MISS CLAVEL THEORY
This month we have a look at a share risk management technique called Miss Clavel Theory that can be useful when considering buying, selling or holding a stock. This indicator is particularly useful in a share market like the current market which is still in broad uptrend but mainly going sideways. Miss Clavel Theory says that when the known information about a company suggests that its estimated future value should be x dollars and the share price trend is inconsistent with this value then there is the possibility that the estimated future value is not going to be correct. Which means that any buying or selling decisions based on an expected estimated future value may not end up being smart investment decisions.
If e.g. a stock is trading at $4.00 and it has an estimated future value of $6.00 you would consider (assuming other quality criteria are met) buying the stock. If however you think that the estimated future value is going to be $2.00 you would most likely avoid it like the plague. And the converse applies. If you own the stock and it is trading at $4.00 and you think that the future estimated value is going to be $2.00 you will probably consider selling it. If however you think that the estimated future value is going to be $6.00 you are likely to hold rather than sell.
Miss Clavel Theory is very relevant if you are using a long term disciplined value strategy for your share portfolio where the objective is to have a portfolio of quality businesses that have the potential to increase in value over time. For more information on this share strategy go to www.lifestylefstas.com.au, go to Blog and then read the blog called Share Investing the Value Black Sabbath Approach. With this strategy stock decisions are based upon a number of factors including the forecast future value for a particular stock. This forecast future value is based, amongst other things, upon the future profitability of the business i.e. it is based upon future profit and dividend forecasts. However business is dynamic and there is always the potential for these forecasts to change as new information about the stock is announced. If the estimated future value is above the current price yet the share price is consistently trending down you have to consider the possibility that these future value estimates (which are probably flashing up as bargain) are not going to be correct (in which case it wont be a bargain). And if the estimated future value is below the current price or is at a level that will give an inadequate return taking into account the risks and the share price is consistently trending up once again you have to consider the possibility that these future value estimates are not going to be correct and may be higher than currently forecast.
In the rest of this blog I will be talking about deferring buying shares when the stock is in price downtrend although the converse (deferring selling when the price is rising) also potentially applies. Although I suggest being much less strict with the application of Miss Clavel Theory when considering selling a stock that is rising in price (and particularly when the market as a whole is rising) because it is not unheard of for a stock to announce bad news and fall over 30% in a day. The share price of Navitas fell from $7.00 to $4.90 on 9 July when it announced the loss of a major contract.
There is a whole approach to share investing that is based upon nothing but looking at charts of share prices which is called technical analysis. It has its own wonderful lexicon with terms such as moving averages, candlesticks, stochastic indicators, Bollinger Bands etc. In fact when I look at this stuff my eyes glaze and I get all fibonaccied out. While I don’t believe technical analysis in itself is appropriate for a long term share portfolio strategy it does make sense to at least consider what the broad price trend for a stock is. Where your estimate of future value for a stock is consistent with the broad price trend you can then have some confidence that the forecasts upon which these future values are based are more likely to be correct than incorrect.
Profit and dividend forecasts are (or should be – Newcrest analysts excluded) based upon public information and change as new information becomes available. Assuming that one is a law abiding soul of course. Insider information is both illegal and, for most of us, not available. What this means is that there will always be information that we know about a company and also information that we do not know. And the share price could be being influenced by information that is not public and not being taken into account in future profit forecasts.
A hypothetical information of how this can happen is as follows: A company with a generally strong history of increasing sales and profits may hit a poor patch where sales start declining. It could be a temporary aberration or it could be the start of a longer term change in sales trends. No one including the management of the company knows at the time of course. The company is unlikely to make a stock exchange announcement about it because it may all turn around and, in any case, it isn’t going to make announcements about every short term variation that occurs in sales. Also if a negative trend is developing management will prefer to wait and see if things pick up again (no one likes to announce bad news) and will only make a stock exchange announcement when it really has to in order to comply with its disclosure obligations. Nevertheless this news may start reflecting in the share price as some people close to the company talk about it. This may cause some investors to decide to sell their shares. If a few shareholders do this it may change the balance between buyers and sellers in the market so that there are now more sellers with the result that the price starts falling.
Two recent examples are Coca-Cola Amatil (CCL) and Metcash (MTS) which are both regarded as blue chips that provide popular or essential products. If we look at CCL we can see that the price peaked just above $15.00 in April 2013 and then entered a price downtrend that took the price to about $11.40 in April 2014 when CCL announced a substantial profit downgrade. The proverbial hit the fan and the share price dropped to about $9.00 in a few days. After going sideways for a long time the share price for MTS fell from above $4.00 in May 2013 to $3.25 in March 2014 at which time MTS downgraded profit expectations. Bombs away. The price fell to $2.70. Both of these stocks prima facie looked good value before the downgrades particularly when looking at what appeared high dividend yields. At the pre downgrade announcement prices and based on historic dividends CCL was yielding 5.2% (7.4% grossed for franking credits) and MTS 8.0% (11.4% grossed). Although the dividend is now being cut for both companies because of the lower expected profits. Many investors would have been tempted to buy what looked like good value. If that stockmarket guru Miss Clavel had been consulted she would have said yes CCL and MTS may well be becoming good value but we should wait for the price downtrend to finish first just in case something is not right.
The difficulty in practice is that share prices can fall for any number of reasons (many of which are irrelevant from a longer term point of view). It may be a short term blip or the start of a longer term trend. A fall in share price does not necessarily mean that a negative announcement is coming. So how do we apply Miss Clavel Theory in practise? My experience is that you get the best results by forming a view about a stock based on fundamental reasons i.e. is it a quality business, what is the forecast future value etc. and then look at the price trend to see whether price movements appear to be corroborate this view. If so well and good. If they don’t it means that one should be cautious. My approach is to wait for the shorter term trend to change or at least show signs of potentially levelling off and then (assuming the fundamental view remains unchanged in light of any further information available) buying the stock. The advantage of this is that you will buy shares less often just before there is bad news than would otherwise be the case. The disadvantage is that you won’t buy at the bottom because, by definition, that will have passed. Still my rejoinder to that is that if you buy on the way down who is to say that you are getting the bottom or the top anyway. Just remember that share investing is a probability exercise. It is impossible for every decision to be correct because share decisions are all about the future. The objective is to increase the probabilities of a correct investment decision so that over time you make more correct than incorrect decisions. For more information on how Lifestyle Financial Services helps investors improve their investment experience go to www.lifestylefstas.com.au.
In the current market where most stocks are either going sideways or rising in price one has to at least question a stock that is in sustained price downtrend. If you nevertheless insist on buying get your stockbroker to issue a valour certificate along with the contract note.
So if you are thinking about that stock that looks fantastic but is going down in price maybe you should just like Miss Clavel wake in the middle of the night and say “Something is not right”.