Learn Investing Secrets

First we have to be aware of the overall market "trend" and we want to take a moment to clear up just what a trend really is. There is an "overall trend" like the downward one we have seen in the NASDAQ for over a year, and then inside that overall trend there are smaller "mini" trends. Yet during those periods of upswings and downswings, there were "mini" trends forming.

It's those mini trends that produce profit or losses for you the investor or the short term trader. Long in a bull mini trend, short in a bear mini trend.

Is there any way you can remain completely safe from taking losses in the market? No, but you can sure pare down the odds and make it a lot more in your favor. Likewise, it's foolish to think you cannot make money in literally any market environment. If you look for leadership, good register patterns and time your entries well, even in a raging bear market you can still go long with success.

Obviously that is "fighting the tape" right? Absolutely. It would be more profitable to be short during a down market time frame and easier to do too. We have many readers that simply won't go short or buy "put" options. So we try to show that if you are labour-saving and do your homework, you can go long in a bear market. But fighting the tape is the wrong way to go. So, for the first installment of our mini series, let's look at the tape, and where it comes from.

First we have to be privy to of the overall market "trend" and we want to take a moment to unclogged up just what a trend really is. Remember a few up days is not a bull market any more than a few down days signals a crash. Markets go up, markets go down. Our main priority is to try and figure out which way they are going for the longer term, not just tomorrow. There is an "overall trend" like the downward one we have seen in the NASDAQ for over a year, and then inside that overall trend there are smaller "mini" trends. For instance, the lows hit on April 4th, 2001 to in reverse June 5th, 2001 were a "mini" uptrend. The NADAQ gained something like 40%.

Let's suppose we are looking at a scenario like this: We are in warnings season and the market is really nasty. Volatility reigns, and we are trading sideways to down. Then finally the warnings start drying up, and they focus more on perceived "good news" and the market starts moving up again, into the physical earnings season. Then posterior earnings the market settles back and drifts lower. Now, its mid-August and we are at the same levels on the averages we had when we started. What was the trend? See, there really was no "overall market trend". We were essentially directionless and getting tossed about on news, hopes, fears, probability etc. Yet during those periods of upswings and downswings, there were "mini" trends forming.

It's those mini trends that produce profit or losses for you the investor or the short term trader. Get on the wrong side of that mini trend when the market is falling and you will be trapped in losing positions that could get really costly. Likewise going short when the mini trend is "up" can add some gray hair to your head quickly. So naturally, correctly identifying the mini trend is the first step in playing safely. If the trend over the short term has every delusion of human "down" then you don't want to be loading your boat with longs. Sure you can still pick off the leaders and the breakouts, but you will have to be very fast and very stock specific. None of this "buy em all up" mentality.

On the other hand if the mini trend is up, you don't want to be holding a ton of shorts, or missing the boat by only having one stock in your basket. Both are costly mistakes. So again, job one in playing safe, is every hour going to be to try and place yourself on the correct side of the tape. Long in a bull mini trend, short in a bear mini trend. Remember the old adage, "only salmon swim upstream, but then they die". Likewise fighting with respect to the tape is a tough way to go. So how do we find and identify these little trends? Well yeah our job is to try and weed them out for you, but you too should be doing your own homework. What we use is support/ resistance lines, overall "mood" of the market, and significant changes such as rate cuts, earnings seasons, etc., all of them lead towards the formation of mini trends.

Someone who reads the blog sent me this email:

Geoff,

In a previous email to me you explained how Warren Buffett values a company.  The text that your wrote was:

"He wants his investment to increase 15% in value. For every $1 of capital he lays out today he wants a day one return of 15 cents. That means a 15% free cash flow yield or buying a bank with an ROE of 15% at 1 times book or buying something for less than a 15% initial yield as long as it is growing."

I understand that no problem whatsoever.  However, I am just curious.  How does he apply a margin of safety (for example 50%) to this fcf yield valuation?  Thanks for the help.

Chad

He doesn't.

Buffett has said that with something like Union Street Railway - bought back in the 1950s - he saw the margin of safety was that it was selling for much, much less than its net cash. For Coca-Cola the margin of safety was the confidence he had in future drinking habits around the world.

Buffett felt sure people would drink Coca-Cola in larger and larger amounts per person per day in countries where Coke had been introduced more recently than in the United States. History was on his side. Per capita consumption of Coke had been rising everywhere for years. In contrast, history was not on the side of Union Street Railway.

Passengers - Union Street Railway

1946: 27,002,614

1947: 26,149,937

1948: 24,224,391

1949: 21,209,982

1950: 19,823,933

1951: 18,736,420

Bad trend.

But Union Street Railway had $73 in cash and investments – not a single penny of which was needed to run the actual business. The stock traded between $25 and $42 during 1951. So, even at its high for the year, Union Street Railway's stock was trading for more than a 40% discount to its net cash.

At its low, the company's cash covered its stock price almost 3 times.

Union Street Railway had a big margin of safety.

But so did Coke.

Buffett believed both Union Street Railway and Coca-Cola had an adequate margin of safety when he bought them.

With Coca-Cola it came from human drinking habits. With Union Street Railway it came from the cash and investments on the balance sheet.

Buffett was as confident in Coca-Cola as in Union Street Railway.

It's just that his margin of safety in one case was people's buying habits and in the other case it was the cash on the balance sheet.

Buffett doesn't apply some standard 50% margin of safety to an intrinsic value estimate.

He just looks for situations where he's confident his investment will earn an adequate return from day one far into the future.

And he wants to pay less than the stock is worth.

But that doesn't mean it's necessary to do an actual intrinsic value calculation and then slap on some percentage discount to that value.

It just means seeing the obvious.

It means seeing that Coca-Cola is priced like it's going to have a fine future when it's clearly going to have an extraordinary future. Or seeing that Union Street Railway is priced like the business itself isn't just worthless but worth such a big negative number that it offsetts the huge amounts of cash and investments the company piled up over half a century.

It's not about rules. It's about common sense.

Just ask yourself what's the chance you'll lose money on the stock - in the long run - if you buy it at today's price.

Buffett figured the chance was very, very low for both Coca-Cola and Union Street Railway. There was no rule to give him the right answer in both cases. He needed to apply a little common sense thinking to each stock's unique circumstances.

Talk to Geoff about How Warren Buffett Apply His Margin of Safety

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