About Judgment in Successful Stock Evaluation and Selection

About Judgment

An indispensable ingredient in successful stock evaluation and selection is the application of ―judgment. While not nearly so complicated as some would have you believe, this is nonetheless more of an art than a science. It‘s a personal skill that you will develop and fine tune as you gain experience.

However, don‘t be intimidated by your lack of experience if you‘re new at it. In fact, because you‘re apt to be more conservative than the investor who has been doing it for a while, you could very well have better results.

The essence of judgment, in this context, is the application of the wisdom that you gain about industries, the natures and ―personalities of companies within certain industries—or just in and of themselves—and the significance of the factors that contributed to the history that you are studying. Such items as the extent to which acquisitions—rather than increases in sales— contributed to growth, the extent of past and potential competition, the changes in management, and so on, all contribute to your judgment. Nor are these at all mysterious. They are all common sense issues that you will simply be more mindful of as you progress.

The approach described below is a very basic approach to help those of you who may be still learning fundamental investing to make the crucial judgment decisions. Each of these suggestions is directed toward the most conservative action to take on the basis of the numbers and the pictures that you see, alone. You may very well change these steps as you grow in experience and gain confidence.

The Three Levels of Judgment
There are three distinct levels of ―judgment:

1. Discounting irrelevant data or ―Cleaning up data to be sure that only applicable data is used in assessing historical trends or performance.
2. Estimating future trends or performance based upon the historical assessment.
3. Estimating future price performance based upon those future trends.


1.  Discounting Irrelevant Data
With respect to the relevancy of data, we know that history cannot be denied. What has happened has happened, and the only decision that you can make about an historical event is whether or not it is applicable in your study to influence your vision of the future.

Eliminating ―outliers is your way of discarding irrelevant data to make historical information more useful and to guide you toward the next step.

2.  Estimating Future Trends
Using your conservative historical trends as starting points, you seek to predict what the future trends in the company‘s performance might be. Here again, you will want to be reasonably modest in your view of the future.
Analysts are paid to be accurate. You are rewarded for being right.

The more modest your estimates, the more likely you are to be right!

3.  Estimating Future Price Performance
By making careful and conservative estimates of the company’s performance, you can then forecast, within limits, how the stock‘s price will perform—and therefore what kind of return you might expect your investment to give you. 


Generally, it pays to accept the conservative alternative in all cases when decisions must be made. Lower estimates in projected growth rates will result in less optimistic price predictions. Since you are focused upon investing rather than speculating—and since there are many stocks available that can meet your requirements—it would seem foolish indeed to ―fudge the figures just to justify the purchase of a particular stock.

Following a systematic approach will help you overcome your psychological biases and know when you are making a judgement call.

To apply psychology in your stock buying and selling decisions, the first thing you should explore is your primary reason for making that decision.  

Consider a situation in which you decide to buy a stock because the stock's P/E ratio is low.  Knowing the primary reason for your decision, you should ask yourself:

Is buying a low P/E stock rational?

• There is plenty of evidence in the literature to suggest that in the long run, buying a low P/E stock results i higher-than-average returns.

Thus, your motivation appears rational.  You may have follow-up questions:

• Why is the P/E low? 

or

• What percentage of low P/E stocks actually outperforms the market within three years?

or

• How long should I hold a stock after I buy a low P/E stock?

Because you realize that you are not very patient, you may not like the answer that you should hold a stock for three to five years, and you may decide not to invest in low P/E stocks.

Systematic thinking will help you determine what you know or do not know and overcome your psychological biases.  When you do not know the answer, you need to make a judgement call.  

In the case of buying a low P/E stock, you might find that one possible reason for the low P/E is that the earnings are temporarily high.  

• It may not always be possible to gauge the extent to which earnings are temporarily high, and you may have to make a judgement call based on your knowledge of available financial data.  

In computing intrinsic value, we have to make estimates or judgement calls.  


Ultimately, everyone has to make judgement calls, but following a systematic approach will help you know when you are making a judgement call.

Related:

Strategies for Overcoming Psychological Biases

The field of behavioural finance highlights many psychological biases can impair the quality of investment decision making.

Commenting on selected KLSE stocks.

Portfolio tracking of selective KLSE stocks.
1. The severe bear market offers many opportunities.
2. One can buy good QVM companies at reasonable or bargain price.
The primary reasons for the motivation in March 2009 were rational.  The included stocks involve some judgement calls.

****Be a Better Investor

The barriers to success are psychological rather than physical.

Carefully examine the possible alternatives when you invest

Find Your Financial Style -- and Avoid Its Pitfalls

Find Your Financial Style -- and Avoid Its Pitfalls
by Jonnelle Marte
Tuesday, October 27, 2009
provided by The Wall Street Journal

There are few relationships more complicated than the one we have with money.

Some of us are intimate with our finances, endlessly doing research and keeping track of every penny. Others are more distant; they have a general idea of where their money is going, but aren't sure if it's the right move or if it's enough. Then there are the emotional ones, those who cling to money at the wrong times and make impulsive decisions.

So, what kind of investor and saver are you?

Not sure? Ask yourself these questions: Do I consistently keep track of my spending? And do I do so weekly, monthly or annually? Do I feel that I'm OK financially as long as my checks don't bounce? Do I plan and save for big purchases or do I buy on a whim?

There also are online quizzes, such as J.P. Morgan Chase's "Financial Styles" found at ChaseFinancialStyle.com, that can help you determine your investing and saving profile.

Once you determine your style, you can use certain strategies and tools to reinforce the positive aspects of your approach -- and contain the negative ones.

Understanding your financial approach can help you figure out where your "strategy is most vulnerable to pitfalls or problems," says Hersh Shefrin, a professor of behavioral finance at Santa Clara University who helped J.P. Morgan Chase develop its quiz.

The Analytical Investor

You're a stickler for details and data. And while it's good to be thorough with your research, if taken to an extreme people can forget to take their personal situation and goals into account when making financial and investment decisions.

This type of investor can get hit with what some advisers call "analysis paralysis," where they have trouble making decisions because they can't help thinking there is always more research to be done.

"They're what I call 'see mores' -- they always want to see more," says Bryan Place, founder of Place Financial Advisors, a financial-planning firm in Manlius, N.Y. "Rather than overwhelming themselves and spending too much time digging through content," they should limit themselves to three or four reliable sources, he says.

If you have a tendency to delay acting on your financial goals, Mr. Place says, make a list of the pros and cons and give yourself a deadline to decide -- and stick to it.

While you may be great at budgeting, you might benefit from online expense-tracking tools offered by Mint.com or financial-planning software from Quicken (quicken.intuit.com) that can help you distance yourself from your day-to-day transactions to recognize spending and saving trends over time.

At Mint.com, you can build graphs that show how your spending, income, debt or net worth has changed over a specific period. You also can see changes in spending in certain categories, such as groceries.


The Big-Picture Investor

You know your bottom line, but you don't keep track of every transaction or plan every action or expense. While this approach can be less stressful if you're able to consistently save and meet your financial goals, it can leave you unsure about exactly where your money is going and where you can cut back.

To avoid falling into a set-it-and-forget-it routine and ending up with outdated and unsuccessful strategies for investing and saving, review your strategies at least once a year. For instance, the retirement-savings plan you started five years ago might not be on pace to fund the lifestyle you live today given the recession, so re-evaluate allocations at least once a year, says Carlo Panaccione, a financial planner in Redwood Shores, Calif.

Break down your expenses into two categories: "necessities," which would include mortgage payments, utility bills and food; and "lifestyle," optional costs such as cable television and gym memberships, says Larry Rosenthal, a financial planner near Washington, D.C. Tools at Mint.com and Quicken's software allow you keep track of spending in each category.

To monitor your spending, use a debit card or credit card instead of cash, says Mr. Place, and look at your accounts online at least once or twice a week. But make sure to pay off the credit-card balance each month.

Meanwhile, online calculators such as the one offered by Discover Financial Services, discoverbank.com/calculators.html, can help you devise a monthly plan for reaching a long-term savings goal.

The Emotional Investor

Emotional investors are reactionary, often making financial decisions based on what's happening at the moment and ignoring long-term needs and goals.

"They might look at it as 'Gee, my kid's education is really coming up soon, I have to focus on that and kind of put their retirement on the back burner," says Mr. Panaccione.

For such investors, he suggests creating two lists: one with short-term goals, such as a vacation or car purchase, and one with long-term goals, such as saving for retirement.

Then, set up savings or investing accounts for each goal -- one account for, say, the purchase of a house, one for retirement and another for college tuition. To ensure that each portion is funded consistently, set up automatic deposits to each account, says Mr. Rosenthal.

Matt Havens, partner at Global Vision Advisors, a financial-services firm in Hingham, Mass., suggests forcing yourself to plan for emergencies by building a cash reserve to cover at least six months of expenses. Having that safety net will help you avoid an impulsive move.

And when it comes to investing, don't make drastic changes to your asset allocation. "A main weakness of this group is that they tend to buy high and sell low because of emotion and fear," says Bryan Hopkins, a financial planner in Anaheim Hills, Calif. It might help to sit down with a planner to create a long-term investment plan.

http://finance.yahoo.com/banking-budgeting/article/108022/find-your-financial-style-and-avoid-its-pitfalls;_ylt=Aue6pPmm7eT0U980IRHY3ha7YWsA;_ylu=X3oDMTFhYjhrOGtsBHBvcwMzBHNlYwNwZXJzb25hbEZpbmFuY2UEc2xrA3NtYXJ0d2F5c3Rvcw--?mod=oneclick

Recognizing Value Situations - Growth at a Reasonable Price (GARP)

Recognizing Value Situations - Growth at a Reasonable Price (GARP)


GARP is the mainstream scenario of reasonable market valuation - or undervaluation - of growth potential. Solid and improving fundamentals and supporting intangibles are key. As part of the assessment the value investor must ask how realistic are the growth projections, particularly over time, and whether the company takes a balanced approach to the business and fundamentals. In short, is the business a good business, capable of sustained growth, and selling at a reasonable price? Key words not to lose sight of are good, sustained, and reasonable.


Or is the business a bet on an extreme but temporary success in short-term margins, market share, revenue, or profit? The G in GARP must be sustainable, not based on a short-term blip, fad, acquisition, or worse, a wild hope. The business model and its perception in the marketplace must be solid and on the rise.


Stocks with a PEG ratio of 2 or less with other solid fudamentals are good candidates, but "GARP" is not a matter of ratios alone.


Select companies with solid fundamentals and strong growth prospects based on various factors to analyse, but beware the growth maybe far from a sure thing.

Also read:
Recognizing Value Situations
Recognizing Value Situations - Growth at a Reasonable Price
Recognizing Value Situations - The Fire Sale
Recognizing Value Situations - The Asset Play
Recognizing Value Situations - Growth Kickers
Recognizing Value Situations - Turning the Ship Around
Recognizing Value Situations - Cyclical Plays
Recognizing Value Situations - Smoke and Mirrors

Analytical Judgments in Value Analysis

Six Examples of Analytical Judgments.

A series of six quite diverse examples were used by Graham in Security Analysis (1951 Edition) to illustrate the scope of value analysis.

Example 1: United States Savings Bonds and high-grade bond issues in the year 1950.
The broadest and perhaps the most important judgment that security analysis can make in the year 1950 is that United States Savings Bonds, Series E and Series G, are so much more attractive than other high-grade bond issues that the individual investor of moderate income should buy nothing but these for the bond portion of his portfolio.
(In the higher income brackets, the alternative purchase of tax-free state and municipal issues may be indicated.)
This recommendation is grounded on careful calculation, and it can be put forward with a maximum of confidence in its validity.

Example 2: Average price level of DJIA in 1947 – 1949
The security analyst, studying the well-known group of 30 leading stocks comprising the Dow-Jones Industrial Average, could express the opinion that they constituted a sound investment purchase, in the aggregate, at the average price level of about 175 prevailing in 1947 – 1949.
This judgment would be based mainly on an estimate of average future earning power plus consideration of standard interest rates. It assumed a much higher level of business activity than in prewar years.
There was some danger that this opinion would prove incorrect, but the hazard here was probably no greater than that involved in most careful business judgments involving the future. Hence the security analyst could feel he was discharging a sound and useful function in making this evaluation and in advising accordingly.

Example 3: Inherent nature of market behavior of income bonds as a class (Income Mortgage 4 ½% bonds of Chicago & North Western Railway in 1946)
In 1946 the Income Mortgage 4 ½% bonds of Chicago & North Western Railway sold as high as 98 ¼. A competent analyst would have suggested their sale at that price.
The reasoning did not relate to any specific projections of the earnings of the North Western, but rather to the inherent nature and the characteristic market behavior of income bonds as a class. They are subject to wide fluctuations in price, responding emphatically to changes in business conditions or sentiment.
The upper limit could not be much above 100, because of their limited coupon and their call price of 101 1/8. On the other hand, past experience showed that their low quotation could easily prove to be 50% below the current market. The case for selling was thus pretty conclusive.
(It so happened that the price of this issue fell to 60 within six months.)

Example 4: Wright Aeronautical Corporation. Here is a set of three examples, referring to common shares in the same enterprise at different times (in 1922, 1928 and December 1947).

1922 (prior to the boom in aviation securities, $8 per share)
In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed ore than $8 per share in cash assets in the treasury.
In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price.

1928 ($280 per share)
Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share.
A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects – in other words, that the intrinsic value was far less than the market quotation.

December 1947 (Curtiss-Wright Corporation, the successor enterprise)
Curtiss-Wright Corporation, the successor enterprise, had class A stock selling at 18 ½ and common stock selling at 4 ½. The combined market price of the two issues was under $50 million.
The total net assets of the company were about $130 million; the net current assets about $106 million, and the cash assets alone $87 million.
Earnings had been poor in the postwar period, but the company was clearly undervalued at a price below the cash and government bonds on hand.

Example 5: Comparative merits of two security issues (Graham-Paige Motors Convertible and Its common stock)
Many analytical judgments turn upon the comparative merits of two security issues.
A simple and satisfactory example of these is provided by Graham-Paige Motors Convertible 4s selling at 102 in May 1946 as against the common stock simultaneously selling at 13 ¼. Each $1000 bond was convertible into 76.9 shares of common stock (76.9 x 13 ¼ = $1018.9).
Hence the bonds were selling for slightly less than the current market value of the shares for which they could be exchanged.
The common stock was paying no dividends and had shown very small earnings.
Obviously the bonds were a better purchase than the common stock, since they offered the same opportunities for profit, by reason of their conversion privilege, and they were much better protected against loss.
Sequel: Both the bonds and stock declined sharply in price after May 1946. The bondholder’s principal shrinkage was much less than the stockholder’s; and he has received full interest (to the end of 1950) while the stockholder received only one dividend of 45 cents during this period.

Example 6: “Arbitraging” the securities of railroads going through reorganization in 1941-1945.
During 1941-1945, profits at the annual rate of 20% or better could be made by “arbitraging” the securities of railroads going through organization. The operation consisted of buying existing bonds and selling against them the “when-issued” securities to be exchanged for them under the reorganization plan. The indicated proceeds were always substantially more than the cost.
The major risk involved was that of failure of the plan to be carried out; the minor risk was that consummation would be delayed so long as to make the operation relatively unattractive.
An experienced security analyst could have appraised these risks intelligently, and could have determined that most of the arbitrage operations were well worth entering upon.


Also read:
The Estimate of Future Earning Power
Analytical Judgments in Value Analysis
Securities Not Suited to Valuation Analysis