technical analysis and portfolio management - Knowledge Base

College LevelIntroductionto TechnicalAnalysisTechnical Analysis and Portfolio ManagementLecture 11Objectivesl Investment Policy (Charles Ellis)- Investors Need 3 Characteristics- The Loser’s Game- Beating the Marketl Invest Like the Best (James O’Shaughnessy)- Styles- Timing- Value Factors- Growth Factors- Mixing Stylesl C-A-N S-L-I-M (William O’Neil)- C-A-N S-L-I-M Definedl The Best Time to BuyThis lecture series is produced bythe Market Technicians AssociationEducational Foundationbased on the detailed class notes ofCharles D. Kirkpatrick II, CMTCopyright © 2007. All rights are reserved.M a r k e tT e c h n i c i a n sA s s o c i at i o nE d u c at i o n a lF o u n d a t i o nIdentifying and fundingeducational programs in the fieldof Technical Analysis since 1993MTA Educational FoundationPost Office Box 425127Cambridge, MA 02142-5127617/253-8959 • Fax: 617/452-2199info@mtaef.org • www.mtaef.orgReadingMaster TextbookTechnical Analysis: The Complete Resource for Financial Market TechniciansCharles D. Kirkpatrick and Julie R. DahlquistChapters 21, 23; pp. 509-535; 571-590Additional ReadingWinning the Loser’s Game, 4th EditionEllis, Charles D.(McGraw Hill, 2002)How To Make Money In Stocks: A Winning System in Good Times or Bad, 3rd EditionO’Neil, William J.(McGraw Hill, 2002)Invest Like The BestO’Shaughnessy, James P.The Anatomy of a Stock Market WinnerReinganum, Marc R.,(Financial Analysts Journal, March-April 1988)Stock Selection – A Test of Relative Stock Values Reported Over 17-1/2 YearsKirkpatrick II, CMT, Charles D.Journal of Technical Analysis, (Fall-Winter 2002)(Download available at mtaeducationalfoundation.com/lecture)

Chart 1Successful Investors Need 3 CharacteristicsChart 2Portfolio ManagementInvestment Policy (Charles D. Ellis)Investors need 3 characteristics (Chart 1)1. A genuine interest in developing an understanding of their own true interestsand 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 inachieving their realistic investment objectives.The Loser’s Game (Chart 3)Chart 3The Loser’s GameChart 4Portfolio Management as a Loser’s Game1. Outperforming the market.If the premise that it is feasible to outperform the market were acceptable, thendeciding how to go about achieving success would be a matter of straightforwardlogic.• Because the overall market can be represented by a passive listing suchas the S&P 500 Index, the successful manager need only rearrange hisportfolio more productively than the mindless S&P. He can be differentin stock selection, or strategic emphasis on particular groups of stocks, ormarket timing, or in various combinations of these. (Chart 4)• Because the active manager will want to make as many ‘right’ decisionsas possible, he will attempt to identify underpriced securities to buy andoverpriced securities to sell.2. The Results• Unhappily, the basic assumption that most institutional investors canoutperform the market is not true. The institutions are the market. (Chart 5)• Because investing institutions are so numerous and capable and determinedto 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 thewinning actions of the winner. In a loser’s game, the outcome is determinedby the losing behavior of the loser.Beating the MarketChart 5Investment Policy - Why It Matters1. Market timing. (Chart 6)One careful study of market timing concluded that an investment managerwould have to be right on his market forecast 75% of the time for his portfoliojust to break even after measuring the costs of mistakes and the costs oftransactions. As Fischer Black put it, “The market does just as well, onaverage, when the investor is out of the market as it does when he is in. So heloses money, relative to a simple buy-and-hold strategy, by being out of themarket part of the time.”College Level Introduction to Technical AnalysisTechnical Analysis and Portfolio Management • Lecture 11, page

Chart 6Beating the MarketChart 7Beating the Market (continued)Chart 8Invest Like the Best2. Stock selection. (Chart 6)Professional investors devote an extraordinary amount of skill, time and effortto this work. Stock pricing dominates the research efforts of investing institutionsand the research services of stockbrokers. Unfortunately, security analysis doesnot appear to be a useful or profitable activity. The problem is not that investmentresearch is not done well; the problem is that it is done so very well by so manythat no one group of investors is likely to gain a regular useful advantage over allother groups.3. Portfolio strategy. (Chart 7)Strategic decisions involve major commitments that affect the overall structureof the portfolio. They are made to exploit insights into major industry groups orchanges in the economy and interest rates or anticipated shifts in the valuation of majortypes 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 validinsight into the forces that drive a particular sector of the market or a particulargroup of companies or industries and systematically exploit that investment insightor concept. Organizations are committed to either ‘growth stock’ or ‘value stock’investing.Chart 9Investing StylesChart 10TimingInvest Like the Best (James P. O’Shaughnessy) (Chart 8)If you study the techniques used by the greatest investors, you’ll find that mostof them used simple and direct strategies consistently. All managers with longtermsuccess in the stock market made it to the top by consistently using a superiorinvestment strategy. Refusing to act emotionally and second-guessing your methodsis one of the toughest assignments investors face. Most fail.The four horsemen of the investment apocalypse are Ignorance, Greed, Fearand Hope. Portfolios that do so much better than the market do so by being verydifferent from the market. The factors favored by market participants in any givenyear determine how the top performing portfolios will differ from the market. Allinvestors have a style, a perspective on the market that determines how their portfoliosdiffer from the market.Styles (Chart 9)Growth investors believe in a company’s future prospects, thinking that a stock’sprice will follow its earnings higher. Value investors buy stocks with current marketvalues substantially below true liquidating value; they believe in a company’s balancesheet, 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: aggressivegrowth, established growth, and momentum growth. In the value categoryCollege Level Introduction to Technical AnalysisTechnical Analysis and Portfolio Management • Lecture 11, page

Chart 11Value InvestingChart 12Stock Market WinnersChart 13Stock Market Winners (continued)Chart 14Growth FactorsChart 15C-A-N-S-L-I-Myou 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 isattributable to the manager’s underlying style.Timing (Chart 10)Styles come into and out of favor. The best long-term managers do well by findinga great style and sticking with it throughout the various market cycles. Portfolioswith similar factors have similar performance. We can look at the essence of greatmanagers’ styles by looking not at the names of the stocks they buy, but at theirunderlying characteristics. By understanding that a portfolio’s underlying factorsare responsible for its performance, we have a tremendous edge on people whorefuse 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 aremet, such as market capitalization, price stability, adequate liquidity and otherindicators of good financial strength. Because a low P/E ratio by itself canlead you to stocks on their way to bankruptcy. It’s best to apply low P/E ratiosor 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 acombination of factors that require larger, more financially stable stocks whenusing a value strategy; you need a larger capitalization, even with stocks thathave high ranks for financial strength and stability. While almost all big cap,College Level Introduction to Technical AnalysisTechnical Analysis and Portfolio Management • Lecture 11, page

Chart 16C-A-N-S-L-I-MChart 17C-A-N-S-L-I-MChart 18C-A-N-S-L-I-M: When to BuyChart 19The Buy DecisionChart 20The Buy Decision (continued)high-yielding portfolios also have low P/E ratios, not all big cap, low P/Estocks have high yields. History gives the nod to choosing the high-yieldapproach over the low P/E strategy when applying them as relative factorsto large companies. Many times a low P/E ratio is quite warranted, with thecompany having very limited prospects for the future. High yield on the otherhand, at least compensates the patient investor with an excellent dividendincome.Growth Factors (Chart 14)• Twelve-month earnings per share percent change 1,000% higher thanaverage.• 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 StylesMixing growth and value strategies gives you the best of both hemispheres,substantially reducing the volatility of strategies based on growth alone and increasingthe capital appreciation potential of strategies centered on value. This blendedportfolio’s factor profile is fascinating. You have a big-cap portfolio with high pricestability, a low beta, a low P/E ratio, a yield 75% higher than the market- all thebest of value. Yet you also have a portfolio with positive relative 26-week pricestrength, 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 basescovered. 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 oftenlead the fundaments, but eventually the fundamentals have to unfold.C = Current Earnings per Share Growth which should be a minimumof 20%, and showing acceleration from quarter to quarter. Watch out formisleading reports, and omit one time gains.A = Annual EPS Growth which should be a minimum 15% to 20% for 3years. (Growth stocks are early bull market leaders. Each new cycle producesnew leaders.)N = New. The greatest market winners either had a major new productor service, new management, or an important change for the better in theconditions of their particular industry. A new stock price high can alert you toCollege Level Introduction to Technical AnalysisTechnical Analysis and Portfolio Management • Lecture 11, page

Chart 21The Sell DecisionChart 22The ResultsChart 23ConclusionChart 24Putting It All Togethernew developments at companies that you might have missed. (Chart 16)S = Shares Outstanding. The number of shares outstanding of the mostsuccessful stocks is generally less than 25 million.L = Leadership. Winning stocks have high and rising relative strength foritself and for the stock’s industry group. If a stock or group is beginningto outperform the market that should indicate future strength and should bebought. If relative strength is falling, the stock or group is weakening andshould be sold. If the relative strength line does not precede or confirm theprice move- watch out. Avoid buying any stock unless there is confirmation ofits strength and attractiveness by at least one other important stock in the samegroup. Industry-wide moves are the most powerful. Leaders in one cyclerarely repeat in the next cycle. (Charts 17-20)I = Institutional Sponsorship. A good stock should have sponsorship frominstitutional investors. Look for stocks that are under accumulation by topratedmutual funds. Also, look for company insider ownership and companypurchases of their own stock. (Company purchases are not critical; it may bean 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 youneed to know is what the market is doing (follow the flow) and be on the rightside of it. Let stock and group performance guide your market outlook. Buyand hold the best stocks when the market is going up. Too often institutionalholders are reluctant to sell a laggard because they are forced to find areplacement. 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 inbull markets. Observe as many stocks as possible during market correctionsbecause it is easier to spot potential leaders during corrections. Weed out theweak holdings from your portfolio. (Charts 21-22)The Best Time to Buy1. Buy on a breakout into new-high territory on at least a 50% increase involume. 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)College Level Introduction to Technical AnalysisTechnical Analysis and Portfolio Management • Lecture 11, page