How To Invest In The Stock Market

Presentation to the Episcopal High School Investment Club, Alexandria, VA. 17 Oct. 2013

What Is A Stock?

1. One element of a corporation’s capital structure.

2. Corporate capital structure ranked by declining priority of claim:

Secured debt

Senior unsecured debt

Subordinated debt

Preferred stock

Common stock

3. Common stock is the only security that participates in the financial performance of the firm: no fixed interest or dividend, no claim in bankruptcy.

4. Stocks are the only asset class that offers the opportunity to “strike it rich”, or to lose it all.

What Makes Stocks Special?

1. Stocks permit an small investor to participate in the ownership of a large company.

2. The smallest investors can own shares in the biggest companies.

3. Stocks are a much better hedge against inflation than bonds.

4. In the postwar era, stocks have outperformed bonds by a wide margin: Dow was at 160 on V-J Day; at 1000 30 years ago; is now at 15000. I expect it to go to 20000 over the next two years.

Ways To Invest In Stocks

1. Stock-picking based on fundamentals

2. Market-timing based on valuation

3. Market-timing based on patterns

4. Mutual funds and ETFs

>Stock-Picking Based On Fundamental Analysis

1. Revenue and earnings growth (growth): GOOG, AMZN, AAPL

2. Low PE ratio, undervaluation (value): out-of favor sectors

3. High dividend yield (income): utilities, cyclicals

4. Long-term stability (blue chip): JNJ, KO, PEP, GE

5. Strong free cash flow (value): tend to be unsexy

6. Return of capital (stewardship): management that works for the shareholder

7. Strength of franchise (moat): brand names

8. Financial fundamentals: capitalization, profitability, cash generation, cash disposal policies, accounting conservatism, management risk tolerance.

>Market-Timing Based On Valuation

1. Analyzes the market like an individual stock

2. Values the market based on expectations of earnings and PE ratio.

3. Some look at overall dividend yield, some look at PE and some look at the equity risk premium over bonds [market earnings yield vs bond yields].

4. Buy cheap (March 2009), sell dear (now?)

>Market Timing Based On Patterns

This is called “Technical Analysis” and looks for patterns in the prices of individual stocks or of the overall market that are believed to provide information about future price movements. While many respected market gurus use technical analysis, economists consider it to be pure voodoo.

>Mutual Funds And ETFs

1. Mutual funds and ETFs are an efficient way for the small investor to diversify his equity portfolio.

2. Managed funds offer the style, sector, objective and expertise of the portfolio manager.

3. Style: e.g., large cap growth; sector: e.g., financials; objective: e.g., long-term capital gains; expertise: e.g., technology.

3. Passive funds seek to efficiently replicate the performance of an index with minimal overhead.

3. ETFs offer a somewhat static portfolio, with a stated style, sector, and objective, with periodic rebalancing.

4. Indexed ETFs, like passive mutual funds, seek to replicate the performance of an index. The most popular market index is SPY, which replicates the S&P 500.

5. Some good performers: PKW, RPV, RPG, CSD, USMV, PFM, FPX, CSM, VIG, SPHQ, HDV, SDY, DVY.

Beta and Alpha

1. Beta measures the degree to which a stock or portfolio matches the performance of the overall market (SPY). A low beta means low correlation, while a high beta means high correlation or a super-charged correlation (more volatile than the market but in the direction of the market).

2. Alpha measures the ability of a portfolio to produce returns in excess of the market average. Indexed funds have low alpha (= to market), while managed funds may have high or low alpha. The goal in active investing is to outperform the market, i.e., to generate alpha. Most managed funds lack alpha. Some indexed ETFs have alpha (e.g., PKW).

Understanding Corporate Cashflow

Revenue

-Operating Expense

=Operating profit

-Taxes

=Net income

-Capital expenditures

-Acquisitions

+ Noncash expenses (e.g., depreciation)

=Free cashflow

-retained cash

= cash returned to shareholders (dividends, buybacks)

Should You Invest In Individual Stocks?

1. Are you a full-time professional equity analyst?

2. Do you have access to proprietary valuation models for each industry in which you invest?

3. Are you an expert in the relevant industries?

4. Do you listen to quarterly earnings calls and attend the annual Investor Day? Can you call the CFO with questions?

4. How well do you understand the financial dynamics of technology stocks, or pharmaceuticals?

5. Do you possess information not shared by the wider market?

If you answered no to these questions, then don’t buy individual stocks.  Invest in mutual funds or ETFs.

How Can I Know When It’s A Good Time To Buy Stocks?

1.You will need to work on yardsticks for estimating the intrinsic value of the stock market in order to compare your estimates with the current market price.

2. Typical yardsticks are: PE ratio (looking both backward and forward, which requires forward earnings estimates), dividend yield, market-to-book, market to FCF.

3. The problem with such yardsticks is that they only compare the market to itself, not to interest rates. High interest rates lower the value of the corporate earnings yield (E/P), while low interest rates raise the value of corporate earnings (lower discount rate).

4. The best measure for market valuation is the Equity Risk Premium which can be crudely be described as the market earnings yield minus the risk-free rate.  

5. Today's ERP is almost 6%, which is high by historical standards.

6.If we calculate the ratio of ERP to the risk-free rate, we get a multiple of 3.3x, which is extremely high by historical standards. If you accept the premises of this analysis, then you must conclude that stock prices today are very cheap, and that you should buy stocks right now.

7. Why are stocks so cheap? Because it is only five years since the Crash, and investors remain highly risk-averse. They think they are “safe” and “conservative” holding 3% bonds.

8. What could derail this view? Either (i) higher interest rates, which I do not expect; or (ii) lower corporate earnings due to another recession, which I also do not expect. What I expect is that stock prices will continue to rise until the ERP and the EY/RFR normalize. That would imply that stocks could double over the next few years, as greed replaces fear.