Tuesday, August 30, 2011

Lesson 7: When to buy a stock

Benjamin Graham made a fortune buying dollar bills at fifty cents a piece. In his time, the markets were far less efficient than today and fortunes could be made by far more easily. In Graham's book, The Intelligent Investor, he found that Northern Pip Line Co was holding about $80 per share in high quality bonds. The stock however, was trading at only $65 per share. He bought the stock, and convinced management to raise the dividend, walking away with
$110 per share just 3 years later.

This was quite a beautiful example of buying a dollar bill for fifty cents. And unfortunately, this is an example that we probably will never have the opportunity to participate in. The markets are much more efficient than before, because information about companies are much more easily accessible. There are so many people and computer programs looking that these opportunities just won't appear anymore. We cannot invest the same way that Graham made his fortune.

Fortunately, our buddy Warren Buffett has been able to improvise on Graham's strategy so that we can still make money in a safe way. Buffett figured that good companies that have competitive advantages will always outperform their competitors. Therefore, you can theoretically achieve a rate of return better than the market average if you are holding these superior companies. Now with a bit of sweat and hard work, we can find good companies. However, they are not always at attractive prices. Buying great companies at high prices is not likely to show you a good return. This goes hand in hand with our magic formula, high return on equity and low price to earnings ratio. A superior company is represented by a high return on equity. McDonalds has a higher return on equity than Burger King or Wendy's. Price to earnings ratio tell us how attractive the price is. The price to earnings ratio relates to how much we should be paying for our grocery store example. There is such a thing as overpaying for something good and we need to make sure that we don't overpay.

The thing with premium companies is, they often command premium prices. The best way to find an entry point is to wait. Every now and then, the market does something silly and Mr. Market decides that he wants to do a clearance sale. We had a nice clearance sale during the crash of 2008. We had another one, although smaller, right after the US got their credit rating downgraded. Most companies were largely unaffected by these two events, especially if they had weak or no ties to the finance industry. During the credit rating downgrade, when the market tanked for no real reason, I snapped up 10 Jan 2013@75 BRK.B calls, shorted 8 Jan 2013 @ 60 BRK.B puts, and shorted some AAPL and GOOG puts. This was a great bullish opportunity.

The best time to buy is when the world is scared. If you are holding positions and you are losing money day after day, there will come a day where you just can't bare it. Market is down 5%, every news article is bad looks like armageddon is coming, and all hope was left at yesterday. This is the perfect time to buy more of a great company. The thing with a great company at a good price is that you don't have to worry if it the price drops more. If we buy our grocery store for 10 bucks, which yields 3 dollars per year in earnings, it is an even better deal if the price drops to 8. We need not fear and we can hold our position with confidence. This is not the case if we buy the grocery store at 100. It could drop to 50, then to 10, then to 5, and it may be 40 years before it makes its way back to 100. Do NOT overpay for a company. And make SURE the company that you buy is a GOOD company. Otherwise, you won't be able to stay confident that about your purchase.

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