This is the fourth article in the My Secret Recipe series. In the first article, My Secret Recipe: The Index Card, I talked about the three essential ingredients including profitability, sustainable growth, and compelling valuation. I’m going to focus on the compelling valuation ingredient in this article.
Simply put, I like to buy stocks that have a margin of safety and thus they are on the bargain rack. This term was popularized by Benjamin Graham. A short discussion on this topic can be found here. What essentially this means is you are buying a stock on the bargain rack for less than what you determine it is worth. When I determine a margin of safety it is usually either based upon a multiple of trailing earnings or forward earnings. I usually only buy stocks that I think can double in price in the next two years.
I’m an engineer by training and have been accused of being very analytical. Given that, you probably expect that I would have a complicated formula or spreadsheet that analyzes all the factors to mathematically calculate a margin of safety. Unfortunately, there is no such simple metric. So, this is something that is determined more by experience than anything else.
More often than not, buying from the bargain rack means I’m buying right after a major catalyst has been announced in a company press release or filing which implies that this news has not been factored into the stock price yet. This catalyst could be the announcement of a large order, a breakthrough product, excellent guidance, or more simply the announcement of increased earnings. All of these imply an improved earnings situation. I find this information early after it is disseminated so that the good news isn’t reflected into the stock price. By buying on news I am investing based upon facts and not on speculation.
When I’m buying, the catalyst usually means that I’m buying a stock that that is cheap on a price-to-earnings ratio (PE) or price/earnings-to-growth ratio (PEG). It could be cheap based upon trailing and/or forward earnings ratios (PE or PEG). I have found that buying a stock when a change in earnings has just been announced often precedes a very predictable increase in the stock price if the purchase is made at the correct price.
Someone could misinterpret my bargain rack purchases as waiting for a stock price to retreat significantly so it is less expensive than what it once was. It is rare that I use that as a strategy unless it is a company that is already in growth mode and the stock price simply got ahead of the company’s performance. Buying a stock solely because it has retreated in price is like buying day-old bread at the grocery store. Often, you are buying a product that isn’t as good as it once was.
Buying with a margin of safety provides some protection if your thesis is not precisely correct. For example, if company xyz announces a large order that wasn’t expected by the market, the stock price will usually rise in response to that news. My thesis usually has multiple facets to it and it could be that in practice I’m wrong on one or more of them. However, the stock will usually increase in value because of the catalyst so I’ll make money even if parts of my thesis are wrong. Buying the stock on announcement of a catalyst often gives me a heads-I-win, tails-I-don’t lose situation.
What I have written in this article probably seems easy but it is far harder to execute. I comb through a universe of approximately 14,000 companies to find my investments. I don’t have precise statistics, but I usually own stock in the neighborhood of 60 companies each year although it is roughly half that at any given time. My strategy results in a high turnover rate. I’d say that less than half of the stocks owned in a year are found as new ideas and the others are ones that I have owned in a previous year. I have to look through hundreds of companies before I find a new company to buy. My process of combing through companies literally takes several hours each day. Depending on the news flow that could be anywhere from 2 hours to 16 hours in a day and is probably averages in the 4-5 hour range. Once I find something that is interesting, I have to research the company as I have discussed in the third installment, My Secret Recipe: Inspecting the Ingredients. Research has to be done quickly when I am buying on news as that news rapidly is factored into the stock price. This research time isn’t factored into the time I mentioned above. I have a personal database of research on almost 700 companies which I have collected over nine years. That database helps to speed my research as many times the company with news is one I have researched previously and often one that I have owned previously.
What I have found is that by being careful about my margin of safety and by carefully researching a company, I can greatly increase the odds that I make money. I reported in my first installment that “Over the years I’ve refined the process that I use and am able to select winners roughly 73% of the time based upon positions closed between 1/1/2010 and 9/27/2012 in my personal accounts.” I looked at how I’ve done more recently just to see how I’m doing. In 2013 my success rate was 82%, in 2014 it was 81%, and YTD it is 85%. I believe the incremental improvement has come largely because I have refined my recipe to be even more particular about buying from the bargain rack.
Previous My Secret Recipe articles:
Part 1: The Index Card
Part 2: Shopping and a Taste Test
Part 3: Inspecting the Ingredients
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