An Investing Lesson from the Subprime Mess

Posted by Wayne on January 12, 2008 – 12:03 am

What a week, what a week!

ChaosNantuko asked the question that I’ve been dying to see someone ask on TickerHound:

Has the current subprime crisis caused these subprime assets to become UNDER-valued?

Now that is an AMAZING question and let me explain why…

First off, at some price ANY asset is worth buying. I know a lot of folks who ask me general questions like, “Is Microsoft a buy? How about GM? How about Sony?”

Those are all the wrong questions to ask… the question they should be asking - and the one you should be asking each time you make an investment - is, “At what price is this asset a buy?”

This might sound complex, but it’s really simple…think about it this way:

Imaginary Friend: “Wayne, I’ll sell you this computer for $10,000 - do you want to buy it?”

Me: “No, but I’ll buy it for $500.”

Imaginary Friend: “But it’s worth $1,000.”

Me: “Yeah, but I only buy things when they’re on sale - so I won’t pay you $10,000 or even $1,000 - I’ll pay you $500.”

That’s essentially what I do in the market each time I buy a stock. It doesn’t happen as quickly as a quick negotiation between me and my imaginary friend here, but it DOES happen. This of it this way:

Mr. Market: “Intel is at $40 per share”

Me: “Not buying it - I think it’s worth $30″

Mr. Market: “Intel is at $30 per share”

Me: “Sorry, still not buying it - I want it a better value.”

Mr. Market: “Intel’s at $15 per share”

Me: “Ok, I’ll buy a boat load of it!”

So that’s how you make money in the market - we come up with a value for an asset and then because we know we’re not smart enough to come up with an EXACT value, we use what’s known as a “margin of safety”.

Meaning, if I think something is worth $100 - I won’t buy it until it’s selling for $50, thus giving me a 50% margin of safety which not only decreases my risk, it also increases my reward!

So back to our subprime asset question my friend ChaosNantuko asked.

Are some of these subprime assets undervalued?

Well Bank of America sure seems to think so - they just bought Country Wide Financial for $4 billion!

This was a much needed bailout for the company and gave the rest of the market hope that some of the other troubled lenders will get scooped up on the cheap.

While I think there’s some more downside left in the subprime credit markets, now might be the time to start taking a look at some of these stocks. Like I said, I’d be ANY asset at the right price!