Value Price and Graham Number

Both Value Price and Graham Number are attempts to calculate true intrinsic value of a business. The methodologies and formulas are quite different and this is what makes it interesting – ability to see evaluations of the same thing (intrinsic value) calculated differently. It allows to see the same thing from a different angles.

This is like using wireless signals to pin point a cell phone location. It is never enough to have just one signal, but if you have 3 or more signals, you can compute a location relatively good. This is what we are trying to achieve using different methodologies.

So what is the difference?

Value price is based on the approach described the best by Phil Town in his book “Rule #1”:

“The Sticker Price of any business is based on its future EPS and future PE. In other words, if we can figure out what a company’s future EPS and PE numbers are going to be in, say, ten years, we can multiply those two numbers together and determine its future price in ten years and than, from that, work backwards to determine its Sticker Price today.”

There are 3 projections computed in stock2own: pessimistic, moderate and optimistic. The difference between them is described in details in the Theory section:

http://www.stock2own.com/StockMarket/Theory/FundamentalAnalysis/Value-Price

I think it is wise to use different projections in different times: we may use an optimistic approach in a bullish time, while in a downturn it is better to be more pessimistic. Different people may have different risk tolerance, different objectives and different investing styles and therefore may found one or another projection type more suitable for them. I, personally, love to see all three numbers and compare them visually to see how big the difference is. If the difference is relatively small it makes me think that business is fairly predictable, at least analysts expectations are in sync with the numbers. Understanding of how similar the projected numbers are gives me extra confidence or makes me extra cautious if the numbers differ a lot.

Now the Graham Number. 

The Graham number or Benjamin Graham number is a figure used in securities investing that measures a stock’s fair value and named after Benjamin Graham, the founder of value investing. The formula itself is rather simple, BUT as Benjamin Graham explained in his book, he would not recommend to use it blindly and apply for every business. There are certain criteria must be met in order to use this formula successfully. I think most important criteria is investor must think of himself as a “defensive investor” in Graham’s terms. You can read more about it in the Fundamental Analysis section:

http://www.stock2own.com/StockMarket/Theory/FundamentalAnalysis/Graham-Number

As you can see, different methodologies are using different approach for value or intrinsic price estimation. I think it is safe to say that there is no single universal formula exist. Therefore at stock2own we are trying to add more than one approach and let investor decide which one to use and to what extent. 

In general, when I see that all numbers are agree to each other, in other words they are on the same ballpark, it gives me higher confidence in the estimate. If I see that numbers are quite different, I have to dig dipper and carefully analyze all numbers and other aspects of a business to reach the same level of confidence in one of those estimates.

Stock2own MA Ratio / Price Ratio Interpretation

It’s been a good beginning of the year and until late March we saw pretty much all sectors were rising. As a reflection of that, MA and Price ratios were rising too across all sectors and pretty much all countries.

However, last few weeks I can see that while stock2own’s MA Ratio is still rising week after week, the Price Ratio is decreasing. I think this is due to inertness of MA (moving average). MAR is based on 150 days MA versus 200 days MA comparison – both of them are long-term moving averages.

MA Ratio – ratio between number of stocks where MA150 is above MA200 (Bull or uptrend condition) and number of stocks where MA150 is below MA200 (Bear or downtrend condition).
Price Ratio – ratio between number of stocks where Close Price is above MA150 (Bull or uptrend condition) and number of stocks where Close Price is below MA150 (Bear or downtrend condition).
The market condition is considered Bull only if Price Ratio is greater than 1 (majority of industry/sector stocks are in a Bull market).

The way I see it is we should expect MAR (MA Ratio) to be a few weeks behind. More than that, I read on several financial blogs the idea that market should be considered in a Bull or Bear condition only after 5-6 weeks of actually being in a negative or positive territory correspondingly. Therefore MAR is quite a good indicator for an overall market condition. If MA Ratio and Price Ratio are moving in the same direction, they are confirming each other.

Currently we can see that PR was going lower for last 5 weeks, while MAR was still rising. I think MAR was rising because of inertness and PR gives you an early signal that not everything is as good as we want it to be. When market is going up I expect both of them (MAR and PR) rise, but now I can see sort of wave, where MAR and PR are moving in an opposite directions. Basically, it means that market is volatile. And VIX index is confirming it (rising).

Below are chart representation of the same MAR and PR ratios for latest 6 weeks:

Stock2own’s MA Ratio

Stock2own’s Price Ratio

In general, MAR is increasing means that more companies were moving up few weeks ago. Remember, we are talking about long-term MAs – 150 and 200 days, this is almost a year! And when PR is decreasing it means that more companies have their close prices below MA150 now; technically speaking, getting into stage 4 or bear market.

MA Ratio can be used as a long-term gauge of the market, while Price Ratio is a short-term gauge. Last week’s gain helped move Price Ratio a bit up, at least it stopped falling. We will see where it go the next week.

The Graham Number

I started to read posts on seekingalpha.com and I enjoy it very much. I like the whole idea of the site and admire that so many educated people are registered there as individual contributors.

Several times I read there about “The Graham Number” and want to have some sort of note for myself about the subject. The Graham number or Benjamin Graham number is a figure used in securities investing that measure a stock’s fair value, named after Benjamin Graham, the founder of value investing. 

I found the explanation below is quite simple; I’m quoting a post from seekingalpha.com. Here is the link to original article:

http://seekingalpha.com/article/254745-20-oversold-stocks-that-are-undervalued-relative-to-the-graham-number

The Graham Number is named after a formula developed by legendary value investor Benjamin Graham. It is the maximum price an investor should pay for a stock, and it is derived using only two data points: current earnings per share and current book value per share.

Here’s the formula:

The Graham Number = Fair Value of a Stock = Square Root of (22.5) x (Earnings per Share) x (Book Value per Share).

The math of the Graham number is relatively straightforward. It is predicated on the belief that the price-to-earnings (P/EPS) ratio should be no more than 15, and the price-to-book value (P/BVPS) ratio should be no more than 1.5.

From that, the product of the two should not be more than 22.5. In other words,

(P/EPS of 15) x (P/BVPS of 1.5) = 22.5,

from which the equation was created.

Nice and simple! I’m going to add it to stock2own valuation.

S2O Trading Diary – CELG (Celgene Corporation)

Several weeks ago we started a paper trading portfolio in Investopedia account. So far, there was only one trade – on December 12, 2011 we bought 300 shares of CELG at $63.73 a piece (read original post for details). Apparently we held this stock for almost three month and on March 6th our long position was closed by a stop-loss which was set at that time to $71.95.

So, here is the confirmation from Investopedia (by the way, account name is stock2own):

The overall result is good:

ROI = (71.95 – 63.73) / 63.73 = 12.89% for 3 months.

It seems that stock is consolidating at the current level. It is still well above MA150 and therefore it is in Stage 3. The price may go even further up into uncharted territory if the stock will break the next resistance level at $76.09 (52 week high). Stock2own fundamental analysis saying that value price of a stock is $148, therefore we have plenty of safety here (51%) and I’m going to set a conditional buy at level $76.15 for the same 300 shares.

There is also a chance that price will go down. I’m going to watch the next support level around $71.20. If it will bounce off $71.20 level, it will confirm a nice corridor between $71.20 and $76, which means that we may have pretty good ride up to $76 level if we buy stock at $72, which is almost 5% ROI.

If the stock will break down below $71.20, it would be interesting to see if the price will go down to MA150 line and then bounce off – that may be a good entry point for the next run. If it will break down MA150 then I would say that CELG is in Stage 4, in other words in a down trend (I’ll make sure that we will not have long shares of CELG at that moment).

Guess what they have planned for you?

Stock2own user:
What were your recommendations on Sept 1 2011? I wanted to see how well they did in the third quarter.

In a summer of 2007 I bought Phil Town’s “Rule #1″ book. I read it and started to analyze stocks one by one, just like it was described in a book. Soon enough I realized that I need some sort of automation and created an excel spreadsheet, which did all math for me. My job was to find a stock that I like and at least partially understand, go to public web sites and copy all numbers from financial statements to my spreadsheet. Easy enough, but not too much fun especially if 19 out of 20 stocks I had to reject after I entered all those EPS, BVPS and PEs. So I was dreaming about some sort of software which will do all that copy-paste work for me.

Shortly after that I started stock2own.com. At first there was only one single page, which could do just that one thing – collect all data for a single stock, calculate all numbers I was interested in and show results. Fantastic! But in a few days I realized that analyzing hundreds of stocks one by one is not very efficient. I needed something that will allow me to do group analysis; I needed something to identify hot industries and hot stocks. This is what I was dreaming about two years ago.

October 5, 2010 – Stock2Own launched new service “S2O Pro Industry and Stock Screeners”! One more dream came true. Now I can analyze industries, I can filter out all stocks that do not meet my criteria and focus only on those which fundamentals I do like. On top of that, price chart with some technical indicators are just one click away. What else can I dream of?!

Skills! This is what I need. I have all these instruments and know that they are just like a loaded gun: I can use it for good or shoot myself. I have managed to lose some money on a stock, which made other people 40% gain in 6 month! I know for sure this is possible to lose money at the time when everybody else making profit and vice versa. Therefore I’m not looking for a hot tip and would not recommend it to anybody else. Therefore there are no recommendations of any kind on stock2own.com, only pre-calculated data to save time to those who are going to make a decision. As Jim Rohn said: “If you don’t design your own life plan, chances are you’ll fall into someone else’s plan. And guess what they have planned for you? Not much.”

Price Charts: Weekly or Daily?

If you watched recent Netflix (NFLX) move, I think you are one of those who are screaming “Yes!” because they own the stock, or those who sigh “Wow! I wish I have bought it earlier.”

Sometime ago, after I read Stan Weinstein’s book, I promised myself to never buy a stock which price is below its MA150. And I’m glad I did, because it saved me from many mistakes (I’ve made plenty of others though). I used to set a buy transaction right above MA150 and every time when I saw stock price drop lower without braking MA150 level and without triggering my buy, this rule got stronger and stronger in my head.

That is why I did not buy NFLX even everybody around me were screaming about this company’s return. Well, here is a daily chart and the price is clear way below MA150 even when it moved up 20% in just one day.

However, if you take a look to a weekly chart (shown below) you can see that weekly price crossed MA30 line 4 weeks ago.

Just to make it clear, for weekly chart MA30 means 30 week MA therefore it is the same indicator as 150 days moving average on a daily chart (30 weeks * 5 days per week = 150 days).

So, I think on a weekly chart it was a “buy” even when daily price is still way below MA150.

Conclusion:

1. I should use both weekly and daily charts and even when price is below MA150 on a daily chart, but crossing MA30 on a weekly chart, well, maybe this is an early signal to buy.

2. If I got an early signal to buy, but if it is violating one of my own rules – perhaps a short-term call option will solve the problem. It minimizes the amount of money at risk and potentially can bring quite a good gain.

P.S.
If you really like options you may find the following video interesting. The author is talking about option strategies for NFLX:
S-Trade Option Startegy

The Four Year Presidential Cycle

“Regular emails help change your attitude from reactive to proactive. And with our busy lifestyles, having that gentle reminder may help us keep an eye on the prize,” says Rick Hall, RD, who serves on the advisory board for the Arizona Governor’s Council on Health, Physical Fitness, and Sports.

I remember reading about recurring patterns in stock market in the Stan Weinstein’s “Secrets for Profiting in Bull and Bear Markets”. He is saying that most important pattern is “The Four-Year Presidential Cycle”. 2012 is an election year and this is a gentle reminder that based on analysis described in the Mr. Weinstein’s book, the year following the election is usually a disaster, no matter who is elected.

Behavior of Prices on Wall Street

Historically, the probabilities are strong that in the second year the bear market will continue until a bottom is reached around mid-year (as occurred in August 1982). The rest of year two is bullish, and then the third year of the presidential term is the best one of the cycle. The fourth year, which is the election year, is a choppy one, with weakness usually occurring in the first half and strength in the second half.
Over the past 100 years, this four-year cycle has unfolded with such unbelievable regularity that it almost seems as if the politicians are writing a script.

This data analysis was done not too long time ago, but what is going on in the 21st century? Below is a price chart for S&P 500 index for latest 12 years (3 presidential cycles). Well, I would say that two out of three are pretty close to the pattern described by Mr. Weinstein and current year is a “choppy one”. Something to keep in mind…

S&P 500 Historical Prices

——————————————–
* Chart Publication from Stan Weinstein’s “Secrets for Profiting in Bull and Bear Markets”, originally from NY: Analysis Press, 1984, p. 4.
** Quotes from Stan Weinstein’s “Secrets for Profiting in Bull and Bear Markets”.

Paper Trading Account or S2O Trading Diary

We just started a paper trading account in Investopedia.com (user name is stock2own). By saying “we” I mean a small group of stock2own enthusiasts. The whole purpose of this is to exercise our trading philosophy, test investment ideas and gain some confidence of what we can do and what we cannot. So, ideally, we would like to have it transparent and available for everyone to view, criticize, question and follow if you wish. However, so far I cannot see how to make our trades available for you (if you know how, please, comment in this blog!). So I will post a short description of every trade here, in this blog. We will try to add a reasonably well detailed explanation of how we found a stock, why we think this is a buy or sell and so on.

Before I describe our first trade a few notes about Investopedia and rules we will try to follow:

• Option transactions are limited to simple buy/sell and Scott was really upset about that. We will see what he can do with the limited set of tools.
• By default each new account has $100,000 paper money to invest. So, we will try to keep approximately 5-6 securities in our portfolio at any given time. In other words, each transaction should have total cost of no more than $20,000.
• We are going to use fundamental analysis to select stocks and technical analysis to get in and out. Both types of analysis we are going to do mostly using stock2own.com web site.

I think this is it and here is our first trade.

On December 11th I booked our first paper trade in Investopedia:

Buy CELG (Celgene Corporation) 300 shares @ $64.05 (limited price)

Explanation:

It seems that CELG just crossed up its MA 150 at the beginning of December. It has an average volume, which is not very promising for a long trade, but all other indicators suggest that there is a potential to move up:

• Stock just crossed up MA 30, both long-term Moving Averages (150 and 200 days) are pointed up.
• MACD and Stochastic show positive signs.
• RSI is just crossed level of 50 and pointed up.

CELG Price Chart

I set first order to be executed if the price will go higher than $64.05. Personally, I do not place orders when market is closed, because all those orders will be executed first deal in the next morning and there is always some crazy activity for the first 20-30 minutes of trading day and you never know what is going to be next… But first trade I booked on Sunday night when market was closed. Latest close price is $63.58, based on the current chart it seems that next resistance level is around $66? So, I just added some threshold for the stock, just in case if the price will go down tomorrow morning, so the trade will not be executed and we will have time to review and adjust our strategy.

The next first half of day CELG price was moving down and Scott adjusted the purchase price of our order to $63.70. In a middle of the day price started to move up and out order was filled in with the purchase price of $63.73.

At that point we had to book a stop-loss order with activation price in a range of $60.70 – $60.50. The chart shows support in the range of $60.70. We want to give price a bit of room to move up and down, but do not want to give up more than 5-7%, so price of $60.50 seems right.

All these days since purchase, the volume of the stock is average, which means that “volume does not confirm price move up”. However last few days CELG price is moving up and when it went over most resent resistance line at $64.80, we moved stop-loss a bit up to the level of $63.30 (right under 30 days MA and a bit below most resent resistance line, just to give stock price a bit more room).
As of today we have in our portfolio:

S2O Investopedia Portfolio as of 12/20/11

We are looking for other prospects to buy and will keep you posted.
Any suggestions? Comments?

Is there anything you can’t see?

I just read in a “Blink” by Malcolm Gladwell:

“Some of these new thinkers say if we have better intelligence, if we can see everything, we can’t lose. What my brother always says is, “Hey, say you are looking at a chess board. Is there anything you can’t see? No. But are you guaranteed to win? Not at all, because you can’t see what the other guy is thinking.”

This is quite an interesting book, by the way. And I was thinking about all those tools we have, all these technical indicators… Aren’t they supposed to help you “see everything”? Or maybe we do see everything, but to master the game we need skills to use all these information? And I think one of the skills is ability to filter out only that information that is important, to get rid of the “noise” in order to have a clear picture.

Just a thought.

Trading options in a small account

Lately we have a lot of talk about option strategies in stock2own community. I think I could find one more reason for myself to trade options. The reason is minimizing risk. And I’m not talking about total amount of money invested (options are cheaper than underlying securities); I’m talking about risk in general.

What is the best way to manage risk? Diversify. How can I diversify if my account has only few thousand dollars in it? I mean, how many securities can I invest in? Well for $5000 I can buy only 10 shares of Google or 12 shares of Apple. This is not a diversification.

At the same time, I can buy 1 contract (100 shares) of Google for about $500. And it will take only 10% of my account money. This is exactly what I want – do not invest more than 10-15% of my money into a single security.

I used to find myself in a position where I find a stock I like, I can see that all technical indicators suggest “buy” and I jump in. I paid 60-70% of my account to buy as many shares of this stock as I can. I had to do it simply because the size of my account is too small. And very often in a day or two I could find another stock with even better fundamentals and even stronger technical indicators. And … I had no money left to invest. Trading options should solve this problem. But, where is the catch?
The catch is when you buy a stock and you are right about price direction, you have a good chance to make money. Trading options you have to be right about underlying price moving direction AND time as well! As Mr. Natenberg put it in his book “Option Volatility & Pricing”:

If someone thinks the market is going up, he or she will tend to buy calls. And if it turns out these people are right, and market did go up, they might end up losing money. Why did they lose money? Buying calls is supposed to be a bullish position, and the market went up. But of course what was happening is the market was going up slowly, not sufficiently fast enough to offset the decay in the option.

So, using options you can reduce the risk by diversifying, but you have to be right in both market direction as well as timing. Nothing is free, I guess.