The main focus of our trading strategy is to achieve financial gains by buying undervalued stocks and selling them with profit during the current quarterly earnings cycle.
One of the things that we must always keep in mind is that the market fluctuates, sometimes uncontrollably, but instead of fearing volatility, we have to use it to our advantage to buy undervalued stocks or to sell the stocks we own that become very overvalued.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market—to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.".
We will use together the two ways described above by Benjamin Graham. In the way of “timing” we will buy and sell stocks during the current quarterly earnings cycle and in the way of “pricing” we will buy and sell stocks whose price is below their fair value.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "Note that investing, according to Graham, consists equally of three elements:
• you must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock;
• you must deliberately protect yourself against serious losses;
• you must aspire to “adequate” not extraordinary, performance.".
In our trading strategy we will cover the three elements mentioned above. The most relevant steps of our trading strategy are indicated in the description below by numbers (1) to (5).
Our goal is to achieve a minimum profit of 5% in the quarter without considering leverage. Using the recommended leverage (2:1) our profit can reach 10% and using the maximum leverage (5:1) our profit can reach 25%.
Fundamental Indicators and Metrics and Research Analysts Recommendations
The stocks we are going to trade were discovered through their:
(1). Favorable fundamental indicators and metrics. The values of all fundamental indicators and metrics are within the ranges considered positive.
(2). Favorable recommendations given by research analysts. Good research analysts give stocks good ratings and target prices that allow them to have ‘Potential Growth’ values equal to or greater than 15%.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "The intelligent investor will not do his buying and selling solely on the basis of recommendations received from a financial service. Once this point is established, the role of the financial service then becomes the useful one of supplying information and offering suggestions.".
Stocks that meet the two conditions mentioned above are considered to have growth potential in the current quarter. Only these stocks will be eligible for trading.
Trading Undervalued Stocks
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways..., even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security.".
Let's consider a scenario in which a stock showed very positive results in the last quarter and on the day of the last earnings announcement it had a closing price of $X. If the results are released after the market closes, we will consider the value of $X as the closing price on the day following the day of the last earnings announcement. We will consider the value of $X as the fair value for the stock. If we analyze the stock and see that the forecasts remain very positive for the current quarter, verifying that its fundamental indicators and metrics are positive and that the recommendations given by research analysts are also favorable, then there is no reason for the stock to depreciate and maintain its depreciation below its fair value for a long period of time. It often happens that the stock price maintains or exceeds its fair value when the earnings announcement day is close. So as long as the stock remains depreciated below its fair value we can consider that it is undervalued and that we have a great buying opportunity!
The behavior described above is the one we should look for and pay attention to when analyzing a stock, as our main focus is to buy stocks that we consider to be undervalued (quoted below their fair value), wait for prices to adjust and rise above their fair value, and then sell them for a minimum profit of 5%.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may be well suited to the aggressive investor but too unconventional for the defensive investor.). In other words, they should be bought on a bargain basis or not at all.".
(3). We should buy a stock only when its price is below its fair value (closing price on the day of the last earnings announcement).
Stock Trading vs CFD Trading Phases
Our stock trading will be carried out in two distinct phases:
1st phase - up to 4 weeks before the next earnings announcement
2nd phase - during the 4 weeks before the next earnings announcement
During the two phases mentioned above we will use two types of trading that offer different ways to take advantage of price movements. In the 1st phase we will use Stock Trading and in the 2nd phase we will use CFD Trading.
Stock Trading - should be used as a longer term approach where the investor expects the price to rise over several months.
CFD Trading - tends to be considered a short-term investment, where traders open and close positions within days or weeks, in part due to the overnight fees involved.
(4). The purchase of a stock, through Stock Trading, should be carried out up to 4 weeks before the next earnings announcement (avoiding the first week), when the stock price falls below its fair value and also if it falls more than 5% or a multiple of 5% below that value. If conditions remain favorable, we should also invest after this period, that is, until the day of the next earnings announcement. We should buy a stock through CFD Trading, during the 4 weeks before the next earnings announcement (avoiding the last week), when the stock price falls below its fair value and also if it falls more than 5% or a multiple of 5% below that value. With CFD Trading we should use a leverage of 2:1 or, if higher, a maximum leverage of 5:1. We should only use 5:1 leverage when the capital available to trade a stock is already very limited and the price of that stock is more than 15% below its fair value. These phased purchases will significantly reduce the average purchase price.
Profits and Losses
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "The only thing you can be confident of while forecasting future stock returns is that you will probably turn out to be wrong. The only indisputable truth that the past teaches us is that the future will always surprise us—always! And the corollary to that law of financial history is that the markets will most brutally surprise the very people who are most certain that their views about the future are right. Staying humble about your forecasting powers, as Graham did, will keep you from risking too much on a view of the future that may well turn out to be wrong. So, by all means, you should lower your expectations—but take care not to depress your spirit. For the intelligent investor, hope always springs eternal, because it should. In the financial markets, the worse the future looks, the better it usually turns out to be. A cynic once told G. K. Chesterton, the British novelist and essayist, “Blessed is he who expecteth nothing, for he shall not be disappointed.”.
The most relevant conditions that we must take into consideration when selling our stocks are indicated in the description below by the letters (A) to (E).
(A). Our goal is to achieve a minimum profit of 5% in the quarter without considering leverage. To achieve our goal, we will try to make a minimum profit of 5% for each stock traded.
(B). As a rule, if a stock has a 5% gain and its price is above its fair value, we should sell it immediately! We should aspire to “adequate” not extraordinary, performance.
(C). In a scenario where a stock depreciates to a price much lower than its fair value and we buy the stock at that price, there is always the expectation that we will be able to obtain a profit much higher than the minimum profit of 5% that is expected for each stock that is negotiated. However, in these cases, if we have already obtained the minimum expected gain of 5%, we must always bear in mind that we must sell the stock as soon as its price adjusts and reaches or exceeds its fair value.
(D). If we have purchased a stock that has not achieved a minimum gain of 5% during the current quarterly earnings cycle, we will have to sell it before the next earnings announcement day, assuming the financial loss that could result from selling it.
(E). One of the moments in which stocks can be subject to large fluctuations in their prices are the days before the earnings announcement (official declaration of a company's profitability), which are often full of speculation among investors and can give us the possibility to obtain considerable profits.
Risk Management
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham:
- "Successful investing is about managing risk, not avoiding it.";
- "The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin.";
- "There is a close logical connection between the concept of a safety margin and the principle of diversification. One is correlative with the other. Even with a margin in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.";
- "Graham’s guideline of owning between 10 and 30 stocks remains a good starting point for investors who want to pick their own stocks, but you must make sure that you are not overexposed to one industry.";
- "When a company repurchases some of its stock, that reduces the number of its shares outstanding...And if the shares are cheap, then spending spare cash to repurchase them is an excellent use of the company’s capital.".
We saw above the importance of the margin-of-safety, which can be verified by analyzing the information provided by research analysts and always based on the fundamental indicators and metrics of the stocks. We also saw that one of the best ways to mitigate risks is not to invest everything in a single stock but to diversify our portfolio and repurchase stocks when they are cheap.
DIVERSIFYING THE PORTFOLIO
From what was explained above, we conclude that we must diversify our portfolio and distribute the invested capital equally among all stocks that are eligible for trading.
We will stipulate a maximum amount to invest in each of the stocks that are eligible for trading.
Let's consider that on average there are 10 stocks per quarter eligible for trading. The maximum amount stipulated to invest in each stock will be the total available capital to invest divided by 10, that is, we have a maximum of 10% of the total available capital to invest in each of the stocks that are eligible for trading. For example, if the total available capital to invest is $100.000, we have a maximum investment capital for each stock of $10.000.
STOCK AND CFD TRADING SUB-PHASES AND STOCK REPURCHASES
In the amount stipulated for each of the stocks, we must take into account at least the following four investment sub-phases (sp1 to sp4): with Stock Trading, (sp1) when the stock price falls below the closing price on the day of the last earnings announcement and (sp2) when it falls more than 5% below that price. With CFD Trading, (sp3) when the stock price falls below the closing price on the day of the last earnings announcement and (sp4) when it falls more than 5% below that price. These repurchases in each of the 4 investment sub-phases will significantly reduce the average purchase price of the stocks.
USING MULTIPLE TRANCHES FOR INVESTMENT
Taking into account the existence of the 4 investment sub-phases described above for each of the 10 stocks eligible for trading, we must reserve at least 10×4 = 40 tranches for investment. Assume that each tranche corresponds to a purchase order. Therefore, the maximum capital invested in each tranche will be the total available capital to invest divided by 40. For example, if the total available capital to invest is $100.000, we have a maximum investment capital for each tranche of $2.500. Each of these tranches may be used in other investment sub-phases of the same stock or even in investment sub-phases of other stocks that are eligible for trading. This flexibility allows us, for example, to carry over one of the available tranches that by default is associated with the 2nd trading phase (CFD Trading) so that we can use it during the 1st trading phase (Stock Trading) in case the stock price falls by more than 10% below the closing price on the day of the last earnings announcement. However, we must always ensure that the maximum investment amount stipulated for each stock is never exceeded.
EXAMPLES OF RISK SCENARIOS
Let's try to understand how our investment risk management behaves in scenarios where there is market devaluation, the devaluation of just one stock and even when we resort to the use of leverage. We will see that the diversification of invested capital and the existence of different investment sub-phases for each type of investment may have some influence on mitigating the risk of our investment.
SCENARIO A:
The market drops 25% and all our stocks also follow this fall. We will assume an intermediate scenario in which half of the negotiation conditions are met in any of the existing investment phases and sub-phases that were described previously.
Let's consider that we have $100.000 available to invest, but that only half of the stocks eligible for trading meet all the necessary conditions for trading. On average there are 10 stocks per quarter eligible for trading. Therefore, we have a maximum investment capital for each stock of $100.000 / 10 = $10.000 and our total investment capital is 5 * $10.000 = $50.000. Taking into account the existence of at least 4 investment sub-phases (2 sub-phases in Stock Trading and 2 sub-phases in CFD Trading), we have a maximum investment capital for each tranche of $10.000 / 4 = $2.500. Considering that only half of the trading conditions are satisfied in the 2 investment sub-phases of both types of trading (1 sub-phase in Stock Trading and 1 sub-phase in CFD Trading), we will have the capital invested in the Stock Trading equal to 5 * $2.500 = $12.500 and the capital invested in the CFD Trading equal to (5 * $2.500) * leverage = (5 * $2.500) * 2 = $25.000. Therefore, our total investment capital will be equal to $12.500 + $25.000 = $37.500.
If the market falls by 25% and all our stocks also follow this fall, we will have a total loss of $37.500 * 0,25 = $9.375, which corresponds to a loss of less than 10% of the total capital available to invest. This is a much lower loss than the 25% we would have had if we had invested without any criterion all our available capital in stocks that were suitable for trading.
SCENARIO B:
We invest all our available capital in just one stock that as a 25% drop. We will assume the worst-case scenario in which all trading conditions are met in any of the investment phases and sub-phases that were described previously.
Let's consider that we have $100.000 available to invest and that there is only one stock eligible for trading that meets all the necessary conditions for trading. Therefore, we have a maximum investment capital for each stock of $100.000 / 10 = $10.000 and our total investment capital is 1 * $10,000 = $10,000. Taking into account the existence of at least 4 investment sub-phases (2 sub-phases in Stock Trading and 2 sub-phases in CFD Trading), we have a maximum investment capital for each tranche of $10.000 / 4 = $2.500. As all trading conditions are met in the 2 investment sub-phases of both types of trading (2 sub-phases in Stock Trading and 2 sub-phases in CFD Trading), we will have the capital invested in Stock Trading equals to 2 * $2.500 = $5.000 and the capital invested in CFD Trading equals to (2 * $2.500) * leverage = (2 * $2.500) * 2 = $10.000. Our total investment capital will be equal to $5.000 + $10.000 = $15.000.
If the stock falls 25%, we will have a total loss of $15.000 * 0,25 = $3.750, which corresponds to a loss of less than 5% of the total capital available to invest. This is a much lower loss than the 25% we would have lost if we had invested all our available capital in just one stock.
SCENARIO C:
We will verify that even using the maximum permitted leverage of 5:1, the maximum capital to which a stock is exposed does not exceed the capital available to invest. We will assume a scenario where all trading conditions are met only in the 2 investment sub-phases of CFD Trading.
Let's consider that we have $100.000 available to invest and that there is only one stock eligible for trading that meets all the necessary conditions for trading. Therefore, we have a maximum investment capital for each stock of $100.000 / 10 = $10.000 and our total investment capital is 1 * $10,000 = $10,000. Taking into account the existence of at least 4 investment sub-phases (2 sub-phases in Stock Trading and 2 sub-phases in CFD Trading), we have a maximum investment capital for each tranche of $10.000 / 4 = $2.500. As all trading conditions are met only in the 2 investment sub-phases of CFD Trading, then the capital relating to the 2 sub-phases in Stock Trading will be used alternatively in the 2 sub-phases of CFD Trading. Our total investment capital will be equal to (4 * $2.500) * leverage = (4 * $2.500) * 5 = $50.000.
If the stock falls by 25% we will have a loss of $50.000 * 0,25 = $12.500, which corresponds to a loss of less than 15% of the total capital available to invest. This is a much lower loss than the 25% we would have lost if we had invested all our available capital in just one stock.
CONCLUSION:
Through the three scenarios described above, we can verify the importance of mitigating the risk of our investment through the diversification of invested capital and the existence of different investment phases and sub-phases. We must always take into account that changing the investment tranches that were predefined for the trading sub-phases of a stock, especially when they are used in investment sub-phases where leverage will be present, can considerably change the exposure of our invested capital in this stock in relation to other stocks or even in relation to the total capital available for trading if we use too much leverage. Therefore, we must always be aware of the leverage we use with the investment tranches and also ensure that the exposure of the capital invested in a stock is the same as that existing in other stocks already traded, as only in this way can we guarantee that our capital will be distributed appropriately equally for all stocks eligible for trading.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "Losing some money is an inevitable part of investing, and there’s nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money...For the intelligent investor, Graham’s 'margin of safety' performs the same function: By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.".
Technical Analysis
(5). We will trade based on a technical analysis tool defined by a set of trend lines called Bollinger Bands® in conjunction with other significant and well-known technical indicators (RSI, Stochastic Oscillator, MACD, 9 EMA and OBV). Using this technique we will consider the lower band as support and the upper band as resistance. We will use a daily chart to analyze the stock's price movement.
Below are described step by step the conditions that must be met for each of the technical indicators for buying and selling stocks.
TRADING LONG - BOLLINGER BANDS® - LOWER BAND TO UPPER BAND
Buy Conditions (preferably all conditions should be satisfied or the deviation should not be very significant)
BUY PRICE: Is lower than the closing price on the day of the last earnings announcement
RSI: < 30 (Oversold)
1. K-Line and D-Line are rising
2. K-Line and D-Line < 20 (Oversold)
3. K-Line > D-Line (Uptrend)
MACD:
1. Line and Signal Line are rising
2. Line > Signal (Bullish)
OBV: A rising reflects positive volume pressure that can lead to higher prices
1. BUY as close to the lower Bollinger Band as possible
2. Set a conservative STOP LOSS below the lower band support level and adjust it as the price moves
Sell Conditions (must be satisfied at least one condition)
SELL PRICE: Is higher than the closing price on the day of the last earnings announcement
RSI: > 70 (Overbought)
1. > 80 (Overbought)
2. K-Line < D-Line (Downtrend)
1. The upper band comes to represent the PRICE TARGET
2. SELL as close to the upper Bollinger Band as possible
Final Considerations
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham:
- "Let us close this section with something in the nature of a parable. Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful. Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.";
- "The intelligent investor shouldn’t ignore Mr. Market entirely. Instead, you should do business with him—but only to the extent that it serves your interests. Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. By refusing to let Mr. Market be your master, you transform him into your servant. After all, even when he seems to be destroying values, he is creating them elsewhere.".
Source: Benjamin Graham, THE INTELLIGENT INVESTOR, Fourth Revised Edition, accessed 23 June 2024
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