Profiting From Statistical Indicator Analysis: AAR, Microsoft

Includes: AIR, MSFT
by: Friedrich Research

An investor should never rely on just one method in analyzing stocks, but should try to verify investment decisions by using a variety of different methods. Much of my success as an investor has come from using free cash flow analysis. By using Owners Earnings (OE), Cumulative Owners Earnings (COE), Free Cash Flow Return on Invested Capital (FROIC) and CapFlow, I have been able to establish a solid methodology for identifying strong companies selling at attractive prices for purchase.

I have never really had a problem identifying what to buy or when, but have always struggled with when to sell. I hate to lose money more than anything and thus tend to sell once a company hits a certain level of price to owner’s earnings per share or for example have their FROIC go from 20% to 5% in a given year. I run my business a certain way and my company’s motto is “Capital Appreciation through Capital Preservation”. I take that statement very seriously and don’t mind going to large positions in cash when negative catalysts are everywhere (October 2008) or going fully invested when positive catalysts are everywhere.

The business of security analysis is a very complex one, as most of your fellow investors do little or no research at all when they buy and just mindlessly invest in Indices in one shot investments or throw caution to the wind when they get a supposedly good stock tip from CNBC or a friend. Also if a stock that I own gets included in an index, its fortune then gets linked to that index. Basically it’s all about money flows and as an investor, if you get caught on the opposite side of an outflow from an index, your stocks could get seriously affected, even though the fundamentals of the company are sound and the management has proven itself competent.

The actions of the market are mostly due to investor behavior or panic on the upside or downside. Since most investors do little or no research at all, they become extremely confused when things turn against them and tend to panic. This was clearly the case in 2000 when the dot com Bull Run burst or in 2008 when Lehman filed for bankruptcy. When panic erupts things tend to move to extremes and are clearly shown throughout history in both Bear and Bull Markets.

So though we have done all our research and feel confident that we are in the best stocks, if panic erupts, then unfortunately we will go down just like everyone else and this proves why most money managers cannot beat the Indices. In the end we are just one investor in a sea of investors and though we may have the best stocks, in a panic we will suffer as well.

In order to avoid getting caught in this sea of panic, I have come up with a way to gauge it. My method is called Statistical Indicator Analysis (SIA). Before I explain how it works, I will just give you a little historical background. Prior to the formation of the Security and Exchange Commission or the groundbreaking work by Benjamin Graham called “Security Analysis”, people in my field were called Statisticians and not Security Analysts, like they are today. Prior to 1934, corporations were not required to give out details on their internal finances, such as balance sheet, cash flow and income statements and all investors had to rely on was price data. Unless you were an insider in the company you never had the opportunity to look at “The Books” like we can today.

So basically price action in the market was all that was in the public domain and that data is what I call “Statistical Indicators” or what investors as a whole (fractal geometry) thought the true value of the company was worth. From this data what we know as “Technical Analysis” was created and theories were formalized for short term analysis of the markets. The problem with Technical Analysis is that it is geared to traders, who look for short term movements to make trades. But if you go out further than 200 days, Technical Analysis is of little use.

In creating “Statistical Indicator Analysis” I have broken out of the short term limitations of technical analysis and created what I believe to be a solid base for analyzing market sentiment and investor behavior. What SIA does is run a moving average that plots the average of 3650 trading days at a time, but not days on a calendar - for example 10 years, but actually 3,650 trading days, where the markets were open. I have experimented with 1 year, 3 years, 5 years etc.. and the number that has worked best has been 3,650 trading days.

My last two articles have been on AAR Corp.(NYSE:AIR), so it is only logical that I introduce SIA using that stock. Here is the SIA Chart for AAR Corp.

As you can see the blue line is the daily price action of the stock and the red line is its 3650 trading day moving average. In my previous two articles I have clearly established that both the company and its management are superior and on Main Street the company is doing great, generating some $23+ in Cumulative Owners Earnings per share since 1969. Therefore by introducing SIA (Red Line) I have been able to find a level where one can find the statistical mean of investor sentiment. The farther a stock trades above its SIA line the greater the risk to the investor and the greater the stock trades below its SIA the greater the opportunity is for gain.

I have been blessed to have Yahoo Finance as it has allowed me to view historical price actions for basically any stock or indices that I want and run my analysis for free. If you go to and type in AIR in the quote box it will bring up AAR Corp. When you are there you will see on your left “Historical Prices”. Click on that and then you will see that historical prices are available for AIR from July 19, 1984 until today. All you then have to do to get them is click on “get prices” and then download them all to an Excel Spreadsheet by going to the bottom of the table.

Once you have them on your spreadsheet you eliminate all columns but two, the date, which is column “A” and the “Adj Close” which will be column “B”. Those are all that should remain. Now in order to be able to make a chart and do the analysis properly you just need to reverse the dates from oldest to newest, so just highlight the entire spreadsheet and hit the “Sort Oldest to Newest” button. If you have done it correctly “July 19, 1984” will be on the top and yesterday's close will be on the bottom. Now all you have to do is insert the following formula in the last blank box in column “C” on the last date available;


Basically there are 6662 rows or price points. If you minus 3650 from 6662 you get 3012. So you are telling Excel to go back 3650 days and add up all the days and then divide by 3650 days to get the average. Then all you have to do is copy and paste that formula in all the preceding boxes in column C and you will populate the whole sheet. You will notice that line 3650 to line 2 all have a #REF!. This happens because the first day the SIA analysis is available is on the 3651st day which is 12/28/1998. So basically a company has to be publically traded for 14 1/2 or so years before it can be analyzed using SIA.

Once you have the data highlight only columns B and C from 3651 to 6662 and then go to Insert, hit chart and then create a line chart. The result will be a chart that looks like the one above.

In analyzing the chart you will notice the periods of excess and opportunity. The numbers at the bottom of the chart are the days of analysis, so the “1” is really equal to 3651 on your excel table and if add 3650 trading days to each number and you will be able to line it up to the exact date in the spreadsheet.

So if you look at the number 2,161 on the chart that will equal line 5,811 on your excel spreadsheet. That date will be equal to August 8, 2007 where the price of the stock was $33.70 and the SIA was $14.12. So obviously from an SIA point of view the stock was trading at 2.38 times higher than its SIA, which is dangerous. Remember that the farther above the red line you are the greater the risk. If we were to compare that to the fundamental data of AAR we can find the fundamental data for 2007 for AIR by going here.

We use the 2006 numbers of $1.32 for owner’s earnings and $17.57 for COE. So at $33.70 we are trading at 2.38 times SIA, 25.53 times its OE and 1.91 times its COE. We eventually hit a high price $38.54 on December 26, 2007 and that would have been a price to OE of 29.12 (we usually like to sell at 30, so we were very close to picking the top). At that price we were 2.6 Times its SIA and 2.19 times its COE.

So there you go, we now have three solid tools to use in analyzing stocks. SIA is important as not everything can be analyzed with OE or COE, but one can analyze anything with SIA that has at least traded on the market for 3650 trading days.

Here are a few more things I have analyzed using SIA that you may find interesting.

The first chart is the SIA Chart for Microsoft (NASDAQ:MSFT):

The first date or (1) on the chart was August 21, 2000 and on that day it traded at 3.77 times its SIA. Then the bottom of the big dip around number (2,100) came on March 9, 2009 where the stock was trading at .6980 of its SIA. As of Fruday MSFT stock had an SIA of $23.51 or is 1.2 times its SIA and far from overvalued.

The next chart is of the S&P 500 Index and is from 1964-2010;

The current SIA for the S&P 500 Index (NYSEARCA:SPY) is 1147.29 and is 1.09 times it SIA so it is very attractive at this point. The peaks that you see in the chart are from May 21, 2001 when the Index was trading at 2.03 times its SIA and the second peak is from July 19, 2007 when the Index was trading at 1.56 times its SIA. The first valley you notice around 9361 is from October 7, 2002 and there it was trading at 1.09 times or about where we are today. This is a reason why I am so bullish right now as I don’t see us ever visiting the extreme selloff that you see on the last dip we had in 2008-2009, which got us down to the absolute bottom on March 9, 2009 when the Index was at .62 of its SIA.

Finally as proof that the SIA can be successfully used on any stock or Index here is a chart out of left field that no one would expect. The company is called Delaware and Hudson, which was a public company from 1825 to 1853. In those days they only published stock quotes once a week so I took the 3650 and divided it by 7 and got 521 so the chart is now equal to what we are doing on the others;

Here is the chart;

So even with this stock, the all time low was .63 times its SIA and the all time high was about 1.85 times its SIA, so we have a solid proof, coming from as far left field as you can get, which shows that human nature has changed very little in the last 175 years, when it comes to the stock market. Boom and Bust with little moderation is basically how human nature operates in the stock market. The boom lasted from 1839 to 1848 both starting and ending in June of each year for this stock.

So hopefully I demonstrated in this article as well as my last two on AAR Corp that if you can establish a solid methodology and track what the crowd is doing at the same time through SIA, then you should successfully practice “Capital Appreciation through Capital Preservation”.

Disclosure: Long AIR, MSFT. No Position in SPY