All About Price: The (Price) Margin Of Safety

This is part of my intermittent series on price, one of the most important and commonly encountered considerations in investing and trading. For this post, I will talk about the deemed “price” margin of safety (or price safety margin), and the accompanying concept called “freehold”.

I had mentioned about the price margin of safety in my post on Apple (post here). To have this margin in the first place, a position has to be initiated on a counter, which was selected based on one’s sound fundamental analysis. Subsequently, when the price moves up to its new level due to the company’s value or growth story, the margin is formed.

A few concepts can be derived from this “price” margin, a couple of which are psychological in nature. Let us have a look at these concepts.

 

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Concept #1: “Freehold”

“Freehold” in some investors’ lingo meant that the initial capital on an investment had at least doubled, either through capital gain, or dividends or both. Since the investment had paid off itself, it is deemed as “free”, and the price margin of safety stands at 100%. While the thinking is purely psychological, the next step is what to do with these gains. If the growth story continues, then it could just sit there and continue to evolve to multi-baggers with a huge capital gain, or some or all of the gains can be redeployed, either on itself via averaging up (see Concept #2) or on other counters.

 

Concept #2: Averaging Up

If the belief of a continued growth story is there (with an analytical basis or “guesstimate”, of course), then one could continue to average up the counter. Though by averaging up, the price safety margin would be reduced, but overall it is still lower than the present price. 

For example, let us say that one bought 100 shares of  Company A at $10, and after a while the price rose up to $20, thus having this 100% gain. Since fundamentally Company A has a long way to go in its growth, an additional 100 shares were bought, thus making the average price at [(100 x $10) + (100 x $20)] / 200 shares = $15, which is lower than the present $20.

 

Concept #3: When The Going Gets Tough

Conversely, if the price is heading downwards, one would have to see his/her average price overall. Given the example in Concept #2, when the price of Company A falls to $18, there is still a $3 price safety margin as buffer ($18 - $15 = $3), and it would still be in an overall profitable position if the decision to liquidate is there, though some may comment the loss of $2 as an opportunity cost of not releasing it earlier.

However, when things get tough, one would also need to see the reason(s) behind the fall, and if the company is still fundamentally sound, then it is not an excuse to exit (unless he/she is one of those panicking investors that shouts “run for the hills” at the very sign of a price downtick), but rather a chance to do the opposite of Concept #2, which is averaging down. This is logical, for the price would most likely go back up, and in turn, create a larger price safety margin overall.

 

Concept #4: Coverage By Dividends

Relating back to Concept #1, the use of dividends to provide the price safety margin is based on the total returns equation, which is capital gains + income, where the income part are dividends. Supposedly, looking at the performance of a company’s share price, if the price remained constant throughout the past year, but it paid a 5% dividend yield at the same period, then it could be assumed that the price margin of safety is 5%.

It is not wrong to view it this way, though looking deeper we need to know why the share price did not budge; is it because there may be some future valuation issues, or is it because no one gives a hoot on this counter? The reasons could be varied and mixed, though not all are seen as negative.

 

As an active investor, one need to scan, scrutinize and scour one’s counters, whether inside the portfolio or on the watchlist.

 

Check out the other posts in my All About Price series.

All About Price: Introduction & Valuation of Value 

All About Price: Buyer/Seller Remorse and Premorse

All About Price: The 52-Week High/Low

All About Price: Reversion To The Mean

All About Price: Bottom Fishing

 

Illiquid Liquidity

The term may sound like an oxymoron, but what I meant is the pool of cash that cannot be withdrawn or spent easily due to regulatory reasons. With this reasoning, one of the first things that come to mind for a local would be one's Central Provident Fund (CPF) monies, and the next would be the Supplementary Retirement Scheme (SRS) funds.

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But these pools can be invested, though subjected to selected financial instruments and for CPF, quantum quotas. Currently CPF is paying at least 2.5% for the Ordinary Account (OA), and 4.08% for the Special Account (SA).

 

Whilst for my case I would not use the SA for investing given the relatively high and almost riskless rate, the 2.5% yearly returns for OA can be statistically surpassed depending on the duration and type of assets invested, though with an element of risk. Similarly for SRS, which are typically under the prevailing bank savings account rates (now is less than half a percent), the impetus to invest it is even greater.

 

As the saying goes, make money work harder for you. Granted that placing them as they are (i.e., inside OA and the SRS account) would still bring the dough albeit on a safer side, I would like to have more by taking on some risk and volatility. This is for getting a higher amount when OA (at least from age 55) and SRS (for me from age 62) turned liquid, which in turn increase the funds to supplement our step-down/retirement phase of life.

 

Related post:

 

Should I (Really) Invest My CPF? (Part 1)

 

Are You Mentally Prepared For Investing?

Having enough capital to start off the investing journey is one thing, but whether one is mentally prepared to undertake the road is another. In my opinion it is important to ready up one’s psyche before jumping into the fray, as this mental strength is needed throughout; falter and the whole thing will unwind itself.

For this blog post, I will provide a simple three-step guide on whether one is ready for the long arduous investing road ahead.

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Step #1: Why Are You Investing?

The first thing one needs to know is why he/she is investing. Planning for retirement? That is a good one. Saving up for a kid’s university education? That is another good one, too. Never mind how detailed it will be (i.e., calculating the future value, etc.) as this can be worked along the way. The main thing is to have a goal in sight.

If one starts off without any clear coherent aim in mind, or just doing what others are doing, or as a means to get rich quick, these are red flags, and it is better to be hands-off from investing until the above are resolved.

 

Step #2: Acknowledge And Embrace Risk

As I had said many times, risk is one must live with in investing (and trading). The need to acknowledge that these risks exist forms half of the picture here and be able to embrace them forms the other. By embracing, one must learn that risks are just the possibility and probability of them occurring and these are to build into the mindset.

Not all risks are created equal; the possibility of being knocked down by a vehicle is there, but the probability is lower for a person who looks out for traffic while crossing the road than one whose ears are stuffed with earbuds playing loud music and just jiggle across the street. Similarly on the investment front, the possibility and probability of a company’s share going to zero is more likely than a brokerage firm absconding the funds away. If one is totally risk adverse, or even if not, allocate the possibilities and probabilities of all risks equally, would need to take a step back.

 

Step #3: Perceiving Opportunity Costs

The adage of “only invest with money you can afford to lose” holds true to a certain degree. While it is ideal not to lose money, there will be times when an investment did not go as planned in terms of losses. If the thinking then was “I should have gone for the other financial instrument as the returns over the period are far better than this losing one”, this is okay as one is perceiving the opportunity costs in a professional manner.

However, if the thinking was “I could have one month’s worth of my meals in my losses there”, that would be, in my view, a sign that one is not mentally prepared. The separation between our daily lives and investments is important as we do not want to spill the element of emotions into the latter, which is ill-advised and at times, dangerous. This may result in an early termination of an investment plan, and worse off, a complete abandonment of the markets and never to come back.

How We Organise Our Portfolios Via Brokerages

We had talked about investment strategies, methodologies and styles, but we seldom delve into the intricacies of the administrative part, which are brokerages. Before we jump into the deep end of the market pool, we need to plan and equip ourselves properly first, like having a float of some sorts and a good swimming attire.

For our portfolio multiverse, we use a multitude of brokerages to keep our holdings. Definition-wise, the term “brokerage” used here denotes any agent or platform that we use to execute trades with for our portfolios.

Being brand-neutral here, I will anonymise the brokerages with alphabet letters.

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The Bedokian Portfolio (Main Portfolio)

Brokerage A, Brokerage B, both CDP (Central Depository)-linked, under my name

I use CDP-linked brokerages to hold individual counters listed in the local Singapore Exchange, primarily because I want to have better control on corporate actions and events, as well as the attendance of annual general meetings without the hassle of notifying custodian brokerages. I mainly use two brokerages so that I can have contingencies for each other.

Brokerage C, CDP-linked, under my spouse’s name

Besides the reasons above, the other reasons for this account are: it provides my spouse an avenue to familiarise with trading platforms, and an additional application for initial public offerings and fixed income instruments (e.g., treasury bills).

Brokerage D, Brokerage E, both custodians, under my name

These two custodian brokerages are used for holding local and foreign exchange traded funds (ETFs), and foreign individual companies, since CDP is not eligible for foreign-listed counters. I am OK to keep local ETFs in custodian as there are very few corporate actions to begin with. Why two? Brokerage diversification, of course.

The main guideline that I follow here is that a counter would not be split between the different brokerages (e.g., out of 10,000 shares of 123 Company, 3,000 is at Brokerage A, 3,000 in Brokerage C and 4,000 in Brokerage D). This is to prevent the incident of short selling, facilitate a quick transaction (especially sell orders) and not to confuse myself what is at where.

CPF And SRS Portfolios (Own And Spouse’s)

Brokerage A, Brokerage B, under my name; Brokerage C, under my spouse’s name

We use the same CDP-linked brokerages for our CPF under the 35% stocks limit, and SRS portfolios. Also, cross-brokerage ownership of the same counter is allowed (i.e., 123 Company shares are present in my CDP Bedokian Portfolio, and in my spouse’s CPF portfolio), where in this way, we can attend the AGM together.

Brokerage F, roboinvesting platform, under my name and my spouse’s name, separately

Based on my previous writings, I think you could guess which roboinvesting platform we are using. 

 

Trading Portfolio

Brokerage G, custodian, under my name

This platform is purely used for trading purposes with no long-term holdings inside, save for covered-call ETFs. Sometimes I would use Brokerages D and E for trading, too, depending on circumstance (e.g., I need to execute a trade but there are insufficient funds in Brokerage G, hence using others).

Brokerage H, crypto platform, under my name

I would like to categorically state that Brokerage H is regulated by the Monetary Authority of Singapore. I also use a cold wallet to safekeep cryptos that are not designated to be traded often.

 

Hope the above tips assist you in your own brokerage organization.

 

Related post:

Of Custodians And Ringfencing

 

Race Among The Top Three

Forget the Euros which is happening right now or the Olympics next month; we have a new competition going on and it is called the market capitalisation (or market cap) race. Akin to the English Premier League table, we saw the world’s largest companies (not intentionally anyway) jostling for the top three positions, and so far, the current ones in the leaderboard are Microsoft, Apple and Nvidia.

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The last couple of weeks saw quick positional changes, with Nvidia pushing Apple from second to third.  Then just a few days ago after their announcement of new operating systems and Apple Intelligence, the fruit symbol climbed back up to first after a price spurt, reclaiming the top spot from Microsoft. As of the end of trading on Friday, the ranking was, in order, Microsoft, Apple and Nvidia.

It is kind of exciting to see these things happening, and finance news channels make a big hoo-ha over them (and maybe some market frenzy, too, in these counters). But the real question is, are the market cap rankings useful in our investing decision?

The Numbers Game

To recap, market cap is calculated by the current share price multiplied by the total company shares outstanding. With a huge market cap, and deducing from the mathematical formula, it could mean that:

• The number of outstanding shares is high, or
• The price is high, or
• Both.

Let us look at market cap first. Though having a high number of shares outstanding is part of the market cap equation, it does not really matter in our three examples above; from the financial website Finviz as of the end of Friday, top spot Microsoft has only 7.43 billion (bn) outstanding shares, as compared to Apple’s 15.55 bn and Nvidia’s 24.64 bn (granted that the latter had just gone through a stock split).

Price Is What You Pay…

In the markets, the price of a share/stock is the function of its demand, supply and the accompanying market sentiment. The last component of sentiment is what drives prices to outlandish highs, or unbelievable lows, because it is fuelling the demand and supply part along with other traders/investors not hyped up to it.

With price, there is also the concept of value, and that is, is the price worth the share/stock that I am paying for? Hence the famous adage by Buffett on “price is what you pay, value is what you get” comes about.

Sustainability

Hypes (or fads in my terminology) do not last long. We have counters like GameStop and AMC charging up the market cap rankings due to the inflated prices, only to fizzle out after the meme had died down. Fundamentals play an important role of whether the company can sustain its profitability, and in turn their prices and market cap ranks. The current top three are not there for nothing, and time has proven the sustainability of these companies (of products, services, etc.).

However, that does not mean they would be there forever. Before 2010, oil companies such as ExxonMobil and PetroChina, and General Electric dominated the top positions (yes, and Microsoft, too). Though Microsoft still hangs around, proving its resiliency, the other mentioned ones were not even in the top 10 going into the 2020s (save for one occasion by ExxonMobil in Q4 2022).

Is Market Cap Ranking Still Important?

The short answer is, not really, but it does provide a quick look on the health of the long-term trends of a company. We still need to go back to the fundamentals on learning about the company’s financials and guesstimating its future positioning. Deterioration takes time and does not happen overnight, so there is some time in re-evaluating before making the decision to either add, keep or sell.

A final point that I want to make is that there are other good companies around which are not in the top 100. If time is affordable, you can prospect for them using screeners and dive in further on the selected companies before making a choice. This is value investment play, looking at counters whose prices are below their intrinsic values.

Disclosure

The Bedokian is vested in Apple and Nvidia directly, and SPY ETF which includes Microsoft, ExxonMobil and components of General Electric.

Disclaimer

Fundamental Analysis Is Relatively Easy Until…

Fundamental analysis, or FA, is the analysis of a company’s financial statements, the said company’s environment (including strengths and competitors) and the whole economy in general. Hence, for The Bedokian Portfolio, FA is done over three levels that consisted of the company at the lowest, followed by environmental factors, and then economic conditions at the highest.

There are many financial sites providing the latest figures and ratios of a company. There are a few places where one could look up on market data of the sector/industry where the company is in. Also, there are country data showing the latest economic information such as gross domestic product, interest rates, etc. Usually in an FA, some, most or all these numbers are gathered, crunched together, and the results interpreted to make the decision of whether to go into the counter.

Yet, the biggest challenge comes not from the above, but rather the greatest unknown factor of all, the future. Sure, we can get leading indicators such as consumer confidence indices, yield curves, etc. to predict, but we cannot precisely pinpoint the exact outcome.

However, if done right, past and current results do somewhat reflect the potential performance in the future, though it is not indicative (hence, past performances are not indicative of future results, a phrase which is commonly encountered in investment literature). What I meant is to guesstimate (portmanteau of the words “guess” and “estimate”) by using available data, plus a judgement call on the trends of the future, to decide. We need to know that we do not know exactly what will happen, but at least we are making a call with the highest probability of the outcome that we wanted happening.

An example would be the news of inflation happening around. With inflation, by textbook economics central banks with interest rate policies would try to raise rates to combat it. This in turn would bring some stimulus to the banking sector, but also meant that it would hurt companies with huge debt/leverage. Also, we need to identify which sector/industry and companies, besides banks, benefitting from all these potential goings-on. Yes, it is not a simple example, but these were what went through my mind back in 2022, among others, but I still consider myself slow as other people had also anticipated and acted earlier than me.

A simpler way would be to go the Buffett-ish style of going for wider-moat, resilient companies with a strong and healthy balance sheet and cash flow. Yes, we can go almost no wrong on these as their future are somewhat safe at least for the next five to ten years or so (barring any black swan event, which is a we don’t know what we don’t know thing).

The conclusion here is there is no right and wrong method of FA especially looking at things that have not occurred. We try not to get exact answers but justify ourselves by trying to get as close to it as possible to increase the chances of profitability.

Investing Is Boring, Trading Is Fun

Yes, most of us know it, which is why we love to go for individual stocks/shares, speculative plays and assets, and going for the latest flavour of the moment. And admittedly, I am guilty of that, too.

Though the words ‘investing’ and ‘trading’ are used interchangeably by many, the main distinctions between them are the methodologies used and time horizons; in investing, we have different styles such as passive, active, value, dividend, etc., and the time horizon is long (at least 10 years for my definition), whereas for trading, signals, trendlines and indicators are usually used for decision making, and the duration between a buy and sell transactions are at most one year.

Due to the long duration nature of investing, and if we do not really have many hobbies and non-monetary preoccupation, the tendency and temptation to go for “quick bucks” are there. Since we have the knowledge of the financial markets and their instruments, why not make use of it to do some punts and bets?

At least one investment book had acknowledged this risk-taking aspect of humans. In The Permanent Portfolio, there is a chapter dedicated to this¹, where they described that the trading portion (dubbed The Variable Portfolio) is made up of funds that one can afford to lose, not be replenished from the main investment portfolio, and the losses cannot exceed the initial capital allocated.

Adopting what the book had suggested, we had created a trading portfolio mentioned a few times in our other blog posts, to separate speculative plays from our primary investment methodology, thus setting the stage of our portfolio multiverse concept. Mental accounting, in a positive form, is at play here where we see the monies in the various portfolios differently based on their aims, nature and methodologies. Yet, we also acknowledge that they are working in tandem to complement one another in the overall building of wealth, with capital being transferred across one another in an objective and responsible way. Putting it simply, differentiate, then integrate.

Some examples of instruments that we have in our trading portfolio are cryptocurrencies, covered call ETFs, recovery plays that we do not intend to hold long term, forex, etc. And overall, the trading portfolio made up around 5% of our portfolio multiverse.

If you are wondering whether The Bedokian Portfolio eBook contains a chapter on the trading portfolio, the answer is no, as it is primarily meant for beginners and investing. However, I do not rule out the possibility of including it as a chapter in future editions, or perhaps coming out a companion publication for it.

 

1 – Rowland, Craig & Lawson, J.M. (2012) Ch16: The Variable Portfolio. The Permanent Portfolio: Harry Browne’s Long-Term Investment Strategy. John Wiley & Sons.