Joe asked me a very good question and as I was answering it, it started getting long so I felt it should be discussed in a post rather than buried in the comments. (Joe, I apologise if you didn’t want your question to become a topic.) Here I answer the question and more.
Joe asked the following question:
“The next part I am trying to get down is how to make a comfortable estimate of how much room is there b/t my purchase price, the floor and ceiling. I know that using a margin of safety in a great business helps take away downside risk (so that there is less likely a floor of $0), while also giving you room b/t the purchase price and the intrinsic value (which is what we believe is a fair price, so not exactly the ceiling).
Are you using any specific ratios (assets/share, liquidation value, free cash/share, etc) to see how far a stock could drop, or any ratios for how high it may go (estimate growth investors will take the current P/E to around 40, historical highs in similar environments, etc.). Or do you use trend lines for support/resistance?”
Margin Of Safety (MOS)
Margin of safety isn’t about limiting downside risk. MOS is required because of our inability to foretell the future. When we calculate the intrinsic value of a company, we are making assumptions about the future and since our calculations can and will be wrong, we need that extra cushion. Hence, we compensate with a huge margin of safety.
“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety…”
Say you’re in the market for a new car and you’ve done all the research, what it does, what it can do, the colour, the options and a price you are willing to pay. You go from dealer to dealer each day and every dealer you go to has a different price to the other day and the other dealers.
Your initial price target is $20,000 but one day its quoted at $14,000 so you buy it. You got a sweet deal and you are confident in your purchase. The next day, just out of curiosity you visit the dealer again and check the price of the car you just bought. The asking price is $12,000.
You could have gotten it for $2000 less, but you had no way of knowing that the price would go to $12,000. However, will you kick yourself for buying at $14,000 when you calculated the car to be worth $20,000? The car was a great deal at $14,000 and $12,000. The car was always worth around $20k. The sticker price didn’t reflect the actual value of the car. If money was not an issue you would probably buy another one right?
The more important part is that before buying the car, you did all the research. You compared it to other cars in the same class, you checked out the reliability, warranty, options, resale value, power, fuel efficiency and whether it has cup holders. THEN you started shopping around.
The same principle applies to stocks and prices. Do all the research and then come up with a price which you think is the true value, then wait till the market quotes an attractive price.
Coca Cola Example
After thorough research, let’s assume Coca Cola’s true value is $60. It closed today at around $52 and next week it will close at $30 because Pepsi announced it produced the Cola killer. I then stuff my pockets with $30 KO. As Pepsi get closer to the launch of Cola Kila, KO’s stock price drops to $20 and I grab more. For the next full year, the price hovers around 20ish and even reaches 15 at one point. Analysts constantly upgrade and downgrade the stock. Finally, the markets wise up that KO’s moat cannot be penetrated and the price travels up to and beyond $60.
Dissecting The Example
The above example is practically the same as the car shopping analogy and the moral of the story is clear.
When we look at stock prices, we should use it as a tool, and not as a guide or indication of how the business is performing. If I had the money, I would buy the car at $14k and $12k. Same with KO. I would buy at $30 and $20 again and again.
If I walked up to you and offered my $1 for your $2, you would probably slap me in the face. However, if I offered you $2 for your $1, you would probably ask for another trade.
Buying prices isn’t about knowing the floor and ceilings. It’s about buying when you can without worrying too much about daily fluctuations. Unfortunately, this is extremely hard for most people, which is why they end up buying high and selling low.
Timing The Market
I’m not a fan of quoting clichés but here’s one. We can never time the bottom or top of a market. Actually, I would think that constantly worrying about tops and bottoms would detract your objectivity and research. The people that lose money and miss opportunities trying to time the market bottoms and tops greatly outweigh those that luckily manage it. Note how I use the work luck when it comes to market timing.
There are many useful ratios and just as many useless ones, such as beta.
The main ratios and stats I do refer to are;
- CROIC / ROIC
- Shareholders Equity
With this information, I can get an understanding of the company’s financial health but I find it just as important to look over the entire financial statements. A good book for understanding financial statements is here. I use ratios, not to determine how far a stock could drop, but what the intrinsic value is and whether a market inefficiency exists.
PE is usually last on my list of ratios.
When I first started getting into investing, I thought charts, trends, candlesticks, trading on days at the first week of the month etc were going to guarantee success and riches beyond my two greedy hands. Now I know better. Technicals such as volume, trends, support and resistance values mean nothing to me. It all looks and points the same way if you look at it upside down.
Value investing, is all about investing in businesses where we are business partners. We commit our capital into real, tangible entities. We don’t put money on the table and try to guess what the 135th decimal of pi is.
- Daily fluctuations shouldn’t be of much concern.
- Buy when you can and buy more if the market offers it to you. (Low risk = high return concept)
- Stock price is a tool. Not a guide or indication of how the business is performing.
- No point in timing the market. You’ll lose more money.
- Technicals look the same whether you look at it upside down or from the side.
- Trends are for lemmings.
Advice of the Day
A little bit of deodorant goes a long long way.
Disclosure: No positions in KO