My Secret Recipe: The Bargain Rack

Mike Schellinger Blog, Educational 12 Comments

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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Comments 12

  1. Great write up Mike! I’ve been eagerly following these posts and regularly revisiting them when my head is cloudy.

    On your portfolio make-up, do you really hold 60 stocks at one time? if so, how do you have the time to follow-up with each? And what percentage of your portfolio does your top 10 account for?

    Thanks and keep up the good work.

    1. Thanks for you comments, Tom.

      Over the past several years my portfolio has typically had somewhere around 30 positions at any given time. However, over a year I tend to have around 60 different companies that were in my portfolio. On average a company is in my portfolio for less than a year.

      Right now my top 10 ideas are around 75% of my invested assets. I’m not sure how that has varied over time but I would imagine that it is typically over half of my invested assets. I think that 75% is probably on the high end for concentration of my top 10 ideas.

      Some of the reason I hold that number of positions is that liquidity is often an issue with my holdings.

  2. I have a question for both Mike and Ian. How much time do you guys spend on dissecting financial statements and forecasting? I know equity analyst spend more time than is actually necessary for this purpose because that is their job, but do you guys really find it necessary to build models of the three statements several years into the future?

    1. I spend a fair amount of time reading financial statements and filings. That is important to understand any business thoroughly.

      Sometimes I build models and sometimes I don’t. It depends upon the company. With most small companies it is very hard to predict more than a few quarters out with any degree of precision. Sometimes predicting the next quarter is nearly impossible even if you are the CEO. I’m likely to build a model if I think I can accurately predict earnings but if I can’t predict I will not bother with a model. Often it is more of a gut feel. For example, I may have a good idea that earnings are going up but have no idea if it is 20% or 40%. Sometimes, it is clear that an improvement is coming but the timing is uncertain (e.g. improvement coming in one of the next three quarters). If I do build a model it is often for the next quarter or next year. Sometimes I go two years out but rarely do I go three years out. When I build models it is usually only for earnings. If the business model warrants, I might look at cashflow too. It is very rare that I model the balance sheet. About the only thing I might look at on the balance sheet is where I think cash might be by a certain time. For example, if a company has to pay off debt by a certain date, I might do a prediction as to whether they can generate enough cash internally to pay off the debt. When I do make models, it isn’t to the detail that you see with many equity analysts.

      I think the best way to summarize is that I model where practical and to the extent that it makes sense. In most cases, only a little bit of modeling makes sense because there are so many variables that any more modeling is a waste of time.

    2. Good question. I don’t do detailed modeling. Mine is more basic. If I can’t extrapolate the thesis and my expectations of the next year on a small square napkin it’s normally not an investment for me.

  3. V.Insightful write up Mike sir!

    It’s quite helpful for every beginner analyst/investor to learn & develop themselves.

    Sir i’v 2 queries-
    1)Same As Mr. Tom- On your portfolio make-up, do you really hold 60 stocks at one time? if so, how do you have the time to follow-up with each? And what percentage of your portfolio does your top 10 account for?
    2)whether a person who’s having very less money and resources can profitably practice value investing(micro caps) in Indian market in order to get stable financial freedom?

    I’d like to thank Ian sir & team:microcapclub.com for the wonderful blog,
    keep up the good work guys.

    Best
    Amit

  4. Post
    Author

    Amit,

    Thanks for the questions.

    I haven’t kept detailed statistics on my portfolio over the years. However, I’ll comment based upon a few data points and memory.

    Over the past several years my portfolio has typically had somewhere around 30 positions at any given time although right now I only have 18 positions. However, over a year I tend to have around 60 different companies that were in my portfolio. On average a company is in my portfolio for less than a year.

    Out of my invested capital, the top 10 positions tend to be a large percentage. The percentage of invested capital that my top 10 positions is will vary significantly depending upon a number of factors. A big factor is the total number of positions. Right now my top 10 are roughly 87% of invested capital which historically is unusual but I also only have 18 positions. I have a large percentage of my capital in cash right now so the percentage of capital is much lower. I haven’t kept statistics but I would estimate that my top 10 positions tends to be between 30%-80% of my invested capital but probably are typically over 50%.

    I am a full-time investor which enables me to spend more time on my investments. Also, the companies I own are microcaps which have infrequent news. So, it isn’t that hard to keep up with them. What is much harder is finding new ideas.

    I can’t comment on the Indian market. However, I believe even someone with a small amount of capital, some intelligent strategies, and patience can eventually reach financial freedom.

    Mike

    1. Mike Sir thank you for your guidance, your time and consideration ,
      I appreciate it.

      Frankly speaking i was not expecting such a detailed/in-depth & prompt reply like this.
      V. few people/the rare ones now a days believe in this saying….
      “True Leaders don’t create followers,they create more leaders”. : A Wise Man

      Sir,i am totally agree with “Investing requires a supersized gulp of patience.”:@MikeDDKing.

      it’d be highly beneficial to all guys who are financially challenged today but having a vision of financially better tomorrow,If u cud pl. throw sum light of knowledge on “how to find great companies(micro caps) /upcoming big ones, presently which are running but in stealth mode and for a beginner its currently invisible ,any methodology & lesson on that,

      Sir feel free to say no/any reply, i understand the professional/other limitations.

      Thanks

      Best
      Amit

  5. Amit,

    In order to find great companies early, you need to turn over a lot of rocks and/or develop a network of contacts that do the same thing. I’ve been investing in microcaps for two decades and that is still what I do.

    I know this is a shameless plug, but IMO the best “shortcut” to finding great microcap companies early is to join MicroCapClub. We have ~150 talented microcap investors scouring the US and Canadian markets plus a little bit of the UK markets for the best microcap companies. By being a member not only will you harness the network of investors for their ideas, but you will also learn how they analyze companies.

    Mike

  6. Dear Sir,

    Thanks for the reply.

    Sir i’m totally agree with ur statement “Investing requires a supersized gulp of patience.” and i’m completely believe in the power of patience/long term thinking & power of compounding.
    sir i dnt believe in taking “shortcuts”in life/investing , coz ‘shortcuts’ cut the life short.

    Best
    Amit

  7. Informative post Mike. I came here from your other post where you gave me link to this series. I am impressed by your process. I liked the idea of combing through news and then researching the stocks based on the promising idea. It is interesting search process. In your 2012 article in this series you gave a case study/example of your (then) recent pick BioSyent . Just curious to know how long you were invested in BioSyent? Because I looked at stock price performance and the stock almost went 7x from the time you wrote the article. How much of that gain you could capture? Also curious to know when did you decide to exit this stock and what was your rationale? What is your typical holding period for your stocks?
    One other question I have is …Do you use commercial database for your research? Or you solely rely on company provided data in different format and forums?

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