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Asset Values And Valuation

What’s a stock worth? “The market is overvalued.” “No, it’s fair.” “No, you’re missing the point – the economy has changed.” “What? Are saying it’s different this time?” “It’s always different.” Arguments over stock-market valuation have been around ever since stocks have traded. In many ways, the purpose of an open stock market is to discover what the clearing price for a company should be – what price satisfies both the buyers and sellers of a company’s shares. But just knowing something’s price doesn’t tell you what it’s worth. As Warren Buffett is fond of saying , “price is what you pay, value is what you get.” There are two general ways to value an asset: bottom-up, fundamental analysis that focusses on the present value of expected cash flows; and top-down, relative-value analysis that looks at the entire market and the range of investment alternatives. The first examines a specific company; the second evaluates an entire industry – or even the whole economy. Any economic asset generates cash over time. This cash flow can be forecasted, and the results discounted to present value. With bonds, this is fairly straightforward; the cash-flow is contractual. With stocks earnings can be more volatile, but they can also grow over time. We compensate for this by increasing the discount rate. Lower risk means a lower interest rate. Net present value formula. Source: Wikipedia The top-down approach looks at any asset and asks, “Compared to what?” So we use various financial ratios – price/earnings, price-to-book, enterprise value over free cash flow. With bonds, we focus on the “spread” – their level of yield above comparable risk-free government bonds. By checking what else is out there – playing the field – investors can see how what they own looks relative to everything else. Map of S&P 500 PE ratios. Source: Financial Visualization Both methods have their merits: bottom-up analysis generates an intrinsic value – something that is fairly stable over time. Top-down valuation looks at the range of investment alternatives. No investment, after all, is an island. But folks who only focus on bottom-up analysis can get distracted by the details and miss the forest for the trees. Top-down studies can be too volatile: the world may always be changing, but it doesn’t change that much from day to day. And human nature never really changes. Financial analysis tries to answer the question of what an asset is really worth. It’s a good question. In the end, though, a stock is only worth what someone else is willing to pay for it.

Wheel Of Fortune?

The only thing we can control is ourselves. True happiness comes from inside. In the same way, investors can’t control the circumstances of the market or the global economy. Market prices are always fluctuating. But they can control the quality of the securities they hold. Circumstances may be volatile, but economic values don’t change all that much. Where are you on the wheel of fortune? When I was growing up, one of the most popular TV game-shows was “Wheel of Fortune.” Contestants would solve a word puzzle similar to “hangman” and spin a giant carnival wheel to win cash and prizes. The show has run for over 30 years. Its appeal is that it encourages viewers to play along – to try and guess the mystery phrase before the contestants. But before there was a TV show, there was another wheel of fortune, or rota fortunae . It’s a concept from ancient and medieval philosophy that characterizes fate, or chance. The goddess Fortuna would spin the wheel at random, changing the positions of those on the wheel. Some would suffer misfortune, others would gain windfalls. Fortune herself was blindfolded. The concept has come down to modern culture, although Fortuna is sometimes replaced by Lady Luck. Jerry Garcia co-wrote “The Wheel” and performed it with the Grateful Dead in the ’70s and ’80s. In the TV series Firefly, the main character notes “The Wheel never stops turning” several times. It’s important for investors to understand the role of fortune in their portfolios. The investment world is not an orderly and logical place. Much of investing is ruled by luck. Every once in a while, someone makes an outsized bet on an improbable outcome that ends up working out and ends up looking like a genius. But whether a decision is correct can’t be judged just from its outcome. A good decision is one that’s optimal at the time it’s made, when the future is unknown. A good decision weighs the probable outcomes and measures potential risk and reward. In the sixth century Rome, philosopher Boethius was awaiting trial – and eventual execution – on a trumped-up charge. While in prison, he reflected on how to be content in a world beset by evil. He concluded that current conditions are always in flux – rolling on the rim of the Wheel of Fortune. The only thing we can control is ourselves. True happiness comes from inside. In the same way, investors can’t control the circumstances of the market or the global economy. Market prices are always fluctuating. But they can control the quality of the securities they hold. Circumstances may be volatile, but economic values don’t change all that much. The Wheel of Fortune is always turning, lifting us up or taking us back down. Bad things can happen to good companies. We need to look inside what we own to see what our investments are really worth. Share this article with a colleague

When To Double Down

Here is a recent question that I got from a reader: I have a question for you that I don’t think you’ve addressed in your blog. Do you ever double down on something that has dropped significantly beyond portfolio rule VII’s rebalancing requirements and you see no reason to doubt your original thesis? Or do you almost always stick to rule VII? Just curious. Portfolio rule seven is: Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes. This rule is meant to control arrogance and encourage patience. I learned this lesson the hard way when I was younger, and I would double down on investments that had fallen significantly in value. It was never in hopes of getting the whole position back to even, but that the incremental money had better odds of succeeding than other potential uses of the money. Well, that would be true if your thesis is right, against a market that genuinely does not understand. It also requires that you have the patience to hold the position through the decline. When I was younger, I was less cautious, and so by doubling down in situations where I did not do my homework well enough, I lost a decent amount of money. If you want to read those stories, they are found in my Learning from the Past series. Now, since I set up the eight rules, I have doubled down maybe 5-6 times over the last 15 years. In other words, I haven’t done it often. I turn a single-weight stock into a double-weight stock if I know: The position is utterly safe, it can’t go broke The valuation is stupid cheap I have a distinct edge in understanding the company, and after significant review, I conclude that I can’t lose Each of those 5-6 times I have made significant money, with no losers. You might ask, “Well, why not do that only, and all the time?” I would be in cash most of the time, then. I make decent money on the rest of my stocks as well on average. The distinct edge usually falls into the bucket of the market sells off an entire industry, not realizing there are some stocks in the industry that aren’t subject to much of the risk in question. It could be as simple as refiners getting sold off when oil prices fall, even though they aren’t affected much by oil prices. Or, it could be knowing which insurance companies are safe in the midst of a crisis. Regardless, it has to be a big edge, and a big valuation gap, and safe. The Sense of Rule Seven Rule Seven has been the rule that has most protected the downside of my portfolio while enhancing the upside. The two major reasons for this is that a falling stock triggers a thorough review, and that if I do add to my position, I do so in a moderate and measured way, and not out of any emotion. It’s a business, it is not a gamble per se. As a result, I have had very few major losses since implementing the portfolio rules. I probably have one more article to add to the “Learning from the Past Series,” and the number of severe losses over the past 15 years is around a half dozen out of 200+ stocks that I invested in. Summary Doubling down is too bold of a strategy, and too prone for abuse. It should only be done when the investor has a large edge, cheap valuation, and safety. Rule Seven allows for moderate purchases under ordinary conditions and leads to risk reductions when position reviews highlight errors. If errors are eliminated, Rule Seven will boost returns over time in a modest way, and reduce risk as well. Disclosure: None