Stock Market as a System--

1. Stock Market is a Complex Adaptive System

2. In order to beat the System, you have to be outside the System—This is the core
reason why Technical Analysis, Marketing Timing Prediction and Momentum Investment
would fail most of the times.

3. Graham essentially established “Intrinsic Value” and “Margin of Safety” as “Outside the
System” parameters to aid investment decisions. Magic Formula’s “Earning Yield” and
“Return on Capital” are also “Outside the System” parameters.

4. Stock Market has been known to portray mainstream investors momentum led system
idiosyncrasies that often lead to short to medium term under-pricing or over-
pricing of stocks relative to their intrinsic values. Intelligent investors attempt to take
full advantage of these system anomalies.
More notes:
1. Intrinsic Value determination is hard; Business Model Quality Analysis Framework in
conjunction with certain key financial parameters can be a big help here. “Return on
Capital” is the most important parameter here.

2. Margin of Safety implies adopting the Contrarian type of investment strategy. You
have to bet against the market mainstream crowds at times when the stock market is
overly optimistic or pessimistic. “Earning Yield” is the most important parameter
here. You invest in stocks when their earning yields are high, and sell stocks
when their earning yields are low.

3. Per John Neff, the Stock Market tends to price stocks based on the P/E ratio, so
dividends are kind of being free gift to the investors. Also, companies which offer
stable dividends tend to perform better in sustainable earning power over the longer term.
So dividend stocks deserve some more weight in portfolio decision.
C.T. Wu’s Magic Formula Dividend:
1. Low P/E (<= Sector Stocks’ Historical P/E Average)
2. High ROE (>=15%) and High ROA (>=12%)
3. Good dividend yield (>= 10-YR T-Bill Rate) and track records
4. Good EPS Growth Rates (>=15%) track records and future prospect
5. Low debt/equity ratio (<=25%)

Note: (1) &(2) are the Magic Formula for buying good companies’ stock cheap

(3) is from John Neff’s perspective on Dividend advantage.

(4) is based on the fact that the main driver for stock’s value appreciation in the long term is
its EPS growth power, which is derived from David Dreman’s Constrarian Strategy perspective
and his new definition for investment objective and risk minimization.

(5) is just to insure that the company’s financial risk exposure is minimized.
 Value Investing
The Systematic Way

C.T. WU, PHD

TAITA MONTHLY SEMINAR
10/11/2010
 Ben Graham’s Value Investing Principle

 Pay 50 Cents for a Dollar

 A Dollar’s Intrinsic Value is always a Dollar!

 Pay 50 Cents for a stock whose Intrinsic Value is a

Dollar
 How to determine the Intrinsic Value is a Dollar? (Valuation)
 When the Market will offer you 50 Cents for a share whose
Intrinsic Value is a Dollar? (Patience)
 The Holy Grail of Value Investing

Price  Earning* (Price/Ear ning)

P  E* PE
(Gee! Any 7th Grader can be the Next Buffett!)
 Components of Expected Returns

P(t 2) E (t 2) PE (t 2)
R [ ] *[ ]
P(t 1) E (t1) PE (t1)
Company Dependent Market Dependent
Reward Reward
(Investment Reward) (Market Reward)

A Superior Investment Strategy should be both

Economically and Statistically sensible!
 Representative Guru Value Investors

 Warren Buffett
 Focus on High Quality Large Cap Stocks

 E(t2)/E(t1)>1 over several years (7 - 15% EPS Growth Rates)

 PE(t1) at least 20% lower than the Fair PE Ratio

 Peter Lynch
 Focus on High Quality Small Cap Stocks

 E(t2)/E(t1)>>1 over several years ( >25% EPS Growth Rates)

 PE(t1)<=20
 Martin Whitman’s Remark on Value Investing

 Buy cheap (Ben Graham)

 Buy only High Quality Stocks (Warren Buffett)

 Buy Growth, but don’t pay for it (Peter Lynch)

 Profile of High Quality Companies

 Quality in Assets
 Strong balance sheet with good liquidity
 Low debt
 Quality in Earning
 High and stable ROE (>15%)
 Free Cash Flows in line with GAAP Earnings
 High and sustainable entry barriers (Wide Moat)
 Quality in Growth
 7 – 15% EPS Growths for established market leaders (Buffett)
 >25% EPS Growths for emerging market leaders (Lynch)
 Quality in Management
 Competent and ethical
 Concern for investors’ interest
Don Yachtman’s “Investing in Stocks like Bonds”

 Bond Investing Criteria

 Company Credit Rating (AAA, AA, …, CCC) for Risk
Assessment
 Promised Annual Interest Rate by the Issuer

 Stock Investing Criteria

 Company Quality Rating for Risk Assessment

 Expected Annual Return Rate

 A Unified Reward/Risk Investment

Framework for All Classes of Assets!
Expected Annual Rate of Return (EARR) for Stocks

EARR = Expected Annual Investment Return (EAIR) +

Expected Annual Market Return (EAMR)

Where
EAIR = Expected EPS Growth Rate + Expected Dividend
Yield
EAMR = Expected EPS Growth Rate – Current PE Implied
EPS Growth Rate

EARR = 2*Expected EPS Growth + Expected Dividend Yield

– Current PE Implied EPS Growth
 Fair PE Ratio Valuation Formula

 Ben Graham’s 1934 Formula

 Fair PE = 8.5 + 2 * G (EPS Growth Rate)

 C.T. Wu’s 2010 Formula

 Fair PE = 8.5 + 1.5 * G (based on Post WW II Regression Data)

 Current PE Implied EPS Growth Rate

= (Current PE – 8.5) / 1.5
EARR Calculation Examples (Yahoo! Finance 10/4/2010)

Company Expected 5-Yr Expected Current PE EARR

EPS Growth Dividend Yield Implied EPS
Growth
IBM 11.5% 1.5% 2.8% 21.7%

APPL 20% N/A 8.3% 31.7%

TSYS 17.5% N/A 0% 35%

CKSW 20% N/A 6% 34%

* Analysts’ Average on Yahoo! Finanace

 Wireless Communication Theory and Value Investing

System Objective Wireless Communications Value Investing

(Maximize Signal/Noise (Maximize
Ratio) Reward/Risk Ratio)
Step 1 Received wideband signal Over 8000 public
company stocks

Step 2 Narrowband Filtering to filter Use “High Quality

out unwanted signals Company Criteria” to
filter out 95% of stocks
Step 3 Demodulate signals to “Demodulate” financial
baseband data to “Expected Annual
Rate of Return” (EARR)
Step 4 Signal detection by threshold Consider investment
(S/N >= C dB) when EARR > 20%
 Build a Personal Portfolio of 6 Stocks

 X+Y=6
 X: High quality large caps at reasonable PE ratio

 Y: Potential high growth emerging market leaders within your

circle of competence
 Replace an existing stock only when another stock
with better reward/risk profile is identified
 “If you take out the top 15 – 20 investments by
Berkshire, you get mediocre results”
– Charlie Munger, Vice Chairman of Berkshire
Spotting the Emerging Market Leaders Early On

 Two Asymmetrical Factors

 Motivations

 Skills

 Software-centric service/solution small caps

 TSYS (GPS / e-911 / SATCOM)

 CKSW (Service Chain Optimization Software)

 Emerging consumer franchises (Piloting -> Scaling)

 Chipotle

 Panera Bread
 Key Factors Affecting Stock PE Ratios

 Major company performance announcements

 Inflation & 10 year Treasury Bill yield
 Secular Bull/Bear cycle reversion-to-the-mean forces
(~ 7–20 years)
 Cyclic Bull/Bear cycle reversion-to-the-mean forces
(~ 1–3 years)
 Short-term (<= 3 months) macro economic
sentiment
 Pure price-driven volatility (Account for roughly
90% of short-term volatility)-per Robert
Haugen’s 35-year regression analysis
 Q&A

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