Foolish Collective
Merck and the Value of Half

Format for Printing

Format for printing

Request Reprints


By wax
October 4, 2004

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Last week I received an e-mail from a friend of mine asking what my thoughts were about a stock he owned that was, as he put it, "headed down the crapper." From the tone of his note I knew he was a bit distraught, but at this point I didn't even know what the name of the stock was that, again as he put it, "was headed to hell in a hand basket."

What could be so bad I wondered? Is there a problem in the Middle East? Did an old nuclear reactor from a Soviet submarine wash ashore at Cape Cod? Just what could be so horrible?

The answer of course was that Merck and Company, Inc. (MRK) was tanking. My immediate response to him was to buy more shares and go back to whatever it was he was doing. Once I replied to him, I had no intention of giving he or Merck another thought, assuming that he would actually buy more shares and go back to whatever it was he was doing. But then it occurred to me that the vast majority of folks would probably have no idea just what Merck was worth.

With a company like Merck, many investors just take the advice of their brokers, or the advice of the guy standing at the urinal next to them, or the guy next to them on the subway. They own a few shares because, well, because it's a good investment. Then again...aren't they all until there's a problem?

The truth of the matter is most folks that own stocks have no clue what a reasonable value for those stocks actually is. The sad part is, their investment professionals normally don't know either. If you ask these investment professionals about a company like Merck they just look up what their analysts have said about the company and read that information to you. The next thing they want you to do is make a trade. So much for good advise. Just make a trade, I'll get paid, and you'll get, well who knows what you'll get.

For a very long time, I believed that all of the metrics and all the rest of the fundamental analysis was actually what led me to determine a reasonable value for a company. Several years ago I learned that wasn't the case. I learned that all of the reading and all of the metrics I calculated should work to support what I had already determined was a reasonable value for a stock. Even today, that still seems backwards to me.

And so I sent a note back to my friend and I asked him what he thought was a reasonable value for Merck. As I had expected, he had no idea. What I had not expected was the next line of his response, which was to stop bothering him because he was on the Internet trying to understand what puts and calls were so he could hedge his losses.

My curiosity of course was piqued by his response, so I headed to the Internet to find out what was going on. From what I could gather from several other folks, this what pretty much the order of the day. Investors, and I use that term only because I have no idea what else to call them, were frantically looking for information after an event had occurred.

What I was discovering was the world of "puts" and "calls". To be quite honest as far as I'm concerned a put is something children do with their toys, they put them away, and a call is something a parent does when it's time for those toys to be put away. I remember growing up that a call always seemed to get my attention faster than a put. I wonder if that's true today?

As you can tell, I know less about puts and calls than hog knows about the hereafter, and truth be told, I have even less interest in learning about them. But in an effort to try and understand what was happening I zoomed around the web reading stuff on the various discussion boards about what folks were doing to hedge Merck positions, or as one poster put it, to "profit from the slaughter".

To profit from the slaughter at first seemed like pretty strong words to me, but then I'm usually so unaware of the stock markets that I finally decided this guy was a trader who could care less what a reasonable value for Merck was. All he wanted was to trade the stock, sort of like the investment professional I spoke of earlier.

Several weeks ago, I wrote that the prudent investor would always want to consider preservation of risk capital first and that investing was the art and science of managing that risk capital. I said that understanding what a reasonable value for a stock was, buying shares of stock at a substantial discount to that reasonable value, and selling shares along the way were all paramount to being an outstanding long term investor.

I got a lot of response to my thoughts on what makes an outstanding investor, and for the most part, while almost everyone agreed with me about understanding what a reasonable value was before you buy, and that buying at a discount to that reasonable value was a must, nobody, and I mean nobody, agreed with me when it came to selling shares. No one seemed to understand that selling was an integral part of my long-term buy and hold strategy.

Last year I bought shares of Steel Technologies, Inc. (STTX). When I was finished buying, my cost basis was $11.75. Last week I sold half of my position for $25.04. My cost basis is still the same, $11.75, but how much exposure to risk does my original investment capital have? The answer is none, zero, zip, nada. The reason is because I don't have any of my original investment capital left in the stock. It's all back in my brokerage account ready to be put to use when I find another stock on sale. The hold part of my buy and hold strategy is working for me now, since I'm going to hold the stock until it reaches the $30 to $31 neighborhood. That may take a week, or a year, or ten years, I have no idea. But if the price falls significantly, I won't be afraid to buy more shares, provided I still understand what a reasonable value for the stock is.

Maybe it's just me, but I like to be able to buy things at half of their reasonable value, and I like to take money off the table when I think the time is right to do so. Owning a stock for 50 generations has no appeal to me. Sure it's cool to say that a stock has been in your family for all that time, but at the end of the day, and I'm wondering this out load, I just wonder how much value there is in keeping a stock for that long without ever selling a share?

Okay, back to Merck. What if folks had taken the time to figure out what a reasonable value for the stock actually was before they bought it? What if folks had used dollar cost averaging to buy more shares on pull- backs in the price? What if folks had sold a bit along the way? Do you think those investors that managed risk in such a manner, would have a problem buying more shares of Merck at current prices? Or do you think they would be on the Internet trying to understand what "puts" and "calls" were?

The nose dive that Merck took, an almost $12 fall in a single day, should be a huge sign in front of the eyes of every investor that 's interested in the company, and it should read buy me, buy me, buy me! As the lawsuits over Vioxx pour in, and believe me they will, the price of the stock should fall a bit more, and again, if you're interested in Merck, those should be buying opportunities, provided of course your portfolio doesn't become to over weighted with shares of Merck.

So what do I think is a reasonable value for Merck? Well in looking at the stick figures I scratched out in the dirt, the company has to me, a fair value of between $51 and $53, which means, according to the value of half, when the price gets to about $26, I would take half a position, adding to that position on pullbacks in the price. Then once the stock had gone up by half, to around $39, I would sell half of my shares, leaving me with capital at risk of about half of what I started with. Once the price of the stock got to around $52, four halves, I would close my position, and again wait for the price of the stock to fall by half, so I could start the process all over again.

Sound simple? The reality is, it isn't. What's required is patience, and in visiting different websites and reading things about Merck, I would say "investors" have about half of the patience they need, which will yield none of the value they want.


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.