Interesting observation about downgrades

…I recently tracked the share price action of a group of stocks that were downgraded to “hold” or “sell” primarily because the analyst thought they were overpriced.

I found that six months after the downgrade, the valuation-downgraded stocks had averaged a 20% return (price changes plus dividends), double the S&P 500’s 10% return over the same period. By comparison, a second group of stocks downgraded for reasons other than valuation, averaged a 7% return.

Thus, I found that stocks downgraded for valuation reasons outperformed the S&P 500, while stocks downgraded for non-valuation reasons underperformed.

While my research was hardly rigorous by academic standards, the results were consistent with similar research that I published here almost 12 years ago (October 30, 2005) when I found that, over a six month period, 11 valuation-downgraded stocks averaged a 12% return vs. 3% for the S&P 500…

https://seekingalpha.com/article/4065981-sell-means-buy

I goes along with the MF RB mantra that you should buy overvalued stocks because they are overvalued for a reason. Interesting.

Saul

16 Likes

so is SHOP in the 1st (downgraded due to valuation) or 2nd group (down due to others)?

tj

Hard to say. Two in the last 24 hours. Looks like the first one could be valuation:

===

RBC Capital Mkts downgraded Shopify (SHOP) to Sector Perform rating with price target $77
Previous rating: Outperform
Issuance Date: 2017-04-26

Copyright 2017 Briefing.com, Inc.

===

BTIG downgraded Shopify (SHOP) to Neutral
Past Rating: Buy
Issuance Date: 2017-04-27

Copyright 2017 StreetInsider.com

===

4/26 RBC downgraded SHOP to sector perform, good news embedded in the current share price = valuation

Rob

A while back I looked at all my sells and divided them into two groups, those that I sold based on valuation and those that I sold because I thought something was wrong with the company. I can’t find my old post but based on my hazy recollection those that I sold on valuation actually outperformed the stocks I held by a few percentage points. Those that I sold because I thought something was wrong had a negative return of like 5%. So it was held ~14%, sold on valuation ~20%, sold based on somthing wrong, -5%.

1 Like

The corollary to Saul’s interesting revelation is crystal clear: that the analysts’ method of valuation is faulty. It was for exactly that reason that I began to look at very high-quality growth in a different way and establish a valuation method that reflected it.

I do not (italics) agree with the RB maxim that a description of ‘overvalued’ is necessarily an accolade because where the ‘very high-quality’ element is absent, ‘overvalued’ may well be completely and dangerously true. But should quite different ratios be used to value very high-quality growth? Definitely!

4 Likes

The corollary to Saul’s interesting revelation is crystal clear: that the analysts’ method of valuation is faulty.

Cassius:
“The fault, dear Brutus, is not in our stars,
But in ourselves, that we are underlings.”

Julius Caesar (I, ii, 140-141)

It would seem that no one has yet found a mathematical formula (model) to calculate the value of growth. It took a long time to find such a model to value options and the math it uses is inappropriate in that it supposes that prices have a normal distribution, they don’t, they have a power law distribution but then the math does not work. What this is telling me is that the future really is unpredictable and therefore not calculable with our standard tools. But Mr. Market uses some kind of hunch or something to value the future expanding and contracting P/E ratios. That means that not all the growth comes from inside the company but some (or a lot) of it comes from “animal spirits” or the expectations of Mr. Market. I have no idea how to model that beyond accepting that grow has value. The enemy is the loss of growth and it can be violent with double digit losses overnight. This makes it specially important to detect loss making hurdles in time. Optimism can be hazardous to your wealth!

My approach is to find fast growers and then to look for reasons for that growth to stop.

Imagine for a moment that you could predict the future accurately, that you could tell what a stock will be selling for a year from now. Immediately some form of arbitrage, hedging, or discounting would set in to make all stocks pay out the same returns. This would destroy secondary markets as we know them. Uncertainty would disappear and risk would be perfectly hedged. Not a likely scenario. An impossible scenario IMO.

If I’m right then we need to outsmart the competition and traditional tools that everyone uses are of little help. We must discover those cases where risk is overstated and therefore the price is set too low. Stock picking!

Denny Schlesinger

15 Likes

Denny,

You’ve used Yogi Berra before I believe, and I like to use the following line of his.

Predictions are tough to make, especially when they are about the future!

The simple fact is the future cannot be predicted with any sort of accuracy and precision. This is obviously not an astute statement, but a fact of life. Math can’t predict chaotic events. In physics, we can predict say the motion of a ball thrown at a specific trajectory and initial velocity. But in reality, our prediction won’t be perfect because we won’t know the exact wind speed at the time the ball is thrown and traveling through the air. We can’t predict that because it is far too chaotic. The chaotic events or systems in our lives simply have too many variables to predict.

Therefore, the way we look at investments differs as well. You choose to use ample price history as a starting point. Many choose to look for small businesses whose market cap will grow faster than the overall market (while outpacing dilution too) when seeking alpha. These small businesses often don’t carry 20 years worth of price history. Is it a more risky game than having 20 years of price history? More than likely, yes. However, one could also say the reward could be much higher as well.

I choose to look at businesses for my investments. I’m not saying I’m right always. In fact, quite the opposite. However, so far, I’ve been right more than wrong and am more accepting of the fact I won’t be right every time.

However, if I didn’t enjoy looking at these businesses, I would have a much different take on all of this. It seems from what I’ve read, you are somewhat tired of evaluating businesses especially newer businesses. Or you simply don’t want the risk associated with that - certainly understandable.

I’m not denigrating your method. It works for you. However, there is more than one way to skin a cat. The market reminds us of that constantly.

Take care,
A.J.

1 Like

I’m not denigrating your method. It works for you. However, there is more than one way to skin a cat. The market reminds us of that constantly.

I certainly hope I didn’t give the impression that I consider my method to be the only one that works, that would be presumptuous in the extreme. The purpose of my post was to state why I think my method works, what it’s based on. Some of the criticism I make of some models are not my original but learned from authors like Mandelbrot and Taleb. I also owe a great deal to Brian Arthur and Stuart Kauffman about the science of complexity and its application to investing. I also have learned quite a lot from a number of Fools not to mention Peter Lynch and Warren Buffett. The only thing I claim as original is my way of integrating all these lessons into a portfolio strategy.

I have done many different things in life and the most difficult one I ever attempted is investing in the stock market. The most important instruction my father gave me was that whatever I did I should do well. I have dedicated a lot of time to the study of the market for the past quarter century. It has been both fascinating and frustrating. I believe that I have finally assembled a good working strategy. I though the same thing a year ago but the past 12 months taught me that there were things that needed improving. I suspect the next 12 months will do the same but I won’t know it until after the fact.

I don’t usually disclose much about my portfolio but I decided that it was time to put my new investing strategy to the test. I’ve uploaded my current picks to CAPS and I’ll let it score my results.

Denny Schlesinger

The simple fact is the future cannot be predicted with any sort of accuracy and precision.

That is certainly the case for specific events like the result of a football match or the performance of a single stock but some things can be predicted with quite amazing accuracy, for example the life expectancy of a large population and the takings of a casino in the long run. Accurate predictions can be made if sufficient data is available. That’s the thesis behind big-data AI.

2 Likes

You’ve used Yogi Berra before I believe, and I like to use the following line of his.

Predictions are tough to make, especially when they are about the future.

Yogi also said: “Buy stocks that go up. When they go up, sell them. If they don’t go up, don’t buy them.”

Wisdom for the ages.

Jeb

1 Like

I believe that I have finally assembled a good working strategy. I though the same thing a year ago but the past 12 months taught me that there were things that needed improving. I suspect the next 12 months will do the same but I won’t know it until after the fact.

Hi Denny, You know, I don’t think that the results of any one-year period can tell you that there are things you do that need improving. Even the best method, that will give great long term results, will have some years far from the mean. For instance, if your method will give you a profit of 15% per year on average, at the ends of the normal distribution (bell-shaped curve) will be some years that are up 40% and others that her down 10%. It would be a mistake thus to look at a down year and decide you have to change your system, which may make it worse long term, not better.

Sorry for rambling,

Saul

My point was not about growth but quality. I submit that it is possible to value quality. It involves collecting all the necessary fundamentals which demonstrate it (and without which quality is absent). Just one of these will be sales growth. Ratios, created to show if the price is cheap are then applied. The ratios themselves must also reflect quality, thus will not use earnings.

It took me more than three years to finally hone that down to something that seemed to work. But flexibility will one day be required. What has worked for years will not work forever. Once I began by screening for various high-quality fundamentals and P/FCF under 1.2 which supplied an interesting list to look at to begin with. Artificial interest rates and artificial stimulus have created a strange and different world. Now, doing that might offer you a hideous value-trap or two but nothing more.

Saul:

Thanks, ramble on! :wink:

It’s one thing to rate the overall system by a year’s performance and quite another to detect certain specifics that need improving. The strategy has a lot of moving parts, selling covered calls being an important one for generating cash and lowering the cost basis of each position. Sorry to have to mention options on this board but that was one specific area that required rethinking.

While the overall strategy is buy and hold I maintain a wish list of fast growers to pick from should cash become available. I discovered that the option strategy does not work well with certain stocks (SABR, LKQ, HCSG). I now take into account the workings of the option strategy of each stock when picking one of several alternatives from my wish list. That was one reason I picked SRCL over ROST and BCPC as my latest addition.

One never stops learning.

Denny Schlesinger

My point was not about growth but quality. I submit that it is possible to value quality. It involves collecting all the necessary fundamentals which demonstrate it (and without which quality is absent).

Yes, quality is important. Why do you think it’s missing in my approach?

It would take a book to explain the complete strategy in detail. I would love to write such a book but I don’t think I have the staying power to do it. What makes my approach different is that there is only one qualification for inclusion: a history of long term fast growth. From then on what I look for are reasons not to buy and the list is quite a long one, in no particular order: wrong industry, incomprehensible or illogical business model, credit risk, excessive debt, stock option abuse, lack of profits, excessive valuation, shrinking margins, lawsuits, excessive P/S, weak balance sheet, etc.

One of my past lives was as a management consultant which makes a lot of the above quite intuitive for me. That could be why I don’t put much emphasis on them in my writings.

Denny Schlesinger

Sincere apologies then Denny. My reason is that quality is invariably missing from most people’s approach. For instance when I hear of a company which might be interesting, I run a ‘quickcheck’ (lasting about 10-15 seconds) of just five features: FCF must exist, ROIC must be over 16, CR > 1.7 and two others. By this means, I do not waste time and am not detained unnecessarily.

1 Like

Thank you, strelna, but there is no need to apologize. I love these spirited but civil discussions.

For instance when I hear of a company which might be interesting, I run a ‘quickcheck’ (lasting about 10-15 seconds) of just five features: FCF must exist, ROIC must be over 16, CR > 1.7 and two others. By this means, I do not waste time and am not detained unnecessarily.

Note how similar our approaches actually are: we get a stock tip and we find reasons not to buy. You start by checking quality. If it does not pass that hurdle you waste no more time. Perfect! The first hurdle I check is the business sector. I avoid some like finance with credit risk and most retail. Then I keep drilling down looking for other reasons not to buy. If it passes all the hurdles it goes on my watch list where it competes with the other candidates. Of a list of 50 stocks 10 might be in the portfolio.

Denny Schlesinger

1 Like

Hi Strelna,
Do you calculate the Roic yourself or is there a place that you go that you trust to have the correct calculation? If so could you tell me the site you are using?

Thanks,
Andy

Andy, while I do now check for myself things like FCF to make sure I get the up-to-date figure, ROIC is one among others that I get from MS ‘Key Ratios’ because you also get the (to me) all-important history.

I often check figures on Finviz, Marketwatch and Reuters but of course the question is, where are they getting their figures? (eg Bloomberg, Capital IQ, etc.; TMF gets its figures from Capital IQ.).

Saul is better and safer on this, getting figures from the company and understanding much more than I do about accounting.

2 Likes

Saul is better and safer on this, getting figures from the company and understanding much more than I do about accounting.

Hi Streina, Thanks for your kind words. I DO get figures from the company (because who knows what figure some computer is picking up off the press release. Here’s the quote from the Knowledgebase: Get the information yourself. I suggest that you don’t get earnings (or other information that’s important to you), off Yahoo, or eTrade, etc, but get earnings off the company’s earnings press releases, which you can always find on their Investor Relations site. You just don’t know what Yahoo’s computer is grabbing.

On the other hand, while I appreciate your faith in my knowledge, I really don’t know anything about accounting.

Best,

Saul

1 Like

Thanks Strelna,

Roic is time consuming to calculate so thanks for the information. While we all realize doing these calculations ourselves is important having a way to use a shortcut can be very helpful. Use the shortcut but verify later.

Thanks,
Andy