The Deep Discount Strategy is a value investing approach to buying select stocks at a price below their fair value. I recently wrote an article detailing how to use this strategy to set a price target to buy Apple (AAPL) at significantly less than its fair value.
As stated in that article, Apple meets all of the criteria for a high quality company that is both high in growth potential and predictable. These are traits that suit the Deep Discount Strategy well. I went through a detailed process to calculate my estimate of the current fair value for Apple and arrived at a price of $978.88 per share. This is based on an expected EPS growth rate over the next five years of 20% and a future PE ratio of 18.6.
Calculation of the fair value is only half of the battle. The discount portion of the strategy involves attempting to purchase the stock at a price much lower than its value. I used a discount rate of 50% to arrive at a purchase price target of $489.44. This target was met with much criticism from readers of the article however, primarily on the basis that it was too low. It was felt by many that the chance of Apple reaching that price level again anytime in the near future was so remote that would-be investors would never have the opportunity to purchase the stock, or would be sitting in cash for so long waiting that the potential returns would be diminished.
First, let's revisit the reason for choosing such a large discount. The fair value of $978.88 is based on a variety of inputs, many of which are estimates of future performance. As no-one can predict the future, there is a certain degree of uncertainty in the calculation. By purchasing at a discount, we in effect are applying a safety factor to our calculation. With a 50% margin of error, we can be quite off the mark in our inputs to the fair value calculation and still be in a position to make a substantial profit (or at least minimize our chances to lose money).
An Alternative Approach
What about an entry strategy where a certain margin of safety could still be maintained, but was flexible enough to allow entry at price levels that were more likely to be seen in the near future?
One Seeking Alpha reader, "ubeenfranked," suggested a potential solution. I have used his idea as the basis for a more aggressive approach, but modified it slightly to suit my own preferences.
Instead of only purchasing at a fixed discount level, we instead scale into the position based on how deeply discounted below fair value the stock currently is. I've chosen to quantify this modified strategy as follows:
- We allocate a fixed amount of capital to each security we intend to purchase. For purposes of this example, we will assume that we have $100,000 to invest in Apple.
- 25% is the minimum discount below fair value that we will purchase a stock that meets the eligibility criteria outlined in the original article. A 25% discount below Apple's current fair value is $734.16.
- We will target to be fully invested with all of our allocated capital at a discount of 70% below fair value. A 70% discount to Apple's current fair value represents a price of $293.66.
- We will scale into the position linearly, with 10% of allocated capital invested when the stock is at a 25% discount, and 100% of allocated capital when the stock is trading at a 70% discount.
- After the initial purchase either one month must pass, or a further discount of 5% must be achieved (whichever comes first) to trigger an addition to the position.
Let's look at a graph showing how this scaled entry looks for Apple:
As of today (August 17, 2012) Apple closed at a price of $648.11 which represents a discount of 33.8% below fair value. We can buy right now! Based on the modified strategy above, we would allocate 27.6% of our capital, or $27,600 to Apple today (found using linear interpolation).
If/when Apple drops in price to $599.07 (38.8% discount to fair value) we would add to our position. At a 38.8% discount, we should have 37.6% of our capital allocated, or $37,600. Since we would already have $27,600 invested, we would invest only another $10,000 at that time.
This highlights a way to simplify the calculations. There's a reason for the numbers I chose for this strategy: For every 5% additional discount to fair value, we allocate 10% additional capital.
It's easier to see this in a table. Below is the correlation between the amount a stock is discounted to the amount of capital that should be invested:
|Discount below fair value (%)||Capital Invested (%)|
The strategy still isn't perfect. The most glaring problem is that to become fully invested, the stock must still dip to low enough levels that represent a discount of as much as 70%! This is clearly very unlikely to happen with a stock such as Apple in the near future. But the key point here is that yes, there's very little chance the investor will become fully invested in the majority of stocks purchased with this strategy; instead the investor will become partially invested in a number of great companies. For example, Apple may dip to $587 again in the near future, which is a 40% discount. The investor would have $40,000 invested, and $60,000 capital remaining. If there are other opportunities to invest all or a portion of that $60,000 in other companies, by all means do so!
This modification to the Deep Discount Strategy allows investors to enter at a much smaller discount than the 50% discount typically recommended to achieve the maximum safety factor using the original Deep Discount Strategy. The modified strategy is essentially a tradeoff between conservatism/safety and the likelihood of getting into the position in the first place. This may be a reasonable compromise for more aggressive investors.
In conclusion I recommend sticking to the original strategy if being extremely conservative is the goal, while this alternative approach will allow for a smaller, but scaling position at higher (more likely attainable) price levels.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.