HH A Universal Theory Of Stock Market Investing

The very fact that the S&P 500 can include two technology stocks like Citrix Systems (CTXS), with a P/E of 123 and a price-to-book ratio of 21, and Hewlett Packard (HPE), with a P/E of 7 and a price-to-book ratio under 1 (these figures are as of 11/25/18), gives the lie to conventional measures of value. In addition, as I have shown, you can invest very successfully without ever looking at the price of the stocks you’re buying, which is further proof that “value” is an overrated factor.

Tenet 3: Successful investing requires thinking in terms of probabilities.

Successful investing lies not in accurately predicting the future value or prices of stocks but in holding the stocks that have the highest probability of delivering strong returns. In other words, think in terms of odds rather than targets.

Because stocks are so unmoored from so-called value and prices are set so capriciously, it makes more sense to focus on the odds that a stock’s price and dividend payments will go up or down than on how much the stock is “really worth.”

Tenet 4: These probabilities are determined by two interrelated things: the likelihood of a company’s future success and the likelihood that investor expectations are mistaken.

The stock market is quite a bit like parimutuel betting (betting where the odds are determined by aggregate bet size rather than by the house). Just like at the race track, the payout is determined by two things: whether a company succeeds and how much investors have bet upon that company (the stock’s market cap). When we buy a stock, we are essentially making a bet that its price (or market cap) will increase and/or that its dividends will pay off and/or that it will be acquired at a premium. And our odds are dependent on other people’s bets.

In parimutuel betting, we must take into account not only the factors that will make a horse more likely to win but the factors that will make other bettors less likely to bet on it. An example of the first kind of factor might be the horse’s pedigree or its time in previous races; an example of the second might be if you think the jockey or trainer is underestimated.

In the stock market, the first kind of factor is the kind that directly drives investor interest and thus increases prices, such as an excellent earnings report or an upgrade in analyst estimates. The second is the kind that signifies that a company is likely to exceed investor expectations, such as a high ratio of unlevered free cash flow to enterprise value (a value measure that few people use).

The ideal factor, then, is one which reverses conventional wisdom. For example, conventional wisdom says that a strong company has a high return on assets, exceptional revenue growth, a low debt ratio, a healthy ratio of net operating assets to total assets, a high beta, a high dividend yield, and a low price-to-book ratio. But a low return on assets is a strong predictor of future earnings growthlow but sustainable revenue growth is less likely to lead to investor disappointment, a high debt ratio enables a company to more efficiently use its capital resources, a low ratio of net operating assets to total assets signifies low accruals and a high proportion of cash on hand, low-beta stocks are more likely to have high alpha, a stock with a low dividend yield is less likely to have an unsustainable payout ratio, and stocks with very low or negative book values have an edge over those with high book values because equity financing is so much more expensive than debt financing.

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Disclosure: My top ten holdings right now: ZIXI, ARC, GSB, CTEK, KTCC, PERI, HALL, OSIR, CRNT, NTWK.

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