Upgrade Your Success With The Upside To Downside Ratio by Jae Jun,
Out of the millions of people that invest, only 2.6k have watched this video.
Out of the 2.6k that have watched this video, I bet less than 10% (260 people) will apply this technique.
Charlie Munger: Invert And Use “Disconfirming Evidence”
Here’s the video that you can’t miss.
Investor Arnold Van Den Berg 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 thumb rules. 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 Arnold, his years of experience has helped him create his own internal database, from where his upside to downside ratio came from.
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 buy out news are announced, large caps stock prices are around 60-65% 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 and 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?
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.
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 60-65% below the the Private Market Value. Worst case is 35-40% 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 thumbs, 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 = 13.8/6 = 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 = 16.3
- to worst: case 12.3 – 9 = 3.3
- 16.3/3.3 = 5
Why Do This?
This is Arnold Van Den Berg’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 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 #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 Howard Marks memo’s you know that he focuses on behavioral economics and finance where the biggest mistakes that 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 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.
Thanks to Manual of Ideas for the great interview. Check out their site for one of the highest class newsletters and investment resources you can subscribe to.
If anybody who took Benjamin Graham’s basic rules; if you took the basic rules and just sort of my on the rise in because things have changed a little but wouldn’t take much change, I think they could do very well.
As a matter of fact Benjamin Graham felt that with his simple rules you might not be able to do extraordinary, but you could do very well and he proved it many times over and 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 and I thought, I had multiples that I developed you know through the Graham philosophy
And I thought jeez I wonder what they see in this company because based on the Graham philosophy they paid almost 50 percent more than its worth. So I started studying acquisitions and I realized if these guys in the business they spent their whole life 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 what I did is that got me to thinking. You know one of the rules I’m gonna do is I’m gonna follow every acquisition so whenever I read about an acquisition I would cut out the article newspaper I get the value line or the standard sheets, throw it into a shoebox and on the weekend I come run every ratio: Price to Book, Price to Sales. Now we use Enterprise Value to Sales, Price to EBITDA (and they don’t call it EBITDA at that time but you know price operating earnings report) and so on.
And so I categorized all these acquisitions and then after a while I had so many, I said okay 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 how many 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 for, and that usually is about 20 percent more than what 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 for.
And I didn’t figure this out the other guys did, the people who were buying these company so then I said I started to realize that the highest the stock would go in the market is about 80% of what a sophisticated buyer would pay because it you can control the company you have you’re willing to pay a little more because you can move the levers around. So that became my sell point so now I had a sell point that was about as rich as you can get – eighty percent 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 so I started grouping the company’s together and I realized that big cap stocks, big companies, usually the cheapest you’re gonna get is about a 50 percent discount to Private Market Value each.
The medium companies are about 60-65 and a small caps about 75 percent. So then when I get a small-cap company I say okay, here’s the price of the stock. I’m gonna buy it where my worst case is going to be 25 percent of that Private Market Value.
So that became my worst case if something happens then I say ok am willing to pay a little bit more cuz I don’t wanna miss it you run a risk amiss get. So then I worked out a ratio so that I said if I have a company that’s worth $36 Private Market Value. $30 dollars is my sell point then I’d wanna buy it now i look down and see how cheap can get it get to about 12.
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 to one ratio that turned out to be a good ratio 5to1: 3 on the downside 15 on the upside — 5:1.
Now look what happens when you pay seventeen dollars if you pay seventeen dollars you got five on the downside at three right and your reduce your reward from 13 up comes you pay seventeen you only have thirteen on the upside to you divide the 13 by the seven and you only got two and a half to one or maybe three so you can see by paying up a little bit you take the reward risk from a five to 1 to a two and a half to one.
So I learned to be very disciplined. I had the Private Market Value I had the worst-case and then I buy it no more than 20 percent above the worst case and that gives me my 5 to one and if I have a mid cap I might go 4 to 1 and if I have a really great Buffet franchise kind of company, then I would only take a 3 to 1 because you 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 4th 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 Benjamin Graham said that whenever I see formulas – that have a lot of formulas, a lot of sophisticated math in it, I distrust them.
You know that’s true. Think about an immigrant comes over starts a business and makes a billion dollars. 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 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.