The post Speculation with Investing first appeared on ValueInvestingNow.com.
]]>
“You must never delude yourself into thinking you’re investing when you’re speculating” – Benjamin Graham (Father of Value Investing)
There is no distinctive cross-over point between investing and gambling. Both have elements of speculation involved. Speculation refers to ‘Guessing’. To guess, one relies on their gut feeling. What is interesting is that the gut feeling is directly tied to availability of good information and one’s experience gained from speculating in the past. The latter, most folks refer to as ‘An Educated Guess’. Speculating is more commonly inferred with gambling than with investing; but in reality, it exists in both to certain degrees. It is speculation that incorporates risk. In effect, speculation and risk are somewhat synonymous to each other. As you rely more on guessing, the risk factor also increases.
To illustrate, games of chance such as flipping a coin, rolling die or roulette have certain mathematical chances of winning for their respective outcomes. There is really no speculation here because guessing is eliminated by the fact that chance is predetermined; the information is maximum because it is well known what the chances are for the respective outcomes. However, if you step up into a greater level of risk in the gambling zone such as playing Blackjack or Poker, the player has less information input because the information available is based on the cards that have been played or discarded. This information allows the player to evaluate the chances of winning; as such, the player has to add speculation. Risk increases from pure chance games of flipping a coin or dice. With pure chance, the house has an automatic percentage of winning; whereas with the next level of gambling, the house has increased risk of losing because the table players have an opportunity to incorporate speculation and take ‘An Educated Guess’ at the most probably outcome. With greater speculation, comes greater risk.
This is also true with investing. At the extreme with investing is the most conservative investment such as the purchase of a Federal Treasury Note. Similar to the extreme with gambling (games of pure chance), it has a hint of risk involved. The information about the bond is boundless. However, there is a remote possibility the U.S. Government will fail to honor their obligations. But since this minute risk is so negligible, there isn’t any real speculation involved with this highly conservative investment.
In between these two extreme points of the gambling/investment spectrum lie all forms of risks which are often dictated by the level of good information available to the gamer/investor.
Speculating is the act of taking risk in exchange for sizable returns with investing resources. The greater the reliance on speculation, the more likely the increase in the reward. The key is this: the more reliable information available, the less speculation involved. As information dissipates, speculation increases as the gambler/investor must rely more on their ‘Gut Feeling’ than on information available.
Pure speculation does exist. Speculation peaks at around 90% of the decision related to certain types of gambling/investing. At this level, it is pretty much pure speculation with maximum risk involved. The perfect example is a crypto investment. There is very little reliable information about crypto, but it does exist and many folks call this investing. The reality is that it absurd to spend sums of money in hopes that the market price will continue to rise and at some point you exit this particular so-called security (technically, it is not a security). This is about as much ‘Gut Feeling’ as anyone can get related to investing or gambling. The nearest historical similarity is the ‘Great Dutch Tulip Craze‘ from back in the 1630’s. The author DOES NOT endorse readers even considering risking their money with crypto or non-fungical tokens (NFT’s).
This article explores the various levels of speculation with both gambling and investing. The key element is information; is it available and reliable? Both forms of risking money are similar when comparing risk/speculation. However, there is one key difference between the two venues. With gambling, the risk of loss is pure, i.e. one loses all of one’s money put up to get involved. With investing, it is rare to lose of all one’s invested monies. Typically, the investment takes longer to come to fruition or the level of return is diminished due to either unrealistic expectations or market/management factors that lowered the final outcomes.
Finally, the article explores why value investing practically eliminates risk and assures an investor of a reasonably good return because speculation is almost eliminated. Note how it is stated that ‘speculation is almost eliminated’. This is because there will always be some hint of speculation with investing. Just as with government bonds, there are no such investments that ‘GUARANTEE‘ a return.
Speculation with Investing – Gambling/Investing Spectrum
Speculation exists in both gambling and with investing. Many novice investors believe speculation only exists with gambling. This is not true. Speculation refers to guessing. Even with investing, there is some guessing going on. The key is the degree of guessing. To reduce risk, which is one of the primary principles of value investing, the degree of guessing is reduced by only utilizing companies with extensive available information; especially those that report production on a regular basis. As an example, all the Class I railways report their weekly loads hauled. This allows an investor to monitor the trend towards revenue generation and ultimately the expected profitability at quarter’s end.
This graph/depiction below illustrates the various levels of speculation for both gambling and investing. Take note, speculation peaks with with certain types of gambling and with certain types of investments. The absolute worse level is with crypto and NFT’s (non-fungical tokens). With these types of investments/gambling venues, there are no underlying assets, no reliable information and neither pays dividends or even have formal audits to validate their existence.
With gambling, it is known upfront that this risk adventure is for entertainment purposes and is not a legitimate form of methodical investment to grow a portfolio of securities. As gambling begins to shift from pure chance to information based decision making, think of sports betting, the risk/reward relationship begins to take on a new dynamic. In this case, speculating begins to create a greater emphasis and as such, there can be some unusual outcomes. However, these infrequent explosive returns do not constitute investing; they still tend towards gambling than legitimate well thought out risk reward transactions.
Moving along the spectrum towards investing is another form of gambling but it is perceived by many as investing. This involves crypto. Just because something is publicly traded doesn’t make it investing.
As the graphical line moves more towards investing, investment opportunities begin to have good information available. But in many cases, the information is inadequate or unreliable and thus, speculation is required in order to guess at the return. Great examples include new start-ups, penny stocks and day trading. Information exists, but either the method of investing or the information is unreliable; thus, speculation is required.
Moving further down the graph line, speculation begins to dissipate rapidly especially as you move towards highly reliable and more secure forms of securities. The underlying companies are more forthcoming because they are stable and highly reputable operations. Value investors thrive in this zone. Information is plentiful, accurate and reliable. In addition, these companies are run by some of the best and brightest managers available. They rarely disappoint with their financial results. When a value investor buys in this zone, the odds that the investment’s value will decline further or in an extreme downturn is remote. Speculation is practically eliminated.
It is important to note that there is some element of speculation even with good quality investments. The level of speculation is so low with high quality investments, for all intents and purposes it is considered irrelevant with one’s decision model; but, it still exists. It is possible for the company to have a series of setbacks or have an accident which greatly affects value; think of Exxon Valdez oil spill or Enron. Value investors look to eliminate as much risk or speculative element as possible when considering investments. Act on Knowledge.
The post Speculation with Investing first appeared on ValueInvestingNow.com.
]]>The post PUT Options – Leverage Tool for Value Investors first appeared on ValueInvestingNow.com.
]]>
PUT options are an excellent tool to leverage the realized return for a value investment based portfolio of securities. In general, options are very risky financial derivatives and are not recommended for unsophisticated investors. In laymen terms, options are classed as mildly speculative instruments in the world of investing. The key to proper use is to eliminate the risk aspect by only utilizing PUTs in a very restrictive set of circumstances. When properly applying restrictions, PUT options can add between four and ten percent of a value investment fund’s annual realized earnings. This marginal improvement is how a value investment fund outperforms even the best performing index based funds.
This particular lesson lays out how to properly use PUT options to leverage higher the performance of an investment fund. First, options are introduced and why only a particular position with PUT options is utilized. Secondly, a set of highly restrictive conditions are provided that must be followed in order to practically eliminate the risk options carry for traders of such speculative financial instruments. With this knowledge of restrictive conditions required to use PUT options, the next section explains how they are utilized in a value investment fund portfolio. Finally, several examples are presented to assist the reader with proper application along with a set of most likely outcomes from employing PUT options.
As with any sophisticated financial tool, an introduction is required.
PUT Options – Introduction to Options and Their Risk Factors
If you ever watched a sporting event, it is common to see folks involved in ‘Side Bets’. The actual event has it own set of winnings or prestige for whoever triumphs. But spectators often create their own friendly bets with others. Thus, the ‘Side Bets’ have nothing to do with the actual event itself. The best way to describe options is to think of them as ‘Side Bets’.
Options are considered financial derivatives. Basically, they are not a financial security (notes, bonds, convertibles, preferred and common stock) issued by a company. They are outside of a company’s financial makeup. Thus, the connection to the principle of a ‘Side Bet’. However, they are monitored and regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission. In effect, they are regulated and derive their value directly from the financial information provided by the respective companies they are tied to in the market.
With financial securities, the issuing company backs the security by providing different rights or collateral depending on the nature of the security. Naturally, common stock has the least amount of rights or collateral in comparison to secured notes or secured bonds. With common stock, the holder has three key rights.
- First, the holder has a right to their share of dividends.
- Secondly, a shareholder has the right to vote when it comes time to determine board leadership and for certain changes to the charter or policies.
- Finally, a shareholder has the right to sell their security if they want to get out of the financial relationship.
With options, all these rights are nonexistent or highly restricted. Options provide no financial reward from the company; literally, the company doesn’t care about your side bet. Secondly, options provide no rights to vote. As for the third aspect, in some situations you are indeed allowed to sell your option and get out of the financial deal. Typically though, this costs money and unlike securities where the seller receives money, with options, if one wants out of the deal, one has to pay money.
Notice immediately the much higher exposure an options trader places their investment into when dealing with this type of financial instrument. Simply stated, options categorizes one in a much riskier situation in comparison to directly buying and selling issued financial securities. These ‘Side Bets’ can get you into a lot of financial trouble. Thus, CAUTION is warranted. This lesson is designed to teach the reader that only a certain kind of option is utilized with value investing. In addition, this particular kind of option should only be used under highly restrictive conditions. The key is ‘Risk Reduction’.
With this mindset of caution, it is time to introduce the two types of options (CALLs and PUTs) and their respective purposes.
Introduction to Options
CALL Options – this particular side bet is designed to give a buyer a right to purchase a particular stock at a preset price (strike price) no matter what the market price is for the respective stock. It is designed to allow the buyer (holder of the CALL contract) to purchase from the seller of the CALL the stock. Realistically this would only occur when the market price of the stock suddenly jumps much higher than the strike price. The owner of the call, i.e. the buyer, would naturally elect to exercise this right and purchase the stock for the agreed upon strike price. In turn, they would sell the stock at the current higher market price and pocket the difference as profit. The seller of the CALL, this so called side bet, is gambling that the current and future market price will stay the same or go down and as such will have cash earned from the sale of this call option as additional margin while holding this stock. Take note of the risk involved with the two respective positions of the buyer and seller:
Buyer – Pays a sum of money for a RIGHT to buy this stock at a preset price (strike price) before a certain date (expiration date) from the seller of this CALL. The seller typically owns the particular stock but doesn’t have to own, they must be willing to buy it at the current market price and sell it to the buyer at the strike price if the buyer exercises the CALL. For the buyer, the risk is that the market price will not surpass the strike price by the expiration date. If the market price does not increase, the buyer’s financial risk is the premium they paid for this right.
Seller – Sells a right to someone to buy a certain stock from the seller at a certain strike price in the future but before an expiration date. For the seller of this CALL, they firmly believe that the market price will not reach this strike price by the expiration date. The seller’s risk is that the market price for this particular stock soars past the CALL’s strike price and they are forced to sell the stock at the strike price to the current owner (buyer) of the CALL.
Example – Seller (‘S’) owns 100 shares of Coca-Cola stock. The current market price is $62 per share. ‘S’ firmly believes that Coke’s market price will dip or stay at or lower than the current market price for the next three months. ‘S’ sells a CALL option (contract) to anyone for a strike price of $68 per share on Coke for $3 per share, i.e. 100 shares at $3 each or $300. The strike price is $68 per share and the expiration date is three months out. A Buyer (‘B’) firmly believes that Coke will hit $74 per share within three months. ‘B’ pays $300 to have a right to buy Coke at $68 per share and is willing to wait the three months to see what unfolds. During this three month period, Coke’s share price fluctuates from $59 per share to as high as $66 per share. There are now two weeks remaining to the expiration date. This CALL option has dropped in value to 50 cents per share and the current market price is $66 per share. ‘B’ can continue to wait it out or elect to sell this contract for $50 (100 shares at 50 cents each) and just end up losing $250 in total. ‘B’ elects to get out of the option contract and proceeds to sell it for $50 (50 cents/share). The new buyer (‘B2’) now has a contract with the original seller with two weeks remaining. Suddenly the market price for Coke soars to $77 in less than three days. ‘B2’ knows a good thing when it happens and proceeds to exercise the option and purchases from the seller 100 shares of Coke for $6,800 (100 shares at $68/each). ‘B2’s total investment into Coke is $6,850 ($6,800 paid for the stock and $50 for the option). The current market price is $7,700; ‘B2’ immediately sells the 100 shares of Coke and realizes an $850 profit from the overall deal. ‘S’ did earn $6,800 from the sale of shares of Coke and also earned $300 from the sale of the CALL option for a total amount of $7,100. ‘B’ lost $250. ‘B’ took a risk and lost some money, ‘S’ also took some risk associated with the difference between $7,100 and the final market price of $7,700. ‘S’ lost out on $600 had they waited it out. However, ‘S’ is risk averse and preferred to get their $6,800 plus a $300 premium for selling the CALL option.
The graph below depicts the overall financial relationship for the two parties. The strike price is the core ‘win’ or ‘lose’ crossover point. On the left of this crossover point of the market price, the seller of the CALL wins the bet outright as long as the market price does not crossover the strike price point. The area between the strike price and where the net payoff line cross at the market price point is the ‘marginal’ exchange range. Using the example above, this is that $3 range between the strike price of $68 and the value the seller earns of a marginal $3 ($71 market price for the stock). If the buyer exercises the CALL option when the market price is $69.25, the seller earns $68 for the sale of the stock plus $3 for the sale of the CALL. In this $3 zone, the seller is technically the winner of the ‘side bet’. As the market price transitions past $69.50 per share, the buyer of the CALL now begins to gain a better overall financial situation, the buyer is still paying more overall in this transition zone as the total cost of $71 still exceeds the market price value. But once that market price exceeds $71 per share, the buyer of the CALL is in a superior financial position and is now winning the bet.
One final pertinent part of this overall situation. The exercising of the option only occurs if the buyer is going to sell the security to a third party to reap the reward between their cost of $71 (the price paid for the stock and the option). It is rare for the buyer to exercise the option and then just hold the security. They can do this, especially if there is some significant dividend announcement during this time frame. While the market price is in that ‘marginal’ zone, the buyer’s risk is elevated as it becomes difficult to decide the best course of action; does the buyer wait or act? This is where adequate information as to what is happening not only in the market, but within the industry and at the company level comes into play. In most cases, unless there is a sudden dramatic price increase in the securities market price, buyers opt to wait it out. Time benefits them. As the price transitions through this ‘marginal’ zone, if the expiration date is not close, waiting is prudent. After all, this is what the buyer desired when paying for this option.
“Option Pricing Theory and Models” – Chapter 5
Neither ‘B’ nor ‘B2’ are obligated to buy the shares from ‘S’; the option contract is a RIGHT to buy them. ‘B’ or ‘B2’ could at any time, no matter what the market price is, elect to buy the shares at $68 each. Even if the market price is $66 per share, the buyer can elect to buy the stock right then. Of course, a prudent money manager would not do that; but, they still own the right.
The one party at most risk of financial loss is of course the seller of the CALL option. They may be force to sell that stock and lose out on all that upper market price range (the area exceeding $71 per share in value in the graph above). Thus, sellers of CALLs risk significant POTENTIAL reward if market price jumps. In effect, a seller is exchanging potential high reward for a more secure financial position, in this case $68 per share. Both buyers, ‘B’ and ‘B2’, risked the market price decreasing and as such only risked their investment into the option contract; i.e. their maximum financial risk is the amount paid to buy the CALL. Think of it this way, they are leveraging their bet with a little money that the particular stock will suddenly soar in value (win the game and hopefully win big) and get a high return on their overall small investment. Remember, they will have to put out money to buy the shares; but immediately, they would turn around and resell those shares at this current high market price.
PUT Options – With CALL options, the primary driver of value is the overall belief in the market price increasing for the underlying security. The price of a call goes up as market price for the underlying security goes up. This is the opposite for PUT options. PUT values are driven by a decreasing market value.
With PUT options, the typical buyer already owns the stock and is fearful the stock’s market price will decline over time and therefore wants to force another party to buy this stock from them at some floor value; a value they are willing to tolerate. This strike price guarantees the holder of the PUT a minimum market price in case of a sudden or slow market decline for the respective stock. For the seller of a PUT option contract, they firmly believe the market price is currently stable or will recover for the respective stock and as such are gambling that the buyer of the PUT will not exercise the contract and force the seller of the PUT to purchase the stock from the buyer (current contract holder). Review the positions and thought process of the two respective bettors:
Buyer – Owns stock in a particular company and wishes to eliminate their downside risk; i.e. the stock’s market price will drop dramatically or slowly decline over an extended period of time. As such, the buyer of a PUT option contract is willing to pay some kind of premium to minimize their respective potential losses. The closest comparable financial instrument is insurance. With insurance, the asset owner (auto or home as an example) fear that the value will suddenly drop due to some unforeseen accident and as such is willing to pay for insurance to protect that potential value loss. With a financial security, the asset owner is buying a PUT option, a form of insurance, to protect against a sudden or extended market price decline for the asset they own. Note that with typical insurance, insurance protects against acts of God or acts of physical mistakes (auto accidents). Insurance does not protect against declines in market value for a home or auto. PUT options are designed to act as insurance against value decline for the underlying security instrument.
Seller – Firmly believes the market price for a particular security will not decrease but either stabilize or improve over time and is willing to sell an option in order to earn some money. The seller sets the strike price well below intrinsic value of the underlying security involved. This reduces the chance the particular security will continue to decline in value over time. As an example, look at this pricing structure for a PUT option on The Walt Disney Company. The intrinsic value is estimated at $116 per share, the current market price is at $100 per share; thus, the market price is already 14% less than intrinsic value. The chances the share price for The Walt Disney Company continues decreasing are remote. Naturally, there is a greater chance it will decrease to $95 per share than to $90 per share. Thus, the price for a PUT option is more expensive at $95 per share due to the risk it will be exercised at $95 than $90 per share.
Notice how even at $60 per share strike price with a three month expiration date, there is some interest (161 buyers have indicated a desire to buy a contract) to buy a PUT option in the market. These buyers have indicated that they are willing to pay 32 cents per share to have insurance that their Disney stock could be sold to someone if that market price goes below $60 per share. The key to this chart is that there is less and less risk of Disney’s share price continuing to drop further and further as first, the open interest in insurance wanes and the price buyers are willing to pay drops dramatically too.
Example – Seller (‘S’) is convinced Disney has hit rock bottom in market price due to several underlying reasons. First, it is a rock solid company and is traded as a DOW Industrials member. Secondly, the company’s revenue and net profits are significant and have improved over the last three years. Third, the real driver of this current decline is the overall mindset in the market which is experiencing declines. ‘S’ is highly confident that the market price will not dip below $90 per share and as such is willing to sell a PUT option contract for 100 shares at $4 per share or $400 for the entire contract. There are currently 2,486 buyers interested in purchasing a contract to force the seller to buy Disney at $90 per share. One of them enters into this arrangement. The buyer (‘B’) purchases from ‘S’ this PUT option. The strike price is $90 per share with an expiration date of 09/16/2022.
Over the next month, Disney’s stock price waivers, ebbing and flowing, and begins to creep back up towards $110 per share. In late July, Disney releases their financial results and to everyone’s surprise they didn’t perform as well as they predicted. The market price dips to $89 per share. At this point, ‘B’ has the right to force ‘S’ to buy the stock from ‘B’. ‘B’ decides to wait a little longer, after all, ‘B’ has until September 16th to force the ‘S’ to oblige the terms of the contract. ‘S’ isn’t nervous yet because ‘S’ is convinced this is a temporary setback. In early August, Disney releases a new Pixar movie and it becomes the number one summer hit and earns more than $200 Million in one weekend. On Monday morning, Disney’s stock price improves due to this batch of good news and goes back up to $95 per share. The price continues to improve as more good news comes out of Disney’s information center that their subscriptions to the their Disney+ channel are exceeding their expectations. The price of Disney’s stock soars to $112 per share and never looks back as the expiration date finally expires. ‘S’ did indeed earn $400 and was only truly at risk for a few days. ‘B’ paid $400 to protect his investment in Disney and at one point could have forced ‘S’ to buy the stock from ‘B’.
Take note of the financial relationship with PUT options. The seller’s risk only exists if the market price goes below the strike price. Even then, that risk doesn’t actually exist until the market price drops below the strike price less the sales price of the PUT option. In the above example, ‘S’ isn’t really at risk until the price drops below $86 per share. At that point, if ‘B’ exercises the option, ‘S’ has to pay $90 per share and own Disney. Thus, the total amount out of pocket for ‘S’ is $86 per share ($90 per share paid to own the stock less $4 per share for the option sold). If the market price continues to slide further lower, ‘S’ will experience an unrealized loss for the difference. This is important, ‘S’ has yet to realize an actual loss because in order to realize an actual loss, ‘S’ would have to sell the stock at a price lower than ‘S’s basis which is currently $86 per share. ‘S’ can simply wait it out and hope the market price will recover in a short period of time.
This is an important aspect as a seller of PUT options. As a seller you only realize losses IF you sell the stock you were forced to buy at a price lower than the net realized basis in your investment ($86 in the above example). Look at this graphical depiction to help clear up this viewpoint:
Payoff on a PUT Option
The risk for the buyer is the area to the right of the Strike Price. As for the seller, the risk factor starts when the market price for the security is less than the Strike Price. As the market price crosses over the net realized value (strike price less the value derived from the sale of the PUT – $86 from the above example), the seller’s risk begins to increase financially from zero to the difference between the net realized amount (strike price less sale’s price of PUT options) and the current market price because the current owner of the option may force the ‘S’ to buy the shares at the Strike Price. The further the decline in market price, the more likely the buyer of the option will exercise the agreement and force the seller to pay the strike price.
Remember, the buyer has until the expiration date to force the hand of the seller. It is possible and often common for the market price to dip well below the strike price and the buyer continues to wait it out. The buyer has time on their side in this set of conditions. Their risk of financial loss is practically zero in this situation and often they will just wait to see what happens.
Options and Respective Risk Factors
Both types of options are technically side bets in the market. However, unlike a traditional side bet which utilizes a strong position of speculation due to limited information, options are directly relatable to the underlying asset, i.e. the company in question. Therefore, the speculation element in the decision matrix will match the speculation spectrum of the company under review. Thus, options on large caps and DOW companies are less speculative than options tied to small caps or start-ups. The general consensus among unsophisticated investors is that options are highly speculative and therefore dramatically riskier.
In general, options are riskier due to the fact that the buyer and seller are not trading an actual security. This by itself moves this particular financial instrument into a riskier territory of investments. But, the risk factor for this aspect is tied more to the required knowledge to understand the forces that drive an options current market price. Not only must an investor understand the underlying securities financial matrix, the investor must also incorporate the forces that move an option’s market price. An investor must be more sophisticated with these forces of deriving value.
In addition, each of the four possible option positions have their own distinct risk factors. With CALL options, a buyer’s financial risk is strictly limited to the cost paid to purchase the CALL. In most cases, the price of the underlying stock doesn’t soar above the strike price and therefore the buyer only loses out on the cash paid to buy the CALL. The seller of the call carries a greater financial risk in that if the stock’s price does suddenly soar in value, the seller can’t reap those dramatic gains. They are limited to the strike price for the particular stock investment. PUT options also have distinct risk factors for each of two positions. Seller’s are at the most risk because the price could keep falling and of course they will have to pay the strike price for stock that the market now deems dramatically less in value. Buyers of PUT options only risk the initial premium paid to own the right to force the seller of the PUT to buy the stock from them.
Thus, both sellers of CALL options and PUT options are at the greatest risk with their respective options. But of course, this makes sense; after all, they are also earning some money from the sale of the respective option and as such should have the greatest exposure to risk.
PUT Options – Value Investing Risk Factors
A value investor’s mantra is tied directly to the business tenet of ‘buy low, sell high’. This tenet is focused on four key principles of exercising risk reduction, understanding intrinsic value, conducting financial analysis to sell high, and having patience to allow time to achieve both aspects of buying low and selling high. The primary key driver of realizing good returns with any investment is the ability to buy low. When a value investor determines intrinsic value and then sets a buy price that creates a strong margin of security such as 15% or more, buying low creates tremendous wealth as time will drive the value of the security higher. The key is to buy well below intrinsic value.
Only as a seller of PUT options can a value investor realize earnings and gain an additional opportunity to buy low. However, this should only be done under the following restrictive conditions:
- The particular PUT option is sold tied to one of the opportunities within a Value Investment Fund portfolio. In effect, this particular investment complies with the risk reduction tools commonly used as criteria for investment opportunities:
- A top 2,000 company;
- Company must be financially stable;
- Company demonstrates good growth beyond inflationary growth.
- The option pricing structure has marginal decreases for significant step downs in strike price points.
- The underlying company is not currently involved in an intensive stock buyback program.
These restrictive conditions mimic the criteria customarily used with purchasing traditional stock in a value investment portfolio. However, there are couple additional restrictions involved:
Pricing Structure Has Marginal Decreases for Significant Step Down in Strike Price Points
This restrictive condition refers to the marginal loss of revenue from the sale of an option for a decrease in strike price point. Here is that same chart for Disney’s PUT options from above:
Notice the price for a PUT option is $5.60 for a marginal change in the market price of the stock from $99.40 to $95.00 or $4.40. However, the next $5.00 of market price reduction only costs the seller of the PUT a mere $1.60. To go from $95 to $85 strike price, the marginal reduction in the PUT option price dropped $2.86 (from $5.60 to $2.74). Thus, an additional $5.00 of savings from $90 to $85 only cost the Seller another $1.26. The first additional $5 of savings costs $1.60, the next $5.00 of protection costs $1.26; from there it continues.
This pattern is common with all PUT options for their sales price. Each incremental price reduction costs less and less in terms of the sales price reduction for the option.
For value investors, the secret is to find significant strike price reductions for a very low overall decrease in the PUT option’s price. As an example, look at this schedule for Norfolk Southern Corporation, one of the five publicly traded Class I Railways in North America. Its current intrinsic value is approximately $197 per share. A value investor could achieve a margin of safety of 15% by selling a PUT option at $165 strike price for $2.75 each. Thus, 100 shares PUT option contract will earn the value investor $275 and an opportunity to own a high quality company paying $5 per year in dividends, earning more than $11 per year on average over the last five years AND is tracking for $12 of earnings in 2022. The current market price is $220 per share.
At $165 per share, there is a 16.25 % margin of safety over intrinsic value, a $64 margin of safety from the current market value ($229/Share) which exists in a depressed market (Norfolk Southern was trading at a peak of $299 a mere six months ago).
The primary key point here is to notice two distinctly different value points. A seller could sell the option at $175 strike price which is $5 lower and make 10 cents more per share! For a marginal reduction of 65 cents per share ($3.40 to $2.75), a value investor can acquire an additional $15 of safety margin. What is really more important is that a typical ‘BUY’ point for Norfolk Southern is only 9% safety margin. Thus, this sites’ Railroad’s Pool has Norfolk Southern as a ‘BUY’ at $180 per share!
Imagine the value acquired if a value investor could own this company at $165 per share? It is $15 lower than the set ‘BUY’ price and at $165, the margin of safety far exceeds the required amount. The likelihood of Norfolk Southern’s market price dropping to $165 per share is so remote that this type of opportunity is simply unheard of with investing. Again, the key is the marginal cost (reduction in the form of PUT option sell price) for dramatic strike price changes; this is what a value investor seeks as a risk reduction tool for PUT options.
What a value investor desires with PUT options is a good return with as little risk as possible. If a value investor is forced to buy the security, at least it is purchased at LESS THAN what is determined to be the preset ‘BUY’ point for that security. This just adds additional protection against further security market price reductions.
Who wouldn’t want to own a top 2,000 company with a 3% dividend yield ($5/YR on a purchase price of $165/Share) earning more than $11 per year with a prior peak market price of $299 per share? This is a solid company.
No Intensive Stock Buy-Back Program
The third restrictive condition for risk reduction with PUT options is the underlying company’s stock buy-back program. Stock buy back programs typical work against intrinsic value determination. Intrinsic value determines the in-house value of the company. Think of it as the value that would exist in the equity section of the balance sheet and would equal the book value of the company’s stock. If a company participates in a buy back program and pays more per share to buy stock back off the market (Treasury Stock), the company is literally taking existing book value from the remaining shares and giving it away to those whose shares are being purchased. It is an intrinsic value killer. Rarely do highly stable companies trade in the market for less than intrinsic value. Think about it for a moment, this is why value investors set intrinsic value in order to determine the real worth of the stock. Value investors are not in the business of buying securities for more than they are worth.
If a company has a stock buy back program and the company is one of these highly stable operations and included in the value investment portfolio, it means that the intrinsic value is going to go down depending on how much value is shifting out of the company to buy back the stock. Most treasury stock programs are small and a company is trying to buy back two to four percent of the whole portfolio of outstanding shares in a three year period. At this level of a buy-back program, the reduction in intrinsic value is relatively low (maybe a net effect of seven to nine percent overall reduction), but it still affects the calculation related to PUT options due to the leveraging concept. Thus, look for programs whereby the stock buy-back is less than two percent of the total outstanding number of shares. If greater, the value investor must look at the impact over the period to the expiration date; how much value will shift out of the company during this time frame?
Continuing with the example above, Norfolk Southern’s buy-back program allows for the repurchase of up to 6 million shares by December 31, 2022 including the six months remaining. The current number of shares outstanding as of March 31, 2022 is 238 Million; thus if all 6 million shares are repurchased as treasury stock, the company’s intrinsic value would thin down approximately 2.6% assuming share are repurchased at more than $220 per share. This means, intrinsic value COULD decrease to $192 per share by December 31, 2022 which covers the open period of this option. In effect, Norfolk Southern’s stock buy-back program (repurchase program) should not impact the decision model related to selling the PUT options with a strike price of $165 per share.
As long as a value investor adheres to the three required restrictions for selling PUT options, the risk factors tied to PUT options can be dramatically reduced or eliminated. The other three remaining positions do not have this ability to utilize restrictions to reduce this risk and in general, are counter intuitive to what value investor is about. With this information, how can a value investor properly apply a system of utilizing PUT options to increase a portfolio’s annual return?
PUT Options – Proper Application in a Value Investment Portfolio
The post PUT Options – Leverage Tool for Value Investors first appeared on ValueInvestingNow.com.
]]>The post Vertical Integration in Business first appeared on ValueInvestingNow.com.
]]>Vertical integration in business refers to the process of gaining control over more steps of the product production stream. Whenever a business obtains or can greatly influence any one of these steps along the process of producing and selling a product, it is referred to as vertical integration.
Many of the Fortune 500 companies utilize this business technique to increase profitability and control the market for their products. A good example is Apple Corporation. Apple manages many of its manufacturing plants, controls the distribution system and owns many of its retail outlets. Furthermore, Apple creates its own software for its products.
Why would a company do this? Well, the primary reason is typically profit driven. By owning each of the steps, the profit generated in each step under the traditional process is retained with the company. Secondly, by controlling the entire stream from raw resources to the final sale of the product, the company can ensure the proper quality and volume of the end product for sale to the consumer.
To fully understand vertical integration, I’ll explain the term in more detail and provide some modern day illustrations of its use. From there, I’ll explain how the volume issue restricts vertical integration in small business and how it should be applied. Finally, there are risks involved in becoming vertically integrated and as a small business entrepreneur; you need to understand these risks and their respective impact in your business.
Business Definition and Illustrations
In the world of business, the production process is analogous to a water stream. The underground spring or the snow melt is referred to as the raw resources and the stream flows downward to the river. The final few yards of the stream is the final sale of the product to the end user. At any point in the stream you can look upstream back towards the beginning or the raw resources or downstream towards the final disposition of the product to the consumer. When exercising vertical integration, any involvement from any point in the stream going upstream (backwards towards the raw resources) is often referred to as ‘backwards’ integration or ‘upstream’ integration. If you are going to control or own parts of the stream headed towards the consumer, this is referred to as ‘forward’ integration or ‘downstream’ integration. Remember these four terms (backwards, upstream or forward, downstream) as they are often used in conversation.
Vertical integration is the process of incorporating any one of the steps along the stream of production and sale to the consumer. If you owned a chain of retail outlets for any product or line of products and decide to invest or control the raw materials generation and skip over the production part, you are still backwards integrating. You do not necessarily have to purchase or control the prior step or the next downstream step in order to qualify as vertical integration. The key is that when a business tries to control either through purchasing or negotiating contractual relationships any step along the stream of production, it is vertically integrating its business.
Remember, there are two main reasons or justifications to vertically integrate. The first is profit driven and the second is control. The following sections explain these two main motives to vertically integrate.
Vertical Integration – Profit Driven
If you own a business, you often get the feeling that the vendor or supplier is making some good money off of you. You may purchase hundreds of a particular part or item and you just get the sense that the vendor does well from your book of business. You feel that if you could own that supplier or that step, you could make money off of yourself. This is the primary motive for vertical integration. But just how much profit is there? Well, to understand this, let’s work a simple example.
You own a toy store. Your biggest selling item is a model building kit of a car. You sell this kit to the consumer for $10 and you make a margin of $5. This means you are buying the kit from the manufacturer for $5. Now the manufacturer makes a profit too. It just so happens that his margin in manufacturing that kit is $1.25. But the manufacturer buys two materials to make the kit. The major material is the resin for the mold and the second material is the box purchased from the printer. The resin is made by a huge world-wide corporation that produces resins for all forms of plastic manufacturing. We don’t really know how much profit the resin supplier makes. However, the printer sells the box to the manufacturer for 29 cents each. Their margin on the box is 13 cents. But they only imprint an image on the cardboard. They purchase this cardboard from a paper mill for 9 cents each. The paper mill has a margin of 3 cents for each cardboard box sold. They pay 3 cents to a company for the wood pulp. We have no clue how much the margin is for the wood pulp, but for this illustration, let’s just say a penny. If you owned the entire process, that is full vertical integration, how much margin is there in that one kit? Let’s add it up.
-
- Wood Pulp – $.01
- Paper Mill – .03
- Printer – .13
- Resin Maker – Unknown
- Kit Manufacturer – 1.25
- Toy Store – 5.00
Total Margin $6.42
Out of the $10, $6.42 is the margin for all of the steps along the stream of production. This doesn’t include the amount the resin supplier makes either. From a business perspective, you can see why any party along the production process would like to control the entire stream.
Vertical Integration – Control
I can’t count the number of times I have been disappointed by the quality or quantity of the items I have purchased in my lifetime. Every one of us has felt this way. Well imagine owning a business and your suppliers are either late with deliveries or sell you a lower quality part or service. If only you could control that situation so you could have the type of service or level of quality/quantity desired? Vertical integration addresses this secondary driving force of business operation. Let’s continue with the toy store example from above.
As the clerk in the store, your customers make comments and one of the comments is that the model kit is designed for teenagers and adults. They explain that if you added part numbers to the different pieces and had a set of easy to read directions you could expand the market to include kids from ages 8 up. Wow, what a great idea. But the kit manufacturing will not do it because they feel it isn’t justifiable. Well, you could just own the manufacturer and then make the change. You now get the product you desire because this is what the customer wants.
The control aspect of vertical integration isn’t just about making sure you get the product you want, it is includes:
- Quantity or Volume
- Quality of Materials or Construction
- Gain Market Share to Reduce Supply to Competition
- Re-engineer the Product Faster to meet Changing Demand
- Change the Flow (Speed) of Production
The key here is that as a business in one of the steps in the production stream gaining control whether upstream or downstream reduces risk for your business.
This all seems simple enough, but let’s remember, this really is easier in much larger production runs. This is because of the economy of scale involved. The example with the toy store is unrealistic. The cost and knowledge required is prohibitive. However, for well capitalized companies with significant market share they can manage the production stream with greater ease. The top four in the world are:
- Apple
- Proctor and Gamble
- Cisco
- Walmart
How do they do it? Let’s look at some examples:
Walmart – all of the large grocery chains use their own private label as a competitive product on the store shelf. Walmart uses the ‘Great Value’ brand as its private label. In the home entertainment industry, Walmart purchased VUDU, an on-line movie streaming company back in 2010.
Proctor and Gamble – when P&G started out in the late 1800’s they had one plant in the U.S. Located in Cincinnati, P&G expanded to Kansas City and to New York. In addition it starting the corporate philosophy of vertical integration in 1901 forming a company called Buckeye which produced cottonseed oil. In those days, cottonseed oil was essential in making soap. In 1903 P&G purchased Schultz & Company out of Ohio to begin its entry into the laundry soap powder business (this example is more in line with horizontal integration discussed in a different article).
Coca-Cola – Coke started out in 1886 in a single pharmacy in Georgia. A good day was 10 servings sold. Today, Coca-Cola has over 500 different brands and serves 1.7 Billion drinks per day. To cut out the middle man, Coca-Cola purchased the independent bottlers that controlled local markets throughout the United States.
The value with vertical integration is actually the economy of scale involved. Do you think a small soft drink retailer can purchase a manufacturing plant to sole source its preferred brand? Very unlikely, so volume is essential to vertical integration’s success. If this is true, how can small business vertically integrate? Well, it may not be simple, but it is doable. The next section explains how to apply vertical integration in small business.
Application in Small Business
In small business, economy of scale does exist, but you should only go after an economy of scale that mirrors your business. Suppose you are a licensed mechanical contractor. You install heating and A/C systems in new construction and as a service company. The only brand of systems you work with is Trane. Now you are interested in getting vertical in your business. Well, I can assure you that you cannot buy the Trane Corporation. Trane is a subsidiary of Ingersoll Rand, a publicly traded corporation on the New York Stock Exchange.
I know, DARN! Well so much for vertical integration. Well, not so fast. There are other aspects of your business that can allow you to go vertical. In addition to installing the units, you install the ductwork in the houses. Currently you farm out the assembly of the metal work to a local metal fabricator. He basically purchases sheets of tin and uses a bender (a large table with a huge bar and straight edge for leverage in bending aluminum and tin) to form your duct work in accordance with your measurements. In addition, he has a guy that brazes the joints together and VOILA, you have ductwork.
Now we have opportunity. This part is doable. How else can we expand the vertical integration? Well, let’s look at the customer end of the situation. Is the sale the end of the relationship? Actually no, often the customer needs someone to come out twice a year and conduct routine maintenance. Why not you? Remember the term ‘Forward Integration’? After all, you installed the system; why pass off the profits related to service and maintenance.
A great tool to capture this market is identified in my article: Inventory Management – Specific Identification Method.
There are still other avenues for vertical integration. Let’s assume that you now run 20 crews in your mechanical company and purchase over a $1 million per year in copper tubing from a local metal supplier. Now it is time to research the possibility of buying directly from the manufacturer of copper tubing. You are effectively knocking out the distributor (intermediary).
In a real life example that I was a part of occurred with a residential contractor. He was building more than 13 homes per year and kept a brick layer busy pretty much 50% of the time. The brick mason was exhausted by having to not only run the jobs but having to go out and do marketing, managing the financials, and having the financial depth to pay all the various bills. The contractor created a partnership relationship with the brick mason and brought the entire crew into the company. He then went to a few of his closet fellow contractors and farmed out the brick mason to them to fill the down time periods.
Notice how the contractor is using ‘Upstream Integration’ to gain control over the brick mason and bring those profits in house?
To apply vertical integration in small business, don’t leverage the economy of scale too much. If that brick mason was only used by the contractor 20% of the time, I believe the contractor would over extend his reach because it will be difficult to find work for the open 80% time frame. As the provider of goods or services to your company he has more and more of his capacity of operations consumed by you, the greater the likelihood of success in integrating his operation with yours.
I’ve seen in other businesses too. Farmer markets will often control the sources of the vegetables or fruit by growing the produce themselves. In one case that I witnessed, the stand sold baked fruit desert pies. When the volume had reached several dozen per day, the owner decided to control the quality and quantity by baking them in one of his customer’s restaurants. To compliment this, he used his own fruit from the stand!
Vertical integration is possible in small business, but you need to think it through. The best way is to write it down and identify the possible positive attributes and the drawbacks. Clearly document how this can go wrong. There are a lot of issues related to the various risks involved and finally there are economic concerns to address too.
Issues Related to Risk and Economics
There are several risks involved when a business vertically integrates. The highest risk factor relates directly to the primary reason to integrate. When a business expands its scope along the production stream it also increases its reliance on the particular product. Any change in consumer purchasing habits affects all stages of production from start to finish. If your business owns several of these stages, each stage is impacted in a similar fashion. When you leverage the profitability, you also leverage the risk associated with earning a profit.
This is a critical risk factor. Let’s go back to my contractor example. If the sales of new homes go down 20%, the workload for the brick mason also goes down. It is actually worse, because half of the time the brick mason is farmed out, this means that the other contractors are probably feeling the same pain. Therefore, the workload from these sources decreased 20% too. In effect, the leverage aspect works both ways.
In large scale integration, the risk associated with the lack of knowledge about the particular nuances associated with one of the stages is not as big of a problem. For large companies, they can easily hire the right people or even better people to solve the problem. But in small business, this is not as easily done as someone may believe. For example, I used the mechanical contractor bringing the ductwork fabrication in house. Well, one of the skills needed is someone to braze the parts together. It isn’t like there are 50 people available in the market that have this skill. And those with this skill are usually already employed and doing well. There is no incentive for the better welders to come work for this mechanical contractor. Often, when a small business takes these steps the management team fails to recognize the business dynamics involved with expansion. Sometimes so much focus is aimed at the new segment; the primary business purpose falters.
So, do you or don’t you vertically integrate? The best answer is if you have the financial resources (the economic power) and the appropriate economy of scale, it can be considered. However, there are other tools available to the small business owner to exercise that will create a similar outcome. These include forming partnerships with your suppliers, generating contractual arrangements that are enforceable and many other tools.
This article introduces the reader to the term ‘Vertical Integration’ and how it works in small business. If used and implemented with proper financial backing and an appropriate economy of scale, a business can vertically integrate with successful results. Act on Knowledge.
The post Vertical Integration in Business first appeared on ValueInvestingNow.com.
]]>The post Economic Bubble – The Great Dutch Tulip Craze first appeared on ValueInvestingNow.com.
]]>Universally accepted as the first economic bubble, the Great Dutch Tulip Craze, also known as Tulipmania, of the late 1620’s to February 1637 serves as a reminder to all of us involved in business, that value can be driven by greed and not intrinsic worth. During this time period, a tulip bulb rose in price from 60 times its original value to over 150 times the original price. Think of this in terms of the modern era; imagine buying a stock and selling this stock within a year for over 100 times what you paid for that share of stock.
To understand the first economic bubble burst, I’ll explain a little history leading up to the expansion of the tulip price. From there a new financial term will be introduced and explained – Futures. Then we’ll look at continuation of the story and how new players or buyers got involved, driving the price up further. At this point I’ll discuss the importance of having knowledge of the situation is superior to having financial resources. The last step in any bubble is the ‘POP’ element. What actually burst the bubble? The last section will describe how this compares to some modern day business operations such as real estate flippers and even the popular TV series about buying storage units.
Prelude
An economic bubble is defined by Robert J. Schiller as “a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value”. This statement is coined in his book Irrational Exuberance. Interestingly enough, the phrase ‘irrational exuberance’ was a reference made by Alan Greenspan in a speech back in December 1996. Mr. Greenspan’s statement was “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions …”. As you read this story, refer back to the above two comments and you’ll begin to understand the concept of an economic bubble.
Although the Dutch Tulip Craze is considered the first economic bubble, it was not widespread as to affect millions of people. It was rather localized to many towns within Holland. The reason was the rest of Europe had not taken a liking to the tulip. Most Europeans at that time did not see the value because the tulip offered no fragrance like the rose nor lasted for an extended period of time once the flower bloomed.
History
Tulips were introduced to Europe from Turkey in the mid 1500’s. They began to gain popularity over time and grew well in the climate and soil in the Netherlands and Germany. A typical bulb has a life expectancy of 8 – 12 years and produce offshoots from the bulb after about 3 years of growth. The offshoots are cut from the bulb and replanted to start a new plant. Unbeknownst to the growers, the tulips experienced a viral infection causing the plant to produce multicolored flowers. These bright differences generated a strong desire within the elite society to own them. The price of the bulbs began to increase in the late 1620’s. This is similar in nature to a novice good becoming a luxury item.
As the price started going up, more and more folks began to grow and covet the rarer colors. The picture on the left is of a rare color combination and this particular pattern is called the Semper-Augustus. Ultimately this particular bulb sold for the highest amount in early 1637.
Due to the risk that a rare color combination bulb would not create a similar pattern in the offshoot bulb, tulip trading remained within the circle of wealthy families. More importantly, these individuals became aware of optimum growing conditions and only traded when the flower was in bloom. However, others desired to get in on the act of owning and trading bulbs. A creative tool was designed to trade the bulb/offshoots throughout the balance of the year – Futures Contract.
Futures Contract
A Futures Contract is simply a document that a seller of a commodity will deliver the commodity at a given date for a set sum. That sum can be paid today or on the day of delivery. Because this is a document, the owner of the contract can sell this financial instrument at any time.
For more information about futures contract please read the following: A Core Definition of a Futures Contract.
Now an owner of a bulb that is in the ground can sell his offshoots or the bulb itself via this futures contract. This satisfied the need to trade throughout the rest of the year. The new owner of the futures contract can sell this contract to someone else. Notice how we are no longer selling the bulb itself, but a piece of ownership rights to the bulb. This is similar to stock, but it is for a physical item in the future. Naturally, as the transactions become more complex, the risk begins to increase significantly.
From the home page of the U.S. Commodity Futures Trading Commission:
APPROACH THE FUTURES MARKETS WITH CAUTION
- Trading commodity futures and options is a volatile, complex and risky venture that is rarely suitable for individual investors or “retail customers”
- Many individuals lose all of their money, and can be required to pay more than they invested initially
History Continued
As the wealthy merchants with the actual product began to sell these futures, others realized that they could get involved and not even own a garden. During this time frame, the Netherlands was experiencing an increase in its overall wealth due to trading overseas. New money and more wealthy individuals became interested in the trading of the bulbs fueling the price increases.
In 1635 and into 1636 many of the towns began to form small groups of traders that would meet at night in the local tavern and begin to trade the contracts like trading stock. Most of the individuals had their own gardens and others became experts by learning from the original owners. Now begins a social group of individuals that begin to correspond and foster the value of owning tulips. This process allowed the middle class to easily trade this commodity pushing the prices even higher.
Prices began to increase and for the rarer types of tulips, the prices really accelerated. Notice the players involved, we have collectors of rare tulips, growers, traders, and now speculators for the tulip.
Knowledge over Financial Resources
While researching the facts for this article, I came across an abstract written by A. Maurits van der Veen an assistant professor of government at William & Mary. He wrote The Dutch Tulip Mania: The Social Foundations of a Financial Bubble. He writes about a social understanding between the experts and that reliance on each other can allow the price (bubble) to expand. At some point, a third party not within the group bids the price beyond the value level tolerated by the experts. Van der Veen goes on to reference Golub and Jackson’s article in American Economic Journal: Microeconomics, 2, pp. 112-149 whereby “… a small number of “prominent” agents in a social network can distort an entire network’s beliefs about a value, even if they have no greater knowledge about that value and everyone else in that network knows this”.
Those individuals aware of the supply and limited varieties available in that town (the knowledge base) were mindful of the newcomers into the market. With the ease of trading future contracts, the prices began to rise rapidly, especially for the rare types of tulips. By the time February of 1637 came around, the experts began to realize that there is no underlying principle to maintain the price of the bulbs. In effect the ‘investors’ enthusiasm’ maintained and elevated the price of tulips. This irrational exuberance (Alan Greenspan’s phrase) has escalated the price of the asset to the point where the intrinsic value of the asset was no longer the fundamental basis of worth. Those with knowledge of the tulips began to exit the trading and discontinued purchasing contracts. At this point, nobody was willing to bid the price up any further.
Pop Goes the Bubble
There is a story where in December 1636 an auction was held for an orphanage. The master of the home had left bulbs as a part of his estate to benefit the orphanage. The price fetched for the various rare bulbs earned enough to take care of the children for many years to come; just in time too.
In January, rumors began to circulate that this was getting out of hand and some of the more knowledgeable began to depart the market.
In early February 1637, bidders for bulbs failed to show up at an auction. News spread quickly to other towns via the social networks that exist in these groups. Within a week, prices dropped to 1/100th of what the value was a week earlier. The bubble had burst.
Modern Day Economic Bubbles
The most recent economic bubble burst is the crash of the real estate market and the underlying mortgage notes tied to the real estate back in 2007-2008. This particular bubble burst affected millions of Americans and reverberated throughout the financial markets word wide. Another example includes the significant change in the stock market back in late 2000 and early 2001 associated with the inflated value of the dot.com stocks. Technology stocks grew significantly during the late 1990’s and more and more money fed the growth. There are many examples where the price paid for stock was way out of alignment with the intrinsic value associated with the underlying assets of the companies. In effect, the price was fueled by the belief that the dot.coms would continue to expand.
A current example is crypto currency. It is mimicking this pattern to the ‘t’. Within a few years, crypto currency will ‘Pop’. Right now, April/May of 2021, many new players that have no real knowledge or background in this unregulated security are getting involved. This is the same concept of new money fueling its growth.
Notice the same basic business principles were violated in creating the economic bubbles as illustrated with the Dutch Tulip Craze. The concept of “… irrational exuberance has unduly escalated asset values …” in all the above cases. Only those with the fundamental understanding of the true intrinsic value of the asset were able to get through the bubble burst without significant financial losses.
The following lessons should guide the small business entrepreneur in day to day business deals:
- If it is too good to be true, then don’t do the deal.
- Just because a few knowledgeable individuals claim it’s a great product or deal, doesn’t make it so. Ask questions and if the market is in hyperactivity mode dealing with this product or situation, odds are that the price is being driven by the high level of activity and not by intrinsic value it brings. To me, the best example of this is toys at Christmas time or electronic devices/software subscribed to by our youth.
- When individuals without knowledge of the core product or stock get involved, then it is time to exit as novices will drive the price up as what happened in the Dutch Tulip Craze.
Modern Day Business Comparisons
There are numerous examples of modern day business activities employing similar economic bubble comparisons to the tulip craze of Holland. The following are some examples and how they compare:
House Flippers – in every community in the country there are a small band of house flippers. Their respective job is to purchase a foreclosed home, repair/renovate the house, and sell the house at fair market value. They conduct their gathering on the courthouse steps and wait for the sale. Each member of this group is acutely aware of each other’s activities and knowledge.
Compare this to the meetings at the taverns at night for the tulip auctions in the 1630’s? The gatherings comprised holders of the bulbs (in our modern day situation, this is the attorney representing the mortgage holder), those knowledgeable in the industry or buyers/sellers, (the house flippers themselves) and of course novice or new buyers (at the courthouse steps is usually somebody wanting to get into this industry). As the price begins to ratchet up for the property, the house flippers are knowledgeable of not only the going fair market value of the house in the neighborhood but have seen the house and are also aware of the costs of repairs. As the margin for the property begins to decrease, there is a point where the knowledge base stops bidding, just as they did in the tulip craze. Now the novice wants in so bad, he keeps bidding up the house and finally those with the knowledge and experience realize that the bid value exceeds the intrinsic value or fair market value in real estate for this house. The novice ends up owning the property at a much higher price than those with experience are willing to pay. Do you see the similarity to the Dutch Tulip Craze?
I have written an article concerning house flipping and the overall average these flippers make per deal. Read The Financial Truth about Flipping Houses for a better understanding of the financial aspect of flipping houses.
Storage Wars – ever seen this show on TV? Just like the house flippers, these guys come in to purchase those storage units whereby the tenant failed to pay their rent for the unit. The landlord is the supplier in this scenario; the buyers are those that do this for a living. These guys are smart, they have learned over time to pay attention to the details when the door goes up for the respective unit. It is the newcomers that jack up the price for the unit and the regulars leave it well alone knowing that the risk is too great for the price.
In this little microeconomic world, sometimes the more experienced buyers allow the first few units to get high in price and pull the dollars out of the group. Then the bubble pops and the experienced buyers can buy the latter units at a lower price.
Others – there are numerous other examples including auto and horse auctions.
Summary – Economic Bubble
Many underlying factors contribute to economic bubbles and the ultimate ‘POP’. A common social contribution is ‘irrational exuberance’ as coined by Alan Greenspan – investors inflating the value of a product/service or stock with a disregard towards the underlying intrinsic value starts the process. Next, novices see potential for gain and invest more money into the investment and the price begins to accelerate further. Finally, those with the understanding of the product/service or stock realize that this can not continue and sell off their ownership. Finally, less and less buyers are willing to get involved and the ‘POP’ occurs. The bubble bursts and finger pointing begins.
As a value investor, you need to pay attention to the signs of a possible bubble. Remember bubbles may be limited in nature or span across the entire economy. Depending on the nature and scope of the product/service or stock will determine the effects from the ‘POP’. Act on Knowledge.
The post Economic Bubble – The Great Dutch Tulip Craze first appeared on ValueInvestingNow.com.
]]>