A New Way of Thinking about Stock Selection

Aparadigm is a framework or model. As we learn and experience, we begin to establish various paradigms relating to all aspects of our lives. Eventually, we establish a framework with which we’re comfortable. We begin to expect that certain ways of thinking or behaving will bring certain results, and we reach a certain comfort level between our actions and the reactions they will create. Sometimes the paradigms we establish serve us well for our entire lives. Other times,
we become dissatisfied with the results our actions create and it becomes necessary to create a new paradigm. When it comes to selecting individual stocks, 99.9 percent of investors and Wall Street analysts are operating using a dog-eared, shop-worn paradigm that is coming apart at the seams. They are all looking for the same thing: growth stocks with earnings momentum that will deliver strong earnings gains indefinitely into the future and enable these companies to justify their sky-high stock prices.
There are two problems with this paradigm: First, it’s been in existence for nearly 20 years and it’s getting a bit creaky. In fact, it’s probably on its last legs. The second problem with this paradigm is that it’s not new; it’s only a new version of other paradigms that have come and gone over the years. The late 1960s version, for example, was called the “One-Decision Stock Paradigm.” In this version, certain stocks had earnings that would grow forever, which meant their stock prices would go up forever. That, in turn, meant that investors would never have to sell the stocks. Thus, only one decision was necessary—to buy them.
That paradigm eventually collapsed when it turned out that some perpetual growth industries (like bowling) reached their saturation points far sooner than analysts expected; other perpetual
growth industries attracted competitors and price competition, thereby reducing profit margins (like calculators and CB radios); and economic recessions still surfaced from time to time, which had a tendency to affect all industries, turning growth stocks into normal, run-of-the-mill cyclical stocks. This way of thinking is new paradigm territory for 99.9 percent of investors and analysts. At first it may seem difficult and unusual, but if you have the courage to enter this new paradigm, you will find yourself in a fascinating new world where all sorts of new and exciting stock ideas will present themselves. You’ll also find that this new paradigm is sparsely populated, which at first may be uncomfortable. But eventually, seeing things that others do not see will eventually turn out to be the source of great excitement and satisfaction. You will understand things that others do not understand. At times, you’ll feel almost as if you can see the future, and
you will marvel at the inability of others to do the same.

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THE BULLS, THE BEARS, AND THE HORSES

The recent trend toward microanalyzing the stock market on a minute-by-minute basis has less to do with investing than it does with providing a “fix” for stock market addicts. In his classic book The Money Game, author George Goodman, writing under the name “Adam Smith,” says that most people are not in the stock market to make money; they are in it for the excitement. And if you were to catch a stockbroker in a moment of candor, you would probably discover that many have reached the same conclusion. A large part of the stock market’s explosive popularity in recent years is that the advent of financial television and the Internet has turned investing into a form of entertainment that provides a welcome diversion from the predictability of day-to-day life.
I completely understand this, of course, having spent 25 years of my life transfixed by the stock market. Watching the minute-by-minute analysis on financial television and having a real-time quote system on your desk is part of the appeal of the whole business. Nothing wrong with that, although this book is a way of pointing out that there is another way to approach the business of picking stocks, one that allows you the opportunity to get up from in front of your television set to get a glass of water and maybe even do a little gardening.
There are many people who will tell you that the stock market is actually just like horse racing, and if you stop to think about it, they may have a good point. As every horse bettor knows, there is nothing quite like the adrenaline rush one gets when your bet is down, the bell rings, the starting gate opens, and the track announcer says, “They’re off!”
This, of course, is precisely the feeling a day trader gets at ninethirty each morning when he or she is tuned in to CNBC. The only difference is that the chairman of Time Warner is not standing at the starting gate ringing the bell.
It is probably no accident that as the stock market has become increasingly popular and accessible to the masses over the past 15 years, the horse-racing industry has gone into a steady decline.
Financial magazines are multiplying like rabbits while the Daily
Racing Form has been sold and resold several times as its circulation
eroded year after year.
Let’s face it: Wall Street is beating the horse-racing business at its own game. While a horse race can provide periodic bursts of entertainment and excitement, each race lasts only a minute or two and is followed by a period of boredom and slowly building anticipation until the next race begins. On Wall Street you get nonstop action for 61⁄2 hours 5 days a week, and if you’re a real glutton for punishment, you can buy a sophisticated quotation system that allows you to sit around all night watching after-hours trading, and the opening of the Asian markets and the start of European trading in the predawn hours.
Wall Street never stops. How can horse racing compete with this? For one thing, they might try out the concept of horse brokers. In New York State there are Off Track Betting parlors scattered all over the place. What’s the difference between this and brokerage
firm branch offices? There are no horse brokers. The only thing these OTB parlors lack are salesmen with clients who can be badgered over the telephone to bet on the horses and generate some commission business. And why stop there? To support the sales force—excuse me, the horse brokers—OTB could even hire analysts to write research reports. If you are a “value” investor who concentrates on fundamentals, your horse broker could send you a report on the pedigree and training performances of a good-looking prospect in the seventh race at Belmont Park. Or if you are a “momentum” player who concentrates on technical analysis with a preference for following the “smart money,” you could get a frantic call from your horse broker doing his best James Cramer imitation moments before post time about some mysterious movement in the odds that could indicate somebody knows something.
“Who cares why the odds are going down?” he would scream into the telephone. “This is a momentum horse! Get your money down now, before it’s too late!” The similarities are endless. Was the jockey holding his horse the last time out so the trainer can turn him loose today and cash a big bet at large odds? Has that corporation been overstating its earnings to keep the stock price up so insiders can bail out at high prices? You want to take a shot at big money? Forget options—play the daily double—here are our top picks, for speculators, of course. What’s that? You’re wondering what to do with your pension funds? Why, that calls for a more conservative approach—how about allocating 5 percent of your account on the favorite, to show? One reason the stock market fascinates so many of us is that there are so many ways to approach it. This frantic moment-tomoment approach, in which the market is treated as though it were a racetrack or a casino, is certainly a valid way.

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TYPES OF VOLATILITY RE-EXAMINED

In order to stack the odds in your favor when developing options strategies, it is important to clearly distinguish between two types of volatility:
implied and historical. Implied volatility (IV) as we have already noted, is the measure of volatility that is embedded in an option’s price. In addition, each options contract will have a unique level of implied volatility that can be computed using an option pricing model. All else being equal, the greater an underlying asset’s volatility, the higher the level of IV. That is, an underlying asset that exhibits a great deal of volatility will command a higher option premium than an underlying asset with low volatility.
To understand why a volatile stock will command a higher option premium, consider buying a call option on XYZ with a strike price of 50 and expiration in January (the XYZ January 50 call) during the month of December. If the stock has been trading between $40 and $45 for the past six weeks, the odds of the option rising above $50 by January are relatively slim. As a result, the XYZ January 50 call option will not carry much value. But say the stock has been trading between $40 and $80 during the past six weeks and sometimes jumps $15 in a single day. In that case, XYZ has exhibited relatively high volatility, and therefore the stock has a better chance of rising above $50 by January. A call option, which gives the buyer the right to purchase the stock at $50 a share, will have better odds of being in-the-money and as a result will command a higher price if the stock has been exhibiting higher levels of volatility.
Options traders understand that stocks with higher volatility have a greater chance of being in-the-money at expiration than low-volatility stocks. Consequently, all else being equal, a stock with higher volatility will have more expensive option premiums than a low-volatility stock. Mathematically, the difference in premiums between the two stocks owes to a difference in implied volatility—which is computed using an option pricing model like the one developed by Fischer Black and Myron Scholes, the Black-Scholes model. Furthermore, IV is generally discussed as a percentage. For example, the IV of the XYZ January 50 call is 25 percent. Implied volatility of 20 percent or less is considered low. Extremely volatile stocks can have IV in the triple digits.
Sometimes traders and analysts attempt to gauge whether the implied volatility of an options contract is appropriate. For example, if the IV is too high given the underlying asset’s future volatility, the options may be overpriced and worth selling. On the other hand, if IV is too low given the outlook for the underlying asset, the option premiums may be too low, or cheap, and worth buying. One way to determine whether implied volatility is high or low at any given point in time is to compare it to its past levels. For example, if the options of an underlying asset have IV in the 20 to 25 percent range during the past six months and then suddenly spike up to 50
percent, the option premiums have become expensive.
Statistical volatility (SV) can also offer a barometer to determine whether an options contract is cheap (IV too low) or expensive (IV too high). Since SV is computed as the annualized standard deviation of past prices over a period of time (10, 30, 90 days), it is considered a measure of historical volatility because it looks at past prices. If you don’t like math, statistical volatility on stocks and indexes can be found on various web sites like the Optionetics.com Platinum site. SV is a tool for reviewing the past volatility of a stock or index. Like implied volatility, it is discussed in terms of percentages. Comparing the SV to IV can offer indications regarding the appropriateness of the current option premiums. If the implied volatility is significantly higher than the statistical volatility, chances are the options are expensive. That is, the option premiums are pricing in the expectations of much higher volatility going forward when compared to the underlying asset’s actual volatility in the past. When implied volatility is low relative to statistical volatility, the options might be cheap. That is, relative to the asset’s historical volatility, the IV and option premiums are high. Savvy traders attempt to take advantage of large differences between historical and implied volatility. In later chapters, we will review some strategies that show how.

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Common versus Preferred Stock

Officially, there are two kinds of stocks: common and preferred. A company initially sells common stock to investors who intend to make money by purchasing the shares at a lower price and selling them at a higher price. This profit is referred to as capital gains. However, if the company falters, the price of the stock may plummet and shareholders may end up holding stock that is practically worthless. Common stockholders also have the opportunity to earn quarterly dividend payments as the company makes profits. For example, if a company announces a $1 dividend on each share and you own 1,000 shares, you can collect a healthy dividend of $1,000.

In contrast, preferred stockholders receive guaranteed dividends prior to common stockholders, but the amount never changes even if the company triples its earnings. Also, the price of preferred stock increases at a slower rate than that of common stock. However, if the company loses money, preferred stockholders have a better chance of receiving some of their investment back. All in all, common stocks are riskier than preferred stocks, but offer bigger rewards if the company does well.

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Active as Opposed to Passive Management of Assets

The Wall Street establishment generally espouses the cause of passive investment management. Buy your favorite stocks or mutual funds or bonds, hold on through thick and thin, and hope that the stock and bonds markets are on upswings when you need the money. Not necessarily the worst of strategies—unless, of course, you happened to need to draw on your capital in mid-2002, at a time when stocks were more than 50%, on average, below their all-time peaks.
By the time you finish this book, you can be a successful active manager of your own investments and by so doing add to the returns available from the usual sources to passive investors. As an active manager, you will be able to do the following:

• Actively monitor the investment universe and select investment areas—and individual investments within those areas— likely to outperform the average investment of similar risk. In other words, you will have some idea as to when to emphasize bonds, stocks, gold, real estate, and international positions and when to opt for money market and other safe havens.
• You will have the ability to enter, and will enter, into investments relatively early in their rise and exit relatively close to their peak, either prior to or relatively soon after the final top is made. This does not mean that you have to be the first one in and the first one out. It does mean that you will be able to catch the major portion of up moves, while avoiding at least significant portions of the downswings that plague every investment at some time or other.
• And finally, you will be alert to special opportunities that develop from time to time in almost all investment areas and be able, ready, and willing to take advantage of such opportunities.
  

The benefits of active and successful management are self-evident.

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