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That should give us our answer. Although no investment is truly risk free, let's use a low-risk, 90-day Treasury Bill, with an average return of 2%. Our Sharpe Ratio for Investment A would be as follows: 9 (Investment A's average return) minus 2 (T Bill's average return) = 7 (Excess return over a risk-free investment) 7 (Excess return over a risk-free investment) divided by 6 (Investment A's standard deviation) = 1.67 (Sharpe Ratio) Our Sharpe Ratio for the Benchmark would be as follows: 7.25 (Benchmark's average return) minus 2 (T Bill's average return) = 5.25 (Excess return over risk free) 5.25 divided by 5.5 (Benchmark's standard deviation) = .95 (Sharpe Ratio) Because Investment A has a higher Sharpe Ratio (1.67) than the benchmark (.95), it is deemed to have a better risk adjusted return. If you want more information on standard deviation and the sharpe ratio, there are several sites on the internet that will be happy to accomodate you. Remember, these are only two tools used in the process of selecting securities. Article: If you're pick investments based on total returns over specific time periods (i.e., 1yr, 3yrs, 5yrs, and 10yrs) without estimate the risk, it's time to add surplus component to your selection process. Standard Deviation and the Sharpe Ratio are two substantial tools that are used by investment professionals for determining risk and, with a little practice, you can be using them too. Although standard deviation isn't limited to the area of investments, it is a measurement of volatility that translates into risk. High standard deviations denote a wide range of investment returns and low deviations denote a narrow range of returns. A word of caution: standard deviation won't do you much good unless you're using it to match up with standard deviations other like investments. Taking things a step further, if you rival the standard deviation to a example (i.e. an indices standard deviation), you can see how nearly those investments are performing to their touchstone on a risk orientated basis. Now for the fun part. Let's compute some standard deviations using hypothetical investments: Assume Large Cap Investment A has a 9% so so return over a three year period (the most tacky time frame for measuring standard deviation). Assume, also, that it has a standard deviation of 6. Now also overact that Large Cap Investment B has an besetting return of 9% over the same three-year period, but that it has a standard deviation of 7. To find the range of returns for either of our hypothetical investments, you need to take the prescriptive rate of return and add (or subtract) the standard deviation for that investment. The result will give you the range of returns for that investment 68% of the time. In our hypothetical example above, while both investments have a 9% midmost return, Investment A has a range of returns from 3% to 15%. Investment B has a range of returns from 2% to 16%. since Investment B has a wider range of returns, it would be deemed to be the more volatile (or riskier) of the two investments. Now let's look at a hypothetical norm to inspect these investments. Let's infringe that the example return for Large Cap Investments is 7.25%, with a standard deviation of 5.5. Using the beside formula, the seminal range of returns for Large Cap Investments would be 1.75% (7.25% minus 5.5) to 12.75% (7.25% plus 5.5). So far so good, but now how do we match Investment A (with a 9% centre return and a standard deviation of 6) to the touchstone (with a 7.25% middle course return and a standard deviation of 5.5)? For that we turn to the Sharpe Ratio. Developed by Bill Sharpe, the Sharpe Ratio attempts to quantify an investment's risk relative to its investment performance. The higher the ratio, the predominate the investment's performance in compliance with compliant for its risk. Our formula takes the difference betwixt and between the return on a particular investment and the return on a risk-free investment. That difference is then divided by our standard deviation. That should give us our answer. Although no investment is truly risk free, let's use a low-risk, 90-day Treasury Bill, with an regnant return of 2%. Our Sharpe Ratio for Investment A would be as follows: 9 (Investment A's fold return) minus 2 (T Bill's commonplace return) = 7 (Excess return over a risk-free investment) 7 (Excess return over a risk-free investment) divided by 6 (Investment A's standard deviation) = 1.67 (Sharpe Ratio) Our Sharpe Ratio for the gauge would be as follows: 7.25 (Benchmark's equatorial return) minus 2 (T Bill's suburban return) = 5.25 (Excess return over risk free) 5.25 divided by 5.5 (Benchmark's standard deviation) = .95 (Sharpe Ratio) Because Investment A has a higher Sharpe Ratio (1.67) than the measure (.95), it is deemed to have a success risk run-in return. If you want more information on standard deviation and the sharpe ratio, there are several sites on the internet that will be happy to accomodate you. Remember, these are only two tools used in the process of selecting securities. They are not infallible, but they can be of tremendous help in keeping your portfolio in top-notch shape. 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Yes. "You Can Be a Stock Market Genius" is probably the most practical investment book out there. I'd say the 1949 edition of The Intelligent Investor - which includes a section on valuation - and Peter Lynch's books are probably the other practical books. Phil Fisher's book is also practical. But I don't think many people are going to actually adopt his approach. Almost no one I talk to is willing to limit themselves to just a handful of stocks that they research for hours and hours and hours before they buy and then hold for a long time. Even though I think – both for value guys and growth guys – that is by far the best way to go. Back to "You Can Be a Stock Market Genius". I'm not sure why you think the spin-off market is much more efficient than it once was. It may be by some measurement. But all the estimates I've seen - there were some really good ones over at a now defunct blog called the special situations monitor - show that spin-offs still do better than the rest of the market. In addition, spin-offs (like net-nets) aren't that hard to separate the possible very, very bad performers from the rest of the pack ahead of time. That's similar to net-nets where a stock with zero retained earnings, losses in most of the last 10 years, and some leverage is a lot more dangerous than a stock with a history of profitability and almost no use of liabilities at all. It may work out. It may even turn out to be one of the best net-nets. But, it doesn’t belong in the “safe” net-net category. Spinoffs – like net-nets – are a place where a little selectivity can remove a lot of risk. Obviously, that’s because they aren’t being very carefully scrutinized by the people selling the stock. Spin-offs are a great place to invest. And when folks ask me how they can learn about analyzing businesses and what is the best place to do it my answer is spin-offs. The big reason is that you don't see the price ahead of time. You can evaluate the business before it trades separately. There's no better learning experience than that. I haven't written about spin-offs in a while, because there haven't been many that interested me. Right now, you have Huntington Ingalls – a spin-off from Northrop Grumman (NOC) – which is interesting in the sense that it might work out well. But it's not something I'm likely to write about. There are a few reasons for this. One, it's carrying a lot of debt relative to EBIT and it’s got slim margins. So, it really depends on EBIT expansion to survive and thrive. The stock is leveraged and that's where your returns will come from. You’re depending on an uptick in EBIT margins being multiplied by a lot of leverage – they’re borrowing at 7% in a low ROC business – to make you money. That might happen. And if you know a lot of about shipbuilding for the federal government, you might want to buy that stock. That one comes down to a qualitative analysis of how much of a risk there is that a business like that could ever get so bad it can't cover its interest. Basically, you’d have to feel much better about the risk that nothing especially bad can ever happen in that business than I’m ever going to feel. It’s just not something I know or feel I can know well enough when you’ve got that much debt. I talked about Hanesbrands (HBI) when it was spun-off from Sara Lee (SLE) in 2006. That was definitely my favorite stock idea around the fall of 2006. I mentioned it in a roundtable discussion as being my favorite idea. It was (and is) leveraged. But it's got a good position in a good business. The competition in the U.S. is just Hanesbrands and Berkshire Hathaway owned Fruit of the Loom. I understand underwear better than shipbuilding. That’s the difference there. Part of the problem with writing about spin-offs is just the audience that I'm writing for. Spin-offs and special situations are - well - special. People would like to learn some tools in addition to some stock picks. Or at least I'd like to think I'm giving people the ability to find stocks on their own. Spin-offs are pretty simple. They just involve reading. You read about them yourself and then you value them. If they trade at a very much lower price from what you think is right, you buy them. That's it. It’s not even that important exactly how you value them. You don’t need the perfect model. You just need to be able to read about a business, appraise a company, and tell an elephant from a mouse. I mean, if you look at Hanesbrands, I think it was spun-off in the $18 to $19 a share range. It’s at $28 right now. It’s leveraged. That’s the part you can argue about. But it’s not like $28 is expensive. In fact, if it can handle the leverage it’s got, the stock is worth more than $28 a share. And yet $28 is about 50% higher than where that stock was spun-off. I wouldn’t say anything especially good has transpired at Hanebrands. You just had a brief period where people were willing to sell something for $18-$19 that was in all probability worth $30+. So, the impediment to people understanding what I'm writing about enough to buy the stock really isn't some concept they don't get. It's just that a lot of people who read my blog or my articles at GuruFocus aren't going to read the SEC reports, the investor presentations, etc. Spin-offs are very basic that way. You look at them and try to value them a bunch of different ways and then you just judge if the market is way off. If it is, you can buy stock. I'd be happy to discuss spin-offs in the future. And this is an area where I think there should be a lot more coverage. Even bloggers don't write enough about spin-offs. So, yes, spin-offs are an area I'm very interested in. And yes, it's the general approach Greenblatt uses - and the way the book is written - that makes me say “You Can Be a Stock Market Genius” is the best investment book ever written. It's extremely practical. It's really not about how great spin-offs are. It's about how you just need to analyze a few situations independently of the market and have confidence in your independent analysis. It's like Buffett says... Don't look at the stock price before doing your analysis. Value the company. Then check the price: You can do that in micro caps as well as spin-offs; foreign stocks as well as domestic stocks. The key is doing that totally independent analysis - just an honest appraisal of the business. If you have the skill to make that honest appraisal of a business all you have to do is go looking for neglected stocks. They can be neglected because they are illiquid, family-controlled businesses with market caps under $100 million or $50 million or whatever. They can be neglected because they are spin-offs. They can be neglected because they are in Japan. But the basic idea is that if you can understand the appraisal idea that Joel Greenblatt talks about in "You Can Be a Stock Market Genius" or Ben Graham talks about in "The Intelligent Investor" all you have to do is find neglected stocks and appraise them. That's it. So, I don't really think of “You Can Be a Stock Market Genius” as being about spin-offs. I think of spin-offs as being places where people can easily - in a psychological sense - appraise businesses honestly, because they don't have the stock price and stock price history skewing their brains. It’s just very natural to appraise assets where you don’t have a price quote. And if you want to invest in stocks, you need to be able to appraise them apart from that quote. You can’t rely on the market. You have to do the work yourself. And spin-offs are all about working out what a company is worth on your own. Article Index: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 | 16 | 17 | 18 | 19 | 20 | 21 | 22 | 23 | 24 | 25 | 26 | 27 |
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