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Trade Alert: Margin of safety

Cody Willard

Apr 26, 2016 — 5 min read

After two and half months of a market that has been going almost straight up, you would think we were do for a pull back. There is an old saying that “the market will punish the greatest number of participants as often as possible”, if I may paraphrase. Of course, time frame can make anybody feel like a genius or an idiot.

I did a poll on Scutify (see poll) and in the TradingWithCody Chat Room this morning, asking people:

CodyWillard Feeling good about stocks? Feeling safe? Are any of you scared about the markets right now? Let us know in a Scuttle.It’s interesting that most of the feedback I’m getting here on Scutify and from Trading With Cody people is that most people ARE scared right now and longs still seem far from complacent despite this huge rally we’ve had in the last 2.5 months.

Judy

I think we are in for a rocky turbulent summer with the market.

RichardSharpeI feel stocks are over priced , oil is a problem, China is a 1000 pound gorilla, earnings are weak…….can you add to this?

chrischerry I’m scared the downturn I’m expecting might be preceeded by a prolonged rally that I’m not in position to ride. What scares me more is talking to co-workers who have no fear or concern about the market or economy at all. To them, 20 Trillion in debt is just a number. They say, “hey I couldn’t afford my house a couple years ago and had to go bankrupt, now I’m fine, wasn’t that big of deal.” Or worse, “the government can just print more money and pay off that debt” Now THAT’s scary!

@frustratedbullI’m scared. I’m particularly concerned about Apple tonight. What are your thoughts?

@jakef1111I’m worried that after earnings season sinks in… And the guidance is still muted… The market will sell off heavily since there will be no catalysts

@olivepetuniaYes feeling very cautious; negative reactions to GOOG and NFLX earnings doesn’t make me feel optimistic looking forward to $AAPL, $FSLR, $FB. Is Mr. Market looking for any excuse to take profits?

This worry of crashes has been the case since we put in that February 11^th bottom in the stock market. And sure enough most market participants feel pretty darn foolish right now. I am not in the business of trying to game short term swings in a market that consists of tens of thousands of publicly traded companies’ stocks. That being said, I’m going to raise some cash today and continue to let the rest of our portfolio do the heavy lifting for us. All of this brings me to a few quotes from legendary investor Benjamin Graham, the” Dale Earnhardt Senior of Wall Street.” (Those of you who have spoken to Cathy from customer support with Trading With Cody probably didn’t know she is a NASCAR fanatic. But, I digress.)

Benjamin Graham talks a lot about “margin of safety”:

“Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. Benjamin Graham”

You can see quotes from Benjamin Graham daily on Scutify, by the way.

Margin of safety is something a lot of growth will make irrelevant, but margin of safety is something to keep in mind all the time, regardless of the short term outlook for the stock market. There is no guarantee of any margin of safety in any investment because you see companies as big as Lucent, and Volkswagen who have to re-state their numbers. Long time Apple investors remember the Steve Jobs back-dating options scandal. There is a risk any time you place your money outside of your mattress and always a risk that some junkie might steal your money from your mattress too.

But by focusing on companies that have huge net cash balances, more than enough liquidity, that are revolutionizing the world and buying them at reasonable valuations does provide some margin of safety. Which finally leads me to Netflix.

I’ve been struggling with my Netflix position, in large part because the valuation has already priced in so much huge topline and earnings growth in the years ahead. I’ve owned Netflix off and on for years now, but I am worried that there’s a lack of margin of safety with the stock now worth $50 billion. We’ve taken profits on our Netflix common stock back when the stock was near $130 and we’ve had some nice profits buying some Netflix call options during the times when the markets have been tanking and people panicking.

Our mission is to maximize the gains in our portfolio while minimizing the risks. And while I remain a believer that Netflix is going to continue to revolutionize the way we watch TV in years ahead, I’ve grown uncomfortable with the risk profile of the stock here. I’d love to revisit and buy this stock back if it were to get hit hard in weeks or months ahead. But for now I’m going to move to the sidelines on Netflix and open up that cash for some other opportunities that I am looking to buy soon. Speaking of which, I’ll leave you with a list of the stocks I am working on for both the long and short sides.