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SHARE PORTFOLIOS


Stress test 2: market recognition When Benjamin Graham introduced the mythical character Mr Market, he wanted to emphasize that stock markets have moods. Some days shares in a particular company will only be available at high prices. Other days, with no further information, they will be available at much lower prices. The easiest way to see these swings is via the price-earnings or P/E ratio. The P/E ratio tells us how much Mr Market is willing to pay for the projected stream of earnings being generated by a company. Even for stable iconic companies such as Woolworths, this


can vary considerably over a financial year by 50 per cent or more. What we need is a stress-tested P/E ratio at a level that we can be confident will be exceeded in the future.


Stress test 3: dividend policy What has been the level of dividends in the past compared to earnings per share? Has the board given any indication about the future dividend payout ratio? If the payout ratio were cut back, what would be the impact on the expected return on an investment? These are the types of questions that can be included in making forecasts of payout ratios. Once more we are stress-testing the particular forecasts and their outcomes. It is vital that such stress tests be objective – otherwise it


is too easy to be led astray by behavioral biases into thinking that an investment is more robust than it really is. Objective computational methods are available that isolate weaknesses in the historical financials of a company and make these stress-tested forecasts. These methods are contained within Conscious Investor® as part of the Teaminvest approach to finding superior investments.


Similarly for the share market, before a purchase is


made, the investment needs to be systematically stress- tested. In this way, stress testing goes far beyond the general idea of asking that an investment has a margin of safety. Precise stress testing is the key to ensuring that a purchase meets the needs of a successful investment, ranging from preservation of capital through to a healthy, secure return. There are three specific tests that should be applied.


Stress test 1: growth of the business Professional analysts make forecasts of the growth of businesses. Unfortunately, despite all the publicity about these forecasts, many large-scale academic studies show that they are generally not accurate enough for responsible investing. Fortunately as investors we do not need to make


accurate forecasts – we just need to avoid results that are less than projected, so-called negative surprises. In other words, we want to make forecasts that the actual growth rate is very unlikely to fall below, and highly likely to exceed. This is what is meant by a stress-tested forecast. It can be interpreted as a worst- case scenario.


Calculation of the expected return In light of the above, what minimum return would be required to compensate for the risks associated with it? For example, suppose the risk-free bank rate is five per cent. What extra return would be required to compensate for the risks associated with investing in a particular company? Without answering this type of question, we are really just speculating with the hope that we are going to get a profitable return but no real idea whether we will or not. Again there are products such as Conscious Investor®


that will perform this analysis. After activating the above stress-tested forecasts, the software calculates the return that can be expected with confidence from purchases made at the current price. If the return that is calculated exceeds the required return, it may be time to buy; if not, further calculations show what would be the appropriate purchase price.


Conclusion Portfolios held by family offices have special requirements. The steps described above provide a clear pathway to meet these requirements to maintain wealth over generations and to grow it prudently.


Dr John Price is director of research at Teaminvest Pty Ltd, a membership organization for investors who wish to manage their own money. He is also an author and software developer.


FAMILY OFFICE: ASIA TOMORROW 61


OPERATIONS


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