How to Predict the Stock Market

In a recent article in the Wall Street Journal (WSJ) by Jason Zweig, titled The Simple, Best Way To Predict The Market, we see some very fundamental concepts being preached.

Citing a Journal of Portfolio Management article written by John C. Bogle, three factors are mentioned that account for all stock returns dating back to 1915, plus the future.  What are these three factors: (1) the current dividend yield of the stock, (2) earnings growth of the company, and a speculative premium (i.e., herd mentality factor, measured by the P/E ratio) for the company (perhaps industry driven).

What does this look like then as an equation:

rFuture = DFuture, Annualized Future/P0 + gEarnings, Annualized Future + g(P/E), Annualized Future

The only new concept here is to add the P/E speculative premium to the DDM model.  Note that this model is based on some major assumptions, which may take a crystal ball to foresee, such as the future growth of the company’s earnings, and future growth of the company’s P/E ratio.  This seemingly easy equation looks simpler than it is.

This same article quotes the best predictor of bonds to be their current Yield to Maturity (YTM).  To state that YTM is the best predictor of bonds could not be truer, but this assumes that all bonds are held to maturity, otherwise one may want to account for duration and convexity, because the price/interest rate risk of the bond could be very high, resulting in large losses if the bond is sold before it reaches maturity.


A Simplistic Model Examining Offshoring

Many companies choose to offshore their manufacturing and other labor such as call centers.  The reason behind this is simple, foreign labor is cheaper, and this will increase the company’s profit margin.

To explore this, let’s take a look at Apple Inc., and make a few assumptions to see the potential impact of offshoring.  Apple was not chosen for any reason, and this exercise could equally be applied to any set of financials.  I’ll make two simple assumptions: (1) that COGS is 50% labor-based, and (2) that this will be offshored at 20% of the original labor cost (i.e., it takes 5 workers overseas to equal one U.S. salary).

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The Leverage of DSO, DPO, DOI, and the CCC

When optimizing a company’s cash conversion cycle (CCC), it is important to understand both the value and the cost in doing so.

First the value:  when a company collects it’s receivables earlier (Days Sales Outstanding, DSO), delays its payments (Days Payables Outstanding, DPO ), and/or reduces its inventory (Days of Inventory, DOI), it is maximizing its free cash.  The company can then use this free cash to (1) invest back into itself by purchasing operating assets, or (2) payback its stakeholders in the form of dividends, stock repurchases, and/or paying off debt (i.e., buying back its bonds, paying down its revolver, etc.).

The value of investing back into itself will earn the company’s return on invested capital (ROIC), and paying back its stakeholders will earn the company’s weighted average cost of capital (WACC).  Both of these interest rates should be compelling enough to make any astute company eager to implement six sigma/lean practices to maximize their free cash, and thus capture this value.

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The Top Line Versus the Bottom Line

In business, the sales force is considered the revenue center, while all other functional areas within the company are viewed as expense (i.e., cost centers).  This practice is obviously the result of the income statement where sales (revenue) leads at the top, less all other cost centers to obtain the bottom line (profit, or loss).  Because sales pay for the expenses incurred by the company, the sales force is typically the most compensated and monitored area within a company.  But the objective of a company should be to obtain the highest profit (i.e., bottom line) for the shareholder, not just the top line (i.e., sales).  Below is the structure of the income statement in very simplistic terms:

Revenue -Variable Expenses – Fixed Expenses = Profit

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Blog format is changing, and Wiki has been launched.

I have begun the development of a new wiki site called FinWiki (click link here or access on top menu of this blog), which is short for Finance Wiki.  Once I have mastered the wiki structure, expect to see this wiki become a living textbook of finance theory and analysis.  This wiki will be open to anyone who wishes to contribute, but you will be asked to first register to gain editing permissions.  All registration data such as name,  email address, and IP address will be kept confidential unless required by court order.  This does not mean that security of this data is guaranteed against third-party hackers who gain access through illegal means.

BE Blog will become strictly a blog where I post my personal finance thoughts, on occasion.

I look forward to any future readers of my blog, plus any future contributors to my wiki.