Don’t be high when you are buying or selling stocks
… you can take that advice to the bank! 😛
Don’t be high when you are buying or selling stocks
… you can take that advice to the bank! 😛
The KC-inspired discussion on Rule # 1 Investing (thanks, KC!) has prompted me to create a new group on Share Your Number, the home of people who want to help others (and themselves) to reach their Number ,,, and, now also the only web-Community [webmunity?] partially devoted to all-things-Phil-Town – well, at least to his book: Rule # 1 Investing.
To kick things off, I am sharing some resources (including my very own Rule # 1 spreadsheet!) … so, why don’t you join today?!
[pro-player width=’530′ height=’253′ type=’video’]http://www.youtube.com/watch?v=HiW2-hygtzU[/pro-player]
I’m not being rude when I say this guy is one-eyed about stock … apparently, his Canadian ‘friends’ call him “The Pirate” 🙂
He gives a nice explanation that stocks follow interest rates, more so than the general economy (as measured by GDP growth) … but, in his next video he gives 5 rules, the only one of which really makes practical sense to me: FWO
Fundamentals Will Out
This means, that no matter what crazy gyrations the market may undertake in the short-term, over the long-term the fundamentals will ultimately decide which way stock prices go: buy on value!
There are three main ways to make money in the stock market:
Last week we spoke about the disparity between private companies (that sell for 3 to 5 times their earnings) and public companies (that can easily sell for 15+ times their earnings):
‘Value investors’ like Warren Buffett look at what a business is really worth, and buy it when it’s at that price LESS a margin of safety (they usually try and buy when the current stock price values the company at 50% – 80% of the ’sticker price’ i.e. what their discounted future cashflow analysis tells them the company is really worth).
This is the long-but-true road to financial success in the stock market (after all, do you know ANYBODY who has made more from the stock market than Warren Buffett?).
This is what Brandon was referring to when he said:
That’s why the holy grail for private equity firms is the IPO. Buy a company at 5-10x earnings and take it public for a valuation of 15-30x.
You ‘explode’ a company into lots of tiny pieces and, magically, the parts add up to many times the original value … nice.
If the ‘big money’ is made by the great ‘Value Investors’ and the venture capitalists and private equity firms that ‘explode’ companies via IPO’s and capital raisings, where is the SMALL money made and the BIG money lost?
Well, the SMALL money is made by trading the ‘flow’: once the company has been carved up and it’s stock is worth, say, between 15 and 3o times its earnings as Brandon suggests, there is no concensus as to what a stock is really worth … so money is made by trading the ‘flow’ of a stock’s price between the upper and lower estimates of what the ‘market’ thinks the stock is worth.
Now, don’t give me the ‘market is perfect’ spiel because the whole point is that money is made (and lost) by trading stocks between those who BELIEVE the market is perfect and those who don’t!
In fact, come up with ANY theory of how to value a stock and as soon as you buy or sell it, you are betting against the person on the other side of the transaction … you are both betting on FLOW.
Except for one of you it is an ‘ebb’ (they lose) and for the other it is a ‘flow’ (you win) …
… of course, the flow does have a preferred overall direction … fortunately for us, that is UP.
Over the long run, company earnings (profits) increase due to inflation … and, where the profits go, so does the share price (sooner or later … but, fortunes have been made and lost on the exceptions); but, it is a SLOW increase.
So, how is the BIG money LOST in the stock market?
Simple, look where the BIG money is MADE …
… it’s lost as soon as the FLOW investor buys their stock from either the Value investor or the guy who triggered the initial Explosion, and that loss is passed on – plus or minus the ensuing ebbs and flows – from ‘flow investor’ to ‘flow investor’ until the value dribbles back out of the stock [enter the Value Investor, again].
I’m hoping that after today, you’ll never look at stocks quite the same way again … first we need to go back to when Debbie asked how “the value of a company … translates to the price per share?”
Now this is REALLY key:
IF private companies (from your neighborhood hairdresser to the engineering firm in your local industrial estate) sell for 3 to 5 times their annual net profit (i.e. a P/E of 3 to 5), then
WHY do public companies (those traded on stock exchanges around the world) sell for P/E’s of 15+?
There are a number of reasons, but if you had to pick four they would be:
a) Convenience: you can simply buy/sell as much/little of the company as you like,
b) Regulation: by necessity, these companies are well-regulated by the various government overseeing authorities (e.g. in the USA it’s the SEC, amongst others),
c) Transparency: by law, companies are required to disclose everything about their companies so, in theory, the guy holding one share of the company knows as much about it as the majority shareholders [AJC: enter Martha Stewart!],
d) Liquidity: as Brandon said:
P/E ratios are all about liquidity. I can sell my stock in 30 seconds but good luck selling a business in under 6-12 months.
If I had to boil it down to just one factor, I would say that Brandon is right: it’s all really about allowing people who don’t know what they are doing to get in and out really quickly.
Now, think about this: even though, I have never seen this explained quite this way [AJC: so, perhaps I’m the idiot here?!], to me, it explains why (i) Warren Buffett is the richest man in the world, (ii) the best fund managers around can’t ‘beat the market’, and (iii) why the typical investor averages less than 4% return from the stock market and would be better off just leaving their money in cash:
People pay FOUR TIMES WHAT A COMPANY IS REALLY WORTH just for the privilege of not having to worry about getting in and out!
Read that again … before you buy your next stock 🙂
So, stocks have TWO values:
1. Their ‘intrinsic value’ i.e. what the underlying business is really worth, and
2. Their ‘market value’ i.e. what people are willing to pay for the privilege of throwing them around like casino chips.
Traders and speculators (and, aren’t we all?!) buy on the second … but, true investors (e.g. Warren Buffett) buy on the first.
Warren Buffett, and a relatively few investors like him, don’t care about the advantage of getting out quickly … they deal with that by avoiding selling! Sneaky, huh?
So, ‘value investors’ like Warren Buffett look at what a business is really worth, and buy it when it’s at that price LESS a margin of safety (they usually try and buy when the current stock price values the company at 50% – 80% of the ‘sticker price’ i.e. what their discounted future cashflow analysis tells them the company is really worth).
[Hint: because of some of the other advantages that we mentioned, it’s usually when the P/E is around 8]
So, think about it: Warren buys when the stock is valued at much closer to what he thinks the underlying business would be valued at if it were a private company (like that hairdresser) … then, he sells it – if he sells at all – to all of those other suckers out there when the stock gets up to normal valuations: for ‘normal’ read ‘sucker’ 😉
That’s why Brandon also is right on the money -literally – when he says:
That’s why the holy grail for private equity firms is the IPO. Buy a company at 5-10x earnings and take it public for a valuation of 15-30x.
Now, THAT’S a way to make a quick buck …
… but, hang on: if they are MAKING a quick buck selling at 15x – 30x valuations, what are WE doing when we are BUYING AT THAT PRICE?!
What is a stock? What is a share? Are they interchangeable, and who even cares?
Well, Debbie does … asking on the Share Your Number community forum:
I understand why you would need to have a good idea of the value of a company if you plan to buy stock in that company – But I don’t understand (and I’m sure this is stocks 101) how that translates to the price per share.
Even though this blog isn’t about Stocks 101 … there are plenty of other places on the web to find that sort of info … this does open up some interesting questions:
For example, even though I owned some of my businesses 100%, they were structured with lots of shares (usually between 100 and 1000).
Well, ‘just in case’ …
… it makes it easy for banks, partners, JV’s, partial sales, etc. to buy in – just transfer them a % of the shares: if you have 1,000 shares (or 100, it doesn’t matter … larger numbers just have more divisors and the ability to make finer and finer ‘cuts’ of the company value) and they are buying 40% of the company, you just give then 400 (or 40) shares.
If you want to be sneaky, you create two classes of shares: A (say, 600 of the shares) and B (the rest), with the voting rights going to the A stock, which you – naturally – keep. You get to sell 40% of the company to some sucker and keep 100% of the control (actually, 60% still should give you majority control, so it’s not such a big deal, anyway)!
Unfortunately, for my New Zealand Joint Venture (fancy term for ‘partnership’), where I owned just 40% of the stock, that wasn’t possible … and, for my US JV, where I ‘controlled’ the company with 51% of the stock, there were so many “by unanimous agreement” clauses written into the shareholder’s agreement, I couldn’t blow my nose without seeking my partner’s approval, first 🙂
So, the first lesson we learn about stock is that numbers and/or percentages CAN matter less (or more) than you think … it’s all in the fine print 😉
Public companies are the same, except that they are usually (a) huge, and (b) divided into LOTS of small pieces (1,000,000+) so that people can buy very small chunks of the company, and trade them very easily i.e. for small sums of money.
These shares/stocks are traded on public stock exchanges, which are heavily regulated to make up for the fact that ‘idiots’ like me buy small pieces of businesses without the effort or forethought that they would put into buying the WHOLE business: we take all the risks without any of the business controls.
And, that’s why the stock market is more akin to a casino than to ‘real’ business or investing … we have no control, and only limited understanding of the underlying business that we are – in effect – buying into.
Now, here’s Josh to answer the second part of Debbie’s question (“how that translates to the price per share”):
If you think a company is worth 1 billion and there are 100 million shares outstanding, the price you think the shares are worth are 10 dollars each. Of course you want to wait until you have the opportunity to pay less then this.
So, if you would be willing – that is, if you were Warren Buffett instead of Jane Doe – to buy the whole company for $100,000,000 and it had 1,000,000 shares, then you should be willing to buy one (or each) share for $100. Except, Warren reads the financial reports and calls the shots, while we read Money Magazine and wait patiently (what other choice do we have?!) for our dividend check 😉
This leads to some other key numbers:
In a private company, we have sales and profits.
In a public company (i.e. traded on a stock exchange), we also have sales (or ‘revenue’) and profits (or ‘earnings’), but we can now also divide each of those by the number of shares available to come up with numbers like Revenue per Share and (more importantly) Earnings Per Share.
Also, if we COULD buy the whole company for $100,000,000 and it had a 25% profit margin, then for each $100 share we buy, we would expect $25 in company profits … which means the company is now selling for a Price/Earnings Ratio of 4.
Which leads me to the Grand Mystery of the Stock Market:
If a P/E of 4 is right on the money for a private company (they typically sell for 3 to 5 times annual profit/earnings) why is a P/E of, say, 15 for a publicly traded stock the ‘norm’ and a P/E of 8 to 12 times earnings so damn cheap that even Warren Buffett might buy the stock by the truckloads?!
[AJC: I know the answer … but ‘knowing’ doesn’t make it right 😉 … do you know the answer?]
So, Debbie – in case you’re worried about asking a 101 question – please remember: there’s no such thing as a bad question, only a bad answer 😛
Even though guys like Tom Dwan (a.k.a. Durrrr) can run up a $200 starting bankroll to over $10 million in 3 or 4 years playing poker online, I don’t recommend this as a serious ‘investment’ strategy!
Nor, do I recommend simply dumping your entire portfolio (401k included) into just one stock pick, as Josh has done ….
… even though both Tom and Josh are both ‘big winners’ … so far 😉
That’s why I recommended – for those amongst my readers who insist on traversing the high-wire of their financial life (there ARE rich prizes at the other side, IF they make it, so who am I to say “don’t!”???) – a simple three-part strategy to protecting their finances, by taking:
1/3 of any ‘windfall gains’ for spending (presuming that the speculation activity is their primary source of income);
1/3 of any ‘windfall gains’ to fuel a parallel ‘passive income’ investment strategy; and,
1/3 of any ‘windfall gains’ for their trading activity (this could be trading stocks/options; developing or flipping real-estate with little money down; etc.; etc).
If the person has another (reliable) source of income, then any ‘windfall gains’ can simply be split 50/50 between ‘speculation’ and ‘passive investments’.
Of course, this will slow down growth, which is why Josh still wants to:
Go 100% 401k and 200% brokerage … [because] sometimes the opportunity is so obvious and risk so low
Spoken like a true Most Probably Will Go Broke Someday Trader!
This strategy is just there to protect the Josh’s of this world in the unlikely event that they should miscalculate ever so slightly 😉
Look, I’m not going to attempt to teach anybody anything about trading, but it’s always good to remember: it takes just ONE bad piece of news on a ‘volatile stock’ (bad ceo, drug that doesn’t get FDA approval or shows unexpected adverse side-effects, law suit) to override the fundamentals.
It’s the equivalent to a ‘bad beat‘ in poker (a.k.a. ‘variance’) … they are inevitable in poker – and, I would argue, also in trading – and you survive them by good bankroll management …
… after all, there are still Enrons out there that people are trading up every day 🙂
On the other hand, Jeff throws a curve ball:
Looks like you have changed your stance a little on diversification. [http://7million7years.com/2008/12/19/the-allure-of-diversification/, where you don’t recommend diversification due loss specialized knowledge and consigning yourself to average returns]
I’m interested why you made the shift…
As I said to Jeff, this may appear to be a shift, but it’s not …
Diversification ≠Bankroll Management!
… for example:
– if Josh said that he was going to invest 100% in buy/hold cashflow-positive real-estate, I would say “go for it”
– if Josh said that he was going to invest 100% in an existing profitable business, I would say “go for it”
– if Josh said he was going to invest 100% in 4 or 5 stocks that he felt were undervalued and was prepared to hold for the long-term, I would say “go for it”
… but, I would say that if the future income stream is in any doubt (e.g. if it is a royalty, or speculation, or short-term investment) to divert some of the cashflow produced from profits (capital gains and/or operating profits i.e. one of the ‘thirds’ that I mention above) and use those to start creating your own Perpetual Money Machine: that’s VERY different from the standard type of diversification that most financial advisers talk about.
Phil Town (author of Rule # 1 Investing) talks about his approach to Value Investing as a way to achieve a minimum (presumably, long-term) 15%+ compounded return in the stock market.
On his blog he recently fielded a question from a reader who asked:
Even though the reader doesn’t tell us how much ‘retired’ is, I think it’s worth revisiting Phil’s response:
The time frame is too short to stockpile stocks and be sure to retire in 5. We need more like 20 to make that work. So you’re going to trade using Rule #1 strategy and tools.
1. You’ll live to 95, so retirement is 60 years.
2. You’ll need at least $50,000 a year in 2009 dollars.
3. Assume you’re trading and making 30% adjusted for inflation (so 34% or so before inflation).
4. Assume you’re adding $10,000 a year for next 5 years.
5. In 5 years you’ll have $283,000 in 09 dollars.
6. You’ll have to make 18% after inflation to get $50,000 a year in 09 dollars.
7. Conclusion: Doable, but you are not retired clipping bond coupons on some beach in the South Pacific. You’re still investing. Better if you had more in the nest egg in 5.
So, Phil’s basically demonstrated that it’s not doable … at least not with stocks; it MAY be doable with a very high risk (read: great deal of luck) aggressively trading options and / or business startup strategy.
Here’s Phil’s suggested solution:
Q: How to get more when you have less?
A: Leverage. Other people’s money.
Q: How do you get other people’s money?
A: Four ways:
- Trade on margin: 50% loan. You’ll more than double your return to $558,000.
- Trade derivative (options) so your dollar represents only a small portion of the underlying security
- LP: Raise $600,000, 34% ROI is $2.4 million in 5 years. You keep $500,000. Plus you got $40,000 a year to manage it. This is more or less what Buffett did in the 50’s and 60’s
- Put half the money in a startup and help make it go big.
Warning: This is a High Risk Post … it’s only for those poor misguided souls who INSIST on speculating (be it: stocks, real-estate, FOREX, commodities, etc., etc.) … don’t do it! But, if you MUST try to gamble your way to a fortune (admittedly, it has – albeit RARELY – been done), at least read on ….
I have a confession to make: I love playing poker.
I had never played a hand – nor gambled at all (I hate any game where the casino odds are even 1% or 2% against me … why throw money away?!) – but, then I arrived in the USA and turned on the television just as Chris Moneymaker was bluffing Sammy Farha on his way to making history at the 2003 World Series of Poker …
… it was like meeting the eyes of a woman across a crowded room; it was (I am ashamed to admit) ‘love’ at first sight 🙂
Which brings me to the Universe’s Cruel Joke, and it goes something like this:
I exclusively play No-Limit Texas Hold’em but met a friend who is one of the world’s top Pot Limit Omaha pro’s … in fact, I now take tennis lessons with him. This (not him!) convinced me to give the game a try, so I throw $40 (being sensible, no need to throw ‘real money’ away) into an online table while I’m chatting to a friend over the ‘phone and what do you know, I’ve made $200 about 3 minutes later!
This is a game I could grow to love, so I proceeded to lose $4k over the next few weeks, playing my usual limits …
… oh, I know this is just ‘variance’, because I’m in with the best hand almost every single time 😉
Which brings me to Josh:
Josh is one of our 7 Millionaires … In Training! and he intends to make his money trading according to a system that he has been developing for trading pharmaceutical stocks. I have high hopes for Josh, and he will probably end up with his own hedge fund, if he survives his good luck.
You see, Josh has just hit it big – and sudden – as, he explains:
My net worth increased over 1200% on May 7. Check out my networth profile I updated recently.
[I put] the whole 401(k) and personal brokerage account into a penny pharmaceutical stock, (avg price was around .0475 cents.) Today it closed at .82 cents. The stock is TTNP, Titan Pharmaceuticals.
Adrian, when are we starting MM-201, I’m jumping out of my skin here?
As I said to Josh:
If you MM201′ed any harder, you’d burst
You see, it’s easy to make money when you find a stock that climbs straight up like Jeff’s Hornet on full after-burners, it’s MUCH harder to:
a) Repeat until rich, and
b) Keep it, once you’ve made it.
What has this to do with poker? More importantly, what does poker have to do with investing?
Well, if you are a trader/speculator … everything!
You see, poker is a high ‘variance’ activity – that means that there is both a skill and luck component – but, you may know this as high risk / high reward. And, the best friend of the professional poker player is not skill … or even having luck on their side … it’s bankroll management.
At its simplest, ‘bankroll management’ means not allocating too much of your bankroll (i.e. capital) to any one session, and walking away when you lose that … at its most complex, it can involve a whole set of rules, such as Chris Ferguson’s poker bankroll management system …
… Chris is a top poker professional who – as his own ‘grand experiment’ – set out to make $10,000 starting with just one penny. Even though he had great skill – far greater than any of his opponents at the levels that he was playing at – he knew that he needed to protect himself from that devil known as ‘variance’ (i.e. sheer bad luck):
Starting with nothing but a Full Tilt Poker account, Chris played in Freerolls until he earned enough to graduate to games with real-money buy-ins. From that point on, he adhered to a strict set of guidelines to build up his bankroll:
- He never bought into a cash game or a Sit & Go for more than 5 percent of his total bankroll; the only exception was at the lowest limits: he was allowed to buy into any game with a buy-in of $2.50 or less
- He didn’t buy into any multi-table tournaments for more than 2 percent of his total bankroll; the only exception was $1 MTTs
- If at any time during a No-Limit or Pot-Limit cash-game session the money on the table represented more than 10 percent of his total bankroll, he had to leave the game when the blinds reached him
Getting started wasn’t easy. In fact, it took more than seven months of steady play until he got his bankroll to stabilize at about $6.50. Undaunted, Chris maintained his discipline and dedication and continued with his challenge. Then, on November 26th, 2006, Chris made a major breakthrough. He turned a $1 tournament buy-in into $104 in prize money when he finished second in a 683-player tournament. Even with that huge bankroll boost, it still took Chris nine more months of hard work to reach $10K. But because he strictly adhered to the bankroll management strategy that he’d set for himself, Chris achieved his goal the following September.
Besides the sheer similarity in Josh’s and Chris’ graph, there are clear parallels between poker and trading … if you still can’t see them, stop and play a little $1 / $2 no-limit hold’em online … you’ll begin to see my point, pretty soon 😉
What has this to do with personal finance??!
Well, for traders and speculators,’bankroll management’ – which we call Making Money 101 – is also the most important skill that you need to learn so that you have a base to work from and a fall-back …
… if you are still not 100% convinced, I would encourage you to grab the book about Jesse Livermore – The World’s Greatest Trader. I want you to see that he became rich and broke FOUR separate times (then, blew his own head off) … I don’t want this to happen to you.
Once you really FEEL this, read on – otherwise, just bookmark this post and wait … nothing produces discipline better than the inevitable major loss …
OK, if you are now TRULY ‘on board’, I want you to break your ‘windfall’ into three easy (well, equal) pieces:
1. Trading Account: do more of what you just did, and hope to repeat (just remember NOT to put all of your position into one investment … ONLY invest into one ‘event’ what you would be happy to lose 100% of without suffering unduly)
2. Passive Investment Account: Buy a rental; or buy/hold ‘boring stocks’ that you would be happy to own forever … fight the urge to trade these stocks!
3. Savings Account: This is what you live on (assuming trading is your major source of income), keep this in cash or CD’s. I told Josh to use this as a deposit on his own condo.
When you lose 1. (almost all poker players – and traders – lose their ‘bankroll’ at least once in their lives … some MANY times a.k.a. Jesse Livermore) forget about ever ‘dipping’ into 2. or 3. to try and ‘catch up your losses’ … it won’t happen(!): you will simply have to go back and build up a new trading account from scratch … just like you did when you first started out.
Always remember this ‘3 easy pieces’ approach to windfalls and you won’t ever go [completely] broke …
Rich 1; Broke 0; Head [Intact] – not a bad scoreline
Rick is skeptical about the value of technical analysis:
I would be very skeptical that technical analysis works- here is a link discussing the controversy:
I’ve never heard of anyone getting very rich from technical analysis. Plus neither Peter Lynch nor Warren Buffett believes in it.
A web site that tells you when to buy/sell stocks strikes me as too good to be true. Let’s say that you had a stock purchasing system that WORKED- would you
A Make it available to the world on a website/write a book and make $1M
B Keep it secret, start your own hedge fund and make $1B.
I’m guessing A wouldn’t be too likely… Also if you did have a system that really worked then making it widely known will cause the system to be useless. Why? For every transaction there must be a buyer and seller. If many potential sellers see a “buy” signal at the current prince they will demand a higher price to sell driving the price up. Similarly, if many potential buyers see a “sell” signal at the current prince they will demand a lower price to buy forcing the price down. The final result is that the pool of believers in the system will force the actual price to agree with the system’s prediction of a fair price.
Rick might be a little surprised to know – given my recent posts, apparently condoning technical analysis a lá Phil Town – that I tend to agree with him!
Firstly, keep in mind that I am on record as stating that I am not the ‘go to’ guy on any specific form of investment (perhaps some on business, less on real-estate, even less on stocks, and so on) … my ‘expertise’ (more like ‘passion’) is in the overall strategy of wealth-building, and showing how these individual pieces fall into place.
Also, I am a ‘value guy’ … I love to sniff out a bargain – be it a business, property, or stock – and pounce, and am a fan of Phil Town’s valuation methods (although, I will point out my ‘issues’ with his methodology in a future post).
And, I agree in principle that if you COULD:
a) Identify a stock that was under-priced, and
b) Avoid the market dips by selling out (then rebuying)
… you would increase your returns and – MUCH more importantly – avoid holding onto an under-priced ENRON … one that you thought was cheap but some disaster strikes that the ‘big Boys’ get wind of early.
In principle, that is 😉
1. There have been successful traders, but none that I know of with longevity; it’s a speculation / business … so, if you are prepared to take the chance on the big run up – then sell off – PERHAPS, just perhaps, you can make it big? Jesse Livermore did it 4 times (before putting a gun to his own head when he crashed for the 4th time).
2. Phil Town suggests that the ‘big guys’ (the huge mutual funds) put so much money in/out of the market that they have to make their move over a number of weeks to avoid the sudden price movement that you suggest. IF this is true and IF you can use technical signals to tell you when the run up/down is occurring, then Phil says that the smaller investor can use these signals to move instantly (in 8 seconds, v the ‘big guys’ 6 weeks).
… and, I have certainly used Phil’s methods to suffer ‘only’ a 15% loss when the rest of the market soured by 50+% (and, you need to remember that I have been actively trading since the crash UNTIL it bottomed and have been in cash since for reasons unrelated to the market), so my personal experience is that the ‘3 indicators’ ARE useful.
The catch is, I don’t know why, because they are all PRICE indicators, not VOLUME … in fact, volume only tells you of an increase in activity, there can be no net buying/selling because there are two parties in every trade (the ‘hint’, I guess, is in the price … it goes up/down according to market sentiment).
So, I am a fan of ‘value investing’ (if you can find the right way to reliably value a stock and can then find one that is way under priced … I believe that this happens often enough to make it useful) and am experimenting with the technical indicators to get in/out, but am – like you – skeptical, but not complaining while I am getting positive results …
… but, please DON’T read this post, I am planning to start my own hedge fund 😉
This week’s Carnival of Personal Finance is out; we’re buried in their list somewhere ….