Understanding Bottom Fishing, The X-Factor, Risk Levels And The Buy Zone

Summary

  • The “buy zone” marks the first price support we might be interested buying at and the “bottom fishing” price.
  • The “bottom fishing” is where we take a more half or full position if downward momentum has tapered off.
  • The “risk level” is measured relative to the S&P 500 as speculative, high, market or low.
  • The “X-Factor” is the factor that I believe a stock can rise by within 5 years under ideal conditions and with excellent corporate execution measured from the “bottom fishing” price.
  • Building a position generally takes 2 or 3 purchases at fairly wide price intervals.

This is a brief glossary of terms that I use for identifying important investment related ideas for buying stocks. 

First things first.

Rule #3 (respective of Buffett’s rule 1 and rule 2): 

  • Only invest in stocks that you believe can beat the market by at least 5-15% on average per year over the next 5 years. It is not worth single stock risk to accept any lower potential return. 

Bottom Fishing Price

This is the most likely low support price I can envision a stock getting to without a deep bear market in stocks. It takes into account market technical analysis more than fundamental analysis of the company.

This is also the price that I base the X-Factor on. 

X-Factor

This is the factor that I believe a stock can rise by within 5 years under ideal conditions and with excellent corporate execution measured from the “bottom fishing” price.

So, if a stock has a “bottom fishing” price of $100 and an “X-Factor” of 4, that means I under ideal conditions and with excellent company execution on their business model, I can see the stock getting to about $400 in the next 5 years.

The S&P 500’s presumed X-Factor is 2. This means that in most 5-year periods, the S&P 500 can double, or average slightly under 15% annualized returns under ideal conditions.

After large stock market corrections (bear markets), this might rise to 3. After large stock market expansions (bull markets), this might fall to 1.

As of January 2022, I rated the S&P 500 as having an X-Factor of 1.5, meaning I’d expect the S&P 500 to do no better than rise to about 7000 by 2027.

Risk Level

A basic measure of risk relative to the S&P 500. There are 4 risk levels: 

  • Speculative – could go to zero.  Speculative tocks are only on a VSL (Very Short Lists) if they have extremely high upside. Will not be included unless the stock has an X-Factor of at least 20.   
  • High – could lose 50% or more permanently. These are usually small cap stocks or turnarounds. Will not be included unless the stock has an X-Factor of at least 10.
  • Market – could lose 20-40% permanently. Due to the extremely correlated nature of stocks in the stock markets, most stocks are deemed to have “market risk.” Most “market risk” stocks that made our VSLs have an X-Factor of 3 to 10. 
  • Low – could lose up to 20% and usually only temporarily. These are the most financially secure companies with the best businesses. There are less than 1% of these on the stock market in my opinion. Most “low risk” stocks that made our VSLs have an X-Factor of 2 or 3.

The Buy Zone

This is the range that I believe a stock is “most likely” to fall to in a small market correction or during a consolidation year when it resetting fundamental expectations. 

The top of the buy zone represents a first level of technical support and is reflective of roughly “fair value” for a stock. This will usually hold in a bull market that is having a minor correction. It will usually not hold in a bear market. 

The bottom of the buy zone is the “bottom fishing” price and is reflective of stronger technical support that we can see when a stock become undervalued. This is usually where institutions, hedge funds and family offices (the big guys) step in to be buyers. “Bottom fishing” prices are what to look for in bear markets.

Rule #4:

  • Don’t buy while there is downward momentum on a stock. Usually give it 1 to 4 weeks to confirm downward price pressure has mostly exhausted.

An Example using Microsoft (MSFT) where the orange box represents the “buy zone.”

TradingView Chart 

TradingView Chart

The top of the buy zone around $250 is the price level that would be expected to hold during a bull market correction. 

The bottom of the buy zone (bottom fishing) around $214 is the price level that would most likely be expected to hold in a “typical/normal” 30% downside corrective bear market.  

The area below the buy zone is the “Armageddon Zombie Apocalypse” price level. In general, if we see prices down there, we ask one question about a company: 

  • will it survive?

If the answer is yes, we buy shares.

During an “Armageddon Zombie Apocalypse,” which last happened in March 2020, we buy our 20-30 highest conviction stocks and a few top ETFs, then hold our noses. 

Example: 

TradingView Chart

TradingView Chart

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