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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?

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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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Warning: Real Estate Red Alert

Reuters Writes: Nobel Prize U.S. winner warns of ‘bubbly’ global home prices

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(Reuters) – One of three American economists who won the 2013 economics Nobel prize on Monday for research into market prices and asset bubbles expressed alarm at the rapid rise in global housing prices.

Robert Shiller, who shared the 8 million Swedish crown ($1.25 million) prize with fellow laureates Eugene Fama and Lars Peter Hansen, said the U.S. Federal Reserve’s economic stimulus and growing market speculation were creating a “bubbly” property boom.

This was the case in the collapse of the U.S. housing market, which helped trigger the 2008-2009 global financial crisis. Markets are at risk of committing the same error now, Shiller told Reuters after learning he had won the Nobel prize.

“This financial crisis that we’ve been going through in the last five years has been one that seems to reveal the failure to understand price movements,” Shiller said.

“When asset prices are getting way out of line it should be cause for alarm. The monetary authorities should lean against extreme asset price movements,” Shiller said.

The bubbling housing market is not mainly the result of central bank policy, but reflects a shift toward “a more speculative attitude,” Shiller said. “We cannot expect monetary policy to cure all of these problems.”

Read The Rest Of The Article

I have a lot of respect for Mr. Shiller and I am happy that he won. My respect is not necessarily based on his economic work(even though it has been accurate), but on his ability to take sides. Most economists don’t do that. Most talk out both sides of their mouth without as much as saying anything worthwhile. That is academia for you.

I agree with everything Mr. Shiller states in the article above. Indeed, we are in the midst of a “Global Real Estate Bubble”. This is a unique situation that we haven’t seen before on such a massive scale. The culprit is easily identifiable here as well. Cheap financing on a global scale perpetuated by the FED. The outcome is clear as well, an eventual collapse in credit, real estate and financial markets on a global scale. Anything other than that would defy the laws of physics. For now, it is only a matter of time.

In my previous post I Am Calling For A Real Estate Top Here, I have made a gutsy call that we are indeed topping out here.  I firmly stand by that analysis as we continue to get more concrete evidence that the real estate market rally from the 2010 bottom has indeed peaked.

As such, I once again caution you against speculating in real estate at this time. 

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What Everyone Is Ought To Know About Value Investing

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If you have spent any time in financial markets, you probably already know what Value Investing is. If you are new to investing, Value Investing is probably the easiest investment style to understand and apply towards your own investment purposes.  Also, while debatable, some very successful investors have proven that Value Investing is one of the best ways to approach financial markets over the long term.  Let me first illustrate what Value Investing is with a real world example.

Imagine that you are strolling through your local mall in the middle of July.  The sun is scorching hot and you are just trying to stay cool.  After your 3rd Caramel Frappuccino you decide to check out a nearby sports superstore. Shortly after you walk in you see something and you can’t believe your eyes.  The snowboarding jacket you have always wanted, but were never able to afford is on sale.  And not just any kind of a sale. It is a seasonal liquidation sale. Typically selling at close to $250 during the winter season it is now just $19.99.   

You can’t believe how lucky you are. You check the jacket to make sure there is no big gaping hole in the back of it. Nope, everything looks fine. The size is just right. All zippers work and it’s the color you want. You are beyond excited. You found exactly what you wanted at over 90% discount to what it is really worth.  The timing is not perfect and you can’t use it for the next 6 months, but you know with 100% confidence that you have found a deal of a life time. In 6 months this jacket will be selling at $200-250 again. Without a second of hesitation you take out your wallet and head towards the register.

Value Investing is just like that.

Except, instead of a jacket you are buying shares (or other financial instruments) in publicly traded companies. Basically, you do a lot of fundamental research to find companies that are selling well below their intrinsic or real value and then proceed to buy them at a significant discount. Typically 50-99% discount. The bigger the discount you can obtain the bigger your margin of safety is.  In fact, margin of safety is one of the most important concepts when it comes to Value Investing.

Margin of safety is there to protect your capital. The theory suggest that if you buy stocks at deep enough discounts to their intrinsic value you have an automatic safety net built in. After all, no fundamental research can be 100% accurate and you need something to limit your downside risk. In such a case you are unlikely to lose a lot of money on your stock trade/investment because your investment is unlikely do decline that much further. Remember, it is already very cheap. 

In essences you are buying $1 bills for $0.50 cents or less.  Over time these assets “should” appreciate back to $1 to reflect their true value. Providing you with a large return on your investment while minimizing risk. Yet, as with anything, there are numerous issues associated with value investing. I will cover them in greater detail over the next few chapters.

For now, let me quickly summarize value investing in a five easy steps.

  1. Do a lot of fundamental research to find deeply discounted stocks or other assets.
  2. Buy such bargains or stocks at a significant discount to their intrinsic value. Typically a 50% or more discount is required. By buying at a significant discount you create a margin of safety.  
  3. Margin of safety is your best friend. Maximize it. It protects your capital by limiting the downside.
  4. Patiently wait for asset appreciation to reflect its true value. Such periods can range from days to years.  
  5. Watch your investment like a hawk by constantly updating your fundamental research. Should any developments alter your original investment thesis, you should re-evaluate your investment decision. 

That about covers it. 

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