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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 I Hate Financial Media


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The only time I really enjoy watching financial media is during the time when financial markets melt down. It is fun to watch their blank faces and their dumb expressions repeating the same two questions “Where is the bottom?” and “How come no one saw this coming?”.

Today was a little bit different, but just as fun.  No one could figure out why the market was surging in the morning. There was no real breakthrough or any concrete type of a debt deal coming out just yet.

Quite the opposite, their Armageddon debt default clock was counting down to a “technical” default with just a few hours left. Why was the market surging? I think everyone of them was spinning doom and gloom, yet the market kept surging.

Here is why.  As I have said many times before, the stock market doesn’t follow the news. It doesn’t care about the US Government nor if it defaults on its debt. The market has an exact mathematical structure that it must trace out. It is a future discounting mechanism, not a reactionary one. It has already discounted what has happened or will happen in Washington a long time ago.

Can it get it wrong and drop down big time if the Government doesn’t pass the bill. Sure, but it will be within the range of the overall trend and not the trend change in itself.

In my future writings I will outline the exact mathematical structure of the stock market discussed earlier to prove once and for all that news have no impact on the financial markets.  

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Buffett Agrees…..How US Politicians Just Destroyed America

Reuters Writes: Buffett calls threat to not raise U.S. debt limit a ‘political weapon of mass destruction

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NEW YORK (Reuters) – Warren Buffett, chairman and chief executive of Berkshire Hathaway (NYS:BRK-A – News), said Wednesday that the threat of not raising the U.S. debt ceiling is a political weapon.

The idea that Congress could fail to raise the $16.7 trillion U.S. borrowing limit is a “political weapon of mass destruction,” Buffett told cable television network CNBC.

Buffett said Berkshire Hathaway owns short-term Treasury bills and is “not worried” about the bills being paid, despite concerns about the U.S. debt ceiling.

Of course Mr. Buffett is correct. What happened in Washington over the last couple of weeks is nothing short of a disaster. An absolute disaster. What Mr. Buffett forgot to mention is that this “political weapon of mass destruction” has already gone off.

Surely, the US will not default on its debt. In my previous posts I have clearly stated that neither the market nor should you care about that. The damage has already been done and will be eventually felt on a different front.  This front has to do with our creditors.  I bet you my left leg that this situation was very closely watched and analyzed by both Japan and China (two of our biggest creditors). 

Their conclusion will be very simple. Washington is being run by idiots who have no problem putting the wealth and the future of our countries at risk. Therefore, we should diversify.  I bet you my right leg that these countries will start to lessen their US Debt exposure (if they haven’t started already) as soon as possible. Interest rates will go up and that will cause a significant slow down in the US Economy and a substantial DROP in the financial markets.

BOOM. Thank you Washington.  

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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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Secret Structure Of The Upcoming Dow Decline

Dow Jones Long Term Chart

 

The chart above represents the Dow Jones between 1986 and today. It is clear from the chart that the bear market started at the 2000 top of 11,800 and continues on today even though we have already set two higher tops. Typically the bear/bull markets alternate in a 17 year cycles, so we have another 3-4 years to go before this bear market is over.

However, that is a side point to my main point. What I want you to observe is the structure of the declines between 2000-2003 and 2007-2009. The decline we had in early 2000’s was a more orderly decline with lots of ups and downs, plenty of time (2.5 years) and not to much directional energy. The move in 2007 was quite different. It was directional, it was short (1.5 years), it was high energy and it was violent.    

What’s the point of all of this? First, my work clearly indicates that we are about to start a 2-3 year bear market. All of my technical, fundamental and mathematical work confirm that fact. 

So, what kind of a move should we expect? 

My mathematical work shows that the bear market over the next 2-3 years will be almost identical to the 2000-2003 move. A lot of volatility, overall downtrend, but not too much downside energy. That is not to say that the market will not go low, it is to say that the move over the next few years will not be a violent one. I hope this helps. 

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Who Else Wants A Huge Pile Of Cash?

BusinessWeek Writes: Corporations Are Swimming in Cheap Cash. So Why Aren’t They Investing?

  Cost-of-capital-investwithalex   

The difference is that back then, businesses were actually spending that cash they were able to borrow so cheaply, buying equipment and building factories and hiring workers. Today they’re just hoarding it. The pile of corporate cash on the balance sheets of nonfinancial companies has grown to $1.48 trillion, according to Moody’s. That’s an 81 percent increase since 2006. “Corporations are flush with cash coming off a huge profit cycle,” says David Rosenberg, Rosenberg points out that despite this abundance of cheap money, “we’re in the midst of one of the weakest investment cycles ever.”

Until Congress parts the clouds and gives businesses some bit of certainty as to spending and tax rates, let alone an assurance that the U.S. won’t default on its debt and the government won’t shut down, expect more of the same. Slow growth, weak demand, and more and more cash being piled onto corporate balance sheets.

Read The Rest Of The Article Here

The article claims that the lack of US fiscal clarity is the biggest culprit behind corporations not investing their huge cash piles and/or borrowing at cheap rates and investing it.

I respectfully disagree. First, the notion of huge stockpiles at corporate level are highly questionable at best.  Now, in terms of borrowing and investing, the issue has nothing to do with US Fiscal clarity and everything to do with the fact that everything is significantly overpriced and there is technically nothing left to invest in.

What I mean is, due to a flood of readily available cheap capital over the last decade, most corporation have already heavily invested in and have streamlined the majority of their production capacity. When most of them look around today, there is literally very little for them left to do or invest in. This is the synopsis of the problems I have been talking about here this entire time. 

Too much credit, overcapacity and slowing velocity of credit.  Even though credit is readily available it will have even less impact on propping up our economy going forward.  Just another falling vital sign of a dying patient.  

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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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The Secret Of The Dow Chart

BusinessWeek Writes: Hedge Fund Chart Guru Tom DeMark Sees Dark Days Ahead

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“The market’s going to have one more rally, then once we get above that high, I think it’s going to be more treacherous,” DeMark says. “I think it’s all preordained right now.” He feels this is probably irrespective of how and when the crippling impasse in Washington is resolved. “If you look at the new highs and new lows on the [New York Stock Exchange],” he says, “every time we made a higher high, there were fewer stocks in the index participating in that high. It’s getting narrower.” And once that happens, you typically get a collapse. The opposite looks to be true for gold, which he expects is making its low right now and should start to move up dramatically.

Read The Rest Of The Article Here

I tend to agree with Mr. DeMark to a certain extent as my own work confirms parts of his analysis. There is no doubt in my mind that we are approaching a major top here in most financial markets. Now, it is just the matter of hard work to pin point it. As I accelerate my timing work over the next few months I should have an exact answer for you by the end of the year.

With that said, there are only two possibilities here (based on my work).

1. The market has already topped. Triple tops are notoriously dangerous and tend to mark the end of a bull market. We have already set 3 tops and as I have suggested before the market finds itself in an exciting spot. We either confirm a bear market here by breaking down below recent lows over the next 4 weeks or….

2. The market will top out in March of 2014. This type of a scenario resembles Mr. DeMark’s forecast above.

Either way, we are approaching the end of a bull leg and you should begin thinking about reallocating your capital in order to avoid losses during the bear market.

Will we experience 1929 type of a decline as Tom suggest? My work doesn’t show that. It shows a slow yet volatile decline into the 8000-9000 range on the DOW over the next 2-3 years. 

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