As a special feature for April, TheStreet.com offers a seven-part series on maximizing your IRA. This installment is Part 7. Click here for Part 1, Part 2, Part 3, Part 4, Part 5 and Part 6.
In earlier parts of this series, I've talked about various options available for IRA investments and, based on my own experience and judgment, what investment principles and practices have a good chance of providing superior performance for those willing to become unemotional and independent investors. Now I'm going to outline my own personal approach to investing in individual common stock issues in my IRA.
My approach actually could be applied to any common stock investment portfolio but there would be tax consequences to be reckoned with in taxable accounts.
I am not a true long-term investor. For me, attempting to forecast the future three to five years from now is a laughable exercise. Our world moves so quickly that I am only willing to hazard a guess about the next couple of quarters.
The end result is that I do quite a bit of trading. Fortunately, commission rates are quite low and now can even be zero if you go to the right broker.
My first step when looking at the investment world is to ascertain what I believe to be the current stock market environment and then translate that view into a target cash position for the equity part of my total investment portfolio.
Using technical and psychological indicators, including a couple I have previously profiled in this series, I arrive at what I consider to be the basic trend of the market. Currently, as it has been for several years, I judge that trend to be bullish.
Then, using a set of more intermediate-term indicators, I arrive at an actual target cash position. I have a set of three intermediate-term indicators that include the total volume of individual equity and index put and calls on the Chicago Board Options Exchange, the CBOE option ratio (which is similar but excludes index options) and odd-lot sales and purchases.
Below is a weekly chart of a composite of these three indicators over the last five years.
The black ranges show the high, low and close for the
on a weekly basis, and the red line shows a composite of these three indicators.
The last plot of these indicators was made on March 23, 2007. At that time, on the basis of the bullish long-term trend and the position of these indicators, I had a target cash position of 6%. That was down from 20% a few weeks prior.
Three Key Indicators
Once I determine my cash target, I begin to look for stocks to buy if my actual cash exceeds this level. I do this by using a screening system that I have developed over the last few years (and continually tinker with as I learn more). It has two main components that are evident (really almost obvious) when looking at the attributes of winning stocks: value and momentum.
I measure momentum by looking at the actual price change of every stock over the past year, six months and three months. I restrict my universe to those stocks that have performed much better than the universe over these time periods. For example, the price change over the last year must be in the top 30% of all stocks.
It seems counterintuitive to buy stocks at or near their highs for the last year. After all, haven't we all been told to "buy low, sell high"? Actually, as James P. O'Shaughnessy showed in
What Works on Wall Street
, winners continue to win. Why? Because when things are changing in an industry or within a company, the market often underestimates the scope of those changes. So a true turnaround story, for example, isn't really believed at first.
There are many measures of value in a common stock. O'Shaughnessy came to the conclusion, based on his statistical analysis, that the price/sales ratio was the best measurement of value. This metric does, indeed, seem attractive, because sales data are much more reliable than earnings or cash flow. However, low price/sales ratios unfairly punish those companies that have high profit margins, since price/sales ratios and margins are so positively correlated.
The Little Book That Beats The Market
, I came to be impressed with the metric used there: Enterprise Value/EBIT. Enterprise value adds total market capitalization to long-term debt and preferred stock and then subtracts cash on hand. Then, enterprise value is divided by earnings before interest and taxes to arrive at the ratio.
I like this approach because it takes all long-term financing into account and looks at operating earnings before variables such as interest expense and taxes. Actually, I ran into a bit of a problem with this ratio because I couldn't find a data provider (that I could afford) that would allow me to screen on this variable. Therefore, I made a slight change and now use the ratio of enterprise value to EBITDA, which includes depreciation and amortization in the earnings number.
More specifically, I am looking for companies that are valued at a minimum 20% discount to the median company in their industry, according to this valuation metric.
I have some other factors in my screening system; for example, I exclude American depositary receipts, and a stock's average daily trading volume (in dollars, not shares) must exceed $500,000. But those are the basics.
And this is just a starting point; after applying these screens, I take a more conventional look at the company's prospects.
I also have a standing set of sell rules that are activated immediately when I purchase any stock. I will sell any of my holdings if the price of the stock goes up enough to make the stock fairly valued, if the company reports down earnings or forecasts down earnings, or if I have held the stock for seven months and it no longer appears on my screens as a buy.
I have had a great deal of success using this investment approach. From March 31, 2001 through Feb. 28, 2007, the total return for my IRA has been 247%. Over the same time period, the S&P 500 was up 34%, and the Russell 2000 was up 77% (not including income).
I invite you to follow along with me and my IRA investments in a weekly column that I will be writing for RealMoney.com starting in late April. I will be discussing my market outlook and any transactions that I undertake in my IRA.
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Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback;
to send him an email.