HOW-TO catch the rainbow by the tail?
In one of my first publications on TradingView, I shared my stock investing concept of buying great companies during a sell-off. Of course, this idea is not unique. In one way or another, the masters of value investing - Benjamin Graham and Warren Buffett - have talked about it. However, the seemingly simple statement requires an understanding of how to find a great company, and what price level fits the definition of a sell-off.
All of my posts up to this point have focused on the first question. I've covered what a joint stock company is, what kind of reporting it publishes, and how to calculate the fundamental strength of a company from that information.
In this series of posts, I'm going to start talking about how to figure out whether or not to consider the current price of a stock to buy. So, let's get started!
To begin, I would like to propose a mental experiment. Imagine two small rooms for a game of darts. Each room has a different target hanging in it. It can be anywhere: center, left, right, bottom, or top.
Target #1 from the first room looks like a small red circle.
Target #2 from the second room looks like a larger red circle.
You get a reward for hitting the target, calculated according to the following principle: the smaller the target in relation to the wall surface, the greater the reward you get.
You have 100 darts in your hand, that is 100 attempts to hit the target. For each attempt, you pay $10. So to play this unusual game of darts you take with you $1,000. Now the most important condition is that you play in absolute darkness. So you don't know exactly what part of the wall the target is hanging in, so all your years of darts practice don't matter here.
The question is: Which room will you choose?
This is where you begin to think. Since your skills and experience are almost completely untapped in this game, all of your attempts to hit a target will be random. This is a useful observation because it allows you to apply the theory of probability. The password is Jacob Bernoulli. This is the mathematician who derived the formula by which you can calculate the probability of a successful outcome for a limited number of attempts.
In our case, a successful outcome is a dart hitting the target as many times as necessary in order to, at least, not lose anything. In the case of Target #1, it is one hit or more. In the case of Target 2, it is 10 hits or more.
The probability of hitting Target #1 is 1/100 or 1% (since the target area occupies 1% of the wall area).
The probability of hitting Target #2 is 10/100 or 10% (since the target area occupies 10% of the wall area).
The number of attempts is equal to the number of darts - 100.
Now we have all the data to calculate.
So, Bernoulli's formula:
According to this formula:
You may say, "I think we should go to the first room". However, take your time with this conclusion, because it is interesting to calculate the probability of not hitting the target even once, i.e., losing $1,000.
We calculate using the same formula:
If we calculate the ratio of the probability of a successful outcome to the probability of losing the whole amount, we get:
You know, I like the second room better.
This mental experiment reflects my approach to investing in stocks. The first room is an example of a strategy where you try to find the perfect entry point - to buy at a price below which the stock will not fall. The second room reflects an approach where you're not chasing a specific price level, but thinking in price ranges.
In both cases, you'll have plenty of attempts, but in the first room, the risk of losing everything is much greater than in the second room.
Now let me show you the target I use:
I will now tell you about the Rainbow Indicator, which adapts the approach outlined above to market realities.
I got the idea to create this indicator thanks to the concept of the "margin of safety", which was invented by the father of value investing - Benjamin Graham. According to his idea, it is reasonable to buy shares of a company only when the price offered by the market is lower than the "intrinsic value" calculated on the basis of financial statements. The value of this difference is the "margin of safety”. At the same time, the indicator does not copy Graham's idea but develops it relying on my own methodology.
So, according to Graham, the "margin of safety" is a good discount to the intrinsic value of the company. That is, if a company's stock is trading at prices that are well below the company's intrinsic value (on a per-share basis), it's a good opportunity to consider buying it. In this case, you will have a certain margin of safety in case the company is in financial distress and its stock price goes down. Accordingly, the greater the discount, the better.
When it comes to the intrinsic value of a company, there are many approaches to determining it - from calculating the Price-to-book value financial ratio to the discounted cash flow method. As for my approach, I am not trying to find the cherished intrinsic value, but I am trying to understand how fundamentally strong the company is in front of me, and in how many years the investment in it will pay off. To determine fundamental strength, I use the appropriate Fundamental Strength Indicator. To estimate the payback period, I use the P/E ratio (*). If I am satisfied with both of these indicators, I move on to the Rainbow Indicator.
(*) If you want to learn more about the P/E ratio, I suggest reading my two articles on TradingView:
Price / Earnings: Interpretation #1
Price/Earnings: amazing interpretation #2
Indicator calculation methodology:
The Rainbow indicator starts with a simple moving average of one year (this is the thick red line in the center). Hereinafter a year will mean the last 252 trading days.
Applying a moving average of this length - is a good way to smooth out sharp price fluctuations which can happen during a year as much as possible, keeping the trend direction as much as possible. Thus, the moving average becomes for me the center of fluctuations of the imaginary pendulum of the market price.
Then the deviations are calculated from the center of fluctuations. To do this, a certain amount of earnings per share is subtracted from and added to the moving average. This is the diluted EPS of the last year.
Deviations with a "-" sign form the Lower Rainbow of four colors:
The Lower Rainbow is used to determine the price ranges that can be considered for buying stocks. It is in the spectra of the Lower Rainbow that the very "margin of safety" according to my methodology is located. The Lower Rainbow has the boundaries between the spectra as a solid line. And only the red spectrum of the Lower Rainbow has only one boundary.
Deviations with a "+" sign form the Upper Rainbow of four similar colors:
The Upper Rainbow is used to determine the price ranges that can be considered for selling stocks already purchased. The top rainbow has boundaries between the spectra in the form of crosses. And only the blue spectrum of the upper rainbow has only one boundary.
The presence of the Empty Area (the size of 4 EPS) above the Lower Rainbow creates some asymmetry between the two rainbows - the Lower Rainbow looks wider than the Upper Rainbow. This asymmetry is deliberate because the market tends to fall much faster and deeper than it grows. Therefore, a wider Lower Rainbow is conducive to buying stocks at a good discount during a period of massive "sell-offs.
The situation when the Lower Rainbow is below the center of fluctuations (the thick red line) and the Upper Rainbow is above the center of fluctuations is called an Obverse. It is only possible to buy a stock in an Obverse situation.
The situation when the Lower Rainbow is above the center of fluctuations and the Upper Rainbow is below the center of fluctuations is called Reverse. In this situation, the stock cannot be considered for purchase, according to my approach.
Selling a previously purchased stock is possible in both situations: Reverse and Obverse. After loading the indicator, you can see a hint next to the closing price - Reverse or Obverse now.
Due to the fact that the size of the deviation from the center of fluctuation depends on the size of the diluted EPS, several important conclusions can be made:
In my next post, I will continue to explain how the Rainbow Indicator works and to conclude this material, I would like to return to my example of an unusual game of darts. Imagine you have a flashlight in a dark room where you are. It allows you to see where the target is on the wall. This gives you a significant advantage because now you're not throwing darts blindly, but knowing exactly where you're aiming. The light shed on the wall increases the probability of a successful outcome, which you can also estimate using Bernoulli's formula. Let's say you are in the second room, and thanks to the magic flashlight, the probability of hitting the dart target is now 15% instead of 10%. In that case, the likelihood of ten or more hits on Target #2 is 94.49% (out of 100%).
P. S. In answer to my question, I will say yes, I will go to the second room, but only with a flashlight as a P/E and the Fundamental Strength Indicator.
All of my posts up to this point have focused on the first question. I've covered what a joint stock company is, what kind of reporting it publishes, and how to calculate the fundamental strength of a company from that information.
In this series of posts, I'm going to start talking about how to figure out whether or not to consider the current price of a stock to buy. So, let's get started!
To begin, I would like to propose a mental experiment. Imagine two small rooms for a game of darts. Each room has a different target hanging in it. It can be anywhere: center, left, right, bottom, or top.
Target #1 from the first room looks like a small red circle.
Target #2 from the second room looks like a larger red circle.
You get a reward for hitting the target, calculated according to the following principle: the smaller the target in relation to the wall surface, the greater the reward you get.
You have 100 darts in your hand, that is 100 attempts to hit the target. For each attempt, you pay $10. So to play this unusual game of darts you take with you $1,000. Now the most important condition is that you play in absolute darkness. So you don't know exactly what part of the wall the target is hanging in, so all your years of darts practice don't matter here.
The question is: Which room will you choose?
This is where you begin to think. Since your skills and experience are almost completely untapped in this game, all of your attempts to hit a target will be random. This is a useful observation because it allows you to apply the theory of probability. The password is Jacob Bernoulli. This is the mathematician who derived the formula by which you can calculate the probability of a successful outcome for a limited number of attempts.
In our case, a successful outcome is a dart hitting the target as many times as necessary in order to, at least, not lose anything. In the case of Target #1, it is one hit or more. In the case of Target 2, it is 10 hits or more.
The probability of hitting Target #1 is 1/100 or 1% (since the target area occupies 1% of the wall area).
The probability of hitting Target #2 is 10/100 or 10% (since the target area occupies 10% of the wall area).
The number of attempts is equal to the number of darts - 100.
Now we have all the data to calculate.
So, Bernoulli's formula:
According to this formula:
- The probability of one or more hits on Target #1 is 63% (out of 100%).
- The probability of ten or more hits on Target #2 is 55% (out of 100%).
You may say, "I think we should go to the first room". However, take your time with this conclusion, because it is interesting to calculate the probability of not hitting the target even once, i.e., losing $1,000.
We calculate using the same formula:
- The probability of not hitting Target #1 is 37% (out of 100%).
- The probability of not hitting Target #2 is 0.0027% (out of 100%).
If we calculate the ratio of the probability of a successful outcome to the probability of losing the whole amount, we get:
- For the first room = 1.7
- For the second room = 20370
You know, I like the second room better.
This mental experiment reflects my approach to investing in stocks. The first room is an example of a strategy where you try to find the perfect entry point - to buy at a price below which the stock will not fall. The second room reflects an approach where you're not chasing a specific price level, but thinking in price ranges.
In both cases, you'll have plenty of attempts, but in the first room, the risk of losing everything is much greater than in the second room.
Now let me show you the target I use:
I will now tell you about the Rainbow Indicator, which adapts the approach outlined above to market realities.
I got the idea to create this indicator thanks to the concept of the "margin of safety", which was invented by the father of value investing - Benjamin Graham. According to his idea, it is reasonable to buy shares of a company only when the price offered by the market is lower than the "intrinsic value" calculated on the basis of financial statements. The value of this difference is the "margin of safety”. At the same time, the indicator does not copy Graham's idea but develops it relying on my own methodology.
So, according to Graham, the "margin of safety" is a good discount to the intrinsic value of the company. That is, if a company's stock is trading at prices that are well below the company's intrinsic value (on a per-share basis), it's a good opportunity to consider buying it. In this case, you will have a certain margin of safety in case the company is in financial distress and its stock price goes down. Accordingly, the greater the discount, the better.
When it comes to the intrinsic value of a company, there are many approaches to determining it - from calculating the Price-to-book value financial ratio to the discounted cash flow method. As for my approach, I am not trying to find the cherished intrinsic value, but I am trying to understand how fundamentally strong the company is in front of me, and in how many years the investment in it will pay off. To determine fundamental strength, I use the appropriate Fundamental Strength Indicator. To estimate the payback period, I use the P/E ratio (*). If I am satisfied with both of these indicators, I move on to the Rainbow Indicator.
(*) If you want to learn more about the P/E ratio, I suggest reading my two articles on TradingView:
Price / Earnings: Interpretation #1
Price/Earnings: amazing interpretation #2
Indicator calculation methodology:
The Rainbow indicator starts with a simple moving average of one year (this is the thick red line in the center). Hereinafter a year will mean the last 252 trading days.
Applying a moving average of this length - is a good way to smooth out sharp price fluctuations which can happen during a year as much as possible, keeping the trend direction as much as possible. Thus, the moving average becomes for me the center of fluctuations of the imaginary pendulum of the market price.
Then the deviations are calculated from the center of fluctuations. To do this, a certain amount of earnings per share is subtracted from and added to the moving average. This is the diluted EPS of the last year.
Deviations with a "-" sign form the Lower Rainbow of four colors:
- The blue spectrum of the lower rainbow begins with a deflection of -4 EPS and ends with a deflection of -8 EPS.
- Green spectrum of the lower rainbow begins with a deflection of -8 EPS and ends with a deflection of -16 EPS.
- The orange spectrum of the lower rainbow begins with a deflection of -16 EPS and ends with a deflection of -32 EPS.
- Red spectrum of the lower rainbow begins with a deflection of -32 EPS and goes to infinity.
The Lower Rainbow is used to determine the price ranges that can be considered for buying stocks. It is in the spectra of the Lower Rainbow that the very "margin of safety" according to my methodology is located. The Lower Rainbow has the boundaries between the spectra as a solid line. And only the red spectrum of the Lower Rainbow has only one boundary.
Deviations with a "+" sign form the Upper Rainbow of four similar colors:
- The red spectrum of the upper rainbow begins with a deflection of 0 EPS and ends with a deflection of +4 EPS.
- The orange spectrum of the upper rainbow begins with a deflection of +4 EPS and ends with a deflection of +8 EPS.
- Green spectrum top rainbow begins with a deflection of +8 EPS and ends with a deflection of +16 EPS.
- The blue spectrum of the upper rainbow begins with a deflection of +16 EPS and goes to infinity.
The Upper Rainbow is used to determine the price ranges that can be considered for selling stocks already purchased. The top rainbow has boundaries between the spectra in the form of crosses. And only the blue spectrum of the upper rainbow has only one boundary.
The presence of the Empty Area (the size of 4 EPS) above the Lower Rainbow creates some asymmetry between the two rainbows - the Lower Rainbow looks wider than the Upper Rainbow. This asymmetry is deliberate because the market tends to fall much faster and deeper than it grows. Therefore, a wider Lower Rainbow is conducive to buying stocks at a good discount during a period of massive "sell-offs.
The situation when the Lower Rainbow is below the center of fluctuations (the thick red line) and the Upper Rainbow is above the center of fluctuations is called an Obverse. It is only possible to buy a stock in an Obverse situation.
The situation when the Lower Rainbow is above the center of fluctuations and the Upper Rainbow is below the center of fluctuations is called Reverse. In this situation, the stock cannot be considered for purchase, according to my approach.
Selling a previously purchased stock is possible in both situations: Reverse and Obverse. After loading the indicator, you can see a hint next to the closing price - Reverse or Obverse now.
Due to the fact that the size of the deviation from the center of fluctuation depends on the size of the diluted EPS, several important conclusions can be made:
- The Obverse situation is characteristic of companies that show a profit over the last year;
- The Reverse situation is typical for companies that show a loss over the last year;
- An increase in the width of both rainbows in the Obverse situation tells us about an increase in profits for the company;
- A decrease in the width of both rainbows in the Obverse situation tells us about a decrease in the company's profits;
- An increase in the width of both rainbows in the Reverse situation tells us about an increase in the company's losses;
- A decrease in the width of both rainbows in the Reverse situation tells us about a decrease in the company's losses;
- The higher the profit level of the company, the greater your "margin of safety" should be. This will provide the necessary margin of safety in case you go into a cycle of declining financial results. The appropriate width of the Lower Rainbow will just create this "margin";
- Increased profits in the company (after buying its stock) will allow you to stay in position longer by widening the Upper Rainbow;
- A decrease in profits in the company (after buying its stock) will allow you to close your position more quickly by narrowing the Upper Rainbow.
In my next post, I will continue to explain how the Rainbow Indicator works and to conclude this material, I would like to return to my example of an unusual game of darts. Imagine you have a flashlight in a dark room where you are. It allows you to see where the target is on the wall. This gives you a significant advantage because now you're not throwing darts blindly, but knowing exactly where you're aiming. The light shed on the wall increases the probability of a successful outcome, which you can also estimate using Bernoulli's formula. Let's say you are in the second room, and thanks to the magic flashlight, the probability of hitting the dart target is now 15% instead of 10%. In that case, the likelihood of ten or more hits on Target #2 is 94.49% (out of 100%).
P. S. In answer to my question, I will say yes, I will go to the second room, but only with a flashlight as a P/E and the Fundamental Strength Indicator.
🏅Follow the Golden winner of TradingView Community Awards 2023:
tradingview.com/u/Be_Capy
📊For free access to the Fundamental Strength Indicator and Rainbow Indicator, please send me a message at TradingView or becapy@yahoo.com.
tradingview.com/u/Be_Capy
📊For free access to the Fundamental Strength Indicator and Rainbow Indicator, please send me a message at TradingView or becapy@yahoo.com.
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