Are
In this vehicle selection criteria are outlined that can en- able you to profit substantially from global stock markets and outperform indexes on both a nominal and risk/reward basis whenever you decide to build exposure in any particular market
on the globe.
So we have explained how important timing tools such as valuation, the Austrian Liquidity Cycle, Technical Models, Aus- trian Alchemy and clear understanding, secular themes and trends, and other techniques can help an investor sidestep locate excellent risk/reward and concentrate on
reliable market trends. The focus has been on money management
and defense, as well as on of environments where
an aggressive offense and allocation are warranted. Investors
who use these techniques can avoid large drawdowns and locate
the highest potential markets.
After analyzing the preceding variables and choosing favor-
able equity markets (if they exist at the time), the next
question is, specific stocks do I select for my portfolio, and
how and when do I buy and sell them?" The goal of this chapter is
to answer that question. 240
MUTUAL FUNDS
however, a brief discussion of the mutual fund investor is in order. Could a mutual fund investor simply invest in
fund for each country selected in our top five RS country allocation methodology and get above-average returns with below-average risk? Absolutely, the answer is yes. Many in- vestors may not want to spend the time and effort selecting indi- vidual securities in the manner outlined even after they know the incredible advantages of doing so. If this describes you,
that is fine. Nevertheless you should study this chapter because
every investor needs to understand the variables that lie behind individual equity performance.
For the most part, mutual fund investors should avoid using
closed-end funds. These funds trade a limited number of shares on the open market daily; they are much like a stock composed of a
portfolio of equities. Because closed-end funds trade at market
prices instead of their actual value (net asset value or NAV, which
is the actual worth of the portfolio), they can cost an investor more than the portfolio is worth (in which case they trade at a premium
to or even be trading for a price below their actual NAV
worth (called a discount to NAV). This premium and discount
vary wildly in most closed-end funds causing closed-end funds to
correlate poorly with their underlying index. A typical example of
this problem occurred in 1995: our models were strongly bullish on
the Swiss market; and the Swiss index returning over 42
percent. However, the closed-end Swiss Helvetica Fund rose under 13 percent for the year and actually declined from May to year- end, while the Swiss index returned over 19 percent. The reason was twofold: poor stock selection in the portfolio along with a pre- mium turning into a discount. Global investors are much better off
using WEBS (World Equity Benchmark Basket Securities), if avail- able, for the country they are striving to invest in. WEBS, which are index funds that trade on the New York Stock Exchange
are like a stock or a closed-end fund. They mimic
indexes in the countries they represent, but they are so heavily ar-
that they rarely trade at a premium or discount to their underlying index of more than 2 percent or so. They thus do an ex- cellent job of mimicking their underlying index; in fact, they are
242 EQUITY SELECTION CRITERIA LONG AND SHORT
to WEBS are that there are not enough of them and they represent too few countries.
Next in line would be top-ranked open-end funds (these pur- chase and redeem their shares depending on investor demand and
trade only for their NAV) which tend to closely correlate with their underlying index, or preferably outperform on a risk/reward basis. Why would an investor prefer a WEB to an open-ended fund if that fund outperforms during both up and down market cycles? When an open-ended fund outperforms during good and bad the investor probably should favor it; however, there
are extremely few of these in the real world. The other problem
with open-ended funds is that investors can only transact at the end of the day increasing their risk. If you are using WEBS and a news event hits that is likely to have a very negative effect, you don't have to sit through the rest of the day watching your invest- ment value can exit immediately at the market. There are very few highly index-correlated funds that outperform their respective index during both good times and bad by such a large extent that they are worth the extra end-of-day risk.
Be careful of mutual fund rating services, most of which rate
funds on total return rankings, while ignoring the risk endured
to achieve these returns. Rating services have sadly become the
epitome of investing. Don't get caught in the trap of thinking that a portfolio in one country or sector is safe. Such funds do very well during roaring bull markets, and very poorly in bear markets in general. Try to find funds that out- perform in both positive and negative environments; for a mutual fund manager, that approach is the definition of adding value. The Forbes ratings are the only ones that pay decent attention to how a fund performs in negative market periods.
It is actually quite to find top-quality U.S. domiciled funds for many emerging markets without incurring huge load- fees. For this reason, I suggest global mutual fund investors get an offshore bank account, offshore or offshore company, any of which will allow them to trade offshore mutual funds, which tend to emulate indexes to create a vehicle not available in the United States (see Table 7.1). The other possibility is to take these countries off your potential investment list. However, the return from many of these top global areas is substantial making it worth the trouble to invest in good funds abroad. Another
MUTUAL FUNDS 243
option is to try to use ADRs and stocks traded on
U.S. or London exchanges as a surrogate for country indexes. If you use the patterns and monitor the criteria suggested in this
then this will work. If this is too much work for you, then
do not use ADRs and GDRs. Brokers for Foreign Stocks
Union de Credit ($20,000
Rue de Mont Blanc 3
P. O. Box 1816 Geneva 1, Switzerland 011-4122-73207939 Fax 011-4122-732-5089 Contact: Perusset TD Greenline
Discount Canadian Stocks Minimum Fee C$43 416-982-7686
Hong Kong and Shanghai Bank Securities and Investments Dept. 8/F Edinburgh Tower
The
Central, Hong Kong 011-852-842-2280
Century Capital ($1000/trade) 5 Century Drive #249
Greenville, SC 29607 1-800-752-3233
Anglo-Irish Bank of Austria
Rathastrasse 20, P. O. Box 306
Vienna, Austria
011-43222-43-6161
Charles Schwab & Company
101 Montgomery Street
San Francisco, CA 94104
1-800-648-5300
Fax 415-956-3212
Barry Murphy & Company
77 Summer Street Boston, MA 02210 1-800-221-2111 Fax 616-426-9309 Bank of Copenhagen c/o Ms. Finsen, 4-6 Copenhagen, Denmark 011-45-33-11-1515 Fax 341-1393
Also, most mutual fund investors seem to think of mutual
funds as savings vehicles, which they are not. Don't forget how "mutual funds" got their name in the United States. Closed-end
funds are called investment trusts in most other English-speaking
countries and used to be called investment trusts in the United
244 EQUITY SELECTION CRITERIA LONG AND SHORT
Table 7.1 BROKERS FOR FOREIGN FUNDS
Fund Company Global Asset Management
Street Douglas, Isle of Man, IM99 British Isles
Fax
Foreign and Colonial 47 Boulevard Royal P.O. Box 2 75 Luxembourg 011-352-464-0101 Fax Fidelity Offshore Kingswood Place Surrey 6RB United Kingdom 011-44-1737-838317 Fax Credit Suisse Neuschelerstrasse 1 P.O. Box 669 Zurich, Switzerland 011-411-212-161 Fax Barclays Gredley House Broadway Straford, London 5 4B) Jardine Flemming 4* Floor Tardine House One Connaught Place Hong Kong Equity Funds Australia, France, Japan, United Kingdom, United States Argentina, Colombia, India, Japan, Mexico, Peru, Poland, Taiwan, United Kingdom, United States ASEAN, Australia, Canada, China, Europe, France, Germany, Hong
Kong, Indonesia, Italy, Japan, Latin America, Malaysia, Nordic, Singapore, Southeast Spain, Switzerland, Thailand, United Kingdom, United States France, Germany, Italy, Japan, Korea, Latin America, Netherlands, Spain, United States
Australia, China, Euro
Equity, Hong Kong,
Japan, Korea, Malaysia, Philippines, Singapore, Southeast Asia, Spain, Thailand, United Kingdom, United States ASEAN, Asia, China, Europe, Germany, India, Indonesia, Japan, Korea, Malaysia, New Zealand, Pakistan, Philippines, Taiwan, Thailand Bond Funds East Asian, ASEAN, European bonds, Latin American, United Kingdom, Swiss, German, Japanese
Yen, U.S., Eurobond, Far East, International, Deutsche Mark short term
Australian Dollar, Canadian Dollar, Lire, New Zealand Dollar, Peso, Swiss Franc, U.S. Dollar, Yen
Eurobond, Gilt, U.S. bond, Deutsche Mark bond
Eurobond, Far East bond, Global bond
Money Market Funds
U.S. Dollar, British
Pound, Swiss Franc, Deutsche, Mark Yen
Australian Dollar, Canadian Dollar, New Zealand Dollar, Singapore Dollar, Swiss Franc, U.S. Dollar, Yen, Spanish Peseta, Deutsche Mark, Lire
Canadian Dollar, Deutsche Mark, Lire, Swiss Franc, U.S. Dollar, Yen, British
Pound, Dutch
Guilder, Spanish Peseta
Deutsche Mark, U.S.
Dollar, British
Pound, Swiss Franc, Yen Australian Dollar, British Pound, Canadian Dollar, Deutsche Mark, European Currency Unit, Hong Kong Dollar, Yen , Swiss Franc, U.S. Dollar
INDIVIDUAL STOCK SELECTION 245 the Great Depression era, however, and investors lost all or most of their money. Likewise, open-ended mutual funds used to be called unit investment trusts in the United States, and they still are in most of the English-speaking world. Again, 90 percent of these trusts failed in the Depression. World War II, the bro- kerage community itself lobbied for regulation to create a similar entity with a new fund." The reason brokers wanted a new name is that the term "investment trust" had such a bad reputation: almost everyone who had invested in one lost everything, and almost no investor would invest in them because they had such negative associations to them. The brokers' idea was to create a more regulated version of the same thing and re- name it for marketing purposes. While mutual funds today do not use the leverage employed by the investment trusts of the past, in a bear market they are not safe savings vehicles; investors should remember that one can lose money decades of invest- ment in a secular bear market.
INDIVIDUAL STOCK SELECTION
One of the money management principles stressed in Chapter 5 is that investors should spend most of their time on vehicle selec- tion, because this is where the biggest payoff to effort exists. A fa- mous CDA/Wiesenberger study using data from 1940 to 1973, and repeated using data from 1980 to 1992 highlights just how impor- tant equity selection is in the investment process.
The study is based on two fictitious investors, Mr. Selection and Mr. Timing. Mr. Timing can perfectly call every market swing of 10 percent or exiting at the exact high before every downturn, and buying at the exact low before every upturn of 10 percent or more. Mr. Selection simply invests 100 percent of his funds in the top-performing market sector each year. Who gener- ates more profits? Most investors believe that the two fictitious investors would generate similar profit results. In fact, Mr. Selec- tion beat Mr. Timing from 1940 to 1973, generating over 30 times as much profits. And again from 1980 to 1992, Mr. Selection gen- erated over four times as much While the results are tious, they illustrate that selection is more critical than timing in determining the profitability of your investments. The success of
246 EQUITY SELECTION CRITERIA AND SHORT
top traditional hedge funds, such as Julian Robertson's Jaguar or Zweig's Zweig DiMenna fund, also shows that funds based almost solely on vehicle selection (both long and short) can outperform the market substantially and consistently in both their risk and return.
Once you find reliable moves through the other avenues cov- ered thus far, getting the most out of those moves is accomplished through equity selection criteria and entry/exit methodologies based on research that I completed with Stanford Ph.D. Tom John- son during the 1980s. In addition, the methodologies represent over a decade of real-time consulting.
Dealing with the Risk of Meteors
There's an old market saw that goes: "In the financial world, there are many meteors, but few fixed stars." In other words, many stocks explode up in price, reach extreme overvaluation, and then plummet back into relative obscurity, while few stocks can consistently generate 40 percent earnings growth for more than a decade (along with commensurate stock gains).
If you look over the past century of data, you will find that each decade produces at least one bull move in stocks enough to produce many "meteors" whose stock prices explode up 300 per- cent or more in a one- to three-year period. These fad stocks start out by showing strong consistent or turnaround earnings growth (defined rigorously later in this chapter), then begin to take off in price and become strong relative strength stocks as they are start- ing to be and then in the one third of their price movement they become "darlings" of Wall Street and get wildly overvalued and overowned by institutions prior to collapsing back into relative obscurity and fairer valuations based on much slower earnings growth. These are the meteors of the stock market.
However, you will also find historically, that each decade pro- duces at least one bull move in which a handful of "fixed stars" develop. Just like meteors, these fixed stars start out by showing strong consistent or turnaround earnings growth (defined rigor- ously later in this chapter), then begin to take off in price and be- come strong relative strength stocks as they are starting to be discovered, and often also become popular with the Wall Street crowd. Fixed stars may become overvalued, but very rarely be- come wildly overvalued. What really differentiates fixed stars is
INDIVIDUAL STOCK SELECTION 247 that while their earnings growth slows some, they are still able to produce more than 40 percent annual earnings growth for over a decade. Because of their continued strong growth and lack of high overvaluation, these stocks do not collapse, they just begin to move up with more volatility and at a slower rate than their initial prepopularity phase.
Most of each decade's greatest equity opportunities lie in either its fixed stars or its meteors. The problem is that both ex- hibit similar characteristics in their early phases, and it is often difficult to determine which is which. Further, even if you were able to successfully cut out many faddish trends and themes, it is rare for an individual to be farsighted enough to have a very high hit rate on determining stocks that are going to be fixed stars. And, there are still some excellent opportunities over one- to three-year periods in meteor just have to have a methodology that allows you to exit quickly when stocks become overvalued, overowned, or weaken substantially in price.
Therefore, once one acknowledges that an investor striving to find the top growth opportunities is likely to get many meteors in his portfolio, the question becomes how can one participate in the run-ups in meteors while still limiting risk and avoiding much of their eventual collapse. The answer we came up with is to employ the following:
• Hunt for strong earnings growth and runaway characteris- tics (both of which we will be describing ahead) in stocks Wall Street hasn't yet completely discovered. • Trade these stocks (rather than invest, and hold) using
limited risk pattern recognition strategies for entry/exit/OPS (Open Protective Stop), and get out (at least partially) when institutions begin to dominate trading in the stock.
• Take partial profits when these stocks begin to get slightly overvalued and then tighten up trailing stops and look to exit completely on the sign of serious weakness.
Meteoric Industries from Prior Decades
The following list of historical meteor industries gives some perspective on what they look like. Although in retrospect these industries seem obviously faddish, at the time most observers
248 EQUITY SELECTION CRITERIA AND SHORT
believed the trends that brought these industries to the forefront
would continue for many years:
1910 Buggy makers and cigar stores.
1920 ice, and closed-end investment trusts. 1930 AT&T, higher yielding utilities, no-debt f inancials with
earnings.
1950 Uranium, bowling chains.
1960 Conglomerates, recreational vehicles. 1970 Nifty fifty, OTC growth, oil, gold stocks.
1980 Junk bond promoters, Japanese stocks, discount distributors of goods, PC software, hardware, electronic supplies, pharmaceuticals.
1990 Medical, biotechnology, capital goods, software, telecommunications, communication software and hardware, health maintenance organizations (HMOs), financials, emerging markets and debt, Internet companies, cigar manufacturers.
Investors should understand that most "trends" do not have the power to propel an industry into the forefront of growth for more than a decade. However, if we can and get aboard new meteors with limited risk in this and future decades, and then get out before they become too overvalued, we can still achieve excellent low-risk and portfolio performance. If we happen to catch a fixed star now and then in the process, it won't hurt either.
IDENTIFYING METEORS AND FIXED STARS
When we looked back over the past century of market data to for- mulate a successful equity investment strategy, Tom Johnson and I made some assumptions. The was that J. Paul Getty's most im- portant rule of wealth also applied to stocks. The rule is "Go where the oil is." In stock terms, we went where the strongest stock moves were to see if we could isolate some common characteristics so that we could focus our trading on the strongest trending vehicles. We
METEORS AND FIXED STARS 249
believed that since strong trends were where most stock market profits came from, strong trends were the oil we were trying to find.
Therefore, we sought to historically locate both the meteors and fixed stars and see what characteristics they had in common. Dr. Johnson and I sought to keep an open mind as to what types of characteristics to analyze in looking for common traits. We also tried to review every similar study to be sure we weren't reinvent- ing the wheel, and to see whether others had found characteristics we could start with. I try to advocate always standing on the shoulders of greatness; thus we took a plethora of our concepts from other great investors who had done similar
Frank Cappiello, Zweig, Peter Lynch, Jim Rogers, W. D. Gann, Dan Sullivan, J. Paul Getty, H. M. and many others. From a very early age, I had personally sought to vora- ciously read almost everything connected with building profits in the markets. We weren't trying to come up with original research necessarily, just what worked.
I put hundreds of historical charts up on my walls and ceiling of each of the top winning stocks of each era, along with many of the variables we could get historical data on. One of the first things I noticed was that a large percentage of the big win- ners exhibited what I like to call "runaway market" characteris- tics. Runaway characteristics are chart-evidence of extremely