Technical Analysis and Portfolio Management

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1 College Level Introduction to Technical Analysis Technical Analysis and Portfolio Management Lecture 11 Objectives l Investment Policy (Charles Ellis) - Investors Need 3 Characteristics - The Loser s Game - Beating the Market l Invest Like the Best (James O Shaughnessy) - Styles - Timing - Value Factors - Growth Factors - Mixing Styles l C-A-N S-L-I-M (William O Neil) - C-A-N S-L-I-M Defined l The Best Time to Buy This lecture series is produced by the Market Technicians Association Educational Foundation based on the detailed class notes of Charles D. Kirkpatrick II, CMT Copyright All rights are reserved. M a r k e t T e c h n i c i a n s A s s o c i at i o n E d u c at i o n a l F o u n d a t i o n Identifying and funding educational programs in the field of Technical Analysis since 1993 MTA Educational Foundation Post Office Box Cambridge, MA / Fax: 617/ info@mtaef.org Reading Master Textbook Technical Analysis: The Complete Resource for Financial Market Technicians Charles D. Kirkpatrick and Julie R. Dahlquist Chapters 21, 23; pp ; Additional Reading Winning the Loser s Game, 4th Edition Ellis, Charles D. (McGraw Hill, 2002) How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd Edition O Neil, William J. (McGraw Hill, 2002) Invest Like The Best O Shaughnessy, James P. The Anatomy of a Stock Market Winner Reinganum, Marc R., (Financial Analysts Journal, March-April 1988) Stock Selection A Test of Relative Stock Values Reported Over 17-1/2 Years Kirkpatrick II, CMT, Charles D. Journal of Technical Analysis, (Fall-Winter 2002) (Download available at mtaeducationalfoundation.com/lecture)

Chart 1 Successful Investors Need 3 Characteristics Chart 2 Portfolio Management Investment Policy (Charles D. Ellis) Investors need 3 characteristics (Chart 1) 1.

The discipline to work out the basic policies that will, over time, succeed in achieving their realistic investment objectives.

If the premise that it is feasible to outperform the market were acceptable, then deciding how to go about achieving success would be a matter of straightforward logic.

He can be different in stock selection, or strategic emphasis on particular groups of stocks, or market timing, or in various combinations of these.

The Results Unhappily, the basic assumption that most institutional investors can outperform the market is not true. The institutions are the market.

2 Chart 1 Successful Investors Need 3 Characteristics Chart 2 Portfolio Management Investment Policy (Charles D. Ellis) Investors need 3 characteristics (Chart 1) 1. A genuine interest in developing an understanding of their own true interests and objectives. (Chart 2) 2. An appreciation of the fundamental nature of capital markets and investments. 3. The discipline to work out the basic policies that will, over time, succeed in achieving their realistic investment objectives. The Loser s Game (Chart 3) Chart 3 The Loser s Game Chart 4 Portfolio Management as a Loser s Game 1. Outperforming the market. If the premise that it is feasible to outperform the market were acceptable, then deciding how to go about achieving success would be a matter of straightforward logic. Because the overall market can be represented by a passive listing such as the S&P 500 Index, the successful manager need only rearrange his portfolio more productively than the mindless S&P. He can be different in stock selection, or strategic emphasis on particular groups of stocks, or market timing, or in various combinations of these. (Chart 4) Because the active manager will want to make as many right decisions as possible, he will attempt to identify underpriced securities to buy and overpriced securities to sell. 2. The Results Unhappily, the basic assumption that most institutional investors can outperform the market is not true. The institutions are the market. (Chart 5) Because investing institutions are so numerous and capable and determined to do well for their clients, investment management is not a winner s game. It is a loser s game. In a winner s game, the outcome is determined by the winning actions of the winner. In a loser s game, the outcome is determined by the losing behavior of the loser. Beating the Market Chart 5 Investment Policy - Why It Matters 1. Market timing. (Chart 6) One careful study of market timing concluded that an investment manager would have to be right on his market forecast 75% of the time for his portfolio just to break even after measuring the costs of mistakes and the costs of transactions. As Fischer Black put it, The market does just as well, on average, when the investor is out of the market as it does when he is in. So he loses money, relative to a simple buy-and-hold strategy, by being out of the market part of the time. Technical Analysis and Portfolio Management Lecture 11, page 2

Chart 6 Beating the Market Chart 7 Beating the Market (continued) Chart 8 Invest Like the Best 2. Stock selection.

Stock pricing dominates the research efforts of investing institutions and the research services of stockbrokers.

The problem is not that investment research is not done well; the problem is that it is done so very well by so many that no one group of investors is likely to gain a regular useful advantage over

They are made to exploit insights into major industry groups or changes in the economy and interest rates or anticipated shifts in the valuation of major types of stocks such as emerging growth

3 Chart 6 Beating the Market Chart 7 Beating the Market (continued) Chart 8 Invest Like the Best 2. Stock selection. (Chart 6) Professional investors devote an extraordinary amount of skill, time and effort to this work. Stock pricing dominates the research efforts of investing institutions and the research services of stockbrokers. Unfortunately, security analysis does not appear to be a useful or profitable activity. The problem is not that investment research is not done well; the problem is that it is done so very well by so many that no one group of investors is likely to gain a regular useful advantage over all other groups. 3. Portfolio strategy. (Chart 7) Strategic decisions involve major commitments that affect the overall structure of the portfolio. They are made to exploit insights into major industry groups or changes in the economy and interest rates or anticipated shifts in the valuation of major types of stocks such as emerging growth stocks or basic industry stocks. 4. Investment philosophy. (Chart 7) The fourth possible means to increase returns is to develop a profound and valid insight into the forces that drive a particular sector of the market or a particular group of companies or industries and systematically exploit that investment insight or concept. Organizations are committed to either growth stock or value stock investing. Chart 9 Investing Styles Chart 10 Timing Invest Like the Best (James P. O Shaughnessy) (Chart 8) If you study the techniques used by the greatest investors, you ll find that most of them used simple and direct strategies consistently. All managers with longterm success in the stock market made it to the top by consistently using a superior investment strategy. Refusing to act emotionally and second-guessing your methods is one of the toughest assignments investors face. Most fail. The four horsemen of the investment apocalypse are Ignorance, Greed, Fear and Hope. Portfolios that do so much better than the market do so by being very different from the market. The factors favored by market participants in any given year determine how the top performing portfolios will differ from the market. All investors have a style, a perspective on the market that determines how their portfolios differ from the market. Styles (Chart 9) Growth investors believe in a company s future prospects, thinking that a stock s price will follow its earnings higher. Value investors buy stocks with current market values substantially below true liquidating value; they believe in a company s balance sheet, thinking that a stock s price will eventually reflect its intrinsic value. Each style also has highly defined subgroups. In the growth category you find: aggressive growth, established growth, and momentum growth. In the value category Technical Analysis and Portfolio Management Lecture 11, page 3

Chart 11 Value Investing Chart 12 Stock Market Winners Chart 13 Stock Market Winners (continued) Chart 14 Growth Factors Chart 15 C-A-N-S-L-I-M you find: low price-to-earnings, low price-to-sales,

Eighty percent of a portfolio s return is attributable to the manager s underlying style. Timing (Chart 10) Styles come into and out of favor.

We can look at the essence of great managers styles by looking not at the names of the stocks they buy, but at their underlying characteristics.

Value Factors (Chart 11) Price-to-sales ratio less than the market s mean. Price-to-book ratio less than the market s mean Annual sales greater than the market s mean.

4 Chart 11 Value Investing Chart 12 Stock Market Winners Chart 13 Stock Market Winners (continued) Chart 14 Growth Factors Chart 15 C-A-N-S-L-I-M you find: low price-to-earnings, low price-to-sales, low price-to-book, high-yield, defensive or quality, (investors who buy stocks with very high financial ratings, price stability and balance sheet quality). Eighty percent of a portfolio s return is attributable to the manager s underlying style. Timing (Chart 10) Styles come into and out of favor. The best long-term managers do well by finding a great style and sticking with it throughout the various market cycles. Portfolios with similar factors have similar performance. We can look at the essence of great managers styles by looking not at the names of the stocks they buy, but at their underlying characteristics. By understanding that a portfolio s underlying factors are responsible for its performance, we have a tremendous edge on people who refuse to see the obvious. Value Factors (Chart 11) Price-to-sales ratio less than the market s mean. Price-to-book ratio less than the market s mean Annual sales greater than the market s mean. Market capitalization greater than the market s mean. Average yield greater than the market s mean. Average cash flow per share greater than the market s mean. Combinations: A low price-to-earnings ratio is helpful only after a variety of other criteria are met, such as market capitalization, price stability, adequate liquidity and other indicators of good financial strength. Because a low P/E ratio by itself can lead you to stocks on their way to bankruptcy. It s best to apply low P/E ratios or price-to-book ratios to mature, stable big-cap stocks. The best combination of Value Factors: (Chart 12) Low price-to-sales ratio. Earnings per share up five years in a row (earnings persistency). (Chart 13) High share price relative strength. Low price-to-book (with write-offs this has become less reliable). Return on equity greater than 15%. 8. Price momentum. Relative strength works. Risk is higher; but buying losers is a poor strategy walking dead. Unite relative strength with other factors. You must use a combination of factors that require larger, more financially stable stocks when using a value strategy; you need a larger capitalization, even with stocks that have high ranks for financial strength and stability. While almost all big cap, Technical Analysis and Portfolio Management Lecture 11, page 4

Chart 16 C-A-N-S-L-I-M Chart 17 C-A-N-S-L-I-M Chart 18 C-A-N-S-L-I-M: When to Buy Chart 19 The Buy Decision Chart 20 The Buy Decision (continued) high-yielding portfolios also have low P/E ratios,

Many times a low P/E ratio is quite warranted, with the company having very limited prospects for the future.

Growth Factors (Chart 14) Twelve-month earnings per share percent change 1,000% higher than average. Strong relative strength. 26-week percentage change is an average of 450% higher than the database.

Mixing Styles Mixing growth and value strategies gives you the best of both hemispheres, substantially reducing the volatility of strategies based on growth alone and increasing the capital

5 Chart 16 C-A-N-S-L-I-M Chart 17 C-A-N-S-L-I-M Chart 18 C-A-N-S-L-I-M: When to Buy Chart 19 The Buy Decision Chart 20 The Buy Decision (continued) high-yielding portfolios also have low P/E ratios, not all big cap, low P/E stocks have high yields. History gives the nod to choosing the high-yield approach over the low P/E strategy when applying them as relative factors to large companies. Many times a low P/E ratio is quite warranted, with the company having very limited prospects for the future. High yield on the other hand, at least compensates the patient investor with an excellent dividend income. Growth Factors (Chart 14) Twelve-month earnings per share percent change 1,000% higher than average. Strong relative strength. 26-week percentage change is an average of 450% higher than the database. Last quarter EPS percent change 285% higher than the average. Estimated percent change of EPS for fiscal year 265% higher than average. Mixing Styles Mixing growth and value strategies gives you the best of both hemispheres, substantially reducing the volatility of strategies based on growth alone and increasing the capital appreciation potential of strategies centered on value. This blended portfolio s factor profile is fascinating. You have a big-cap portfolio with high price stability, a low beta, a low P/E ratio, a yield 75% higher than the market- all the best of value. Yet you also have a portfolio with positive relative 26-week price strength, huge recent earnings gains, and earnings forecasts for more of the same or for the best of the growth style. From a factor standpoint, you ve got all bases covered. Just keep the portfolio fresh; and use a small number of stocks. C-A-N-S-L-I-M (William J. O Neil) (Chart 15) The technicals and fundamentals go hand in hand. The technicals very often lead the fundaments, but eventually the fundamentals have to unfold. C = Current Earnings per Share Growth which should be a minimum of 20%, and showing acceleration from quarter to quarter. Watch out for misleading reports, and omit one time gains. A = Annual EPS Growth which should be a minimum 15% to 20% for 3 years. (Growth stocks are early bull market leaders. Each new cycle produces new leaders.) N = New. The greatest market winners either had a major new product or service, new management, or an important change for the better in the conditions of their particular industry. A new stock price high can alert you to Technical Analysis and Portfolio Management Lecture 11, page 5

Chart 21 The Sell Decision Chart 22 The Results Chart 23 Conclusion Chart 24 Putting It All Together new developments at companies that you might have missed. (Chart 16) S = Shares Outstanding.

Winning stocks have high and rising relative strength for itself and for the stock s industry group.

6 Chart 21 The Sell Decision Chart 22 The Results Chart 23 Conclusion Chart 24 Putting It All Together new developments at companies that you might have missed. (Chart 16) S = Shares Outstanding. The number of shares outstanding of the most successful stocks is generally less than 25 million. L = Leadership. Winning stocks have high and rising relative strength for itself and for the stock s industry group. If a stock or group is beginning to outperform the market that should indicate future strength and should be bought. If relative strength is falling, the stock or group is weakening and should be sold. If the relative strength line does not precede or confirm the price move- watch out. Avoid buying any stock unless there is confirmation of its strength and attractiveness by at least one other important stock in the same group. Industry-wide moves are the most powerful. Leaders in one cycle rarely repeat in the next cycle. (Charts 17-20) I = Institutional Sponsorship. A good stock should have sponsorship from institutional investors. Look for stocks that are under accumulation by toprated mutual funds. Also, look for company insider ownership and company purchases of their own stock. (Company purchases are not critical; it may be an indication that the company has many capital investment opportunities.) M = Market. You don t have to know what the market is going to do; all you need to know is what the market is doing (follow the flow) and be on the right side of it. Let stock and group performance guide your market outlook. Buy and hold the best stocks when the market is going up. Too often institutional holders are reluctant to sell a laggard because they are forced to find a replacement. At market tops there may not be many stocks that are suitable, therefore, laggards are held and performance is hurt. Manage by exception. Continuously look for abnormal action. Watch for leaders losing strength in bull markets. Observe as many stocks as possible during market corrections because it is easier to spot potential leaders during corrections. Weed out the weak holdings from your portfolio. (Charts 21-22) The Best Time to Buy 1. Buy on a breakout into new-high territory on at least a 50% increase in volume. Look for confirmation from the relative strength line. (Chart 23) 2. Allow for a minimum of 7 weeks for a stock to base before breaking out. 3. Buy within 5% to 10% of the breakout point. (Chart 24) Technical Analysis and Portfolio Management Lecture 11, page 6

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