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Many of our readers have asked us just how to interpret the "Ratings" that are part of every "Buy" email. Others have asked why we seem to issue so few "Buy" emails, but more on that later. Suffice it to say that, after a placid quarter in which not a single position was added to the stable, it seems as good a time as any to explain this element of our methodology.
Think of the stock buying process as a two-step procedure. First, of course, is the decision whether or not to purchase a stock. Then, once you determine that a buy makes sense, the next logical question is how much of your hard-earned savings you should plop down on the position.
That's where the Rating comes in. It's an indicator, based on a scale of one to four, of how large a position we've taken in a stock. A Rating of 1 represents the minimum amount of money needed to open a position, while a 4 corresponds to the maximum amount. Logically enough, we plow four times as much cash into a firm with a 4 rating as we would if it garnered only a 1. To express it another way:
So far, so good. So, how do you apply this to your own situation? We would be remiss if we didn't point out that it's up to you. Remember, the purpose of the Rating is to give you a guide to match our confidence in a stock with your purchases -- if you choose to follow our system, which is a mighty big assumption.
Let us be crystal clear when we say that we do not advocate that you adhere mechanically to the Contra methodology. The farthest thing from our minds is to create another "herd" of investors who blindly parrot a system.
As independent investors, you need to assess the risk/reward profile differently to suit your own unique financial circumstances -- stage of life, temperament, etc. -- which are huge factors affecting the size of your bets. We've had a good run lately, but long-time subscribers know perfectly well our capacity to make the odd bonehead error.
All that said, if you wish to match the Contra performance, for richer and for poorer, in sickness and in health, for better or for worse, then you'll want to make use of our Ratings.
Let's run through an example to show you how it works. Suppose you have $40,000 to invest and you would like to spread it over eight stocks. If you were to distribute the funds evenly, you'd plunk down $5,000 each. Assign this amount to the midpoint on the Rating scale, which is 2.5. It's a linear scale, so we simply divide $5,000 by 2.5 to find that a stock with a Rating of 1 is worthy of the minimum investment: $2,000. Moving up the line, a "2" stock gets $4,000, a "3" is worth $6,000, and $8,000 should be thrown at a stock rated at 4.
Let's apply this to the purchase of a stock. Say you want to buy the beaten-down three-legged dog that we just acquired on the nyse. It's trading at $3.20. The first thing to bear in mind is that this stock trades in usd. Now look up the Rating -- we'll say it's 3.07. Multiplying your minimum investment ($2,000) by 3.07 yields a product of $6,140 cdn. Assuming an exchange rate of $1.58, we have $3,886 usd to invest in this stock. Divide by the stock price, and you'll find you can buy 1,214 shares.
There is just one more thing to remember: odd lots are a pain. It is worthwhile to round off your purchase to a board lot. In this example, cast your gaze on acquiring 1,200 shares.
The beauty of this system is that the scale can easily be adjusted to suit any size portfolio. Over time -- we hope! -- you'll need to recalibrate the scale to reflect the growth in your holdings. Say your $40,000 portfolio doubles to $80,000 and you wish to stick with eight positions. The minimum punt would now be $4,000, while the maximum would be $16,000.
A further adjustment would be in order if you change your mind about the number of stocks in your stable. For instance, if you decide to go from eight to 10 positions in an $80,000 portfolio, the new range would be $3,200 to $12,800.
All well and good, you say, but how do we come up with our Ratings in the first place? That's a complex matter. It's not as simple as "better potential, more money." In fact, stocks with huge upsides sometimes get a fairly light weighting.
For instance, Kelman Technologies had a low Rating of 1.07, though we reckon it could be a four-bagger. That lukewarm Rating reflects the stock's speculative nature and the firm's near-death experience a few years ago. Plus, at 40 cents, you can buy a heck of a lot of shares, meaning that they can be spun out more easily in stages as the price treks upward.
Stride Rite, on the other hand, garnered a more solid Rating of 2.22, even though its target price of $14.69 represents a more modest expected gain of 153 percent. That's because this firm offers a high margin of safety, so we are comfortable with a higher capital exposure.
The combination of a heavy Rating with a monster target, as are the cases with Sodisco-Howden and OfficeMax, indicates companies that not only have superb prospects but will likely be in the portfolio for many years. Fortunately, pleasant surprises sometimes kick in and stocks rush out of the portfolio more quickly than even our fertile imaginations can envisage.
Finally, sector concentration also needs to be taken into account. Claude Resources was a better prospect than a Rating of 1.43 would suggest, but with Richmont Mines already in the portfolio, it didn't make sense to go hog wild on gold. Yes, Ollie, remaining adequately diversified is a consideration.
Care should be taken when you interpret the Ratings on those stocks that have been kicking around on our Buy list for a while. Would we purchase exactly the same amount if we were pulling the trigger today? Perhaps, but any number of factors might subtly influence the mix and produce a different assessment as to the optimal number of shares to be procured.
That doesn't mean the company isn't still a good buy -- in some cases it may even be a little better. Just bear in mind that a historical number reflects a reality from the past which may not jibe with today's circumstances.
We've tried to come up with a better name for the Rating concept, but so far have run dry. We're aware that the presence of a list of "Rating Adjustments" (now simply "Adjustments") at the end of past editions of Contra might have muddied the waters for some. Perhaps our readers have the answer. Any ideas? The lines are open.
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