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Investing

Table of Contents

Stocks

Buffett Value Investing

  • Purchasing a stock = Buying part of a real business
  • Buy stocks during recession
  • During bull markets, risky and least profitable time to buy stocks

Graham Number

Use financial ratios to identify undervalued companies with strong growth potential. The Graham Number value score results from a formula developed by Benjamin Graham

  • P/E Ratio < 15
  • P/B Ratio < 1.5
  • squareroot( 15 * 1.5 *( net-income/ sharesoutstanding ) x (shareholders-equity/shares-outstanding)
  • Or rewritten as squareroot(22.5* EPS * P/B )

The Piotroski (2000) FSCORE

The Score consists of aggregating nine individual binary signals derived from accounting variables related to profitability. The most favorable value score is 9 and the least favorable is zero.

Efficient Market Hypothesis

1863 french economist Jules Regnault's "Efficient Market Hypothesis" which says the price of any financial instrument will be priced efficiently by the market over time is not accurate.

At any given moment, only a small number of people (volume) in relation to the total number of stockholders are determining how much a stock is worth

Market price of a stock is not necessarily equal to intrinsic value of a stock.

4 rules of valuing a stock

  • Must be managed by vigilant leaders
  • Must have long term prospects
  • Must be stable and understandable
  • Must be undervalued

Managing debt (Debt/Equity Ratio)

  • Equity = what the company is worth right now.
  • If you sold everything and paid bills, what's left over.

Calculate Intrinsic value

To calculate the intrinsic value of a stock - you need estimate future cash flow earnings and divident payments.

  • Use the DCF method to determine the present value of future cash flows.

Estimating the future cash flows of a business

  • Future Cash flow (10 yr period) = Book Value Growth + Dividend payments
  • [estimated future BV (in 10 years)] + [sum of divident payments over 10 years]
  • Then discount the cash flow by the current 10 year federate note
  • Book value = Equity per share
  • Total Equity / Total Shares Outstanding

What can a company do with it's earnings:

  • Pay shareholders via dividends
  • Invest or pay debts ==> More or Less Equity

To analyze a stock

  • Get it's book value for last 10 years
  • Is it increasing? Slow or fast?
  • What rate? Is it stable and predictable?
  • Exercise: plot book value over time
  • Average annual book value growth (%) = Present BV - Previous Years BV / Previous year's BV

    Repeat for all previous 10 years to get book value growth rate

  • Sum of book value growth / total number of figures = average book value growth
  • Book value of a stock: FV = PV (1+i)n

    FV = future book value

    PV = Present Book value (or Current Book value)

    i = Book Value Growth Rate

    n = number of years into future

  • EPS = Earnings per share

    Net Income / Total number of shares outstanding

    To get precise number, calculate diluted earnings per share

  • Diluted EPS = Net Income / Diluted Weighted Average Shares

Johnson and Johnson end of 2011

  • JNJ Book value: $20.95
  • JNJ Avg Equity Growth: 12.1% (avg from 2003-2012)
  • JNJ Diluted EPS: $3.49

Compare company's divident payment to EPS

If dividend payment per share / EPS = ? %

Can the company afford to pay such a high dividend?

Is it sutainable?

If a company is making a high dividend payment every year, it's BV or EPS will stay constant or decrease in value year after year

DCF the future value back to current value by using the DCF method

If the DCF FV of stock is $x

It means if you invest $x today, over next 10 years you'll earn equiv interest of risk free investment.

Compare that to the stock value it's trading today.


Bonds

  • Purchasing a bond = providing a loan
  • During recession - least profitable and most risky to buy bonds
  • During bull market - least risky and most profitable to buy bonds
  • Longer the bond (e.g. 30 year bond), higher the expected interest rate
  • If the graph for 30 year bond is decreasing, assume stocks are in bull (inverted yield curve)
  • As interest rates increase, if bond doesn't pay as much, it's value decreases
  • As interest rates decrease, and bond pays more, value of bond increases

10 year Treasury note

  • Gold standard of zero risk investment which other investments are measured against.
  • Your risk profile is your rule of thumb: E.g. I do not consider any investment that doesn't return x% vs 0 risk investment

Quantitative Investing

High level process

Idea -> Research -> Prototype -> Test -> Implement -> Forward test in real world -> Evaluate performance -> Stick it into trading portfolio or abandon.

  • Portfolio of strategies.
  • When falls below benchmark performance reevaluate and continue or retire it.
  • Vary them from high accuracy with 2:1 Risk:Reward ratios to low accuracy and low risk:reward ratios.
  • Develop a model, based on some fundamental behavior (ews, volume, trader driven).
  • Systematically formalize rules and test.
  • Forward tested with light size. Aim for 85% of backtested performance.
  • use limit orders. Add/remove liquidity on a 50/50 split.
  • Start small size (100 shares)
  • Define your exit trade and let the algo do the rest
  • Step in to close out for black swan events.

Sample Infrastructure 1

  • Tick database
  • Message queue
  • Bespoke Trading framework
  • Simple order management system.
  • Connected to brokers via FIX (e.g. Interative Brokers) 2
  • Use a clearing firm 3
  • Subscribe to data from DTN NxCore whole market feed
  • Compress and save tick data during the market day, slowly built up my own collection.
  • When you need extra data, shell out to get it from tickdata.com,
  • When getting started, you can patch from the cheapest source.

Open source Libraries

  • QuantLib
  • QuickFix
  • MarketCetera
  • ActiveQuant

Trading

  • US equities/options
  • US futures/options (SIFs, currencies)
  • Try start trading in markets which are active after work (e.g. Asian/European markets)

References

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