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When to BUY, HOLD or SELL? (Part 1)

Saturday, August 17, 2013

Buying and selling are natural opposites. The reasons for buying a stock and selling a stock, often, are mirror images as well. Intuitively, it feels right. How do we give form to an intuition? More accurately, how do we decide when to buy or when to sell?

Well, we often read about valuations. Some analysts might have a SELL call saying the stock is overvalued. At the same time, some analysts might have a BUY call saying the stock is undervalued. Then, there are some analysts who might say the stock is fully valued and have a HOLD call.

What can we take away from this? Valuation is subjective! Anyone who tells us it isn't doesn't know what he is talking about or does he?


There is a lot of literature on valuation techniques. If we do a search online, we will know that this is true.


So, which valuation technique to use? This is already an exercise in subjectivity. Then, each valuation technique could require us to make certain assumptions which is another exercise in subjectivity. Of course, we are only talking about bottom up approaches here.

What about a top down approach? This requires a grasp of economics, market conditions and industry specific trends, just to name a few things that come to mind. Reminder: the assumption that consumers have perfect knowledge when we discuss certain economic concepts only works in a classroom environment.

If you have zero or very little knowledge of economics and business, you might want to teach yourself by reading these books:

Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics
Timeless. US$17.61 a copy.

Competition, Competitive Advantage, and Clusters: The Ideas of Michael Porter
This book is heavy reading and somewhat pricey.
Click on the image and search for
"Understanding Michael Porter:   
The Essential Guide to Competition and Strategy".
This is easier reading and much cheaper.


So, it is not surprising that experts could have differing views all the time. They could make different assumptions in their quantitative approaches and they could have different opinions on the qualitative aspects of businesses which require judgement calls. If experts have such a hard time, what can retail investors like us do?

Value investors are often looking to buy stocks at half of their intrinsic values. If a stock that has an intrinsic value of $1.00 is selling for $0.50, simply, it is a buy. Now, if a stock has an intrinsic value of $1.00 and is trading at $2.00, what do we do? You tell me.

The question is, therefore, how do value investors determine intrinsic value. They use an approach called Discounted Cash Flow (DCF). I shan't go into details here because there are many free online resources that will teach us what is DCF and we will realise that we could come up with different intrinsic values for the same stock. Why different values? We could make more conservative or more aggressive assumptions and values will change.

To understand cash flow, we will have to look at a company's cash flow statement. I blogged about it before and you can read it: here. If you want to read up on valuation using DCF, you could go to Wikipedia: Valuation using DCF.

Some people look at PER, NAV/share and NTA/share of a stock to see if it is undervalued or overvalued. Some might argue that if a stock has a very low PE and trades at a discount to NAV, it is undervalued. Well, it could be. However, if by doing a comparison, we find that other companies in the same industry have similar ratios, then, perhaps, it is just the industry norm.

I remember many years ago, I made a very good trade in Singland. At that time, most of the big name property counters rose in value but Singland was still stuck in a rut. I did a comparison of its ratios against its peers and found it was relatively cheap or, if you like, undervalued. I bought and within a couple of weeks, its price shot up. I cannot remember exactly now but it was quite a handsome capital gain. Singland was a laggard. I did not know if it was absolutely undervalued but it was relatively undervalued.

Different industries have different characteristics. Some are cyclical like the property market. So, given changing market realities, property stocks could see their share price fluctuating as well because their earnings are impacted negatively during down cycles and positively during up cycles. The same could be said of shipping stocks.

If you want to read up on how we could possibly make generalisations about stocks and have an inkling as to their characteristics, you might want to read books which I blogged about before by Pat Dorsey (here) and Peter Lynch (here and here).

By now, if you are still with me, good on you because I am not done yet. We are soldiering on in part 2.

Read part 2:
When to BUY, HOLD or SELL? (Part 2)

16 comments:

Solace said...

Hi AK,

excellent post!! just recently i was trying to do valuation on several stocks on my short list. There are so many methods available to do determine the intrinsic value. Very often, we have to assume certain things.

i will always use a few simple n straight forward calculation, i do not wish to confuse myself unnecessarily.

Btw, i dropped a msg to yr mail this after noon.

rgds

Capricon said...

Thanks AK, glad you had overcome the writer's block 😉

Looking forward to part 2

Cheers

MrNg said...

1 thing I learn about valuation is its never static, it changes with the fundemental of the business. So it does not necessarily mean that when price fall, there is more value or vice versa, when price increase, there is less value. 2nd thing, current price while a important determinant of value is also a distraction. Know your fair value based on the existing business, and future earnings, if the price have not reach your target, shut out the noise in the market. Dun bother to time your purchase, maybe I can get a better deal when fed start tapering, maybe I should lock in profits as the German elections is in September, I can get a cheaper price. Just concentrate on your fair value and forget the distractions or temptations mr market throw at in. All above ceased to be valid if you are a trader. :)

My 2 cents babbling again, sorry can't help myself

AK71 said...

Hi Solace,

Keeping it as simple as possible is a good idea. Didn't they say that too much analysis will lead to paralysis? ;p

I will check my emails later. :)

AK71 said...

Hi Capricorn,

You gave me that extra push. ;)

I hope you won't have to wait too long for part 2. Still working on it. :)

AK71 said...

Hi Mike,

Indeed, know what we are after and we will know what to do. Are we a trader or an investor? Well, if we are both, then, ask if we have entered into a long position as a trader or an investor. No? ;p

AK71 said...

Hi Solace,

I received a few emails from readers today and I have replied to all of them. I don't know if yours was one of these.

Anyway, if you did not receive a reply from me, it is possible that I did not receive your email. In such an instance, you might want to resend your email or give me your email address instead and I will send you an email for you to reply to. :)

AK71 said...

Hi Solace,

Thanks. I have sent you an email. :)

la papillion said...

Hi AK,

How about recommending library books to readers? There's a huge store of ebooks and physical books in the library without having to buy one. I'm not against buying books of course, but I'm for the idea of promoting visits to library :)

AK71 said...

Hi LP,

Oh, for sure. Borrowing from the public library is a good idea. I am all for it. :)

However, for people who hardly visit the library for various reasons or who would like to keep a copy for constant reference, buying pre-owned could be a preferred option. Buying from a social enterprise which helps to promote literacy for the poor is an even better option.

This is why although I am an affiliate of both Amazon and BetterWorldBooks, I only use images and links from the latter. They are good people who are doing good. :)

sillyinvestor said...

Hi AK,
Hi Ak,

I have written another article and emailed you. Hope you find it interesting enough for your blog. It is how I determined intrinsic value, and I thought /hope it will generate some discussion.

cheers
Mike

AK71 said...

Hi Mike,

Thanks for this. I will check later. I am sure it is another piece of quality writing. :)

AK71 said...

"There is never a right answer to what the company is worth, or what is the competitive advantage to a business, or how much cash will they generate in five years. These are all forecasts that involve uncertainty and an ever shifting set of variables and that is what makes it so much fun." Pat Dorsey

AK71 said...

The choice is never simple... Looking at the past is important. However, looking into the future is more important and also more difficult.

We are investing in the future of a company, after all, and not the past.

AK71 said...

"Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold.

"When we buy business, we try to look out and estimate the cash it will generate and compare it to the purchase price. We have to feel pretty good about our projections and then have a purchase price that makes sense.

"If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years.

"Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time.

"If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out."

- Warren Buffett

AK71 said...

Taken from a comment I made on FB earlier:

"Is this level of income distribution sustainable? If you think so, why? If you don't think so, why? If you cannot answer this question, as an income investor (and income should be your business) you won't know what to do."

and

"Getting something in the past (whether good or bad) does not mean we will get the same in the future."

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