A long time ago, when the world was full of wonders, there was a town called Las Vegas. It was a place of abundance, where you could get a chicken dinner for less than $2.00. In its gambling arenas, a usual bet was $2.00, so that the mighty winners of a bet won enough money to afford a chicken dinner. That was when the ultimate expression of victory “Winner, Winner, Chicken Dinner!” was born.
At least the legend says something like that. Actually, no one really knows where the expression comes from, but most people indeed associate winning a gamble in a casino with it. The first time I heard about it was in the context of Black Jack, one of the most popular card games, not only in Las Vegas, but in casinos all around the globe. Black Jack is played against the dealer and the goal is to get as close as possible to a value of 21 with your hand, but under all circumstances not above it, since that would imply losing the game. Because the players, of course, have no influence on the cards they get, there is apparently a fair amount of luck involved in Black Jack. Otherwise, casinos probably would think twice about offering Black Jack tables and definitely wouldn’t make as much money with it.
However, there are gamblers that manage to constantly make remarkable profits playing Black Jack. Some of them might have a monopoly on luck, but others probably have tilted the odds in their favor by counting the cards. The basic idea of counting the cards is to keep track of the low and high cards, that have already been played, and by doing so, to add some predictability to which cards come next. Counting cards is illegal and is/was serious enough of a problem to cause casinos to implement extensive security measurements against it.
The conclusion of all this is, that Black Jack is a popular game in casinos that involves randomness for some people whilst others (those who count cards) are actually able to consistently make profits. And when you win, you can shout “Winner, Winner, Chicken Dinner!” and act like an old-established gambler.
From gambling to stock picking
That’s all well and good, but why is that the business of an economic magazine, such as Rostra Economica, you might ask. The answer lies in the, to some degree, common nature of picking stocks and gambling. Investing in a stock basically means betting on whether a share’s price is going to increase or decrease. However, I’m reluctant to label investing in a stock a pure gamble. Investors do not randomly choose stocks and then rely on their luck but they usually put a lot of effort to make their guess as educated as possible. The comparison to playing Black Jack and counting cards would probably be more appropriate. The whole uncertainty won’t vanish, but the right tools can reduce it. The tool in Black Jack is, while not easy to implement, quite straight forward: count the cards. That’s where picking the right stocks gets a lot more complicated. There is a whole spectrum of stock picking strategies and no single right way to do it exists.
In the course of two articles I would like to take a closer look at two famous and in their approach completely different methods of picking stocks.
It’s all about the fundamentals
The first method is called value investing. The most famous representative of value investing is probably also the most famous investor on the planet: Warren Buffet. He is the CEO of the holding company “Berkshire Hathaway Inc.”(BRK-A) whose shares are currently (17.02.2015) selling at $222,555.00 (Yahoo-Finance) and easily are the most expensive shares of all time. Buffett doesn’t categorize himself as a value investor, but a lot of his investments can be assigned to that certain style of investing.
So if you hear something saying “I’m gonna be rich because I’m doing it the Warren Buffett way”, the person is most likely referring to value investing.
I’m doing it the Warren Buffett way
But what exactly is value investing? The basic idea is pretty straightforward and makes sense intuitively: identify companies that are cheap compared to their quality/fundamentals. Analysing a stock’s fundamentals has different dimensions and levels of analysis; dimensions in a sense of qualitative vs. quantitative investigations, with both having different levels ranging from macroeconomic factors to firm specific factors.
Qualitative insights are meant to shed light on factors that aren’t quantifiable or hard to put into numbers, but still impact and distinguish the company from others. Those factors can take the form of management, how income is created, the sectors of operation, the suppliers, geographic location of clients, market sentiment etc. The gained qualitative insights should then be used to augment quantitative analysis which basically seeks to assign concrete values to variables and largely consists of examining financial statements and forecasting relevant figures. The most commonly used valuation methods in practice are the discounted-cash-flow model (DCF) and methods based on financial ratios, such as the price-to-earnings ratio P/E, which are also often referred to as multiples. The DCF, as the name says, focuses on the future cash flows the company is able to create. Today’s value of the company is then equal to the sum of the discounted future cash flows. This definition already constitutes a critical part because it’s impossible to already know what the future cash flow will exactly look like and assumptions need to be made to which the valuation result can be very sensitive.
I’m leaving discussions about Modigliani&Miller, market efficiency, bankruptcy- and agency-costs etc. aside now, simply because it’s not the purpose of my article to discuss the validity of certain concepts and there are probably hundreds of scientific papers about each of those topics available in the web for the interested reader anyway. Coming back to the DCF model, it is still a viable and widely used method that receives most academic support among all valuation methods thanks to its direct link to a company’s fundamentals and ability to generate cash in the future.
The multiples approach requires the determination of and comparison to a peer group of firms, which indicate what the company’s stock price should be. The comparable firms are assumed to be fairly priced on average. This method’s main advantages are the quick implementation and the relativity to similar firms. However, the use of multiples is less firm specific than the DCF approach and offers space for various valuation errors; the first one already arising in the fact that it’s impossible to identify identical firms that have the exact same peculiarities. Moreover, an intrinsic value can only be found under premise of comparable firms being correctly priced, which sort of contradicts the aim of detecting mispricing.
Another thinkable approach to valuing a company would be the dividend-discount-model (DDM) but since there are no common rules for dividend policies, this method appears to be unfeasible.
The valuation of the stock constitutes the last part of the fundamental analysis and takes prior examinations together in order to come up with an intrinsic value of the stock. That’s what the analyst thinks is the true price of the stock and at some point, value investor beliefs, the market price converges to this true value. Comparing the obtained stock price to the actual price tells the investor whether to sell, buy or hold the stock: a higher intrinsic value suggests buying the stock and vice versa.
Even the best fundamental analysis can’t guarantee high alphas. Assumptions need to be made about the future and something like perfect information and incorporation of all relevant information is not possible. The fundamentals still draw a sound picture of the company and its future prospects and are thereby able to eliminate parts of the uncertainty. Right so, there are numerous advocates of the fundamental analysis approach. However, the degree of elimination largely depends on the quality of the analysis.
What to expect from Part 2
In Part 2 of the article, which is going to be published soon, I’ll take a look at technical analysis and expose ideas on how both methods can augment each other.