Out of the millions of people who invest, only 2,600 have watched this video.
Out of the 2,600 who have watched this video, I bet less than 10% (260 people) will apply this technique.
Here’s the video that you can’t miss.
Investor Arnold Van Den Berg (Trades, Portfolio) of Century Management breaks down a fundamental and simple concept that shapes his buying decisions that has led to his success.
The upside-to-downside ratio
If video isn’t your thing, he talks about having a set of rules of thumb, mechanisms and rules to help to simplify your buying decision.
I’ve talked about snap decisions – how to find, analyze and research stocks faster and better.
For Van Den Berg, his years of experience have helped him create his own internal database from which his upside-to-downside ratio came.
To put it simply, when he is buying, he wants a 5-1 ratio.
Let’s see how this works.
Based on Van Den Berg’s analysis and studies, he has found that before buyout news is announced, large caps stock prices are around 60% to 65% below the acquisition price and small caps are priced about 75% below the announced acquisition price.
He calls the acquisition price the private market value.
Stock XYZ is a small cap and is currently on the market for $15; it’s a potential takeover target with a private market value of $36. However, instead of trying to wring out every drop of profit, the sell price is $30, roughly 80% of the private market value.
The current price is $15; the sell price is $30.
For the sake of following the same example from the video, the worst case price it will sell at is $12. The rule of thumb is 25% of the private market value.
What price should you buy XYZ? $15.
Upside is 100%. Downside is 20%; 100 divided by 20 = 5.
The other version is where the upside to $30 is 15. The downside to $12 is 3. Therefore 15/3 = 5.
Now instead of paying $15, let’s say you pay $17.
What happens?
The upside to $30 is now $13. The downside to $12 now becomes $5; 13/5 = 2.6
By paying an extra $2, your risk reward is cut in half and doesn’t look as attractive as it was.
Upside-to-downside ratio rules of thumb
- Max price of public company is about 80% of the private market value.
- Large caps are priced around 60% to 65% below the the private market value. Worst case is 35% to 40% of private market value.
- Small caps are priced around 75% below the the private market value. Worst case is 25% of private market value.
The correct example
In the video, Van Den Berg is talking off the top of his head so he is rounding and estimating numbers.
But when you use his rules of thumb, this is how the numbers would look like.
- Stock XYZ is a small cap and currently priced at $15.
- Private market value is $36.
- The sell target is 80% of $36 = $28.80.
- Worst case private market value is 25% of $36 = $9.
Upside to sell price is $28.80 – $15 = $13.8.
Downside to worst case is $15 – $9 = $6.
Ratio = 13.8-to-6 = 2.3.
After throwing around some algebra, the buy price to maintain a 5-1 ratio is $12.30.
- To upside: 28.8-12.3 = 16.5.
- To worst: case 12.3 – 9 = 3.3.
- 16.5/3.3 = 5.
Why do this?
This is Arnold Van Den Berg (Trades, Portfolio)’s rule of thumb.
Yours may be different or you may want to apply his since it obviously worked for him.
The key is to use this to focus on making an objective buying decision.
Howard Marks (Trades, Portfolio) said in his memo “On the Couch” that “investors tend to emphasize just the positives or the negatives much more often than they take a balanced, objective approach.”
It’s easy to get excited when you find something with a 100% upside, but it’s also easy to forget about the possible downsides and the risks that come with it.
The No. 1 rule in Walter Schloss' “16 Factors Needed to Make Money in the Stock Market” is that price is the most important factor to use in relation to value.
How often do people talk about price without relating it to anything?
That’s a huge mistake.
"How does the price look compared to the value?" is a question you should always be asking.
But calculating and finding value is hard. It’s tedious and time consuming. One of the reasons why I created Old School Value along with the recently launched OSV Online app to streamline the process and make it easier value stocks. The goal is make objective decisions and make the most of out of your time.
If you’ve read Marks'Â Â memos you know that he focuses on behavioral economics and finance where the biggest mistake investors make is not knowing what price to buy and sell.
So next time you value a stock, try out this ratio and see how it works. I’m not finding this ratio comfortable because the truth is it forces you to leave some stocks that you would normally buy.
Remember Warren Buffett said that the stock market is a no-strike baseball game. You can let as many balls pass by, and it won’t hurt you. It’s just going for the winners that counts.
Video transcript
Thanks to Manual of Ideas for the great interview. Check out its site for one of the highest class newsletters and investment resources to which you can subscribe.
If anybody who took Benjamin Graham’s basic rules and just sort of bought on the rise because things have changed a little but wouldn’t take much change, they could do very well.
As a matter of fact Graham felt that with his simple rules you might not be able to profit extraordinarily, but you could do well, and he proved it many times over.
I’ll tell you what really helped me.
One day, we were talking about a stock, and there was an acquisition. The company was bought out and so the company paid a lot more for that stock. I had multiples that I developed through the Graham philosophy.
I wondered what they saw in this company because based on the Graham philosophy they paid almost 50% more than it was worth. So I started studying acquisitions and I realized these guys in the business spent their whole lives in it; if I was gonna buy another money management firm you know that I would know what to pay for it because I’ve been in it for 40 years, and I’m certainly not going to overpay for it right?
So if I am willing to pay that much as a businessman I must be able to pay that much and still make money.
So that got me to thinking. I decided to follow every acquisition so whenever I read about an acquisition I cut out the article, I get the value line or the standard sheets, throw it into a shoebox and on the weekend I run every ratio: price to book, price to sales. Now we use enterprise value to sales, price to EBITDA and so on.
And so I categorized all these acquisitions and then after awhile I had so many, I said, "OK, this was the acquisition price for retailer and this is the acquisition price for a manufacturing," and then I would compare it to the Graham philosophy, and then I added that on to the Graham philosophy by saying here’s how low it can go because I would see over many cycles how low the stocks go.
But this is how high it can go because the ultimate price of a stock is what sophisticated buyers and sellers are willing to pay, and that usually is about 20% more than the stock is trading for in market. So now I have an overview, an acquisition pile I called it the private market value template, and I would take every stock and say it was bought out; this is what they paid.
And I didn’t figure this out, the other guys did, the people who were buying these companies so then I realized that the highest the stock would go in the market is about 80% of what a sophisticated buyer would pay because if you can control the company you have, you’re willing to pay a little more because you can move the levers around. So now I had a sell point that was about as rich as you can get – 80% of private market value.
And then I reduced it saying how much of a discount do I want to to make to buy this company? I started grouping the companies together and I realized that with big cap stocks, big companies, usually the cheapest you’re going to get is about a 50% discount to private market value each.
The medium companies are about 60% to 65% and a small caps about 75%. So then when I get a small-cap company I say, "OK, here’s the price of the stock. I’m going to buy it where my worst case is going to be 25% of that private market value."
That became my worst case; if something happens then I say, "OK, I am willing to pay a little bit more because I don’t want to miss it." So then I worked out a ratio; I said, "If I have a company that’s worth $36 private market value, $30 is my sell point."
So if I buy it at 15 I’ve got three points on the downside and 15 on the upside so I’ve got a 5-1 ratio.
I learned to be disciplined. I had the private market value, I had the worst-case, and then I buy it no more than 20% above the worst case and that gives me my 5-to-1; if I have a mid cap I might go 4-to-1 and if I have a really great Buffett franchise kind of company, then I would only take a 3-to-1 because I don’t want to miss it.
It just came about through natural common sense by watching things in the market and so any investor can learn this. I do not know more than fourth grade math, but you don’t need more than fourth grade math to do these calculations; there isn’t anything when you do a financial statement that would take a lot of math. A matter-of-fact Graham said that whenever he saw calculations that have a lot of formulas, a lot of sophisticated math in them, he distrusted them.
You know that’s true. Think about an immigrant who comes over, starts a business and makes $1 billion. Does he know calculus? No, he can barely sign his name. But they make money. You know why? Because they learned the basic rules of thumb.
I have a hundred different rules of thumb. Scott always tells me, “Dad, one of these days you've got to publish a book called 'Rules of Thumb.'”
You don’t need all this high math. You don’t need all this education. You just need to know business sense.
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