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The Darvas System in a Nutshell

I  truly admire  author and trader Darrin Donnelly for bringing the system thatNicolas Darvas used to make over $2 million in the stock market into modern times by really setting more precise metrics for the Darvas system. He uses moving averages we have today to look at possible price supports in addition to the price boxes that Darvas used. Below is a concise summary of the Darvas system in an up trending market.

While O’Neil is a brilliant trader who has helped thousands make better investment decisions, I feel that there are some aspects of the CAN SLIM system that, frankly, aren’t all that important in picking winning stocks.

Therefore, we offer a new, easy-to-remember acronym for the Darvas System:

D – Direction of the Market
A – Accelerated Earnings and Sales
R – Relative Price Strength (and Return on Equity)
V – Volume Increasing
A – Aggressive Growth Group
S – Sound Base Pattern

To further explain:

D – Direction of the Market

Is the market, as a whole, in an uptrend?  It is highly unlikely that a stock will have huge gains when the overall market is in a downtrend, so make sure the direction of the market is moving upward.

A – Accelerated Earnings and Sales

Is the company seeing increases in earnings and sales this quarter compared to the same quarter last year?

Normally, you want to see stocks with at least 40% increases in earning AND sales in the most recent quarter compared to the same quarter last year.  And remember, the higher the increase in earnings and sales, the better.  If you have a choice between a stock with a 50% increase and one with a 90% increase, definitely go with the 90% increase stock.

R – Relative Price Strength (and Return on Equity)

Is the stock outperforming most other stocks in terms of its price increase?

Darvas wanted to see stocks that had at least doubled over the past year before he’d consider buying.  If a stock has already increased a great deal over the past year, most investors are fearful of a steep decline, but many studies have shown that Darvas was right in his assessment; if a stock had already made a powerful move, it proved that it had the ability to move in such a fashion and therefore, was likely to do it again.

Another important characteristic of ideal Darvas stocks is a high Return on Equity.  Fund managers love to see a high ROE.  Some put a higher value on ROE than they do earnings and sales. (more…)

Joseph Belmonte, Buffett and Beyond, 2d ed.-Book Review

buffett

In Buffett and Beyond: Uncovering the Secret Ratio for Superior Stock Selection (Wiley, 2015) Joseph Belmonte offers investors a metric he believes is pretty close to the Holy Grail: return on equity (ROE) as configured by Clean Surplus Accounting.

The companies that investors choose for their portfolios should have a ROE that is high and consistent over time. The problem is that practically all investors calculate ROE in a way that is both inefficient and unreliable. Traditional ROE is not a useful ratio for comparing the operating efficiency of one company to that of another because, for most companies, it is inconsistent from year to year. Worse, there is almost no correlation between book value (equity) and stock returns.

Traditional ROE uses earnings to calculate the return portion of ROE. But earnings include both non-recurring items, which are not predictable, and future liabilities. As Belmonte argues, “[i]n no way do these events show how efficiently you’ve been running your operation. And we’re concerned with operating efficiency in our ROE ratio and not branches falling out of the sky because of a hurricane passing by.” (p. 59) So, for the return portion of the ROE ratio one should use net income, not earnings.

What about the equity portion of ROE? Owners’ equity (or book value) equals the common stock issuance plus all retained earnings, where these retained earnings can come only from net income minus dividends.

Based on his research, indicating that stocks with a history of high Clean Surplus ROEs outperformed the S&P 500, Belmonte came up with six simple rules for structuring a portfolio.

(more…)

The Graham Number

Ever heard of the Graham Number? This was a formula developed by Ben Graham, the father of securities analysis, to determine the fair value for a stock.
The Graham Number is:

The square root of [earnings-per-share * book-value-per-share * 22.5]

(Take note that earning-per-share divided by book-value-per-share is our good friend return on equity.)

Price, The Conscious Investor

John Price, author of The Conscious Investor: Profiting from the Timeless Value Approach (Wiley, 2011), began his career as a research mathematician and for thirty-five years taught math, physics, and finance at universities around the world. He then morphed into an entrepreneur, developing stock screening software that emulates Warren Buffett’s investing strategies. And, as is evident from this book, he didn’t neglect his writing skills. He proceeds with the analytical precision of a mathematician but with the facility and clarity of a careful wordsmith.

Price describes over twenty methods of valuation. He explains the circumstances in which each method is most appropriate. He also evaluates each method’s strengths and weaknesses.

Here I am going to confine myself to describing the screen that underlies Price’s own investing system. He focuses on earnings forecasts, offering objective methods in place of the strategies of analysts, which are tainted with behavioral biases. Critically, he screens to find companies that are actually amenable to growth forecasts. They share three characteristics. “The first two, stable growth in earnings and stable return on equity, are based on histories of financial data taken from the financial statements. The third one, strong economic moat, is based on the ability of the company to protect itself from competitors.” (p. 292) Since many readers will be familiar with Warren Buffett’s notion of moats, I will discuss only the first two characteristics and how to measure them.

Price developed a proprietary function called STAEGR which “measures the stability or consistency of the growth of historical earnings per share from year to year, expressed as a percentage in the range of 0 to 100 percent. … STAEGR of 100 percent signifies complete stability, meaning that the data is changing by exactly the same percentage each year. The function has the feature of adjusting for data that could overly distort the result, such as one-off extreme data points, negative data, and data near zero. It also puts more emphasis on recent data.” This function is “independent of the actual growth. This means that whether a company has high or low stability of earnings is independent of whether the earnings are growing or contracting. In this way the two measures, stability and growth, complement each other in describing qualities of historical earnings.” (p. 294) (more…)