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April 1 - July 8, 2024
It follows from the technique that the chartist is a trader, not a long-term investor.
Indeed, the psychiatrist Don D. Jackson, author with Albert Haas Jr. of Bulls, Bears and Dr. Freud, suggested that such an individual may be playing a game with overt sexual overtones.
Why is charting supposed to work? Many chartists freely admit that they don’t know why charting should work—history just has a habit of repeating itself.
First, it has been argued that the crowd instinct of mass psychology makes trends perpetuate themselves.
Second, there may be unequal access to fundamental information about a company.
Third, investors often underreact initially to new information.
Thus, the stock market will often adjust to earnings information only gradually, resulting in a sustained period of price momentum.
First, the chartist buys only after price trends have been established, and sells only after they have been broken.
Second, such techniques must ultimately be self-defeating. As more and more people use it, the value of any technique depreciates.
Perhaps the most telling argument against technical methods comes from the logical implications of profit-maximizing behavior.
If some people know that the price will go to 40 tomorrow, it will go to 40 today.
Fred Schwed
In estimating the firm-foundation value of a stock, the fundamentalist’s most important job is to estimate the firm’s future stream of earnings and dividends. The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive.
Because the general prospects of a company are strongly influenced by the economic position of its industry, the starting point for the security analyst is a study of industry prospects.
Determinant 1: The expected growth rate.
A useful rule, called “the rule of 72,” provides a shortcut way to determine how long it takes for money to double. Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money. For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years).
And even if the natural life cycle doesn’t get a company, there’s always the fact that it gets harder and harder to grow at the same percentage rate.
Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
Our reformulated question now reads: Are actual price-earnings multiples higher for stocks for which a high growth rate is anticipated?
Determinant 2: The expected dividend payout.
Stocks that pay out a high percentage of earnings in dividends may be poor investments if their growth prospects are unfavorable. Conversely, many of the most dynamic growth companies often pay no dividends.
Rule 2: A rational investor should pay a higher price for a share, other things equal, the larger the proportion of a company’s earnings paid out in cash dividends or used to buy back stock.
Determinant 3: The degree of risk.
The more respectable a stock is—that is, the less risk it has—the higher its quality.
measuring risk is well-nigh impossible. This has not daunted the economist, however. A great deal of attention has been devoted to risk measurement.
Rule 3: A rational (and risk-averse) investor should pay a higher price for a share, other things equal, the less risky the company’s stock.
Determinant 4: The level of market interest rates.
Interest rates, if they are high enough, can offer a stable, profitable alternative to the stock market.
On the other hand, when interest rates are very low, as they were in the early 2020s, fixed-interest securities provide little competition for stocks and stock prices tend to be relatively high.
Rule 4: A rational investor should pay a higher price for a share, other things equal, the lower the interest rates.
Caveat 1: Expectations about the future cannot be proven in the present.
Caveat 2: Precise figures cannot be calculated from undetermined data.
There is, I believe, a fundamental indeterminateness about the value of common shares even in principle.
Caveat 3: What’s growth for the goose is not always growth for the gander.
Despite its plausibility and scientific appearance, there are three potential flaws in this type of analysis. First, the information and analysis may be incorrect. Second, the security analyst’s estimate of “value” may be faulty. Third, the stock price may not converge to its value estimate.
A faulty analysis of valid information could throw estimates of the rate of growth of earnings and dividends far wide of the mark.
The second problem is that even if the information is correct and its implications for future growth are properly assessed, the analyst might make a faulty value estimate.
The final problem is that, even with correct information and value estimates, the stock you buy might still go down.
Not only can the average multiple change rapidly for stocks in general, but so can the premium assigned to growth.
Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.
Difficult as the job may be, picking stocks whose earnings grow is the name of the game.
Rule 2: Never pay more for a stock than its firm foundation of value.
What is proposed is a strategy of buying unrecognized growth stocks whose earnings multiples are not at a premium over the market.
Lynch calculated each potential stock’s P/E-to-growth ratio (or PEG ratio) and would buy for his portfolio only those stocks with high growth relative to their P/Es.
Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus—both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy—both the earnings and the multiples drop.
Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.
Individual and institutional investors are not computers that calculate warranted price-earnings multiples and print out buy and sell decisions. They are emotional human beings—driven by greed, gambling instincts, hope, and fear in their stock-market decisions. This is why successful investing demands both intellectual and psychological acuteness.
So Rule 3 says to ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd.
You might simply use your intuition or speculative sense to judge whether the “story” on your stock is likely to catch the fancy of the crowd—particularly the notice of institutional investors or individual traders following Internet memes.
