How do Events Cause Stock Market Prices to Change?

This is one of the most important things I could ever teach you about stock market prices…

How is a stock price determined? What causes stocks to go on sale?

The reason this is so important is because there’s a huge number of people who invest in the stock market, mostly your pension fund managers, mutual fund managers, and insurance fund managers, who have been taught in business school that stocks never go on sale.

They are taught that the value of the business is always the price of the stock.

I’m going to tell you why this isn’t true…

Stock Market Prices Don’t Always Equal the Value of a Business

Rule #1 investors don’t think that’s true. Warren Buffett doesn’t think it’s true, and the rest of the best investors in the world don’t think it’s true.

We in fact think that the market can get very emotional and sometimes, Mr. Market puts things on sale that shouldn’t go on sale.

What Causes Stock Market Prices to Rise and Fall?

Now, why would that ever happen? The guys that control the stock market are managing all the little guys money. They control about 85% of the money in the market. They’re very rational guys. They were the valedictorians of their high schools. They were the number one graduates out of Harvard. They went to Columbia Business School and they graduated number one there. They got into Goldman Sachs training program and they were the number one guy there. They got their own fund at age 30 years old. They are incredibly smart guys, smarter than we will ever be.

Why in the world would they ever put something on sale?

Why would they sell it to us at the wrong price?

We talk about going out to buy ten dollars of value for 5 dollars, that’s your basic Rule #1 strategy.

Who would ever sell you a ten dollar bill for five bucks?

Why would that ever happen?

The reason is because when these guys have a fund, their investment strategy for almost all of them, I would say 99% of them, is just to be sure that they are following the market.

The Big Guys are Momentum Investors

In other words, they are what is known as momentum investors. A long-term hold for most of these investors is 3 months, not 5 years. They’re in it for short-term gains on momentum. The stock is moving up, they join the trade, they try to get out at the top and then they move to another stock that’s going to move on. That’s how almost all of these guys invest.

If that’s how they’re investing and the length of time they’re going to be in a stock is 3 months, what do you think they are going to do if something happens to a company that’s going to make it a bad investment for a year?

How Stock Market Events Cause Stocks to go on Sale

Let’s say that cotton prices start to go nuts because of the Arab Spring. Maybe they’re not going to harvest Egyptian cotton crops, so cotton prices go from .85 cents to $2 dollars. The guys who own companies that depend on cotton prices to be low, let’s say a t-shirt company, the investors look at the price and say, “Oh my gosh, it’s going to take over a year before cotton prices come down, I need to get out of this company.”

This happens even if there isn’t anything wrong with the company, it’s just going to have a bad year, but they bail out on it. That company could go from 45 dollars to 15 dollars simply because there are no big buyers. They all get out of the company on momentum. This is what causes stock market prices to change.

How Rule #1 Investors Take Advantage of Stock Market Events

Well, we’re a really small investor. We don’t have to worry about our investors being momentum related. We can buy for the long term. We can wait, and when we see something that’s on sale because the big guys have sold it off, it takes us just a few seconds to get in there and take advantage of these stock market events.

This particular stock that you can take a look at for yourself is Gildan. In 2011 the cotton prices went to the moon and Gildan went on sale. We got to come in and buy at $16 bucks a share and Gildan went back to $50 dollars a share in just the next year or two.

This is how we take advantage of the fact that the big guys are momentum traders and we’re long term investors following Rule #1.

Conclusion

Take advantage when stocks go on sale. As Rule #1 investors, this is what we do best. If you want learn more about what you need to retire as a millionaire and get the most out of the stock market, click the button below to get my FREE Rule #1 Quick Start Guide to Investing.

Now go play.

best-of-guide-bottom-blog-644x200-2

About Phil Town – Phil Town is an investment advisor, hedge fund manager, two-time NY Times best-selling author, ex-Grand Canyon river guide and a former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence. You can follow him on google+, facebook, and twitter.

  • Garrett

    Eric L, Rulers,

    Regarding your question about basis reduction (I incorrectly replied to you yesterday and addressed you as Mike Mac – my apologies for any confusion as I was hustling out the hotel door).

    I know there are lots of blog readers who have been to Phil’s Transformational Investing Seminars that understand simple option strategies. I also know and try to respect Phil’s desire to avoid such conversations on the blog because it simply is not the place to learn them. That being said, in the following post, I used cash secured puts and covered calls as a means to reduce basis. Just consider them a seed to grow where you can go elsewhere to get more help.

    I’m interested in BP so I’ll just look at them as an example for my own homework and type out some thoughts based on them. You probably clearly know the first part about what I’m posting here, but I’m just starting from the beginning for our Newbie Rulers and will post more tomorrow. Hopefully, it will encourage them to learn more about basis reduction strategies and take a look at getting in Jeff Town’s course for a few months like Moncho has.

    So to summarize, here’s your question:
    how do you go about “lowering basis on these companies as the months and years go by. If these companies tend never drop below a certain point and the market knows this, how do you sell puts to lower basis when there is usually no (or very little) premium beneath the assumed bottom?” – In this post, I probably won’t answer your question just yet…but I’ll get back to some ideas that I should be able to post tomorrow.

    When we buy a company, ideally we like to place ourselves in a what I call a WIN /Win/ win situation – if the stock goes up, down or sideways we are happy with the outcome. All outcomes are favorable even if one outcome may be more desirable.

    As maturing Ruler #1 Investors, we need to start thinking about building a position in a company as an investor over a period of time as opposed to just making a “one and done” investment in it and then trading it at the first sign of a profit. It’s a pain to keep doing that if you have a life outside of your portfolio. It’s better for most of our lifestyles to be like a developer building an apartment complex over the course of a year or more.

    During this phase we’re definitely NOT “ALL IN” – as a minimum, we begin with the end in mind and determine how much of XYZ we want to own and how much capital we plan to allocate to that goal.

    If we want to own $100,000 of XYZ, then we’ll start with no more than a $25,000 investment. I always divide by 4…nothing wrong with dividing by 5, 6, 7, etc.. I just start with 1 out of 4 tranches initially.

    Let’s use BP now. I like buying 100 shares at a time because it’s convenient for using options. So if I wanted to get that first tranche at today’s prices, here’s a way that I’d considering entering the position just as an example.

    Invest $25,000 at $40.80 =’s 612 shares…I’d round down to 600 shares for a $24,480 investment.
    Next, I’m in the building phase here – what’s my goal? My goal is to invest $100,000 and get it at the best possible price and reduce my basis as quickly as possible to reduce my market risk.

    In order to get more, I’m going to allocate my next tranche to a cash secured Jan 2016 LEAP $40 PUT for $4.00 per share – a $24,000 investment. I’m not even going to use any leverage here since I don’t want to cause panic on Phil’s blog. I’ll sell 6 more of those contracts and collect $2,400 cash. That’s 427 days till expiration and about an 8.5% annualized return on that cash with the OBLIGATION to buy those shares at $40 if the price is at or below that on Jan 15th, 2016. I must be willing to do that in the future.

    Third step is to consider selling what I call a Rule One Call. This is an insurance plan to lower my basis in case the price drops even more after this first tranche.

    The way I look at it, my initial investment poses the most risk to me because let’s face it…we are WRONG sometimes about our 4M analysis (Meaning, Moat, Management, MOS) and perhaps I messed up “The Story”. I have to protect myself from that mistake and doing a covered call is a way to have a little insurance against my own stupidity, laziness, ego, confidence…the demons in my life!

    With BP, clearly I don’t know if oil prices are going to drop much below that $75.00 floor. If they do, I have to protect myself. I’m protecting the downside because I know I can always get more on the upside if the story turns out better.

    So next I’m going to sell another 6 contracts of the Jan 15, 2016 $42 CALL for $2.30. That’s another $1,380. When I do this, I must be ready to sell my 600 shares if the price is over $42.00 on that date.

    Now I’ve obviously collected $2.30 + $4.00 =’s $6.30 x 100 =’s $3,780. I have a total of $48,480 invested. I have $3,780 / $48,480 which is a 6.7% ANNUALIZED return.

    Our next step is to WAIT and continue to WATCH and READ Seeking Alpha articles.

    Suppose BP drops to $35.00 per share over the next 400 plus days by Jan 20, 2016. That would be a significant drop. What would our investment look like and how would we stay rational?

    Our investment looks like this then:
    600 shares we bought at $40.80 went from $24,480 to $21,000 ($3,480 loss)
    We “got put” another 600 shares at $40 for $24,000 ($3,000 loss)
    We collected the Call premium for $1,380 profit
    We collected the PUT premium for $2,400
    We collected a dividend over 12 months on the 600 shares …let’s say $2.00 per share: $1,200

    Total it all up: I’m sitting on about a Negative $1,500 loss so far on a $48,480 investment. That’s not a violation of Rule #1. Why? Because we are building a position in BP. We still have over $50K to invest. This is like being in the construction phase of an apartment complex. We’re still building…. Are we freaking out? No. We have plenty of money to invest and continue reducing basis because we Begin with the End in Mind. So what would we do next?

    It’s Jan 2016. We’d sell the Jan 2017 $35 PUT and collect about $4.00 per share. How many? Well, this would represent our THIRD tranche so $25,000 / $35 =’s about 700 shares or 7 contracts =’s $2,800.

    See how this has been about getting allocated over a period of over a year…we’re building something here…an investment. You don’t have to be in a rush to lose money. Take your time, watch the trends. If Mr. Market goes up you can always buy to replace the 600 shares you initially bought and that will likely be called away because of your covered call. I do this frequently. It would represent Tranche. Worse case is maybe you made SOME money but didn’t make as much as you could have because you didn’t buy $100,000. Poor Ruler. You made money but not as much as you would have liked. That’s a good problem to have!

    So you can see where I’m going with this, hopefully. By properly allocating money and being prepared to buy more as the price goes down, we can stay reasonably rational buying more of it when we’re allocating properly and reducing basis for those market swings.

    Ok…let’s go back to present day…where are we now then…our Fourth step is to WAIT.

    I still have about $50,000 that I’ve pre-determined that I want to allocate towards owning more of BP. Now I’m patiently waiting to see if we break out to new Floors, Ceilings or just stay in a channel for a few months.

    There’s nothing wrong with using this $50,000 to trade BP short-term in a tax free retirement account while you’re waiting to get more info from the next earnings statement or waiting for new trends to develop.

    I’ve learned it’s better to aggressively manage/trade the company I currently own than to desperately find another investment. If BP now channels between $40 and $42.00 for while, that’s a nice $2.00 price swing or 5%. If you can pick up 2% or 5% on short-term trades or even Rule #1 Cash Flow strategies over a 30 to 60 day period, that can be rather awesome – A channeling stock is like Rule #1 Nirvana. This can all be done in an IRA where you can do credit spreads and dance in and out of short-term trends.

    Again, if you don’t know how to do that, consider getting involved in Jeff Town’s Rule #1 course like Moncho did.

    In this example, we saw the price go down, but we were ok with it because we were able to stay reasonably ahead of the problem and have more cash to stockpile.

    The problem is when we are “all in” and the price goes down well below our basis. When that happens, we have to either hope and pray or we have to cut our losses and take the hit. When you’re all in and with no more money to invest….the only thing you can do is wait, pray, hope it goes up and hope it doesn’t go down anymore. That is investor hell. You want to avoid investor hell.

    There’s much more to say about all this, but I’m long-winded enough. I’ll share some more thoughts on basis reduction via BP’s dividend and share buybacks tomorrow. I’ll try to give some suggestions for Eric’s actual question. I just felt like for all the Newbie Rulers out there we needed to get to a common ground. And CLEARLY most Newbie Rulers don’t understand the option part of investing which is why I suggest you get into Jeff Town’s course. In the meantime…

    To Your Wealth!

    Garrett

    • Donovan

      Garrett: I’ve read your posting here (on Rule 1 option plays) 4 time now. You bring great clarity on the issue and I just can’t thank you enough for sharing your thoughts and expertise.
      Donovan

  • Jay Shippen

    Hi,

    I used to get my stock info from MSN Money but can’t get all what I need since they changed the site. Does anyone know where (websites) to get the numbers that I need to run the numbers to get the sticker price etc?

    • Moncho

      Jay,

      You can find many of the numbers from finance.yahoo.com and gurufocus.com

      Moncho

      • Jay

        Thanks for the info! Much appreciated!

    • Keith

      Jay,
      Moncho is right. In fact, right now I’m getting my 10 yrs.’ ROIC numbers from Morningstar.com along with comparative fwd P/E estimates . For the other four of the “Big 5” numbers (equity/BVPS, EPS, sales/gross profit, and free cash flow) I use gurufocus.com which also gives you an at-a-glance bar graph of cash to debt ratio for the past 5 yrs that makes it really easy to see if debt can be paid off in 3 yrs or less simply by seeing that the cash bar is a third the height of the debt bar. Kinda cool. For analysts’ estimated growth rate for the next 5 yrs, you’ll find that on Yahoo! finance. For current EPS, you can use Yahoo! finance, the trailing twelve month number from Morningstar and GuruFocus along with your own intuition and the companies’ own guidance from quarterly webcast(s) from which you can extrapolate an educated “guesstimate”. I don’t pay a dime for any of this which is fine because I get the info needed for Rule #1 computations for free between all three of these websites combined. I used to only use MSN Money & Morningstar until, like you, I discovered MSN went “poof” –gone!! This actually works out better though because MSN Money was laden with political propaganda “news” articles which were related to investing only tenuously at best.

      • Jay

        Thanks for the info! Much appreciated!

      • Keith

        I may be wrong about the bar graph(s) regarding cash/debt ratio. It indicates “cash”, but I don’t know if that means something different form “free cash flow” or not. Oops. You can still get the rest of the big-5 and analysts’ estimates, though.

  • Garrett

    Rulers,

    The other day I mentioned DeVita (DVA) and suggested it might be time to buy again. Today I learned that Berkshire, under the leadership of Warren’s replacement, Ted Weschler, purchased over 944,418 shares on Nov 10th.

    This is again the type of confirmation I want to see before I go jumping into an investment. I’m not smart enough do to all the homework on my own. I cheat…I look at other people’s homework. When it comes to Rule #1 Investing, if you aren’t cheatin’ you aren’t tryin’!!

    To Your Wealth!

    Garrett

  • Garrett

    Rulers,

    Lots of Seeking Alpha articles to digest as some of my “Just One” companies are reporting their quarterly results.

    One such company is DeVita HealthCare – DVA

    Devita specializes in Kidney Dialysis. I would have never noticed DVA had it not been such a large holding by Berkshire.

    What I like about DeVita is that it’s recession proof – you either get your kidney dialysis or you die. And once you’re a customer, you’re a customer for life. And it’s not like DVA is out there hoping people have kidney problems.

    DVA provides “industry-leading, no-cost diet- and health-management resources to people diagnosed with [chronic kidney disease], DaVita will continue its pursuit to keep people off dialysis as long as possible—and to improve access to treatment and quality of life for those who do need dialysis.”

    Phil talks about investing with your values – I believe DVA’s purpose and passion are worthy of my investing dollars.

    When their quarterly earnings report came out, it gapped down on a 5% sell-off. Not a huge deal, but why?

    Well, DVA suggests that 2016 may bring in lower income than 2015 and 2015 operating cash flow may be even less than 2014.

    Ok, that’s a bummer, right? But sometimes as investors we have to keep the big picture about what’s going on behind the scenes in our business. I liken my investments in DVA as if I were investing in a new construction real estate apartment complex.

    Over the years, I’ve been and continue to be involved in several real estate investments. Most of these projects tie your money up for at least two years from the initial raising of capital to completion. Permits, construction, etc…none of that pays you anything. In the meantime, your money isn’t earning anything. Then when the project is complete you get the big windfall when its finally sold (hopefully!)

    DVA has something like that going on. As part of their growth strategy, DVA opens new clinics. While this is certainly good news for the long-term, in the short-term, the new clinics lose money in their early years. But once they turn profitable, we’ll see lots of cash flow.

    In 2015, DVA should have about $3.5 Billion in cash. What will they do with that? If DVA’s history gives us any clues, we can expect them to buy back shares and continue to grow through some additional acquisitions. And you can see that today, the price is catching up to where it was right before earnings were announced.

    Might be time to buy again.

    To Your Wealth!

    Garrett

  • Garrett

    Good morning fellow Rulers,

    Ever hear or use any of these products – Kleenex, Huggies, Cottonnel, Depends, Kotex, Pull-ups…???

    These are amazing BRAND moats. Do you reach for a tissue or do you ask for a Kleenex? Does your toddler where “something that’s in-between a diaper and underwear” or does your toddler wear Pull-ups? Does your wife just love to wrap the baby in diapers or Huggies?

    These products and many others are manufactured by Kimberly-Clark (KMB) and touch 1 out of 4 people EVERYDAY around the entire world. Nice, yes?

    Is this company going to go out of business? No way.

    If I had $1 Billion dollars, could I successfully compete against KMB? No.

    Is there a difference between cheap diapers and Huggies? Yes. Do you really want that stuff leaking out of your baby and making a mess all over the place?

    This is a great company to own. Who doesn’t use Kimberly-Clark brand products? Dad likes to say “every time someone goes to the bathroom, I’m making money.”

    Dad bought them last year at $90.00 per share. Today they are trading at $113.00. They’ve recently completed their health care spin-off and that’s another reason why their shares have recently hit new highs.

    ROE and ROIC are all consistently above 10%. Debt is manageable and consistent. 10 years ago they had 507 million shares. Today they have 384 million shares. BookValue per share Growth Rates are safely averaging 10%.

    This company isn’t going to go on sale based on a 50% Discounted Cash Flow analysis…just won’t happen because they’ve been consistently paying a dividend.

    And this is what I’m seeing more and more with some of these big brick and mortar companies…the baby boomers are buying them for the consistent and growing dividend and if the dividend climbs much above 3% to 3.75%, then they start buying the shares, bidding the price back up and dropping the dividend yield back down 2.5% to 3%. The retirees just don’t have a safe place to put their money and big brick and mortar companies that pay a consistent dividend is their only hope.

    These are the types of companies I want in my retirement portfolio…something that will just grow at 10% or more per year where I can reduce basis, collect the dividend and rest at night because in 20 years the money will be there when I retire.

    To Your Wealth!

    Garrett

    • EricL

      Garrett,

      Great post per usual and I appreciate all the writing that you have done on this blog. I get the logic of these iconic companies that are growing 10%+ per year and throwing off great dividends but my question is about lowering basis on these companies as the months and years go by. If these companies tend never drop below a certain point and the market knows this, how do you sell puts to lower basis when there is usually no (or very little) premium beneath the assumed bottom? If you are selling puts close to the market value to gain premium you are going to wind up stockpiling a lot of shares, which is great but you can’t really do that every month and if you do, you aren’t really lowering basis on the shares you do own. What piece am I missing? Is there another way to lower the basis? Maybe with LEAPS (but often the premiums aren’t worth tying up the capital that long on these companies)? I appreciate any insight that you can lend.

      • Garrett

        Mike Mac,

        Gotta go…but late tonight or tomorrow I’ll share some thoughts on that question – because I want to dig a little bit too and see how I can reduce some of my market risk with some basis reduction strategies.

        To Your Wealth!

        Garrett

    • Haley

      I researched Kimberly-Clark early on as a possible Rule 1 company but the numbers didn’t look reliable enough to me to be considered a Rule 1 company. On the toolbox (which I know is not the be all and end all of deciding the worth of a business but still a good barometer), their predictability score is only 6. BVPS numbers are good but the rest are either up and down or hanging steady between 4-7%. ROE and ROI are good. It also appears to be in the upper echelons of the red zone so I think the only way to make money off this stock would be to use options strategies which, until I build my position (as you put it in another post), I can’t afford to do atm.

      Speaking of which, are there any other sites that allow you to paper trade options besides Think or Swim?

      • Haley

        Free sites, I mean.

  • Mike Mac

    More talk of BP being a takeover target due to low oil prices and the possibility of an oil spill settlement. Interesting…

  • Mike Mac

    Great example. It was fun making money with Gildan.
    http://www.ruleoneinvesting.com/blog/mike-thinks-gilmead-gil-deserves-a-rule-one-eval/
    I hope we can find the same clarity with some companies in the current market environment. I am still trying to wrap my head around the decline in oil prices. How low will/can it go? I don’t know. But I do know that if it continues heading lower, the stock prices of oil companies and oil services companies will get put on sale.
    http://www.ruleoneinvesting.com/blog/mike-thinks-gilmead-gil-deserves-a-rule-one-eval/

    • Greg Garner

      Looks like GIL down almost 10% today even though they had a record quarter/year. Is this an example of an irrational market event or justified? Might be an opportunity here…