# Fundamental Money Management Methodology



## ducati916 (8 June 2006)

This appeared on another thread, and demonstrated the opinion that *Fundamentals* is really another way of saying *Buy & Hold* & further that the selection of undervalued stocks are few and far between.



> It would be suicide for a newsletter to do true Buffet/Graham type investing. People want lots of buy and sell suggestions, while I would be surprised that there would be more than one or two new "value" stocks coming up every year according to Graham's value rules.




This really isn't the case.
Lets take an actual example, SGTL, one of *tech/a * personal hate stocks, and also currently a particularly horrible performer on the current list.

Criteria;
An undervalued business, some can have speculative elements, but you must recognise them as such (for example a leveraged Balance Sheet) This is important, the business must really be a good business, you cannot utilize speculative, no earnings, newly listed IPO's, etc, and you must understand the fundamentals, and how to analyze them.

A calculated *fair value* at a minimum of 50% above current price. This is your starting point, if it is further below it's fair value, so much the better.

Position size.
Take the *all time high* or *52week high* as the starting point, calculate the drop from this to the current price.

*SGTL* .......52week high = $24.00
Fair value (coincidently) = $24.00 - $30.00
Initial entry price $10.29 (which is approximately 50% of 52week high)
Therefore, initial position 50% equity, 50% cash
A $10K initial allocation of capital = $5K equity, $5K cash

If price falls, as it has in this case, you use the cash component to pyramid into the full position at lower prices.
I took entries at; $8.49, $6.90, $5.50, & $4.88
Equity = 90%
Cash = 10%
The final 10% would be purchased @ $4.50 or below.

On *Exits* the reverse procedure is implemented, with a gradual selling out of the position, so assuming todays price was the lowest, I would start selling 10% of the position @ $7.48, $8.30 etc

Therefore my *return* would look a little like this;
Shares purchased @ $4.88 and sold at $7.48 = 53.3% return
@ $5.50 and sold @ $9.23 = 67.8% return
@ $6.90 & sold @ $10.24 = 48.4%
@ $7.48 & sold @ 11.37 = 52.0%
@ 10.29 & sold @ 12.63 = 22.7%

This exits 100% of the position for a 37.2% return on aggregate if a total exit is taken at $12.63............if you hold the 50% to *fair value* the returns are higher. Obviously the price doesn't go straight down, and then straight back up either, so you can continue to trade the position until *fair value* is reached, where a 100% exit is taken.

Therefore, it isn't actually required to find *undervalued* stocks on a daily basis, probably 5/10 year is all you require. Your *trading* thus requires far less trading than a technically based methodology, which cuts down dramatically the danger of overtrading.

A good example of a selection that is working well, are *SAFM & GKIS* both which traded lower than the initial entry price, and additional positions taken, and gradually sold as the share price has gone from the low of $19.93 to $30+

*SAFM* .......Entry @ $26.45
Initial position size 50% equity 50% cash ........52week high $49.00+
Purchase @ $21.54
@ $21.05
Total = 70% equity 30% cash
Sell @ $29.27 (both positions) = 37.4% return
Holding 50% equity 50% cash
Next sell price = $33.67

Anyway, you should get the idea.

jog on
d998


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## professor_frink (8 June 2006)

interesting stuff duc, thanks for that


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## tech/a (8 June 2006)

Thats all well and good Duc if the stock actually reverses.

But *MichaelD* at Reefcap has this suggestion/idea which I like.

Duc,

Given the system parameters you have supplied, I am now going to challenge your thinking, just as you have challenged mine. I am going to try and convince you that at least a Money Management stop loss would help your system.

Let's look at your FORD trade.
You purchased 3000 at $10.74.
The last quote for FORD in this thread was $5.11.

I'll accept your premise that this trade has a 95% chance of being profitable by 3 years time.

I haven't seen your profit target for this trade, so will make an assumption of $15 (doesn't matter for the point I am making). All figures below are arbitrary for ease of calculation but the principle is I believe robust.


Scenario 1: How you are trading FORD.
Purchase 3000 @ $10.74. Total cash invested = $32,220
As it currently stands, you have still committed $32,220 to this trade.
Let's say it moves to your profit target and you sell at $15.00. Cash returned from sale = $45,000 from a committment of $32,220.


Scenario 2: How FORD would have traded with the use of a Money Management stop.
Purchase 3000 @ $10.74. Total cash invested = $32,220
Set MM stop at 10% below this, at $9.66.
Stop gets hit. Sale nets $28,980 so you have crystallized a loss of $3240.
Stock continues to go down in price with no change in the fundamentals. A cursory inspection of the chart reveals the stock seems to have reached support at $5.11.
You re-enter 3000 @ $5.11 as the enter signal remains in force.
Committment to trade = $15,330.
This time, the stock does respond favourably and moves up.
Stock reaches $15.
You sell for $45,000.


Nett from Scenario 1: $45,000 less $32,220 = $12,780
Nett from Scenario 2: $45,000 less $15,330 new cost of stock less $3,240 loss from initial entry. Net profit = $26,430 AND you have had the extra $32,220-$15,330 = $16,890 in cash to invest in another value stock.

As an aside, I won't work the example, but even if FORD turns out to be the one dud, trading it with a money management stop will reduce your downside $ significantly.

Your system's weakness (given an acceptance of your claimed performance parameters) is in missing out on significant opportunity cost whilst stocks continue to reverse.


What we must answer is which way makes more money in the long term. Is being right 95% of the time more or less profitable than being right 40% of the time. (I don't know the answer.)

I also wonder about the time component of stock selection - I spend seconds picking stocks to add to my portfolio at present as it is fully mechanical. How long does it take you to select a stock to trade? (And are the bottom line results going to be worth the added effort).

Perhaps a hybrid answer of using value to pick stocks and then trading them technically at least partially will maximize both % winners and minimize lost opportunity cost. 

*I like it*


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## ducati916 (8 June 2006)

*tech/a* 

I just was looking at reef, and my answer will appear there.

jog on
d998


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## ducati916 (8 June 2006)

The *problem* of course is correctly identifying the *BOTTOM*.......if I or anyone could do this consistently, then there would be numerous market billionaires walking around.

If on my current example of SGTL, if the five entry points had been utilised on a technical basis, then I currently would have *actualised* five technical losses, and we still don't know if we have found the bottom. All the time, I am accumulating real losses.

With my methodology, I am legging into the positions, my assumption being that my risk is of a bankruptcy or liquidation, market quotational price is irrelevant. I can quite easily turn a profit with only a return to my entry price, never mind a move to *fair value*.


quote:
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 Your system's weakness (given an acceptance of your claimed performance parameters) is in missing out on significant opportunity cost whilst stocks continue to reverse.

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With the added information, you can now see that this is not the case.


quote:
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What we must answer is which way makes more money in the long term. Is being right 95% of the time more or less profitable than being right 40% of the time. (I don't know the answer.)

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Assuming an *exit at fair value* and or a trailing stop if fair value is exceeded, my system will crush a technical system. 


quote:
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 I also wonder about the time component of stock selection - I spend seconds picking stocks to add to my portfolio at present as it is fully mechanical. How long does it take you to select a stock to trade? (And are the bottom line results going to be worth the added effort).

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It will take me at least 1 full day to crunch the numbers, sometimes, depending on the industry longer. So yes, it takes some time, but it easily rewards the extra effort.


quote:
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 Perhaps a hybrid answer of using value to pick stocks and then trading them technically at least partially will maximize both % winners and minimize lost opportunity cost. 
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Technical analysis has simply too many fundamental flaws within the paradigm to even consider it as anything but a bit of fun.

jog on
d998


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## mit (8 June 2006)

I can't see how that invalidates what I said. I just said that most punter's want lots of buy and sell recommendations and would not be happy subscribing to a newletter that just said "Nuttin new this week" for 47 weeks a year. This was in response to an earlier comment somebody made about the "Intelligent Investor" newsletter not following Grahams/Buffets rules on buying value companies.

MIT

ps Im a technical trader as I would rather make money than be right all the time.


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## ducati916 (8 June 2006)

*mit* 

No, of course it doesn't invalidate your assertion, it was just apparant that there are some misconceptions as to what *fundies* actually do.

Buy & Hold is trotted out consistently, and while some do buy & hold, many do not.

jog on
d998


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