Using Charts to identify trends and valuations

In this chart series, we will be focusing on Trends and Cycles of stock prices. More specifically, we will narrow down to just chart trends for this article. Trends are general directions of where prices are moving. It can be uptrending, downtrending or even sideway trending. Below is a chart of PPZ (Papa Johns) which short the 3 types of trends. Depending on how your view or zoom in/out of your parts to different periods (daily, weekly, monthly or intraday), you can further identify smaller trends within a larger trend.

Chart 1

The main goal of this article is to show you how looking or interpreting a chart (as most people would do) will not help you get the insight or confidence you need to trade or invest in your stocks. A good saying goes “The trend is your friend until it ends” sounds great but it will be too late before you know that the party is already over. Or even more so, we have the tendency to see the end while the trend is still going strong..

The trend is your friend until it ends

We will use Walmart (WMT) as a case study of this trend in charting. WMT chart is a good example of how difficult it can be to spot the beginning or end of a trend. After a long run up from 2010 to 2015, the stock took a strong correction back from its high of $90 to 60. Can you consider yourself being in either one of the scenarios?

• You had bought into the stocks early back in the early decade of 2000 and after running up to $90 in 2015 from close to $45, you will be glad to have sold it at the high before coming back down. Though you probably made a 5% annual return over the years and especially when the stock doubled in price in just a few years after a long secular period of stagnation that lasted in the first decade of the millennium.

• You throw in the towel when the stock is back down to $60 after you had bought earlier at $55 thinking you didn’t want to make this investment into a loss like so many of your other investments. Great job … pad on the shoulder. But is it?

• The worst case of all, you had rushed in to buy at the high of $80 after reading a couple good quarterly earning releases but later it fell back down to $60 turning it into a loss.You might say I don’t want to hold on to dud for the next 10 years as it did in the past decade. And clearly the old saying goes cut your losses short and let your winners run.

In all 3 cases, you would have made regrettable mistakes...all to a varying degree of regrets!

Chart 2

Had you held on to it, the stock would have then continued to reach new heights on each subsequent earnings reaching a new high this year at $150!

Chart 3

Unfortunately using technical analysis to spot and identify trends will not help you much either. Common indicators like looking at the short and long term moving averages would have all indicated a sell signal at various points of the chart. Trendlines would have also been broken and trigger some sort of sell signal as well.

Relying on fundamental analysis will not help you either. After you read the latest earnings on Oct 14 2015, you might have probably gone on to sell your loser stock in your portfolio despite the fact the company had a couple of good quarters in the past 2 years.

The news release from the company warns about profit warning and the reaction from the market certainly made it look very dire. But this is all NOISE from the horse’s mouth and the masses (aka Market)

Certainly you will argue that there is no way one could have seen this coming. Or is it so? So are you ready to learn how to use technical and fundamental charts to be a better investor to hold on to your conviction of your investment? Let me teach you how not to act on your whim, gut or your biases. Don’t let the noise (news), rumors or feedback from your pals influence your judgements.

Big Reveal...

Alright here is the Big Secret, ok...it’s no secret. Instead of a Big Secret, it really boils down to the Big View and having a holistic approach to investing and understanding what drives the markets. I will try to break it down in a few simple steps. Best of all, the analysis does not require hours of research. Alright it’s not a 5 minute research, perhaps half an hour. Not much of a sacrifice to give in especially when we are talking about a lot of money at stake.

1. Get Some Perspective. The first step is to get a Big Picture of what has been happening to the company or stock. What was your reason to buy into this stock to begin with.

Zoom out the stock chart to see what was happening. Walmart was trading a rather boring sideway trend since the bubble bust in 2000 which lasted over 10 years. On the one hand, it didn’t fall much during the bear market nor did it go up at all during the recovery. Then something mysterious happened in 2012 as the stock broke out to new highs above the $60 mark and we certainly need to address this big clue. The Big Why? Why did it reach a new high?

Chart 4

Next, let’s try to find the next clue. Since I value much about how the managers are allocating their capital, we can see below that their shareholders were well rewarded since the bubble burst as the company is no longer a growth company during its heyday of the 1990's. So instead of reinvesting their cash for future growth, they are better off paying or rewarding the shareholders with dividends. In the ensuing decade, we see the dividend yield rose from 0.25% to 2.50%.To continue to reward the shareholders, management decided to buy back a substantial amount of outstanding shares reducing its count from 4.50 to 3.50 billion.

On a side note, this trend of raising dividends and buying back shares were exhibited in many former high flying growth tech stocks like Microsoft, Cisco and Intel. This is likely prompted by the low interest rate environment that persisted for the following the next 2 decades.

Chart 5

Further investigating, we discover that Walmart funded much of their share buybacks by increasing its debt load from just $10 billion in 1999 to over $45 billions in 2015! So is this something to worry about? The answer is a NO. Simply the company had total assets of $50 B and $200 B during those two periods. And the chart below shows that the company had maintained a reasonable debt-to-equity of around 60-70%.

So is this increase in debt load to buy back shares and pay dividends a bad thing? In the case of Walmart, it is actually a good thing to borrow some debt to pay back the investors. It is a good capital allocation decision when management is not hoarding too much cash or cash flows by returning some of the cash in the form of dividends. As for borrowing money to pay the shareholders, this might be counter intuitive as we are raised and taught not to borrow money. However in the investing world, profits of a company are usually shared between the shareholders or debt holders. If a company has no debt holders or creditors, all of the profits are returned to the shareholders in the form of earnings (per share) and dividends. If the company borrows to buyback shares, it can reduce the share count and hence more of the profits will be allocated to the remaining shareholders. This will increase the EPS and subsequently the share prices. This can be done only if the cost of equity for the shareholders is higher than the cost of borrowing.

Shareholders expect anywhere between 10 to 15% easily and some are even higher for high growth stocks. In the case of WMT, the cost of equity would be around 15 to 25% given the stock was increasing at a pace of 30% a year from 1993 to 2000.

As for creditors, bonds can be issued out at the prevailing treasury rate plus a premium to reflect the company's credit worthiness. For Walmart, its cost of borrowing is around 6% which is considerably low given it has a relatively high credit rating.

Considering when the company’s cost of debt is much lower to its cost of equity and it has a solid predictable cash flow from its operations, it should increase its long term debts to reduce its outstanding shares. Walmart was pulling in $25 B in operational cash flows and its interest expense today is just 2.5 B.

Chart 6

With that in mind, a stock that traded within a range from $45 and 60 in the first decade of the millennium along with growing dividend and investor-friendly management, it’s not a mystery that the stock did not fall below the $45 mark support. Though it also did not garner enough support to push the stock price higher for most of the decade until 2012.

2. Look at the valuations. Whenever we mention valuations, investors are quick to jump to look at the PE (price-to-earnings) ratio or other similar ratios like P/S (Price-to-sales), Price-to-book, etc to make a conclusion that the stock is over or undervalued. Some value investors would use the DCF (discounted cash flow) method to calculate what the price is in relation to what it’s worth (via DCF). In all, I simply do not like to use any of these ratios or methodologies as a standalone tool to value a stock. The reason is twofold

• A high PE stock can go a lot higher. You might miss out a 10 bagger (one that goes up 10 times its current prices). Also the “E” in the equation is usually the current earnings per share (EPS) of the forward EPS. Unfortunately, stock investing is forward looking and valuing a stock on its current or near current earnings is just a fallacy of investing. The opposite is also true with a low PE stock as its share price can go lower. As that was the case in WMT after 2000.

• Then it is also a fool’s errand to try to predict what the 10 year future earnings would be. Simply we want to feel good by predicting the current value of a stock by predicting the future of its earnings.

• Alright there is a third thing. Investment valuation is always a “relative game”. Investors constantly value a stock with another stock or the market. Or in fact with different asset classes like bonds and real estate. So in a low interest environment like we are in today, it can justify a higher valuation. Nothing is ever static.

So how do we do this valuation if we are not going to look at PE, P/S or using a DCF method? Again the trick is look at it from a holistic point of view.

So the pivotal moment of this stock was on March 17 2012 when it reached a new high breaking well above the $60 barrier that it had failed 5 times in the past 12 years since the bubble burst. A breakout event as such should always be put under the microscope for further analysis.

If you had read the article on this Q1 earnings, there is hardly anything to jump out of the chair but the markets certainly took note of it as it broke above the $60 and 3 months later, it went all the way up 25% to $75! Don’t fret about it if you don’t read the article, as I will sum it up for you below.

• Wal-Mart reported first-quarter profit that beat Wall Street estimates

• It earned $3.74 billion in the first quarter comparing with $3.39 billion a year-ago period (11% jump in profits)

• Revenue at stores opened at least a year — considered a key measure of a retailer's health — rose 2.6 percent in the division. That's above the 1.4 percent estimate from Wall Street and the third consecutive quarterly gain after suffering nine straight quarters of declines.

• Wal-Mart executives cautioned that the U.S. economy remains weak

• It expanded an internal probe into alleged bribes at its Mexico unit

As in any earnings releases, investors would be more confused after reading it and end up not being too sure whether it's all a good thing or a bad thing.

At the time when the stock broke out above the $60 mark, it was trading at 13x its EPS. Considering that...

Revenue per share grew at 3% from 2014 to 2015 and 0% from 2015 to 2016.

Earnings per share grew at 2% from 2014 to 2015 and declined 10% from 2015 to 2016.

Had anyone known of these numbers then, I would say the stock is way overvalued yet investors disagreed with this sound logic.

Here is the messy truth: Investing is more an art than science.

In this instance in May 2012, it defied sound logic yet it is not wrong to have the price bidded higher. If we look at Walmart as a standalone investment given its prospect (or the lack of it), it would not make any sense but here lied the great opportunity with low risk because we know the stock today trades in the range of $140 a piece (double from where it was in 2012 or CAGR of 11% excluding dividends of 2% a year)

So now you are confused! You are telling me that valuations were too high in 2012 and yet it was a great opportunity to buy in. And when the stock cratered all the way to $57 in 2016, it was a great buying opportunity. Hell yeah. That’s because that would have rewarded you with a CAGR of 25% excluding dividends of 3% a year! In other words, whether you bought it in 2012 or 2015, they were both good buys. And when the stock took a drop in 2016, it was a great opportunity to add in more. If you were to rely on pure technical analysis, you would have sold out a long time ago. And if you were to rely on fundamentals, relying on conventional valuation methodologies, you would have bought it way too early in 2004 perhaps as you were buying a cheap PE ratio or Not buy it at all given that it looks pricey in relation to its future earnings growth.

Chart 7

So let me teach you how to better put a valuation on a company such as Walmart. Just by looking at the conventional valuation metrics like PE, P/S or P/Cash flows is no guarantee for making it a good investment unless you consider seating on a dud for the next 10 years as an investment.

Instead of relying on fundamental metrics above, I suggest using a ratio chart. Chart 7a below shows the price ratio of WMT over its competitor TGT (Target). Many chart tools like Tradingview.com can now allow you to manipulate a stock chart. A ratio chart maybe a better tool as it shows what the sentiments of the investors are towards a group of stocks which takes into the consideration of the current market environment. The ratio chart below shows the hidden cyclicality of its valuation between WMT and TGT. When WMT priced hits $46 level back in Oct 2015, we can see below that it was worth at the bottom of its valuation when compared to TGT.

Chart 7a

Tip: Ratio Chart! Use ratio charts to look at hidden Cycles which can give you a better view of its valuation to its peers.

If we want to look at valuations, we need to consider what will drive the stock price higher. Earnings per share is everything that matters and how the market puts a multiple on its growth are the things that truly matter.

So what drives up EPS? Simple. More sales or revenues. In Walmart’s case, it’s been growing sales every year since the bubble burst in 2000. Just because you bought it between 2002 and 2011, it does not make it a good investment and let it seat around collecting dust and dividends.

Chart 8

Tip: Hidden Trend! The price chart shows the stock was going side ways but when we look at Revenue per share, it has been just trending up all along. This can certainly provide a Confidence booster that your investment is in good hands.

So when is it the right time to buy WMT?

• On May 17 2012 when it came out with the earnings, the stock chart showed a technical breakout to New Highs over the $60 hurdle. Despite the confusing news, investors realized that it has been mistreating WMT badly as it was valuing its peers like Target (TGT) at higher prices. Not fair!

• And then on Oct 14 2015 when WMT had its steepest decline (12%) in over 25 years touching a low of about $56, precisely where the technical breakout was back in 2012. In hindsight it was a great buy! And it was much cheaper stock than in 2012 as it produces more revenues than it was a few years ago.

Chart 9

If we look at the very BIG PICTURE of Walmart. Growth has been slowing down since 2000. We can segment the company revenue growth to different phases over the decades.

Chart 10

Understanding this growth phase, you will know why stock behaves the way it does. In phase 1, the stock price matches pretty much with its revenue growth. During phase 2, the stock price went on growing at double the rate of its revenue growth. This was made possible as the stock market in general was exuberant in pricing everything with high valuations during the times of the dotcom boom, the Enrons and GEs. This also explains why during the first decade of 2000 (phase 3), WMT was stagnant as it had a PE multiple of 50x at the start of the millennium and despite annual growth in sales and earnings, the stock went nowhere. Fast forward to phase 4, the stock is now growing double its sales growth rate.

So how is this rational? So once you rule out logic and proper valuation, the only explanation that can justify such a valuation is the higher market multiples that investors are putting on stocks in this very low interest rate environment.

'Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.” - Sherlock Holmes'

In summary, charts are super useful tools when they are being used properly. With the right holistic view it can better explain why stock prices are moving the way they are.

• By the late 1990’s, we now know the price is overvalued as the price went up twice the rate of its revenues.

• This then explain why the stock went nowhere for the next decade because it was coming with a high valuation

• The stock did not crater either during the dotcom bust as it was supported by the continued growth in its sales

• By 2012, the stock breakout to new highs despite meagre sales growth, it was not because investors were expecting higher earnings. Rather the stock was way undervalued and they are not recognizing it. The growing and high dividend was also an added motivation to bring in income hungry investors to the stock.

• And today, despite the stock price growing at once again double the sales growth, the overall valuation is still relatively low to its peers and the market in general. This will provide a continued momentum for it to go much higher up.

I hope this article helps you become a better investor as investing can be confusing when we are looking at so much information and opinions.