You’ve probably found your way here because you heard about my stock picks on Seeking Alpha, many of which have tripled in value. It’s also possible that you heard about some of my losing picks and decided to investigate me for yourself (if so, kudos). Either way, I’m sure you’d love to add a few future triples to your portfolio.
My goal is to help you do both… but there’s something you have to do first. You have to read this document (along with a few lessons, the links to which will be provided below).
The reason you have to do this is simple.
Think of it this way — you’ll be excited if someone gives you a new Ferrari, right? But if you don’t know how to drive it, you could end up in a nasty crash. In other words, every powerful system needs to be understood. Otherwise, that power can work against you.
In other words, if you don’t learn how to utilize my method, don’t come crying to me with your losses. You’ll only have yourself to blame. I’ve done all of this for you for free. All I ask is that you follow the instruction manual. It’s ok if you choose not to, but if you do, please don’t buy my picks. You’re only liable to hurt yourself and I’m here to help, not hurt.
Got it? Good. Let’s jump in…
For those who don’t already know the story, I’m a first-generation American who grew up in a lower-middle class town. I attended Northeastern University thanks to a Track & Field scholarship. Like many college students, I was broke. My total monthly budget was $300. To get by, I shared the basement of an apartment with two other guys for $143 per month.
I wasn’t a fan of the 2-hour classes, but could spend days in the library studying stocks. In 1993, I graduated with honors with a major in Finance & Insurance (I also minored in Economics, Marketing, and Management).
My first stock account was at Waterhouse Securities (which was acquired by Toronto-Dominion Bank, which was later acquired by Ameritrade). I funded it with $2,000 which I borrowed from a credit card. Armed with my Finance degree and years of work in the library, I was ready to make my millions.
Only one problem. I was TERRIBLE.
In my first year, I lost the $2,000. I had to apply for another credit card… and then another one… and another. By year-end, I had lost $7,000. The next year, I lost another $4,000. The following year started similarly, but ended up being the most important year of my life.
It was 1996. I was working at International Data Corporation (IDC), one of the world’s most respected technology research firms. Our analysts knew virtually everything about technology. Because of that, Wall Street professionals paid IDC for access to our reports and analysts. I started out as an Associate Analyst (a fancy name for “fax boy”). My job was to find what our Wall Street customers wanted and fax it to them.
Two of those customers took note of my zeal for stocks and took me under their wing. Each had their own method, but both made something very clear to me — my college professors didn’t teach me $#@& about how to REALLY analyze a stock.
In the months that followed, I learned that P/E is really B.S. My mentors taught me about operating leverage, industry trends, and how to identify them early. They also taught me about Geoffrey Moore’s chasm and how it causes many winning stocks to emerge in three phases.
They were shaping me into a winning investor. It wasn’t easy though. I paid attention to every word they said, but a lot of their lessons went against my view of reality. I also found it near-impossible to own a falling stock and not want get rid of it.
Before long, I learned that the proper response was to double my research to find out if something was wrong with the company… or if investors were just panicking because the stock was dropping (which is what I often did).
I still lost money that year, but the damage was cut to just $1,000. I also earned a promotion due to my expanding knowledge of technology and stocks. I would take another 15 years to shake the urge to sell a falling stock. However, thanks to my mentors, I learned how to resist the urge to sell (and occasionally even found the courage to buy more).
My mentors’ training worked. In 1997, I made $68,000. I also earned another promotion and was later recruited to become the head of investment research at AMR Research (now a part of Gartner Group).
You can read more about my career on Pipeline Data’s About Us page, but the short story is that I formed my own Wall Street research company in 2004 and averaged over 45%+ per year for a decade, leading to my semi-retirement (and return to Track & Field) in 2008.
Needless to say, I feel blessed. I was LUCKY. Heck, I didn’t even choose to get into the technology industry — one of my track teammates got me the job at IDC. Because of this, I felt the need to give back for everything that was given to me. So, I started volunteering as a coach for children and the residents of Miami / Miami Beach. In 2009, I started volunteering time to write for Seeking Alpha.
Now, if you’ve been paying attention, you might realize that you can’t just start buying my picks and expect to make money. It’s not that easy! You have to buy at the right time, sell at the right time, buy the right amount, and not succumb to the psychological urges that are inherent to most human beings.
This document – my methodology – is designed to help you understand how I do what I do. If you read it carefully (many times) and adhere to its lessons, you’ll be on your way to becoming a successful stock investor too. So, keep reading and good luck!
Mark Gomes, CEO
Pipeline Data LLC
p.s. If you are a beginner, it’s important to make sure you start by learning exactly what a stock is. Investopedia.com provides a great set of lessons to help beginners understand the basics of stock investing. I’ll provide more beginner guidance when time permits.
There are a few things you must learn about Mr. Gomes’ investment methodology:
- Mr. Gomes’ investment philosophy was specially designed by combining the best lessons from investing legends like Warren Buffett, Benjamin Graham (Warren Buffett’s mentor), Peter Lynch, and Mr. Gomes’ personal Wall Street mentors.Each of these mentors preached the virtues of focusing on valuation and having the patience to wait for a fair valuation to be achieved. Accordingly, Mr. Gomes’ price targets generally incorporate the expectation of a 18-36 month time horizon to achieve fruition.Further, Mr. Gomes endeavors not to predict how a stock will react to specific news, as that has been proven to vary on a case-by-case basis. In other words, a stock can rally on bad news or dive on good news. This is due to the interworkings of supply, demand, traders, sentiment, and other factors which no investor can analyze with consistently. This makes it even more important to focus on calculating a stock’s fair value, which is much more within reach of an investor’s abilities.
- His research philosophy revolves around utilizing industry experts to identify companies that offer superior potential for reward relative to the perceived risk. No human being has the time to analyze stock prices and become an expert on the markets in which every stock competes. Therefore, for the best investment results, it is best to focus on valuation analysis and outsource the market/product/competitive analysis to experts who work in each company’s industry.
- Once candidates are identified, the proper amount of investment is determined, largely based the riskiness of the investment. This is absolutely crucial. Investing too much money in a risky security can lead to detrimental losses in an investor’s portfolio. The designation of size of Mr. Gomes’ positions tell the story. Speculative stocks are the riskiest. These are only 1% positions, because of their potential to go bust (he calls some of them “Ten Baggers or Bust”). On the other end of the spectrum are Core and Value plays. These are established ventures with lower risk at attractive valuations. They are figuratively ten-times safer, justifying commensurately larger (10%) positions. Other types of picks sit in between. Pay careful attention to his position sizing to understand the risk.
- The other major factor in Mark Gomes’ investment and trading philosophy centers on his proprietary “Risk/Reward Charting” technique. This technique enables the visualization of a company’s short-, intermediate-, and long-term risk/reward profile, based on its perceived fundamental value and expected secular growth rate. It has the appearance of technical analysis, but differs greatly and has proven to be far more efficacious.
These topics (and more) are covered in the following three-part video series:
Part I – Introduction (Click HERE for a transcript of Part I)
Part II – Risk/Reward Charts (Click HERE for a transcript of Part II)
Part III – Portfolio Management (Click HERE for a transcript of Part III)
A complete transcript of all parts is provided at the bottom of this page.
Additional Required Reading
Detailed Methodology: “The Multi-Millionaire Method”
My Complete Track Record – The Good, Bad, & Ugly
Portfolio Management Spreadsheet
Lessons From Legends On How To Hit It Big On Stocks
Poised To Triple Investment Method: Chapter 1
Poised To Triple Investment Method: Chapter 2
Using My Method To Make Money (Video)
Final Comment: My financial future is secure. Now it’s your turn. Be sure to learn and understand the lessons taught here. Also, make sure you are receiving my real-time alerts from Seeking Alpha, Twitter, and the Pipeline Data Newsletter. If you don’t, the burden of your losses will be yours alone to bear.
So, do your part and start building your millions. Good luck!
Appendix: Methodology Video Series Complete Transcript
Methodology Transcript (Part I – Introduction)
This is our special methodology videocast. We’re going to go through the latest iteration of my personal investment methodology. First, I want to let you know if you haven’t visited us at PipelinedataLLC.com and entered to receive my free Pipeline Data Newsletter, you’re missing out on our best and latest analysis of the market and my favorite stocks. They are delivered to Newsletter subscribers first, so sign up there today. Also you can visit me at Seeking Alpha, where you can click the Follow button and automatically receive my Seeking Alpha contributions via email as well. Be sure to do that today.
- Let’s get into the meat of today’s subject, my investment methodology. I’m going to give you the broad brushes today in this lesson. I’m going to come back with additional lessons on risk/reward charting and portfolio management later. For now, let’s go over the high level aspects of the investment methodology that enabled me to make millions in the stock market.
This is a top-down methodology. As you can see here, there are a number of layers and we start at the very top with macroeconomics. What that means is I look at demographics of the world largely birth, death trends for reasons I will explain in another article at some point, but it’s extremely powerful to understand the demographics of our country and world. Monetary policy, of course, the US Fed has tremendous sway over what happens to investment vehicles. Of course, geopolitics, things that go on around the world particularly in 2016. You could see that oil and the policies of various international governments, weighing oil prices and therefore having an impact on the market as well.
Once you have a good handle on the macroeconomics of the world and our country, you can make some very broad decisions that alone can make you many more millions over the life of your investing lifecycle than not and that if you never pick a stock, just understanding macroeconomics and applying it appropriately to your portfolio can add millions to your lifetime earnings. We will explain that a little bit more as we move along here.
Now once you understand the direction of macroeconomics whether it be economy is going to be strong or weak in the near future, talking a year, two years, three years down the road, you can properly set up your portfolio exposure which is the second tenet of my investment methodology. What that means is each portfolio should consist of longs, shorts, and cash. Now if you are watching this, there’s probably a ninety-nine percent chance that you have longs and cash. Cash is cash, of course. A long in an investment stock. If you own a stock, you have a long position. What most people don’t have are short positions. That’s against the stock.
Now if that concept seems foreign or even scary to you, I very much recommend that you learn about this concept, go to Investopedia.com, go to Google, learn all you can about shorts because this has been an absolute instrumental aspect of my success over time and it is not scary. In fact, it is quite the opposite. It is a savior, an absolute savior for portfolios particularly at points in time where the macroeconomics are working against you. As a result of this, proper portfolio exposure, the right amount of longs, the right amount of shorts, and the right amount of cash, you can make money not only when the stock market is going up but you can also make money when the stock market is going down or even crashing. I’ll show you some examples a little bit later.
Now, once you got your portfolio exposure figured out, once you know how long you want to be, how much money you want to allocate to long positions, how much money you want to allocate to short position, and how much you want to keep in cash, once you have that figured out, you can actually allocate your money into the longs and shorts appropriately. How do you do that? Well, quite simply. You find your favorite stocks and you buy them and you go along. You find the stocks that you think are going to fall and you short them. The allocation of each pick is very important. If you put a hundred percent of your money in one stock and that stock goes bankrupt, you go bankrupt. What you need to do to properly allocate your funds is to focus on the risk involved with the investment, not the reward but the risk. The riskier the investment, the less money you want to put in it.
I know, I know. If you find a fifty-cent stock and you think it can go to five dollars, that’s ten times your money. If you can make ten times your money, why wouldn’t you want to put half of your money into that pick? Well, quite simply because that fifty-cent stock can just as easily go to zero. If you have fifty percent of your money in that pick, you will be wiped out largely. You will be set back tremendously. To recover from a fifty percent hit to your portfolio, you need two years of forty percent returns to get back to where you were. The rare individual that can earn forty percent a year, I was able to do it early in my career for about twelve years running. I know the step that I’ll be able to do that on an average basis ever again the rest of my life, and I wouldn’t want to be faced with having to do that because of a big mistake such as putting a large amount of money in a risky stock.
For our highest conviction name, the names that we feel the best about but also feel that the investment is relatively safe, I will put upwards of ten percent of my money into those picks. Usually, that’s about five to ten percent is generally the max for those types of picks. The riskier ones, even the one that have the chance to go up ten X, I typically will not put more than one or two percent of my money on those selections. That way, if they go bust, if they go down sixty, seventy, eighty percent, I only have one percent of my money in those picks. They can only have a small impact on my portfolio. If you have a one percent position and it goes bankrupt, your portfolio has only gone down one percent.
In the meantime, if that pick does indeed go up ten X, your portfolio has gone up ten percent just from that one selection alone, keeping in mind that you have other selections to help you create additional rewards to your portfolio. To make ten percent on your entire portfolio from one pick is tremendous without taking a tremendous risk.
Now how do we pick these stocks? How do we pick the stocks that we want to allocate? Maybe I should put this up here. Research is absolutely paramount and aside from macroeconomics, research is the most powerful tenet of this methodology. The key to this is to only trust independent experts. When I say expert, I’m not talking about a Wall Street analyst. I have great respect for firms like Goldman Sachs and Morgan Stanley. They were clients of mine for several years. They’re very smart individuals. However, they are not truly independent. There are ulterior motives in any analyst’s psyche. As a result, you could end up succumbing to the same biases that will be inherent in those folks.
Now what we do here at Pipeline Data is we enlist professional expertise basically independent industry analyst, people whose job it is to look at an industry and in my case, I focus on technology. There are companies out there like Gartner Group, like Forrester Research, like International Data Corporation, the first company I ever worked for. These companies are largely independent in thought. How they view an industry and how they view the companies within those industries is largely independent. They have no vested interest in telling you fairy tales about a company’s prospects because their job is to lead you in the right direction. That’s what they do to help us. They’ve been instrumental in several lot of picks over the years.
Attunity comes to mind, a small software company nobody knew about. Our contact in the industry felt like these guys would be an ideal partner for Big Data initiatives of Amazon.com. Sure enough, Amazon became a big partner of Attunity. The stock tripled. We sold at that point ($9), but the stock went much higher ($16) before the stock market started to roll over. That pick was thanks to our independent analysts.
We also have independent consultants — individuals who work in these industries who know these industries better than we can possibly hope. They went to school to learn about a particular subject, went to work in that area, and deal with that particular subject fifty, sixty, seventy hours a week. We can’t possibly hope to match their expertise in that regard… and that’s what makes them so valuable in the investment selection process. They know the important details and secrets, both good and bad.
One consultant helped us ascertain that Himax would be chosen by Google to be the optical supplier for Google Glass. Now, Google Glass never really made it to commercial deployment in a massive scale, at least as of 2016, but the announcement that Google had chosen Himax sent the stock rocketing. Then after that, the Wall Street analysts jumped on the bandwagon, pushing the stock up to about sixteen bucks a share. We got customers out at $10 with a triple. Meanwhile, most investors and institutions were just being introduced to the stock by Wall Street firms.
Those investors got crushed when Google Glass failed to launch as planned. This exemplifies the importance of dealing with independent experts.
Finally, let’s talk about risk/reward charts. Risk/reward charts help to protect you from yourself. In another video, I’m going to show you what risk/reward charts are all about. Stay tuned for that. They are absolutely critical to dealing with the psychology within yourself which will typically, if you are an average investor such as myself, typically drive you to buy a stock as it rises based on the euphoria that you feel or the fear of missing out on a further rise. On the flip side, selling a stock as it falls as you feel the pain of loss which within human beings typically triggers a fight of flight reflex which we have a hard time fighting. The body wants to protect us from ourselves, and so it tends to flee what it perceives as danger.
Unfortunately in the stock market, a low-priced stock, a stock that is falling tremendously may actually be an opportunity not a threat. As a result, there’s a big difference between that and a lion chasing after you in the wild which is typically what that fight or flight [is in 00:16:00] to help with. Risk/reward charts helps to take the emotion out of investing and allow you to maximize your profits, so stay tuned for the next video on that subject.
Let’s see how this has played out for me historically. You can read this on your own and I suggest that you do as I speak. The gist of it is that the macroeconomics enabled me to weather or navigate, I should say, market ups and downs. From 1997 to 1999, the NASDAQ grows by two hundred percent. My independent expert contacts, mostly colleagues and companies I was working for, told me which areas were really hot. As this macroeconomic backdrop was very positive, I invested heavily in long positions, staying away from short positions, and focusing on the areas that these independent experts were high on. As a result, while the NASDAQ grows two hundred and fifteen percent, my portfolio was up to almost eight hundred.
In 1999, however, I was informed that things were starting to change and the assessment, my assessment of the situation led me to believe that the macroeconomic conditions in our country were going to change alongside these changes in demand for internet software. Sure enough in 2000 and 2002, the NASDAQ fell sixty-seven percent. However, because I anticipated this change in the macroeconomic picture, I was able to sell my longs, get heavy on shorts, and instead of falling, instead of losing sixty-seven percent of my money as the average investor did during that time period, my portfolio was up an additional hundred percent on top of the eight hundred percent I had made from ’97 to ’99. I hope you had a chance to read the rest of this. I won’t need to get into it. I’m not here to pat myself on the back. This is meant to tell a story that you can have for yourself. This could be your story if you follow the investment methodology that I have outlined here.
Stay tuned to Pipeline Data and my writings on Seeking Alpha. Shortly, I will provide you with a portfolio management spreadsheet that will help you to take this investment methodology and bring it to life as well as a risk/reward charting lesson that will teach you how to use those charts to protect you from yourself, giving you the complete kung fu of my investment methodology.
Methodology Transcript (Part II – Risk/Reward Charts)
Hey there. Welcome back. This is Mark Gomes with part 2 of our Methodology Series. This one is going to be focused on risk/reward charts, but first, I want to remind you, if you haven’t been to Pipeline Data, LLC and signed up for our free newsletter, you’re missing out on the premier newsletter where we send out our best picks in analysis to our readers first. You can also see what we’re talking about via my Instablog. You can go to this address at Seeking Alpha. Click the “Follow” button, and you will also be emailed what I write there, but our free newsletter is the premier way at this point in time to get the first and earliest analysis that I’ve been putting out.
Okay. In the first part of this video series, I went over the investing methodology and how macroeconomics, portfolio exposure, portfolio occasions, and research can help you to make millions. Risk/reward charts are one of those 5 tenants, and I’m going to go over that in this video. Okay? First thing you will need to know, and I’ll show you a chart to give you an idea. This is a chart of the Russell 2000 going back to 1992, and what you’ll notice that I’ve done in this chart is drawn a few lines. You got these white lines here, and what you’ll notice about these white lines is they are parallel. They’re identical. Okay? The only thing that separates one from the other is that one is drawn at the tops or near the tops of the market or chart that we’re looking at, and the other one is drawn at or near the bottoms. Okay?
Now, if you look at the trajectory, the slope, how steep this line is moving, okay, you can see that this is the steepest line. This line is much steeper. You see it moved at a much higher rate, and this line here is much flatter. In fact, this one is moving down. Okay? The important thing to notice here is how steep these lines are moving. I call this the “CAGR,” the compounded annual growth rate of these lines. The compounded annual growth rate of these particular lines happens to be 6%. Both of them are moving at 6% per year, so if you look at the line at this point, 1993, in 1994, this line has moved up 6% from where it was in ‘93. In ‘95, it’s moved up another 6%. Over time, it grows, and grows, and grows. Okay?
This is absolutely critical to understand. There is a formula, and you can look it up on Google for calculating the annual growth rate of anything, and so you can do this on your own over time. Okay? Why that’s important is that the foundation of this risk/reward charting methodology that I invented is based on the common sense suggestion that if a company is growing, it’s earning by 20% a year, its stock should also return an average of 20% a year over time. Overtime is critical here because if the Russell 2000 is returning 6% per year in earnings, then the Russell 2000, the next should return 6% per year over time, and indeed, it has. From bottom to bottom to bottom, that’s a 6% return as we discussed based on the slope of this line. Also, from top to top to top, 6%.
However, if you buy at the bottom to sell at the top, it’s much more than 6% per year, so the important thing to know is that on average, through ups and downs, the Russell will move in what I call a “channel.” The channel is what sits in between the top and bottom line. It will move in between this channel at a rate of 6% per year. Okay?
The other aspect of this foundation is that risk/reward charts, as you have already seen, is a graphical representation of its fundamental growth, a company or an index in this case, which an index is simply a number of stocks all in one. In this case, the Russell 2000 is made up of 2,000 stocks, small companies. Okay? By graphically representing a company’s fundamental growth, in this example, 20% per year, we can create a visual guide to determine when it is overvalued or undervalued. Quite simple, right? It’s meant to be.
Now, you may notice that there’s a line sitting in the middle here. This represents the center. Okay? The Russell or any other company oscillates up and down along the center, and that is what tells you whether it is overvalued by a little, overvalued by a lot, undervalued by a little, or undervalued by a lot. Okay? Let’s delve a little bit more into this with the key tenant of risk/reward charting. Okay?
As I’ve just discussed, understanding the difference between a short-term channel and a long-term channel, okay, these long-term channels give us the framework of understanding whether the Russell is overvalued or undervalued at any given point in time, but it is a long-term channel. In other words, the Russell, as long as it continues to deliver 6% growth per year, the index will continue to rise at 6% per year on average over time. Okay?
However, there are short-term channels, and as you see here by the … depicted by these yellow lines. If you look in the chart and this is what you see, you will tend to draw these lines. This is what a technical analyst will do. Okay? A trader. They will draw these lines, say, “These are the tops and the bottoms.” What a technical analyst or a trader does not tend to do is calculate how rapidly these lines are moving on an annual basis. They don’t calculate the CAGR.
Now, if you do that with these yellow lines, you will determine that the slope, the trajectory, the CAGR of this line is 25% per year. This [loss here 00:08:27] at the beginning of 2011 is at 552, and one year later in 2012, it’s at 618. That’s roughly 25% growth, and the same goes for 2013, 2014, and so on, and the same holds true for the top line because they are parallel. By the way, one important point, it must be a logarithmic chart. If you draw it arithmetically, it will, as you could see here, get a little messed up.
Everything in the stock market moves logarithmically. It grows upon itself, okay? A company growing at 50% a year is 50% bigger the next year and 50% bigger than that year the following year. Okay? It will grow from 2 to 3 to 4-1/2 not from 2 to 3 to 4 to 5. It grows 50% per year, not a fixed amount per year. All right?
By determining that these yellow lines are growing at 25% a year and comparing that 25% figure to what we know about the long-term earnings growth of the entity whether it’s a stock or an index. In this case, the Russell grows its earnings about 6% a year. Okay? We know that these yellow lines are unsustainable. A stock cannot grow at 25% per year indefinitely if its earnings only grow at 6% per year over the long-term. It’s just impossible for that to happen. Okay?
As a result, you can understand the difference between whether the lines are short-term in nature or long-term in nature. If they are short-term in nature, they are what I refer to as “technical channels.” These yellow lines are technical channels and destined to break. They will break, and I do think at some point, and you start to see it here at this point in early 2016, the Russell is breaking its short-term channel.
Now, this channel has been in place since 2009 for over 5 years … over 6 years, sorry, getting close to 7 years. This channel has been in place, so many people can tend to forget that these lines are short-term in nature. Now, if you stay focused on the long-term lines, you can start to understand when this channel might break because these lines are stronger than these. In other words, these lines will almost never break above this.
In this particular example, when we saw the Russell get to the top of not only of the short-term line, but also the long-term line, we knew it was the beginning of the end because it won’t be long before this bottom line also intersects with the top, making it impossible for this security to move anywhere but down below this one, and it usually happens before they come together. Okay? That’s what we see starting to happen here with the Russell. Okay? That’s why a channel’s trajectory must match the company’s multi-year growth rate or the channel will break.
Now, the difference between a technician and a fundamentalist is that a fundamentalist will know to get out right here at the top and not play with it anymore. Okay? You could trade, you can try, you could take your risks, and we do, we’re human, but the fact of the matter is, is that this is essentially a peak that will be breached at some point. In other words, if you sell here or even short here and this level was 1,200 on the Russell, you will make money eventually. In this case, it took from April or February of 2014 until now, nearly 2 years now, but here, nearly 2 years later, the Russell has fallen almost 20%, so if you were short, the Russell, for the last 2 years, you’ve made 20% on your money, but if you’ve been long, you lost 20%. Big difference. Okay?
Now a technician will just feel like, “Well, risk is still inside of this channel. It’s great until the channel breaks.” When the channel breaks, a lot of technicians will run for the hills. Okay? Now, okay. Savvy technicians will know enough to get out closer to these tops, but a lot are novices out there, and many of us are novices, myself included. As far as technical analysis goes, you’ll see this break, and you’ll realize that the trend is no longer intact and you get out.
In this case, you’re getting out at 1,000 on the Russell instead of 1,200. Big difference between knowing the fundamentals and only knowing the technical. This is why fundamental analysts like Warren Buffett become among the richest people on the planet, but you can’t name for me one trader, one technical analyst who is among the top 20 richest people on the planet. You can’t do it because it doesn’t exist. On the long haul, if you are simply focused on technical analysis, you will not make as much as somebody focused on the fundamentals. Okay?
Now, a couple more tenants before we go. Quite obviously, I think you realized by now, buy low, sell high. Okay? In this chart, you can see if you’ve drawn it properly, and by properly, I mean you have 2 parallel lines that are growing at the sustainable rate of growth of the underlying entity’s earnings. In this case, 6%. Very sustainable for this small company at next. You buy when you’re near the lows, and you sell when you’re near the highs. Now, look what would happen if you did that. Now, you don’t have to catch it right at the bottom. I actually like to move these lines like that and not be greedy to know where we’re reaching some danger levels. Okay?
Now, look at what would’ve happened if you bought at the lows and sold at the highs. Boom. This series of trades would have netted you significantly more than just 6% a year that the average person who rides out the ups and downs will get. Six percent might sound pretty good. The bank pays next to nothing right now, but how does 20%, 30%, 40% sound? Much better of course. Buy low, sell high.
Also, the trend is usually your friend. Not always, but usually. Okay? What that means is as we get low and we start to head higher, that will tend to be your friend. That will tend to be the direction that we take until it shifts dramatically. As you see here, we could draw a short-term line. [We can bring that 00:16:50]. Here we go. Now is pretty much the trajectory of this short-term movement. Short-term being a few years, right? Now, once it broke, the trend was then down. Okay?
What we have there is a nice combination of a stock market that was near its peak, pretty close, very little reward left. Here, the loss of potential risk, and what end up happening? A lot of that risk came up in the market. It didn’t go all the way, but a good chunk did, and those of you got out of the market, ‘98 for the Russell as well as 2000 as well as 2007. Some of those years sound familiar with good reason. You saved yourself a lot of money and maybe made yourself a lot of money if you bought in 2002 and even in 2008.
Now, here’s an interesting point. You see, this line gets broken. Okay? The difference between fundamental analysis and technical analysis is that when a line, a fundamental line gets broken, if the line is drawn properly, if we have confidence that this 6% earnings rate of growth for the Russell will hold up, we must also have confidence that a breach of this lower line only means that the Russell has gotten cheaper. It’s not a sell signal. It’s a buy-more signal.
Now, that could be very painful because if we close in on this chart, what you’ll see is if you bought at the bottom line at 413 in November of 2008, you went through a very nasty loss before recovering back to 413 in April of 2009, so you had to wait 5 months, go through 5 months of pain just to get your money back, but when you did, you went from 413 all the way to 864. More than double your money in just the next 2 years and much more than that as the Russell continued higher. Actually, ended up tripling.
Five months of pain might not sound like something you want to go through, but it beats the heck out of the people who didn’t get out at the highest here in June 2007, and let’s see how long they had to wait to get their money back. May of 2011, 4 years. Five months versus 4 years. Big difference. This is the power of risk/reward charting. Stay tuned. Next, I’ll give you a lesson on portfolio management to wrap up our methodology series. That lesson will help you to keep track of your market exposure and the stocks that you are buying/shorting.
Methodology Transcript (Part III – Portfolio Management)
Welcome to the third and final installment of my personal investment methodology series. Before we get into this, I want to remind you to sign up for our free newsletter. This is where you get the best and latest analyses first. I also provide my analysis on Seeking Alpha. You can go there, click on this URL or type that into your box and click the follow button and you’ll get my latest blogs via email automatically.
Okay, in the first two parts we discussed most of the tenants of my investment methodology. Macroeconomics, portfolio exposure, portfolio allocation, research, and of course, risk reward charts which had its own standalone video. In this video I’m going to wrap things up with a focus on portfolio exposure and allocation, particularly how to track them. Now, on our website in this methodology page, you will find a link to this spreadsheet that you can download for yourself and use to track your own portfolio. Now, this is not the professionals, professionals have stronger tools of their things that they track. This is my personal old school approach to portfolio tracking. Let me just say, it works. If you don’t have something that is like this or better than this, this video is for you. Again, you can download this. This link will be provided. This file will be enabled for sharing so you can download a copy for yourself. I put in some fictitious values. The good folks at Google are good enough to provide us with some functions that allow us to automatically have prices placed in here and updated in real time so that a number of the formulas that I have incorporated into this spreadsheet are also recalculated in real time so that you know exactly where your portfolio stands at any point in time.
Let’s start within the basics. First of all, I separate this spreadsheet into longs and shorts. From the first video you should understand by now what shorts are, having looked that up if you don’t know. Very important for portfolio. It helps you a lot to make money during these down turns as opposed to losing money or just sitting on cash. You want to make money for one, two three years, or do you want to lose money, or sit on cash for one, two, three years? That’s your choice. When the market is falling, like it did during these three years, like it did during these two years, and like I see happening now, for the next two years or so. That’s a grand total of eight years out of eighteen or so, nearly half the time for the market. You can either be losing money or sitting on cash or you could be using shorts to make money as I discussed in the earlier video. So we’ve got our longs and our shorts. We’ve got our ticker symbol, we got the name of the company, we got the number of shares we hold. Our good friends at Google provide us with a current price of the security. This will give us the total.
If you see here, I put in a fictitious position in Glu Mobile. I do own Glu Mobile as of this video, but for the purpose of this particular video, and this is just a sample where I own ten thousand shares at the current price of two twenty eight which is a total of twenty two thousand eight hundred, automatically calculated for you here. This box right here is going to be a little new and foreign to most of you. This is what I call adjusted net tangible assets per share. What that means is every company has a number of assets and liabilities. A lot of those assets and liabilities are necessary for the operation of the business. It could be property, could be a factory, could be machinery, things of that nature, probably plant equipment. There are receivables, money that your customers owe you, there are accounts payable, money that you owe people that provide you with your goods and services. There’s inventory, the products that you sell, which in the case of Glu Mobile is just software, so it’s usually a zero here.
There are a number of things that are necessary for the operations of the business. I’ll show you a quarterly version of this for Glu Mobile. What’s interesting is that during the June quarter, Glu Mobile picked up about a hundred and twenty million dollars of cash by selling shares of its stock to Tencent, a large Chinese company. They have this enormous cash balance of a hundred and eighty two million dollars as of the end of the September quarter which contributed, you go down there, then you see shareholder equity. That’s book value, for those of you who don’t know. If you don’t know what book value or shareholder equity is, look it up, you can go to Investopedia or look at Google for that, and they have a book value for three hundred million. However, that three hundred million balance of book value or shareholder equity includes a number of intangible items like Goodwill, perhaps a company that they acquired for more than the value of the assets that the company has. Goodwill is not tangible, you can’t really sell Goodwill most of the time unless it’s represented by a brand like Coca Cola.
Since that’s the case, I don’t want to give any credence to this Goodwill, unless it does have true value and you can go into the company’s 10-K at SEC.gov to see some of the constituents of some of these things, to see if there is value here. If not, what we end up with is Yahoo provides with a net tangible assets value. That’s the value of all of the tangible assets minus the value of the tangible liabilities. What you’ll often find in technology companies, particularly software companies, is that tangible asset value will closely mirror times the amount of cash it has minus its debt. In this case, there’s no short term debt and no long term debt, but great deal of cash. $180 million, and that closely approximates that tangible asset value, nearly two hundred million for Glu Mobile.
I provide, I actually calculate for myself an adjusted figure, because at a company like QAD where they have net tangible assets of a hundred and eleven million, there are some assets that are going to be overstated and some that are going to be understated. For example, somewhere in here in the other liabilities, this is represented by differed revenue and differed revenue in QAD is largely made up of maintenance revenue that is paid up front by its customers for support on its software. That money is supposed to be earmarked for QAD to provide those support services. However, QAD makes a huge profit on this money. The true liability is not ninety six million for QAD, because they’re going to make a big profit on this money. They real liability is probably closer to seventy, or sixty five. I make adjustments to a number like this and add it to the net tangible asset balance.
Similarly, if you look at property plant equipment, QAD’s listed as thirty two point six million, a number that has been declining from thirty three a few quarters ago. However, a good chunk of this is represented by a large piece of land that they own on a cliff in Santa Barbara, California. You can bet your butt that that asset has not been declining in value over the years as depicted here, but increasing in value, as land and property is want to do. If you notice, then you know that this number is understated. However, because of accounting rules, QAD has to depreciate the value of these things over time, so even as they add lots of property equipment every years, this number stays the same, because they are depreciating the stuff that that have. That makes sense for computers and cars and things like that, but not for land, which they own.
That’s a long-winded way of talking to you about why I use net tangible assets per share. I put that in here because if I have a company like Glu Mobile that is sitting on a hundred and eighty two million dollars of cash of excess tangible assets that aren’t required to run the business, well if somebody comes in and acquires this company, and if we look at the value of the company right now, two hundred and ninety nine million. If I could acquire this company for two hundred and ninety nine million, I wouldn’t really be paying to hundred and ninety nine million. I wouldn’t really be paying two dollars and twenty eight cents per share for Glu Mobile because I would be able to pocket the hundred and eighty two million in cash that’s sitting on their balance sheet in addition to some excess net tangible assets, which get us pretty close to two hundred million.
Rather than paying three hundred million, I’m paying three hundred million minus two hundred million which is really a hundred million. That’s the true value, or what I call the adjusted enterprise value of Glu Mobile, which is really only seventy cents, not two dollars and twenty eight cents. The other dollar and forty cents or so, not giving you exact numbers here, roughly seventy or eighty cents of enterprise value and roughly a dollar forty, a dollar fifty in net tangible assets. That dollar forty, dollar fifty is not actually part of what I’m buying here as far as the underlying value of the company. If the underlying value of the company goes down, the value of that cash does not. I want to enter that number here because it helps me understand how exposed I am to the business, because I don’t care how exposed I am to the cash, the excess value, the excess net tangible asset of the business, okay? I’ll enter that there.
Now, I’ll also enter the beta of the stock. You don’t know what beta is, find out from my previous lessons, please look it up on Investopedia or Google. Beta is a very important measure to understand, it’s a measure of volatility of the company, of the stock. That will help you understand how exposed you are to market moves to the upside and downside. When the market’s moving up, it’s great to have a stock with a high beta like Glu. Well in the excess of one, one is the average. Three, well above average. When the market’s moving up, Glu will tend to move up faster. When the market’s moving down, Glu will tend to drop faster. That makes it dangerous to own during down markets as many of us have already experienced here.
There’s a calculation here of an adjusted position. What that does is it takes into account the net tangible assets, takes into account the beta, tell you how truly exposed you are to the stock. Now, once you enter all of your positions, all the stock you own on one side, you will add up your total positions, you will also add up the total adjusted positions. Then go over to short side, we’re going to use negative numbers to represent what we own. I don’t like ZAGG. I’m betting against ZAGG, I’m short ZAGG. So in this spreadsheet I’ve entered five thousand shares negative, short. You see it depicted here as a negative number.
Now, one thing to note. I’ve entered this here. This SH is an ETF that shorts the S&P 500. If you own shares of SH, it shorts the market for you. When you buy one-thousand dollars of SH, you are actually shorting the S&P 500 to the tune of one-thousand dollars. So be careful to make sure that if you have any short ETFs that go into the spreadsheet that the number goes in as a positive, but the calculation goes in as a negative, you have to change the formula just by adding a minus sign up here as opposed to here there’s no minus sign for the rest of them, to accurately depict your short position in the SNP which is represented by a long position in SH.
Once all these numbers are added up, they get rolled up here and I get to see what my total exposure is to the market. As I’ve discussed in other recent videos and articles, I see the market as topped out and as I’ve been talking about since two thousand and fifteen. I thought there was some trouble coming ahead, we had the risk rewards charts topped out, I saw a lot of problems that the Fed had created through its quantitative easing program coming home to roost as we’ve already seen happen in the oil market and other industries. I expected a downturn in the market. I spent a good deal of two thousand fifteen with zero exposure, in other words I had just as much money in my shorts as I did in my longs. Right now, as you can see by my actual exposure, the actual stocks I own, minus stocks that I’m short, and the adjusted number which is right here on the adjusted column that I talked about. I am exposed somewhere between twenty two and thirty five percent for the market, depending on which measure you want to use. These are not exposed at all right now.
I’m taking a gamble that the market has had short term bottom and will rebound a bit, perhaps to this level before crashing down farther. We can assess that when it happens, but in the meantime you see this sharp drop down represents panic. When panic sets in, usually there is a digestion period. Sometimes that digestion period results in a bounce. You can see here that there’s some risk that the market continues down, sure, but there’s a nice potential reward if it bounces. I have exposed myself to the market to the tune of twenty two or thirty five percent, depending on how you want to measure it. Modest, not a major allocation. Most people are a hundred percent exposed. If a hundred percent of your cash is in long position, or mutual funds, you are a hundred percent exposed to this potential drop in the market. I’m taking a little gamble for the short term, before I will probably go short, make these numbers negative by having more shorts than longs, and take advantage of the decline by making money. Making a profit from the market dropping as you would in owning SH.
Then you get a breakdown here, total portfolio value, the amount of it represented by long, the percent represented by long, percent represented by short, and the difference between a hundred percent and these two numbers, you get fifty five percent long, and twenty percent short. Of course, you are about twenty five percent in cash, non-allocated part of your total portfolio value.
That’s the basics of this. Understand this, and utilizing the spreadsheet, you’ll have a better chance of following along as I look at how the market progresses and in determining if we are in for a big downturn in which case we want our exposure to be negative or if we’re going to rebound from this, in which case we want to increase our exposure close to a hundred percent, I doubt it. For the time being — because we’re going to be elevated as long as we’re above this midline — we’ll be looking for big drops in the market to get us down to these levels here where we can get back involved and for those of you who have been following me on Seeking Alpha from the beginning, know that I joined Seeking Alpha here in 2009, so I’ve been largely focused on long positions. However, as long as the market is at overvalued levels, I will be focused more on short positions (until we get a nice reset in the market).
I hope you enjoyed this lesson concluding our methodology series. Again, check out PipelineDataLLC.com to sign up for our newsletter for more lessons. Also, make sure you understand every aspect of this methodology. Review it often (I do!)… And stay tuned so we can navigate this market together!