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The Secret To Not Losing Money On Wall Street

CNBC Writes: Dow could rise 10 percent or more in 2014: Siegel

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Wharton School professor Jeremy Siegel told CNBC on Monday that the Dow Jones Industrial Average (Dow Jones Global Indexes: .DJI) could rise 10 percent or more in 2014.

That may not be on par with this year’s roaring return but is still historically robust, he said, considering that 2013 has been an “extraordinary year” for stock gains.

“I think they are going to kick the [budget] can down the road a whole year,” Siegel said. “So that’ll be off our plate and that will be a very, very positive factor [for] first-quarter 2014.”

Read The Rest Of The Article

This post is to quickly remind you of two very important facts.

1. Most financial media is worthless. Half the time they don’t even know what they are talking about.  They continuously recycle worthless stories that have no impact on financial markets or individual stocks. As I have said many times before, news do not drive stock prices. I want you to be aware of that.

2. Never listen to teachers when it comes to real world applications. Most of them have the theory down, but that’s it. They do not have what it takes to be on Wall Street. If Mr. Siegel knew anything about the markets he would be managing money and making millions of dollars each year. Instead he teaches. Those who can…do and those who can’t….teach.

Anyway, what kind of garbage is this…..only 10%?  Why not 50% or 100%. Might as well just say that. As a matter of fact, any number will do.  The point I am trying to make and the secret I am sharing is this…..

If you listen financial media and/or take advice from those who do not directly participate in the financial markets, your money and you shall soon be separated.  

Okay, I am done bitching for today. 

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How To Determine The Intrinsic Value Of Any Company (Part 5)

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As you can see the calculation itself is fairly simple and straight forward. What is not easy when it comes to doing Intrinsic Value calculation is doing the fundamental research and figuring out which inputs to use.  A slight deviation in any of the variables above can have a huge impact on your overall Intrinsic Value calculation and your subsequent valuation estimate.   

For example, are you 100% confident in your management team analysis? Are you sure they will be able to turn the company around? Is your estimate of $0.50 EPS in 2015 and a growth rate of 11% thereafter really valid or is it full of holes?  Are you sure the company turns around and what about the competition?

These are the real variables and the real questions that determine the Intrinsic Value. Yet, none of them can be known with 100% certainty. They can be very well researched and you can make very accurate estimates, but they are not exact. In many cases these are guesses at best.  That is the point I want to drive home. You will NEVER have an exact Intrinsic Value, it will always be an estimate.

That is why Margin Of Safety plays such an important role. Let’s say you have worked very hard on determining RadioShacks Intrinsic Value at $10.72. With today’s stock price of $3.75, it gives you a 70% Margin of Safety. That is exactly what you are looking for. This type of a large margin of safety will protect you on the downside should your analysis fail to deliver.

If the management team has failed, if the growth rate or the P/E ratio don’t materialize the chances of this stock going much lower is small. Why? Because it is already selling at 70% discount from what a reasonable fundamental research and valuation work indicate. Should you make a mistake your losses will be limited. Yet, should the company surprise to the upside your return will be significantly higher. A low risk and high return setup.

Can the stock still go to zero? Absolutely. The company can still fail and file for bankruptcy, but if you have done your work right and continue to follow the company on the daily basis you should be well aware of that long before it happens. That is what value investing is all about. Finding these undervalued gems, doing a lot of fundamental research, valuing companies and trying to identify investment opportunities that sell well below their intrinsic value. That in return provides you with a low risk and a high return type of a setup.

Chapter Summary:   If you take anything away from this section of the book, take away the fact that no Intrinsic Value calculation can be exact. Even complex models used by investment banks and Quants yield best guess estimates.  There are just too many unknown variables that depend on future events that comprise the calculation.  

That is why you will be very well served by doing your own fundamental research and concentrating on stocks that provide your with the biggest margin of safety and plenty of upside.  

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How To Determine The Intrinsic Value Of Any Company (Part 4)

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With that said, let’s take a look at our previous  example, RadioShack,  for clarification.

  • Stock Market Price: $3.35 (Oct 18, 2013)
  • Current EPS (Earnings Per Share): $-2.71 (EST $0.50 in 2015)
  • Estimated Future Growth Rate:  11%
  • Weighted Average Cost Of Capital (WACC): 7%
  • Average P/E (Price/Earning) Ratio To Use:  14.8

RadioShack presents us with an interesting real life valuation example that you will run into more than you can imagine. Particularly if you are looking for cheap value oriented stocks.  First, you will notice that last year EPS were negative. 

Well, we cannot perpetuate negative earnings into the future in order to determine Intrinsic Value. Earning have to be positive.  In addition, negative earnings means that you do not have a workable P/E ratio to use in our formula. That is where fundamental analysis comes in so handy.

It is obvious that RadioShack is going through a rough time and its stock price reflects it.  If this continues,  in the not so distant future RadioShack is likely to be filling for bankruptcy.  Yet, if the company is able to turn itself around and grow again, the stock price will appreciate significantly….providing investors with large gains and very little risk.

Let’s assume that your in depth fundamental analysis has yielded the following points (this is done for valuation explanation purposes and NOT  based on the real life analysis of RSH).

  • The new and highly experienced management team has taken over operations.
  • The new management team has put forth a plan that you believe they will be able to execute.
  • Based on your fundamental research you estimate that the company will turn around and earn  EPS $0.50 in 2015.
  • Thereafter the company will grow at 11% per annum(based on your research).
  • After looking at RSH average P/E Ratio and industry averages you feel comfortable with using a P/E ratio of 14.8 for your valuation work.
  • Most importantly, based on your work you believe the company will turn around and prosper.

Let’s take a look at the valuation.  

STEP#1:  Figuring out EPS in 10 years.

  • Formula:  (Annual EPS x Estimated Growth rate^10)
  • RadioShack:  $0.50 x  1.11%^10 = $1.42

Explanation:  If RadioShack grows its EPS at 11% over the next 10 years (after EPS of $0.50 is acheived),  in 2025 its earnings per share will be equal to $1.42

 

STEP #2:  Figuring out stock value at year 10

  • Formula (EPS at year 10 x Average P/E Ratio)
  • RadioShack:  $1.42 x 14.8 = $21.02

Explanation: This means that if EPS and Average P/E ratio holds, the price of RadioShack stock should be $21.02 in the year 2025.

STEP #3:  Discounting future value to determine today’s Intrinsic Value

  • Formula (Future Stock Value/ WACC^10)
  • RadioShack $21.02/(1.07^10)=$21.02/1.9671=$10.72

Explanation: That means the stocks Intrinsic Value today should be is $10.72. With the stock price being $3.35 today, it appears that RadioShack is selling at about 70% discount to its Intrinsic Value. 

To be continued…..

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How To Determine Intrinsic Value Of Any Company (Part 1)

How To Determine Intrinsic Value Of Any Company In 5-10 Minutes
No Harvard MBA Is Required

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In the last chapter we took a closer look at how the margin of safety works and what kind of things we should look for in order to make a proper value investment. As previously discussed, one of the most important things to know when figuring out the true margin of safety is the Intrinsic Value (IV) of any given company.

Wikipedia defines Intrinsic Value as the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.

Now, there is something very important you must understand.  Determining the IV of any company is arbitrary at best. It could be a highly complex process involving hundreds of excel sheets and data points or it could be a fairly easy process involving a few easy to understand middle school algebra calculations. At the end of the day, neither approach will give you an exact IV of any company. 

Why? Because we are dealing with the unknown. What we are doing when we are determining an IV of any company is taking various existing data points and projecting them well into the future.  In fact, most models call for at least a  5 year discounted cash flow projection to value a company.  The problem is, the future is unknown and in the fast paced business world everything can change on the dime. Making your original IV calculation obsolete.

New products, new technologies, new competition, economic booms and busts, political developments, regulations, etc….. and the list never ends.  How can we make an accurate IV calculation when so many different “unknown” factors can impact your model.  Well, we cannot. 

We can make our best estimates, but we can never achieve a 100% proper IV valuation for any given company. Give 10 different analyst a company to value and they are likely to come up with 10 different answers. Most likely within +/- 20% of each other.  The point I am driving at is this. There is no possible way to achieve perfection when it comes to IV calculation. We are dealing with too many unknowns and future developments. All we can do is estimate.

Let me give you a quick example. Why did Investment Banks who were involved in the Facebook IPO (initial public offering) valued the company at $38 a share?  Did these Investment Banks have a bunch of complex and secret valuation algorithms valuing Facebook before the IPO.  It’s probable, but not likely. You see,  whatever number any such valuation yields would technically be garbage because the future of Facebook is unclear. It is a fast growing tech company, but without a clear path. Everyone is making assumptions. No one knows if Facebook will grow at 20% per annum over the next 10 years or make a series of mistakes that will put it on the path previously walked by MySpace.

As such, everyone can make estimates in order to derive the IV, but in reality no one truly knows. Anyone who claims they can properly determine the IV value of Facebook is simply lying. What ends up happening in a situation like this is investment bankers basically figure out what “the market” is willing to pay and set their IPO price based on that.  

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The Secret To Margin Of Safety (Part 3)

Businessman falling

One of the first things we have to look at from the value investing perspective is the price/book value ratio(P/B Ratio). The book value is defined by total assets – total liabilities/divided by total number of shares outstanding or it could also be determined by dividing shareholder equity/total number of shares outstanding. There are other ways to calculate the book value, but that is the most basic form.

Now, without making this too complicated, book value per share basically means the value left over if you decide to liquidate the company, sell all inventory and assets,  pay off all liabilities and return all remaining capital to the shareholders.  For example, a P/B Ratio=1 means that if the company is liquidated at that time you will get $1 for every $1 invested.  The P/B ratio of 5 means that for every $5 dollars you have invested in the stock, if the company is liquidated now you will only get $1 back.  The P/B ratio of 0.5 means that for every $0.50 cents you have invested, you will get $1 back if the company is liquidated.

Value investors typically try to identify stocks with P/B ratio of 1 or less because it automatically gives them a margin of safety. As with the Radio Shack example above we can see that their P/B ratio stands at 0.67. This is a good start. Meaning that if you invest in Radio Shack today,  you are buying $1 in assets for just $0.67 cents. This gives you an automatic margin of safety to the tune of 33%. This also mean the company is undervalued, providing an investor with a possible gain of 33% or more. Not a bad start.

The next thing we try to do is determine the Intrinsic Value of the business. If you recall, the intrinsic value of the business is typically above book value. It includes its brand name, future growth projections and cash flow, interest rates, etc…. While figuring out Intrinsic Value could be a time consuming process I will show you how to do it fast in the next chapter.  No degree in finance is required.  We then look at the management team, business prospects, competition, products and a few other metrics to add into the calculation.

Once the Intrinsic Value number is estimated (it will never be 100%) we have a much better understanding of what the business is truly worth or we can see the true value of the company. Jumping ahead a little bit,  next chapters shows Intrinsic Value for Radio Shack at $10.  That means that the current stock price of $3.35 gives us a margin of safety of 66.5%.  This is indeed a significant margin of safety that allows us to protect our original capital.  In addition, the 66.5% margin of safety could be viewed as a potential profit margin which could be realized when the Radio Shack stock moves towards its intrinsic value.

Even thought it could be as simple as that, in the real world it is rarely so.  Depending on the future performance of the company both the book value and the intrinsic value calculated above can go up or down. Sometimes substantially so. That is why obtaining a significant margin of safety when purchasing any given investment is so important.  In the majority of the cases that lowers your risk profile and gives you an opportunity to get out without big losses if a mistake is made.

As such, value investors should always strive to minimize their risk by maximizing their margin of safety.

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The Secret To Margin Of Safety (Part 2)

Why?

Because the stock market is a much more complex discounting mechanism.  The stock market constantly discounts fundamental data, human psychology and future projections into any given stock price. During this process many errors are possible.  It could based on simple misunderstanding of the fundamental data or a negative psychological mood of the overall crowd or due to a market correction/surge.  As such, stocks end up being either…..

  • Significantly Undervalued $25
  • Undervalued $50
  • Properly Valued   $100
  • Overpriced  $150
  • Speculatively Overpriced $250

Obviously, as value investors we are interested in the first two categories because such stock give us the best margin of safety. Yet, that doesn’t necessarily mean that the margin of safety you are able to obtain will automatically become your profit margin.  For example,  if you have bought an “Undervalued” stock at $50 giving you a 50% Margin of safety,  it doesn’t mean that the stock will simply appreciate to $100 over a certain period of time so you can sell it at 100% profit. It should, but it doesn’t mean that it will.

Many outcomes are possible here.  Yes, if you have done your work right, this particular stock should appreciate to its true value of $100. However, the path it takes is unknown. It could decline even further to $25 before surging back to $100.  It can stay at $50 for a couple of years before surging all the way to $250.  Should you sell at a $100 or keep the stock in your portfolio due to improving company fundamentals?

As you can see there are way too many possible outcomes here to clearly define if your margin of safety is your profit margin. That is why it is best to look at the Margin of Safety as your insurance policy as opposed to your profit center. The profit or loss that will eventually come from your investment can realize itself in many different ways, yet there is only one Margin Of Safety and it is clearly defined. Now, let’s take a look at a real life margin of safety example and how to apply it to an individual stock.

(*I will keep the analysis very simple here without going into an in-depth analysis and/or valuation work).

 rsh

  • Date: 10/18/2013
  • Company Name: RadioShack Corp (RSH)
  • Stock Symbol:  RSH
  • Stock Price: $3.35
  • Market Value: $334 Million
  • Enterprise Value: $613 Million
  • Price/Book Ratio: 0.67
  • Revenue:$ 4.19 Billion
  • Net Loss: ($206 Million)
  • Total Cash: $432 Million
  • Total Debt: $712 Million

A stock that just 3 years ago was selling at close to $25, is now selling at $3.35. That is a about an 85% decline in value for a famous brand name we all know.  This type of a situation (significant decline and strong brand name) should definitely peak an interest of a value investor.  As mentioned earlier, there could be a million different reasons of why this stock has declined so much, but for the sake of simplicity and our margin of safety discussion lets simply look at how much (if any) margin of safety does this stock offer.  

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Bernanke Is Over-Stimulating Americans

Reuters Writes: Fed’s Fisher warns of potential U.S. housing bubble, MBS buys

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(Reuters) – A top Federal Reserve official said on Thursday he is seeing fresh signs of a U.S. “housing bubble” and warned about the central bank’s ongoing purchases of mortgage-based bonds.

“I’m beginning to see signs not just in my district but across the country that we are entering, once again, a housing bubble,” Dallas Fed President Richard Fisher told reporters after a speech in New York. “So that leads me … to be very cautious about our mortgage-backed securities purchase program.”

But citing rising year-on-year house prices in Texas cities, and elsewhere in the country, he warned that the central bank’s hyper-accommodative policies could be inflating dangerous asset price bubbles.

“We have to be watchful and realize there has historically been an era of the Fed over-stimulating” since the Great Depression, Fisher said.

“I worry we are following that tradition now,” he added on the sidelines of a meeting of the New York Economic Club. “No one knows when the bubble pops. But I would argue that … with each dollar we buy in Treasuries and mortgage-backed securities, we’re getting closer to the tipping point.”

Read The Rest Of The Article Here

I have a lot of respect for Fisher. Simply put, unlike most others at the Fed he doesn’t have his head stuck up his ass. He calls it as he sees it. He is absolutely correct by indicating that the Fed is over-stimulating (once again) and that causes all sorts of issues, including another housing bubble.

I do disagree with him on one issue. The fact that “No one knows when the bubble pops”.  There are ways and signs to figure it out. When it comes to the US Real Estate market there are multiple signs that the real estate market is completing its bounce from the 2010 bottom and is in process of rolling over. So much so that I went out on a limb a few weeks ago to call for a housing market top. My previous article “I Am Calling For  A Real Estate Top Here“ I have outlined a case of why I am making that decision. I highly encourage you to revisit that post.

While certain local markets might continue to surge upward for the time being, the overall market is reversing itself NOW. If you are speculating or investing in the real estate right now, it is not going to end well. 

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The Secret To Margin Of Safety

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Margin of safety is one of the most important concepts in value investing and as such deserves a more in depth look and analysis.  

As I have mentioned earlier in this book, your margin of safety is the difference between the price you pay for an asset and how much that asset is truly worth. Let’s take a quick look at another example for better understanding.

Imagine a suburban street with 3 identical houses on it. The house on the right sold a few months ago for $500,000 and the house on the left is on the market right now for $520,000. Yet, you are interested in the house in the middle. The previous owner has defaulted on the loan and the house is soon to be auctioned off. Your house is not in as good of a shape as the other two houses.  In fact, it has been run down by the previous owner and you estimate that it will cost you about $75,000 to bring it back to the condition of the two adjacent houses.

On the day of the auction you are able to purchase the house for $150,000. With an additional $75,000 in repair costs, your true cost is $225,000. At the same time you know the true value of the house is about $500,000.

So, $500,000-$225,000=$275,000 Is Your Margin Of Safety

By definition, the $275,000 or 55% discount from the true value of the said house becomes your Margin Of Safety. It becomes your safety net to prevent any losses,  it becomes your security blanket against adverse developments and it becomes your possible profit margin.

What if it takes $150,000 to fix everything up instead of $75,000. That’s fine you are still in the black. What if you find out that there is an additional $50,000 lean against the house? That’s fine, you are still in the black. Your margin of safety on this house will protect you against various unpleasant developments to the tune of $275,000. Yet, an important question still lingers.

Is the Margin Of Safety your insurance policy or is it your profit margin?

Well, it is both and that is why it is so important when it comes to value investing.  First and foremost, margin of safety is your insurance policy. As Warren Buffett so famously said “Investing rule number one…never lose money. Investing rule number two…..never forget rule number one”.  Basically, the margin of safety is there to protect you against any losses and unforeseen events.  

We live in a complex world where your fundamental analysis will not always be right. You will not always be able to predict unforeseen or as insurance industry calls them “Act Of God Events”. Should such events occur your investment will have a large cushion built into it to protect you against significant losses.

It is only after acting as an insurance policy does Margin Of Safety becomes your profit margin. Technically speaking, your asset should appreciate to its true value.  As with the real estate example above your margin of safety of $275,000 becomes your profit if/when you decide to sell the house.  Yet, that is not always the case in the stock market. When we deal with publicly traded companies the situation becomes a lot more complex.  

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Why Do Stocks Sell At A Significant Discount (Part 2)

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Company Factors

The next primary factor of why certain companies or stocks sell at a significant discount to their intrinsic value have to do with the internal company causes. There could be a number of different issues here, but some of the primary ones include.

  • Management Change or Internal Infighting
  • Financial Failure, Financial Mismanagement or Fraud
  • Competition Is Eating Their Lunch
  • Product Failure or Market Failure
  • Falling Growth Rates, Deteriorating Financials and No Clear Future/Catalyst
  • New Technologies Are Entering The Market

Once again, there are many others, but these are the primary issues.  Any given corporation can have one or multiple factors working against it at the same time. Whatever the situation is, it can greatly impact the value of any given stock.  If investors are aware of any such negative developments there is a good chance the stock will be sold off.  So much so that you are likely to find it selling at a significant discount to its intrinsic value.

Let me give you an example.  I believe it was in 2003 when I was invested in a fast food concept out of San Diego called Pat & Oscars. It was a very well run company at the time, selling at a very reasonable valuation (that was well below its intrinsic value) and the company was planning to grow its chain nationwide.  So, value and growth all in one.  Yet, at some point in 2003 the company  had an E. Coli outbreak in its San Diego restaurants, poisoning a bunch of people in the process. The stock sold off the next day to the tune of 50%, giving investors a chance to buy a good company at a huge discount (assuming this E.Coli outbreak doesn’t kill the company).

This is what you would call a company factor.  It is company specific and depending on a situation it can provide investors with amazing buying opportunities. The trick here is to figure out if the issues is a permanent one or a temporary one as in the example above.  If it is a temporary one and if your research is proven to be correct a significant amount of money could be made while taking very little risk.

Industry Factors

Finally, various industry factors can push any stock into a significantly undervalued category. It could be because of cyclicality, it could be due to industry wide technological change, it could be due to pricing pressure and so forth. The trick here is to find the best performing company in the sector and make sure you buy it at a significant discount. When the industry eventually recovers,  the best performing companies should outperform the rest of the sector by appreciating the most.

For example, let’s assume that your research indicates that the price of gold should go through the roof over the next 5 years. Yet,  for some reason gold mining stocks are selling at an all time lows due to the price of gold being low today.  In fact, most of them selling well below their liquation value.  What you should do if you really believe in your investment thesis is identify 1 or 2 best companies in the sector and invest in them. If your research proves to be right, your stand to gain a substantial amount of money while keeping your risk at a minimum.

In summary,  while the are many other …. market, company and industry factors are the three primary forces responsible for driving stocks well below their intrinsic value.  When doing fundamental research you should clearly know which one of these forces is responsible for pushing the stock in question into the 50-90% discount category. Clearly understanding that could mean the difference between making a great investment and making a disastrous one. 

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Why Do Stocks Sell At A Significant Discount?

Most people would classify the stock market as irrational and volatile. Yet, it is the best pricing and discounting mechanism that we presently have.  It is not perfect, but what it lacks in predictability it makes up in opportunity.  The stock market tends to flow and oscillate up and down. Sometimes drastically so. It is during those oscillations that we are given opportunities to either  buy low/sell high, buy high/sell low or any other combination of the said.

We will discuss exactly how the stock market works and what causes those oscillation in the later chapters, but for now we have to figure out why and how certain stocks or the overall markets can sell at a significant discount.

So, why and how are such value opportunities created? 

To be honest with you there could literally be a millions of reasons of why any particular stock sells at a significant discount. It could be caused by an economic collapse, internal company infighting, product failure, management failure, fraud, management change, financial mismanagement, industry decline, new technologies, competition and so forth.

Whatever the fundamental situation is, the market always gives investors plenty of opportunities to purchase good businesses at 50-90% discounts to their value. When such opportunities present themselves, an outsized return could be generated while taking very little risk. An ultimate setup for any investor.

With that said, let’s take an in depth look at the 3 primary reasons of why various companies sell at a significant discount.  

Market Factors

Most stock market indexes such as the DOW Jones have their own rate of vibration and flow. They tend to rise and fall in conjunction with the economic cycle. The market represents an overall state of financial health and growth prospects for corporate America.  As such, when the overall stock market rises (Bull Market), all stocks tend to do very well.  When the market falls, most stocks tend to decline as well.

weinstein stage analysis 2007 bear market 

While most of the time declines are not deep enough to present investors with 50-90% discounts, at certain times they are. For example,  1929, 1949, 1972, 1982, 1987, 2002 and 2009 bottoms are just a few examples of when investors could have made a killing if they would have purchased stocks at the bottom.  During those times the market presented investors with a galore of stocks selling well below their intrinsic value.  

Such occurrences are caused my major failure and/or panics that tend to dominate financial markets.  For example, the most recent decline of 2007 – 2009 was a perfect illustration of that. Caused by a number of fundamental and cyclical factors I discuss on my blog, it ended with major panic in early 2009. With the Dow Jones below 7,000 it presented investors with an opportunity to buy hundreds of great companies/stocks selling well below their intrinsic value.

In summary, the overall market flow and human psychology tend to push stocks well below their intrinsic values at various points throughout history. At such times enterprising investors can easily pick up wonderful businesses at 50-90% discounts.  Investors should not be afraid of such severe bear markets. Rather, they should be excited. The market gives them an opportunity to pick up great businesses at significant discounts, insuring a large margin of safety (low risk) and a significant return on investment in the near future.

As Warren Buffett says, “Be greedy when others are fearful and fearful when others are greedy”.   

To be continued…..

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