Beat the Averages by Reducing Risk
Tom Jandt
July 19, 2007
In my 15 year quest to find investments that provide both income and above average growth, without having to assume unacceptable market risk, I have found a very basic but often overlooked method to achieve success in this endeavor. In the search for identifying investments that beat market averages excessively, I have also found that applying these very same methods of identifying value frequently produces extraordinary results for speculators and value investors alike.
It has been my experience that if you first identify true intrinsic value in the various depressed "sectors" of the market by utilizing the Value Pricing Method created by investment legend, Benjamin Graham, you will find yourself at the fundamental starting point of identifying an area of the market worth exploring for individual stocks as investment candidates. Without clearly identifying an entire "sector" that is trading below fair value, it is an attempt in futility to find an individual investment that can perform well without the assumption of excessive risk should a broad based sell off occur. Although it is impossible to completely eliminate market risk in stocks, it is quite possible to manage it much more efficiently to deter dramatic price swings to the downside.
Equities will typically trade at multiples that are based on past earnings, as well as future earnings growth estimates or run rates. When selecting an investment worthy of consideration, it is important to identify companies that actually have "value" relative to the current market trading price. If a broad based sell off does occur due to some unrelated catastrophic event, economic downturn, or other significant financially related event, it is imperative to know that your holdings have enough net asset value to prevent any serious declines. A value stock will usually only experience a minor sell off and then quickly recover, depending on the severity of the decline.
The reason that value plays don't drop as much and tend to recover much more quickly is that each company in every industry has a "break up value" or a "net asset value", which represents a dollar amount per share that an acquiring company would be willing to pay to purchase the business. Most companies have competitors whom would quickly act on an opportunity to acquire them if the price was right. When looking at a company for individual investment consideration, it is imperative to attempt to adequately assess this value and compare it to the V/P ratio of the proposed investment selection. If a conclusive "net asset value" or "break up value" is determined, a risk assessment is much easier to make. If there is a small gap between the "net asset value" or the "break up value" of a business and the V/P ratio, you will have likely found an excellent candidate for your portfolio.
Stocks involve some degree of risk and there are no guarantees that losses will be avoided using this strategy, however, this method has proven to eliminate much of that risk due to the relatively low entry purchase price of each respective investment identified using this value pricing method and I have personally seen some very exciting results.
The appreciation of a security is not the only benefit of buying these value stocks when they are priced at the low end of their trading range, but there are some additional ways to generate significant amounts of income from equities through dividends, as well as writing call options on positions.
Purchasing a security that is trading well below fair value also provides additional income generating opportunities that do not exist with equity purchases that are made in fully valued securities, or even "speculations" on high multiple stocks. Although fast profits may not be likely, great returns over the long term are garnered relatively easily. Due to the intrinsic value of the underlying business relative to the stock's price, it is possible to assume the risk of an individual security, which is traditionally considered risky, but an investor can still achieve above average results without extreme downside due to the ability to generate income from dividends while waiting for the depressed security to gain value as the related sector appreciates and returns back to fair market value. Additionally, if a security is trade at or near it's lows due to a seasonal downturn or cyclic economic shift, the dividend return that is traditionally 1-2% could exceed 8% on some stocks due to the low trading price. This may also increase the net return significantly over the long term.
Securities that are purchased on a value basis are excellent stocks to generate additional income on a monthly or quarterly basis by writing call options against the long position. Since these securities are typically bought at or near their trading lows when the Value Pricing method is utilized, it is very likely that these stocks can make significant moves to the upside from time to time after your purchase. So, as a general rule of thumb, when a value stock moves up in excess of 8-12% in the short term, it is typically a reasonable strategy to write short term call options at a strike price equivalent to the market price or above in order to generate additional income from the holding. Should the stock continue it's rise, the stock may be called away at a profit, but you'll keep income from the sale of the call as well the full value of your stock when sold at the strike price. Since stocks don't usually go straight up and frequently pause prior to continuing to increase in value, writing call options will generate income you otherwise wouldn't receive if you just held onto your position without an "active" investment management plan. The only risk in writing call options is that you might have to sell your stock early, but personally, I've never thought of taking a profit as a negative. However, depending on your income tax bracket and other tax considerations, it is always prudent to speak with your accountant prior to any investment strategy that might create income and short term capital gains.
Extremely conservative investors can also utilize the same methods to identify value, however, by allocating assets into managed mutual funds that are invested in the value sectors identified by the Value Pricing method, they can preserve their capital with lowered risk while achieving above average results. When properly implemented, this sector rotation through this value approach nearly eliminates risk. As long as the timeline is extended beyond 10 years, a frequent shift from overvalued to undervalued is made in the investment pool and a competent financial manager is overlooking this portfolio, this investment strategy should result in higher returns, less risk and should lead to an early retirement. Since most business cycles last an average of 7 years from peak to trough, it is typically likely that a non-performing sector will eventually recover if given at least 10 years. If you are an investor acquiring assets in a sector that is in the "trough" phase of the cycle, it is very likely that the sector should recover in a relatively short amount of time. At this point, a sector's down cycle should be midway through the decline and, if the Value Pricing ratio is at 1.2 or better, an opportunity for even greater net returns is significantly higher."
As a financial professional for the past 15 years, I have found these methods to work the best in poor market conditions. When the stock market is booming, as it is today, these techniques won’t be as effective in returning large returns. However, if the market were to decline dramatically one day, you’re risk aversion will be greatly rewarded.
Happy Investing!
It has been my experience that if you first identify true intrinsic value in the various depressed "sectors" of the market by utilizing the Value Pricing Method created by investment legend, Benjamin Graham, you will find yourself at the fundamental starting point of identifying an area of the market worth exploring for individual stocks as investment candidates. Without clearly identifying an entire "sector" that is trading below fair value, it is an attempt in futility to find an individual investment that can perform well without the assumption of excessive risk should a broad based sell off occur. Although it is impossible to completely eliminate market risk in stocks, it is quite possible to manage it much more efficiently to deter dramatic price swings to the downside.
Equities will typically trade at multiples that are based on past earnings, as well as future earnings growth estimates or run rates. When selecting an investment worthy of consideration, it is important to identify companies that actually have "value" relative to the current market trading price. If a broad based sell off does occur due to some unrelated catastrophic event, economic downturn, or other significant financially related event, it is imperative to know that your holdings have enough net asset value to prevent any serious declines. A value stock will usually only experience a minor sell off and then quickly recover, depending on the severity of the decline.
The reason that value plays don't drop as much and tend to recover much more quickly is that each company in every industry has a "break up value" or a "net asset value", which represents a dollar amount per share that an acquiring company would be willing to pay to purchase the business. Most companies have competitors whom would quickly act on an opportunity to acquire them if the price was right. When looking at a company for individual investment consideration, it is imperative to attempt to adequately assess this value and compare it to the V/P ratio of the proposed investment selection. If a conclusive "net asset value" or "break up value" is determined, a risk assessment is much easier to make. If there is a small gap between the "net asset value" or the "break up value" of a business and the V/P ratio, you will have likely found an excellent candidate for your portfolio.
Stocks involve some degree of risk and there are no guarantees that losses will be avoided using this strategy, however, this method has proven to eliminate much of that risk due to the relatively low entry purchase price of each respective investment identified using this value pricing method and I have personally seen some very exciting results.
The appreciation of a security is not the only benefit of buying these value stocks when they are priced at the low end of their trading range, but there are some additional ways to generate significant amounts of income from equities through dividends, as well as writing call options on positions.
Purchasing a security that is trading well below fair value also provides additional income generating opportunities that do not exist with equity purchases that are made in fully valued securities, or even "speculations" on high multiple stocks. Although fast profits may not be likely, great returns over the long term are garnered relatively easily. Due to the intrinsic value of the underlying business relative to the stock's price, it is possible to assume the risk of an individual security, which is traditionally considered risky, but an investor can still achieve above average results without extreme downside due to the ability to generate income from dividends while waiting for the depressed security to gain value as the related sector appreciates and returns back to fair market value. Additionally, if a security is trade at or near it's lows due to a seasonal downturn or cyclic economic shift, the dividend return that is traditionally 1-2% could exceed 8% on some stocks due to the low trading price. This may also increase the net return significantly over the long term.
Securities that are purchased on a value basis are excellent stocks to generate additional income on a monthly or quarterly basis by writing call options against the long position. Since these securities are typically bought at or near their trading lows when the Value Pricing method is utilized, it is very likely that these stocks can make significant moves to the upside from time to time after your purchase. So, as a general rule of thumb, when a value stock moves up in excess of 8-12% in the short term, it is typically a reasonable strategy to write short term call options at a strike price equivalent to the market price or above in order to generate additional income from the holding. Should the stock continue it's rise, the stock may be called away at a profit, but you'll keep income from the sale of the call as well the full value of your stock when sold at the strike price. Since stocks don't usually go straight up and frequently pause prior to continuing to increase in value, writing call options will generate income you otherwise wouldn't receive if you just held onto your position without an "active" investment management plan. The only risk in writing call options is that you might have to sell your stock early, but personally, I've never thought of taking a profit as a negative. However, depending on your income tax bracket and other tax considerations, it is always prudent to speak with your accountant prior to any investment strategy that might create income and short term capital gains.
Extremely conservative investors can also utilize the same methods to identify value, however, by allocating assets into managed mutual funds that are invested in the value sectors identified by the Value Pricing method, they can preserve their capital with lowered risk while achieving above average results. When properly implemented, this sector rotation through this value approach nearly eliminates risk. As long as the timeline is extended beyond 10 years, a frequent shift from overvalued to undervalued is made in the investment pool and a competent financial manager is overlooking this portfolio, this investment strategy should result in higher returns, less risk and should lead to an early retirement. Since most business cycles last an average of 7 years from peak to trough, it is typically likely that a non-performing sector will eventually recover if given at least 10 years. If you are an investor acquiring assets in a sector that is in the "trough" phase of the cycle, it is very likely that the sector should recover in a relatively short amount of time. At this point, a sector's down cycle should be midway through the decline and, if the Value Pricing ratio is at 1.2 or better, an opportunity for even greater net returns is significantly higher."
As a financial professional for the past 15 years, I have found these methods to work the best in poor market conditions. When the stock market is booming, as it is today, these techniques won’t be as effective in returning large returns. However, if the market were to decline dramatically one day, you’re risk aversion will be greatly rewarded.
Happy Investing!
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