Price Based Margin of Safety

You might laugh at this one.

However, it is need based. 

We have been talking so much about small entry quanta. 

A small entry quantum allows for smaller mistakes.

It allows you to enter many times. 

It is small enough to make your capacity for entry outlast the number of margin of safety market days in a year. 

You take your savings. You define what you want to invest in equity for the year. 

You divide it by an estimate for the margin of safety days you might be getting for the year. You arrive at this number by estimating over a ten year average. 

Upon this division, you get your daily entry quantum, for the whole year, on margin of safety days. 

I go one step further to keep a constant small entry quantum defined for longer periods, for any particular entry day. 

As we said, small entry quanta should also mean many entries. 

We won’t be getting the same margin of safety every day.

On many days, we won’t be getting margin of safety at all, in the purist sense of its definition.

We will need to tweak the definition of margin of safety a bit, to have access to many entries. 

We are doing this because we are already on safe grounds. 

First up, we are playing with money we won’t be requiring for the next ten years, or so we estimate. 

Then, this is the money that is coming from our savings and is going into equity. It is for no other purpose. If it eventually doesn’t go into equity, we will end up finding some other use for it, such is human nature, and such is the nature of these multi-tasking times. 

Thus, if we see even a smallish entry possibility, we take it, because of the nature of the small entry quantum approach. 

How do we propose to tweak margin of safety?

We watch the price of a scrip we are unable to enter in. 

We watch, and we watch. 

Still too high. High, too, are fundamental entry allowers (FEAs), like price to earnings, price to book value, price to cash-flow, price to sales, etc., and we don’t enter. 

Then, one day, price starts to drop, for whatever reason. 

It continues to drop to a level, where we feel that for this particular scrip, that’s a pretty decent correction. 

It’s all feeling. 

You can look at charts, but then you tend to look once a month, and the feeling element fails to develop properly. 

So, we’re feeling pretty good about the level of correction, and we cast a glance at the FEAs. 

These are still a tad high, albeit much lower than before. 

For the FEAs to become lower than classic margin of safety levels, there could be a longer wait, or this event might not even happen, especially if we are looking at growth scrips.

If the event does not happen, it means no entry, and with our approach of small entry quanta, this leaves us high and dry with respect to the scrip. 

Are we going to let that happen?

Because of our safe small entry quantum approach, we are not going to let that happen if we can help it. 

When price offers margin of safety but FEAs are still a tad high, we enter with one quantum. 

Then we wait.

Scrip quotes some percentage points (2%, 3%, 5%, you choose) lower than our last entry. We enter with one more quantum, and so on. 

Now, two things can happen. 

The scrip can start zooming from here, and you are going to feel good about your entries. 

Or, the scrip falls further, and quotes lower than classical FEA definitions for margin of safety. 

Are you going to feel bad about your previous entries, which were small mistakes?

No.

Why?

You are too busy undertaking further entries into the scrip, quantum by quantum, for as long as the scrip quotes at levels below classical FEA definitions for margin of safety. 

Soon, you have a lot of entries done, at these safe levels, and you have more than made up for your few small mistakes. 

You’re good. 

In the other scenario, you were good anyways. 

Thanks to your small entry quantum strategy, it’s been a win-win for you all around. 

 

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Not Everyday is an MoS Day

Dear Long-Term Investors,

How are you?

Hope this finds you in the pink of health, and without itchy fingers. 

After running through a 70-odd day corrective phase, the Indian markets don’t seem to be offering margin of safety (MoS) anymore. 

Or so I feel. 

The groove had become natural from mid January to the beginning of April. 

There was something to be bought, almost everyday. 

One would wake up thinking about what one would be buying for the long-term when the markets opened. 

Over the last ten days, I haven’t felt like buying anything. 

My fingers are itchy.

I’m raring to go. 

However, margin of safety is not there. 

It might return, in some form or the other, and that too soon. However, it doesn’t prevail just now, as per my understanding. 

Where does that leave me?

I can now opt for compulsive buying. However, my market experience has taught me otherwise. It’s a simple rule – no margin of safety, no buying. Period. 

I focus on other stuff. 

I have a trading operation. 

I focus on that. 

I write. 

I read.

I chant. 

I plan my summer vacation. 

I attend to family matters. 

There’s other business that needs attending. 

I travel. 

However, I don’t resort to compulsive buying. 

Can you stop yourself from compulsive buying? However itchy your fingers are?

It’s not easy. Nevertheless, it’s mandatory. 

The follow-through energy from an existing groove needs to be diverted until it is fully dissipated. 

If you don’t succeed with this, you’ll end up with over-priced buys in your long-term portfolio.

This spells disaster, because lack of margin of safety won’t allow you to sit when markets crash. 

And crash they will. 

Every market crashes, some time or the other. 

That’s when your margin of safety allows you to sit quietly and sleep properly. 

You then have the acumen to recognize the re-existence of margin of safety.

Also, you have the energy to act upon your identification of the re-existence of margin of safety. 

You buy more, because MoS days are there again. 

… And Why Growth Stocks…?

Well, why not?

We’ve got History on our side.

Buffett shifted a tad from value to growth in the latter part of his career.

Forget about all that.

We get into growth because we wish to get into growth.

We’re not buying at growth prices, mind you.

Our value background comes in handy. We use value techniques to pick up growth.

We continue to accumulate upon opportunity, quantum by quantum.

Our portfolio gets rounded.

Over the long run, its gets a bit of a boost.

Ideally, we’d like our growth stories to continue, forever.

Consider this. What if even one of our holdings makes it to a 1000-bagger?

What do you think this would do to our portfolio?

Exactly.

Lots that starts out as value becomes growth later.

We pick value with growth in mind.

Sometimes, we’re not offered value in something we want to pick, for a long, long time.

We’re not offered value in the traditional sense of the way we expect value to be.

At these times we evaluate.

Is this something to “wantable” that we have to have it, like Buffett and Coca Cola?

No?

Continue as normal.

Yes?

Create new criteria for value, within growth.

Enter only when these criteria prevail, quantum by quantum.

Sit on your growth holding. Don’t just exit in a growth fashion, upon any odd market high.

Exits are reserved for when you comprehensively don’t want the stock anymore.

Why’s it not stinging you when there is a correction?

Meaning, that growth stocks fall considerably during corrections.

Well, firstly, you are not using money that you might need in the foreseeable future.

Then, the correction is an entry opportunity, so instead of being glum, you are busy going about entering.

Thirdly, because you are entering quantum by quantum, you have tremendous entry potential still left, with more being added to this month upon month, from your savings.

So, you’re not worried when your growth stocks fall.

When they rise, your portfolio burgeons, so…

…for all the above reasons…

…that’s why growth, too, apart from your value pursuits.

How to Enter into a Growth Stock

You can play this one in different ways.

The successful way for you will depend upon your risk profile.

What we will be discussing here is a kind of a value way for growth stock entry.

Fine. What sets growth stocks apart from value stocks?

Valuation.

Growth stocks have high multiples.

What does that leave us margin of safety people?

Will we completely have to stay away from growth stocks?

No.

There’s a way.

Loosen your margin of safety criteria slightly. Bring it up to, for example, PE < 15, amongst other things. (We’ll compensate for this loosening, you’ll see).

Now wait.

Let the stock correct.

PE goes under 15.

Don’t enter yet.

Now we compensate.

We let more margin of safety develop in the price.

We want price going down to a technically viable level for entry.

This can be a Fibonacci level, a support, a base, a pivot, or what have you.

Three things have happened.

You have identified a stock through your due diligence.

You have waited for it to reach desired valuation after raising your valuation criteria a tad to compensate for the growth aspect.

You have compensated for your compensation by waiting further for a technical level to be hit before entering.

Now, you enter.

Your entry price becomes your base. (Subsequent entries will always refer to the base-price average).

You have entered with your minimum entry quantum.

You will take many entries, each with your minimum entry quantum.

You will keep taking entry till all the above criteria keep being met.

When even one criterion is not met, you will stop entering and will sit tight.

You will keep watching the stock and its management.

If entry criteria are not met for a long time, but stock is still not over-valued as such, you can enter once for every shareholder-friendly act of good governance, upon an interim dip in price.

You will only stop entering when over-valuation rules and becomes obvious.

You will think of exiting when you are no longer convinced about the stock.

Exit will be done upon a market high only.

Hopefully, you won’t need to exit for a long, long time, so that your investment turns into a multi-multi-bagger!

🙂

When is it Ok to Average Down?

Just remember one thing…

…that the words “averaging down”…

…only go with long-term investing. 

They do NOT go with trading. 

After you have fully digested and understood the above, let’s to to the when. 

When does averaging down go with investing?

The answer to this is – only after doing proper homework. 

If you’ve not researched the underlying well enough, don’t even think about averaging down, because you could be throwing good money after bad. 

When there’s a correction, the long-term investor does get tempted to increase his or her holding, because of the lucrative prices that are on offer. 

Sure, why not?

Please understand, that this “sure, why not” is coming out so casually because of course the long-termer has worked overtime to arrive at the conclusion that he or she wishes to increase his or her stake in something that is already being held. 

The fall in the price of the underlying does not perturb the long-termer. Solid research has been done, and the markets make huge mispricing blunders when in free fall. Market players go all psycho and discard their precious holdings at throw-away prices. Picking up quality stocks at bargains is exactly what the long-termer is in it for.

The long-termer has done a few more things. 

Family has been secured with multiple income-sources and emergency funds. What’s going into the market is sheer surplus, not envisaged to be required over the next ten years. 

Then, entry quantum is small each time, small enough so that entries can be made all year round, and there will still be ample savings left after all entries. 

How does one calculate a small enough entry quantum that satisfies all of the above criteria?

One works backwards. 

Pinpoint your income after tax for the year.

Decide what you wish to amply save. Subtract this from your income. Further, subtract expenses. You are left with an amount. Decide whether all of this amount can go into the market, or whether only a part. Maybe you wish to go for a holiday with your family, or perhaps you wish to buy a vehicle, or what have you. Subtract such additional expenditure too. Finally, you are left with the amount that you wish to plough into the market, over the course of the year. 

Next, take the amount, and divide it by 30, or 40 or 50. 

Why?

On the down-side, the market could offer you margin of safety on 30 of the days that it is open in the year. On the up side, the number could be 50. We are talking about ten-year average numbers. During a singular correction, the market could offer margin of safety continually for the whole year. Decide what your magic number is. 30-40-50 days per year works ok over a ten year period. Divide the amount you’ve set aside with the number you’re comfortable with to arrive at your entry quantum per entry-day, for the year in question. Now you can keep going in with this same quantum through out the year whenever margin of safety is offered, and you generally won’t have to worry about running out of investing money, on average. 

Great stock-picking, excellent due diligence, surplus going in, small-enough entry quantum, ability to sit – the long-termer is armed with these weapons, and now, he or she can average down as much as desired, whenever margin of safety is offered.  

Margin of Safety and Trading

MoS and trading have a somewhat funny relationship.

When MoS is offered, you don’t feel like looking at your trading portfolio.

Why?

Because it is bleeding?

Maybe.

Actually, you are in a hurry to clock some long-term investments. After all, there’s MoS on the table. Yes, you’d much rather occupy yourself with your long-term portfolio.

With serious MoS in the pipeline, the market makes it easier for you. It bludgeons your trading portfolio, such that you sheer exit it, and now you are free to focus solely on your long-term investing portfolio.

Fine. Great. Is that it?

There’s a tad more to the connection between MoS and trading.

What is trading?

Buying high, and selling higher? Selling low, and buying back lower? Yes, that’s trading.

On first instinct, you’d buy on a high, or sell on a low, that’s what you’d think.

However, on the ground, margin of safety makes itself felt.

Players wait for the underlying to correct a bit, or rally a bit, and then pick it up, or sell it. They’re not picking it up on the fresh high, with no resistance opposing them. They are taking a chance, that there will be a correcting move, and that’s when they will pick it up. Vice-versa for the bears.

Those few extra buck of fall will add to their profits when the underlying starts to rise again and makes new highs. Expressed for the bears, those few extra bucks of rise will add to their profits when the underlying starts to fall again and makes new lows.

The pay-off is, that this doesn’t always work. The trader might miss the trade altogether, if the correcting or rallying move does not take place, and the underlying zooms (falls) to make one high (low) after another.

So when does waiting for MoS actually work in trading?

Almost always. Except…

…when it’s a full-blown bull or bear run.

This means that it works like 90% of the time, which is a pretty high number.

Does that make you want to adopt MoS full-time while trading too?

Of course it does.

How do you still make use of the opposite strategy – buying upon highs, or selling upon lows?

You let a few setups go amiss. Missing a couple of trades due to bull or bear runs is the signal.

Now you can switch to buying on fresh highs or selling on fresh lows.

A Small Entry Quantum per Day Keeps the Doctor Away

Your ears are probably swelling from all this talk about a small entry quantum (SEQ) per day.

However, you are also noticing the practical element of the SEQ, especially during the current correction.

Whatever’s happening in the world is happening. We need to long-term invest on the basis of what’s being offered to us. When we see margin of safety, we act.

However, we could go on seeing margin of safety for years upon end. Therefore, our entry quantum per day is small, so small that we can last out purchasing for quite a while, and still have ample liquidity left over for all other necessary aspects of life.

There’s another benefit of the SEQ though.

Let’s say that one of your holding turns rogue.

It can happen. So many scams are emerging. There’s a new scam every day.

So let’s just assume, for assumption’s sake, that the management of one of the stocks you are holding is involved in a fraud, and this fraud has come to light.

Where does that leave you?

You stop accumulation of this stock immediately.

Don’t expunge it yet. You’ll lose out. What if the scam is a hoax? Find out. It might blow over. Management might change. Your conviction in the stock might be rekindled. Wait for a market high. If you’re still not convinced about the stock anymore, expunge it on a market high.

What did the small entry quantum do for you here?

You had accumulated the stock over some kind of period, SEQ by SEQ, right?

When the fraud exploded, your holding wasn’t that sizeable. SEQ, remember.

A fraud management won’t wait multiple years to let their fraudulent natures act. Sooner or later, a fraud will get caught. Sooner the better. When this one is caught, your holding is not enormous. It’s size depends upon the number of years of holding and conviction.

The greater the conviction, the longer the holding and the lesser are the chances of the management consisting of fraudsters.

Your small entry quantum has ensured that over many, many years, stocks that end up getting accumulated majorly are the ones where conviction strengthens year upon year upon seeing multiple practices of good governance and shareholder-friendliness.

Scammers stop getting accumulated long ago. They are expunged on market highs.

After a decade or two, your portfolio is brimming with honest multibaggers.