Wednesday, September 9, 2009

Goodbye, And What I've Learned

Sorry to say so, but I've decided to wrap this blog up. As it turns out, I've bitten off more than I can chew with this approach; that's why it was turning into little more than a daily round-up. Also, I have to admit to being a writer at heart. Perhaps I veered out of my own circle of competence.

I have, however, learned a lot by watching low P/E, high-yield stocks. Just below, I've got the most important lessons I've learned:

1. The Low P/E strategy is counterintuitive. That's what makes it work, but it only works if done statistically. Picking and choosing, I've found, doesn't work all that well because the counterintuitiveness makes for an added barrier. More than patience, the categorical approach is needed.

2. Because the strategy is counterintuitive, active trading while using it induces specific perils. I'm sure you've already encountered the well-tested advice that it's better to stay pat than trade, but there's a specific performance-drainer that kicks in with low P/E stocks. Because their rising is usually counterintuitive, I've found, they seem to go up too fast. Consequently, active trading often means throwing a lot of the gains away.

More generally, I found that active trading also wrecks diversification. Also: it might be tempting to see the stock market as something of a casino, and to stop trading when your hot hand seems to have vanished. The trouble is, the stock market isn't a casino. Taking this approach leads to opportunity losses.

3. Low P/E stocks that suffer huge one-day plummets often, though not always, bounce back. If there's nothing wrong with the company itself, taking advantage of a big one-day drop often works out.

4. Buying low P/E companies with above-average long-term returns on their equities seems to add performance. I haven't been at this a long time, but investing - categorically - in stocks with long-term return on shareholders' equities has resulted in a mock fund with the highest positive alpha of all the ones I tried. To be specific, "long-term return on equity" is measured in this way: ([sum of net incomes over ten years] / (sum of shareholders' equities over ten years)]. If there are fewer than ten years' worth of financials available, then use what's available but cut out any stock with fewer than five years' worth.

4a. The above strategy does have vulnerabilities. The high-ROE approach would have blown a hole in the investor's portfolio in 2008 due to the bank stocks getting in. (Remember: this approach uses long-term ROE, not short-term.) It also malfunctions in the case of cyclical stocks when in the middle of a cyclical downturn. However, given the counterintuitiveness of the low P/E strategy, I have to urge caution when excluding some companies. My own experience suggests quite plainly that the stocks that shoot up are often a surprise. The best approach to selecting is to make an entire list based upon the low P/E, high-dividend, high-long-term ROE criteria and examine each of them individually. If any individual company has something wrong with it, strike it off individually. Categorical strike-offs should not be done except for cyclicals - and only if you're sure the downcycle will continue for some time. Ironically, the best approach that works is the one Ben Graham recommended for bond selection - with the exception that the only companies to be struck off are those with "clear and present dangers." It's often unclear as to what's junky and what isn't in this part of the stock universe, so confining the exclusion to explicit trouble-criteria is best.

5. Remember to reposition any low P/E portfolio once per year. This turnover rate is enough to keep it roughly current, while also providing enough time for the winners to run.

6. Except for prophylactic research, it's best to work the low P/E strategy mechanically. Once again, the counterintutive performace of many low P/E stocks is the reason why.

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I hope these rules give enough basics to use the low P/E, high-dividend strategy successfully. The works of David Dreman go into more details, and supply copious evidence that shows the strategy works. I'd like to thank everyone who's checked in here, regulars as well as occasionals, and I'd also like to point out where I'm going to be in the blogosphere now. I've set up a new blog that's a real veer-off from this one; it's called The Gold Bubble. I hope the title is self-explanatory.


Note: I've read the blogs in the blogroll regularly. There's lots of talent therein; I suggest you give them a try.

4 comments:

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  2. I have to say you sure have the nerve to invest in banking stocks. I have never regarded banks' insurance companies' financial services companies as real busineses. All they do is recycle money. I also have never invested in any financial services companies and never will. Just look at their record almost 2 out of every 3 savings and loans went out of business in the 1980's and just think about what happened a couple of years ago. Do I need to say anymore. Oh one other thing most If not all of the publicly traded subprime lenders are out of business today.

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  3. Hi, I came across your site and wasn’t able to get an email address to contact you about a broken link on your site. Please email me back and I would be happy to point them out to you.

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    Aaron Grey
    aarongrey112 at gmail.com

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