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Real-Money Stock Picks / Messed-Up Expectations Portfolio


Subject:  Re: More thoughts on discount rates Date:  12/13/2010  4:29 PM
Author:  TMFGebinr Number:  100 of 1282

Hi tj,

Thanks for your comments.

Yes, exactly, you pass over some good investments

Oh, certainly. But I'm not trying to find all the good investments. Honestly, nobody can. I'm trying to find enough that the market thinks very poorly of that actually are likely to do better than expected, and then ride the share price up as the market readjusts its expectations. If I manage to pick only winners (defined by rising stock prices after purchasing), nobody will be more surprised than me.

but what is worse is that this method will select the riskiest stocks. That can be very dangerous. Your screen will pick all the value traps and then you have to manually sift out the ones that are not "traps".

Yes, that is a concern. You always have to ask, "Why is this company disliked now?" And you can find yourself in the position of convincing yourself that it's "better than that, really!" That's where the due diligence comes in, asking questions about the accounting, the management, and the situation the company is operating in (e.g. Transocean). And that's also where my position sizing will play a role. For those that are most questionable, but still deemed good enough, a 2% position is all they get. For those that are pretty good, 4%. For those that I believe are great, 6%. So when I'm wrong, hopefully it won't cost too much.

I believe you have to account for the riskiness of the investment. You make good critique points about CAPM and beta. I think your "judgment beta" is better than completely ignoring relative risk.

Well, my standard 15% discount rate is already pretty pessimistic. However, if the company lives down to market expectations and only manages to produce free cash flow at the priced-in depressed level that puts it onto the watchlist in the first place (like the screened stocks do --, then I'll expect to get an average of 15% return per year.

But there's another issue even when using a judgment beta applied to the cost of equity that I hadn't discussed yet. Here's the equation to remind us:

cost of equity = risk free rate + beta * equity risk premium

Right now, the risk free rate (commonly, the yield on 10-Year Treasurys) is pretty darn low.

Second, what equity risk premium (ERP) should we use? I've seen papers where it's been measured to be anywhere from 4% to 6% or so. Apply a 2.0 multiplier to that and that's a 4-point swing betwee