3 Ways a Stock Should Pay You

Do you get a lot of useless mass emails? I know I do.

You know the type of emails I’m talking about. They have a catchy headline and a thin veneer of information, but really they’re simply advertising. Mutton dressed up as lamb.

Among the deluge of email noise, Tom Jacobs stands tall. I asked his permission to reprint the following email, as both it and Tom deserve more attention. I’ve followed, liked and learnt from him for 15 years. I recommend you do too.

3 Ways a Stock Should Pay You

Many people incorrectly think there is magic to stock gains and losses because they consider only price. Rather, what matters is whether the business creates what’s called shareholder value. If it does, the stock price will eventually follow. Very simple.

You’d think creating shareholder value would be the goal of every company, right? Sell products and services, take in more money than you spend, and reinvest the excess cash to earn more than if it sits in the checking account. This creates value for owners, whether of a lemonade stand, coffee shop, or Apple, and someone would pay more to buy the business-through our shares.

Yet many businesses are in business to create value for management, not owner-shareholders. And even those who try to be shareholder friendly aren’t often good at it. There are very few truly good CEOs, or every company would make shareholders better off. How do we find good management?

 

The Five Choices

There are five places execs can spend cash beyond what’s needed to run the business: (1) property, plant, equipment, research and development; (2) mergers and acquisitions; (3) dividends; (4) buying back the company’s own undervalued stock; and (5) paying down higher interest debt.

The first two are growth investing. Here, companies build more manufacturing and distribution facilities, hire more software developers, buy other companies and grow empires! More often than not, these fail to create a more valuable company. These investments don’t earn a sufficient return, and roughly 85% of M&A activity fails to add shareholder value. Simply, most CEOs don’t spend shareholder cash well.

 

The Virtuous Cash Cycle

The other three choices help prevent management from blowing our money on skittles and beer. They provide shareholder yield. Paying down debt saves on interest payments, freeing up more cash. If the company’s shares are selling at a price that places a very low value on the company, buying its own stock is a good investment. And when the company buys back shares, our shares own more of the company, and earnings and cash flow per share rise, usually leading to stock gains.

Plus, if a company pays dividends, every share it buys back eliminates paying the dividend on that share forever. If the dividend yield is 4% a share, the company “earns” 4% a year forever just by not having spend it anymore. Even more cash is available to increase the dividends, buybacks, and debt paydowns. It’s a virtuous cycle.

Despite this simple thinking, most investors avoid companies that pay dividends and buy back stock, believing their best days are over. Quite the opposite. The best days for management moon-shot paydays may be gone, but the sweet paydays for shareholders have just begun.

Don’t worry about our vibrant entrepreneurial culture. Venture capitalists and institutional investors will always provide capital for companies with new ideas, products and services to enhance our lives. However, let’s leave it to them to speculate.

Instead, we will buy cheaply and get paid. It’s as simple as that.

 

Tom Jacobs is the co-author of What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. He is an Investment Advisor for separately managed accounts at Dallas’s Echelon Investment Management and serves clients worldwide. You may reach him at tjacobs@echelonim.com.

Falling knives cut deep

Don’t try to catch a  falling knife.

Do you know the game mumblety peg? As kids we called it knives and loved playing it.

Alas the mollycoddled generations will never know the thrill and the fear of throwing knives at their own and each other’s feet.

Most versions of knives involved two players and a pocket knife. Our favourite version of the game was stretch.

The object of the game is to make the other player fall over from having to spread their legs too far apart. The players begin facing each other some distance apart with their own heels and toes touching, and take turns attempting to stick their knives in the ground outboard of the other player’s feet.

If the knife sticks, the other player must move their foot out to where the knife stuck while keeping the other foot in place, provided the distance between foot and knife is about twelve inches or less. Play continues until one player falls or is unable to make the required stretch.

The ‘traditional version was also fun.

Two opponents stand opposite one another with their feet shoulder-width apart. The first player then takes the knife and throws it to “stick” in the ground as near his own foot as possible. The second player then repeats the process. Whichever player “sticks” the knife closest to his own foot wins the game.

If a player “sticks” the knife in his own foot, he wins the game by default, although few players find this option appealing because of the possibility of bodily harm. The game combines not only precision in the knife-throwing, but also a good deal of bravado and proper assessment of one’s own skills.

There is nothing quite like the fear of a knife in your foot to sharpen one’s skill assessment.

Anyway that’s  enough of a stroll down memory lane.

Falling knives

The major appeal of trying to catch a falling knives is rooted in anchoring. Coca Cola Amatil was $15 last year, it must be a bargain at $9!

Coca-Cola Amatil falling knife

Last week I confessed to anchoring when selling. Unfortunately I still occasionally fall in to the trap of anchoring with falling knives. I have been closely watching Coca-Cola Amatil (ASX:CCL) since it’s precipitous fall in April. It appeared relatively cheap. Relatively that is compared to its past multiples.

Fortunately Peter Phan of Castlereagh Equity pointed out to me there are other large Australian companies priced similarly that have better growth profiles and less execution risk than Coca-Cola Amatil.

Falling knives present numerous dangers, most of which are as painful as a knife in the foot.

  1. They can and often do keep falling. Cutting deep as they fall.
  2. Even when they eventually land they often turn in to value traps, that is the stock doesn’t rebound to capture past glory.
  3. Those stocks that do eventually bounce often don’t provide a good compound annual growth return. CAGR is the key return long term investors should focus on. If it takes too long for the investment to “work out” then a good absolute return can become a poor CAGR.

Coca-Cola Amatil is a good, but not great example of a falling knife. It has decent underlying businesses and negligible chance of falling to zero.

Speaking of zero, a much better example of a falling knife is Xero (ASX:XRO). Xero is a classic falling knife. Since XRO began falling in March, every single person who has tried to catch this falling knife has been badly cut. And those cuts could get a lot worse.

With no earnings and well heeled incumbents successfully fighting back there is no sign of the floor for Xero’s falling knife.

Xero closed today at $18. And just in case you think I’m jumping on the beat it while it’s down bandwagon, I’ve been screaming watch out below since Xero was $42.

xero falling knife xro asx

Falling knives are worthy of a place on your watch list. If they fall hard enough for long enough then they can provide sensational opportunities, with limited downside and massive upside.

Hopefully my recent purchase of Maverick Drilling at $0.16 will be a case in point.

The trick is patience. Wait, wait, wait and then wait some more. Stocks can keep falling by yet another 20 percent over and over again. Take Xero for example, it’s closing in on its fourth 20 percent fall from its March high. From here it could easily fall 20 percent twice more in normal market conditions or even 5 more times if a bear market bites.

Here’s an old post on the footwear company Crocs that illustrates just how far falling knives can drop, $75 to $0.79.

Disclosure: Please seek expert advice before playing mumblety peg. I am not authorised to provide advice on knife throwing.
Long MAD. CCL is still on my watch list.

Show me the Momo – momentum investing

Show me the money

MomentumMomentum investing or momo for short is one of a handful of reliable money making setups that persist despite the market’s awareness of them. Value and small cap stocks also continue to outperform despite market participants being aware of this for decades.

  • Momentum studies like this, Momentum Strategies by Louis Chan, Narasimhan Jegadeesh and Josef Lakonishok, reveal how past earnings surprises predict large drifts in future returns as analysts and the market are slow to respond.
  • Momentum Profits, Non-Normality Risks and the Business Cycle by Ana-Maria Fuertes, Joelle Miffre and Wooi Hou Tan. This paper shows that momentum profits are not normally distributed and that the momentum profitability is partly a compensation for systematic negative skewness risk in line with market efficiency. (You understood that, right?)
  • In this post Patrick O’Shaughnessy highlights two ways to improve the momentum strategy, that is by overlaying value or quality.
    You may think that value and momentum are polar opposites, but they work remarkably well together. Think of the combination as cheap stocks that the market is just beginning to notice. … A second way to improve the momentum strategy is to focus on companies with higher quality earnings. The simplest way to define quality earnings is by looking at non-cash earnings. The fewer non-cash earnings (which come from accruals like accounts receivable), the better.
  • For more information on momentum.

A classic momentum investing example

Australian investors need look no further than Nearmap (ASX: NEA) for a recent classic example of momentum outperformance.

nearmap-earning-momentum

Nearmap announced excellent results on the morning of August 22nd. It closed at $0.465 that day up 19 percent from $0.39.

In the close to 3 weeks since then Nearmap has put on another 22 percent, compared to the markets 1 percent decline.

Look forward not back

I believe one of the main reasons momentum is profitable is the psychological bias of anchoring. People focus on the $0.39 they could have bought Nearmap at “yesterday”. They choke on coughing up 20 percent more to buy today. This and other biases prevent them from rationally assessing the situation and buying.

I bought Nearmap on the day of it’s earnings announcement, despite already being long at around half the price. What has gone is gone, it’s useful for reference, but it’s the future that counts. Always look forward not back.

Confession time

I’ve overcome anchoring on the buy side, but where I still struggle is in selling. Here’s an example.

While enjoying a few beers — perhaps a few too many — with other analysts and fund managers I was asked about Acrux (ASX: ACR). I said I’d tried to sell at $2.10 two days prior and was foolish not to lower my price to sell that day. It was especially greedy of me as a short time prior I’d tried to sell the shares at $1.90, but missed selling on that day too. If I’d been happy with $1.90 then it was greed and anchoring keeping me from accepting $2.08.

Acrux is now 23 percent lower at $1.60. I’m not selling as that’s a fair price with the looming FDA decision. One day I hope to overcome my anchoring on the sell side.

Disclosure: I am better educated, more experienced, smarter, taller, hold more passports, have a bigger penis and am less likely to screw you over for a commissionthan almost all people accredited to provide financial advice. But this not advice, it’s for amusement only. I am not licensed to provide advice. I will talk my own book, but I won’t act contrary to what I say. While many financial professionals talk their books to enable them to sell at higher prices, I mainly talk my book so I can say “I told you so!” Annoying I know. Being right is my guilty pleasure and a personal fault, but for me it simply never gets boring or old. Yes you should feel sorry for my wife and kids, living with someone who is usually right is probably pretty annoying. But as I say to them, I wish I could find out for sure! I actually prefer being wrong, as failure is an excellent teacher. And if you believe any of this then you’re crazier than I thought.

Volatility is my friend – Fusion Fund February performance

Last month I wrote about my Buffett inspired performance. At the end of February our 5 year annual returns leapt from 26 percent to an incredible 30 percent. Unfortunately that jump in return was more a reflection of poor results in February 2009 than strong February results.

I’m pleased, but not excited about our results. As Joe Kunkle said last week “stay humble – Helen Keller can pick winning stocks in this market – don’t get complacent”.

The first two charts show my performance, but it is the last two charts I want to talk about this month, so see you down below.

fusion-fund-performance-2014-02

fusion-fund-performance-vs-all-ords-accum-2014-02

Love that volatility

Could you stomach 20 percent monthly declines? How about a 10 percent draw-down? Since July 2008 we’ve had three roughly 20 percent monthly declines and six declines around 10 percent. This volatility is a result of my move back to running concentrated portfolios, after temporarily flirting with diversification.

Do what I say, not what I do.

I still believe in the mantra to concentrate to accumulate, diversify to protect, and strongly believe most people should automate their saving and investment plans by long term averaging into low cost index funds. This excellent article succinctly summarises the path most people should take to wealth creation.

4. Automate everything. When it comes to saving and investing, you are your own worst enemy. So remove yourself from the equation. Automate your savings, bill payments and investments. You’ll save time and hassle–and be less inclined to impulsively spend your retirement savings on a hot tub.

fusion-fund-monthly-returns-volatility
February marks our seventh straight month of positive returns. We twice hit our prior record of four consecutive up months, in 2009 and 2012. So we’re way out in uncharted waters, yet we’re certainly enjoying these green seas!

With half yearly reporting now over here in Australia, whether we record an eight up month or not mostly depends on one company. Fingers crossed Prana Biotechnology delivers good results for their IMAGINE trial.

Show me the money

Our cash balance is increasing. As I’ve said before the cash piling up is predominately a result of limited investment opportunities rather than a macro call. Still as we enter what is likely to be the last leg in this cyclical bull market I take comfort from our cash weighting. If you’re not concerned with the preservation of your capital, then by all means remain 100 percent invested.

fusion-fund-performance-asset-allocation

If you’re still 100 percent invested or worse leveraged, then you simply must read these extracts from Seth Klarman’s latest investor letter.  Lots of people jawbone about focusing on downside risk, Seth Klarman actually does. So what’s your cash weighting?

As mentioned, there is a high probability we’re in the final stages of a cyclical bull market, so as Klarman says it’s time to concentrate on return of capital rather than return on capital.

Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.

Just because the music is playing, there is no need to keep dancing.

One last thing, if you haven’t read this post by Peter Phan I encourage you to do. Buying highly speculative stocks with little or no earnings at this stage of the cycle is not rational. I’m confident that a smidgen of patience will let me purchase some current high flyers for a fraction of their current price tag. I just hope you’re not one of the fools I buy from when you can’t stand your losses anymore.

Focus on what you’re best at

This fable by G. H. Reavis (Cincinnati Public Schools Assistant Superintendent) is wonderful reminder to focus on what you are best at. Play to your strengths.

THE FABLE FOR “SCHOOL PEOPLE”

Once upon a time, the animals decided they must do something heroic to meet the problems of a “new world”. So they organised a school.

They adopted an activity curriculum consisting of running, climbing, swimming and flying. To make it easier to administer the curriculum, all the animals took all the subjects.

The duck was excellent in swimming, in fact better than his instructor, but he made only passing grades in flying and was very poor in running. Since he was slow in running, he had to stay after school and also drop swimming in order to practice running. This was kept up until his web feet were badly worn and he was only average in swimming. But average was acceptable in school, so nobody worried about that except the duck.

The rabbit started at the top of the class in running, but had a nervous breakdown because of so much makeup work in swimming.

The squirrel was excellent in climbing until he developed frustration in the flying class, where his teacher made him start from the ground up instead of from the tree-top down. He also developed cramps from over-exertion and got C climbing and D in running.

The eagle was a problem child and was disciplined severely. In the climbing class he beat all the others to the top of the tree, but insisted on using his own way to get there.

At the end of the year, an abnormal eel that could swim exceedingly well, and also run, climb and fly a little had the higher average and was top of the class.

The prairie dogs stayed out of school and fought the tax levy because the administration would not add digging and burrowing to the curriculum They apprenticed their child to a badger and later joined the groundhogs and gophers to start a successful private school.

Fund managers I’d trust to manage my money

There are two basic ways to invest in the share market. Via low cost index funds or active management.

Low cost index funds are a low cost means to get slightly below market average. Humm, I don’t know what you think, but paying for guaranteed under-performance seems bizarre to me. If you must settle for bottom half performance, then at least time the market to ensure you finish in the top half at the end.

If your brain is exploding due to my heresy of commonly accepted wisdom, all I can say is look at the trees not the forest. Statistics tell a general story, but in investing it’s the individual stories that count.

So, that leaves active management as the only sensible basic approach. The decision then becomes, should I be the manager or hire someone? For the vast majority of people the answer is you should hire someone.

How to choose the best fund manager for your money.

Play the man not the ball. The ball is the game, the share market. The man or woman is the individual fund manager.

Collectively, active fund managers suck. Active investors pay a higher price for worse performance than index funds. You of course know that, as the poor average performance of active fund managers has been the major marketing thrust of index funds for decades.

Fortunately, as with most human endeavour, there’s a rough bell curve in ability and expertise. Our task is to find those top managers.

Sadly this is where most people trip up. But they shouldn’t feel bad as selecting a top fund managers is bloody hard to do.

Top criteria for  picking a fund manager

Here’s my list.

  • Go with a  boutique manager. You want a manager making final investment decisions not an investment committee. Do not go with a major ASX listed company. That includes the legendary Kerr Neilson’s Platinum Asset Management. Investing with one of them is investing with the crowd, and the crowd always finishes in the bottom half. Platinum is an exception, but I’m not sure it will be for the next decade or two.
  • Go with someone with almost all their own funds invested alongside you.
  • Someone 30 to 50. Perhaps older if you have good reason to believe they still have passion and will continue to perform for another decade.
  • Make sure they have reputable back-end companies. The companies then ensure the safety and integrity of your money.
  • Give preference to a value investing philosophy – intrinsic value, business focused investing.
  • Bonus points if they have a track record of picking growth companies.

Are you one of Australia’s best fund managers?

I going to list my top three below as a benchmark. If you believe you’re a better fund manager or know of one, then please drop me a line. Comment below on at the bottom of this page.

I’ve had some funds invested with OC Funds Management for nearly a decade now. I choose the OC Dynamic fund in 2004 based on an article I read while still living int he UK, plus a read of everything on their website. Both the performance and communication has been outstanding.

OC funds management performance

My current favourite  fund manager is a young Kiwi guy called Mike Taylor. This guy may even be better than me! LOL.

Mike founded and manages Pie Funds. Bummer, checking his site he’s soft closed his flagship funds, so getting in would be difficult. The global small companies fund is till open, but I believe that is predominately managed by external fund managers. 

I’ll sub Smallco in for Pie Funds.

smallco investment fund performance

In the young guns category of my top three fund managers is Tony Hansen of Eternal Growth Partners.

I think Tony is highly likely to continue beating the market over the long haul. But if he doesn’t at least you know he’ll go hungry! Here’s how Tony puts it.

Over the course of the last few years, I have actively and unsuccessfully sought a product which is accessible to the average investor which has two desirable characteristics – 1. no management fee & 2. fee for performance only. I have found no suitable product, and so decided to create one.

One final word of advice.

It’s no coincidence Mike Taylor of Pie Funds has soft closed his funds. Good investments are very difficult to find now.

Good fund managers are even harder to find. This is a good time to be reducing debt and building cash reserves.

Disclosure: I continue to target 50 percent invested. I’ve been selling down our units in OC Dynamic Fund. I just bought a new house and have taken on a mountain of debt. I am not you, and what’s right for me is not right for you. You may be the unnamed Star Trek security officer beaming down to the alien planet with me. This is not advice.

Investing in biotech companies

Here’s what a clever guy said about investing in biotechnology companies.

After many years investing in Bio’s a few lessons that I learned have helped greatly in making money from them.

  • Charts have a place, but can’t predict those Black Swan announcements…like the data base ann…so relying on charts is very dangerous..
  • Very good deep research and experience count for a lot. That’s how the big killings are made in Bio’s.
  • BAD MANAGEMENT is the real killer, and the hardest to spot. The road to success in Aussie Bio’s is littered with wrecks from idiots sitting in CEO chairs and on Boards…
  • It [PBT] has very good management… A stable long term team who have skin in the game….
  • The successful outcome with PBT2 will make these guys Billionaires and Nobel Prize winners.. They have a very strong interest in success…
  • Management and Directors who have a lot to win or lose have much better outcomes….
  • There are enough companies that fit those rules to diversify and make a very lot of money here..
  • Finding time to do the of research is hard.

Good observations, except for calling the Prana database announcement a black swan. Most probably that was simply a clinical operations screw up. Mistakes happen all the time, so are common white swans, not black swans.

In short, dig deep, and focus on management’s ability and their skin in the game.

Here’s my last tweet on Prana  [old now] .

Prana Biotechnology ASX:PBT alert

I sold some of our Prana shares later that day at 71 cents. That trade was simple risk management. The trigger to sell Prana was the sudden deterioration of its risk reward  profile, fused with my euphoria meter peaking.

Risk management is one of the keys to long-term investment success.

I shoot for a win win strategy. Naturally I sometimes loss, occasionally badly, so here’s what I mean by win win.

  • I try to think of at least the two most probable outcomes. Then I decide what I’d have liked to have done in the event of those two outcomes occurring. That is, how would I fell like a winner in each event.
  • Then, multiply each outcome by the rough probability of the event occurring. Prior to gaining experience, a wild ass guess at the probabilities will help you think along the right lines. Always err on the conservative side.

I started writing this four weeks ago, and post it now after I  failed to implement my own rule on Psivida $PSDV.

Here’s a rough example using PSDV.

  • FDA reject 50% probability multiplied by $2 target if happens, plus FDA approve times $8 target, for a fair value of $5 [50%*($2+$8)]. At $5 PSDV had a 1:1 risk return ratio, $3 downside for $3 upside based on a binary event.

My own rules screamed trim the position. 30% would have left me felling like a winner in either event. I didn’t as I was not focused enough. Massive life change is so freaking distracting! I take a moment to think damn.

For those without a position in PSDV, now is a good time to tune in, as you may get a wonderful opportunity to buy, as I outlined back here.

Disclosusre: Long Prana and Psivida

What Australian company is this?

telstra dividend adjusted share price tlsWithout the Tees I wonder how many of you would have guessed Telstra Corporation (ASX: TLS). The common thought is that T2 buyers remain deep underwater.

No matter when you bought Telstra you’ve made money. As the dividend adjusted chart above shows.

You won’t believe this, even T2 buyers have made 60 percent.

Here’s a comparison of the common perspective and the dividend adjusted return.

Telstra dividend adjusted versus share price ASX: TLS 

 Wonderful things happen when you consider things in a new light.

Step beyond margin of safety

Margin of safety is the much vaunted investment tool of value investors, and by value investors I mean all sensible long-term investors. Margin of safety is a great concept, but is it the best tool for investment selection, risk management and portfolio optimisation?

Michael Mauboussin argues it is in this excellent 2001 paper.

Investors should base the magnitude of their investments on the size of the margin of safety.

Mauboussin’s Ruminations on Risk is a brilliant paper. I mostly agree with him, but want to share an even better investment tool we can easily use.  But before we get to that, let’s play a game.

Game on

Imagine you have two investment options. Investment A has a margin of safety of 12 percent, while Investment B has a MoS of 8 percent. Which would you invest in?

Probably neither, right? So for the sake of the game imagine you must invest in either A or B.

I’m going to hazard a guess you opted for A. Its MoS is 50 percent greater than B and for some of you that return may even be above your hurdle rate.  Investment A is the logical choice if you use MoS as you primary investment selection tool.

Let’s keep exactly the same investments, but throw my preferred investment selection, risk management and portfolio optimisation tool into the mix. Let’s look at the return/risk profile of these investments.

risk/return ratio

The current price of both A and B is $5. Investment A has an 80 percent chance of being profitable, that is a 60 percent chance of 20 percent upside and a 20 percent probability of a juicy 60 percent profit. Conversely Investment B has a mere 20 percent of being 20% profitable.

Remember, I haven’t changed the game, the respective margins of safety for A & B are still 12 percent and 8 percent.

Are you still happy with your investment decision? As a reminder, A has a 12 percent MoS and an 80 percent chance of being profitable, whereas B has an 8 percent MoS and a mere 20 percent chance of profitability.

Think risk

If you’re still opting for A, then perhaps the following sentence which encapsulates my investment philosophy will help change your focus slightly. Focus on the downside, and the upside will take care of itself. (Hat tip to Mark Sellers.)

The downside for A is 60 percent, whereas B has a comparatively modest 20 percent potential loss. Hopefully, that changes your investment decision. For me, focusing on the risk rather than the return has led to better investment decisions, and I’m confident it will for you too.

Investment B is the better investment choice, despite having both a lower margin of safety and lower probability of profit. I know some of you won’t be convinced and may even believe the higher probability weighted MoS for A means that over time successive investments in A will result in higher overall returns.

The pain of asymmetry

We’ll you’d be right, except for the asymmetry of returns. For those not familiar with the asymmetry of returns, all it means is that identical percent gains and losses are not the same, e.g. it takes a 100 percent gain to make up for a 50 percent loss. Losses hurt more and not just psychologically.

This asymmetry results in B having the higher probable return after a number of iterations. For example if we start with $5 then after ten iterations B will have grown to $8.20 while A will only have grown to $6.10.

If you’re using a probability weighted margin of safety you’re already way ahead of most dart throwing investors, but it may be time to take another step on your investing journey. Adding the return/risk ratio to your tool kit helps you focus on the downside and will improve your risk management.

My hurdle rate is not a percent return, it’s a return/risk ratio of three. For every dollar risked I want a potential payoff of three dollars. Investment B meets that criterion, whereas A has return/risk ratio of 1:1. See what a huge difference the return/risk ratio makes? It’s like pulling back a veil to see the real picture.

As I said in this post, using a risk return framework forces me to consider multiple outcomes and to look forward. It provides a rationale mechanism to overcome the noise of fear and greed. Most importantly, it forces me to consider what could go wrong.

The return/risk ratio is also my portfolio optimisation tool of choice. The higher the ratio the larger my investment.   As I said 3:1 is my hurdle, I may invest a small portion of funds in companies meeting that hurdle, I start getting excited with ratios over five. I invest a lot when the ratio is over seven, as I did when I was pounding the table on Telstra in early 2011 – back when everyone else was calling Telstra a dog. Currently Telstra does not meet my hurdle rate, but as I’ve sold most of our holding and admit to being slightly addicted to its dividend, I continue to hold a small weighting.

Part Two – Putting the return/risk ratio into practice

Once you start regularly using the return/risk ratio it makes investment decisions easier.

What’s the probability and size of the downside? What’s the probability and size of the upside?

This same frame work should be used for both prospective and perhaps more importantly to current positions.  After all it’s only what you own that can hurt you. Saying that, I admit to not rigorously applying it existing holding, although I really should.

Imagine you’re a reasonably smart investor and followed my recommendations of investing in Integrated Research (ASX: IRI) at around $0.45. Hold on, I think I’ve written about this before. Yes here you go.

When I sold, Integrated Research was up 265 percent since my recommendation in the first edition of Motley Fool Share Advisor. IR was also up a market obliterating 300 percent since I’d recommended it as one of TMF Australia’s radar stocks.

Like me, you may have found IR was close to 3 times larger a position in your portfolio than originally intended. That’s a nice problem to have, but it is still an issue that requires thought. For example if you bought a 5 percent position, IR was now over 13 percent of your portfolio.

Above $1.30 IR was significantly overvalued. So why hold 3 times your normal position in an overvalued company? That would be stupid right? But hey if you see it differently please let me know in the comments below.

Here’s how someone summarised IR on Hot Copper:

However, it tells the story: 1st article when IRI had earnings of 4.5c, share price under 40 cents, dividend 4 cents, and cash. Relatively low risk.

Now, 2012 earning 5.4 cents, SP $1.20+, dividend 5 cents, still has cash.

Company obviously in a sound position, however value … ? One would have to say the “easy” money has been made.

I like that thinking. It’s simple, value focused and based on tangible information.

At the current price of $1.24 my analysis suggests a possible downside of $0.40. Yes, you should always work out the risk fist, remember focus on the risk and the return will take care of itself. So I only need to answer one question, is a $1.20 upside probable?

Can IR double in price from here? I see virtually no chance of that.

IR has grown revenues at 3.5 percent a year over the last five years, while earnings per share have grown at a miserly rate of 1 percent. The growth rate has been slightly higher over the shorter time-frames, but still nothing to get excited about.

While I respect the excellent management team and think Mark Brayan justly deserved the IT Executive of the year award for his excellent strategy and execution, there simply is no sound investment case that can be made for IR at the current price.

Mr Brayan sensibly diversified IR’s revenue stream due to the sword of Damocles hanging over the company – the huge risk in HP Non-stop infrastructure revenue collapsing. He has added a few more hairs to the sword, but make no mistake, software is a cyclical business and if, or more likely when, those infrastructure revenues go into terminal decline the slowing growth of unified communications and payments are unlikely to stop investors being cut.

Back to the point

Anyway, I’m getting away from the point of this article, which is that a return/risk framework is a superior investing tool than margin of safety. It conveys more information and focuses on both the risk and return, whereas margin of safety tends to focus the mind on returns. My returns have improved since adopting the return/risk ratio and my losses have shrunk. For me it is the ultimate risk management and portfolio optimisation tool.

Steven Romick – Fusion Investor

Steven Romick has the sweet smell of fusion investing. This go anywhere, buy anything, top 2% fund manager is my kind of guy.

He buys everything from great companies at a good price, to farm land. But he also gets that sectors and macro are important.

Romick covers a lot of ground in this interview with Consuelo Mack. He is the complete investor.

He looks for fear to buy cheaply from distressed sellers – people who just can’t stand it anymore or need the cash for other reasons.

Sectors mater for many reasons. From the simply yet effective rising tide lifts all boats, to the bottom up if this great company is cheap maybe others in the sector are too, sectors mater. Companies aren’t islands, they operate in sectors within industries, so it sensible to know what’s going on in the sector and to compare ratios and multiples.

In a low return environment insurers are going to find the going tough. Data centers are destined to be commoditised, so ask yourself, do you feel nimble today?

1 2 3 6