- If it all looks good and you still feel confident, you buy the company’s shares on the stock exchange.
- Hang on to the share until the share price reaches the “target price” you set for it and also enjoy the dividend flow if there is any before it reaches the “target price” but once the share reaches this price you sell it.
Sounds pretty logical, doesn’t it?
Well yes, it is logical and many professional equity investors have made a lot of profitable trades using this methodology. The question that now needs to be asked is, how many non-profitable shares did the investor buy using this very methodology which after analysis looked like it was going to be a ‘winner” turned out to be a “loser”?
Now do not get me wrong, it’s not that I believe you should invest in listed shares without doing due diligence and of course one must analyse companies before you invest in them, it’s just that the problem is this…
We as humans forget that our behaviour changes things. Our behaviour is reflected in our risk models and then impounded into stock prices.
In the strategy mentioned above, does the professional equity investor really sell the share when it reaches the “target price” they have set for it, or do they hold the share for a bit longer, hoping to squeeze just a little bit more performance out of the share? We are all good at buying things but are awful when selling things. We are trained to acquire but not to sell.
Think about it, we all read the same publications, so if Company A, listed on the JSE posts good results and explains their future business prospects to the financial journalists then all the investment company analysts hear and read the same story, they all start analysing Company A, they all come to a similar conclusion (sometimes referred to as “consensus view”) and they all start buying Company A’s shares, pushing the prices of that share above the ability of Company A to deliver to the expectations implied in the elevated share price.
In essence, what these analysts are doing is that they are forecasting the future performance of Company A, based on the information they have today, which may be accurate for today but maybe by tomorrow has changed materially, especially if the share price has changed.
Are forecasts ever accurate? When was the last time you read a weather forecast and the weather the next day did exactly as the forecaster said it was going to do? Economists forecast the performance of the economy based on the information they have available at the time of publishing their forecast. Then what happens? A global viral pandemic from China brings the world’s economies to a near dead stop for months on end. Economists may argue that no one could have foreseen something like the Covid-19 pandemic, and yes, they are right, but the point is forecasting is an art and science that is mathematically flawed.
Simply put, you do not know what you do not know!
But what if there is a better way?
What if there is a better way of analysing shares listed on stock exchanges?
What if there is a way to avoid those shares whose share prices have been pushed beyond the company’s ability to deliver to the expectations implied in their share price?
Many professional investors and asset managers will agree with us that stock picking is flawed and that one should simply buy an index tracker fund that tracks the index because historically, active stock pickers cannot outperform the index anyway, thus we as investors are paying the active managers a fee to underperform an index fund which blindly tracks the index at a much-reduced investment fee.
The problem with typical index-tracking investment products is that they track the general index. Think about it, take the S&P 500 index as an example. What is it made up of?
The largest, largely US publicly traded 500 shares by market capitalisation. What is market capitalisation? Market capitalisation is simply the number of publicly listed shares a company has multiplied by the share price.
So, if we go back to my Company A example mentioned above, let’s assume Company A has 1 million shares in issue and the current share price is $5 per share then the market capitalisation of this share is $5m.
Why is market capitalisation an issue for an index tracker? An index based on market capitalisation would include those shares whose share price has been pushed beyond the capability of a company to deliver the growth implied in the share price.
So, let’s ask the question again? Is there a better way?
New Age Alpha in New York believes so and we at Global & Local Asset Management agree with them.
So how does one avoid the “Human Factor” in the market of humans pushing the share price of a company beyond the ability of the company to justify its share price?
New Age Alpha says that to invest successfully in the stock markets one should use an actuarial approach to asset management and not managing share portfolios like a portfolio manager.
By analysing the only two known facts about a listed company, these two facts being the company’s current share price and the company’s published financial statements.
It is the relationship between the company’s implied growth and the share price that is important.
In other words, if Company A sells 100,000 widgets a quarter and this produces $5m of revenue then next quarter if the share price is $10 per share, the company should therefore be producing a high revenue to justify its share price at $10 per share.
New Age Alpha analyses over 6 000 shares globally (including JSE listed shares) in this manner and produces a tool which provides the probability of a company being able to justify its share price daily.
The interesting aspect of the New Age Alpha’s tool (one can use the tool for free by accessing it through the Global & Local Asset Management website, www.glamasset.co.za) is that if one looks at the S&P 500 index, then by using the tool one removes 70% of shares that have the highest “Human Factor Score” or those shares with the highest probability of NOT being able to justify their share price, then the return of this portfolio increases by 2.88% per annum, as this screenshot from the New Age Alpha online tool demonstrates:
So let’s recap in a very simple way, you want to improve the performance of a listed share portfolio, don’t be a portfolio manager and look for the next winner by using analysis which is made up of vague and ambiguous information.
Rather be an actuary and avoid the risk presented by human behaviour and then avoid the shares whose share price reflects the high probability of not being able to justify its share price through its actual business performance. By using this method New Age Alpha’s statistics show that you could be right as much as 65% of the time.