Here’s How We're Evaluating Potential Investments
3 min read.
|Caleb Dismuke||Apr 6|
Businesses are like machines
They are made up of simple parts like revenue, expenses, cap-ex, etc.
Right now, we know two things:
Most businesses will see a decrease in revenue.
Most businesses will cut expenses.
We don't know:
How much revenue will slide and how long it will take to recover.
How deep businesses will cut expenses.
This makes determining future business value almost impossible.
But once companies start reporting earnings, we'll get a better handle on what future revenue, expenses, and earnings look like.
The first reports will allow analysts to set future expectations.
And remember, it's not the absolute earnings number that matters, but earnings relative to the expectations embedded in the price.
So what can we do?
How can we determine what has the potential to be a good investment in a chaotic environment?
We'll start with a simple framework.
Reframing the upside
Nick Maggiulli penned a smart post about buying stocks during a panic. He implored investors to think differently.
Despite the seemingly obvious upside to buying during the current panic, many investors (even those sitting on lots of cash) are afraid to do so. This seems to be partially an issue with uncertainty around a further decline, but it also seems to be a framing issue as well.
To re-frame this discussion, please answer the following question:
How long do you think it will take before the market reaches a new all-time high?
If you believe the market will make it back to the previous all-time high, you can calculate the percent gain needed to get there.
For example, the S&P 500, as of Friday's close, sat at 2,488. That's a 27.8% decline from the previous all-time high of 3,393 made in February of this year.
The index would need to a 36.4% gain to reclaim the all-time high of 3,393.
A 36.4% return is great! But how great depends on the time it takes to get there.
If it takes seven years to make new all-time highs, that's not so great.
Let's break this down using our CAGR (compound annual growth rate) spreadsheet.
What these numbers mean:
Beginning Value: Friday, April 3rd closing price.
Ending Value: Previous all-time high set in February of this year.
3, 5, and 7-year CAGR: The expected annual return for 3, 5, and 7 years.
Again, I want to emphasize these returns aren't guaranteed. They're theoretical, based on inputs which could be, probably are, wrong.
So why is this useful? It gives us a range of potential returns we can use to see how investments stack up against one another.
Let's compare the potential returns for Amazon ($AMZN) vs. Boeing ($BA).
* Boeing's ending value is the 50% retracement from the $296 break down level to the recent low at $89.
At first glance, the investment case for Boeing seems like a slam dunk. A 15.13% 3-year CAGR vs. a 4.66% 3-year CAGR for Amazon.
But it's not that simple. We have to figure out which scenario is more likely. Which again, is more guessing.
Maybe Amazon hits a new high in one year. Or perhaps it takes Boeing four years to tag $190 — all possible outcomes.
Using the CAGR spreadsheet is a starting point. More research and thinking, both quantitative and qualitative, are required to make optimal estimates as to which investment outcomes are most likely.
If you want to run these calculations yourself…
Here's the formula:
*CAGR = (ending value/beginning value)^(1/number of periods)-1*
You can adjust the beginning and ending values and the number of periods (years).
With our handy CAGR calculator, we're going through the Russell 1000 in search of potential investments.
We're looking for stocks that have a minimum 3-year CAGR of twenty-percent.
We'll publish the best opportunities we find. And show you how we would execute them.
In this volatile environment, we're primarily using charts to identify potential investment opportunities.
Fundamental analysis has its place, and we will call upon it when needed.
But who knows what the fundamentals will look like going forward? We've never experienced a situation when revenue went from X to zero in a matter of weeks for thousands of companies across America.
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