Not All Haircuts Are the Same

by FI Fighter on December 15, 2015

in Precious Metals, Real Estate Thoughts, Stock Investing Thoughts

pennies1

When it comes to investing, really, who doesn’t love a good deal? We are all well aware that if you want to get to early financial independence, you must amass a good amount of wealth in a relatively short-period of time.

What’s the best way of accumulating wealth?

Most freedom fighters like to focus on consistent cash flow. Some like appreciation. Regardless of the route you take, though, everyone will experience a good degree of bumps and bruises along the way.

That’s just how markets work.

Every asset class is cyclical so turbulence along the way to early FI is to be expected.

The key to navigating through these tricky waters, I believe, is to convert some of that same turbulence into opportunity; focus a portion of the offensive gameplan on buying up the most undervalued assets at any given time.

Nominal Value

On the surface, a 50% drop is a 50% drop… It doesn’t matter what heights you started from. If you have $10,000 invested into a stock and it gets cut in half, you’re left with $5,000. Similarly, if you are invested in a $500,000 residence and it falls to $250,000 due to a market crash, nominally speaking, you’re out the same amount of percentage points as the stock investor.

After all, 50% is 50%.

In either case, both freedom fighters are probably not going to be too happy with those end results!

But it can become all too easy to generalize nominal values as being reflective of true value, or the risks involved with the underlying asset under consideration…

Again, let’s use another example to illustrate this point.

Let’s say we have two stocks, Stock A and Stock B. For all intents and purposes, let’s assume everything about these two investments are EXACTLY the same (industry, revenue, profits, debt, share structure, etc.).

The share price of each stock proceeds to witness the following decline:

Stock A:

2015: $10.00

2016: $5.00

 

Stock B:

2011: $10.00

2012: $5.00

2013: $2.50

2014: $1.25

2015: $0.625

2016: $0.3125

 

In both cases, Stock A and Stock B are starting from the same nominal value of $10.00. If Speculator A purchased Stock A in 2015 at $10.00 and continued holding until after the 50% haircut in 2016, the underlying asset would now only be worth $5.00.

Similarly, if Speculator B purchased Stock B in 2011 at $10.00 and held it while it was at $5.00 in 2012, the results would be identical as in the first scenario, a 50% drop (provided we froze time at this point and didn’t let the remainder of this story play out)…

But what if Speculator C came along in late 2015 and picked up shares of Stock B while it was trading for $0.625? If we map out the final data point, we will see that this speculator will have no better luck than the others, as Stock B will proceed to slump to $0.3125 in 2016, an identical 50% reduction as in the other cases.

Roadmap

So, again, 50% = 50%, right?

Well, not really…

Although in each particular moment when the stock is down 50%, all three speculators will experience the same EXACT pain (assuming the same initial capital investment was made for each specualtor), the final verdict will most likely be vastly different for all parties.

When it comes to speculating, it’s especially important to consider valuations (current, historical, and to a degree projected future).

For instance, what if Stock A was vastly overvalued in 2015? A drop from $10.00 to $5.00 might have simply been a reversion back to the mean… If that is indeed the case, then you can imagine how tough a time Speculator A might have in holding onto the stock; not in hopes of making a profit, but just trying to get back to break even on the investment!

The same logic would apply for Speculator B.

But for Speculator C, the story could be completely different. If a reversion to the mean for Stock B is also $5.00, then being able to pick up shares at $0.625 must be considered a fortunate gift! “An opportunity of a lifetime”, as is often stated… provided the asset being purchased is of high quality and not junk, of course…

Yes, in the short-term, Speculator C experiences no better luck, and also has to stomach the same unpleasant 50% drop, down to $0.3125. In fact, the stock could even decline further and get slashed 50% yet again before it finally recovers!

That’s of course the risk you take with any speculation, but again, that’s why a speculator needs to rely on valuations; it serves as both your roadmap and compass…

How else would you have any idea of where you are, or where you might be headed next?

Coiled Spring

For this speculation to work out, Speculator C might need an iron stomach (and a ton of patience) to get through the volatility, but in the quest for early FI, there really is no better way to turbocharge progress than to speculate on deep value propositions.

In the case of Speculator C, at $0.625, a reversion back to the mean would require an 8x increase just to get back to $5.00.

Deep value investing, or the coiled spring approach, can produce massive total returns, but there are NO guarantees, of course… To execute this strategy successfully, a speculator must choose asset classes (investments) that have a better than reasonable chance of not only returning back to their previous means, but to overshoot to the upside.

What type of investments are we talking about? Well, in 2009-2013, housing was the name of the game… In 2015 (and presumably over the next few years moving forward), it looks like commodities are and will continue to remain in disfavor…

As a freedom fighter, quite frankly, I don’t discriminate… I’ve learned to accept whatever the market hates with great glee.

Don’t look a gift horse in the mouth…

My Thoughts

Currently, my commodities speculations are down about 15%… Now, I have no way of knowing where I currently reside on the Stock B spectrum of discrete values… My own guess would be that I am currently trading at least in the $1.25 range, possibly lower…

$1.25 back to $5.00 represents a 4x jump, or 300% return…

Do I believe we’ll get there?

Yes, in due time… which helps explain how I can accept these “devastating” paper losses in stride.

After all, as outlined above, not all drops are created equally. And as I’ve mentioned before in the past, I like to get into speculations AFTER they’ve already been chopped in half numerous times (similar to Speculator C)…

Falling from a skyscraper can be devastating… but rolling off a mattress (with no bedframe) onto the floor?

That shouldn’t hurt too bad…

 

I hope…

 

Happy Speculating!

{ 9 comments… read them below or add one }

1 BeSmartRichNo Gravatar December 15, 2015 at 12:40 pm

You are exactly right. 50% drops aren’t equal to each other. $1.25 range is a very good time to get in when you think that the value of stock should actually be $5.00. It would be fair to say a lot of mining& precious metals companies are in that range. Hopefully your calculated speculation pays off!

I have purchased some mining and oil companies lately but building up cash now as they are still in downtrend. If they recover quickly then I am already heavily invested so I will be good, if they drop further then I can take advantages of already lower prices with saved cash.

Thanks for sharing!

BSR

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2 FI FighterNo Gravatar December 16, 2015 at 7:07 am

BSR,

Thanks for the support! I like your strategy as well.

Let’s hope it works out for the both of us! 🙂

Cheers!

Reply

3 uncle bobNo Gravatar December 15, 2015 at 12:41 pm

Losing 50% when you know we’re near the bottom is a lot better than losing 50% near the top, when a second, third or fourth 50% loss is still possible. I think ultimately all you can do is evaluate the potential upside vs potential downside at any given moment, and on that meta level your articles and approach are solid.

On a somewhat unrelated note, is it my imagination or does UUUU seem to move in parallel with gold prices?

Reply

4 FI FighterNo Gravatar December 16, 2015 at 7:09 am

Uncle Bob,

Yup, it’s upside potential that we are chasing here.

In regards to UUUU, yeah, I wouldn’t be surprised if it tracked gold on occasion, since in many instances all commodities (gold, silver, copper, uranium, etc.) all go up an down in tandem.

Hopefully, better days are just around the corner.

Take care!

Reply

5 No Nonsense LandlordNo Gravatar December 15, 2015 at 5:10 pm

I have watched stocks of mine fall, fall, and fall again. Then, they may do a 10-1 reverse split. Then, they get pink-sheeted. And sometimes they no longer trade any more.

At least it is a great write-off though.

Be careful. Stocks go down because they are worth less, not because they have value no one sees.

Reply

6 FI FighterNo Gravatar December 16, 2015 at 7:11 am

Eric,

True. But in the case of commodities, right now, EVERY stock in the sector is beaten up and battered…. If it was only a particular stock and not every single one of them, then you would have to tread a bit more carefully…

Many of these companies aren’t broken… the entire sector is just in liquidation so the good stocks are also being hammered.

I see lots of opportunity now and over the next 2-3 years, potentially.

Take care!

Reply

7 SeanNo Gravatar December 15, 2015 at 9:01 pm

Curious you compare housing in 2009 to investor C. Housing was down 30-40%, not the 94% that investor C is facing buying at 62 cents with all time high of $10. I can appreciate what you’re trying to do but it is a far cry to call a 30-40% drop in an asset class that everyone NEEDS to survive to a 94% drop in what you’re referencing junior good mining stocks are at or will see. Do I see potential value? Absolutely. But let’s not compare housing drop of 30% to junior gold mining stock drop of 90%+

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8 FI FighterNo Gravatar December 16, 2015 at 7:14 am

Sean,

No, the point of the article isn’t to compare housing to mining stocks… That’s irrelevant.

Essentially, I am just looking for opportunities that the market makes available to us…

In any case, a 80% or 90% sell off in mining stocks (like today) is somewhat on par with a 50% decline in housing…

With housing, most purchases are made using financing… In the case of Bay Area real estate, prices did come off by about 50%… Through the use of financing, a reversion to the mean produced leveraged returns in excess of 300% for many investors…

Gold mining stocks may very well do the same, unleveraged…

But again, that’s not the point of the article…

Buying deep value that is selling for well below historical means and has potential to produce a ton of alpha, is.

Cheers!

Reply

9 Tax NewsNo Gravatar December 18, 2015 at 12:43 am

Everyone fails.
A 50% drop is 50% drop, and so the 100% and so on.
We take risks, we patiently wait and then we fail.
But after all of the challenges we stand again and thats when success comes,
and thats the best part in being an investor :).

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