I don't look at it as a gift. There are many things I can do with my money. For example I can buy bonds and make 6%~10% on my money. So why should I buy a stock if all I may make on it is only another 10%? The riskier a stock is (risk is closely related to volatility but is not the same) the less inclined an investor should be to buy it at its "fair" price, because invariably some of the stocks in your portfolio will fall and if those stocks are risky, they may fall by a lot. Barring special situations, stocks move plus or minus 30% of their fair value. There are people who discount the next 3 years of growth to justify a high present value. That is too risky for me. I like to buy them at the lower end of the 30% band to compensate me for the risk that the fair value may be lower 3 months from now or that I may be totally wrong about the stock. Now if 6 months from now the fair value has moved higher due to new developments, then I am compensated even more for my risk taking. But that has more to do with luck than skill.
Let's look at TECD as the example again. They had some disappointing numbers and were downgraded because at 32 they were considered dead money until August (when the new product cycle and back to school season resumes). This means that 6 months from now, the best you can hope for based on *current* knowledge, the stock would be $32. Of course by the time August comes the situation may have changed for the better or for worse, but I am not smart enough to know that yet. This analysis led to a sell off and the stock dropped 34% to $20, because nobody else wanted to hold onto the stock either if it wasn't going to go anywhere. At which point I calculated that at worst the fair value is 27~28. This is a risk premium of about 38% in case the fundamentals got worse by August. As well, *if* the stock was to move slowly towards 32 by August *and if* the fundamentals would not deteriorate more by then, I could sell covered calls for about 10% gain every 2 months. Even though the momentum was against me, I felt that I could afford to fight the tape on this one due to the huge premium and the 30% gain on options. Total gain by August then would have been 90% (12/20 + 3x10%).
In reality things hardly move according to the plan. So this 90% is really a best case scenario, barring a change for the better in the fundamentals. When the stock moved to 25, then the risk premium was only 10% to my estimated 27.5 fair value. Since the momentum was still against me, the rewards no longer justified the risks and I sold with 25% gain. Since then the stock has moved back to 20. If the stock is still there when the market conditions improve, I will reconsider a position in it.
I hope this clarifies things,
Sun Tzu |
