When a stock you think is value takes a plunge, what should your thought process be when evaluating your entry point.
Everyone wants to own that stock with that great business model when its beaten down. But how low is low?
We talk about having a game plan when waiting for a correction recently. When it comes to an individual stock or a specific market segment, the game plan is a bit different.
Evaluating the stock’s valuation
As with the previous article, it goes back to your fundamental valuation. Valuation encompass a lot of of the aspects we talked about in the article but in the case of this, there is a focus on
- What is the issue here and
- how it affects your previous valuation model
Your previous model will have evaluate the returns per unit risk. But what if this issue here is an unknown unknown?
The concept of margin of safety Benjamin Graham talks about involves taking care of the known risks, known unknowns, but also leaving enough buffer should there be unknown unknowns.
Now that the unknown unknowns have become known, can you see how this affects the underlying cash flow forecast?
Is this business permanently impaired?
My view is no matter how impaired it is, there is always a liquidation value to it.
Finding the fair valuation
The difficulty of not catching a falling knife, or a lost cause and getting the attractive once in a lifetime bargain hinges on your skill in valuation.
The difficulty for most people is that they have not done enough deep research and do not have adequate information to estimate a close enough fair valuation.
That fair valuation, would let you know if the stock have fallen low enough.
Howard Mark’s explains it best
Superinvestor Howard Marks explains it best when asked about his thought process about buying so called undervalued assets in Europe:
”…anything which has gone down in price a lot is potentially a source of opportunity. But the question is, has it declined sufficiently relative to reality? If a stock was efficiently, fairly priced five years ago at X. Today the stock is down half, but in some sense reality is also down half — then the stock is only fairly priced, lower in price but not cheaper.”
“What the investor has to do is weigh out on the one hand price and on the other hand reality. Everybody thinks very dire thoughts about Europe and the Euro, and I would be the last person in the world to argue against that position. Then the next question is, European assets are lower in price because of the macro conditions, but are the macro conditions being viewed too pessimistically? The answer is, how do you know? Go back to second-level thinking. Are you capable of thinking different and better about the fate of Europe? I don’t think so. I don’t think I can. I don’t think anybody really has a good handle on what is going to happen in Europe. So then, how can gaming the Europe situation give you an edge?”
“If you don’t have control over something, superior insight — I don’t see control in the sense of being able to make it work — if you don’t have superior insight, then how can something be to your advantage? One of the tenets of our philosophy — you named number one, which is risk control — number five is, we don’t bet on macro forecasts. It is very hard to consistently be above average in correctness with regard to the macro.”
In the case of a macroeconomic situation like Europe, valuation is hard to know whether all the known risks have been priced in.
In individual stock, that might be the case as well.
Starhub takes the plunge
Hypothetically, lets say Starhub has an event that caused the stock price to plunge.
Starhub, is the blue chip with that recurring income that is thought to be as very defensive, paying out 20 cents of dividend yearly.
Say for example, over the top TV have become so prevalent that people don’t watch pay TV anymore.
Here is a 3 year chart of Starhub. Click to see a larger view.
Lets say the stock price falls from the current high of $4.44 to $3.2 (1). A drawdown of 27% would have been a good price to buy.
But what if its still not fair value.
Without the over the top TV encroaching of their pay TV business, the fair value would have been at (3).
The yield investors will be pilling in at ( 2). They would be thinking getting 20/300 = 6.66% yield is a sweet deal.
If you have evaluate what a permanent or a partial impairment of the pay tv business to Starhub, you would have arrive a value close to (4).
But no one knows (4). You can only estimate to the best of your ability. This is why I say this can be a rather challenging game.
But knowing (4), gives you that yardstick to know what kind of risks you are taking.
Should the price go below that to (5), that would be a sweet deal. (Of course that is 8.33% yield at $2.40. If you have a greater than 8.33% yielding asset at a lower risk, then perhaps you should be going for that!)
Whether it is BP, Apple or Starhub taking a plunge in a normal market condition (read not a bear market), you can either punt or you can speculate rationally. It’s a challenging task, but if you are willing to work for it, you may own that dividend stock with that great yield.
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