Most readers here know there is this “Golden Rule” in investing; if the company announces increased profit this quarter compared to the corresponding quarter, or preceding quarter, the share price will go up and vice versa, or something like that. This is the only way to invest to be a super investor, so they said.
I am already deeply confused with the use of this “Golden Rule” after seeing its application to this stock called Gadang recently. Very confused indeed, as I thought this “Golden Rule” is a simple one.
On the surface, this investment strategy appears to be plausible. But is this obsession merited? Do earnings announcements have significant effects on value? What were the evidences? More importantly, can you make money off earnings announcements?
When you hear about 1, 2, or 3, or 10 friends who have gone up to Genting highland and made money playing the One-Armed-Bandit. Can you make the conclusion that “people who go up to Genting Highlands and play the One-Armed-Bandit will make money”? of course you can’t as you have not shown “statistically significant results” using a population of people going up there and more than, say 70%, of them have consistently making money doing it. More importantly, there is no plausible reason to say that.
So, how can you say, a certain rule of investing, say the “Golden Rule”, is a sure win strategy in investing in the stock market? Have you got the statistics that 800 out of 1000 times investor using this “Golden Rule” have been successful in investing using that strategy?
I will here use my own personal experience to show if I could make extra-ordinary gain by using this strategy. Please note that this is also a simplistic example using just my personal experience as a simple “null hypothesis”, and it is by no means a vigorous proof.
By the way, this strategy is still basing on the historical accounting profit as suggested by the proponents of this “Golden rule”, a past record too.
Return of Watch List of Magic Formula (MF) Stocks from 30th October 2016
A month and a half ago, on 2nd November 2016, I have sent out to my course participants a watch list of carefully selected 15 MF stocks at the closing prices on 2nd November 2016 as shown in Table 1 in the Appendix for their consideration for investment for long term, clearly showing the three metrics of return on capital, earnings yield augmented with an additional metric of cash yield. These metrics were based on the latest trailing twelve months’ income statements, the latest balance sheet and an average of cash flows over a few years, and the latest share prices at that time i.e. on 30th October 2016.
Anybody interested in what Magic Formula investing is can refer to this link below,
http://klse.i3investor.com/blogs/kcchongnz/55070.jsp
A month and a half has past and Table 2 in the Appendix shows the performance of the portfolio since then until as at 15th December 2016.
The portfolio return 3.01% during the last one and a half month, including all dividends paid or ex-dated during the period. This total return out-performing the return of the broad market of negative 1.02% by 4.04%. Nine out of 15, or 60% of the stocks have positive return. This value investing of the MF has done well again, supposed to be in the long -term, but also in this short-term of one and a half month too.
The best performer was RGB at +18.6% at its closing price of RM0.255. Next comes Hevea, with a total return of 11.9%. Thong Guan Industries did well too with a total return of 10.4%. Perstima also did well with +8.9%, all in the one and a half month’s period.
RGB reported an excellent set of quarterly result last month with revenue and net profit increased by 18.7% and 62.1% respectively. The share price performance of this stock seems to meet the “Golden Rule” very well indeed.
Hevea reported 5% drop of profit for the third quarter result ended 30 September 2016 on 22nd November 2016. Its share price did drop the next day by a few percent, but quickly recovered at the end of the day. Hevea’s share price had dropped to RM1.05 after reported earlier poorer 2nd quarter result in end of August 2016 as shown in this link here,
http://klse.i3investor.com/blogs/kcchongnz/104613.jsp
Hevea’s share price closed at RM1.52 on 15th December 2016. Followers of the “Golden Rule” would have lost the opportunity of making 45% in 3 months.
Thong Guan reported an excellent set of quarterly results too on 24th November 2016 with net profit increased by 37% compared to the corresponding period last year. Its share price, however, did not move much for two weeks until recently and closed at RM4.44 on 15thDecember 2016. It has since gained 10.4% from one and a half months ago. I have written something about thong Guan Industry in this link below,
http://klse.i3investor.com/blogs/kcchongnz/104956.jsp
The worst performer was ESCICT with a negative return of 4.6%, although it reported a better set of results compared to the corresponding period last year, with net profit increased by 29%. Next comes Willowglen and Kumpulan Fima with -3.9%, although they both also reported a better quarterly result compared to the corresponding period last year.
This shows a very mixed bag of results on stock return on reported earnings. The “Golden Rule” that stock price will go up if reported better result and vice versa is a myth, at least from my own experience.
In actual fact, as Bursa is made up of more than 70% of institutional investors, it is somewhat, but not completely, efficient in some way, that the prevailing stock prices have incorporated some kind of expectations of the results, before they are announced. Unless the quarterly report is better than the expectation, the share price may not go up, or even go down, if the reported good results, say +20% in net profit, are not better than the expectation of +40%; or share price may even go up if the poor results of decline profit of 30% are better than the expectation of decline of 50%.
In my opinion, if you are very good in estimating the future earnings of a company, and can do it right consistently, you will make a lot of money in investing. Absolutely no doubt about it.
How good are you in guessing this expectation? Unless one is an insider, or has insider information, which is illegal to use it to trade, there is no way an average retail investor has that advantage. I must admit that some of the investors do have that prowess in estimating the expectation, but there are far and few in between. For those few who are good in estimating future profit, most likely they already have the good knowledge in financial statement analysis and some valuation techniques, rather than those with vague “business sense”, or the fuzzy “pivotal moment concept (!@#$%&* is it?), or the what the hell “dynamic investing”, and nothing else. Otherwise, how can one estimate future expectation well?
Think about it, how can one have any business sense when putting out money to do business, doesn’t have the common sense that it must earn a higher return than the costs of capital? they don’t even know what ROE or ROIC are! How can one have good business sense when the business makes profit, only in accounting term, but keeps on putting out hands for more money from the owners, instead of allowing them to withdraw cash from the business?
In fact, the estimation of expectation is made more complicated with companies becoming more attuned to playing the earnings game, and have become increasingly adept at beating earnings or earnings expectations, or analysts work to mold the actual earnings, using both accounting choices (earnings management) and operating discretion (timing of capital and R&D expenses, for instance) to deliver results that try to beat or smoothen earnings or beat expectations. The problem with this game is that markets will eventually catch on with it and adjust expectations accordingly.
I am sharing with you my personal experience in investing with published records (always) in i3investor showing that the so-called “Golden Rule” doesn’t (accidently) work for me. I would like to hear from you too, of course with published records such as that in i3investor, that your “Golden rule” works for you.
Please bear in mind that we are talking about investing, not the vague “Dynamic investing”, the fuzzy !@#$&* “Pivotal moment concept”, etc.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” Benjamin Graham
In my opinion, it is better to follow a well-established and proven investing strategies backed by academic research, well documented success, and plausible reasoning to build long-term wealth.
KC Chong (ckc13invest@gmail.com)
Appendix
Table1: Return of MF stocks from November 15 2016
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