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In the fields of
observation, chance
favours only the
prepared mind.
Louis Pasteur (1822 1895)
Chemist and Microbiologist
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Contents
BY THE SAME AUTHOR
DEDICATION
NOTE FROM THE AUTHOR
Searching for Perfection
Intelligence does not always equate to success
PREFACE: HOW THE BOOK WORKS
A Story to Offend
Predictable Habits of Traders
o Still Crazy The Following Is For The Uninitiated
o What are shares?
o Is it risky to buy shares?
35 Essential Rules
o General Trading Rules
o Rules To Consider Before You Trade
o Rules That Are Trading Specific
o Rules That Relate To Actual Trading
o Rules For After You Have Placed Your Trade
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A Day In A Newsroom
o Analytical Method 1: Fundamental Analysis
o Analytical Method 2: Technical Analysis
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Aggressive Portfolios
The Defensive Portfolio
The Income Portfolio
Speculative Portfolio
The Hybrid Portfolio
A Time To Forget
The True Issue Be Prepared
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o Step 2: OB/OS
Financial Modelling
o Negative Aspects of Financial Models
o Positive Aspects of Financial Models.
Stock Splits
Reverse Stock Split or Share Consolidation
Share Dividend
O The Free Cash Flow Method
O Calculating An Investors Total Return
Market Sentiment
Looking At Prospectuses
Combining Averages
o Step 1: Determine Whether To Trade Or Invest
o Step 2: Establish Substance
Conclusion
Final Word
APPENDICES
REFERENCES
GLOSSARY
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to know what the national debt is, or that unit trusts helped investors to shift their interest to ordinary
shares.
There seems to be an unbelievable compulsion by many financial writers to give in to popular trends
and fashionable thinking during specific economic circumstances, such as highlighting trends in
boom or bust markets. This book is not driven by a compulsion to provide you with yet another book
on popular trading methodologies. Rather, it happened as a consequence of a culmination of a
number of very specific events. Three of these events are as follows:
The first happened in 2008, was when a client asked me the following question: Is it
possible to break up the complexities of trading into a few very pertinent steps?
The second event took place in Durban in 2009, during a share trading workshop. I had just
explained to the group that trading is a logical process, determined and ruled by strategy and
market emotion, when an attendee asked: Doesnt market sentiment ultimately kill any
logic?
The third event took place when the massive Japanese earthquake happened in 2011. I was
hosting a conference for Chinese entrepreneurs when the news of the devastation broke.
Instead of sympathetic comments, one entrepreneur simply stood up and said: I have to get
back to Shanghai. There is market share to be gained
From such simple questions, Six Steps to Trading Like A Pro was born; the above influencing
events will become clearer as you read this book. In fact, its composition comes from the mere fact
that the raw material gathered from workshops during these past three years stemmed from many
questions asked by intelligent men and women anxious to broaden their knowledge of trading and,
eventually, investment as a whole.
Ultimately, if increasing trading logic helps to create successful and more sophisticated online
investors, then increased tradability should result in a better economic environment that, in turn,
promotes a climate in which companies can prosper; bringing benefits to a wider scale than many
people suspect.
This book thus builds upon the knowledge gained from working with novice traders and professional
stockbrokers since I started my career in stockbroking in 1990. Through them, I have gained a
deeper and more pertinent understanding of the role of sentiment in markets and, as such, my
analysis has become more succinct and accurate.
The purpose of this book is to give beginners and more experienced traders a fresh look at the
principles and applications of using charting signals in conjunction with fundamental analysis. These
methods are important, because when a trader applies them with precision, they provide him or her
with a deeper understanding of the strength of their chosen investment, taking into account market
sentiment as well as current trends.
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I hope that this book will engender debate on how many steps it really takes to get from novice to
experienced trader. Recently, I read an article that stated: Only 140 steps to trading perfection! My
first thought was that, by the time you get to step 15, you will have lost the advantage of any
profitable trade. If nothing else, I hope that the new trader will find an enhanced ability to detect and
act upon changes in prices and to benefit from such action. The use of fundamental analysis
provides you with better understanding of what you have to do before you buy shares, while
technical analysis is used to determine investor interest in the share before you time such trades.
I have also noted from lengthy discussions with professional traders that only a handful of their
clients are happy with their personal trading strategies. As one said: Few traders are perfect, and
most can certainly improve their performances, adding, the aim is to be more consistent in trading,
before trying to make big profits.
market to another can significantly impair his or her ability to make consistent profits. Hence, the
ability to apply charting signals in conjunction with pertinent fundamentals will enable the trader to
understand a shares price data, possible changes in that data and enable him or her to project key
trading ranges. The aim is to establish areas of resistance or support before implementing technical
signals. By using these alternative methods to forecast key price ranges, the trader actually gains
skills and enhanced confidence to shape his or her long-, medium and short-term strategies and
tactics.
The result is improve decision making and thus profitable trades. The Six Steps to Trading Like A
Pro should provide enhanced confirmation and better understanding about trends and related
direction and strength. When used correctly, the Six Steps should also reduce traders reliance on
subjective opinion, whether from media, corporate or Investor Relation news and releases. In fact,
too much technical analysis without a foundation of sound fundamentals will hamper correct trading
decisions.
Consequently, I hope that the proposed approaches set out in this book help you to evaluate trends
in an easier and quicker manner. It is also my hope that this book will promote new research into
fundamental analysis and how to use these factors with technical signals. Charts should track global
market cycles, differences between world major economies and political systems. Currently, they do
not.
Charting analysis usually focuses on price and price history. The norm is thus to ignore all outside
influences and forces that could move prices. I have heard technical analysts say: You dont have
to understand anything other than technical signals, as everything is already included and
accounted in the securities price.
What about new company listings? These do not a price history, so should we ignore all of IPOs?
How can you tell that an earthquake will happen? Is the potential of a future disaster already taken
into account in a securities price?
Least of all, politicians often make capricious statements which move markets in unpredictable
ways. Technical analysis on its own ignores such influencing events. There is thus a very urgent
need to assess world trends and patterns in a simple format and then to relate these variables to a
set of technical signals and guidelines.
Once such combined fundamental and technical variables have been assessed, a final decision to
trade must be based on a filter that incorporates sentiment analysis and timing. While all this may
sound too time consuming and complex, relax - all these factors are amalgamated in this book in a
simple set of guidelines.
Trading is not a Get-Rich-Quick scheme. New traders will encounter obstacles and major problems
that must be immediately resolved. Trading is thus not for the faint hearted.
I believe that day trading necessitates complete and in-depth knowledge of industry and markets
and the ability to rapidly assess the tsunami of contradictory information that will engulf you if you let
it. Build a character of discipline and patience to endure boring routines and you will have a starting
point to changing your career.
To many professionals, who have approached me to change their careers to that of trader, the idea
of trading means long lunches, spending more days at the seaside than in front of their computers
and a life of luxury. It takes time, patience and diligence to achieve a life of uncompromised wealth.
The good news is that all this is possible!
If you want achieve unbelievable wealth, contact me on mentor@magliolo.com and I will assist you
to effortlessly move from your current career to that of trader. So, come with me on this journey and
lets set simple rules to trade effectively.
As always, enjoy and contact me personally if you have any question, whether theoretical or
practical.
Jacques Magliolo
mentor@magliolo.com
www.magliolo.com
2011
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product; or even prevent the importing of any such goods to protect their own workers. What do you
think will ultimately happen to the country, its workers and the product itself?
Even more pertinent: What will happen to those listed companies producing or selling this product?
This book looks at how these unbelievably complex fundamentals can be simplified to produce a set
of conclusions that will help traders to make better choices. As such, the principles, theories and
ideas presented in Six Steps to Trading Like a Pro calls for novice and professional traders and
investors to think and understand what it takes to achieve success in an increasingly growing global
elite that operates on ruthless free market ideals.
Therefore, there is a need to stress that, without an understanding of factors that affect overall
markets, business and share movements, investors and traders alike cannot make informed
decisions for the short or the long term.
Among the many factors assessed, this book can be explained in a two- fold structure: The first
looks at three steps that explain fundamental analysis and the second looks at three steps in the
technical analysis area. Of course, there has to be chapters dedicated to setting the scene and
some to conclude and explain the various chapters.
Back to the globalisation debate: if free trade across the world does force companies to be more
efficient and provides all nations with the ability to gain wealth, then all this simply means is that
stock markets around the world will see new ones open and proposer; a global traders dream to be
able to diversify across new global exchanges.
From this books perspective, globalisation is merely one variable to successful trading. However,
more specifically, the fundamentals outlined in this book account for correlations between various
exchanges, so that the trader is able to achieve his or her desired trading targets. So far,
globalisation has created millionaire traders around the proven We have seen Western traders
become ultra-wealthy individuals, with many using their knowledge of global economics and
business trends to make profitable informed trading decisions.
Alternatively, I have seen traders who have become obsessed with technical systems. These socalled Systems Junkie or Techies believe that they can become ultra-wealthy by only using a few
well-placed technical signals. When markets become volatile, like in the 2008 financial crises, many
simply become bankrupt and disappear from the trading scene. The main reason is that they were
focused on one system, while the other was ignored, to their financial detriment.
Quietly, they leave trading and their voices are no longer heard.
The problem is that many novice traders dont take the time to build skills, experience, knowledge,
discipline and control. Those who do, even pure technical traders, do become wealthy. So, Six
Steps to Trading Like a Pro may mention the psychology of trading, but not in great depth. It is,
however, a book, whose lessons are simple and easy to understand and implement.
The idea after all is to get you in front of a trading desk quickly, but not before you have learnt
the seriousness of becoming a trader. If you are really serious about trading, I strongly recommend
that you spend as much time with drafting logical trading strategies as you do with looking at
technical indicators and charts.
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DECISION TIME
Two parts six steps: unlike many books on trading, the aim of this book is to use an equal
and evenly based system, with unbiased emphasis on fundaments and technicals.
o
Once securities have been identified, Technicals should be used to time the strategy.
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Step 1: Setting up a portfolio strategy must include an ability to build wealth for the long
term, while taking advantages of short-term market mishaps and anomalies.
Step 2: once your three portfolios have been designed and set up, you need a system to
choose companies to trade. There are literally thousands of companies around the world
to choose from, so how do you go about finding investment and trading opportunities?
Step 3: Once companies have been chosen (Step 2), these have to be investigated and
understood in great depth. Among the list of required information is an understanding of
the companys share price. How has the company price moved during the past 12
months? How does this relate to the companys net asset value?
Step 4: In the first three steps, the trader has identified through fundamental strategy
a list of shares that offers potentially solid investment and trading opportunities. These
companies shares have been investigated. Now, the trader needs to assess what
patterns and trends are dominant.
Step 5: The list of shares have been filtered down to ones with strong trends and
investment patterns. The strategy now is to look at these stocks and to identify which
have strength and momentum. It is pointless buying a share that has a strong trend, but
the momentum of that trend is weak.
Step 6: all issues and strategies have been implemented and the trader is ready to buy
his selection. This final Step sets out buying and selling levels to enable the trader to
optimise returns.
Type of trader you are: In Lore of the Global Trader the various forms of trading are set
out.
The issue here is that you need to decide what kind of trader you want to be. Do
you want to trade every day, weekly, monthly? This influences the amount of time
you need to research stocks and also the amount of time you need to assess
trading patterns.
Define Your Risk: When developing your system (or trading style), it is crucial to define how
much you are willing to lose on each trade. This is a personal matter and only you can determine
that amount. A general rule of thumb is that you should never commit more than 2% of your total
capital on any single trade.
There are many systems that do work, but many traders simply lack enough discipline to follow their
own set of designed rules. Consequently, many end up losing serious money. In essence, a trading
system should attempt to:
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If your trading is profitable, but you use only some of the above steps, then you have done well.
Once you've tested your trading system for at least 2 months (as a demo account) and you are still
profitable, you are then ready to trade on the exchange.
However, you must always remember to stick to your rules.
Opportunities will always arise from improved knowledge. How can the shareholder or trader
position himself or herself for future growth if they do not have an understanding of how current
worldwide trends could affect their business?
In addition, how can they position their trading business without a fair prediction of how current
trends could change in the future.
So, this is a book of investment and trading strategies. I need to stress that the only way a strategy
can work is if it is used in a logical manner. Therefore, dont ignore one system of the other. Use
these to your benefit and to improve your trading; especially with world economic forces continually
moving and changing investment techniques.
What and where will you be as a trader in future if you dont understand global macro-economic and
political trends?
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Chapter 1: Introduction
The four most dangerous words in investing are, Its different this
time.
Sir John Templeton (1912 - 2008)
US-born British stock investor, businessman and philanthropist
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Now, there are libraries full of books on how to set up personal trading strategies. I have written
many articles about trading journals, how to establish strategies and how to trade world markets,
from local and global securities. This book cannot cover all these issues in great depth, but can start
by telling you what the pertinent facts are to establish yourself as a serious trader.
The first step in any serious venture is to conduct your own analysis of the market or business you
are about to enter. I dont know of any real business that is free, so I am assuming that you intend to
spend hard earned cash to start a trading business.
Trading, like any business, takes patience, time and funds to establish. There is no point in saying
that all you need is the funds to invest in securities and everything else you will learn as you go
along!
That is the easiest recipe to financial ruin.
I have written many business plans in the past decade, some complex and running into several
hundred pages; covering issues relating to corporate profiles, shareholder structures, strategies,
financials and growth plans. A trading business plan is important, but should cover two main issues,
namely those relating to personal daily routines and, secondly, issues relating to the trading
business itself.
These two topics are set out in the following text.
PRIVATE ISSUES
You are about to enter a complex financial world where greed, panic and hope are the order of the
day and often takes place at the blink of an eye. I have told the story before: a colleague spent 12
hours watching markets nothing happened. He decided to take a 10 minute break. Guess what
happened? In those 10 minutes, the market he had invested in had fallen by a staggering 20% as
the World Trade Towers fell in 2001.
In 10 minutes, he had lost an unbelievable R7.3 million. To make matters worse, his portfolio was
not diversified and the shares that fell represented 60% of his portfolio, so he lost - in that 10
amazing minutes 50% of his entire wealth.
Not to put a finer point on the issue, I asked him if he had a business plan to set out how and when
he should trade. He just glared at me, which in itself was an answer. He seemed to have ignored the
premise that trading is a business where people lie, cheat and create rumours just to influence share
prices. In addition, professional traders can today trade for clients and simultaneously for their own
book. Many market observers say that this is a conflict of interest and often creates unrealistic share
movements in favour of brokers and thus to the detriment of private clients.
Maintaining a positive attitude during such trying times is in fact extremely vital for success, and
negativity is one of the greatest challenges a trader must overcome; especially when massive
earthquakes render the worlds third largest economy useless. In addition, I have seeing successful
traders doubt themselves at crucial times and that loss of confidence no matter how brief
renders traders useless.
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You cannot expect to succeed in the long-term if you cannot see trades in an objective and
unemotional manner. If you lack confidence and skill to take logical trading steps without hesitation,
then I suggest that you look for a less tense career.
The answer is to start your trading career slowly, to enable you to build confidence while assessing
your risk profile. You do this by first establishing a long-term share portfolio, which concentrates on
blue chip stocks.
The three portfolio of billionaire traders is outlined in Chapter XXX.
What I can reiterate in this section is that the first goal is to look at why you are negative in aspects
of trading. As a trader, you need to be positive, but always have a healthy and realistic respect for
the market. Some experts suggest that you only have to stop reading negative media stories to build
a positive attitude.
I believe that this is in a world where you can make money in a bull or bear market insufficient
and actually sets a dangerous precedent. The aim is to actually see negative events as a positive
trading opportunity. Look at the various needs around the world and ask yourself: who will benefit
from such an event?
The answer is usually: those who will rebuild that which has been devastated. Look again, and ask:
which listed companies will benefit from such rebuilding?
While many of the older professional traders will see the above as a complete waste of time, newer
market players in the field of futures will tell you that trading equities does help you to improve your
trading results. Dont try to trade Futures without skill, knowledge, trading savvy and, of course, the
ability to trade with confidence and positive thoughts.
Yet another obvious statement to make is to stay away from people who are trading as a hobby.
You want to associate with professional traders. After all, it is through such associations that you will
develop necessary skills to build confidence and trading skills. I have a wide cycle of colleagues in
the market, who exchange trading ideas and debate new issues.
As an analyst and trader, therefore, I am constantly on the lookout for trading ideas that will make
me think and possibly rethink my strategies.
There are many groups in South Africa that enable you to discuss market and company related
issues. Apart from chat rooms on the internet, look for professional business associations. These
will be made up of analysts and traders who are making a living from these professions.
ESTABLISH A ROUTINE
Start the day with a lengthy fast walk; at least 30 minutes. Remember that you will be sitting in
front of a computer for hours a day so start the day with an exercise that will keep you strong.
Spend at least the first hour of the working day with administrative tasks. Get these out of the
way as they become a distraction during the crucial trading hours.
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Check the profile of world market indices for the past 24 hours.
Determine how much time you intend to invest in your trading day.
o
For some traders this might be a few hours a day or even a week.
Trading Objectives and goals: What is your trading objective for the day and how does this
apply to the overall trading strategy? For instance, how many trades do you intend to do each
day and how much will you spend on each trade?
Trading programme: Do you have a tactic to improve your trading ratio of profits over losses.
Defined Trading Plan: A professional trader will always clearly define the point at which he or
she will buy a security and also the point at which he or she will sell that security.
o
Entry method: based on market conditions, such an entry point may be on the down or upside.
Examples:
if ABC Limiteds share falls by 15% off its current high, I will buy R10,000
worth of stock.
If ABC Limiteds share breaks the Resistance level twice, I enter the
position if the moving average confirms the buy.
Exit method: Always choose a trailing stop loss and clearly define the sell point. There
must not be an ambiguity to the statement.
Examples:
I will sell my entire position when the share has climbed by more than
30%.
I will sell my entire position if the share falls below the second stop loss.
The exit will always be just under the support of the first hour range.
Examples:
o
If the above happens, many traders decide to stop trading for at least a week, while they re-evaluate
their strategies and trading techniques. In addition, check out and conduct more analysis on the
market and trading conditions and risk management.
Finally, what about you?
If trading is a business, then you have to have a section of the business plan that covers salaries.
Ask yourself: what do you need to cover your expenses? If trading doesnt meet your expectations,
maybe you should review your trading objectives or stay in your current career.
CHAPTER SUMMARY
This chapter stresses that homework has to be done before the real business of trading can
commence. Novice traders need to be prepared to spend time laying down a serious
foundation of knowledge, before they can expect real success and also real returns from
trading.
IN THE NEXT CHAPTER
In Chapter 2, beginners are frightened by jargon, level of work and sheer technical and
fundamental expectations.
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A Story to Offend
I apologise if the following story offends you:
And so it has been said in ancient script that .
.. one day, Odin - chief of all Gods and the ruler of the universe came down to Earth on
his great white steed. He roared over the clouds, bringing thunder and rain to a small South African
town.
The steed swept past vast landscapes filled with flowers and shrubs. He finally came to a standstill
on a quite beach and dismounted, rubbing his one good eye. He surveyed the world he had won
when he had overthrown the primeval giant Ymir and fashioned the world from his remains.
He shook his head: I left my home in Asgard (near Valhalla), where I feasted with the spirits of slain
warriors, to come to this? He said, with sadness. He threw his spear into the soil and again
rubbed his good eyed, having exchanged his other eye for wisdom millennium ago.
If I really had wisdom, he thought, I would have slayed Frey, so-called God of Peace and
Prosperity eons ago. Odin stood tall and thought of Thor, his son and also Gold of Thunder. Now, if
I had combined the God of Prosperity with Thunder, maybe I would be back home in Valhalla.
He waited patiently, knowing that the person he sought would soon be walking his way. The most
beautiful mansion in Asgard, where the heroes slain in battle feasted each night would have to wait
for Odin, for more urgent matters needed his attention.
Trader Jack for that was what Odin would call him came walking rapidly and Odin smiled. That
was what he liked - warriors gathering accurate information.
You. Come here. Odin had never quite understood the meaning of politeness. But it was Trader
Jacks turn to smile. He too didnt know the meaning of politeness.
After a brief introduction, Trader Jack waited no time to answer Odins question.
He said: Odin there is a fundamental contradiction in your setup. Odin listened.
After natural disasters, like the one in Japan in 2011, two things seem to happen almost
simultaneously. The first is that religious zealots immediately claim that its retribution for some
misguided policy, such as Aids in Africa after famine or not been a Christian after floods in India.
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The second is that economists and analysts will claim that natural disasters are good for economies
and companies.
Trader Jack added: If the above is true, then you cannot have a God of BOTH Peace and
Prosperity. Death and destruction thus leads to wealth as rebuilding starts. It is therefore not peace
that results in wealth.
Trader Jack continued . pure destruction results in significant construction (often paid for by world
economies through charities) which, in turn results in jobs being created for the poor. More people
become more wealthy. GDP and GDFI are boosted as labourers spend wages that stimulate all
facets of their economy.
Japan must surely be better off after its earthquake and tsunamis? asked Trader Jack.
Odin looked at Trader Jack: For that matter, then what is the difference between Wealth and
Prosperity?
The truth is that the wealthy can more easily overcome disasters thrown at them by Mother Nature.
Prosperity, on the other hand, is derived from the Latin word for hope and confuses the goals of
attaining prosperity with the means of achieving such targets.
Trader Jack finished by saying: In essence, during peaceful times wealth can be attained, but
money flows stronger during disasters that affect people.
So you dont really care that peace is good to attain? Odin said.
I am a trader. My job is to look for short term market anomalies which will make me wealthy. I know
that if I continue to do this, that over time, I will become prosperous whether there is peace or not.
In the longer term, disasters are obviously not good for world economies, as these divert much
needed funds away from important projects to life saving ones. Those important projects still have to
be done but often at higher costs.
And let Peace be left to the Gods. Odin roared with laughter. You, said Odin, will be my next
God of Wealth.
And with that Odin was gone - back to Thor and Freya, his son and Goddess of Beauty and Love.
If the thought of taking advantage of the weak in society appals you stay out
of the market; if you dont, others will.
Remember, you are competing against other traders. Disasters are resolved by
world politicians, organisations and banks it is not your responsibility.
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The heading for this chapter is Are You Crazy? The full heading should actually be Are You Crazy
To Be Entering This Industry With So Many Unpredictable Variables? One minute you are making
so much money that you are stunned and living the life of a millionaire, the very next minute you are
losing it all, facing the Sheriffs-of-the Court and having repossession orders lodged against you. Yet
another trader will be making trades based on solid fundamentals and lose his or her capital, while a
complete novice (without experience or skill) will pick the right stocks and become instantly wealthy.
Do you really want to be part of such an industry?
Years ago, I started looking at the habits of traders (novice to professionals) and noticed a number
of common threads among their behaviours. In fact, there are surprisingly few threads that should
enable you to become more perceptive before we plough through serious fundamental and technical
analytical theories in later chapters.
The answer is quiet simple: Yes, you have to be a little crazy to be a trader, but it is fun and certainly
beats working for a boss. And, again yes, you can make serous money if you are professional
about trading. There will always be the lucky and inexperienced trader who will make serious money
you can take comfort that they usually lose it all in the end.
Of course, depending on how markets behave, traders perception also change. Trader habits can
be narrowed down to a number of market-linked reactions. Imagine that you could determine how
other traders will react when a set of economic statistics is released. If such data is negative, will
they sell or buy? Knowing such information would enable you to place your securities in a better and
more profitable position before data or environmental events take place..
The key is thus to know what the relationship is between trader and market. The first thread (or
common behaviour) is that of traders who simply react to events without analysis. They sell on
negative news and buy on positive. They wait for the market to react before they take a position.
The norm is that they make little money and often not enough to cover their costs. These are, what I
call, the Market Sheep.
Another common behaviour is that of traders who buy based only on long-term trends, called an
Investor as opposed to A Trader.. They also do not really affect short term traders, other than to
provide a sense where the long term trend is.
I am more interested in the next two types of trader habits. The first is that of the professional trader
who sticks to his or her belief no matter what happens to the market. The second is that of traders
who speculate. In the first, someone who believes that the market will always be in an uptrend
ignores that markets do fall (The Ultra-Bull or Ultra-Bear), while the second is merely following
rumours and innuendo, called The Speculator. the
To take the above habits into account, I have also developed a set of personal habits; as follows:
Never let a trade fall or rise to a point where you start to worry. Remember that Market Sheep
will continue to trade until overall sentiment changes, then you will be on the wrong side of the
trend.
Anxiety, hope or greed should never be part of a trading habit. Ultra-bulls or Ultra-Bears will be
there to take up your sale or buy orders, but waiting too long makes you susceptible to loses.
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Remember, equities will always outperform banks interest rates so, getting into the stock
market is not really crazy. A simple look at the JSE All Share Index over a 10 year period
confirms this.
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There is an stock market saying that the higher the risk, the higher the potential reward. This means
that if you buy a share that is risky in the sense that the company is small, has not made great
profitable strides, then the potential reward if the company does perform well is high. For
instance, some years ago io was analysing the coal-related market and came across a share trading
at one cents. The company had only one contract, had not made profits in years, but it did have
unique technology. Further analysis indicated that this technology was highly sort after in the US. It
does not take a genius to see that the company must, surely, be in discussions with potential
buyers.
I recommended the share as a High Risk - High Gain speculative stock.
As expected, the company soon announced that it had plans to join a foreign partner in developing
new markets. The share rose from one cent to 300 cents in a matter of two weeks.
The alternative is that the company could have continued to perform badly and even be delisted;
shareholders would have lost all their investments. The less risky shares tend to be the bigger
companies, which make up the Indices. These multi-nationals are called Blue Chips and tend to
have strong finances, a long history and are far less risky than small, recently-formed companies.
Such companies are unlikely to go bust, but the safety aspect tends to give you less capital growth
than the higher risk ones.
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35 Essential Rules
Here is a truism: people hate losing money. I am no exception. They will go to the extent that they
will deny having made a loss in the market! They will blame market conditions, or slow and
inefficient computer software before they will stand up and take responsibility for their actions?
Personally, I hate admitting that I am wrong even more than making a trading loss. How do these
relate? Well, if you follow your own set of rules, then you should achieve more profits than losses.
However, if you deviate from your own rules, and make a loss whose fault is it?
If you do ignore your own rules, either change these or admit that you made a mistake and say that
you have learnt from the loss. In this manner, you can move on to becoming a better trader.
The focus of trading is not to never make a loss! That will simply not happen. The goal is actually to
have more profitable than losing trades. With this in mind, the following general rules should provide
you with some helpful hints for you to start building a solid foundation for your trading career.
Remember that a very small percentage of all new traders around the world are successful within
the first year of trading. Yet, some traders do accumulate immense wealth very quickly. What do
these successful traders do that is so different to enable them to benefit from intimidating world
markets? Searching for the answer to this question is what started the process of gathering the raw
material for Six Steps to Trading Like a Pro. Some of the following rules are very basic and obvious,
but many have been used often by millionaire traders. As such, it offers you a basic start to the more
complex rules that are set out in this book.
The following are some of the more important rules that were generated from the many workshops
carried during the past decade.
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Can you focus enough not to drown in the massive amount of market information (often
contradictory) continuously made available on the internet?
Rule 2: Can you afford to lose? There is a rule which suggests that you should never trade with
funds which you need to live on. In other words, dont use money to buy shares if you need that
money for groceries. Then, there is a school of thought which says that people get mortgages to buy
vehicles and homes, so why not do the same to buy shares? After all, if you have a well-defined
trading plan, shouldnt your risk profile be minimal?
The reason that many pundits suggest that you do not use funds needed elsewhere, is that such
funds will affect and influence your trading decisions. Often, the emotional aspect of trading is much
more severe for beginners than for the more skilled trader. When you are staring out, there is a
greater likelihood that emotions will influence trading decisions, compared to the more experienced
trader.
Consequently, trading funds should always be viewed as money you can afford to lose. One of the
keys to reducing emotions in the trading sphere is emotional independence between private wealth
and your trading account.
Rule 3: Personal wealth and trading funds should be separate. Following on the previous rule, a
trader should not be in a position whereby he or she hopes that their trade will be profitable. The
successful trader must always be able to remove personal from trading emotion. When you find that
you are hoping that a purchase will be favourable, usually it isnt.
Rule 4: Preserve your trading capital. Without wishing to sound like a pessimist, there will be
times when you will encounter losses even if you follow the above two rules. The answer is to
ensure that each trade doesnt influence the entire portfolio. this is achieved by having a diversified
and balanced portfolio. these terms are explained in Chapter XXXX.
Rule 5: Dont be a sheep. Successful traders are not influenced by current or fashionable trends.
When everyone concentrates on long positions, they tend to be contrarian and go short. The theory
is that, if 85% of buyers are bullish, then the market is overbought. Conversely, if less than 25% are
bullish, the market is oversold. Only sheep follow. Successful traders use this theory to buy when
everyone else is selling and vice versa.
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Rule 27: Can you judge potential profits before you trade? My personal trading mentor back
some 15 years ago told me to have a plan in place to sell your security even before you enter a
trade. Essentially, it goes like this: if a stock rises by 15%, place on a watch list. If the stock rises by
another 10%, sell enough shares to recoup your original cost. I have added the following to my
mentors strategy: when you recoup your original cost, remove the share from your portfolio. have a
second Free Share portfolio, which you keep for the long term. Have a stop loss of 15%.
Rule 28: Place stops immediately. This is merely a rule to stress the importance of stops. Never
break this rule, under any circumstance as it is the best way to protect your capital.
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CHAPTER SUMMARY
Some of the most important and crucial concepts (stated as rules) in the world of trading
were outlined to provide some ground rules for novice traders. Guidelines outlined in the
chapter covered issues prior to, during and after trades have been placed.
IN THE NEXT CHAPTER
In Chapter 4, the concepts of fundamental and technical analysis the basis for this book
are set out.
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Chapter 4: Forms of
Analysis
It has been my experience that competency in mathematics, both in
numerical manipulations and in understanding its conceptual
foundations, enhances a person's ability to handle the more ambiguous
and qualitative relationships that dominate our day-to-day financial
decision-making.
Alan Greenspan (1926 - )
US economist and former Chairman of the US Federal Reserve
A Day in a Newsroom
THE JSE ALL SHARE INDEX
One day in October 1987, I was sitting in the newsroom of the Business Times, the financial insert of
South Africas most successful weekly newspaper, The Sunday Times. I had been appointed as a
junior financial journalist and the following discussion with one of the senior editors needs to be
repeated; as follows:
Editor: So, what form of analysis do you subscribe to?
JM: Well, Ed, I believe that as a graduate of economics fundamental variables will always rule
the day. Technical signals are visually more agreeable, but I dont really believe that they take all
factors into account.
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Editor: Oh, really? It was his face that really told me how he felt about my comment.
I quickly realised that I had just made a major blunder. Here I was, a junior, telling this senior editor
that I was a graduate (I found out later that he had been trying forever to graduate) of finance and
that I didnt truly believe in a technical analysis. My comment may have come across as knowing
better than him!
I tried to repair the tramped toes: Ed, what do you see as being the major current technical
signals?
Ed: Resistance levels are solid, and shares still have some upward momentum.
The date was the 19th of October 1987 and the JSE All Share Index was at 2804. He had barely
uttered these words when a senior writer entered the newsroom and practically shouted: the market
is crashing!
Within two weeks the JSE All Share Index had fallen by 40% to a level of 1682.
Let me reiterate: I am not advocating any analytical system over another. All systems have merit if
they can help a trader make a decision on what to trade and at what price. There are effectively two
main systems, namely technical analysis that assess share movement and price and fundamental
analysis that assesses the company and the environment within which it operates.
Recently, another form of analysis had started to become more prominent. Sentiment analysis is
used in Six Steps to Trading Like a Pro as the final filter to decision making (See Chapter XXX).
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no specific report has been released, but the anticipation of such a report is so great that
speculators move markets.
One of the most used and spoken about economic indicators is that of supply and demand. This can
be used as an indicator of where price could be headed with the following basic guidelines:
Supply: when there are less buyers than sellers of a share, supply exceeds demand and the
price should fall.
Demand: when there are more buyers than sellers of a share, demand exceeds supply and
the price should rise.
Price: this is influences by quantity of shares in the market and the ability of traders to buy
and sell, i.e. liquidity and tradability.
The single most important fact to remember about fundamental analysis is that it is an assessment
of stock markets (companies) relative to economics. In essence, the stock market is the leading
indicator of economic growth and, therefore, if a country's future economic outlook is good, then
companies should improve todasy, or stated differently the current performance of the stock
market is indicative of future economic growth. This means that the JSE is the leading indicator of
economic growth.
This is one of a number of crucial issues that has to be understood if you want to be a successful
trader. If you dont understand this concept, then every trade you make will be based on incorrect
assumptions. Can you image how successful your trades will be if that is what you ewnd up doing?
From a global perspective, if your countys economy is solid, the more foreign businesses and
investors will invest in your country and stocks will ultimately rise. So, ass the economy gets
improves, interest rates are raised to control growth and inflation, which makes securities more
attractive. In order to get their hands on these assets, traders and investors have to buy which
results in the value of the shares increasing.
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The assumption is that a share will bounce between AB and CD (or EF and GH).
I believe that the real lure of technical analysis is the instant graphic appeal, enabling traders to
easily visualize trends and thus trading opportunities. The important thing is that novice traders
understand technical concepts before they try to implement them. They use weird and wonderful
terms like Fibonacci, Elliot Wave and MACD forms part of the appeal for novice traders
CHAPTER SUMMARY
The way the world works: you have those who believe solely in technical analysis (at the
exclusion of all other variables) and then you get those who believe that fundamental
analysis is the only viable form of share selection. Seldom do you get traders who believe
that both systems can work together. This chapter set out the beginnings of a concept on
fundamental-technical analysis cohabitation.
IN THE NEXT CHAPTER
In Chapter 5, Fundamental analysis concepts are explained in greater detail.
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ECONOMIC GROWTH
There are two basic forms of economics pertinent to traders. The first is called Macro-Economics
and deals with the overall market, while Micro-Economics deals with the company and related
issues. As a trader, the importance of macro-economics is that, the wealthier consumers are within
a political environment, the happier and safer they feel, which in turns leads to more spending.
The more these consumers spend, the more money flows into company coffers and the higher their
projected profits become. Higher profits mean higher share prices and once again happier
investors.
Companies that sell more product tend to expand, which creates higher demand for funds from
shareholders and banks and, not forgetting, higher tax revenue for government. Government in turn
spend more money on infrastructure and so on. A strong economy benefits everyone. Alternatively,
weak economies are usually accompanied by little spending and, ultimately, businesses stagnate,
profits dwindle and investors stop buying shares. The latter is a recipe for a declining trend in share
prices.
CAPITAL FLOWS
In Lore of the Global Trader I set out how easy it is for traders to buy various forms of securities
anywhere in the world and on any exchange. When economists and the media speak about the flow
of funds do they means the amount of shares bought and sold around the world?
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Definition: The flow of funds is the movement of foreign exchange from one country to another and
can be viewed as including loans, loan repayments, bond issues, foreign direct investment and
portfolio investment such as stocks, bonds and derivatives.
So, the more money flows into your countrys stock market, the higher share prices will move.
Traders need to look at Capital Flow Balances.
Capital Flows
Net Balances
Negative Flows
Positive Flows
Influence on Securities
Excess supply of currency
over demand leads to a
weakening of the currency.
This makes imports more
expensive and often devalues
shares.
Excess demand over supply
for that country's currency
causes the currency to
increase in value. Imports get
cheaper and shares often rise
in price.
Traders need to be aware that foreign investors love moving their funds around the world, looking
for:
INTEREST RATES
Simply put, banks borrow funds from the State Lending Bank, often called The Reserve Bank or
Federal Reserve, to enable them to lend money to consumers, such as businesses. The banks lend
this money from Reserve Bank at an interest rate called the Prime Rate. They in turn lend money to
consumers at above the prime rate.
The explanation is simple. If many entrepreneurs need money to expand, the borrow money in
increasing numbers. This money is used to buy goods. Ultimately, too much cash is chasing too few
goods and prices increase. This is inflation.
A higher prime rate is then used as a State tool to reduce inflation; higher interest rates are a
disincentive to borrow and thus less cash is chasing goods, and the cycle of falling inflation is
resumed.
Examples of Global State Banks:
Australia Reserve Bank of Australia (RBA)
Canada Bank of Canada (BOC)
European Union European Central Bank (ECB)
Japan Bank of Japan (BOJ)
South African Reserve Bank (SARB)
Switzerland Swiss National Bank (SNB)
United Kingdom Bank of England (BOE)
United States Federal Reserve (Fed)
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The importance for traders of the State keeping inflation at reasonable levels, is the fact that
companies need to grow with minimal influences on their profits.
Take note: the higher interest rates are, the worse the effect is on profitability. For instance, if
Company A has a net debt level of R100 million and interest rates are at 10%, the company will
have (simplistically calculated) a debt repayment of R10 million. If interest rates rise to 12%, then his
debt repayment rises to R12 million.
Without a comparable rise in earnings, the companys profits fall, which is usually met with a
declining share price.
The reverse is also true. When interest rates are falling, businesses tend to borrow more, pushing
up retail and capital spending, thus earnings rise.
MONETARY POLICY
In well run countries, fiscal and monitory policies are designed and implemented by national
governments and corresponding central banking authorities to achieve desired economic objectives.
Monetary Policy: This is the process and established policies a State and Central Bank of a
country uses to control the supply of money to the public through the determination of a rate
to achieve a set of objectives relating to growth and stability of the economy.
Fiscal Policy: This is the States strategies and implementation policies and decisions
relating to how, on what and how much money is spent and collected (tax) and the balance
between to achieving high employment rates and controlled inflationary economy.
Knowing that inflation targets exist will help traders to better plan their entry and exit strategies.
CONSENSUS FORECASTS
A consensus forecast is sometimes just called a consensus. This is a general agreement by a group
of experts, whether analysts or economists, as to upcoming economic or corporate events or media
releases.
Economic forecasts are usually made by leading economists from banks and financial
institutions. The norm is for the financial media to pool these experts forecasts and then
comment on the results.
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Corporate Forecasts: This is the pooling of analysts expectation of listed companies financial
results. However, with new legislation in South Africa relating to corporate governance and
insider trading, it has become difficult to find such consensus corporate forecasts. It is thus
recommended that traders find specific website that offer such services.
In essence, the benefit of these consensuses, is that it removes inaccuracies in the ultimate release
of information via novice traders simply following the pooled advice. For instance, assume that
Company As consensus profit is expected to be down by 30%. When the consensus hits the media,
the share is bound to fall on such negative news. Assume that your analysis shows that profits will
fall by only 2%.
What does that mean to the astute trader?
Large degrees of consensus inaccuracies lead to a reversal of the major stock movement caused (in
the first place) by the consensus.so, in the above example, astute traders would buy the stock as it
fell, wait for the bounce and then sell.
Without doubt, a lot can happen before a report is released, so it is always prudent to keep vigilant
as market sentiment can quickly change just before a release. The essence is that pooled
expectations can be wrong so the answer is not to invest all your funds on someone elses
forecasts.
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As the company undertakes its restructuring, expenses and possible problems are incurred. In
addition, a major restructuring most often takes more than 12 months to complete, which means that
investor interest diminishes, as the company often does not meet financial expectations. During this
phase investors should buy the share as it declines. The next step is for the company to consolidate
its restructuring and the financial start to benefit from the restructuring, which filters down to
earnings per share. The share rises as shareholders and other investors scramble for more shares.
It is then time to sell.
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CHAPTER SUMMARY
Crucial economic concepts were briefly outlined. The focus of the chapter was to get novice
traders to understand that wider macro-economic conditions have major influences on
markets and all related businesses. If you are serious about trading as a business, these
concepts must become part of your daily routine.
IN THE NEXT CHAPTER
In Chapter 6, the basis for using technical analysis is explained.
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So, when Company As RSI hits the Oversold Position, the share rises, but when it hits the
Overbought Position, it falls.
It would be wonderful if that always happened. Yet, the information is useful, but would be more so if
could help the trader to answer these questions:
If used independently of fundamental analysis, most technical studies simply dont reveal pertinent
and crucial trading information, such as length of a trend and a definable price target.
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Therefore, while fundamental analysis highlights crucial corporate trends and technical
analysis identifies trend patterns, investor sentiment holds the key to whether prices will
actually move.
This book adopts the stance that fundamental and technical analysis are mutually inclusive. In fact,
they these two systems can be used in reverse. Traders can use technical analysis to identify
securities with potential positive trends and then use fundamental analysis to filter out those that do
not meet your predetermined strategies. If more traders used both systems to determine what and
when to buy or sell securities, many would be more successful.
Basic fundamental analytical concepts were covered in the previous chapter. Now, lets do the same
for technicals, which can be applied as follows:
Tools:
A filter tool to identify potential investments.
A timing tool to determine more accurate tune entry and exit points.
Questions:
When did this trend last change?
What are the major support and resistance levels?
Where is the stock positioned relative to these major support and resistance levels?
Could the overall market assist or hinder specific stock trends?
Have there been any important reversal patterns?
Where is the price relative to its moving averages?
Is the stock in a strong sector relative to the market?
Are momentum indicators positive or negative and do they confirm the stocks current
movement?
Has there been strong volume activity?
Did such activity coincide with a likely trend change or help confirm an area of support or
resistance?
By answering the above questions, traders will eliminate securities that are weak, so that they can
concentrate on those that offer potential.
Political events: Any political event can move markets. News that former president Mandela
was ill in 1995 created havoc in South Africa, while Irans declaration that they had intensified
their nuclear program fuelled the fall of the US$ in 2007.
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Economic data: Some of the most sort after economic reports include employment data, GDP
reports, manufacturing surveys and major budget speeches.
Natural disasters: disaster that are perceived to influence production supply can move markets
contrary to any technical forecast.
Terrorism: Any act of terrorism can affect securities, in unpredictable ways. Notably, the US
Towers attack in 2001 and the London train bombing in 2005.
War: Any conflict can affect securities, especially if deemed to negatively influence supplies,
such as the Northern African conflicts in 2011; disruptions of oil production saw oil prices rocket
to above US$120/bl.
CHAPTER SUMMARY
The aim of the chapter was to warn that, while technical analysis does form a major part of
trading, it is also dangerous to use signals without sound and in-depth understanding of
implications of using such triggers in isolation.
IN THE NEXT CHAPTER
In Chapter 7, the previous two chapters are summarised by showing you how to combine
both the concept of technical and fundamental analysis to gain better and improved
understanding of markets and what makes (and how) them move.
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In the old days, technical analysis was called Charting, which is actually a better name as the Trader
doesnt really have to do anything technical as it is simply a method of determining if a stock or the
overall market is worth buying or selling. I understand the argument that some indicators are
technical and seriously complex, but it doesnt have to be.
Charts or graphs can certainly signify patterns and trends and they can even highlight strengths and
weaknesses in specific securities or markets, but the problem is that it doesnt always work.
Technical proponents counter the argument by saying that fundamental analysis also doesnt always
work either. That is a fair statement to make. So, technical analysis does give us a clear picture of
past performance and all its related trends. Simultaneously, fundamental analysis gives us deeper
understanding of the variables that will ultimately influence price.
At this point, It is important to note that fundamental analysis and technical analysis can give traders
different results. For example, a stock may have a strong technical signal, indicating an overvalued
situation, while the fundamentals are screaming that the share is undervalued. When both
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fundamentals and technicals line up, investors can buy with confidence, but my contention is that
when they do not line up, the combination of the two systems provides the trader with awareness of
the risks in investing in such stocks.
Depending on the exchange that you are using to trade this number will differ, but as a rule of
thumb only trade stocks that have a volume of more than 400,000 shares per day.
Keep the Overall Index on your screen to keep a watch on the broader market or industry.
Determine the strength of that power: Assess how much power is behind a trend
o MACD
o Stochastic
o Volume
If the stock passes all these tests, we have a possible security for purchase.
Trends: This is the easiest technical indicator and is a line drawn on a share graph that touches
meets at least three points. If prices are generally rising, then the general trend is up.
Support and Resistance: If you draw two lines on a graph, the first touching thee points at the
bottom of the graph and the second touching three points at the top of the graph you end up
with an upper and lower price levels that shows the trader where buyers (lower line) come into
the market and where sellers (upper line) exit the market.
Moving Averages: Also called simply price averages, these are average prices over a defined
period of time. The norm is to use two averages in a graph, such as 50 days and 200 days
(longer term averages) or nine and 21 days (shorter term averages). They help us determine if a
trend is turning as prices move above or below the averages.
Volume and Momentum: These two indicators confirm the health of a trend and identify if the
days when prices rise outnumber the days when prices fall (momentum). If either volume or
momentum starts to decline, traders can surmise that the trend is weakening.
Relative Performance: This is used to identify whether a stock is stronger than another stock.
The Relative performance chart is drawn by dividing the price of a stock by a relevant market
index or another company. If the ratio is going up, then the stock is outperforming the market or
company. The alternative is if the ratio is going down, then stock is weakening relative to its
competitor or market.
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Rules
Rules to Success
Take Cognisance
Plan everything
Buy Value
Diversify according to skill.
o Start with equities
o Move to Futures
o Start an Intra-day portfolio
Understand volatility
Carefully select our sources of information
The above applies to local markets, then regional exchanges and
finally global bourses
Three Crucial
Questions
Trading Plan vs
Business Plan
My recommendation is not to rely on just one method of analysis. Use them all in a balanced and
logical strategy.
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CHAPTER SUMMARY
The essence of the debate between pro-fundamentalists and pro-technical analysts is set out
and discussed. In addition, a basic set of recommendations is laid out for novice traders and
the question have you made up your mind which is best? was asked. Think carefully
about the question before you answer it, because your answer will directly tell you what your
biases trading is.
IN THE NEXT CHAPTER
In Chapter 8, the first step in the Six Step conversion process for novice traders to
professional status is started.
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AIM OF STEP 1:
TO ESTABLISH YOUR VARIOUS PORTFOLIOS BEFORE YOU
START TO TRADE
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Over the past 30 years, research techniques and portfolio management systems have changed
drastically. If traders are to survive in a globalised and electronic world, it is important to understand
the influence of globalisation on portfolios and also a few basic concepts from the past.
Six Steps to Trading Like a Pro is not as book on the many facets of globalisation, but certain
pertinent factors were uncovered during my research for Lore of the Global Trader.
A quick note on some key globalisation points influencing traders:
Capitalism is the greatest wealth-creating mechanism ever devised and markets with stock
markets tend to adopt a free-market stance to economics.
As entrepreneurs and traders go about serving their own interests, the value of the world's
economy increases.
The markets, which are an integral part of capitalism, rise to reflect the increase in the world's
economy.
Markets offer all investors and traders the best opportunity to participate in the growth of the
global economy.
Risk should not be avoided, because it offers an investor the opportunity for higher returns.
Most investors and traders cannot expect to meet their reasonable goals without accepting some
level of market risk.
The impact of market timing and individual security selection pale by comparison to asset
allocation and strategy.
The greatest share of the investment process should be devoted to the asset allocation decision
(see Chapter 9).
Asset allocation between shares, gilts, cash and derivatives allow investors and traders to tailor
portfolios to meet their risk tolerance.
MPT offers investors and traders the chance to obtain efficient portfolios that maximise their
returns for each level of risk they might be able to bear.
Investors must accept and expect reasonably regular market declines, which are natural. At
worst, downturns have negligible affected long-term investors; at best they may represent buying
opportunities.
It is vital traders maintain a long-term perspective and exercise discipline with every trade they
make.
Markets are efficient and attempts to time the market have not been effective or reliable methods
of enhancing returns or reducing risk.
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Active management cannot demonstrate sufficient value added to offset their increased costs.
The world economy is expanding, but the world's stock markets will continue to be an efficient
mechanism to capture this growth in securities value.
Cost is a major controllable variable in investment management. Low cost is strongly correlated
to higher investment returns. Management fees, transaction costs and taxes all serve to reduce
investor return. Costs must be rigidly controlled.
Lesson 1 - The economists staple phase: traders operate in a world that is continually changing
and traders must accept that few variables are under their control of they are to succeed.
Economists often precede forecasts with all things being equal, which means their forecasts are
based on variables not changing in the near future. Traders have to adopt the opposite stance using
a phrase like having taken numerous possible risks into account etc. Changing variables does not
mean we cannot build a sound, long-term strategy.
In essence, a sound strategy is one that attempts to maximise returns for the risks investors are
willing to take. Over time, learn from mistakes and systematically whittle down risks and costs of
being wrong. When you start a portfolio, you will be "wrong" a great deal of the time.
Lesson 2 - Equities have provided sound investments around the globe: In South Africa,
investors and traders can today invest directly in foreign shares. Yet many traders have not changed
the Asset Allocation to a Strategic Global Asset Allocation." This is a long-term strategy in which
traders divide their available wealth among the world's desirable asset classes.
The first task is to decide on which assets to include or exclude.
The last 20 years have been good to equities globally, but political risk has played a major role in
converting many traders into speculators. During this period, there was low inflation, high inflation,
booms, recessions and depressions, high and low interest rates. Currencies around the world were
weak, then strong and stock markets around the world boomed and crashed several times during
the last two decades. In short, traders had plenty to worry about when going through those times,
but also plenty of opportunities to trade securities.
The past 20 years has seen portfolios change and todays investment structures are designed with
the leading edge of financial research. However, variables change and the trader should continually
assess new and possibly better investment and portfolio tactics. As new tools are developed, these
will usually first be available to large institutions and investment advisors, but it is only a matter of
time before these tools are available at local retailers.
One means of keeping up to date with latest analytical tools is to ask investment advisors about their
computer programmes. Often the speed at which these filter down to the retail level is purely a
function of demand. The Internet can help in providing such advice. In particular, look for academic
research from the economics and finance departments of the major universities that now maintain
sites on the Web.
Lesson 3 - Beware of numbers: Over the past two decades, investors have been conditioned to
think of market timing, stock selection and portfolio performance as the fundamental keys to
success. These beliefs are deeply ingrained in South Africa, so even superior investment strategies
like Strategic Global Asset Allocation will take some time to get used to.
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In fact, some analysts consider the global arena too risky and unknown for South Africans. However,
globalisation necessitates a radical change in the way portfolio managers and traders operate. For
instance, investment advisors are expected to have an opinion on where the market is going and,
therefore, investors and traders look to these experts for advice. The problem is that the market is
saturated with financial experts.
Through the media, investors are exposed daily to countless different opinions about the market,
trends and recommendations. They tell investors to retreat to the "safety" of cash, which allows
these experts to look responsible, conservative and even caring. In addition, often the first question
people will ask is: "What was your performance last year?" Those numbers become the chief
yardstick to determine whether the advisor is good or bad. Very seldom will the trader ask: "What's
the best trading allocation?" or, "How much risk do I need to take to meet my goals?"
In a global market, traders can diversify between countries and not only sectors. The following
example highlights the problem of using growth rates as the chief yardstick:
Mr M. Brown has R1 million invested in a newly listed company on the JSE, called Zextra
Electronic Ltd. At a price of R1 a share, Brown owns one million shares in Zextra. In the first year
of operation, the company landed a multi-billion rand contract with neighbouring states to set up
satellite stations. By the end of the first year, the companys share has moved to R2.20 a share
and Brown has achieved a return of 120% on his investment.
Mrs. J. Dawson had R1 million invested in the Far East and shifted her funds to First World
markets just before the 1997 stock market crash. Her portfolio looks exceptionally bright,
showing a 40% return on a share that climbed from R100 a share to R140 a share.
Both shares show phenomenal returns. Yet both sets of figures distort the true nature of the return
on these investments. Browns investment return is off a low base and the longer he holds the share
the worse his investment return (in percentage terms) will become. For instance, if the share rises
by another 120 cents in the next year, the share will have climbed to R3.40, which is an increase of
54%. Another 120 cents in year three will mean a share price of R4.60, which is an increase of 35%.
To use percentage increases as a yardstick brings its own problems.
That is, off a low base the company has to continually increase earnings to achieve the same rate of
capital return. This is an impossible task in the short term, but if the investor had bought the share
for the long term then he could see the share rise to R6, which means he would have achieved a
500% rate of return.
Dawsons investment is off a high base and a 40% return is substantial. However, she will be hard
pressed to find another investment that will offer a 40% return in the next year. If the investor is told
by a portfolio manager that a companys attributable profit has climbed by 30%, the investor must
insist on the base that this percentage is made.
For instance, if the company had a profit of R1 million in Y1 and R1.3 million in Y2, this is very
different to a company that has a 30% growth rate of a base of R1 billion in Y1. If the number is in
the low figures (thousands or low millions) then it can be said the company achieved a 30% growth
off a low base of R1 million. If the amount is in the high millions or in billions then it can be said that
the company achieved a 30% growth off a high base of R1 billion.
Comment: It is more prudent to concentrate on a portfolios long-term potential than on short-term
gains. This does not mean traders should miss out on market aberrations. Remember that traders
need to have long-term wealth as well as short term profits.
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Without tools to evaluate risk or choose between alternative strategies, investors often feel they are
left with just one number to compare performance; year-to-date or last year's performance figures
are the only criteria for measurement. If investors believe those figures alone determined a
successful investment plan, they should buy the previous years top-performing unit trust and ignore
market signals.
Unfortunately, this approach is often the worst way to form a strategy.
Lesson 4 - Change is the only constant: Building a successful investment plan to meet
globalisation head on will require a fundamental change in the way traders think about strategy and
performance objectives. The word strategy implies a conscious effort to achieve stated goals. Their
concern should be to at least meet their minimum acceptable return levels without taking excessive
risk.
The way an asset-allocation is designed will determine returns for short and long-term periods. In
addition, risk and returns will be driven more by the investors asset allocation than by individual
share selection or market timing. Any asset class can and will have extended periods of significant
under-performance from its long-term trend. Similarly, there will be periods when the portfolio will
outperform the market trend. Of course, investors can play it safe and stay with mutual funds or unit
trusts, or they can have some risky assets in their portfolios. Why have risk related shares?
Lesson 5 - Risk can be your friend: The reason is this: When risk is measured at the portfolio
level, a risky asset with a low correlation to other assets in the portfolio can actually reduce risk in
the portfolio. A diversified portfolio offers much higher returns per unit of risk than does a single blue
chip share.
Over the long term, investment markets and portions of markets generally sort themselves out. In
the short term, it is not unusual to see a negative sloping, risk-reward line, i.e. the market fell and
shares under-performed relative to the bond market. The trader with a long term return objective
must know that down (and up) swings exist, but these are always temporary and have little impact
on the way to meeting his or her goals.
Statistically, small stocks have a higher return and risk than second liners or blue chips. For reasons
mentioned above, it is never safe to talk about a companys performance in terms of percentage
rates. In the international arena, even size of companies become relative. For instance, Anglo
American Corporation is considered one of our largest blue chips with a market capitalisation of
nearly R450 billion. Yet, compared to some overseas companies Anglo looks like a beginner. For
instance, US based company General Electric has a market capitalisation of US$210 billion, which
is worth R1.5 trillion (May 2011 exchange rate: US$1 = R7).
In addition, emerging nation stocks have a high return profile, but also high risk. These are primarily
large growth areas, but they also fall considerably below the large first world blue chip stocks when
a crisis hits emerging markets. This was amply highlighted during the 1997 Stock Market Crash.
Comment: What is important is how much risk the portfolio has and that it is reasonably
conservative. In addition, this book is about strategy, which also implies a long-term approach. Even
the "best" long-term strategy will not be the best each year and since we are dealing with securities
and associated risk profiles, it is important to understand that even the "best" strategy does not
provide investors with a guarantee against occasional negative periods.
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Lesson 6 - The market will decline at some point: Investors often refer to risk as the chance of
the market falling. There is no doubt that no-one likes to see their securities fail, but if they are
quality securities, losses should ultimately turn into gains. It must be stressed that traders do not
have to wait for the market to turn before gains are achieved.
A solid traders portfolio should include hedging positions.
Traders also seem to have any number of mental yardsticks that they employ relentlessly either
against themselves or their financial advisors during periods of under-performance. Traders not only
want to outperform their countrys main stock index, but they want to do that every day.
Here is a truism not even a superior portfolio will outperform the index every day.
In other words, reality will rears its ugly head just when you think the bull run will continue. The last
30 year period has been characterised by falling interest rates, falling inflation and superior stock
markets, but during this period there were also serious market crashes.
No one should base their planning on high annual returns every year. As a rule of thumb, traders
should expect long-term results of about eight to 10% above the inflation rate. If you do better,
celebrate! Just do not base your whole strategy on attaining returns that are so much higher than
normal.
Lesson 7 - Trust in your long term strategy and ignore the Overall Index: Traders often have
one more mental yardstick for comparison. The temptation to second guess yourself or your strategy
is enormous. Investors are, after all, quite human, and they believe, quite reasonably, that they
should have it all.
For instance, often they want to "beat the Overall Index." We have gone to a great deal of trouble to
build a portfolio that is better (in the long term) than the Overall Index, which tends to have a
relatively low return per year. For instance, if you take all the performance of all the sectors of the
JSE and look at the annual performance of each sector relative to each other, you will find another
obvious lesson. The Overall Index usually lies somewhere in the middle, i.e. it is the average of all
the sectors, which means the negative and positive growth rates of the sectors.
If 10 sectors moved up by 20% and five fell by 12%, what would the Overall Index growth rate be?
Assuming all the sectors had the same weighting, then the Overall Index growth would be 9.3%,
which lies midway between the 10 stock that moved up and the five that declined.
An investors strategy is to seek out asset classes that have a higher rate of return and very low
correlation with domestic large company growth stocks. It therefore stands to reason that this type of
portfolio should not track the Overall Index. There will be times that the Index will outperform even a
superior portfolio.
Comment: Unless traders and investors can focus on their own goals, risk tolerance and strategy,
performance becomes an impossible moving target. Investors must understand that a superior
portfolio will under-perform from time to time, no matter what mental yardstick they are using.
Lesson 8 - Tailor make your portfolio: Investors who desire higher risks and rewards can reduce
the proportion of shares in their portfolio in lieu of Futures. Traders can also shift the asset allocation
to more value and small company stocks and, secondly, include emerging market stocks in their
portfolio.
Lesson 9 Survival lessons to remain sane: These lessons are described as follows:
Do not do totally insane things with your money. The Orange County disaster of the early
2000s was the perfect example. Part of the portfolio was a derivative investment that
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underpinned how investors can make irrational decisions. The portfolio manager had offered a
bond to investors that paid interest at a rate that was determined by a formula: 10.85% less the
sum of the German mark, Swedish krona and Italian lira swap rate plus the British pound and
Swiss franc. In other words, the interest was divided by a factor of five and traders ended up with
valueless portfolios.
Never borrow short and lend long. In fact, you should not borrow to make investments.
Borrowing multiplies your risk. If you borrow R1,000 to buy R2,000 worth of stock, then you will
double your original money (minus interest charges) if the stock rises 50%. However, you will
lose your entire stake if the stock falls by 50%.
Never have a preconceived scenario and fall in love with it. Never have an absolutely
unshakeable belief that economic variable will move your way, that interest rates would continue
to fall and that shares will always be positive or negative.
Never implement a strategy without an exit window. When providing a portfolio manager with
an order to buy or sell shares, make sure there is a stop-loss technique, i.e. always set a definite
price for a sell order.
Do not buy anything you don't understand. If you do not understand Future, Commodity
trading, Options, Derivatives or gilts stay out!
Don't judge an investment simply by its track record. Some companies produce spectacular
returns in the first two years of operation, but run into problems later on. The key for an investor
is not merely to look at what has been done in the past, but to understand why the company has
been so successful.
In the market, no good thing lasts forever. This has been said many times, if you touch hot
investments, you'll get burned.
Knowing which stocks to buy and when to be in the market is the key to investment
success.
A good investor can predict which way the market is going and which stocks will profit the
most.
These stockbrokers will readily share their power with you for a nominal cost.
This minor cost will be repaid many times over by enhanced performance.
However, one must always avoid the charlatans who give false advice. A wise man is
one whose stocks go up, and a charlatan is one whose stocks go down.
Knowing when the market will fall is a prime concern to the successful investor.
One should leave the market when it is about to go down in order to preserve ones
principal investment, i.e. the capital amount.
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Successful investors trade often and dart in and out of the market or a particular stock
with uncanny skill.
An astute investor can apply superior insight to make big killings on mispriced stocks.
Using his superior insight he will be able to take action long before other investors catch
on.
Studying past price movements is an aid to predicting future price movements. This skill
can be applied to both individual stocks and the movement of the market as a whole.
Economic predictions are reliable and form another strong foundation for success. It is
reasonably easy to select good advisors and managers, because their past track record
is a reliable indicator of future success and skill.
Given all that, many traders tend to think of the investment process in the following terms:
Which manager should I hire? Or, what mutual fund should I buy?
Unfortunately, almost all of this conventional wisdom is wrong. It does not do us any good to think of
trading in these terms. In fact, it creates problems and keeps us from enjoying the fruits of a game
strongly tilted in our favour.
Remember that it is important to consider the merits of the investor's obsession with individual stock
selection and market timing. Just how much do these two elements of the investment process
contribute to overall success or failure? Is there a better way to think about investing?
CHAPTER SUMMARY
Important lessons from the past provide a direct link to establishing the three portfolios of
billionaire traders.
IN THE NEXT CHAPTER
In Chapter 9, Step 1 is finalised.
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Diversifying across sectors does make sense as it reduces risk, but there are different ways of
diversifying, and different for each portfolio type. The following common portfolio types: aggressive,
defensive, income, speculative and hybrid are important to understand before we can develop more
personal ones.
The following is thus split into three:
The first section briefly looks at five common forms of portfolios to gain a better understanding of
each type.
The second part looks at the three types of asset allocations for traders, namely Conservative,
Moderate and Aggressive asset allocations.
The third looks at how to combine the above to form the Three Portfolios of Billionaire Traders
Aggressive Portfolios
Such portfolios include highly geared and riskier securities, such as Futures, Commodities and
Forex. The ability of traders to deal solely in such markets means that they have few trades and
positions at any one time, as these have a high sensitivity to the overall market and are often highly
correlated to global markets.
These factors make such trading highly stressful as any minor movement in overall markets tend to
move geared instruments in an unpredictable manner. Consequently, these securities are more
volatile and have larger fluctuations relative to overall market indices or the equities market.
A trader who wants to build an aggressive portfolio needs to look at companies with expensive (high
p/e ratios), high earnings and accelerating share prices. In South Africa, these tend to be the
technology, banking, cellular markets and mining exploration.
Traders secret:
Tight risk management to minimise losses
Take regular profit
Speculative Portfolio
A speculative portfolio is one where the trader buys stocks that he or she believes could make it big
quickly and mostly without analysis. As such, this form of portfolio has more risk than those
discussed above.
Higher risk is not necessary a bad thing, but it must be managed and the recommendation is that,
at most, 10% of the portfolio should be in higher risk shares. These type of purchases include AltX
companies in South Africa and AIM listed companies in the UK. In addition, traders tend to look at
companies that have little in the form of assets like Technology companies and those in sectors
that could be taken over in merges and acquisitions.
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This type of approach offers diversification benefits across multiple asset classes. Traders need to
ensure that these securities have a negative correlation to each other.
Comment
Traders must always be open to gaining knowledge on different forms of portfolio or a
combination of them.
Aggressive shares: Capital appreciation funds, Venture Capital shares, emerging market
shares, Specific global funds and shares.
Conservative shares: Growth and income unit trusts, blue chip shares (first world countries)
and conservative growth funds.
Hybrids: Balanced funds, asset allocation funds, high yield gilts, equity income funds, global
gilts and emerging country debt funds.
Cash: Money market funds, liquid savings accounts (cash in the bank) and short-term
convertible debentures.
The following portfolios are for Conservative, Moderate and Aggressive investors:
Types of securities
(figures in %)
Conservative shares
Fixed Income securities
Aggressive shares
Cash
Hybrids
TOTAL
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Types of securities
(figures in %)
Conservative
Fixed Income securities
Aggressive stocks
Cash
Hybrids
TOTAL
Types of securities
(figures in %)
Conservative
Fixed Income securities
Aggressive stocks
Cash
Hybrids
TOTAL
Comment:
The longer the portfolio time horizon, the less cash-type securities are in portfolios of any kind.
Even the most conservative investor holds very little cash, but he or she does hold a large
portion of funds in fixed income securities.
The shorter the time span, the higher the risk of investing. Therefore, even the aggressive
investor, who is seeking to maximise profits as quickly as possible, holds conservative shares
and fixed income securities.
The trader or investor must keep a long-term goal firmly in mind while having the flexibility to
evolve as new research provides better solutions to the risk management problem or new
market opportunities present themselves.
Discipline remains the key to success for long-term investors, i.e. falling into a panic trap of
selling during bear markets or buying during strong bull markets.
A successful investment strategy involves patience, discipline and periodic reviews that must be
viewed as an opportunity for fine tuning and occasional modest course corrections, not radical
revision and second guessing.
Nearly all novice traders who come to me to join my share mentoring program want to make instant
wealth. This is not a very solid foundation to build your long term wealth. In the same breath, many
say that they want to learn to trade because I believe I can change careers and retire on more
wealth than my current pension.
Then they say that they dont want to save for their retirement from trading or, stated differently,.
They have no Trading Pension Plan.
How can you build wealth and financial independence without first having sound foundational
principles to build upon. I have found that many people simply havent thought about their trading
plans in a logical or thoroughly enough.
There are steps you can take to make sure that you are maximising your wealth, while
simultaneously protecting profits. Without a logical or disciplined approach, novice traders you
simply destined to experience elation at making profits, then panic as they lose those earlier gained
profits. This is cycle that has to be broken if you want to build a foundation of wealth for your future.
The irony is that even skilled traders think that all gains are theirs to spend; what about costs of
trading, living expenses or retirement funds? The answer is that such traders and investors start to
lose their future earning power and end up with no long-term wealth. As such, certainly no
foundation on which to build even more wealth.
Take the following true example:
Ken Smith came to me some seven years ago. His contention was that he could successfully
trade the Single Stocks Futures with a few well-placed technical indicators.
His aim: To turn his R2 million into R20 million within three years.
My recommendation: It would be easier to make his target by gambling at the casino.
The Result: He decided to go it alone and within three weeks had panicked and lost all his
capital in three quick trades.
More to come .
So, before you can start, have a plan, think about wealth and how much you really want to spend
time in building that wealth.
Once you have created a basic trading plan to achieve long-term wealth, start by taking a step back:
think about a retirement free of financial stress. One in which you can enjoy life in a relaxed manner
due to the income streams you have created through a disciplined and long term approach.
The first portfolio is, admittedly boring and not the excitement many novice traders expect when they
start out in stockbroking. This is the basic equity portfolio, which enables you to invest your funds in
longer term shares, but it does give you a number of very important benefits over other portfolios:
You own the stock, so there is no close out or geared effect over the growth of the share.
A long-term benefit is that you have time to build wealth through compounding.
The time also gives you the building blocks to learn more complex risk management techniques
required when you move to the second phase of portfolio management.
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Any emotion related emotion is removed if you have well thought out strategies to buy and sell
shares; as set out in the Six Steps outlined in this book.
Recommendation:
You should have a maximum of 12 shares in your portfolio.
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be less volatile than the market. Conversely, a beta that is greater than 1 indicates that the security's
price will be more volatile than the market.
For example, a Beta of 1.25 indicates that a security will be 25% more volatile than the overall
market.
So, here is the aim: you have 20% of your funds available to buy Geared instruments. This is what is
recommended that you do:
Back to Ken: after selecting four Futures positions, one went wrong and, before he started to panic
he realised that the one loosing position had not influenced his whole portfolio.
For example:
If Kens portfolio had been 100% Futures (as he had done when he first came to me) he would have
lost 25% of his wealth, which is R500,000 (25% of R2million). Instead, he lost 25% of the 20% of his
entire wealth. Remember that 80% was invested in Portfolio 1.
In essence, Ken lost R100,000 and that represents only 5% of his entire initial investment wealth of
R2 million.
Conclusion:
No Panic.
This means that ken can go away and assess what he did wrong, check his traders journal and
ensure that strategies are in place to avoid similar mistakes in future.
Remember that the 80% - 20% ratio should be maintained. So, profits from shorter term trades
should be used to increase the value of Portfolio 1.
of Wealth and a higher risk trading portfolio to expedite growth by trading market anomalies and
opportunities.
So, why do you need a day traders portfolio?
Day trading is actually simple to do if traders have effectively set up the first two portfolios and are
making money. The recommendations is that you cannot move to Portfolio 3 until you have made
between 20% and 30% combined growth in your wealth.
When you have done so, take enough cash to in invest in a separate account to trade the highly
volatile foreign exchange and physical commodity markets. The aim of this portfolio is to take
advantage of global markets. Some professionals include futures related commodities, like platinum,
gold and uranium markets.
A risk approach is to ensure that you always trade for short periods and always close all positions
overnight.
CHAPTER SUMMARY
The essence of portfolio strategy is laid out and important concepts are briefly mentioned.
These are directly pertinent to establishing a solid foundation for your trading ideals; know
them well and it is recommended that you do further research on each topic to broaden your
knowledge base.
IN THE NEXT CHAPTER
In Chapter 10, Step 2 of the Six Steps is explained in a top-down approach.
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A Time To Forget
There I was standing in front of the entire stockbroking firms elite. The directors were there and so
were portfolio managers, traders, arbitragers, corporate finance and commodity and bond traders. In
fact, I lost count at 30 members of this particular very large stockbroking firm.
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It was the morning meeting and it was my turn to stand up and tell everybody what I thought they
should be investing and trading in. This was my first morning meeting and a test of endurance, but
also an opportunity to make an early impression as an industrial analyst.
The boardroom was large, extremely ornate in dark wood and black leather. It is easy to get
intimidated when you are young. I had my list of shares to recommend to the crowd now starting to
crowd me in. I stood up, said a quick morning everyone and introduced myself. I started with a
market overview, a detailed analysis of companies results released the day before I had been up
until 2:00 in the morning preparing for that meeting.
I had only 15 minutes allocated to me, but I did manage to get through the detailed analysis clearly
and to the point. There were a few questions, then a silence seemed to fill the room. I supposed it
could have freaked me out, but thankfully didnt.
Then a trader lifted his hand and asked the question that boiled all the research down to a single
bullet point: What do you expect the price to do today?
There was no interest in the analysis, or how the stock related to its peers or the overall market. It
was a simple question, but one that highlighted that this was a money game, not an analytical one.
Who cares if you spent two weeks in in-depth analysis or that your computer model was so complex
and sophisticated that you had to have it trademarked.
The only interest was what would the company do today?
My allocated time was over and the next analyst stood up and started to outline mining results.
top-down logic, which essentially means scanning the global economic and market arena, honing
that down to the region and then the country in which you wish to trade. This macro-economic
search is then filtered down to micro-economic conditions, which includes company analysis.
Macro-economic: involves analysis of the whole economy and includes total amount of goods
and services produced, income earned, level of employment of productive resources and
general behaviour of prices.
The variables you select to enable you to ultimately filter down hundreds of companies to a
reasonable few, is entirely subjective and, admittedly, no single approach, is wrong or right.
There are traders who will only buy JSE Top-40 stocks, or mining shares or higher risk so-called
penny stocks. That is their filter. What I am proposing is a filter to enable you to choose shares from
the entire spectrum of companies listed on any stock exchange.
Finding interesting patterns is equivalent to finding landmarks in the price action. For some, an
interesting pattern may be a peak or a valley in the prices. For others it may be the shape of a set of
candles. Non-traditional charts can facilitate this process. Once selection of the trading instrument
has occurred, determining entry and exit points are logical next steps. The resulting trade can be a
win, a loss, or a break-even. At any period of time, the trader needs to be able to assess the total
performance and identify strengths and weaknesses that occurred.
Note that this chapter ignores risk issues and variables that influence specific ideologies. The
following proposed filter is aimed at reducing the vast number of investment and trading potential to
a select few. It is my recommendation that traders use the following filter to hone down to those few
stocks and then to implement their personal filters.
Aim of filters: to reduce the emotive element of choosing companies.
A filter is a cold factual tool that ignores the host of conflicting forecasts, bullish fever and bearish
panic. In addition, many professional traders say that developing and implementing a filter is equal
to having a plan, which is better than novice traders who simply throw themselves into the market
armed with a few well chosen technical indicators.
Therefore, traders are not asked or advised to ignore events that take place in the market, such as
strike action hampering share prices or natural disasters influencing corporate action. It is suggested
that a filter incorporate such events as an additional plan and not be the sole means of trading.
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The answer is to identify sectors that are growing by looking at volume growth in the Indices. The
secret is that not all companies listed in a sector forms part of the Index. So, we are immediately
eliminating smaller and thus higher risk shares within sectors by choosing Indices. The first filter is
thus to identify which Indices have the highest volume growth.
Money flow Identifier: This is used to identify whether there are more buyers than sellers
entering a securitys position.
o
SBV Oscillator and Money Flow Index (MFI) are used to define Positive (Bullish) or
Negative (Bearish) money Flows.
Money Flow Index: This is a momentum indicator that takes volume and high, low and
close prices into the calculation.
A better definition: look at indictor and the price will move in the opposite
direction.
Therefore, if the Money Flow index is up, money is leaving the share and the
share will fall.
Volume of net trades: Bullish and bearish volume accumulation can also be assessed by
analysing volume.
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Volume of net trades, also called Bearish and bullish volume accumulations, is used to
assess how strongly net buyers over sellers arte influencing a stock, index or overall
market.
Volume surge Identifier: When sectors are dominated by institutions, a of volume surges is
extremely critical as it can highlight or signal major institutional trader action.
If the Overall Index (JSE All Share or Dow Jones) and Indicator 1 are moving in the same direction,
traders can assume that the current trend will continue. However, if the Index does achieve a new
high or low without a corresponding move by Indictor 1 a warning trigger is issued.
The reason for advocating Indicator 1 is that traders can calculate and draw their own chart. All you
have to do is calculate the net difference between increases and declines and then adding the net
amount to an index; which you make up. For example, if you decide on an index number of 1000
and the net difference between buyers and sellers today is a number of 10 (buyers are 90 and
sellers 80 = 10), then your index has risen to 110. Continue to do that daily and quickly you establish
your own Indicator 1.
Aim
Trader perspective
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The way that traders can do this is via a filter to set the parameters according to their
specific strategies. This includes market cap, price range, liquidity/tradeability, earnings growth
and strength of financials ratio analysis
Decide on the size of company you wish to invest in. Remember that the larger the
company is, the less the risk associated to trading that stock.
The size of the company (in rand terms) is calculated by multiplying the number of
shares in issue with the companys share price. This is called the companys Market
Capitalisation.
If you choose a figure that is too high, you will have too few companies to select. The
aim is to look at companies within a market cap range. For example, Trader A wishes to
select at companies with a market cap of between R500 million and R1 billion.
If you move your parameter up, the companies become larger and less risky.
If you move the parameter down, the companies become smaller and more risky.
If you dont have that amount of cash, reduce the amount of cash you wish to spend per
share. This enables you to reduce the selected shares (Step 1) by looking for at price
per share.
At this point, you have not even looked at the strength of the company.
STEP 3: LIQUIDITY/TRADEABILITY
There is no point in selecting companies to trade if these have no shares to trade.
The average number of share that needs to be traded per week is at least 500,000
shares. Any less, and the company does not have enough free shares to trade.
Decide on the growth (in percentage terms) that will make you feel comfortable and filter
out shares that dont meet that criteria.
The norm is to immediately eliminate all shares that will show growth that is less than the
money market rate. This rate is also called the Risk free rate. For instance, if you can
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invest your money in the money market at 4% a year interest, why would you invest in
shares that have less growth?
Now: you have selected shares from growth Indices. You have filtered these down
according to your risk profile (size of company), then you looked at the price of the
company and removed those companies that are too expensive. After that, you eliminated
illiquid stocks and those that have low profit rates.
Now comes the section that is a little more difficult, but remember that you have reduced
every hundred shares down to a possible six shares. This is the rate at which your filter
should work and you have yet to conduct any analysis.
Step 5 is the use of ratios to eliminate or determine strength of the remaining stocks in
your filter.
Get hold of a companys annual results, either the hard copy or the electronic version.
All companies have web sites from which you can access annual reports.
The following filter is simple. If a companys ratios do not meet industry norms, stop the
analysis.
These norms do differ between industries. If you want a copy of current industry norms,
contact me on mentor@magliolo.com/.
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AREA
Ratios used
Solvency
Liquidity
Profitability
Efficiency
Gearing
Investment Performance
Ratios
The mathematics behind the above ratios are set out in hereunder:
Solvency Check
RATIO
1
General solvency check
This is a broad indicator to assess how many times total assets cover total liabilities. A ratio of less
than 2:1 is a warning that there could be serious problems with the companys financial strength.
If the ratio is displaying such tendencies, look at the company for break-up value buy certainly not
as a long-term portfolio asset. However, a problem could arise if the solvency ratio is taken at face
value. It could create a totally incorrect impression. If the company recently started operation, or if it
had to pay a substantial sum for an acquisition - which is perceived to have solid long-term
prospects - the solvency ratio would be low. It is up to the investor to determine whether the ratio
represented the true state of the company or not.
Liquidity Ratios
RATIOS
1
Current asset ratio
2
Quick ratio (Acid test)
3
Stock to working capital ratio
4
Defensive interval ratio
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These ratios are a solid test to determine if a company will meet its financial commitments on time.
There are two major categories of liquidity ratios, namely ratios to determine the overall position of
the firm and those that help assess the liquidity of specific assets. The latter are also called activity
ratios. The following ratios, therefore, concentrate on how to calculate the overall measure of a firm's
liquidity.
Current asset ratio: This easy to apply ratio is used to calculate a company's short-term financial
position by using current assets and liabilities. If the ratio is high it indicates that the firm's current
assets cover current liabilities (at least 1,5:1) and that it is able to pay short term debt with relative
ease. The popular observation is to assume that, if the ratio is low, the company is without doubt
unable to finance its day-to-day operations and could, therefore, be placed under liquidated at any
time. While this is often the case, there are exceptions, e.g. accounts receivable includes debtors.
In a recessionary climate, can it be taken for granted that debtors will pay? In addition, part of
current liabilities includes bank overdraft, which has become an essential part of a firm's debt
funding programme and, therefore, the current asset ratio plays a less significant role today.
Quick ratio (Acid test): Although similar to the current asset ratio, it excludes stock as this item is
the least liquid asset under current assets. It thus provides a better measure of a firm's liquidity.
Some analysts believe that, in addition to excluding stock, the debtors book should be assessed to
determine the reliability of future payment, i.e. a divisional analysis of the quality of debtors should
be carried out. However, very few (if any) annual reports provide such information and company
directors are unlikely to divulge this type of detail. The assumption is, therefore, that this is a more
accurate measure of liquidity than the current asset ratio.
Stock to working capital ratio: Another means to assessing liquidity is to do the opposite to the
Acid Test ratio. Instead of subtracting the stock item from current assets, this formula uses stock to
determine a company's liquidity position.
In the Acid test ratio, the assumption is that, because
stock is the most illiquid current asset, it should be removed from a calculation to determine a firm's
liquid position. In using the stock-to-working capital ratio, the investor is able to confirm the Acid Test
ratio. Stock is divided by working capital, which is current assets less current liabilities, and the
higher the ratio the more illiquid the firm is.
Defensive interval ratio: This is not a well-known ratio, but is of significant importance. It shows the
number of days in which a company can continue to operate without using cash flow generated from
operations. It is a difficult ratio to use as the variables involved are not displayed in the financial
statements of listed companies. It can, however, be used by businessmen in the computation of
their own finances, especially where the business is operated as a sole proprietor, closed
corporation or private company.
The variables involved in this ratio include:
Defensive assets
Projected daily operating expenditures
# Any security that can be traded through the JSE, namely shares, bonds, futures, options and
even Kruger Rands
* Selling, delivery and administration expenses (less depreciation).
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Profitability Ratios
RATIOS
1
Profit margins
2
Return on shareholders' equity
3
4
Profit margins: Any profit figure can be used to determine efficiency of operations.
For instance, if the operating profit figure is used, the ratio would indicate the level of productivity
within a firm. The higher the ratio, the more profitable the firm is. If the ratio has been improving over
a number of years, it could indicate improved work methods, reducing costs per sale, gaining market
share, better internal controls over stock and expenses.
Return on shareholders' equity (ROSE): This is a measure of a company's profit in relation to the
shareholders' investment in that company, i.e. ordinary shareholders' funds. The use of attributable
profit as a numerator in the equation indicates that the higher the profits achieved (after interest and
tax), the higher the ratio will be. An exception would arise if the firm's equity base (the denominator
in the equation) was increased through a share issue. This would distort the ratio. This ratio is
preferred by shareholders as it excludes preference share capital, loans and minority interests.
Return on net assets (RONA): Also a measure of profits, but relates to total investment rather than
only ordinary equity. This ratio is preferred by portfolio managers, as it indicates profit per net
company asset. It is often used as a target setting for managers, who have to improve profits
relative to its existing asset base.
Return on capital employed (ROCE): This ratio accounts for the total capital employed, rather than
only ordinary shareholders' funds. It indicates the profitability of the company in its use of all
available funds, including borrowings. Unlike ROSE, this ratio is expected to be less likely to rise.
This is due to companies being expected to increase borrowings over time, while ordinary share
issues are not an annual occurrence.
If ROCE is increasing, investors are being warned that the level of borrowings is eating into profits
attributable to ordinary shareholders. Ultimately, investors will receive less dividends.
Efficiency Ratios
RATIOS
1
Stock turn
2
Accounts receivable days
3
Accounts payable days
Stock turn: The ratio is used to determine whether management is efficient in its control of
particular current assets. Generally, the stock turn ratio reveals the ability of management to buy
inventory that will sell and not rapidly become outdated. It also shows management's inability to
control different lines of stock.
However, it is imperative to look at trends over a number of years. The reason is that an increase in
the ratio may not mean that the problem is one limited to only a particular firm, but could be an
industry trend, i.e. sales falling off generally. Other reasons for a sudden increase in the ratio could
be an isolated case, such as the introduction of a new export law that delays shipment of goods.
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Average stock is used to calculate this ratio and is computed by adding the previous year's closing
stock (which is this year's opening stock figure), to the present year's closing stock. This is then
divided by two.
An example shows investors how to use this ratio:
The turnover and current asset figures which appear in XYZ Company Ltd's income statement
and balance sheet for the years 1999 and 2000:
R'000
Turnover
Current assets
Stock
1999
50,000
2000
60,000
10,000
12,000
Calculation of ratio:
Ratio 1
Stock turn
Ratio 2
The investor is able to assess that XYZ Company Ltd. sells entire stock on hand 5,5 times a year.
Or, expressed in terms of months, it takes a fraction over two months to sell all stock on hand.
Accounts receivable days: The first step is to determine daily sales, which is achieved by dividing
the company's turnover figure by the number of days in the year (365); even if the firm does not
operate every day of the year.
The accounts receivable figure, which is listed in the balance sheet, under current assets, is divided
by the subdivided turnover figure. The answer is in days and the higher the number, the longer it
takes a company to collect its debt. Accounts receivable is an asset and liquidity can thus be
impaired if debtors cannot be collected. The quality of a company's debtors book is also important,
but cannot be directly assessed.
One method that could use to assess the possibility of debtors not paying their accounts, is to
investigate the growth in a firm's bad debts. If this has been growing over a number of years, it can
be determined that a company has an inadequate screening policy and that bad debts are likely to
continue growing.
Alternatively, if the level of bad debts incurred is diminishing, it is indicative that stricter policies are
been administered.
Accounts payable days: This figure is obtained from the balance sheet, under current liabilities. It
is calculated in the same manner as account receivable days. In this instance, the higher the
number of days, the longer it takes the firm to pay its debts. The ideal is for a company to collect its
debts at a quicker rate than it is paying creditors. This would release some pressure on cash flows
and also assist in improving liquidity.
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Gearing Ratios
RATIOS
1
Debt:equity (gearing)
2
3
4
5
6
The extent to which loans are used to finance company assets is calculated by using gearing ratios.
Debt: equity (gearing): The comparison of debt, made up of loans and overdraft, to equity (ordinary
shareholders' funds) is a popular method of measuring the level of debt in a company. The figures
are obtained from a company's balance sheet and a number of ratio combinations can be used to
highlight the extent to which assets are financed by loans.
These include the subtraction of cash on hand from total debt before dividing by ordinary
shareholders' funds. The reasoning is that cash-on-hand could be used to reduce loans. Note that
the greater the proportion of borrowed funds to company assets, the higher the financial risk to
lenders and, ultimately, to shareholders.
Proportional debt ratio: Sometimes it is important to determine the proportion of the firm's long to
short-term loans. The necessity would arise in cases where a company has a high debt: equity ratio,
say 50%, but also a high liquidity ratio of which substantial short term loans forms a part of current
liabilities.
In such an instance, it is possible that debt: equity is misleading. If most of the total loan debt is
short term - these would have to be repaid within the firm's operating cycle - then a high debt: equity
ratio should not represent a threat to the financial stability of the company.
The method used to determine the proportion of long-to-short term debt is to start by calculating the
Debt ratio. This is computed by dividing total liabilities (long and current) by total assets.
Secondly, to calculate the long-term-debt ratio. This is done by dividing long-term debt by total
assets. If the Debt ratio is 50% and the long term debt ratio 30%, it shows that the company has
financed 30% of its assets with long term debt and 20% with short term debt.
Ordinary shareholders' interest: This is used to measure the risk inherent within a company's
financial organisation. It is simply the inverse calculation to the debt: equity ratio and, therefore, the
higher the percentage, the lower the risk associated with buying that company's share.
Long term debt to capital employed: This ratio is of particular interest to borrowers of loans. When
a company approaches potential new investors - for loan capital - the investors would be keen to
know how much of the company's capital structure (capital employed) is made up of loans and how
much from issued share capital.
The rule is not to provide companies with loans if they are already heavily geared, unless the loan is
for a particular project which the investor deems will have a short pay-back period and will be cash
generating. The reason is simple, the higher the ratio, the weaker the financial structure.
Interest cover: Once again, the higher the ratio, the less a company is able to meet its interest bill.
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This is calculated by dividing pre-interest profit by net interest paid. It shows the company's ability to
meet interest payments. A low cover would show that the company is not achieving enough
operating profits to pay its loans, or that loans are growing at a rate which the company is unable to
contain.
Gross cash flow to total debt ratio: This is the one critical ratio that links the income statement to
the balance sheet. It shows - as a percentage - how much of cash generated by a firm is used to
pay debt. For instance, if a company's gross cash flow (before paying dividend) is R6 million, while
total loans (long and short term) equal R12 million, then - using the formula set out in the table 50% of the company's cash flow is used to pay debt.
Alternatively, the inverse shows that it would take the firm two years to pay off all its loans, if
dividends were continually passed. The rule is - the higher the ratio, the weaker the financial
structure and the less attractive the investment opportunity becomes.
Earnings per share (EPS): EPS is an indication of the firm's profitability expressed per share. It
thus shows an investor how much profit each share he possess has achieved over the past year. If
EPS has been increasing over a number of years, investors can say that their investment has shown
growth.
Dividend per share (DPS): DPS is the amount of money paid to shareholders (expressed in cents
per share) for their investment in the company. This can occur twice a year, at the companies
interim and annual financial year ends.
Dividend cover: A trend over several years will reveal interesting factors. If a cover is, for instance,
2 times, it means that for every 10 cents earned per share, five cents is paid to shareholders. There
are a number of possibilities, if EPS is constant, but cover changes:
o
If cover is increasing, it usually indicates that less dividends are being paid and that
more money is placed into non-distributable profits. Companies could do this to
bolster reserves prior a takeover bid, or to offset economic downswings etc.
In the case where cover is decreasing, it means that directors have taken a policy to
pay shareholders more relative to the firm's earnings.
However, if EPS has increased or decreased, but the firm pays the same DPS as the previous year,
warning signals are set off for investors. Problems arise when EPS falls, but directors decide to
maintain the previous year's DPS. This means that reserves are being used to satisfy shareholders
at the expense of the firm's financial profile. If this trend is continued over a number of years, the
firm can be expected to run into financial solvency and liquidity problems.
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Earnings yield (EY): The company's EPS expressed as a percentage of its share price. It reflects
earnings relative to market sentiment and thus reveals the return that an investor can expect if he
buys shares. If EY is increasing, shareholders' capital growth is improving, while a decline in EY
would indicate that the net effect of EPS to share price is falling and, therefore, the investment
becomes less attractive.
Dividend yield (DY): Similarly, DY is the ratio of the firm's annual cash payment to shareholders to
the company's share price.
The importance of DY is centered on the principle that only a part of profits achieved are paid out to
shareholders. This is a more accurate measure - compared to ROSE - of a shareholder's return on
investment.
Price:earnings ratio (p:e): This ratio reveals the length of time that it will take an investor to recoup
the cost of his investment in terms of earnings. Therefore, the higher the ratio, the longer it will take
for an investor to re-coup his original investment and thus the more expensive the investment is. If a
p:e ratio is 10 times, it indicates that - if an investor buys a share - it will take 10 years before the
amount of EPS achieved by the company equals the share price.
The following example explains:
In that year the share price traded between 15 cents and 22 cents.
At the end of the financial year the share price was 20 cents.
A. Calculation
1. EPS
=
=
=
Attributable profits
R10,000,000
5 cents per share
shares in issue
2,000,000
2. P:E ratio
=
=
=
Share price
20 cents
4 times
EPS
5 cents
B. Conclusion
It will take four years for XYZ Company's profits (in eps terms) to equal the cost of purchasing the
share (the investor's capital outlay).
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The final step is to ask: if the market stable enough to invest now, or should I wait? Bollinger bands
are used to measure a market's volatility, as this tool warns traders as to whether the market is
sluggish or fast paced.
Invest when the market is fast and stay out when the market is slow!
CHAPTER SUMMARY
From Step 1, a novice trader has chosen a portfolio structure and this chapter established an
important filter to selecting shares for trading. Some brokers will tell you that you do not
need to have a portfolio if you are a trader to be successful, you do!
IN THE NEXT CHAPTER
In Chapter 11, a price range to trade the shares selected as per Step 2 is established. This
will provide novice traders with a set of prices to consider before applying technical
variables.
Page 90 of 192
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In 2003 I wrote and had a book called Jungle Tactics (Heinemann ) published, where the above
was set out in much greater depth and targeted MBA students. Despite the highly complex and
interesting text of Jungle Tactics, I prefer the simplicity of the above diagram, which concentrates
and explains the essential characteristics of the four stock market phases.
Phase One: this occurs after a prolonged downtrend, where stocks have been falling in what
seems to many traders as free fall. The main signal in this phase is that the rate of decline in
share prices starts to slow and eventually moves sideways. This is called forming a base and is
essentially a movement away from sellers to an increasing amount of buyers. The latter
becomes more aggressive and the cycle moves to Phase 2.
Phase Two: at this stage stocks start to move into a bull trend, where the majority of funds are
used to buy shares. Prices start to move rapidly up during this phase, despite some
fundamentals still being of negative, i.e. corporate results are still poor and investor sentiment
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wavers between optimistic and pessimism. It is at this point that professional traders start to
accumulate stocks.
Phase Three:, stock begins to trade sideways. It is often at this late stage that novice traders
suddenly wake up to the fact that the market is in a bull run. They jump in, only to find out that
there is little left of the uptrend. The trends in Phase 1 are being repeated at this level, with
buyers and sellers moving into net buying and selling equilibrium.
Phase Four: This is the phase where most traders make serious money if they are wise,
astute and use various forms of trading tools. While this is the dreaded bear trend, solid
fundamentals are still moving the market (or parts of the market) in short bursts. The trader can
use shorting techniques or play the market anomalies. Those less wise tend to hold onto stocks
in the hope that these will turn around.
I have been asked on many occasions: How can you tell if the market is moving up into a bull run,
down into a bear run or just moving sideways? What, in fact, is the early warning and distinguish
features of the above phases?
In answer is that during a consistent uptrend or bull market as in Phase 2 the shares are daily
displaying a series of higher highs and higher lows. In Phase 4, the series of closing prices turns to
being lower highs and lower lows. This is displayed in a series of peaks and troughs on charts that
traders can trade quite successfully identify.
Below is an example of the share characteristics explained above:
It is also important to note that stocks only move in the above manner between 30% and 40% of the
time. This means that more than half of the markets movement is in a sideways, or ranging bound,
movement. The rest of the time they move sideways in trading ranges. The following share trend
highlights the uptrend and sideways movement.
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Stocks in strong downtrends tend to have short reversals. This gives traders the opportunity to
go short.
Elliot Wave
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Fibonacci
The following Fibonacci-based methodology is used to calculate a date that a trend could change.
The following steps are used to identify a probable change in markets direction:
Step1: Count the number of days, or price bars, between two peaks or market tops. Use 20 as
an example.
Step 2: Multiply the number (as counted above) by 0.618, 1.618 and 2.618.
20 x .618 = 12.36
20 x 1.618 = 32.36
20 x 2.618 = 52.36
Step 3: Next, count the above calculated number of days from the second price peak to forecast
when the trend is expected to change.
Any length of time between price peaks that is greater than five price bars will yield the best
results.
When measuring price peaks measure minor peaks to minor peak and major price peak to major
price peak.
These measurements can be done using any time frame and this projection method is about
70% accurate.
Professional traders use the Fibonacci retracement levels as potential support and resistance levels.
Maybe you want to use one or the other?
Personally, I look at the Indices for changes in share characteristics. That is more than enough for
this step in the process to learning how to become a professional trader. I believe that you will be far
more successful as a trader is you design your own strategy, rather than simply looking at complex
graphs and following someone else's analysis of those charts.
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Months Objectives
1
2
3
4
5
Economic Events
1
2
3
4
5
Corporate Events
1
2
3
4
5
Notes
1
2
3
4
5
Notes
1
2
3
4
5
An
excellent
source
for
economic
news
http://www.bloomberg.com/markets/economic-calendar
and
diary
events
is:
Always look at economic calendars to see what types of reports are coming out that could move
sectors and specific shares.
Page 96 of 192
CONCEPT OF CORRELATION
Correlation is a very simple concept. If investments always move together, there is perfect
correlation, and that is assigned a value of +1. If they always move in opposite directions, there is
perfect negative correlation, and that value is -1.
If you can tell nothing about the movement of one investment by observing another, they have no
correlation, and that relationship is assigned a value of 0. Of course, two investments can fall
anywhere in the spectrum between +1 to -1 in relation to one another.
Take, for example, the correlation of two retail companies. Both the companies are affected by
interest rates, cost of labour, technology, consumer purchasing power and cost of fuel. Traders
could expect (barring growth from acquisitions) that the share prices of these companies would have
a similar movement throughout the market cycle (phases as set out above) and, therefore, these two
shares could be considered to have a strongly correlation.
The same can be said about two markets in different parts of the world.
However, there are factors that can be negative for one industry, but positive for another. In the
above example, if the price of oil rises, oil multinationals would benefit, but retailers are expected to
suffer. As a result, the price of their stocks should move in opposite directions and these have a low,
or negative, correlation.
What does this mean for traders?
Lets assume there are two high-risk, high-return possible trades in different parts of the world. In
addition, the second trade has perfect negative correlation with the first. Every time the first share
price moves upwards, the second will decline, and vice versa. If we put these two trades into a
portfolio, will the combined portfolio have high return and zero risk?
Short-term gains in one holding are perfectly offset by losses in the other investment. However,
because the underlying trend in both investments is a high return, the combination has a high return.
Can this be true? In reality, traders will never find two holdings with perfect negative correlation, but
the good news is that they don't need to.
Any correlation less than a perfect positive correlation will reduce the risk in the portfolio. However,
traders must understand that risk has not been removed.
For the first time, traders are able to construct portfolios free of the old risk-reward line. In
mathematical terms, the portfolio has a rate of return equal to the weighted average rate of return of
the holdings, but the risk may fall below the weighted average of the portfolio.
Traders have now gained an important lesson: Diversification is good, but the extent of the
benefit depends on how the portfolio is constructed. For instance, investors would have a better
diversification benefit by including a multinational oil company and a retailer in their portfolio than by
holding two retailers.
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While classic diversification reduces business risk, it can actually serve to reduce market risk.
Ideally, traders will want investments that combine attractive risk-reward characteristics with low
correlation to other investments.
Traders optimum combination:
Determine acceptable level of risk and then seek the optimum level of return.
o
For instance, an investor might want to be 90% certain there is a limit of a 10% decline in
value during any one year. A trader can then construct a portfolio that has the highest
possible expected return within that risk criteria.
Alternatively, the trader can first determine a required rate of return and then assess a
portfolio to do that at the least possible risk.
These are powerful tools to manage risk and construct portfolios to meet various constraints.
MARKET TO GLOBAL
Assessing your market to global ones is for traders who wish to trade across foreign markets. It is
amply set out in Lore of the Global Trader, so it is suffice to say that traders need to follow a few
simple rules if they wish to look at world markets for guidelines as to the influence of foreign markets
over theirs.
This takes understanding of correlation analysis between markets. So, the easiest way is to look at
one index relative to another. Simply divide your preferred index by that of the foreign one. This will
tell you what the correlation is.
For instance, if the correlation is 2% between the USs Dow Jones and the JSEs All Share index,
then if the Dow Jones rises overnight by 1%, it can be assumed that the JSE All Share Index will
rise by 3%. Conversely, if the Dow falls by 4%, the JSE All Share will fall by 6%.
The above is merely based on assumptions and do not always work. Some traders add a confirming
indicator, i.e. if the Dow fall, then wait for the Far Eastern indicators to also show a decline. If they
dont, stay out of the market.
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In the future sections, we're going to teach you how to correctly identify the market
environment you are trading in to better use these indicators!
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The above indicates that the Sector is cheaper than the average. As such, market sentiment is
returning to that sector.
Now, the Expense Ratio highlights that the retailers share is expensive and above the average price
earnings. As such, the share is not a buy. The question si whether this company is cheaper or more
expensive than its main competitor.
Company PE vs Competitor PE
The next phase is to look at Company A relative to a close competitor, Company B. Assume that
Retailer B is also considered to be expensive and not a Buy. However, when you divide the Price
earnings ratio of Company B to that of Company A, you get the following:
Result:
Retailer A is cheaper than Retailer B and below the average price earnings.
This indicates that if a trader wishes to be in a retail stock Company A is still a better buy.
Are in Stages 2 or 4
These need to be in strong bull or bear trends
Meet the criteria as set out in this chapter.
Using this trading strategy, traders use the Williams %R (outlined in later text) to assess whether
they should go long or short. Once that happens, then need to run through their watch lists to find
potential trades. The ability to establish a solid watch list is important to expedite trades.
The first step is to understand the companies that you have placed in your watch list. For instance, if
you have assessed that the chemical industry is the one to be in, then you need to find companies
that fits that criteria. You will find many misconceptions in the market. With lack of solid data, you will
invest in the wrong company.
A method that some traders adopt is to compare the companys share price its 12 month high and
low and its net asset value. The following table is an example:
NATURE OF BUSINESS
PRICE
SHARE PRICE
12 MONTH HIGH 12 MONTH LOW
NAV
BUY - SELL
Name
COMPANY 1
COMPANY 2
COMPANY 3
COMPANY 4
COMPANY 5
The benefit of doing the above exercise is that - at a glance you will be able to see and assess a
companys share relative to itself. For instance, if Company As share price is 120 cents and this is
close to its 12 month high of 130 cents, is the share still worth buying?
Well, if the share price is still below the 160 cents net asset value, it may be? It triggers possible
shares in the watch list.
Once you have made the trade, stick to your analysis. Use your exit strategy to either take profits or
losses, but dont be swayed by market news and innuendo.
The success of this trading strategy relies on ability to find good stocks to trade within reasonable
ranges.
CHAPTER SUMMARY
Economic cycles were set out as a precursor to an explanation of concepts of correlation
and pricing values. The aim of the chapter was to provide traders with a system to develop a
price range for each share selected in Step 2.
IN THE NEXT CHAPTER
In Chapter 12, groundwork is established for understanding the three technical systems that
make up Steps 4 to 6.
Line chart
Bar chart
Candlestick chart (set out in Chapter XXX)
Now, a basic explain of the first two charts are set out in this chapter, before we move into more
complex explanations later on. The following graphs are for the same period for listed company XXX
Ltd.
LINE CHARTS
A basic definition of a line chart or graph is simply a line drawn joining one closing share price point
to the next closing share price point. When several days (or weeks and years) closing share line
points are joined you get a line that shows a trend. In essence, a trader can see the general price
movement of the share for the period of time he or she have decided on.
The following is an example of a line chart for listed company XXX Ltd.
The share price has fallen from 100 cents in Week 1 to close to 50 cents in Week 3.
In Week 1 the share fell to 90 cents and seem to stabilise at this level.
In Week 2 the share returned to 100 cents and briefly broke through this ceiling.
Between Week 2 and 3 the share price bounced before resuming a downtrend.
BAR CHARTS
XXX Limited: Bar Graph
A bar chart is only slightly more defined and shows more than just a closing share price. It indicates
and highlights the opening and closing price, as well as the highs and lows achieved by the share at
the point taken.
Bottom of the vertical bar: lowest traded price for that time period
Top of the bar indicates the highest price paid.
From an economic perspective, however, it is important to note that the word bar refers to one set or
group of information as set out by that data point. Confusion exists in that this one data point can be
a weeks information or even a years. It depends on the time frame taken for the trader in drawing
the bar chart. The following explains the above magnified portion of the chart.
CHAPTER SUMMARY
The chapter set out and explained what Line, Bar and Candlestick charts are and how these
relate to developing technical analysis skills.
IN THE NEXT CHAPTER
In Chapter 13, the first part of Step 4 (identifying trends) is set out.
Note that Step 4 (in the Six Steps to Trading Like a Pro) is split into two chapters, as
follows:
This section is the first part of a two-fold phase to Step 4. The first is to identify which of your
selected shares (Chapter XXX) have trends that comply with your strategy and, secondly, to
identify trading patterns.
STEP 1: CANDLES
As a precursor to starting you out on your technical analysis journey, I would like to introduce the
concept of Candlesticks to you. These are similar to Bar charts, but Candlesticks are more graphic
in that they display a range of information that is often critical for traders to see at a glance. In
addition to opening and closing prices, Candlesticks display high and low price statistics.
In the above chart, the filled black bar indicates that the share closed weaker than its opening price.
However, if the closing price is higher than the opening price, then the block in the middle will be
white or hollow.
Note that the top of the block is the opening price and the bottom of the block is the closing price.
If you are to use Candlesticks as your preferred line to display shares and other securities, then it
is important to learn the following:
If the closing price is above the opening price, then a hollow Candlestick is drawn.
If the closing price is below the opening price, then a black filled Candlestick is drawn.
The hollow or filled section of the candlestick is called the "Real Body".
The thin lines above and below the Body displays the High/Low range.
The top of the Upper Shadow is the High, while the bottom of the Lower Shadow is the Low.
Selling or buying pressure is indicated by a longer body, while short bodies imply poor buying or
selling activity.
Upper Shadows signify the session high and lower shadows signify the session low.
The purpose of using Candlestick charts is to effectively see basic price statistics in graphic form. I
recommend that traders get used to using these charts instead of the normal line charts as:
Candlesticks are easy to view and thus interpret. They are perfect starting charts for the
novice trader to start his or her chart analysis.
Candlesticks no more difficult to draw than other line forms . Simply click the button on your
trading stock package that states Candlesticks and unclick the Price button.
There are many different types of Candlestick patterns and patterns can be single, dual and triple
candlestick formations. Professional traders usually combine candlestick analysis with support and
resistance levels to obtain better trading signals or triggers.
Now that we have covered the preferred diagram method, let us move to the business of technical
analysis. Step 2 looks at how we determine a trend.
Therefore, an uptrend line is drawn along the bottom of easily identifiable support areas, called
valleys.
In a downtrend, the trend line is drawn along the top of easily identifiable resistance areas, called
peaks.
Two points touching a line at the top and at the bottom defines a valid trend line
However, if three or more points touches the line, the trend is confirmed.
Trend lines are strong indicators when many points touch the line, but these become less
reliable if the line is very steep.
In the above chart, the share price is moving strongly upwards, bouncing off the support and
resistance levels. It can be said that the share is in a bull run as each Support level is getting
progressively higher. This is also called Higher Lows, as each days lowest price is actually higher
than the previous days lowest price.
In addition, the Resistance level is also getting progressively higher. This is also called Higher
Highs, as each days highest price achieved by the company is actually higher than the previous
days highest price.
There are a number of exceptions, which tend to be better viewed when using Candlesticks. There
will be times when a share seems to break through its Support or Resistance level, only to resume
its previous trend. Experts suggest that this a possible change in investor sentiment and the share is
now testing Support or Resistance levels.
How do novice traders know if support and resistance has really been broken?
Unfortunately, there is no definite technical answer, other than to use the break as a warning that a
Support or Resistance Level may be broken. One possible way is to have multiple Support and
Resistance lines, which some experts call Zones.
When the price passes through the first support level, the share moves higher to form a new
Support/Resistance Level. As such the Support level became its new Resistance Level.
When a support or resistance level breaks, the strength of the follow-through move depends on
how strongly the broken support or resistance had been holding.
When the market moves up and then falls back, the highest point reached before the share falls
back is the resistance. The share As the market continues up again, the lowest point reached
before it climbs back is now support. One thing to remember is that horizontal support and
resistance levels are not exact numbers.
Now that the basics of trend lines and Support/Resistance levels have been set out, lets look at how
to apply these in trading. There are two simple trading techniques, namely the Bounce and the
Break.
The Bounce
The first method of trading support and resistance levels is to trade straight after a share bounces
off the support.
Too many novice traders tell me that they want to buy shares before the share hits the support. After
all, they say, you cannot get the share once it hits the Support level. There is some truth to that
statement, as many institutional buyers often mop up shares if they fall below value.
However, the problem of buying before the share hits the Support level is that it may not stop at the
Level. Many traders make the error of setting their Buy or Sell orders directly on Support and
Resistance levels. What actually happens in the market is that everyone else has done the same
thing so you get kicked out of your position, and the share bounces.
What a waste! After all your trading strategy, you get sold out of your position because your stop
loss wasnt just below the Support Level.
If you intend to buy a stock, first wait for the share to bounce off the Support Level. If you already
have the share in your portfolio, have a stop loss just below the Support Level. That way, if the
share falls to the Support and major selling occurs and the share bounces you will have kept your
position.
When playing the bounce, traders need to find confirmation that the support or resistance will hold.
You can be aggressive and dump your stock when it gets to your stop loss (breaks though the
Support Level) or move the Support line to the Resistance level if the share comprehensively
breaks through the Resistance level.
You can sit back and see the share fall through your stop loss in the hope that prices will
return to original trends.
Sell at your stop loss, wait for the Pull back and buy the stock. In this case, the Buy Signal
is your original Stop Loss.
Simple.
Exponential.
Lets reiterate: a single moving average helps traders to determine a trend. However, using two
averages simultaneously can tell you when that trend is changing.
The simplest way is to just plot a single moving average on the chart. When price action tends to
stay above the moving average, it would signal that price is in a general uptrend. If price action
tends to stay below the moving average, then it would indicate that it is in a downtrend. The
following chart highlights these trends.
The following use of two averages on charts gives traders a clearer signal of whether the pair of
averages is trending up or down.
Comment:
In an uptrend, the faster moving average (9 Day MA) should be above the slower (21Day MA)
moving average.
In a downtrend, the slower moving average should be above the faster moving average.
Volume indicates general market health. Price movement is always accompanied by volume,
so price analysis without volume analysis is limited in the sense that we would have s price trend
without understanding how many people are actually interested in that share or market. Only a
combined analysis of volume and price can provide a complete and accurate picture of a trend.
Volume indicates health of an existing trend. Price analysis shows traders a trend, but that
trends strength can only be determined with an additional indicator such as volume.
Volume can detect major shifts in sectors. Volume of indices is considered to be crucial in
predicting trend reversals.
Volume is an indication of supply and demand. The calculation of Volume is the number of
units traded (any security) during a specified time period. So, the more demand for the share
than supply, the stronger the pressures on price. Only volume can tell you that pressure exits on
a price.
Volume shows reversal points. This means that volume can tell traders when to buy or sell.
Therefore, traders must note to include leading indicators in their technical tool bag. Trading
volume is one of a few leading technical indicators that shows traders when and where a change
in market sentiment will occur.
Volume tracks Institutional trading. Volume surges are often ignored by the market. Towards
the end of a rally, a wide volume surge often signals that the institutional traders are dumping
their stocks because the move is at an end. If you weren't aware of it before, note this indicator
and use it as a warning trigger.
Additionally, unlike many indicators, volume is applicable to every timeframe and cannot be left out
of any serious traders bag of signals.
Exchange Volume: Exchange Volume represents the sum total volume of all stocks in a
particular exchange or stock market and thus is a predictor of general market mood or
sentiment. For me, analysis of such technical indicators helps reveal bullish and bearish
markets, define bottoms of the stock market crashes and tops of the market madness.
Index Volume: Index Volume represents the total volume of all stocks included in a particular
index. What many novice traders do not understand is that an Index is made up of some and not
all stocks in a sector. Therefore, the volume of the JSE Property Index would be sum of all
companies indicted as Blue Chip for that sector. Thus, index volume represents the trading
activity in a particular market sector or particular group of stocks that are covered by this index.
Index volume also helps to define the money flow and sentiment in specific market sectors.
Stock Volume: Stock Volume is the number of shares of a security that are traded (bought and
sold) during a specified period of time. It tells you how many shares changed hands between
buyers and sellers. In essence, stock volume represents the volume of a single stock and
defines the liquidity of that stock.
CHAPTER SUMMARY
The absolute first step in technical analysis is to understand whether a number of share data,
expressed as a line on a chart, represents a trend or not. The basics of candles, support and
resistance levels, channels and moving averages were set out in this chapter as a precursor
to far more challenging trading jargon. If these extremely basic concepts are too difficult to
understand, send me a request for a workshop on mentor@nagliolo.com.
IN THE NEXT CHAPTER
In Chapter 14, Step 4 of the Six Steps is completed with an explanation of share patterns and
how to trade these.
In the desire to find patterns within graphs, traders particularly the young and inexperienced tend
to see dragons in the woods. Essentially, the see patterns where non-exist. This chapter is devoted
to showing you some essential chart drawings which should help you to organise and set up the first
step in your technical analysis strategy.
There are five basic configuration that are pertinent to traders in todays volatile investment
environment.
A head and shoulders pattern is formed by a peak (shoulder), followed by a higher peak (head), and
then another lower peak (shoulder). A "neckline" is drawn by connecting the lowest points of the two
troughs. The slope of this line can either be up or down.
Traders trigger: When the slope is down, it produces a more reliable signal.
In the following example, traders can observe the head and shoulders pattern. As started above, the
head is the second peak and also the highest point in the pattern formation. The two shoulders also
form peaks but do not exceed the height of the head. With this formation, traders should place their
entry level just below the neckline. The strategy is two-fold:
For traders going short: to have a purchase entry at the level where your stop loss would be.
So, if the neck line is at 200 cents, then your stop loss or entry point would be at 197 cents or
195 cents. Note that these levels were discussed in Chapter XXX. The share will continue to fall
as explained under the next heading.
For traders going long: While there seems no logical reason for the following calculation, it
seems that historic trends prevail. The length of the shares decline from the neckline is normally
calculated by measuring the high point of the head to the neckline (Points A-B). This distance is
how far the price will move after it breaks the neckline (Points C-D). So, here you would place
your entry level at price (Point D).
Traders can see that lines AB and CD are the same. This knowledge can be used effectively when
trading once the price goes below the neckline.
Inverse Head and Shoulders are essentially the opposite of the above trends. A valley is formed
(shoulder), followed by an even lower valley (head), and then another higher valley (shoulder).
These formations tend to happen after downward movements.
The strategy is the exact opposite to the above diagram. When the share breaks through the
neckline going upwards, the share is expected to move up by the same distance as the Neckline
Head (AB and CD).
Measure the distance between the head and the neckline, and that is expected distance that the
share price should move after it breaks through the neckline going upwards.
Before terminology gets the better of you, and you start to wonder if all these signals are actually
necessary, look carefully at the above pattern. The double lines are just the Support and Resistance
Levels outlined in previous chapters. There will be times when the share price has hit the resistance
level twice and then fall through the support level.
This tends to happen when a share price has hit the resistance level twice in quick succession, but
that resistance level seems to be absolutely solid. Look at the price graph and you will probably see
that the level was seldom broken. At this point the share falls through the support level and this is
called a Reversal Pattern.
Traders Trigger: With the double top, short term traders should place their entry levels below
the neckline (at Point C) because the anticipated fall will be Line CD (calculated from Line AB).
Long-term traders should calculate CD and place entry at such levels.
The double bottom is also a trend reversal formation and in essence the exact opposite to the
Double Top formation. Traders see a double bottom formation and go long instead of short at point
E. the expected climb is line EF, as calculated by Line CD.
You can see from the charts above that after the previous downtrend, the price formed two. Notice
how the second bottom wasn't able to significantly break the first bottom. This is a sign that the
selling pressure is about finished, and that a reversal is about to occur.
In the above chart, the share falls, moves into a sideways motion, then resumes its downtrend.
Traders Trigger: Once the share falls below the Rectangle Support Line, it tends to make a
sudden move that is similar in size of the rectangle.
The trend is the same as the Bearish Rectangle. Traders can expect the share to resume its
uptrend and jump by at least as the same amount s the rectangle formation.
Step 4: Wedges
Traders need to understand that trends do not go on forever and that there will be times when
shares and share price actions will stall. Wedge pattern formation signal a pause in the current
trend. When a Wedge is identified, traders will see that volume of trading has started to fall or has
stalled.
Wedges tend to be used by professional traders as either continuation or reversal signal triggers.
The definition of a rising wedge is when a share price consolidates between an upward moving
wedge-type formation; see following diagram. In essence, a share price moves between support and
resistance lines in a sloping formation.
Here, the slope of the support line is steeper than that of the resistance. This indicates that higher
lows are being formed faster than higher highs. This leads to a wedge-like formation, which is
exactly where the chart pattern gets its name from! With prices consolidating, we know that a big
splash is coming, so we can expect a breakout to either the top or bottom. If the rising wedge forms
after an uptrend, it's usually a bearish reversal pattern. On the other hand, if it forms during a
downtrend, it could signal a continuation of the down move.
Either way, the important thing is that, when you spot it, you're ready with your entry orders!
The important issue to note is that the share price is reaching rapidly new highs and lows every day.
It is this formation that highlights that the uptrend is about to end. It is a warning signal. The
question, therefore, is how far will the share fall at the end of the expected Wedge?
The answer is yet again the same s I the previous chart formations: the price movement after the
breakout is about the same magnitude (Line CD) as the height of the formation distance (Line AB).
Just like the rising wedge, the falling wedge indicates that a trend is about to change.
In the above chart, the falling wedge serves as a reversal signal. After the share has been falling
(lower Highs and Lows), it seems to gather momentum. Upon breaking above the top of the wedge,
the share moves upwards from Point C to Point D. This movement is, in length, about equal to the
height of the formation (Line AB).
Traders should thus place their Buy Signal at Level C or just below that line and a Sell Signal target
would be the height of the wedge formation.
Step 5: Pennants
Pennants are also continuation patterns formed after a significant bullish or bearish movement.
The difference to the previous diagrams is that the consolidation is short lived and the price jumps in
on the strong move, forcing the price to bust out of the pennant formation. The calculation of this
movement is at least the height of the earlier move, also called the mast.
Pennants can be either bearish or bullish.
Use the height of the formation as Buy or Sell signal; depending on whether you are going short
or long.
Type of
Signal
Uptrend
Reversal
Down
Downtrend
Reversal
Up
Uptrend
Reversal
Down
Downtrend
Reversal
Up
Downtrend
Continuation
Down
Uptrend
Reversal
Down
Uptrend
Continuation
Up
Downtrend
Reversal
Up
Bearish Rectangle
Downtrend
Continuation
Down
Bullish Rectangle
Uptrend
Continuation
Up
Bearish Pennant
Downtrend
Continuation
Down
Bullish Pennant
Uptrend
Continuation
Up
Chart Pattern
Double Top
Double Bottom
Head and Shoulders
Inverse
Head
Shoulders
Rising Wedge
Falling Wedge
&
As you probably noticed, we didn't include the triangle formations (symmetrical, ascending, and
descending) in the above sheet. That's because these patterns can form either on an uptrend or
downtrend and can signal either a continuation or reversal.
CHAPTER SUMMARY
This chapter completed an explanation of Step 4, which included how to identify share price
patterns and how to trade these, such as Wedges, Pennants and Triangles. By now the
novice trader has learnt to set up his or her portfolio and related strategies, established a
method of choosing shares from a vast array of companies listed across the world and
determined a price range for these shares. On the technical analytical side, the trader has
identified patterns and trends.
IN THE NEXT CHAPTER
In Chapter 15, methods to detect whether a chosen share has the momentum and strength to
continue is set out.
AIM OF STEP 5:
THIS IS THE SECOND STEP IN THE TECHNICAL ANALYSIS PROCESS
TO TRADING. TREND PATTERNS HAVE BEEN RECOGNISED,
MOMENTUM IDENTIFIED AND CONFIRMED BY STRENGTH
INDICATORS.
This signal is easily available on most software packages, but traders have to input their own
moving average numbers , according to their strategies.
This indicator is an important analytical tool in the traders arsenal to help them to identify changes
in overbought and oversold positions and acts as a warning signals that new trends could be about
to happen; whether bullish or bearish. In the previous chapter, traders identified trend patterns. In
this section it is important to know whether patterns are strong or could change. This is the reason
why momentum indicators are used.
The question traders ask: if I buy a share today based on detected patterns, will the pattern
last?
The most popular momentum indicator is the MACD, which is usually populated with three main
numbers, namely:
Number 3: this is the number of bars that is used to calculate the moving average of the
difference between the faster and slower moving averages.
It is important to note that the MACD line drawn is the difference between two exponential moving
averages. In the following chart, the two moving averages are 21 and 50 day moving averages. The
single line is the difference between these two averages.
Traditionally, when the MACD is below the origin (line 0), the share is considered to be oversold,
and when above the origin to be overbought. The problem with using moving averages is that as
averages they lack substance of the real price. They lag and thus provide late signals. Yet this is
one of the most favoured tools by many traders.
Traders Trigger:
Volume is increasing if the day's closing price is higher than the previous day's (up-volume).
If the share closes at a lower price than the day before, volume is seen as flowing out (downvolume).
OBV is simply calculated by adding/subtracting the day's volume figure (obtained from any
newspaper stock prices) from the cumulative total of volume for the share. This is according to the
day's price movement:
If the share price is higher than the preceding day, today's volume is added to yesterday's OBV
figure
If the share price is lower than the preceding day's price, today's volume is subtracted from
yesterday's OBV.
Therefore, an upward trend in OBV is often a precursor to an increase in price. This is due to
additional investors buying the share; thus volume of trades is increasing. When an OBV trend
changes, it signals to traders that a corresponding breakout in the share price is possible.
Professional traders warn that changes in the OBV trend should be seeing over a period of longer
than three days, or you may get false readings.
Traders Trigger:
Look for a divergence where the security is achieving a new high, but the RSI is failing to a level
that is lower than its previous high.
When the RSI turns down and falls below its most recent trough, it is said to have completed a
failure swing. The failure swing is considered a confirmation of the impending reversal.
Relative Strength Index, or RSI, is similar to the stochastic in that it identifies overbought and
oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30
indicate oversold, while readings over 70 indicate overbought.
Divergences: these occur when the share price achieves a new high (or low), but that move is
not confirmed by a new high (or low) in the RSI. The norm is for prices to correct and move in
the direction of the RSI.
STEP 2: OB/OS
Definition: based on volume and shows the difference between the
number of advancing (rising) and declining (falling) shares.
This is a simple indicator and highlights how many traders are buying or selling the share at a
defined period of time. It in effect indicates interests in the market. The norm is that when the share
is considered to be Oversold, it means that there are too many sellers in the market. In economic
terms, it can be said that supply exceeds demand. Normally, the share price falls to attract buyers in
the market or share.
CHAPTER SUMMARY
The aim of this chapter was to establish a process to detect trends, momentum and strength
before buying the share. Technical indicators - MACD, OBV, RSI and OB/OS - are explained in
greater detail.
IN THE NEXT CHAPTER
In Chapter 16, we take a step back from technical analysis to establish greater understanding
of financial modelling and variables that influence markets, such as sentiment and timing
indicators.
Throughout this book a common theme seemed to develop: for the six steps to succeed,
there is a need to understand what makes up market sentiment and how do traders use this
information to make better trading and investment choices?
Consequently, market sentiment has become the main decision point as to whether the trader
should despite all analysis still buy the security. The second filter is timing, as set out in the next
chapter.
However, before we proceed with sentiment analysis, let me take a step back. When I asked an old
colleague to look at this book and to provide constructive comment before going to the printers , all
he could say was: What about a section on financial modelling?
In the next chapter, I set out advanced trading techniques, but not in the normal sense of the word.
Instead of setting out hackneyed systems, I look at growing trend of investing in new companies that
list. These have no history, so how do we assess a fair value to trade the share? A methodology
was developed and is set out in this book.
In other words, methods of making money in the market not often set out in financial books on
technical or fundamental analysis.
Another statement from my colleague: A section on financial modelling is critical. Traders use
mathematics all the time to trade. So, I relented and included a section on financial modelling and
set out basic but important recognised methods to analyse shares.
Financial Modelling
These are "what-if" models that attempt to simulate the effects of how a change in one aspect of a
company or market will alter the price or trend of a market. This can include changes in alternative
management policies and assumptions about what can influence the firm's financials. In addition,
models can be deterministic or probabilistic. The first type does not include any random or
probabilistic variables, whereas the second incorporates random numbers and/or one or more
probability distributions for variables such as sales and costs.
Financial models can be solved and manipulated to derive current and projected future changes to
trends. As a result of technological advances in computers (such as spreadsheets, graphics,
database management systems, and networking), more and more traders are using modelling
systems.
Models are abstractions of reality and there is thus no guarantee of perfect correlation between
the model and future prospects.
Variables used in models are usually limited and critical events unfolding elsewhere in the world
could influence reality in unexpected ways.
Many models are industry specific, whereas many groups have divisions in different industries.
Even the best trend analysis is only a contingent forecast. It is up to the astute trader to realises
that the future is unlikely to mirror the forecast.
essentially
Where strategic plans are most susceptible to deviations from the forecast.
For planning purposes: to assess the impact on the expected performance criteria due to
possible changes some variables.
For measurement purposes: to assess whether the strategic plan is still on target.
For control purposes: to predict the amount by which control variables must be changed
to keep the company on target.
Equation:
Average
price
By investing a fixed amount each time, more shares are purchased at a low price and fewer shares
are purchased at a high price. This approach typically results in a lower average cost per share
because the investor buys more shares of stock with the same dollars
An investor invests R100,000 per month in ABC Company and engages in the following transactions
Date
6/1
7/1
8/1
9/1
10/1
TOTAL
Investments
$100,000
100,000
100,000
100,000
100,000
500,000
Shares purchased
100000/40 = 2500
100000/35 = 2857
100000/34 =2941
100000/38 =2632
100000/50 =2000
12,930
The investor has purchased fewer shares at higher prices and more shares at lower prices. The
average price per share is:
40+35+34+38+50
5
39.4
With a total investment of R500,000, however, 12,930 shares have been bought, resulting in a cost
per share of
500,000
12930
38.67
On 10/1, the market price of the stock (R50) exceeds this average cost, reflecting an attractive gain.
This is probably the simplest plan among the three. This system consists of investing a constant
dollar amount in common stocks over a long period of time at fixed intervals. The fixed intervals
means weekly, monthly, annually, or some other time period as long as it remains the same.
For example, a person might invest R500 per month in common stocks. Or this same person
might invest R3,000 every six months. The idea is to invest smaller amounts of money on a
regular basis. It is a long term system. The theory is that stocks can always be sold on the
average for more than they cost. It does not get you in and out of trades. It only gets you in
trades.
The person must have a steady amount of income coming in and be willing to invest over a long
period of time. This system shouldn't be used on just one stock. The investor may want to choose
five or six different stocks to invest in this way. One or two different stocks could go down constantly.
However, a properly diversified portfolio will go up eventually.
This system doesn't mean that you should keep under-performing stocks in your portfolio. By all
means, get rid of the dogs. There is a school of thought that says an investor should not purchase
stocks with this program when they reach very high (overbought) conditions. However, when a
Page 131 of 192
person does this, they may spend the money elsewhere, it is difficult to tell when stocks are too
high, and the investor may not continue the program. I recommend that if stocks are at a level where
they may be too high, the money should be invested in stocks which do well in a declining market.
An example is utility stocks.
Some advantages to this method are: The average cost of shares purchased is usually less than the
actual market price. The investor eliminates the possibility of buying too many shares when the price
is too high. Also, periodic declines in the stock market provide buying opportunities at lower prices.
Some disadvantages are: The possibility of liquidating the portfolio when stock prices are low. This
could cause a portfolio loss. One way to minimize this danger is to plan to liquidate the portfolio
several years before the actual liquidation time. This gives the investor time to pick and choose the
best times to liquidate each holding. Another disadvantage is that the investors income might not be
as steady as would be hoped. This could curtail purchases at times that are attractive for additional
purchases. Another disadvantage is that the investor might try to time his purchases.
This turns him into more of a speculator than an investor. Another disadvantage is that the person
may be tempted to use the investment money for something which comes up (e.g. new car, home
repair, etc.) and is also quite important.
Sales
ROI
Total assets
=
Sales
Total assets
Explanation
The top portion of the worksheet deals primarily with the income statement (good operations
management), while the bottom portion emphasizes the balance sheet (prudent use of financial
leverage). This separation highlights that return on equity is affected by firm profitability and
balance sheet structure.
Sales, interest income (other income), cost of goods sold, selling and administration expenses,
interest expense, and taxes are entered from the income statement to determine net earnings
(or net income on some financial statements). Net earnings divided by sales gives us the profit
margin. It might be worth noting that Sara Lee did not break out depreciation as a separate line
item on its income statement, so we left that cell blank. Data from the statement of cash flows or
even changes in accumulated depreciation can by used to determine the depreciation, but for
the purpose of DuPont analysis it was not important to break the information out.
As you work with different companies, you will find slight variations in how they present their
financial statements. The worksheet, with its other categories, should prove flexible enough to
deal with the variations or it can be easily modified to conform to the variations.
Asset data from the balance sheet is entered to determine the total assets. For Sara Lee, other
assets include trademarks, investments in unconsolidated companies and intangibles. Dividing
sales by total assets gives us asset turnover. Asset turnover times profit margin provides the
return on assets.
The liabilities from the balance sheet are entered to determine the total debt. For Sara Lee, other
current liabilities consist of notes payable, current maturities of long-term debt and current
obligations under capital leases. The other liabilities box includes long-term obligations under
capital leases, deferred income taxes and other liabilities. Total debt divided by total assets
provides the financial leverage figure. Financial leverage refers to the percentage of total assets
financed through debt.
Dividing return on assets by one minus financial leverage computes the return on equity.
Examining the interplay between the ratios is the key behind DuPont Analysis. Return on equity
can be increased through higher return on assets or a higher degree of leverage--more debt
relative to assets. The high degree of financial leverage is how buyout artists hope to make big
profits when they take on huge amounts of debt in acquiring companies. The risk in the strategy
is that the company will not generate enough cash flow to cover the interest payments. Proper
use of financial leverage can help increase the return on equity.
Return on assets can be increased with higher profit margins or higher asset turnover. Margins
are improved by lowering expenses relative to sales. Asset turnover can be improved by selling
more goods with a given level of assets. This is why companies try to divest assets (operations)
that do not generate a high degree of sales relative to the value of the assets, or assets that are
decreasing their sales generation.
When examining profit margins or asset turnover, it is important to consider industry trends and
compare how a company is doing within its industry. A supermarket chain, for example, would
tend to have low profit margins, but make it up in high turnover.
Total assets
Stockholders' equity
Conclusions:
The Du Pont formula provides a lot of insights to financial managers on how to improve company
profitability and investment strategy. Specifically, it has several advantages over the original formula
(i.e. net profit after taxes / total assets) for profit planning. They are:
The importance of sales, which is not in the original formula is explicitly recognized.
The breakdown stresses the possibility of trading margin and turnover, since they complement
each other. Weak margin can be complemented by strong turnover, and vice versa
It shows how important turnover is as a key to profit making. In effect, these two factors are
equally important in overall profit performance
The formula indicates where there are weaknesses -- margin, turnover, or both
assess the portfolio on a regular time interval and do one of three things. Either he withdraws the
cash in excess of the R1 million, pays in cash to raise the portfolio back to R1 million or he can
change the level of constant system.
One of the greatest benefits of this system is that it forces investors to buy shares
when they are falling and sell when they are rising. The disadvantage to this type of
system is that a certain degree of timeliness is involved in determining when to
initially set the system up. In addition, a period of constantly rising or declining prices
does not work well. The system works best when prices fluctuate above and below
the original level.
A WORD OF WARNING
While Rand-cost averaging is a sensible investing strategy, it does not assure a profit nor protect
against a loss in declining markets, or against a loss if the investor stops the programme when
the value of an account is less than cost.
Traders should also consider their financial ability to continue making purchases through periods
of low price levels.
There is no method of investing that can guarantee a profit if an investor decides to sell at the
bottom of the market. However, the potential for a high return on an investment is increased with
long-term commitment to rand-cost averaging.
A Risk-Reducing Strategy: Along with being a simple strategy to follow, dollar-cost averaging
can reduce your investment risk, too. Suppose you have $10,000 to invest in the stock market.
You could invest the entire amount immediately - as long as you are prepared for the potential
for substantial loss.
A Disciplined Approach: A commitment to rand-cost averaging ensures that you are investing
regularly - even in the face of market declines. If you wish to follow this approach, it might be a
good idea to establish an automatic program that many fund sponsors offer to investors at no
charge. In this way, your instalment investments are made without your intervention - through
regular transfers from a bank account or exchanges from a money market fund account. In
addition to providing your investment program a measure of discipline, you'll protect yourself
from your emotions - and the natural tendency to cease investing - in a sour market.
Stock splits
At times listed companies will declare a stock split, which is usually done to improve liquidity. For
instance, if Company UU Ltd. has one million ordinary shares in issue, at a share price of 100,00
cents, it is unlikely that there will be too many investors trading the share. There are two reasons:
The company would decide on a split ratio and announce to the public what that split will be, when it
will take place etc. Essentially, if the split is 10:1 it means that for every share that the investor has,
he will now own 10 shares, i.e. the share has been split into 10 shares. However, the price is also
split in the same ratio and the share is now worth 1,000 cents. The investor has more shares, but at
Page 136 of 192
a lower price, i.e. the value of his investment has not changed, but there are now more shares in the
market to trade.
For investors, the opportunity to buy a share (at R10) that was R100 is an opportunity that many
often cannot resist. However, there is no guarantee the share will rise in price after a stock split, but
if the split is not too server (100:1), the share often does rise.
Share dividend
There are many occasions when a companys dividends is not paid regularly and, at other times, the
company will offer a share payment instead of a cash dividend. Assume a company declares a 10%
share dividend. This means that for every 10 shares of a person owns, he gets one new share as a
dividend. If a corporation has 1,000,000 share of common stock outstanding and declares a 10%
stock dividend, the corporation will have 1,100,000 shares of stock outstanding after the stock
dividend is paid.
The individual investor maintains his proportionate share and the same total book value in the
company. While book value per share will be less, due to more shares in issue, his investment in the
company remains the same.
Basically, the company is capitalising its earnings. For the long term investor, the benefits of
accepting a share dividend in an increase in his portfolio that will have future dividend and
added capital growth.
cash = Cash
flow
capital expenditures
Dividends
"How well am I doing with my investments?" If the question really meant a simple increase or
decrease in the value of a portfolio, the formula would be a simple percentage calculation, as
highlighted by the following basic example:
Example:
Ken Rodney invests R111,200.00 with Institution V for a period of nine months.
Institution V placed all the funds equally in two companies, namely Company DD and Company
GG.
Company DDs share is valued at 930 cents a share, while Company GG is valued at 8200 cents
a share.
The investment equates to 5,979 shares in Company DD and 678 shares in Company GG.
In the nine months since Ken invested the money, the share price of Company DD has risen to
1390 cents a share, but Company GG has seen its share fall marginally to 8100 cents a share.
No additional shares have been acquired or redeemed during the investment period.
At the end of nine months, Kens portfolio is as follows:
Details
Initial entry level
Initial portfolio (value):
Current
(value):
portfolio 03/01/199
9
Capital gains/(losses):
03/01/199
9
Capital gains
03/01/199
9
03/01/199
9
Capital growth
Dates
02/04/199
8
02/04/199
8
Portfolio
-
Shares
-
Price
-
Rands
R111,200.00
Company DD
Company GG
5979
678
930 cents
8200
cents
R55,600.00
R55,600.00
Total
Company DD
5979
Company GG
678
1390
cents
8100
cents
R111,200.00
R83,108.00
R54,918.00
Total
Company DD
Company GG
49.5%
(1.2%)
R138,026.00
-
R26,826.00
24.12%
The reinvestment of dividends per share paid from net investment income.
The reinvestment of distributions per share paid from net realized capital gains.
The change in net asset value over a specified time period.
Calculating the total return for your fund investment is relatively straightforward (assuming no
additional purchases or redemptions were made during the period)). To determine your total return,
simply take the difference between your account balance at the end of the period and your account
balance at the beginning of the period, and then divide by the beginning balance. Multiply the result
by 100 to arrive at the percentage figure.
X 100
Beginning Balance
Using the above example:
Total
Return
X 100
Beginning Balance
Total
Return
138,026.00 - 111,200.00
X 100
111,200.00
Total
Return
0.2412410071942
Total
Return
24.12%
X 100
Stated differently, the above formula for percentage returns can be determined as follows:
Total
((138,026.00/111,200.00)-1) x 100
((1.2412)-1) x 100
0.2412 x 100
24.12%
Return
Total
Return
Total
Return
Total
Return
Total
Return
Example:
Ken Rodney invests the same as in the first example, namely Company DD and Company GG, and
in the same amounts.
Add to the above example:
1. Company DD declares a dividend of 400 cents a share for the six months to end
December 1998.
2. Company GG declares a dividend of 1000 cents a share.
3. In addition, Rodney buys 10,000 shares in Company XX, at 320 cents a share, and sells
all these shares at 370 cents two months later. The cash is kept in his account.
The above example now changes to:
Details
Dates
Portfolio
Shares
Price
Rands
02/04/1998
02/04/1998
Company DD
Company GG
5979
678
R111,200.00
R55,600.00
R55,600.00
03/06/98
10000
03/01/1999
Company XX
Total
Company DD
930 cents
8,200
cents
320 cents
5979
Dividend income
Company GG
678
Dividend income
Company XX
Bought at
Sold for
Cash on hand
Interest
months)*
+Total
Capital gains for remaining
portfolio :
03/01/1999
03/01/1999
1,390
cents
400 cents
8,100
cents
1,000
cents
R32000.00
R143,200.00
R83,108.00
R239.16
R54,918.00
R6780.00
10,000
10,000
-
320
370
-
R32,000.00
R37,000.00
R5,000
R1028.24
151,073.10
Company DD
24.12%
Company GG
10.82%
(six
R39,793.62
Total capital growth
03/01/1999
35.78%
Compound interest is calculated as set out in chapter . Interest is compounded per month,
for six months, at a rate of 19% pa.
MARKET SENTIMENT
Over time, I have interviewed hundreds of traders around the world. I always throw in a question
about analysing market sentiment. Strangely, despite the importance of the information, few have
any clue on how to combine fundamentals and technicals to develop a chart to identify investor
sentiment. Each and every trader interviewed has a different explanation as to why the market is
moving a certain way. I have noticed that the answer tends to rely on how well a trader has done on
that day. If, for instance, the or she has competed the Six Steps successfully; the answer is that
investor sentiment was positive and identified during the analytical process.
Page 140 of 192
When trading goes wrong, the answer is always the same: Investors changed their minds for no
discernable reason!
Sometimes, no matter how convinced a trader is that the investor sentiment will move in a
specifically identified manner and direction, with all the signals triggered, he or she still ends up
losing.
Market sentiment can, therefore, be described as a combination of many views, ideas and opinions
by many different types of traders, analysts, media, portfolio managers and investors.
Sentiment-Based System
Junior traders are repeatedly told to gauge market sentiment. In the past, under the open outcry
system traders and dealers could get a strong sense of market noise because they were on the
trading floor talking to clients and other traders. Today, these trading floors have virtually become
extinct. Using a computer to trade means that you have to develop other means to identify market
sentiment, whether bullish or bearish.
So, the answer may sound simplistic lets develop a sentiment-based system to help identify where
traders should buy or sell. The first indicator that can be used is volume traded as an indicator of
sentiment.
Traders Trigger:
If a shares is rising, but volume is declining: signal - the market is overbought.
If the stock is falling, but volume is rising: signal - market sentiment may be changing from bear
to bull.
Without any tools to measure volume, how can a trader measure market sentiment?!
Many technical analytical tools were assessed to identify ways to determine market sentiment. While
many of these technical patterns can indicate changes in market sentiment (via changes in trend
direction, like reversals), the following have been identified as sentiment indicators to gauge the
markets mood.
The CBOE Volatility Index (VIX) is a registered technical analysis system developed by the
Chicago Board Options Exchange, Incorporated. The VIX is often referred to as the fear index.
o
New York Stock Exchange High/Low is calculated as the net difference between stocks at 52week highs and those at 52-week lows. When prices swing radically traders expect to see ratio
rise.
The $NYHL Index a market breadth indicator that is slightly different to the previous indicator as
this one takes into account the difference between stocks making New 52-week Highs from
those making New 52-week Lows. These values are plotted cumulatively to create a NYSE
High-Low trading Line.
Day 1
Day 2
Day 3
Day 4
Day 5
Day 6
Day 7
Day 8
Day 9
Day 10
Day 11
Day 12
Day 13
Day 14
Day 15
Day 16
Day 17
Day 18
Day 19
Day 20
HIGHS
LOWS
NET
NET AVE
350
360
320
180
210
220
195
660
200
320
360
330
280
270
180
178
150
120
110
80
120
100
80
5
660
130
80
10
450
340
178
339
335
180
120
170
133
10
8
120
230
260
240
175
-450
90
115
650
-250
-20
182
-9
-55
90
60
8
17
110
102
-40
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
67.15
What the chart shows: The movement of this line can therefore measure the strength of the
market, or the direction in which it may be heading.
The indicator can be read in two ways.
The line oscillates around the average. If the line is above the average, there are more new
highs than new lows which shows a more bullish market.
Conversely, below the average, the market may be seen to be more bearish.
Sentiment indicators provide insight into the underlying strength of market movements. They are
easy to draft and extreme readings can be strong indicators that prices are set to change.
CHAPTER SUMMARY
Financial models and advantages/disadvantages of using them are set out and include
extremely important mathematical concepts of Du Pont analysis and Averaging strategies;
with examples.
IN THE NEXT CHAPTER
In Chapter 17, the Final Step and perhaps the most important one, of our system to select
and trade shares is explained.
AIM OF STEP 6:
THE FINAL STEP IS TO UNDERSTAND THAT PROFITS ARE
HIGHER WHEN YOU TIME YOUR TRADES. THERE ARE
THREE FORMS OF TIMING.
To identify whether this is the case with the chosen trade, use the Stochastic Oscillator to indicate
whether the share is overbought, oversold or not. This indictor in effect compares todays price to a
preset window of high and low prices to create a range between zero and 100.
When the Stochastic lines are above 80 it means the market is overbought.
When the Stochastic lines are below 20, it means that the market is oversold.
As a rule of thumb, traders should buy when the market is oversold, and sell when the
market is overbought.
Use a spreadsheet to write down the values calculated using the above formulae.
In the same spreadsheet record todays closing price for the past 26 days. This becomes a point
in the delayed line.
Using a spreadsheet, chart all the above lines together with the closing share price; as follows:
The IKH is combined with the closing share price line and the space between IKH line and share
price line called The Cloud. Traders use the lines that make up the cloud as support (lower line) and
resistance (upper line) levels.
Traders Trigger:
When the price is within the Cloud area, the market is not in any specific trend.
When the price is above the Cloud area, the higher Span is the first support level and the lower
Span is the second support level.
A Secret Revealed
While the IKH is brilliant to identify potential future price movements, it is extremely difficult to keep
the information updated for then many shares identified in your watch list. If you look closely at the
formulae above, there is a very close similarity to using the much easier moving averages. Using the
same time spans as the IKH, use moving averages (nine and 26 days MA) as the IKH standard and
turning lines.
Therefore, a traditional moving average technical indicator and the IKH standard/turning lines will
give a similar result. As discussed in this book, a buy signal is triggered when the shorter term MA
crosses the longer term MA going upwards. A sell signals is triggered when the opposite takes
place.
The above triggers also apply to IKH when quantifying market expectation over a specified time
period.
Page 146 of 192
Short term trades: Buy at a premium. If you need to get the stock NOW, a market order will
just place you at the end of the electronic trading execution queue. By the time you get the stock,
the price will have moved and you will have lost the deal. This is especially true in geared
markets.
For the first three days: place your offer at a discount of 6% to market.
If your offer has not been take up, change your offer to 2% discount top market for the
next two days.
After this timeframe, change your offer to at market for one day only.
If after this time period you still havent being able to get the stock, move the offer to a
2% premium.
EXIT STRATEGIES
Always have a stop loss or a trailing stop loss.
A stop Loss is simply a level; at which you feel comfortable in selling the share if it fall. so, if you
think 10% is an acceptable loss, sell the security if it falls to this level. A trailing stop loss is the
same strategy as the stop loss, except that the fall is based on the shares upward movement.
Example:
The stop loss exit points have to be determined before you get into a trade.
If the trailing stop loss is triggered, but your overall portfolio is still only marginally affected,
consider holding the stock until it hits the stop loss.
CHAPTER SUMMARY
The aim of this chapter is to complete the Six Steps by setting out three systems to time (as
best we can) markets and thus entry points. These include a system to detect the current
strength of a companys share, then to see if that strength in based on a trend. The final
system detects whether (and what) the price could be in future.
IN THE NEXT CHAPTER
In Chapter 18, more advanced technical and fundamental analytical tools are explained. The
first concept is that of placing a value on new companies being listed.
On a very unpleasant wintery day in April 2010, I stood in front of the JSEs Alternative
Exchange new listings committee and was asked a simple question: How did you value this
company?
I had been warned by the Designated Advisor (listing stockbrokers for AltX companies in
South Africa) that this question would be asked and a trap had indeed been sprung.
The trap is that the valuation of an unlisted company is always discounted to that of a listed one.
Many brokers tend to compare, and thus value, their potential listing to that of peer companies
already listed.
I wasnt really concerned. After all, this very subject of determining a share price for a company
without a trading history is the subject of my proposed dissertation (accepted) at the Nelson
Mandela Metropol University economics department. In addition, the methodology of valuing
unlisted companies has been accepted by a number of universities in South Africa after the
publication of The Corporate Mechanic (Juta).
Succinctly, I explained the process of how I had valued the company. The listing committee nodded
and the rest is, as they say, history. The new company received one of the fastest Unconditional
listings in the history of AltX.
extent, historic, current and future trends in similar peer companies could have and how such could
influence the targeted IPO.
So, where is the trading opportunity?
The reality is that a listing only determines a price based on very little information which means that
the market is depending on stockbrokers to set the price. The following highlights some of the
problems traders have in buying into IPOs, but it also suggests why IPOs can be profitable
investments:
There are NO RULES in South Africa (from the Companies Act to JSE listing
regulations/schedules) to determine a fair and realistic share price for a company before it lists
on the JSE or on AltX.
Pre-IPO share prices are currently determined using a variety of methods, from Discounted
Cash Flow (DCF) to Net Sales or Asset values. Companies that are in similar industries can thus
be valued using different methods and, consequently, different values can be obtained for
similar companies.
The valuation method and thus determination of ultimate share value is completely left up to the
stockbroker and entrepreneur involved in the listing process.
This usually means that the method offering the highest share price before listing is used to
substantiate a pre-IPO value to the JSE committee and to the investment community.
Therefore, the valuation benefits the owners and not aimed at being fair to investors or traders.
Investigation needs to be undertaken to assess how the US, UK, France and Far Eastern
countries determine a pre-IPO share price. My experience in stockbroking suggests that these
countries also do not have an enforced methodology to establish a fair price.
Yet, South Africa like their foreign counterparts has a set of corporate governance rules and
regulations. In South Africa, the King III set of criteria was first merely guidelines, but are now
enforced.
This chapter examines the IPO process involving companies engaged in becoming publicly-traded
organisations. No-one is suggesting that owners and stockbrokers shouldnt benefit from listings.
After all, if owners, staff and new investors believe in the companys future prospects, then the share
price will rise in future.
The trading opportunity is in how you value an IPO.
Some of the suggestions that follow are fairly intuitive, but common-sense in trading is usually a
prerequisite to success.
The methodology to assess a share price of as company with no trading
history is two-fold.
The second is to hone that value down to a fair and reasonable level via
a set of three discounts.
PART 1
Subtract
PART 2
A trader should approach an IPO by first knowing what it offers relative to its competitors and, no
less importantly, he or she should have a firm grasp on the growth potential of its sector and the
public demand for what its industry offers.
I call the above criteria Price Earnings Market & Company Peer Analysis.
Definition of Price Earnings Ratio (p/e ratio):
This ratio is best described as the amount of cash investors are prepared to pay for R1 of
companys earnings per share. So, if the share price is 100 cents and the profit per share
(companys earnings described per share) is 10 cents, then the p/e ratio is 10 times.
Formula: p/e = Share Price divided by earnings per share.
Phase 1 is a combination of global market research and local trend analysis. Here, the company is
assessed relative to industry trends, specific sector price earnings ratios and comparable peer
analysis (see example below). Many analysts use price earnings as the overall valuation of the
company, i.e. if IPO of Company A is comparable to Listed Company X then why not use the same
price earnings ratio?
Expert contention is that the IPO is an unknown quantity as a listed entity and thus difficult to assess
as a trader, but potentially highly lucrative as a trading instrument.
Page 152 of 192
The comparable price earnings ratio should therefore be the basis to calculate what I define as
gross value. After this, a set of criteria (discounts) has to be used to hone in to a more relevant ratio
and thus share price.
In South Africa, large venture capital firms have a basic method of price earnings valuation: all
companies deemed fit to invest in must be value at between 2.5 times and 4 times price earnings. In
turn, this is also an unfair practice as no analysis of future growth potential takes place and all
companies (no matter which sector they are in) are valued in the same manner.
The following basic valuation uses fictitious numbers:
Analysis:
General markets (All Share and Industrial Indices) indicate that p/e ratios are currently
below two year averages and thus cheap, i.e. entry points are determined.
The Property Index shows that the sector is still expensive relative to other markets, i.e. the
current p/e ratio is above the two year average.
The same is indicated by the three comparable companies, i.e. their p/e ratios are above
the two year averages.
It can this be said that, given that the sector and comparable companies are higher than two
year averages, ABC is listing at an expensive time. It can also be stated that this could be
due to the cyclical nature of the business.
Comment:
This stage determines which price earnings ratio to use, based on industry norms and
comparable listed companies. Analysis of price earnings ratios includes: JSE All Share Index,
which reflect the overall state of the South African market. The JSE All Share Industrial Index,
which reflects the industrial component if the South African market and The JSE Sector Index,
which reflects how comparable companies are doing as listed entities.
ABC LIMITED
INDICATIVE GROSS VALUE
(Before Discounts)
Max
min
mid-way
R100 m
R100m
R100m
R2,750 m R1,570 m
R2,160 m
Data and methodology: This assessment and valuation draws from a wide variety of small and
medium sector data that could be accessed. These include information from Statistics South Africa,
South African Reserve Bank, Trade & Industrial Policy Strategies dataset and enterprise surveys.
Company profile, corporate events and environmental influences (politics, economics, business and
technology) should also be taken into account to determine factors that could negatively or positively
influence a valuation.
2,06
1,89
1,41
34,31
27,64
1,36
31,36
22,31
2,42
1,32
0,41
0,68
1,88
6,42
3,15
2,46
1,62
0,35
0,59
13,28
5,37
12,88
2,70
0,46
5,55
5,08
1,59
0,85
1,17
48,35
20,84
5,67
3,04
8,59
7,52
6,07
4,53
1,23
25,60
16,11
8,43
9,01
Funding structure
Current ratio
Quick ratio
Debt to assets
Debt to equity
Interest cover
Debt to cash flow
Cash flow interest cover
Profitability structure
Share statistics
81,54
67,82
8,62
7,95
Dividend cover
Cash flow dividend cover
1,94
5,98
2,01
4,00
27.5
10.26
23.7
13.77
Based on the above statistics, the Property industry had an Industry Cash Flow discount of 8.62%
and a five year discount of 7.95%. This means that the amount of cash generated by companies in
this sector (as an average) was less than share prices, i.e. if a companys share price was 100
cents, then the cash generated was 100 cents less 8.62% = 91.38 cents.
ABC LIMITED
INDICATIVE GROSS VALUE
LESS DISCOUNT1
Max
GROSS VALUE
min
mid-way
R2,750.00m R1,570 m
R2,160 m
R135.33m
R176.97m
LESS DISCOUNT 1 R218.62m
R2,531.37m R1,434.66m R1,983.02m
VALUE
The next step is to take account of the desire or potential desire of staff, colleagues, directors and
the public in general to acquire shares in the business. Experience in international negotiations
suggests that this discount can range between 25% and 40%, depending on issues outlined in the
following text. BCI uses the worst case scenario and a 40% discount is used; particularly with new
companies.
ABC LIMITED
INDICATIVE GROSS VALUE
AFTER DISCOUNT 2
Max
Min
mid-way
LESS DISCOUNT 2
R632.84m
VALUE
R1,898.53m R860.79m
R573.86m
R603.35m
R1,379.66m
ABC LIMITED
INDICATIVE GROSS VALUE
AFTER DISCOUNT 3
Max
Min
mid-way
LESS DISCOUNT 3
R132.89m
R86.07m
R109.48m
R1,765.63m R774.71m R1,270.17m
VALUE
12.70 times
With the above final indicative value, a trader is able to forecast an expected share price, as follows:
The trader knows that 2540 is fair value for ABC Limited. A trading plan can then be established.
OR CAN IT?
Here is a little secret: the listing stockbroker will always suggest that the company be listed at
between 15% and 20% less than the estimated share price. This is called An Abnormal Initial Return
which traders can use to finalise their trading range. However, besides the immediate discount to
share price, the trader needs to assess where the share will be going to in the near future, to
determine the full annual trading range. Take account of the following:
Summary
Valuing a company is not a precise science and can vary depending on the type of
business and the reason for coming up with a valuation.
There is a wide range of factors that go into the process -- from the book value to a host
of tangible and intangible elements.
In general, the value of the business will rely on an analysis of the company's cash flow
and its ability to generate consistent profits.
It's rare that buyers and sellers come up with a similar figure, if, for no other reason, than the seller
is looking for a higher price. The goal of the trader is to determine a ballpark figure from which
market buyers and sellers can find a comparably fair value for the company.
It is also nave to interpret valuations of IPOs in boom periods to be different to that of crash
periods., but the new issue market is certainly well worth watching.
Nevertheless, it is worth watching the market for IPOs, especially when short term factors influence
the price to below true worth; as calculated above. I believe that a number of additional discounts
could be added in future to improve analysis and share price calculation. For instance, you will not
come across many instances where a company entering the IPO process has dissension among its
members. However, if it does then a price will be influenced. Look out for director dissatisfaction
by looking at media releases.
This, of course, affects the pre-IPO share price.
However, professional traders understand that some companies are obviously much more
successful than others at getting everyone on the same page. It is clear that dissension can only
cease if everyone can agree on what the company wishes to accomplish, what business it will be in
and what its goals and methods will be; if there is any disagreement on this, then becoming a
publicly-traded company should not happen until unanimous consensus is achieved.
The most successful companies are able to do this.
In a matter as important as listing a business on a stock exchange, it is necessary that unanimity be
achieved before the IPO process gets under way; the organisation should also make every effort to
groom its executives for the rigors of being the leaders of a publicly-traded entity.
In essence, if a set of guidelines as set out above exists to calculate a fair share price, much of the
tension is removed from the IPO process.
Looking at Prospectuses
When a company lists, it usually needs cash to begin its operations. They do this by issuing a capital
raising document called a Prospectus. There are general rules relating to the information placed In
such a document, so that investors can make a proper judgement as to whether they would be
interested in buying the share. For traders, this provides them with a starting point in their decision
making process. For instance, if a trader only buys and sells securities in mining and finance, then
why would he spend time assessing a property-related Prospectus?
The minimum requirements for a prospectus are laid down by stock exchanges, listing requirements
and government acts. By the time investors read the prospectus, therefore, they can be fairly certain
that the information in it has been checked for accuracy. What should investor and traders look for in
trying to judge the merits of an IPO from a prospectus? The more pertinent parts or elements of a
Prospectus are set out as follows:
The nature of the business and its history. A long history and a company that is focused in
areas which are assessed to be expanding sectors of industry are major selling points. A short
record and dependence on one product or contract are not.
Premises and plant. Look for companies which own their factors and premises. There are times
when a listed company means that landlords feel that they can push up rentals to a point where
the companys working capital becomes strained and thus has to incur costs of moving.
Directors, key management and staff. Directors and management should be skilled and
experienced in their industry. Ensure that the Board complies with all legislation. For instance,
AltX requires that Boards are made up of 25% non-executives.
Working capital. Traders can be certain of one fact: companies will invariably state that they
have "sufficient working capital." I suggest that you assess working capital against current assets
and liabilities.
Profits, prospects and dividends. The directors' forecast of profits should be realistic and,
when compared to the previous year, should be reasonable. The norm is for companies not to
declare a dividend in the first year of operation.
Auditors report. A profit record should be assessed and analysed for organic growth and
stability of potential acquisitions, look at basic ratio analysis to determine whether fixed and
trading assets are accurately calculated according to latest international accounting principles.
Liquidity, such as cash and short term current assets should be at least 1.5 times higher than
current liabilities.
Some companies have a habit of hiding negative details in a mass of information, such as pending
litigation. As a trader, can you trust a company that does this?
CHAPTER SUMMARY
This chapter concentrated on providing traders with a personally developed method to trade
potentially profitable new shares, but ones that have no market related price.
IN THE NEXT CHAPTER
In Chapter 19, among a number of valuable investment tools the concept of cash flow per
share is set out. Know this intimately, as this system will eventually be your saviour.
If you try to assess triggers, where do start? There are so many that the share price becomes a
straight line. imagine adding yet another indicator to the above mess? When I rather too bluntly told
him that he need to use a maximum of six indicators to be successful in trading he laughed.
What fun is that? he was appalled that I would even suggest such a thing, What I was actually
proposing was that he amend his strategy to become more efficient with less work. The strategy was
simple: Reduce the number of signals, but create a watch list to assess stocks that are triggered by
the more relevant number of signals.
There is a stock market contradiction that never fails to amuse. While it may be okay to be greedy,
when traders get caught up in a market madness panicking when bears roar and greedily buying
during bull runs they are reprimanded by their stockbroker bosses.
There is no skill in buying or selling shares during strong bull or bear markets, but it takes
unprecedented courage to go against mass hysteria and buy when others are selling. Across the
world, traders repeatedly do the same thing; when markets climb, investors pour money in and when
market fall, investors take money out.
There is no other clearer evidence of a less profitable strategy than a classic buy high and sell low!
What is worse, this process is continually repeated. Traders simply cannot restrain themselves from
continuously changing their portfolios.
In fact, trader and investor behaviour is often so weird they throw away years of long-term strategy
to ultimately achieve dismal results. Industrial psychologists around the world have tried to
understand what makes them function. Strangely, no matter how much time or money it takes to
draw up a long-term plan to meet an investors specific requirements, their perceptions and
expectations are substantially influenced by their market experience of the last few months and, in
some instances, the last few days.
Former South African Reserve Bank Governor General Gerard de Kock in the 1980s said that when
markets are bearish for a number of months, South Africans begin to believe that these markets will
continue to do poor forever and they begin to sell everything. If they have been doing well, investors
become euphoric and begin to believe that this time it is different and the markets will continue to be
bullish forever. The higher the market price goes, the more they want to buy.
That strange philosophy was highlighted in 1997, just before the Emerging Market Crash. As head
of research at a local stockbroker I was asked whether the company should dump its shares as the
market was too high to last!
I reiterated that a fall would be temporary and that dumping the shares would result in massive
losses over time. The portfolios would be disrupted and rebuilding them would cost more than the
small benefit of selling before the fall.
I had hardly left the boardroom when the directors stated to sell everything they held. The market did
fall, but had recovered within three months.
Traders and investors have seen - despite a multitude of negative and positive political factors,
financial and business turmoil and progress and personal freedom for all since the general election
in 1994 - the JSE Limited Overall Index rise by over 480%.
When a trader changes a portfolio weekly, he or she is making the assumption that during the next
week the markets will behave like the last week. In other words, the best parameters for a forecast
period of time, is unlikely to be the historic trend that has just occurred.
All traders, in all markets around the world, go through losing periods - no matter what type of
approach chosen or preferred. Performance cannot improve by constantly changing their strategic
approach to managing investment portfolios. Since there are many more losing approaches than
winning ones, traders actually decrease their chances of success by frequently changing systems.
The best advice I ever received from a successful stockbroker: If you want to be a doorman, be one
at the Hilton. In other words, if I wanted to be successful as a trader, I should know what the
investing public want and buy before they do. Alternatively, if you want to be a global player, you
have to be in the international arena. Remember that the same rules apply for all markets. If an
investor can trade for an extended period in a wide variety of markets, he is likely to be successful,
although success in never guaranteed.
This works although markets change their short-term patterns, they tend to show similar long-term
trends. That is your edge. If a trader plays the trends, he or she is likely to succeed in the long run.
Attempting constantly to modify your system to mimic the changing patterns of the recent past will
not improve your chances of success.
It will more likely ensure failure.
A companys earnings per share is calculated by dividing attributable profits by the number of
shares in issue. Consequently, if more shares are issued, the earnings per share must fall as
a number.
If you assume an unchanged price earnings ratio, then the share price will fall.
Remember that share price is calculated by multiplying share earnings per share by price
earnings.
The astute trader also knows that the injection of capital into a companys balance sheet will
influence liquidity. A such, a cash injection improves the companys liquidity ratio and ability to
expand operations. This in turn means that the lower calculated share price should be temporary.
It is common practice for a company to rule off its books when stocks are at their lowest, which
obviously reduces the problem of stocktaking; it also means that the cash balance is at the year's
highest and therefore the balance sheet shows the greatest strength.
When traders set out to evaluate a group's liquidity he or she must first establish the nature of the
trade and the time In the trade cycle that the books are being ruled off. Then and only then can
the effect of a capital injection be determined.
Skilled traders also use the same method to calculate sector CFPS and then use the information to
draw comparisons to other companies or sectors. The following examples shows a company with a
200 cents CFPS. When the line is drawn on a share price graph, you get an indicator of when the
share is overpriced or not.
Essentially, all prices above the 200 cent mark suggests that the company is trading above fair
price, while below the 200 cent mark, the company is undervalued.
PATIENCE
Even when traders have carried out all fundamental and technical analysis and want to buy a
security, they cannot control the market and related price actions. So, instead of waiting for the entry
level to be triggered, traders often plunge in.
Patience is a scarce commodity in stockbroking and particularly among traders. Heres a simple
suggestion: have more than one security which you want to buy. That way you are looking at
multiple entry levels , which should keep you busy and avoid too early market entries.
As investors and traders have no control over markets, look at what you can control. This really boils
down to you and your patience. A suggestion is to conduct research while you wait for e should be
moved to but you can control when you're willing to buy shares. The final device your entry levels to
be triggered. If you want to become successful, you have to be patient enough to wait for a value
price before making a purchase.
CHAPTER SUMMARY
The chapter looked at very useful tools to improve your trading, including liquidity analysis
and a cash flow per share verse share price study.
IN THE NEXT CHAPTER
In Chapter 20, the new trader is really stretched by looking at further use of technical tools.
This time the importance of being able to combine averages is explained.
Combining Averages
STEP 1: DETERMINE WHETHER TO TRADE OR INVEST
One method to use moving averages more effectively, but obviously in a more complex manner, is
to use moving averages as support and resistance indicators.
So, in this instance, you ignore traditional support and resistance lines and use signals based on
specific moving averages. The trick is to combine exponential with simple moving averages to get a
Moving Average Trigger.
A brief reminder: common verses exponential moving averages.
Simple moving averages are basic lines based on a number of days taken as an average. These
indicate the average price paid for a share over time, but are susceptible to giving traders false
signals.
Exponential moving averages have a greater weighting on recent prices as opposed to average
prices. The greater emphasis on current prices mean that traders can rely more accurately on
signals. As such, traders can use exponential moving average to quickly detect changes in
trends.
Note that simple moving averages are a smoother line than exponential moving averages.
The combination of simple and exponential moving averages provides a unique look at the
market, providing traders with signals for both short and long-term trades.
It must be stressed that there are no hard and fast rules as to the length of time used for both the
simple and exponential moving averages. This depends solely on your trading style and strategies.
Whatever timeframe you use, ensure that you test and re-test signals before you adopt these as
strategy.
While there are no rules as to timeframes, experience shows that the following are popular among
professional traders: Look at the 10 Day SMA and 30 Day EMA to determine if you should be
focusing on long positions or short positions.
Here are the rules for timing your trades to the market using moving averages.
If the 10 Day SMA is above the 30 Day EMA: Buy long positions only.
If the 10 Day SMA is below the 30 Day EMA: Buy short positions only.
This simple technique identifies the underlying trend and helps traders quickly decide whether a
position is right for them. Here is an example:
Looking at the chart above, a mere glance can tell you when to trade (buy for the short term) or
whether to buy as a long term investment. The above strategy is fine and can be used without
further signals being added. However. It is preferable to add an indicator to determine whether the
above triggers could be affected by oversold or overbought positions.
As moving averages are trend following indicators, they only provide sound signals in trending
markets and not when the share is moving sideways. At this junction, we need to establish whether
the trigger has substance, which we do by adding the Williams %R technical indicator.
When the indicator lies between 80% and 100%: share is oversold.
When the indicator lies between 0% to 20%: share is overbought.
The indicator uses the closing price relative to a price range over a predetermined period. The
default setting in most charting packages is 14 periods. Many professional traders use a setting of 3,
which is far more sensitive. When combined with the sma and ema, the following rules apply:
Trigger indicating an Oversold position: 10 Day SMA > 30 Day EMA and the Williams %R
is less than -80..
Trigger indicating an Overbought position: 10 Day SMA < 30 Day EMA and the Williams
%R is greater than -20.
Comment: The greater the overbought or oversold position (as indicated by Williams %R),
the greater the chance of a market reversal happening.
Rule:
o
o
Here is an example:
Comment:
Block A: Indicates that the moving averages highlight a LONG TERM BUY. This is
supported by a Williams R% level of below -80%.
o
Block B: Indicates that the moving averages highlight a SHORT TERM BUY. This is
supported by a Williams R% level of below -20%.
o
The importance of these triggers is that they are specifically for day traders as the triggers are not
predicting future events, but short term trends.
Many professional traders use the above method to identify when to establish long or short
positions, and then they use different sets of criteria to determine length of holding, whether to go
long or short and when to exit the trade.
Stated differently:
Traders want to know when to buy or sell at the most opportune time. This is really just another
of saying that traders want to buy at the lowest point and sell at the highest point. This is seldom
achievable as Institutional funds tend to sway markets before you are able to find that top or
bottom.
Traders tend to be bearish when the market moves strongly and gets near the top of the
Sell trigger.
If you set triggers, then use them and not try to add the elements of speculation into the mix. That is
always a disaster for traders.
CHAPTER SUMMARY
The chapter was designed for those keen to further their studies of technical analysis. In this
case, an ability to understand signals to such an extent that traders can combine various
signals to personalise entry or exit triggers.
IN THE NEXT CHAPTER
In the final chapter, a conclusion and final word are set out.
Conclusion
Six Steps to Trading Like a Pro has taken you through a host of variables to enable you to create an
effective trading methodology. It is important to see, however, that you take from this book only what
you need to design your own workable trading system. There is a myriad of financial and trading
books available to you to continually improve your skills. For instance, find books on accountancy.
Not in the sense of drafting financial statements, but rather on how to assess income statements
and balance sheets.
There is no harm in finding out how to read a companys accounts, after all, EPS is derived from the
statements which, in turn, ultimately results in the companys share price rising or falling.
However, what about those who are less than interested in reading to improve their trading skills? Is
there a quick answer to the overwhelming question asked during the many workshops which I have
hosted:
IS THERE A SIMPLE SYSTEM TO TRADE TODAY WITHOUT READING THIS WHOLE BOOK
AGAIN?
Against my better judgement, the answer is yes and relates specifically to those using a swing
trading system; outlined and explained in Lore of the Global Trader:
Swing trading requires, in my opinion, extreme patience as you need to combine fundamental
analysis with daily bar charts to help to time your market entry. In addition, most swing traders are
well capitalised, which allows them to diversify among different global markets and thus reduce risks
of declines in any single market. Being well capitalised means, of course, that you have substantial
funds available to you to trade.
Therefore, you need:
The above moving averages can be used to help you to quickly identify new trends. The simple
signal is:
If the signal indicates that the securities momentum is still strong enough to continue.
When the position becomes oversold or overbought.
The diagram indicates that the shorter term MA has crossed the longer term one in a downward
move, triggering a possible Sell Signal. this is confirmed by the Stocastic indicator, warning of a
slowiong down of momentum and weakening strength via the RSI. The OB/OS indicator is the final
confiormation that a SELL is indicated.
You can see that your investment criteria has been met, with all your predetermine indicators
(moving average crossover, Stochastic and RSI) all pointing to a sell signal. Yet, do you know how
many novice traders still ignore these and hold on in the h ope that the market will turn?
My analysis indicates that more than 80% of new traders hold onto loosing shares.
The final step in the above graph is to include a BUY and Sell entry point. You can use Resistance
and Support lines to do this. Make a note of your entry price, stop loss and exit strategy.
To summarise:
The above is just another way to say that trading systems dont have to be complicated or involve
dozens of indicators. Remember that you created your trading system, so not following it can only
mean that you are lazy, the system doesnt work or that you are not serious about being a trader.
Be disciplined and trust your system and your abilities.
Final Word
It has taken many pages to get to this final message and I hope that it has been a worthwhile
journey. My message is simple: if you have well designed system, are disciplined and serious about
your new career as a trader, then you must follow your own plans and strategies. For instance, it is
useless to say that you will trade IPOs and then decide to trade small caps. If you keep changing the
parameters of your strategies, you will end up the loser and much poorer.
If it helps you as a trader, let me finish this book with a few of the disciplines I have adopted over the
years:
In the share market, only buy Ordinary shares and ignore all other types of marketable
securities. I am not interested in buying Preference shares, even if they offer a higher dividend
I am not trading shares for their dividend, but for capital growth. I seldom hold shares for long
enough to earn a dividend.
Never put more than 2% of your entire capital into any single investment or trade.
Have a solid entry point and exit strategy. This means that at times I take profits too
early or sell a little late; but I keep to my strategy and thus never (I stress) never have
emotions of greed or fear.
My personal FINAL filter is to buy shares that generate more cash per share than
share price.
Believing in your strategy does not equate to being flexible. Markets and companies change
and at times change rapidly. When companies make unforeseen statements, be prepared to
take action and switch trades, often from one industry to another.
Educate yourself: take time to improve your investment knowledge through books, workshops
and keeping up to date on industries and companies by reading investment papers regularly.
Keep an eye on IPOs: I use the strategy and valuation techniques outlined in this book to pick
up quality new investments.
Volatile shares are great for short term trades: Look at companies that are tightly held for
opportunities to buy when they have been slammed by market conditions. If a company is 80%
controlled by a Blue Chip Institution, that organisation often steps in and acquired the share at
the lower value, which is a short term trading importunity for you.
There is a great deal of truth in the old saying that life is a gamble. Every action carries its own risks.
Every trade and investment brings you face to face with a specific risk. Those who are thinking
about trading as a career have to accept that you cannot sit back and accept (or think) that trading is
easy.
You can of course turn to a mentor to help you achieve your goals in an orderly manner.
While markets change and industries move in cyclical manners, I can always rely that properly
selected shares or other forms of securities will offer value.
You have to be patient and serious. This is simply not an industry to be taken lightly, but it can be a
highly profitable one.
And one which gives you the freedom to be your own boss.
Appendices