INVESTING STRATEGIES -Market Cap Investing.

Market Cap Investing.
Blue Chip Investing.


1. Strong Brand name.
• Reputation for quality.
• High repeat purchase.


2. Good Fundamentals.
• EPS, Turnover, and Profit increasing steadily year by year.
• Healthy Cash Flow – Cash Flow per Share greater than EPS; Cash Flow per Share
greater than Capital Expenditure per Share.
• Good management – a stable but ambitious CEO and Board. Forward-looking
with an ability to embrace new technology.
• Good financing – good Interest Cover and Dividend Cover and a Quick Ratio
near to 1.


3. Healthy Debt Position.
• Profit Margin would need to be around 10% to be able to service debt.
• Interest Cover of 7 is good. Interest Cover of 4 is poor unless very
low or negative Gearing.
• A high ROCE would be needed to cancel out the effects of high borrowing.
• High borrowing would need to be justified by the CEO in the annual report.


4. Consistent record of success.
• Steadily rising EPS.
• Increasing Dividend Yield.


5. Competitive edge.
• Sector dominance.
• Higher than average ROCE for the sector.
• Good profit margins.
• Good portfolio of patents, licences and copyrights.

6. Share price that is low for no reason.

Blue Chip Covered Calls.


1. Buy 1000 shares in a company that can be held for the longer term.

2. Buy shares whose Options will produce a minimum of 7% over 3 months, 10 over
6 months or 15% over 9 months. Profit = Striking Price – (Share Price + Option
Premium). % = Profit/Share Price*100.

3. Select shares which are moderately volatile and offer a healthy Call Premium.
(12-mth High – 12-mth Low) /12-mth Low * 100.

4. Check the Beta for relative volatility.

5. Look for a Delta greater than 1.00 where the movement in the Call Premium
exceeds the movement in the share price.

6. Do not select a Striking Price below the Cost Basis unless the Option Premium
offsets the difference.

7. Try not to buy shares that have Earnings Announcements before the Strike Date.
If unavoidable, watch the shares carefully.

8. Sell the Call only after the share price has appreciated somewhat.

9. Do not invest more than 20% of portfolio in one stock.

10. Check the closing prices every day.

11. Compare returns on exercising the Option versus closing and selling the Option.

12. To reduce the risk of exercise when the Stock Price is rising use the Roll
Forward Technique. Buy back the Option and sell a later Call at the same
Striking Price.

13. Buy the Covered Call back when the price of the share shoots up 10% or more to
lock in an immediate profit.

14. Cut losses early by buying back the Call. This should be around 1 point below the
break-even point (Share Price – Option Premium).

15. A Roll Down can be used to replace a Call with another that has a lower Striking
Price.

16. A Roll Up can be used to replace a Call with another that has a higher Striking
Price. Make sure that the loss in the original Call does not exceed the gain
in the increased Striking Price.

17. Total return includes Stock Appreciation, Call Premium and Dividend Income.

18. Add in broker fees when assessing likely returns.
19. Diversify the Covered Call Portfolio with shares from different industries and
sectors.

20. Complete a Covered Call Sale Criteria Sheet for every purchase and stick to the
limits.

Small Cap Risks. (IC)

• Try to choose companies that pay dividends. Dividend Cover of 2 is adequate and
3.5 is good.

• Beware of companies that have Net Gearing over 50%. Interest Cover should be
no less than 3-4 and preferably above 10.

• Current Ratio should be 1 or more.

• Check the Cash Flow. If stated earnings are shooting ahead but net Cash Flow is
heavily negative with extensive use of debt, this is a warning sign.

• Profit warnings are particularly negative for small caps.

• If both Sales and Profits are falling, that is likely very bad news.

• Check the number of shares in free float and who owns them. Watch out for poor
liquidity.

• Look for institutional ownership but preferably more than one institution.

• Be cautious if the only broker coverage is from the in-house broker.

Small-Cap Dynamics – Pradhuman.

http://www.amazon.co.uk/Small-cap-Dynamics-Insights-Bloomberg-
Professional/dp/1576600297/ref=sr_1_1/202-7523631-
9877467?ie=UTF8&s=books&qid=1179000551&sr=1-1

Investing Framework:

• Are Earnings Expectations improving or declining?
• Have all expectations been priced in?
• What is the market consensus?
• Are the shares under-valued or over-valued?

Models:

Momentum. The basic principle is that a company announcement of good news tends to ripple over into subsequent reporting periods. Selecting a 1-month period of price out-performance does not appear to be significant – in fact, after the sudden bounce, there tends to be a reverse. A 12-month period seems to be best, beating the Small-Cap Index by a significant margin. The weakness in the strategy is Market Risk - a declining market wrecks havoc on momentum investing.

Earnings Expectations. Selecting the best Earnings revisions based on the prior 3 months,and compared at the end of the current month, clearly out-performs the market. As with momentum, this strategy under-performs in a downward market.

Value. Relative Multiples are better for Small-Caps than Dividend Discount Models etc.,which make too many assumptions based on limited analyst coverage. The best Valuation measures based on price performance are:
1. Price to Cash Flow
2. Price to Sales (but volatile)
3. Price to Earnings
4. Price to Book Value

Value models hold up well in down markets, providing better downside protection than
Momentum or Earnings Expectations models. Cheap shares can be viewed as the ultimate
low-Beta stocks.

Multi-Factor Models.
For example, a low valuation and high expectations model could
combine Earnings Expectations with Price to Cash Flow.

N.B.
• Growth is best when the economic cycle is down, and Value is best when the
economic outlook is robust, bringing marginal companies into play.
• Sector-adjusted PCF is best for small firms and sector-adjusted PBV best for
larger firms. This may be due to small firms running earnings deficits and trying
to turn a positive cash flow. Sector adjustment removes the bias in favour, say, of
technology against cyclical and financial sectors.
• To remove look-ahead bias, incorporate a Quarter’s worth of lagging data e.g.
Price Dec. 2004 / Earnings end of third Quarter 2004.