1. When net income far exceeds free cash flow for long period of time

All the accounting red flags mentioned below ultimately leads to net income gradually exceeding free cash flow. As mentioned earlier, due to accrual accounting basis, revenue are reported as and when it occurs, while the cash for sale of products and services will received sometime earlier or later from the time when sales occur, this leads to discrepancy in net income and free cash flow, with potential for manipulation.

2. Great mismatch between rate of accounts receivables and revenue/sales growth

As a company is expanding its market and finding new growth areas, its revenue and sales will grow, this will normally accompany by growing accounts receivables. By right, theoretically speaking, if the sales increase at a certain rate, then the account receivables should also increase at around the same rate unless the sales are to customers with bad credit which will translate to bad debt down the road in future. Significantly higher account receivables growth rate than growth in revenue is a clear signal to fraud that warrants some investigations. Comparing and contrasting annual rate of growth in revenue and accounts receivables is a way to detect if the company is recognising revenue too early.

3. Imagine revenue from thin air

The legitimate revenue or sales from a retail shop selling bread is simply amount earned from sales of bread and similarly for other types of companies, there will be other proper things where the company core earnings is. However, there are a few ways where company revenue can be falsified. For instance, if the firm sells its property investments but report the proceeds gain from sale as current income, net income will increase substantially for that year but the earnings will be deceptive since it is not really its core earnings and is nonrecurring. Another way of imagine some revenue out of thin air is simply reporting cash proceeds from a loan as revenue instead of booking it under liability since the loan needs to repay one day and is not really income.

4. Using subsidiaries to generate fake income and store expenses and losses

A subsidiary of a parent company is another company with more than 50% shares owned by the parent company. This category of accounting manipulation is particularly hard to detect because the subsidiary may not be listed on the balance sheet, may be found somewhere in the footnotes or even not being disclosed in the first place. One way a parent company use subsidiary to generate fake income is by lending money to its subsidiaries but no cash actually changed hands while interest income from the subsidiaries are reported by the company. In a similar sense, by shifting expenses to subsidiaries, net income increases for the parent company.

5. Increasing the time period for depreciation and amortizations

Plant equipment being used for 10 years will have its value depreciated over 10 years with depreciation expense booked over the 10 years and capital asset decreases to zero at the end of the 10 years. The firm can decide the period of depreciation, with the longer the time period, like instead of 10 years, it is 15 years now, and there will be smaller depreciation expense for each year of the 15 years. This can also occurs for intangible asset with amortizations.

6. Capitalizing expenses for current year

When physical plant equipments are bought for current year, the expense for purchasing the plant equipment is capitalised as an asset and not reported as expenses based on accrual accounting basis. This is to properly recognise expenses by depreciation over the time period that the equipment is in use but when present year expenses is also capitalised, it will be sort of a fraud or manipulation because the company intend to write those current year expenses off over next few years herby reducing expenses for current year, boasting net income now. But this will get worse in coming years since if it booked most expenses as deferred assets, the amount will only get larger in future, leading to some reduced net income or even large losses in future.

7. Changes in accounting policies used my companies

One of the common ways companies boast net income is how it values its inventory. Take for example the type of inventory holds by business farming and selling pigs. How it defines the cost of goods sold is highly questionable. Red flag when there are changes in inventory valuation policies can be detected through sudden changes in cost of goods sold and gross profit which is profit before other expenses except cost of goods sold. In addition to this, firms can also utilises different ways to recognise revenue. Again, one can see this through abrupt changes in revenue from year to year and fine prints in notes accompany financial statements.

8. Declining revenues for several years in a row

There is only so much you can do in relentless cost cutting, like wasteful spending, unnecessary headcount and inventory management. Long term profitability is eventually still dependent on growth in sales. Like what happen when Steve Jobs is ousted from Apple last time, there is unrelentless cost cutting by the management board that the company may as well axe everyone so that the expenses is zero. There are no new innovative products and sales declined gradually, and then continue to axe and cut cost. What happens with Steve Jobs on board and increasing revenue from new innovative products like IMac, IPod, IPhone and IPad, is Apple surpassed Microsoft to become the world’s most valuable technology company even though Microsoft still owns more than 90% of the operating system market. In general, a company with more than 3 continuous years of declining revenue will not be wise to invest in since any cost cutting will have been realised over this time period already.

9. Current ratio less than 1

Current ratio is current assets over current liabilities and is a financial ratio to measure a company’s liquidity over a short term of one year or its ability to fulfil its debt obligations in one year time. Current ratio of less than 1 is a serious concern for companies in cyclical industries. Cyclical companies are those whose revenue decrease by more than 25% in bad times of economic downturn and contraction compared to good times of economic prosperity and expansion.

Current ratio of less than 1 is not really a cause for concern for non-cyclical stocks like utilities and even tobacco, as their revenue is relatively stable during both good times and bad like for example, smokers find it hard to smoke even during recession and people still need water, heat and electricity during downturn.

10. Ever increasing in outstanding shares

The not so good companies will see their outstanding shares increase over the years (not due to stock split). As this simply implies that the company is diluting current stock owner’s stake through both options and secondary stock offerings. This implies that they don’t generate much profit and don’t have much retained earnings to invest for growth, hence the need to use equity to finance growth.

11. Astronomically large “other” items under income statement and balance sheet

What items does the “other” contain, especially when the amount is in the billions as in a case of a sovereign wealth fund? This includes but not limited to “other expenses” on the income statement, and “other assets”/”other liabilities” on the balance sheet. While most companies have this, the question is when the amount booked under them is too large to be of a concern, i.e. a high percentage of the total net profits, such as fishy deals (related party deals) or non-business related items.

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Detecting the activity of institutional investors is important regardless of your investment methods – be it taking significant positions into small caps with good fundamentals before it became mid-caps due to institutional ownerships, massive sell downs at the start of financial/economic crisis or stock market recovery after end of financial/economic crisis for the case of well known blue chips, for the simple reason that it will leads to large swings in prices. Take note that analysing the activities of institutional investors does not apply when one is trading micro and small caps in general since they don’t usually invest in them.

There may be more than one way to detect institutional investor’s activity but the fastest and easiest way is to look at changes in volume and prices.

Whenever you see large volume increases accompanied by substantial price increases, then it is a signal that intuitional investors are buying into the stock. Conversely, it also means that when there are large volume increases accompanied by substantial price decreases, it means that large capital are shifting out of it.

Key Terminologies

1. Volume in stock market realm is a measure of how many shares are changing hands for that stock.

2. When institutional investors as a whole buy more of a particular stock than they sell, they are in institutional accumulation.

3. When institutional investors as a whole sell more of a particular stock than they buy, they are in institutional distribution.

Elephant analogy

A very good and commonly used analogy used to describe and illustrate the ideas of institutional investors will be that of an elephant in a swimming pool. The stock is the swimming pool itself and the water level sort of represents the price level. When it is in institutional accumulation, more elephants are in the swimming pool, the water level rises (or stock prices). When it is in institutional distribution, less elephants are in the swimming pool and the water level drops (or stock prices). Due to relative physical size of elephants to swimming pool, there is significant rise and drop in water level whenever there is net movement of elephants into and out of swimming pool.

By extension of this analogy, a stock that is owned by almost every insurance companies, mutual funds, pension funds, index funds/ETFs, hedge funds, is likened to a swimming pool having too many elephants inside and the swimming pool can no longer contain any more elephants. In other words, the stock is close to peak of price. A perfect example would be during the dot com bubble in the late 1990s, whereby many technology companies like Intel, Amazon, Dell and Ebay had an amount of institutional ownerships unseen in the past. A free fall in share prices follow shortly afterward.

One can look at a wide range of information regarding institutional activity from some financial websites like the percentage of institutional ownership, number of shares bought and sold in last three months by institutional investors, etc., as they list daily and average volume figures. Most stock exchanges websites also state information on this for each company. One such website is http://www.iimagazine.com/

Arguments for institutional investors are making sound fundamental investments

These large financial companies got the resources to employ teams of analysts to invest billions of dollars, and have to hire team of qualified analysts because billions of dollars are at stake. So the companies they invest in must be fundamentally sound?

Arguments against institutional investors are making sound fundamental investments

It is wrong to assume that institutional investors and individual investors invest or trade with common objectives. Some of them, like mutual funds, have performance goals to meet and exceed so that more investors will placed their money with them, so they cannot possibly buy and hold since doing so will result in approximately market return and hence longer than one year time to see substantial returns. Which means to say that they will trade more often than individual investors, resulting in high turnover, without regard to each company’s fundamentals, hence the outcome that a large mutual fund company dumping their shares of a stock even if there is nothing fundamentally wrong with the stock’s fundamentals.

Another legendary investor, Peter Lynch, once mentioned in his bestselling book, “One Up on Wall Street”, a total of 13 characteristics of the perfect stock, and one regarding institutional sponsorships is “Institutions Don’t Own It and the Analysts Don’t Follow It.”, which follows back to the first point mentioned earlier, Microsoft and Dell were once small caps not owned by any mutual funds and pension funds yet. When they were substantially owned, that is when their prices are overly valued.

Some Caveats

As with most methods of analyses for financial markets, do not always look at one factor in isolation, volume can also be affected significantly by options expirations, short selling and other types of trading noise. Activity of smart money alone also does not tell the whole story.

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Fundamental analysis involves looking over and analyzing the company three types of financial statements and business models while technical analysis is more towards observing and detecting price patterns and trends and developing strategies to exploit them. No amount of candlestick charting, dow theory or wave patterns can save Enron stock owners during 2001 because these tools did not tell them anything about why shares of companies eventually fall and never go up again. Conversely, the same technical analysis tools will also not tell you which companies will become the Coca Cola or Microsoft of tomorrow.

This post will mention a relatively effortless way to find out whether a company has cooked its book. It is a simple screening test for companies that you will not want to touch with a ten feet pole.

What is the cash flow statement?

In layman terms, cash flow statement listed out the exact amount of cash that enter and exit the company during the period which the financial statement is reporting. Compared to income statement and balance sheet, cash flow statement is much more difficult to cook, or that in other words, it takes more creative thinking and innovation on the part of the accountants to manipulate, for the simple reason it is based on how much cash a company has.

With the Internet, there is a relatively easy way to determine the free cash flow and net income of any listed company. What is mentioning here is most probably the first task that investment professionals do before they decide to invest or short a company’s share. When I was studying financial accounting some time ago, I recalled my tutor, an accountant by training and with a bachelor degree (honors) in accountancy, once said that how much profit the company makes is what the company CEO wants it to be. By a stroke of the pen, the entire expenses can be booked under capital expenditure and what is loss of millions can become profit of millions.

But what cannot be easily changed is the cash flow statement as it is based on the amount of cold hard cash that a company owns at the end of the day. As a result, by comparing and contrasting the income statement with the cash flow statement, one can detect the creativity exhibited by accountants working for the company. To put it simply,

If a listed company reports substantial profit on income statement but the free cash flow from cash flow statement does not paint an equally good rosy picture, then there is a warning flag.

The rationale for using free cash flow instead of operating cash flow is its more conservative, reason being that it accounts for using real cash in capital expenditure. To calculate free cash flow of any listed companies, one can use the following procedure.

1. Sourcing for the company financial data.

Go to Yahoo Finance and enter the stock ticker code. Click on Get Quotes on the right of the search box. This will brings you to the summary page of the company financial.

2. Getting into the company cash flow statements.

Under the Financial heading at the bottom left hand corner, click on Cash Flow. Take note that for the case of Yahoo Finance, there are also quarterly data available, for the latest last four quarters.

3. Calculating free cash flow required of a company.

This will be a simple arithmetic exercise; you just need two figures to determine free cash flow.

Free Cash Flow = Total Cash Flow from Operating Activities – Total Cash Flows from Investing Activities

4. Finding out the net income or net profit after taxes

Under the Financials heading at the bottom left hand corner, click on Income Statement, at the bottom of the Income Statement is the net income.

Well, after getting the figures for free cash flow and net income, one can easily estimate the quality of the business earnings but do take note that it is to be used in conjunction with other valuation models or analytical methods.

If net income > free cash flow, especially if there is significant difference, then there is a potential creative accounting and you will need to analyze the company more deeply. If all you are involved in is technical investing, you will do well to not carrying out technical trading on this company as there may be a relatively higher chance that candlestick charting, dow theory or wave patterns do not predict the outcome accurately.

If net income < free cash flow, or around the same, then relative to the above, the quality of earnings is definitely better since the company brings in around the same or more cash than what is reported as net profit.

This simple exercise saved some people from the Enron scandal, and they felt relieved that they did in the aftermath of the incident. Follow this link to Enron financial statement during the year 2000, and you will discovered that there is much more net income than free cash flows for three years running, from 1998 leading to 2000, especially by the first quarter of 2001, when free cash flow is almost doubled that of net income reported but you need to add a negative sign in front of the figure for free cash flow.

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“I look for businesses in which I think I can predict what they’re going to look like in ten to fifteen years’ time. Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people chew gum.”

People say that investing is risky. When they hear the word – invest, they usually think that it is another synonym for gambling. While there are two words that mean the same thing in English Language, investing and gambling definitely do not mean the same.

There is no certainty in gambling; only increase the odds in your flavor using Kelly Optimization Model and stay in the game long enough to reap its rewards, as in Blackjack and Poker.

While there is not much opportunity to tilt the odds in your favor on casino tables, there are many when it comes to starting own businesses and investing in various asset classes. In other words, the risk in investing is inversely proportional to the amount of research and other types of work performed to reduce uncertainty. If you know what you are doing, there will be discoveries of many high probability events for you to bet high. What happens when you only bet on high probability events and over a long time such as over a lifetime, is that there is a statistical certainty that you will reaped the positive expected return.

There is certainty in investing, properties in some areas certainly go up 10 years later, same for certain stocks also. How do you identify them in the first place?

The Internet may change a lot of things, but it sure do not change the way people have sex, do not change how people smoke, do not change how people drink beer and what brand they drink, do change a need to shave in the morning, do not change the need to wear underwear, do not change the need to have insurance, do not change how people chew gum.

Some products will almost be there 10 years later and so do the businesses producing and selling them. If the same companies will still be selling the same things in 15 years down the road, their earnings will also be there. The good news is, you don’t really need a crystal ball to see the demand that is satisfied by some businesses in 15 years time.

In addition, if the products did not change much, unlike General Motors or even Apple which need to consistently introduce new products, then the companies involved can save all the research and development costs, retooling costs etc.

Remember not only these products become their target markets’ needs already; their brands have also own a piece of their minds. Certainty of revenue is equal to certainty of their loyalty to those brands and needs. There is certainty in change, though someone said that the only constant is change.

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“I’d be a bum on the street with a tin cup if the markets were efficient.”

In both academic environment and investment world, there is this efficient market hypothesis which states those stock markets and any other prices on traded assets like bonds and property is also efficiently changes to reflect the true value of the assets. But there are a number of reasons why stock market is always inefficient and why it will remain so in future.

1. 90% of trades, buying and selling is done by institutional investors

These institutional investors include banks, insurance companies, pension funds, mutual funds and sovereign wealth funds.

Depending on the specific institutional investors, for example, actively manage mutual fund especially, as they need to achieve higher than market returns, and higher than other mutual funds returns in order to justify their high commissions and expense charges, they cannot simply buy and hold investment grade blue chips and then do nothing. In fact, by doing so, it will usually only achieve market returns.

As a result, they need to buy when market is going up and sell when market is going down so that annual returns will not look so bad when compared to other mutual funds company. As they controlled billions dollars of assets, a slight change in stock price means that it will either look very good on paper or look very bad.

In addition, when once in a century financial crisis occurs, ordinary small files need to cash out on their mutual fund holdings, but they cannot sell toxic assets because no one wants to buy, so they can only sell investment grades blue chips.

As you can see, this is one reason why stock market will never be efficient, at least some of the time.

2. Short term earnings are used to gauge value of assets, particularly stocks.

Unfortunately for both individuals and institutional investors, what the companies involved expect to earn in one year time, at most five years time, is used to gauge the value of the stocks and not what the businesses are going to earn throughout its lifetime.

The classic example to illustrate this is Warren Buffett purchase of Washington Post Company for $10 millions dollars in 1973 when Wall Street sells it at this price. Wall Street believes that this company will not achieve good earnings for the next year and their analysts are right, Washington Post Company really did badly for the next year but not for the next 30 years.

3. Not every investor is of the same breed

When stock market hits a new high, one can hear students and housewives dabbling in shares. But they most probably were willing to pay $10 millions for a company that is only worth $1 millions simply because they buy when they saw that the price is going up.

Experts in technical investing buy a few lots of shares for a different reason why people like Peter Lynch and Benjamin Graham buy the same shares. What technical investor sees as cheap, Peter Lynch and Benjamin Graham may see the same stock of that price as expensive, simply because based on some candlestick charts, the price is still low.

4. Fire sale of assets when something happen to the owners

If the only son of a billionaire with $1 billions of wealth is kidnapped and kidnappers demand a ransom of $500 millions, then he needs to fire sale his assets to raise money to redeem his son.

Fire sale of assets means cashing out assets like stocks and properties within a short period of time and get substantially less cash than what it is worth.

Or maybe some sovereign wealth fund loses billions by investing in western banks; it needs to sell off national assets to make it look good on paper to its citizens.

“As far as I am concerned, the stock market doesn’t exist. It is only there as a reference to see if anybody is offering to do anything foolish.”

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Be it enter the stock market through direct stock ownerships, actively managed mutual funds or passively managed index funds, it will be wise to at least know how to detect the prices are in the regions of bubbles and to stay away from it until the bubble completely burst. The following analysis can be used in conjunction with simple technical analysis like if the price now is near previous highs within the previous 5 years, then it is considered too high.

The real wealth of humanity eventually comes from annual supplies of human labor, both physical and mental. Real wealth that you can live on is cars, houses, food, health care and other consumables that can be consume. All of these things can only be produced by humans in the course of their employments.

Given that most of what we earn, i.e. income, net of spending and savings, will mostly be invested in equities or physical properties, the difference in value between GDP and market capitalization of all the companies listed in stock exchanges of that countries will be a reasonable and reliable estimate of assets bubbles or undervalued assets.

Image Credits: linnybinnypix

GDP means gross domestic product of a country, the definition of which is the sum of all goods and services produced in that country. It simply represents the real wealth of the real economy. Market capitalizations of all the companies listed on stock exchanges does not really mean the true wealth, as in if all the people cashed out all their holdings in stocks, there will be many dollars chasing too few goods, eventually causing inflation.

For example, by comparing the increase in GDP of United States from 1980 to 2001, GDP increases by only 281% but the stock market prices from Dow Jones Industrial Average, S&P 500 and NASDAQ increase from between 916% to 1400%, which clearly is some unreal or illusionary wealth. As you can see, eventually, buying at a high price is very risky, as a whole and in the foreseeable future; people just cannot buy stocks at high prices without real economic growth in GDP. There is a crash shortly after 2001, though it is due to dot com bubble.

One way I use to detect stock market bubble is to compare GDP numbers with sum of all the listed companies market capitalizations, this is important if your participation in equities investments is through a diversified holdings of stocks, either mutual funds, index funds or you are rich and hold the diversified portfolios of stocks directly. You want to avoid entering a market when there is clearly a bubble.

One may ask how to compare the figures in this case?

The answer is by simply using a simple formula, the difference between GDP for a given year and sum of all market capitalization during a bear year and that for a bull year.

From the two figures, one can see that the smaller the difference, the safer it is to enter the market.

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The drawdown of an investment is simply defined as the largest loss that occurs in the past. That is the difference between the highest and lowest price in all the historical price movements of the asset. Measurement of drawdown needs to consider the time period. In other words, the percentage lost from the highest point to the lowest point within a period.

In equation form,

Drawdown = highest price – lowest price X 100%
lowest price

Further extending the concept of a drawdown, another parameter can be used to assist in deciding on what stocks, bonds and other financial assets to buy and when to buy.

The length of a drawdown is the time taken for the price of an investment to equal or exceed its previous peak price. Again, the time period in measuring the length of drawdown also needs to consider.

What is the significance of using drawdown and length of drawdown as opposed to standard deviation?

The answer is very important and very significant. Standard deviation does not tell you certain elements that are crucial for you as an ordinary investor. Unlike Warren Buffett and Bill Gates, most of us may not have substantial capital in the first place and income along the way to invest until we can simply live on from dividends from stocks, coupon payments from bonds and rental income from properties. That is mean to say we need to cash out the capital from those financial assets.

Secondly, asset allocations accounts for more of the results than selecting individual stocks and bonds. For example, selecting individual stocks does not determine investment performance more than selecting based on value/growth, cap size and industries. One perfect example is in two different and yet related industries in view of changes in oil price. During periods of rising oil prices, a great number of energy stocks rises while that of automobile companies fared badly. In other words, developments that occur across industries had a greater impact on its stocks than company-specific events.

As a result, drawdown and length of drawdown came in handy when invest based on some categories rather than individual stocks as behaviors of these two measures of risk are much more predicable than single stocks.

Subjecting to differences in each person’s profile and his expected holding period, there are three simple steps to compare the risks of distinct investments using drawdown.

1. Determine the “bear market”, i.e. worst period for each investment that you are considering and hence comparing.

This is making a conservative estimate using the historical worst case scenarios.

2. Calculate the historical value of the drawdown and length of drawdown for each investment during the period that it fared the worst which most probably not be the same for each class of asset.

Although past performance does not equal future results, it is still wise to know how badly the investment does in the past.

3. For each worst “bear market” period, a higher risk investment is defined by a larger historical drawdown and/or larger length of drawdown.

A high drawdown, together with high corresponding length of drawdown means that the investment is more risky and allocation of capital in the particular class of asset needs to plan and adjust accordingly. In addition, it’s annualized returns during the calculation of the drawdown period needs to be higher to justify its higher risk.

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Then the high priests of finance, going by the names of financial planners, financial advisers, etc, in the wealth management industry that repeatedly drills you in the head that because it is difficult to beat the market when even professionals in this area are unable to do so consistently, as a result, you should concentrate on your job and profession, then turn over all your investment dollars to professional fund managers and insurance companies.

The people calling themselves “experts” selling three days stock, forex and options trading seminars for a few thousands dollars are not totally wrong when they claim that they can beat the stock market returns. When more than 1000 people sign up and paid for the few thousands dollars three days trading seminars, the sellers of the courses does earn a much greater return than the stock market over the next three days but not necessarily you and most probably not you.

When the high priests of finance, with alternative names like financial planners, financial advisers, banks relationships managers and insurance agents advises you about the need for investing, like stock market returns on average 10% over the long term, they also did not tell lies. Just that the 10% return is not considering load fees, commissions, upfront charges, expense ratios and management fees of mutual funds managed by professionals in this area. Just that they did not tell you that studies after studies from the past decades show that more than 90% of actively managed mutual funds do worse that the market benchmarks that they were supposed to beat that you were better off not paying some clowns 2% or more per year in management fees.

The fact is that most of the stocks trading are done by very highly educated and at the same time well paid professional fund managers, insurance companies, sovereign wealth funds, endowment fund managers, pension fund managers and the likes. Do you think they are financial fools with no college degrees or at least a bachelor degree with first class honors?

While they may be a few average Joe like you and I who occasionally dabble in shares, or people who start to do so after spending a few thousands on stock trading seminars that last only three days, the volume and capital involved is very tiny in comparisons with those highly paid and educated financial elites. The feller selling the three days seminars and earn more than $1 millions if more than 1000 people sign up most probably invest that $1 millions in preference shares of blue chips and physical properties and earn passive income, i.e. sleep and grow rich.

Image Credits: tinyfroglet

Do you think he is going to follow his own stock trading strategies and spend his life watching stock tickers to earn the inflated and most likely false claims on returns? Or already hire 30 hot chicks models to do a naked Macarena dance in a remote island?

As you can see, it is very obvious that the average investor involved in buying and selling stocks in stock market is someone with a first class honors from Harvard and MIT. Stocks is the same with other commodities like apples and oranges, in that when one person is selling, that means need to have another buyer to buy. When almost all the people deciding on buying and selling have around the same knowledge, intelligence and others, the market will be efficient most of the time, it is almost impossible to get a good deal. One does need to think twice about making his or her first million from the stock market.

In my opinion, the stock market is a place to invest your first million but not the place to make your first million, at least for the case of short term trading, though not necessarily buy and hold good companies.

That is the problem inherent in any professional fund managers claiming to beat the market, a so called professional fund manager with first class honors in finance or whatever field from Harvard, Stanford or MIT, is most probably buying a stock that he deems likely to go up from another fund manager with similar educational credentials and experience.

But why the seller with first class honors wants to sell in the first place? Take note that the seller is in every single part as good in this area as your guy managing the mutual fund for you and charging a high management fees.

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But one does have to note that, at least based on historical data, most low price-to-book ratios does yield higher returns over the long run than investment grades blue chips, as far as capital appreciation is concerned. In addition, smaller sized companies are still most likely need to retain a greater portion of their earnings to fund growth, hence unlikely to pay more dividends than blue chips.

My point is that it is more wise or economical to invest in a diversified portfolio of small sized and low price-to-book ratios companies through mutual funds and unit trusts to reap the highest returns from capital appreciation, and to invest in investment grade blue chips through direct stock ownerships for higher dividends and maybe smaller returns from capital appreciation. That is in the case of investing for the long run, long run as in at least 5 years or more.

Size of companies and volatility of them tend to go hand in hand. That is, the smallest sized companies usually have the highest volatility; I defined small size as below $290 millions in market capitalization.

Take note that the emphasis here is in investing in small cap or low price-to-book companies using a diversified portfolio, not dumping whole life savings in a single small cap company. The risk for investing in a single small cap or low price-to-book company is very high, it is not recommended for an average investor unless you are possessed by Warren Buffett.

The rationale for above advices stem from the high risk and high return concept from the capital asset pricing model combined with researches done by Eugene Fama and Kenneth French. They discovered that the smaller the market capitalization and the lower the price-to-book ratios, the higher the average returns. As a result, it would be wise to invest in a mutual fund consisting of the smallest market cap and lowest price-to-book ratios rather than hold them individually. These companies also tend to pay lesser dividends or even none, hence, no point holding them individually through direct stock ownerships. As for investment grade blue chips, it will be the exact opposite.

Do check the accuracy of Fama-French three-factor model for your chosen stock markets.

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Dividend yield = dividend per share received / price of one share

Other than equity risk premium to measure whether stock market as a whole is normal/under-valued/over-valued, I wonder and have considered that dividend yield is another good indicator as well.

The reason why I came to this conclusion is as follows,

You see, as far as an individual company is concerned, we will never know more private and inside information than the managers running the company even if you own one share of the company and technically considered an owner of the company.

However, the company dividend policy is a good signal of whether its future growth is bright or less than ideal. Take a good look at the findings done by Robert D Arnott and Clifford S Asness, their conclusion seems to be that higher dividend payouts ratio correlate to higher earnings growth and earnings growth will eventually leads to higher stock prices.

The fundamental reason may be explained as follows, if managers do not need to retain much cash, then it is more efficient in using company’s resources. If the company fundamental is good, then it don’t really need much of the retained earnings to grow, the revenue itself should be more than adequate to fund growth.

If we extrapolate this idea to the average dividend yield of all the listed stocks in a particular chosen stock market, then average dividends yield is a good indicator to decide when to buy/sell/hold stocks, in conjunction with other decisions making models to further reduce uncertainty.

As you can see, common sense will tell you that if a share’s dividend yield is constantly high for more than a year, it is most likely a good bargain and vice versa. As a result, the average dividend yield of all the company stocks listed on a stock exchange can suggests to you whether market is seriously overvalued or undervalued. This is another measure for doing market cycle investing using either index funds or blue chips.

You may want to check historical data for the following things; an overly high average dividend yield is followed by a high stock market returns one or two years later, or that together with returns from capital appreciation of all stocks as a whole is usually followed in 4 years time, at the most.

To further apply the concepts presented here, one may plot data of average dividend yield and stock market index value and use the statistical concept of regression analysis for even more detailed analysis.

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