Peter Lynch famously said, “… if you have a garden and every day you water the weeds and pick the flowers, that in one year you will have all weeds.” Peter Lynch was one of the most successful investment managers on Wall Street because he pulled his weeds and watered the flowers in his portfolio, metaphorically speaking of course. Unfortunately most traders and investors do the opposite.
You feel good when you make a profit. You worked hard researching a specific stock. Fundamental or technical analysis was used for stock selection. You purchase the stock perfectly and are now sitting on a profit. What do you do? Do you sell the position – pocket the money? Do you hold on for another day, week, year? The market corrects and your unrealized gain on the position disappears. You are reminded of that old Wall Street adage, “Bulls make money, bears make money, and pigs get slaughtered”. The position slips into a loss. You rationalize, when the position increases in price that reverses your paper loss you will be happy to sell – break even. The position continues downward further increasing your losses. You hold the position. You water this weed everyday in your portfolio.
You have been trading for some years. You worked hard researching a specific stock some time ago. You purchased the stock perfectly and the stock appreciated a quick 15%. You learned your lesson in not taking your profits… you bank profits, right! You sold the position and realized a profit. Great. The stock continues to appreciate. You rationalize if and when the stock pulls back to where you sold the position you will re-enter the position. Unfortunately the stock continues to appreciate and it has lost your interest. Some years later, while doing some stock research, you see this same stock trading somewhat higher than you originally sold the position. No problem, you say. Until you look at the additional information supplied from the charting service and find out the stock you once owned, split – stock split – on three separate occasions since you sold the position! Just by holding this one position, the position you traded for a gain, you realize that your investment, long ago, could have enhanced your investment account by more than 7 figures. Yes, by buying this stock, as you did, and done NOTHING you could have exceeded all your investment and retirement goals. Meanwhile all of your hard work and frantic trading resulted in a portfolio full of stocks trading far below their individual purchase price paid by you in the first place.
Model Price to the Rescue
I have selected this model price chart from our database as a visual aid. If you want to see this chart in our Facebook database the company’s name is Crocs Inc. (CROX-us).
Crocs Inc. with monthly price bars, EBV Lines (colored lines) and model price (dashed line)
Forgetting about what the company actually does or produces, I would like to focus on how investors would have enjoyed a move on this particular stock from under the $4 level to $35 in two years, from mid 2009 to mid 2011. As Peter Lynch would say a “seven bagger” or 7 times your investment or almost an 800% gain.
“Coming Out of the Blue” Investment Strategy
For long only investors and/or traders I love this strategy. As you can see above CROX had a break out of EBV-3, or positive transit of EBV-3, back in mid 2009. As I blog frequently I call this strategy, “Coming Out of the Blue” and that’s why we color our last EBV line (which is EBV-3) on our model price charts blue.
So an important point to note, this isn’t technical analysis in action. Quite the opposite, this is fundamental analysis. When a positive transit occurs at the EBV-3 level the market is communicating fundamentally the stated assets values on the company’s balance sheet are either NOT impaired or gaining value from a discounted level. This may occur subsequent to management initiated write offs of unproductive assets or goodwill write down from a previous acquisition. Nowhere in finance does this occur except here with our model price work – in that the market judges the value of a company’s recorded balance sheet assets.
So when an initial transit occurs of EBV-3, I’m immediately thinking I have a potential 100 to 800% gainer on my hands, irrespective of the company making the transit. Why? The market is signaling that something has changed in this company. What has changed? Sometimes you will never know! Could be a new CEO adopting a new corporate strategy. Could be the company has just designed and launched a new market category leader in the marketplace. Could be anything. Do I care what the explanation is? Nope! The market is communicating and I’m listening and acting.
Run to EBV – Point A
Once a transit occurs at EBV-3 (blue line), the company’s stock price quickly trades to EBV (green line). Why? EBV or green line is “our” calculation of book value. Our calculation of book value is different than the accounting definition of book value. Our calculation of book value or EBV includes accounting book value plus our calculation of theoretical earnings, also known as TE – see Key Concepts.
Once the market makes a connection to the company’s balance sheet with a positive transit of EBV-3 (blue line), and having the stock price run to EBV (green line) is usually easy and possibly quick – see chart above, because the market is recognizing the full value of the company’s assets stated on its financial statements. If and when this occurs guess what? You have just made 70% return – from EBV-3 to EBV (depending on the time frame and whether dividends are paid). Not bad. Not only have you made 70% on your investment, but also the stock you invested is only trading at EBV (green line) or our definition book value – a very low valuation for publicly traded companies taken as a whole.
Run to EBV+3 – Point B
Talking in generalities, the stock will usually spend some time around the EBV level or green line. Again, stocks that have a gain of 70% or more – 70% from EBV-3 level however the original move may have started at lower prices before the positive transit – tend to want to consolidate. Once the consolidation is complete, and depending on perhaps quarterly earnings news, the stock can run to EBV+3 (Red Line). This is usually followed by a substantial jump in our model price calculation as equity analysts who follow the stock simultaneously increase their earnings estimates.
EBV+3 (Red Line) will probably be another consolidation level for the position. Again, I’m talking about generalities here but it usually occurs’ more often than you think. So from EBV-3 (blue line) to EBV+3 (red line) you have generated a gain of at least 240% – again depending on time and dividends paid! As you can see from the chart above this gain occurred less than a years’ time. Not bad at all.
Run to EBV+5 – Point C
As equity analysts’ jump on the bandwagon, with “Strong Buy”, “Conviction Buy List” rankings the stock continues to climb. Valuation increases. Earnings momentum is starting to pick up. Momentum stock players begin to invest as the stock reappears on the daily “52-week High” list. Management starts to appear on CNBC and the business press lauds management’s business strategy and acumen. The stock heads to EBV+5 (yellow Line), another consolidation level. Yes, you have gained some 500%. You patiently wait as the stock consolidates the move to EBV+5, and trade along EBV+5 (yellow line) as the stock price uses this EBV level as support. Stock price appreciation is being sustained as the upward slopping EBV+5 line as growth of the company’s balance sheet continues compounding.
Above EBV+5 – Point D
Once consolidating at EBV+5 (yellow line) for a period of time, the stock lifts off for EBV+6, and has a positive transit. Under close examination – as you can see from the chart above – the stock begins to trade above its’ calculated model price or fair market value. You decide if the stock has a down transit of EBV+6 you will exit the position. The stock does transit EBV+6 and you sell the position harnessing capital gains and dividends paid along the way.
Using Model Price to help you stay invested longer in specific stocks
So there you have it! Model Price alerted you fundamentally that something was changing and action should be taken as the stock had a positive transit of EBV-3. With each succeeding positive transit of our EBV lines, EBV-2, EBV-1, EBV, EBV+1… EBV+6 confirmation was given for you to continue to hold the stock for continued gains. Our calculation of model price or fair market value confirmed that fundamentals were improving along with the appreciation in the stock price. When finally the stock started trading above its model price with a negative transit of EBV-6 this was the signal the stock had run its course and gains should be taken.
Granted the example I picked, in this case CROX, was relatively quick – two years! What if the position took 5 years to transit through our EBV levels? Would you be disappointed? I think not.
Believe it or not I highlight stocks all the time emerging from EBV-3 or “Coming out of the Blue”. (I will highlight a few stocks I have written about in the past year in Part 2 of this post.) What if hypothetically you just put a fraction or a small percentage of your portfolio or RRSP (401K) into stocks having a positive transit of EBV-3? You would have a portfolio full of names “Coming out of the Blue” with huge potential and limited downside – you would sell the position when the company had a negative transit of EBV-3.
Even better let’s form a community on Facebook, Model Price, (sound familiar) where we can all inspire ourselves to hold onto “Coming out of the Blue” stocks so we have a chance at 800% gains in our portfolio. Hell, I’m sure we would all be happy with a lousy 100% if you wanted to sell early. Just saying!
Of course shape eyed readers could rightly claim that investors/traders could have been shaken out at point A and B on my example chart and sold their position. I agree with that assessment, but I would counter by saying as the stock re-transited EBV at point A and point B re-entries could have occurred by the investor/trader. Even if no re-entry was established, considerable gains – more than 70% could have been achieved.
P.S. For those investors who love playing the short side or selling stocks short, you can’t help but notice what occurred to CROX from the end of 2007 to the end of 2008 – see chart above. CROX went from over $70 to less than $1 in a year! Obviously model price work can be used for shorting stocks just as well as going long equity investments. Notice how CROX’s was trading well above our calculated model price at the end of 2007. And with each negative transit of our EBV lines, continued to tell the short speculator they were on the right course of action being short the position – fundamentally.