No. of Recommendations: 49
Last week I received an e-mail from a friend of mine asking what my thoughts were about a stock he owned that was, as he put it, “headed down the crapper.” From the tone of his note I knew he was a bit distraught, but at this point I didn't even know what the name of the stock was that, again as he put it, “was headed to hell in a hand basket.”

What could be so bad I wondered? Is there a problem in the Middle East? Did an old nuclear reactor from a Soviet submarine wash ashore at Cape Cod? Just what could be so horrible?

The answer of course was that Merck and Company, Inc. (MRK) was tanking. My immediate response to him was to buy more shares and go back to whatever it was he was doing. Once I replied to him, I had no intention of giving he or Merck another thought, assuming that he would actually buy more shares and go back to whatever it was he was doing. But then it occurred to me that the vast majority of folks would probably have no idea just what Merck was worth.

With a company like Merck, many investors just take the advice of their brokers, or the advice of the guy standing at the urinal next to them, or the guy next to them on the subway. They own a few shares because, well, because it's a good investment. Then again…aren't they all until there's a problem?

The truth of the matter is most folks that own stocks have no clue what a reasonable value for those stocks actually is. The sad part is, their investment professionals normally don't know either. If you ask these investment professionals about a company like Merck they just look up what their analysts have said about the company and read that information to you. The next thing they want you to do is make a trade. So much for good advise. Just make a trade, I'll get paid, and you'll get, well who knows what you'll get.

For a very long time, I believed that all of the metrics and all the rest of the fundamental analysis was actually what led me to determine a reasonable value for a company. Several years ago I learned that wasn't the case. I learned that all of the reading and all of the metrics I calculated should work to support what I had already determined was a reasonable value for a stock. Even today, that still seems backwards to me.

And so I sent a note back to my friend and I asked him what he thought was a reasonable value for Merck. As I had expected, he had no idea. What I had not expected was the next line of his response, which was to stop bothering him because he was on the Internet trying to understand what puts and calls were so he could hedge his losses.

My curiosity of course was piqued by his response, so I headed to the Internet to find out what was going on. From what I could gather from several other folks, this what pretty much the order of the day. Investors, and I use that term only because I have no idea what else to call them, were frantically looking for information after an event had occurred.

What I was discovering was the world of “puts” and “calls”. To be quite honest as far as I'm concerned a put is something children do with their toys, they put them away, and a call is something a parent does when it's time for those toys to be put away. I remember growing up that a call always seemed to get my attention faster than a put. I wonder if that's true today?

As you can tell, I know less about puts and calls than hog knows about the hereafter, and truth be told, I have even less interest in learning about them. But in an effort to try and understand what was happening I zoomed around the web reading stuff on the various discussion boards about what folks were doing to hedge Merck positions, or as one poster put it, to “profit from the slaughter”.

To profit from the slaughter at first seemed like pretty strong words to me, but then I'm usually so unaware of the stock markets that I finally decided this guy was a trader who could care less what a reasonable value for Merck was. All he wanted was to trade the stock, sort of like the investment professional I spoke of earlier.

Several weeks ago, I wrote that the prudent investor would always want to consider preservation of risk capital first and that investing was the art and science of managing that risk capital. I said that understanding what a reasonable value for a stock was, buying shares of stock at a substantial discount to that reasonable value, and selling shares along the way were all paramount to being an outstanding long term investor.

I got a lot of response to my thoughts on what makes an outstanding investor, and for the most part, while almost everyone agreed with me about understanding what a reasonable value was before you buy, and that buying at a discount to that reasonable value was a must, nobody, and I mean nobody, agreed with me when it came to selling shares. No one seemed to understand that selling was an integral part of my long term buy and hold strategy.

Last year I bought shares of Steel Technologies, Inc. (STTX). When I was finished buying, my cost basis was $11.75. Last week I sold half of my position for $25.04. My cost basis is still the same, $11.75, but how much exposure to risk does my original investment capital have? The answer is none, zero, zip, nada. The reason is because I don't have any of my original investment capital left in the stock. It's all back in my brokerage account ready to be put to use when I find another stock on sale. The hold part of my buy and hold strategy is working for me now, since I'm going to hold the stock until it reaches the $30 to $31 neighborhood. That may take a week, or a year, or ten years, I have no idea. But if the price falls significantly, I won't be afraid to buy more shares, provided I still understand what a reasonable value for the stock is.

Maybe it's just me, but I like to be able to buy things at half of their reasonable value, and I like to take money off the table when I think the time is right to do so. Owning a stock for 50 generations has no appeal to me. Sure it's cool to say that a stock has been in your family for all that time, but at the end of the day, and I'm wondering this out load, I just wonder how much value there is in keeping a stock for that long without ever selling a share?

Okay, back to Merck. What if folks had taken the time to figure out what a reasonable value for the stock actually was before they bought it? What if folks had used dollar cost averaging to buy more shares on pull- backs in the price? What if folks had sold a bit along the way? Do you think those investors that managed risk in such a manner, would have a problem buying more shares of Merck at current prices? Or do you think they would be on the Internet trying to understand what “puts” and “calls” were?

The nose dive that Merck took, an almost $12 fall in a single day, should be a huge sign in front of the eyes of every investor that 's interested in the company, and it should read buy me, buy me, buy me! As the lawsuits over Vioxx pour in, and believe me they will, the price of the stock should fall a bit more, and again, if you're interested in Merck, those should be buying opportunities, provided of course your portfolio doesn't become to over weighted with shares of Merck.

So what do I think is a reasonable value for Merck? Well in looking at the stick figures I scratched out in the dirt, the company has to me, a fair value of between $51 and $53, which means, according to the value of half, when the price gets to about $26, I would take half a position, adding to that position on pullbacks in the price. Then once the stock had gone up by half, to around $39, I would sell half of my shares, leaving me with capital at risk of about half of what I started with. Once the price of the stock got to around $52, four halves, I would close my position, and again wait for the price of the stock to fall by half, so I could start the process all over again.

Sound simple? The reality is, it isn't. What's required is patience, and in visiting different websites and reading things about Merck, I would say “investors” have about half of the patience they need, which will yield none of the value they want.


Wax
Print the post Back To Top
No. of Recommendations: 1
<quote>
So what do I think is a reasonable value for Merck? Well in looking at the stick figures I scratched out in the dirt, the company has to me, a fair value of between $51 and $53...
</quote>

Thank you for the amazing post, Wax! Could you please share with us how you came up with the $51 - $53 fair value range?

Thanks,
javaboldie
Print the post Back To Top
No. of Recommendations: 0
Sorry I didn't read you other post. I have occasionally spoken to the selling side with the same response you got. So you do have someone on your side...selling when your set return is achieved makes much more sense to me than holding out on the hope/prayer that it will continue to rise like all those famous stories we hear about.

Good post too.

Buffy (who has sold a few times now...)
Print the post Back To Top
No. of Recommendations: 1
javaboldie;

For the most part I use a combination of historical free cash flows, (usually averaged over 5 years) coupled with what I think the potential for earnings growth for the company is over a set period of time, as well as some leveraged buyout and industry information, most of which you can get from the internet.

There isn't a one stop shop that says the value of a stock is X. Oh there are, but how do you know if that number is accurate? What if it's too high? Does it take into account that the CFO has run off with the CEO and they want to get married and live in Tyrolia and yodel all day, using the money they embezzled from the company? Probably not.

So looking up valuations on the internet may only help to lighten your wallet. The problem with determing what something is worth of course is that it's subjective, having more or less worth to one person than to another. The $51-$53 value I placed on Merck, is the value that I see in the company, which is probably different than the value that other folks see.

Of course the gist of my post was simply to remind everyone that the stock market is a volitale place, and if you have no idea what the value of an investment actually is, it's just that much more volitale because you tend to do dumb things to preserve your risk capital, but it's all done after the fact, when it's too late.

Anyway, probably not the answer you were looking for, since as you can see, there's a lot more than number crunching that goes into the way I value a stock.

Thanx for you comments!

Wax
Print the post Back To Top
No. of Recommendations: 1
Hey Buffy;

Selling to a lot of people is sort of like trying to get gum off of the bottom of your shoe on summer day, when the neighbor's dog isn't around to lick it off. That gums starts off as a lump, and then gets smeared around and then it starts following you. Eventually it just sort of disappears, like money.

Thanx for posting.

Wax

Print the post Back To Top
No. of Recommendations: 3
Wax:

A well-deserved post of the day. I comment on one aspect, though:

<Last year I bought shares of Steel Technologies, Inc. (STTX). When I was finished buying, my cost basis was $11.75. Last week I sold half of my position for $25.04. My cost basis is still the same, $11.75, but how much exposure to risk does my original investment capital have? The answer is none, zero, zip, nada. The reason is because I don't have any of my original investment capital left in the stock. It's all back in my brokerage account ready to be put to use when I find another stock on sale. The hold part of my buy and hold strategy is working for me now, since I'm going to hold the stock until it reaches the $30 to $31 neighborhood. That may take a week, or a year, or ten years, I have no idea. But if the price falls significantly, I won't be afraid to buy more shares, provided I still understand what a reasonable value for the stock is.>

I'm not suggesting any change to your approach. We each do what works for our particular combination of personality and temperament and so on. The highlighted section only points out some mental accounting that you're doing: The dollars remaining invested in the stock are worth the same as the dollars sitting in cash.

Mental accounting isn't necessarily a bad thing. We all play these games on ourselves in order to keep our financial house straight. That said, we need to be aware when we do so.

jacko2
Print the post Back To Top
No. of Recommendations: 1
Hi Jacko:

Thank for you comments.

The highlighted section only points out some mental accounting that you're doing: The dollars remaining invested in the stock are worth the same as the dollars sitting in cash.

First off, and I apologize, I have no idea what mental accounting is though as I respond to the rest of your post, I'm going to try and work through what it is.

Second, my cost basis before I sold, was $11.75, it's still $11.75, that part hasn't changed. What has changed is that all of the actual dollars that came out of my pocket to buy STTX, and then some, are back in my pocket.

You're right that they are worth the same, but they are worth the same for only one day. The next day the price of STTX could increase or decrease adjusting the worth of the associated dollars. However, the dollars in the bank are still worth, a dollar.

However, regardless of whether the stock goes up or down, the one thing that I have been able to "hedge" is my risk of owning STTX. While I still have a risk of $11.75, I also have $11.75, in the bank, which if I'm starting to understand mental accounting, would make my risk factor $0, since one would cancel the other.

I'm sure I do mental accounting, but it isn't something I'm aware of. All I know is that I have shares of stock worth $25 and cash in hand worth $25. If I subtract the $12 I paid for the stock, that still leaves me $13, cash in hand, which if I want to, I can add to the $12 I repaid myself for the original stock purchase, and then go buy more shares of another "on sale" stock.

I know it seems confusing, and I hope I've worked through mental accounting enough to understand it, I'm just trying to link it to something I would do as a part of my normal portfolio management and I'm not sure if I've succeeded?

Wax
Print the post Back To Top
No. of Recommendations: 0
Ok Wax,
Now you confused me....I was following but then you said that the dollars in the bank equal the dollars invested...balancing to zero.

I keep my numbers a little different (and remember I hate numbers). When I put out $100 on a stock, then I am at 100% risk, right? If that stock doubles and I pull out $100, then I should be at 0% risk. The reason is that I have all my original money back. The $100 that are still invested are all gravy money.

Now, if that money does not grow, and I eventually pull it out, then I have doubled my money. I now have $200 in the bank, and I am showing a profit.

Is that way off? Anyone else make sense of what I just said?

Buffy (who is not an accountant and won't even watch them on TV...)
Print the post Back To Top
No. of Recommendations: 4
Wax,

<While I still have a risk of $11.75, I also have $11.75, in the bank, which if I'm starting to understand mental accounting, would make my risk factor $0, since one would cancel the other.>

By continuing this thread, I'm afraid I'm going to mess with something that clearly works for you, and I don't want to do that. But let me continue:

1. "Mental accounting" is something to be aware of, in regards to oneself. But, in a certain sense, it's not something worth writing a thesis on (the academics do, though!).

2. I pulled out the above sentence to highlight the example. The only point I'm making is that the $11.75 still invested in STTX is *completely* at risk, still, even when you've already taken profits equal (or more than equal) to your original investment. By offsetting, in your mind, the money still at risk with the realized profits, that's your "mental accounting" for this current position.

[And just to be clearer: In this use of the word, "mental" just means what you're doing in your head, how you're thinking about your money; it doesn't mean "mental" in the sense of "crazy".]

And, to respond to dlbuffy's comments, the point of recognizing when we're in a mental accounting behaviour, is that the money still invested in STTX isn't "gravy". It's not "free money". It represents an allocation of your hard won capital to a particular investment.

The only point is not to treat the $11.75 still at risk in STTX as being worth any less than the $11.75 sitting in cash in your account. And that's what we do (I do it, too) when we talk about "zero risk" or "free money" or "gravy".

Mental accounting is part of the discussion about "behavioural finance" (or behaviour economics). Academics study how people think when it comes to money. It turns out there are all kinds of bias and games we play with ourselves: over-confidence; anchoring; recency bias; and others. Last year's big prize in Economics went to the guys who started the research, Daniel Tversky (sp?) and another guy who's name I forget (begins with a K).

Here are some resources:

1. The best short resource is Charlie Munger's speech from about 1995 at Harvard. Whitney Tilson has it at his website. Read Munger's speech through half a dozen times. And I see that Tilson has himself started speaking on these issues: http://tinyurl.com/3t25l (link to his website)

2. Larry Cunningham's book on "how to invest like Buffett and think like Graham" covers some of this ground. If you do a search at Amazon, you'll find other recent books.

3. There are some links on behavioural finance at www.undiscoveredmanagers.com. Richard Thaler is one of the academics who writes on the subject. It drives the efficient markets people crazy.

I hope this is helpful to you. But don't mess with what already works.

Cheers,

jacko2
Print the post Back To Top
No. of Recommendations: 0
Very good answer jacko,
And it is a good reminder of personal habits that could trip us up because we don't see them.

Buffy (who remembers something about this over a year or so ago...)
Print the post Back To Top
No. of Recommendations: 0
Jacko;

Thanx for the response. While I did realize that the $11.75 was still at risk, I was doing as you suggested to some degree. It's like winning money at a race track. I've heard folks say they are playing with "their" money now, meaning the track's, but I always believed that once it was in my pocket it was mine.

So to tie the two things together, the gist of that part of my post was that I had recouped my original investment and that while I still had money at risk, the mitigation of that risk was far easier because I had more options available to me, not to mention that my original risk capital was back in my pocket.

As to mental meaning crazy...well let's just say it makes life a little more fun!

Thanx for taking the time to point out a huge part of investing, the mental part! And no, you won't mess me up. It's an investing tactic I've used for a long time and it works well for me.

Wax
Print the post Back To Top
No. of Recommendations: 4
Great post Jacko. You explained the purchase clearly.

I would still however take issue with the statement that $x dollars in cash is the same as $x dollars worth of stock. I don't think it's *completely* at-risk as you mentioned, but it has a different value in two ways:

1- The cash in your hand represents money you can use NOW!
2- The dollars tied up in your stock may or may not be beneficial, but it also means there is an opportunity cost where those dollars invested in something else may provide you with better returns. If the stock is not substantially gaining over time in your MRK or STTX, you can certainly find other investments where you will see realized gains.

Talk to any banker, they will tell you that they would certainly prefer the cash over the shares - even if the shares have high growth potential. Only because you have the shares available now. The basic concept of net present value is substantiated in that $1 now is worth more than $1 in the future. This is the essence of liquidity.

Let me explain with an example:
I have $10. I buy $5 of MRK, I use $5 to buy a CD. Say MRK is not growing fast, at 5%, my CD gives a 10% return (in some other country of course) This means that I immediately have lost $0.25 by not moving my money to the CD over the course of a year ($.25 gain from MRK, $.50 gain from CD, $.5-.25=.25). This is the opportunity cost that I paid for holding onto MRK rather than put all my $10 into the CD. Of course, I would still come out ahead with:
MRK: $5 gain: $.25
CD: $5 gain: $.50
Total: $10.75 gain: $0.75

But I could have gained a total of:
CD: $10 gain: $1.00
Total: $11.00 gain: $1.00

So I lost the $.25 gain by investing in MRK. I'm using the CD as an example, but it could also be other stocks or other investment vehicles to do the same thing.

That doesn't mean that the halfway split is a bad thing. It's just another form of hedging your investment in MRK assuming that it's not going to go through a catastrophic crash. A key factor in this is also the time period. I still recall holding onto shares of one stock for almost 2 years with the hopes that it would rise from a floored out plateau. It didn't move. Those dollars just sat there when I could have invested in many other things that gave substantial returns.

Great thread.

AnandaVar
Print the post Back To Top
No. of Recommendations: 3
AnandaVar:

You're quite correct in pointing out opportunity cost. That's the formal way to quantify the risk. By "completely" at risk, I simply meant that while you're holding a stock there is some chance that the stock price may fluctuate downwards, even to zero. And if we get more accurate, we'll acknowledge that even cash (so-called, for most of us we're talking about an electronic entry on some institution's computer system, which is a whole other kettle of fish) isn't free of risk. It just has different risks.

The other point you raise, also correct, is one we're all familiar with and no doubt apply daily to our investments: diversification, to reduce one's risk (unwanted downward price fluctuations of indefinite duration). Graham pointed out that diversification is corollary to the margin of safety principle. None of us knows the future.

And portfolio theory also tells us that risk (which it defines as price volatility; I acknowledge the criticisms of that definition) can be reduced by prudent diversification (efficient frontier).

And in one of my ports, I use the cash/stock diversification system thought up by Robert Lichello: www.aim-users.com. And read his book. But the basic idea is that you retain a cash cushion for any given stock position (or portfolio) that is used to buy more if the stock drops; and then you sell as the stock rises a certain amount.

jacko2

Print the post Back To Top
No. of Recommendations: 0
Jacko2 -

I don't think I stressed diversification in my post, but you were right in figuring that out from my text that I suggested it. I do know that there are methods such as Value-at-Risk (VaR) currently being used by many hedge funds to determine exactly what part of their portfolios are really subject to possible loss. The problem with VaR is that it is so dependent on % in losses and a time frame - hence making it difficult to compare.

Did your Lichello bands pan out for any return? I've heard that since Lichello wrote his book, people have modified the method to cap the amount of cash cushion so that more money stays in the market (this was good during the 90's, not so sure in 2001+)

I'm still not sure if there are any investment methods other than straight hedges that would handle dramatic drops such as MRK. Minimizing risk has been such a hot topic for investors lately, but as you suggested, there are many types of risk from specific risk to policy risk. This fits with exactly what you mentioned - we don't know the future (and if we did, only the fastest traders could make money on the market)

AnandaVar
Print the post Back To Top
No. of Recommendations: 1
This reminds me of a rather positive surprise that I needed to deal with recently.

A few months ago I was looking into ILMN. I searched through their financials and ran some number crunching. The initial results looked very promising. They were so far unprofitable but showed a clear trend that was working toward long term profitabiliy. They also have more than enough cash on hand to handle a few set backs. It was one of those stocks that many investors got burned on back in the DotCom Days (I love many of these stocks), and I beleived they were still afraid to go back in the water. So looked up everything I could about the company and its employees (I beleive I am investing in the employees, especialy uppermanagement, as much as the financial/number crunching stuff). The more I read, the better I felt about laying down some cold cash for some shares. So I made a purchase after deciding it was currently about 20%-40% undervalued. Then I began to accumulate more shares over the next few months.

After a few months I watched an IP lawsiut get settled, some fat trimming that resulted in some more cold hard cash on the books, and the stock price climb over 50%. This left me with a decision to make. I could continue to accumalate more shares every month or sell some/all of my shares to invest elsewhere. Over the course of a couple weeks I was like a schizophrenic everytime I tryed wieghing my options. On one hand I beleived that the long term potential for growth was still there. On the other hand, I thought with that much of a jump in such a short period of time, the next couple of years of growth was already priced in and I would see little return during that period. I had bought this stock for a long term (according to MY definition) investment and nothing really changed that. Then again with over 50% and closer to 60% return over a three month period it was almost like hitting a few numbers on the lottery and the urge to "take my money and run" was very tempting. In the end I decided to take all but my initial investment out, and continue to purchase more share every month. The "gravy" return I added to some cash I had set back for my next intial stock purchase.
My reasoning for this was definately "mental accounting". I rationalized that the end result is 1. I was continueing as planned with my ILMN investment. 2. I was buying "free shares" in another company, INTC. Was I "truely" investing in ILMN AS PLANNED? No, I planned on investing at that half priced discount that is now gone. Where those shares of INTC realy "Fee Money", no they were my reurn on an investment. However, in hindsight I believe this was a good stategy.
If ILMN rises faster than INTC then I lost money by not investing all in ILMN. If INTC rises faster then I am losing money I would have made by being 100% reinvested in INTC. And if yet another stock rises more than either then I lost money by not buying that stock. All this is the thinking of a "maximizer". These are usualy very driven, successful, yetunhappy people. I went for the "satisfier" reasoning.
When I say "satisfier", I mean someone who looks to meet a goal or expectation, and doesn't concern themself with whether this option or that one pans out better. I look for a return on my investments (at least 4% better than if I had invested in an index fund). Anything else is just a little extra gravy. So, in hindsight, I am very accepting and almost proud of my "mental accounting". Without a little "irrational rationalizing" I would have then, and in many other cases, drove myself nuts over making a decision.
Personaly I dont think the 1/2 in/out approach is too bad at all. I must say in the above circumstance, it was the best way to solve a welcomed surprising change of plans.
Print the post Back To Top
No. of Recommendations: 1
p.s.
I also used my "free money" to increase my holdings in MRK. :)

Print the post Back To Top
Advertisement