Mail Bag: Buying Stock When Valuations Are High
Here’s a mail bag question about investing when stock market prices are elevated.
What are your thoughts about periods when overall stock market valuations look very high? Should people not buy, or should people even sell? It seems like today is a time when most valuation measures show the U.S. market at extreme highs relative to history. What are your thoughts?
Alex
Although I’ve written about reasons people don’t sell stock during crashes and reasons people don’t sell overvalued stock, this is a bit of a different question. It gets more to the heart of the matter of portfolio management. For you to understand my answer, you need to take a step back with me for a moment and look at the entire picture; at least how I see it.
When you decide to buy or sell an ownership stake in a business through the publicly traded securities markets, you are most likely using one of three approaches:
- Valuation: Acquiring ownership by comparing the price you are paying for that ownership to either the underlying assets, net present value of discounted cash flows, or strategic value to some other existing operation in which you are engaged. Regardless of what the stock market does in the short-term, your ultimate performance wagon is hitched to the underlying intrinsic value produced in one capacity or another from the enterprise.
- Systematic Purchases: Acquiring ownership through regular, disciplined purchases (in the olden days, this was called “formula investing”). You might have money swept out of your bank account twice a month to participate in a dividend reinvestment program or you might have a given percentage of your paycheck withheld to buy an index fund through a 401(k) plan. The systematic approach is often coupled with a rules-based system for which securities are purchased; e.g,. with an S&P 500 index fund, you outsource the decision to the committee of individual men and women responsible for determining the methodology who are, indirectly, outsourcing that decision further to the valuation and market timing groups as they are the one setting the price under the present construction.
- Market Timing: You buy or sell based on what you think the stock market is going to do in the future; e.g., selling when you think stocks are due for a crash or buying when you think the market is going to appreciate for one reason or another.
With few exceptions, that’s it. Whether you realize it or not, you’ve chosen a path. Sometimes, people are simultaneously engaging in all three in a single family’s investment holdings. More often, they stick to one core approach (e.g., systematic purchase of index funds) and add a secondary augment (e.g., picking a few individual dividend stocks in great firms during stock market crashes). Let’s take a closer look at each philosophy.
1. Acquiring Ownership with a Valuation Approach
The first approach is most often favored by experienced business owners, value investors, insiders, and executives. It requires an understanding of accounting, finance, (in some cases) economics, relevant regulations, and a host of other factors that give you an idea of what an enterprise is truly worth. It isn’t unusual for specialists to develop certain areas of knowledge and stick to them, building wealth over decades as they focus on banks or oil, technology or pharmaceuticals. Ultimately, it is the only approach that matters because it is intrinsic value that acts like gravity on the other two, exerting its influence as it is the mean to which all else reverts. The key attractions of this approach, when implemented wisely, are what many value investors believe to be more sustainable returns and risk reduction due to the insistence upon a margin of safety. Although some exceptions exist (e.g,. Benjamin Graham’s net working capital basket approach in the aftermath of the Great Depression), valuation-based investors tend to be long-term focused, practice low turnover, and seek optimal tax efficiency.
2. Acquiring Ownership with a Systematic Purchase Approach
Most people have neither the time, skill, nor inclination to dedicate themselves to that sort of operation. As a result, people like Benjamin Graham and John Bogle came along and suggested a formula-based approach be taken as a next, best alternative. This approach took many of the best attributes of intelligent investing – a long-term focus, low turnover, diversification, reasonable tax efficiency – and apply it to a list of individual stocks and bonds held in a cost-efficient way. Graham came up with a checklist of attributes one should use when constructing a “defensive portfolio” as he called it, while Bogle encouraged people to outsource the work to his firm, which, in turn, outsourced it to the aforementioned committees (though, to be fair, that is only for a handful of index funds; of its $3.1+ trillion in assets under management, Vanguard has $2.15 trillion in passive index funds and almost $1 trillion in actively managed funds, with the active funds outperforming the passive funds for many years now because most of the active funds still adhere to the disciplined Graham-like approach and can take advantage of some of the stupidity in the index construction that has happened since 2003 when the rules began to be quietly changed). Roughly, as long as you were paying less than 1.5% for all services, inclusive (with a few exceptions that can make sense – e.g., a $500,000 trust fund at Vanguard once all is said and done is going to run you 1.57%, which still a very good deal all things considered), you might expect to do reasonably well if you stuck with a program and regularly acquired through bull markets and bear markets, good times and bad times.
Graham, perhaps the original behavioral economist, understood that people in the second category would be tempted to “do something” when they felt the market was unduly high or unduly low so he created parameters stating that bonds should not fall below 25% of a targeted asset allocation or rise above 75% and visa versa for stocks. If things got truly out of hand, the investor could use systematic sales, new deposits, dividends, and interest to slowly rebalance his way to the new, preferred mix, relieving the pressure to act while improving the odds that a significant failure in judgment didn’t throw the investor too far off-course. Bogle has indirectly adopted this approach in his writings, though he refers to the excess valuation multiple applied to earnings as the “speculative” return component, which, in turn, informs his own asset allocation. Different lyrics, same song.
3. Acquiring Ownership with a Market Timing Approach
The market timer, in contrast to all of this, is concerned with what he or she thinks the stock market will do in the short-term future; whether a stock or other security will go up or down. Many apply technical analysis to some degree or another. Many try to exploit their hypotheses with the use of derivatives or borrowed money. Most end up broke or doing poorly over time but a handful, either through luck or skill, do extraordinarily well, fueling the dreams and ambitions of those who would seek to emulate them.
An Example of How All Three Ownership Approaches Might Work
Let’s imagine you’re in an ordinary interest rate and inflation environment and you’re looking at a stake in a large, successful business. This stake, your part of the enterprise, produces $100,000 in after-tax earnings with a reasonable expectation of 12% growth over the next decade, 3% terminal growth thereafter. A reasonable investor might conclude fair value is around $2,200,000.
An investor taking the value approach might pay $2,200,000. If the empire were truly remarkable, perhaps a bit more. Ideally, he or she would want a price of $1,474,000 or less, acquired during a period of market panic like 2009. As long as the underlying earnings projections are still intact, this investor doesn’t care if the market quotation of the ownership stake falls to $900,000 the moment after he or she has bought it. It’s inconsequential as long as they aren’t forced out by a so-called “take under” transaction. Charlie Munger is an excellent illustration of this approach. He values each business in which he takes an ownership stake, famously sitting on Treasury bills for years at a time then swooping in to acquire positions he holds for the rest of his life. During the last collapse, he bought obscene amounts of Wells Fargo & Co. stock for practically nothing, unloading cash reserves with breathtaking rapidity. In 1973-1974, the portfolio under his control was down a staggering 75% on paper but it didn’t matter because he had valued the real on-going business value of each position as if it were a private company he were acquiring to operating himself. This investor would be nervous if the stake rose above $3,500,000, perhaps considering selling for a more attractive opportunity as the price could not be justified.
An investor taking the systematic approach would regularly buy into the ownership stake regardless of whether the price was $900,000 or $3,500,000, figuring it would work itself out in the end. Sometimes, they’d get a great price. Sometimes, they’d get a terrible price. Over a lifetime, it’s a wash; at least, that’s the hope, which may or may not turn out to be the case. (It’s worked out that way, historically, but past performance is no guarantee of future results.) The really smart investors in this category, in my opinion, choose the handful of 50 or 100 great firms – the Colgate-Palmolives, Johnson & Johnsons, and Coca-Colas of the world – and buy them for costs that were next to nothing thanks to a dividend reinvestment program or low-cost brokerage or retirement account. With strong balance sheets, diversified income sources, and economic engines that make their competitive position nearly non-assailable, even when bought at stupidly high valuations, they tend to burn off any excess valuation over 20, 25+ year periods and still compound at satisfactory rates despite a few bankruptcies in their midst, such as Eastman Kodak. Again, there is no guarantee that will continue to be the case in the future but I’m trying to explain the reason people take this approach and the general thought process behind it.
An investor taking the third approach – who isn’t really an investor at all, in my opinion – might look at the price at any given moment and say, “I think stocks are going to fall, therefore, I’m going to sell with the hope of buying back at some point in the future” or “I think this stock is going to skyrocket, therefore I’m going to buy it”. At first glance, to the inexperienced, this may look like it has hints or echoes of the first approach; valuation. Nothing could be further from the truth. (I see inexperienced investors mix up the two all the time.) The valuation-based investor knows you cannot predict the market. He or she doesn’t try. It’s a fool’s game. Instead, he or she is acquiring cash flows and exploiting the market price to that end, figuring it will work out at some point but not in any way attempting to bank on it because if they are wrong, they’ll eventually get their intrinsic value extraction either through buybacks, dividends, or a buyout. They don’t know when it will happen.
How Each Investor Might Behave When Stock Prices Are High
Now, to the heart of your question: How to behave when stock prices are high. Let’s go in reverse order this time.
The market timer is likely to sell for no reason other than he or she expects stock prices to fall.
The systematic purchaser is going to stick with the systematic purchase schedule he or she established, plugging away until retirement.
The valuation based investor makes case-by-case, security-by-security decisions. It’s all about owning the most risk-adjusted net present value of future cash flows. That’s it. On the purchasing front, he might have to look around harder for opportunities. There are somewhere north of 30,000 publicly traded businesses in the world so there’s nearly always something intelligent to do. If something can’t be found, the cash reserves grow. He’ll never not buy a good deal, or more ownership of a wonderful firm, because stocks are high and might fall tomorrow if the individual acquisition makes sense on its own. He’s totally stock market agnostic. As for selling, again, it requires a security-by-security analysis of deferred tax liabilities and the amount of cash that would be freed up to acquire other net present value earnings elsewhere. If you have a position you bought 25 years ago and it grew at an average of 10% per annum, turning $100,000 into roughly $1,083,500, you have to decide how much of that $983,500 unrealized gain is really an interest-free loan from the government based on your own tax bracket and asset holding method. Does a 30% overvaluation really matter so much in the long-run if it’s a great business and selling it might cause you to give up $300,000 in capital to various levels of government taxation? Especially if you can pass it on tax-free to your children and grandchildren using the stepped up basis loophole? Not really. It’s a different question entirely if the shares are held in a tax shelter such as a Rollover IRA.
For me, personally: I don’t believe in market timing. I don’t think it can be done in any reasonably consistent way. I think most people who try are fools. I believe the academic evidence is crystal clear in support of this. I’ve seen many, many, many, many, many fortunes built by valuation and systematic approaches. I’ve been treated very well in my own lifetime by the valuation approach. I think the key is intelligently-acquired, mostly passive, long-term, tax-efficient holding. It’s so perfectly obvious, I don’t understand why some people allow their emotions to get the better of them.
Every time I pull the spreadsheets used to monitor our holdings, I look at what we own and think of them just like I do the private businesses or a piece of real estate. I try to figure out how much net present cash flow we should collect under most reasonable economic projections. I look around and see if there is a much more attractive opportunity somewhere else. Sometimes, I make adjustments for the purposes of risk management. I’m looking at the net present value compared to the market price, in light of interest rates and inflation. It’s like an engineer standing back from a set of plans and saying, “This is well constructed. Everything is within reasonable parameters. I’m comfortable with it.”
“I don’t spend a lot of time thinking about the stock market proper. I’m more concerned with the specific earnings of a specific firm relative to a specific price I paid or want to pay.”
Most of my time is figuring out 1. what I want to buy, and 2. the price at which I want to buy it. I’m fine holding cash, if necessary. Most of the selling I do is about risk mitigation. I’m of the school, “Well bought is well sold”.
I wish I could be more “here are some easy rules to follow” but it’s such a unique, situation-specific thing. It’s like cooking, when you need to tweak the seasoning. Or rearranging the furniture in a room. I do the intellectual side of it – the cold numbers – then I tweak the edges until it feels right and I can sleep at night without any worries, even if the stock market were to close for 5 years. I view each position we own as a stand-alone opportunity then analyze how it falls within the overall portfolio. I don’t spend a lot of time thinking about the stock market proper. I’m more concerned with the specific earnings of a specific firm relative to a specific price I paid or want to pay.
I will say that for those who are inexperienced and stick largely to the formula approach, I think it’s a mistake to begin deviating from the plan you’ve put in place if you’re talking about time periods of more than 10 years unless we’ve totally jumped the shark – something like earnings yields on the S&P 500 at 1/2 or 1/3rd the yield of a 30-year Treasury. That seems to happen only a couple times a century, thankfully. I say this because I’ve witnessed too many people who have no idea what they are doing start market timing, deluding themselves they are somehow acting on valuation. They sell some stakes in wonderful businesses because prices are high, but if you actually ask them, “What are the cash flows you expect in the next decade? What was your discount rate? What is the implied real rate of return you expect or demand – is it more or less than the historical 6.5% real (net of inflation) return demand from equities that investors have traditionally required and if so, why? What were your assumptions about taxes and costs? How long could you remain parked in cash at zero percent rates of return before you lost ground to your former overvalued position?” they have no idea. They were simply betting the stock price was going to decline and justifying their desire to act with some general, vague sentiment that felt logical enough for them to waive it off with their hand. This tendency in the inexperienced is so bad that Morningstar Investor Return figures (what investors actually made as they put money into their holdings versus the underlying compounding rates of those holdings) are atrocious. One of the latest data sets I saw covered the 10-year period ended December 2013. The typical mutual fund during that time provided total return of 7.3% but the actual mutual fund investors made only 4.8% because they kept moving money in and out trying to predict the future or chase returns. It’s such a waste both for the investor and for the fund managers, who have to deal with the added costs caused by the folly.
Read More: On January 20th, 2016, I wrote an update and expanded essay on this topic called Market Timing, Valuation, and Systematic Purchases.
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Reader Comments (46)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Jay Young
October 18, 2015
Hi Joshua,
I'm trying to reconcile that last paragraph with something you said in a comment on the McCormick accounting homework posted a while back: https://www.joshuakennon.com/an-accounting-homework-assignment-for-those-of-you-who-want-to-learn-to-analyze-businesses/#comment-1951519825
In that comment you said: " If I recall correctly, they increased the estimated intrinsic value per share of the firm [...] by dropping the assumed return investors might demand for holding such a high quality business from something like 9% to 7.5%. It's an idiotic way to behave. Don't do it."
This sounded to me like you didn't agree with the CAPM cost of equity formula (CoE = Riskfree rate + Beta(ERP)), or at least the equity risk premium piece of it. However, in the last paragraph above, it sounds like you think investors should be considering it when valuing companies. Specifically, the quote "What was your discount rate? What is the implied real rate of return you expect or demand – is it more or less than the historical 6.5% on equities that investors have traditionally required and if so, why?" This sounds like the equity risk premium in the formula above. Maybe there's a nuance I'm missing, but no matter how many times I read those two blurbs it still seems like they're contradictory.
-Jay
PS: Thanks for all of your writings!
Joshua Kennon
October 18, 2015
Replying to Jay Young
Great question; sorry for the confusion. I should have explained what I was doing in the quick illustration.
Since the conversation involved a mention of Graham and Bogle, I was attempting to keep it relevant by using Bogle's preferred method (see essay Don't Count on It! The Perils of Numeracy based on keynote speech at the "Landmines of Finance" Forum of The Center for Economic Policy Studies at Princeton University on October 18, 2002) of estimating intrinsic corporate value by focusing on his belief that a reversion to the mean - in this case, a 6.5% real return on equity - was the only sensible way to behave, slapping on an inflation kicker plus a small margin of safety and coming up with a rough approximation of how he might look at a stock or index based upon those figures. The hypothetical question was simply to see what they thought they were doing - what their process was, had they put any reflection into it at all.
Personally, I take the owner earnings and apply a discount rate equivalent to a reasonable estimation of the long-term risk-free rate (I'm not so keen on using it at the moment as I don't think it's sustainable) with an inflation estimate on top, then valuing all assets across the board as if they were the same. The reason, as we may have discussed in the past, is because it forces you to brutally, unapologetically confront the guesses you are making in the cash flow calculations. People, at least in my experience, like to fool themselves by pulling numbers out of a hat and then upping the discount rate thinking it will protect them. Perhaps it does but if you need it, I don't think it falls into the definition of "investment" as Graham laid out in his work; there isn't sufficient certainty there, you're inherently speculating, so you should acknowledge that and go about it with a different process than an investment. If I'm speculating, I want to know I'm speculating. I want to own it. Fully, completely, and without any lack of clarity. I also want it isolated, in most cases, from my other funds.
I may choose to accept ownership in a firm such as Coca-Cola at a higher price, and therefore lower return, than something else on the roster because I think the absolute certainty or safety of it justifies holding it from a risk management perspective but I confront that at the end of the equation, not the beginning. That's the difference. I still say, "This is what I think Coke is worth", I just am willing to get closer to that figure due to its inherent quality when I take out the checkbook whereas other firms, I might demand a bigger discount.
This is the reason I can't tell you what the intrinsic value of something like Facebook is with the degree of requisite precision I require to part with my hard-earned cash. I have no idea. It's not necessary for me to do well. Anything I put into the formula is going to be a guess so I don't delude myself by thinking I can make it comparable to, say, McCormick by simply applying a double discount rate. Instead, I say, "Too hard" and throw it off my desk. It's a safety mechanism; a way to attempt to avoid a lot of the folly and nonsense most investors fall into because I am honest about the limitations of my predictive power. People are too caught up in their egos. It's nonsense. "I don't know" are some of my favorite words when it comes to identifying assets I want to acquire. The heavens have not called on my to be a genius who can pontificate on any and every stock, but rather, a sniper looking for what I want, picking off shots I'm reasonably certain I can hit under present conditions and visibility.
Now for the stuff that isn't suitable for most ears:
There are times a firm like Facebook may make it into the portfolio but it's when I resort to Graham's "fat man" test we've talked about in the past - his assertion that certain firms cannot be valued precisely but, like seeing a fat man in a crowd for whom you don't need to know his exact weight to know he is obese, specific assets, at specific times, are so clearly outside of the parameters of "cheap" or "expensive" due to some set of unique circumstances, often ephemeral, that no matter how you project the future cash flows, it's clear people are either giving away the farm or have lost their mind. If nothing had changed with the business model and Facebook were at 5x after-tax earnings tonight, I'd buy a lot of it. I might - might - in extreme cases where I thought the upside was substantial but there was a remote risk of bankruptcy that was enough to raise my eyebrows, purchase a long-dated put contract based on an estimate of what I felt the probabilities/certainties were provided the premium was satisfactory but that is not the sort of thing gentlemen admit in public. It's one of those things that disciplined, intelligent people occasionally do in special operations that, if they make known, you run the risk of people doing it all the time as, again, some sort of misguided delusion it is protecting them when after accounting for the expenses, they're going to destroy their returns and they'd have been better off buying a block of Coke and sticking it in a vault for 25 years. This situation sometimes presents itself in entire industries. Several times in the past year, I've mentioned Charlie Munger observing that he lacked the capability to value pharmaceutical stocks because they were outside of his particular area of existing expertise so his solution would be to buy a basket, either individually constructed or through an ETF of some sort, if there were a period where he thought the industry as a whole was suffering some sort of temporary disfavor.
Getting back to the heart of your question, the CAPM cost of equity formula is moronic. The better model is opportunity cost. You look at all potential investments on your desk, you pick the highest returning ones within your risk parameters, and you let time do the rest. It is the only intelligent way to conduct yourself. You will never see me using beta as any sort of valuation input except for short-dated options, where they have some utility. As it pertains to long-term equity investment, beta is cognitive vomit produced by people in ivory towers who want to delude themselves with a false sense of security. In most areas of life, I think it's at least understandable how a person can come to believe another position but this ... this is simply deranged cult thinking.
Instead:
1. Calculate a range of probable cash flows under different scenario assumptions with the greatest certainty you can (discarding those you can't)
2. Discount cash flows at risk free rate + reasonable inflation kicker
3. Compare all cash flows across the board to present market price to determine valuation level
4. Construct a portfolio that keeps your risk parameters satisfied and contains adequate internal stability
Anything beyond that and red flags should be going up because you're building what engineers call "break points" into the model. Each break point, each level of complexity, is a point at which something could go catastrophically wrong because of the inherent assumptions or inputs which begin to exponentially multiply the permutations. By keeping it simple, you reduce it to its rawest, purest form and clarify your thinking.
(I hesitate, strongly, to talk about this sort of thing because there is so much room for misinterpretation; people hear what they want to hear. I've mentioned a few times in the past that gotten messages that are so panic-inducing - e.g., "I want to be a conservative long-term investor like you so I bought call options on Coca-Cola" my immediate reaction, depending on the time of day and the amount of work I have to do, is to try and dive in like a lifeguard at a swimming pool to save them from themselves or, alternatively, delete the blog with a mouse click at the server level, knocking over a lamp as I leave the room yelling, "Bye, Felicia". I've lost count of the number of people somehow connected to my extended circle who bring me their holdings to look over. When I do, I discover - no joke - things like 3x leveraged inverse exchange traded funds. It doesn't even surprise me anymore.)
Jay Young
October 18, 2015
Replying to Joshua Kennon
Thanks, Joshua. That was a better response than I was hoping to get. I dove into this stuff a little over a year ago, and for someone with no formal financial training it seems there's a lot of content on the web discussing investment philosophy but not so much about mechanics beyond the myriad sites declaring "Okay, take EPS, grow it at some rate and discount it at the 10-year T-bond rate. That's what you should pay for the stock. Here's a calculator and please click on some ads." So even though I've read tons of content extoling the virtues of value investing and have really taken it to heart, it's been tough figuring out the best mechanism for calculating intrinsic value. CAPM is appealing to newcomers because it's a set of formulas. Gather inputs, make estimates, and a number comes out the other side. I've read a lot of articles and comments debating why it's off the wall, but not so much about what to do instead. This and your discussion about owners' earnings really give a good sense of what you think truly matter. I understand your reasoning for not discussing details, so I greatly appreciate those insights you choose to share.
Cheers!
Ang
October 18, 2015
Replying to Joshua Kennon
This response would be excellent as its own mailbag article. Although you would need to strip out some of the speculation parts for reasons you laid out above
Joshua Myers
October 18, 2015
Replying to Joshua Kennon
Joshua, you always mention how much you hold back because people misunderstand (or reinterpret) what you say and do crazy or dangerous things with their money as a result. I understand why you don't divulge more. I've seen myself how people can misuse information (i.e. Reading a biography on Warren Buffett and then concluding that they should be day trading in leveraged index funds. I've literally seen that twice.) What's frustrating some times is that a lot of good information is left out for people who aren't acting irrationally. It feels like the discourse gets dumbed down to protect some people from themselves.
I'm not trying come across as blaming you for anything. You obviously don't owe anyone here anything, and you give a lot. I just kind of wanted to vent about it for a second.
Kapitalust
October 18, 2015
Replying to Joshua Kennon
I recall chuckling and shaking my head in undergraduate political science courses when they tried to use complex mathematical formulas to try to explain state behaviours and interactions. Nonsense.
The same thing occurred as I started learning finance. I got awfully suspicious really fast once I realized I could tweak discount cash flow and other formulas to get the exact values I was looking for. Not that there isn't some value in the formulas, it's just so seductively easy to dial the knob on the discount rate and other numbers to get the formula to spit out the numbers you are looking for.
There is a lot of wisdom in what Joshua warns about when it comes to being weary of using set finance formulas exclusively to come to valuations.
lnt90
October 18, 2015
Replying to Kapitalust
Ditto.
Derek
October 18, 2015
Replying to Joshua Kennon
I just want to say thank you for a very educational post, and especially for the phrase "cognitive vomit."
David Evans
October 20, 2015
Replying to Joshua Kennon
Your investment evaluation and decision formula bears a striking resemblance to going through Value Line tear sheets.
Joshua Kennon
October 20, 2015
Replying to David Evans
Generally, I think their analysts do a much better than average job at focusing on the underlying fundamental economic reality of an enterprise. I think their focus on "timeliness" is all but useless for what we do - I don't care if something underperforms the market over the next year, I want the most value. I also think their projections for certain high risk situations are bunk; firms for which no reasonable estimate of intrinsic value can possibly be known due to unknown inputs in the cash flows.
I wouldn't use them for their buy or sell recommendations if you are considering a subscription. The real value is in the convenience of the multi-year summary to serve as a basis point for finding enterprises with certain surplus cash generating properties.
Then again, I don't listen to anybody's buy or sell recommendations. It's inconsequential because I trust my own judgement and experience far more than someone sitting in a cubical whom I've never met and probably doesn't have as big of a risk aversion preference as I do ... I've seen far too many justify valuations during bubbles and recommend selling or building cash during busts.
Todd
October 21, 2015
Replying to Joshua Kennon
Your comments are of a much older person. If I didn't know your age I would think you where in you late 60s early 70s. The knowledge you have at such a young age is puzzling to me. Warren Buffett said one time , The one thing about running money is the older you get the better you get because of years of experience on investing. You seen to be on the fast tract. One thing about Experience you can't learn it from a book.
David Evans
October 22, 2015
Replying to Joshua Kennon
I agree with you that the utility of Value Line lies primarily in identifying businesses with superior economic qualities by the numbers. Also agree that the analyst recommendations and "timeliness" and "technical" scores should be viewed with a healthy dose of skepticism or completely ignored. Thank you for posting this very helpful article.
Jeff
October 22, 2015
Replying to Joshua Kennon
I like ValueLine as well, and get access to it free through my university library. Weight Watchers is an interesting example of a high risk situation. I'm not sure what Oprah can do about all that debt.
Todd
October 18, 2015
Joshua
What investment mistakes have you made and what have you learned from them?
Jeff
October 18, 2015
Replying to Todd
See: https://www.joshuakennon.com/borders-group-the-single-dumbest-investment-we-ever-made/
He also discusses mistakes with regards to not buying Hershey earlier:
https://www.joshuakennon.com/investing-hershey-company-made-generations-investors-rich/
Eric
October 18, 2015
I would imagine when using a systematic approach to purchase single equities, total market valuation wouldn't even enter ones field of vision. I mean, if you're picking the best stock out of 30,000 possibilities every month, you're probably getting a pretty good one. Thanks for the excellent perspective
lnt90
October 18, 2015
I've noticed a lot of people who use traditional valuation methods tend to use short term assumptions of growth and project them out into the future as they were normal. A prime example is Chevron & ExxonMobil, clearly they are going through the abyss of the cycle and are going to post significant declines in profits and cash flow, and many educated people are projecting eight years out into the future that this will continue and judge the stock is not worth it, judging the company only on the last few quarters and totally ignoring the long term views. They completely ignore the quality of the underlying assets and don't understand the qualitative side of the business. On the flip side I've seen MANY people who project Facebook or Apple to continue to grow at the rapid pace they did in recent years and project them out into the future without looking at the reasoning behind the numbers. It baffles me as how people can mix up short term realities with long term projections.
Eric
October 18, 2015
Replying to lnt90
I think Munger said, "I don't look at projections because I don't like to throw up on my desk"
lnt90
October 18, 2015
Replying to Eric
Words to live by for sure.
Brendan
October 19, 2015
Replying to Eric
Haha! Yes, isn't it peculiar that projections always point to "bonanza!"
Jeff
October 18, 2015
Replying to lnt90
The thing is Apple doesn't need to grow to be a good investment based upon recent prices. There is a risk of another technology company surpassing it, but this isn't Nike or Starbucks which are priced with an assumption of continued major growth.
Bob
October 19, 2015
"e.g., a $500,000 trust fund at Vanguard once all is said and done is going to run you 1.57%,"
Can you back this up? Their expense ratios are far lower than this. If I own VTSAX and VTIAX (total domestic and international markets), how could my costs possibly be this high?
joe pierson
October 19, 2015
Replying to Bob
https://personal.vanguard.com/us/whatweoffer/advice/trustservices
you're looking at about $7000/year in fees, depending, on 500K
Brendan
October 19, 2015
Replying to joe pierson
On point! An earlier blog post about starting a global asset management firm alluded to this: "you’ll hear people who have no idea what they’re talking about suggest lottery winners forgo financial advisers to save on fees, buying Vanguard funds instead (mistaking the advice of some intelligent people to avoid “helpers” – which is not what the original authors and commentators were talking about only they don’t know the difference). As I said then, and reiterate now, it’s moronic; indicative of a person attempting to take the most rational situation for a reasonably successful office worker making $50,000 a year and scaling it to amounts he or she neither understands nor comprehends. To try and save themselves 1% to 3% per year over the index fund, they’ll cost themselves 10x or 100x that in opportunity cost on an after-tax, inflation-adjusted basis."
Joshua Kennon
October 19, 2015
Replying to Bob
@joe pierson was kind enough to send you the link to Vanguard's fee disclosures, which spell out their fee schedule (e.g., $4,500 annual minimum base fee + $2,500 annual sole or co-trustee fee + underlying expense ratios on the investments selected, which will range from 0.05% to just shy of 1.00%), so there's no need to discuss the specifics in much detail as they are plainly laid out by Vanguard itself. For what it's worth, were you to split the trust down the middle into the two funds you mentioned (which would be a waste, in my opinion, given what you're paying for otherwise), your all-inclusive annual fees, including "look-through" fees would be $7,475, or 1.50%, per annum.
Instead, let me address the broader point by saying this: 1.57% in annual expenses (or 1.50% in annual expenses if you went with the more restricted, less tailored allocation you suggest) is not high for an account of that type. It's not even remotely high. Vanguard is being more than fair for the services involved. If they were to accept a lower price, I'd think they'd be bordering on irresponsibility given the liability and services they are taking on for the trust client. It begins to drop significantly as you reach multiple millions of dollars in assets under management with them as it scales beyond the base charges but there is no way any rational person with $500,000 would sign up for a trust service charging less than that as it would indicate something was very, very wrong. This is not an area in life where you should be tempted to take the low ball bid.
Even that is not truly indicative of the actual potential cost structure as almost all of Vanguard's funds have significant built-in unrealized taxes that, under the wrong circumstances, could cause the trust to have huge tax liabilities due to a quirk in the tax laws that require it to pay other people's taxes, which could be devastating at the compressed tax rates to which it is subjected. Unless the trust has some sort of internal tax protection, it could get slaughtered. For example, more than 34% of the net asset value of VTSAX consists of built-in capital gains. A decent-size run on the fund could trigger enormous tax payments under the wrong set of circumstances. I don't like that. It's one thing to hold in a tax shelter such as an IRA or 501(c)3, another entirely to invest in it outright or through a trust. Thus, the "real" expense ratio could suddenly skyrocket far beyond what a private bank or wealth management company would have charged for a separately managed account under certain conditions.
That's one of the problems with investor behavior; most people have no idea any of this stuff exists or how to actually look at the entire cost structure to make apples-to-apples comparisons. Stepping back from trusts, specifically, for a moment, for a plain-vanilla, fully-taxable brokerage account, if I were outsourcing the job to someone else, I'd much rather pay a really good asset management company fees ranging from 0.75% to 1.50% on invested equity depending on account balance and mandate for an individually managed account than I would pay Vanguard it's 0.30% advisory charge + the underlying fund expense ratio. The additional control (geographic, income, risk expose), tax efficiency, ability to incorporate ethical values (e.g., a lot of people don't want to own tobacco or weapons manufacturing companies regardless of valuation), and a host of other factors make it extraordinarily more attractive to me. As long as the right behavior is in play, including low turnover, it's a better deal. They'll never see that. I've referred to this recent phenomenon of focusing on the expense ratio alone, in isolation of all other relevant factors, as a secular religion and I mean it: It's risen to the height of total irrationality in some quarters; a tenant of faith and adoration that becomes the only thing worthy of discussion. You'd think they'd be tipped off that there's more to the game then that when they saw that practically all of the rich don't share this singular obsession, rather tailoring their financial affairs based on their own unique needs and opportunity cost (which is how many got rich in the first place - they're smart about money).
The whole thing is so bizarre I once heard someone describe a very good, white-glove private client group that was only open to investors with many, many millions of dollars as "expensive" for charging 1.25% on a global SMA (plus you'd have had a couple of basis points in other fees from the custodian and broker) when the the comparably closest Vanguard fund had a 0.96% expense ratio + you'd have needed to pay the 0.30% advisory fee for a much lower level of personalized service, which would have totaled around 1.26% with all of the horrible built-in taxes that could hurt you and the inability to customize the portfolio on a security-by-security basis. It's nuts to me what people will believe. They get these narratives in their head and can't think straight or see the entire picture.
It's the same way as people associating Vanguard with indexing. Roughly 1/3rd of the entire place is made up of actively managed mutual funds which have trounced their respective indices for many, many years now. Or who talk about selling on valuation as if it were "marking timing", ignoring that John Bogle himself became so overwhelmed with the irrationality of equity prices at one point in his career he wisely went to a 100% bond allocation and he is now sounding the same alarm about bond prices, which are in full-blown bubble territory.
Sorry for going off on a tangent ... you caught me on a coffee break and I get a little wound up about it because it's one of those things I simply do not understand understand, like skinny jeans (in what intelligent world did the British think it was a good idea to attempt to force a fashion trend on a country like the United States, which is suffering from an obesity epidemic?) or doing crystal meth (what sane person looks at the potential destruction it could cause and thinks, "Oh, yes, my life would be much enhanced by trading a bit of momentary pleasure in exchange for adding crippling addiction, financial obliteration, destruction of beauty capital, and potential jail time to my roster of experiences"?). Is the examination of the bigger picture and trade-offs really that difficult for people? I should go back to work ...
Brendan
October 19, 2015
Replying to Joshua Kennon
I had no idea that index funds such as VTSAX had such tax liabilities, especially when held outside of a tax shelter.
Joshua Kennon
October 19, 2015
Replying to Brendan
I'd bet 95%+ of investors don't. It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery. They, quite literally, could be putting a massive amount of their winnings on the chopping block for the IRS to come in and grab it if the stars happen to line up in the wrong configuration. It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
If you want to see a truly, jaw-dropping example, go back and look at the famous Sequoia Fund report from years past. Here is just one example. It was setup by a friend of Warren Buffett following the dissolution of the main Buffett partnership and continued to hold a lot of Berkshire Hathaway stock. In that particular, randomly chosen year (2005), of the $3,772,382,901 in net asset value, $2,345,962,204 represented unrealized capital gains. While the fund was closed to outside investors for decades, management used to outright warn existing shareholders to stop buying it in taxable accounts because the (first world, to be sure) problem had grown so excessive due to their fantastic record they were going to get slaughtered at some point; it was all but an inevitability.
Smaller investors don't have to worry about this sort of thing because almost all of their money is in Roth IRAs or whatnot. That's what I mean when I say they take a rational solution for them (if you don't know what you are doing, have a tiny amount of money, and want good diversification, index funds are a Godsend) and attempt to scale it beyond amounts they can possibly comprehend or understand. It would be like trying to build a skyscraper using the same tools and technology as a log cabin. It's gong to end in disaster because there are complications, rules, regulations, tax quirks, and other things that suddenly become an issue, which they never confronted and don't even know to guard against.
Vanguard's S&P 500 fund is one of the worst in this respect. Of the $198,712,172,000 in assets it had at the end of its fiscal year, a whopping $89,234,130,000 consisted of unrealized capital gains that could someday be triggered. (Take a look at the 2014 annual report in PDF format for yourself.) That's almost 45% of the entire capital base! Stop for a moment and let the horror of that set in. If you're affluent and in a top tax bracket, subject to the 20% rate + the 3.8% Obamacare tax + a state tax on capital gains, we're talking real money that could potentially flow out the door even if you're simultaneously suffering losses as you pick up someone else's tab. What sane person would buy the fund in a taxable account under these circumstances? A 401(k), 403(b), SEP-IRA, whatever ... sure. A brokerage account? No. Absolutely not. Why take on the risk? The generational tax consequences are severe, too. If you held the individual securities, instead, you could potentially pass them on to your children using the stepped-up basis loophole, whereas you can't do it with the underlying appreciated shares of an index fund.
If - if - indexing continues to receive a disproportionate share of asset inflows over the coming few decades and we reach a tipping point where it decouples from underlying intrinsic value due to money flows exerting a bigger influence on market quotations (and therefore market capitalizations), between the potential tax consequences and the silent methodology changes over the past decade and a half that have torn the S&P 500 off its underlying historical hinges, favoring the rich insiders over the mom and pop investors, I think there could come a day, under the wrong set of circumstances, John Bogle - a man for whom I have enormous respect - is scapegoated as having unleashed the equivalent of the CDO or sub-prime debt on the world when the real culprit was the fact that so many of the people adhering to his philosophy lacked his common sense. Bogle wouldn't have been buying an equity index fund at 70x earnings or if it had some how gone off the rails. He's too smart. He's got too much Graham in him. Yet, so many of the acolytes have no idea what they own, why they own it, or why indexing works. They worship its form while remaining totally ignorant to its substance. I vacillate between feeling, "they'll get what they deserve" and "maybe they're good people who, though they'll view you as the enemy for pointing this out, don't know better and you should write about it".
Ang
October 19, 2015
Replying to Joshua Kennon
Maybe a dumb question, but wouldn't it be that the cash outflow scenario you are describing could really only occur in a massive crash (triggering a panic)? In which case, the capital gains would theoretically be wiped out? Of course, that's only assuming that the crash in prices affected securities proportionally by the amount of capital gains built up in the first place, but in any case, I would think it would lower the tax pain felt by fund holders
Could something different trigger a massive enough outflow that would trigger capital tax consequences for fund holders as the fund is forced to liquidate securities?
Joshua Kennon
October 19, 2015
Replying to Ang
Throughout history, many industry or firm-altering outflows have been triggered by little more than a shift in sentiment; like Dutch Tulips, a style is in one minute, out the next, and people are running for the exits to follow some other allocation methodology (I think, on a related note, the recent emphasis on robo-advisory services by some major players, with echoes of the 1980's attempt at automation that led the 1987 crash, are unrestrained idiocy; to put your entire life savings at the whim of an algorithm with no human judgment is asinine. I hope adaptation is not sufficiently high to cause it to become problematic from a system-stability standpoint.)
Unfortunately, even when that isn't the case, you would think your thesis would hold true. It sounds reasonable, right? Sadly, life never seems to work out that way. Real world experience doesn't match what appears to be common sense. Part of this is because you don't know which, specific portfolio holdings were bought at which, specific prices (e.g,. Apple has massive embedded gains and would be among the largest weighted proportion sold if people started redeeming - it could drop by half or more and still have staggering embedded unrealized gains to be taxed, whereas some of the smaller positions might have been recent additions).
The best way to understand it is to look at what actually happens in the real world. Go back and pull the Oppenheimer Developing Markets Opportunity fund during the Great Recession. Let's take an extreme example to show how unbelievably ridiculous and unfair the disconnect can be. Imagine you bought it at $57.13 on 10/29/2007 before the world fell apart. You're a good, disciplined buy-and-hold seller so you don't plan on parting with it for a long, long time. On March 3rd, 2009, you are getting ready to file your upcoming taxes, due in April, for fiscal year 2008. You crack open your account. What do you find?
Your shares were at $13.52. You also had $8.88 in cash sitting in the account.
"That's odd", you think. Nope. The fund was forced to liquidate a lot of embedded gains, which occurred in a way that didn't offset perfectly on the way down. Specifically, $0.5583 per share in dividends, $8.0128 per share in long-term capital gains, and $0.3087 per share in short-term capital gains. Depending on the state, you might have owed $2.66 or more in taxes, leaving you $19.74. So, at this point, you've lost almost 35% of your money on paper and you have to write the government a fairly hefty check, picking up the tab for someone else's capital gains.
If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place.
If you're looking for case studies, another example is the Vanguard mining fund - I forgot what it is called, it's the huge one - back around the same time or a few years thereafter. There was one year where it kicked out a big percentage of its NAV to shareholders for taxable gains based on redemptions forcing the managers to sell off holdings to raise cash. Those especially hurt because it turned around and skyrocketed like crazy within the years that followed if I remember correctly, meaning you'd have had to take money out of that which you had invested in the fund at the worst possible time to pay a tax bill that, in reality, wasn't really yours to begin with and is more of a by-product of our broken tax code; money that could have grown by huge amounts as the reversal was sudden and staggering.
There were some other high-profile examples back in 2008-2009. Search for "embedded gains" if you're starting a research file on it as that is what it usually called by the niche contingent of people who bother to worry about these sorts of things. It's almost entirely confined to professional circles. The retail market doesn't seem to care.
FWIW, you can also profit from this in reverse. Benjamin Graham used to talk about this regrading corporations back in the early editions of Security Analysis but it holds true for open-ended mutual funds too. If you are looking at a fund with large embedded losses, and redemptions cause those losses to be realized, you can basically get a tax credit for things you didn't necessarily suffer and use them to offset your own gains.
Institutional research from Morningstar lets you see which funds have embedded gains or losses using a metric they call "PCGE". It's a wonderful service they're doing for those who care to pay attention. You can read about the methodology they use to calculate PCGE here in PDF.
Ang
October 20, 2015
Replying to Joshua Kennon
I see, I've asked this question before in other forums but the mechanics detailed to me apparently were not accurate. And as far as the robo advisors go, I don't think adoption rate will ever be a problem. I'm counting on behavioral economics here but as soon as we get any sort of extended correction, I think net inflow will be much decreased and the percentage of assets held by them will stay a tiny fraction of wealth (index zealots still love to chase returns, even if their margin for error is slightly reduced because of lower index fund fees, Bogle even points this out in his works). Indirectly too, the robos are reliant on index selections from human judgment way upstream. I also think they will eventually be exposed as adding literally no value down the line as the large established firms come out with their own easy to implement software (as an adopter of such "advisors", why wouldn't you just look at their published allocations and then buy the funds with no commission yourself with a Vanguard account, if you desired? it's no different than the active fund managers index zealots so detest as the fees the robos charge is on top of the fees of the underlying index funds)
It doesn't surprise me anymore that you have such a huge amount of tools you can reference from your knowledge base for all types of situations when it comes to finance and life itself, but still it's nonetheless very impressive. Even though the articles cover more of the basic elements, every exchange you have with the community here is in depth, and marries a multitude of different (and sometimes obscure) concepts each time, which makes me realize how much I have still to learn. This might be over dramatizing things but it really will be a tragedy whenever you shut down (or heavily redact many different articles and the comment sections along with them) the site. I just can't foresee a scenario where you don't become so successful and well known that it becomes a necessity to wipe a lot of things from public access. In the meantime, thank you for taking the time to write out such a detailed response!
innerscorecard
October 20, 2015
Replying to Joshua Kennon
Basically NOLs for individual investors. Wow - I simply had not thought about that before.
Ang
October 20, 2015
Replying to innerscorecard
That part does still strike me as more of a speculation element. You probably have a higher chance of realizing such NOLs if the fund is doing terribly and there is already large amounts of outflow in recent history, but still, redemptions must be triggered somehow. What do you think?
Brendan
October 20, 2015
Replying to innerscorecard
Do mutual fund NOLs carry forward like with an ordinary business?
joe pierson
October 19, 2015
Replying to Joshua Kennon
Doesn't putting mutual funds in a 401K create a worse problem because traditional IRA’s eliminates the preferred tax treatment of dividends and long term capital gains and converts them to ordinary income?
Todd
October 19, 2015
Replying to Joshua Kennon
Taxes is like high blood pressure it is the silent killer of wealth creation. Just think of Roth 401K's and Roth IRA's tax free money this is crazy. I hope they don't change the law on withdrawl rate on inherited IRA's. Joshua would know this but just think if you left your grandkid 50,000 in a Roth IRA and they where 8 years old earning 8% they end up withdrawing 3,082,000 Dollars by they are 82 Tax Free.
joe pierson
October 19, 2015
Replying to Joshua Kennon
You are not really paying other people's taxes, you are forced to prepay taxes (or to defer taxes if the opposite occurs).
Brendan
October 19, 2015
Replying to Joshua Kennon
Well, you've got my sincere gratitude for pointing out the flaws in indexing. I remember reading your S&P 500 methodology changes essay and being challenged, annoyed, and ultimately curious about the whole issue. For me, it was the most transformative article I've read on this site (along with the global asset management article) and I likely would have never even thought to ask the question, because at my level I don't necessarily connect the dots of indices changing their inclusion criteria and weighting methodologies, and how that can increase fund turnover, and how that could set up the large capital gains losses you just illustrated.
And, I understand the hesitation to put the word out to your non-target audience who, as you conclude, are probably better off in a low-cost index fund in a tax sheltered account.
Derek
October 20, 2015
Replying to Brendan
Glad I'm not the only one surprised by that potentially large tax liability. I suppose I read it in the prospectus but never gave it any thought since my mutual funds are all in tax advantaged accounts.
Funny how easy it is to miss something so potentially damaging.
J. Dias
October 21, 2015
From an embedded gains perspective, does anyone have an idea if it is more advantageous to hold Vanguard Total Stock Market ETF (VTI) in an IRA or the Vanguard Mutual Fund version, VTSMX Josh extolled in this post?
I am mainly invested in ROTHs and 529 accounts, so I am not sure how that does or does not protect me from embedded gains—I will research the answer, but thought I’d ask. Between this post and Josh’s previous one titled "The S&P 500’s Dirty Little Secret” I will be making a shifts to ETFs/mutual funds that are not so S&P 500 centric.
Joshua Kennon
October 22, 2015
Replying to J. Dias
Both VTI and VTSMX represents ownership in the exact same underlying fund - the Vanguard Total Stock Market Index Fund. They do not represent different investments as they are the same pool of stocks; same embedded gains, same management team. Think of it like walking through two different doors to get into the same gymnasium. As of the most recent annual report, the fund that sits at the heart of both had $383,002,890,000,000 in net assets, of which $131,048,998,000 is made up of unrealized embedded gains. That is a little more than 34% of the net asset value.
The way the VTI shares work (the ones that are structured as an ETF) is this: Unlike the VTSMX, individual investors can't buy or sell (redeem) shares directly with the fund itself. Instead, certain authorized brokerage houses can buy or sell (redeem) in giant 100,000 blocks of "Creation Units". Right now, a single creation unit would cost you $10,369,000.
Most mutual funds have within them the power to do something known as an "in-kind distribution". This means that if liquidity became a problem and you entered a sell order for your shares, Vanguard could say, "Sorry. Times are tough. We're not giving you cash because we can't raise funds in the market by selling the underlying investments. Instead, we are dumping your pro-rata ownership of all of the underlying stocks in a brokerage account you tell us to and you have to deal with it yourself. Then, we're parting ways, your shares of the fund are cancelled, and you're on your own." (In practical terms, funds almost never exercise this power since it's easier and cheaper to sell the stock and forward the cash though I expect that would change quickly the next time we go into a 1929-1933 style meltdown. I imagine a lot of mutual fund investors who eschewed "individual stocks" will find themselves apoplectic because they had no idea this was a possibility - and that they've owned individual stocks all along - and are now sitting on hundreds of them they can't get rid of easily.)
The ETF creation units are so huge that the theory goes management is far more likely to purposely take advantage of in-kind distributions if it wanted to do so, selecting the shares with the highest embedded gains to kick out the door and hand over to the institution taking the distribution. Goldman Sachs, for example, is probably going to be able to deal with delivery of the underlying stocks rather than cash. This means, at least on paper, the ETFs could serve as a way for the fund to drain off those embedded gains but there is no guarantee it will happen, it's entirely theoretical, and one shouldn't bank on it.
As assets have flooded into passive index-based funds over the past few decades, it's allowed firms like Vanguard to essentially hide this potential time bomb by funding distribution requests with new, incoming funds rather than asset sales when at all possible. The only saving grace is that a lot of the fund shares are held by tax shelters, such as 401(k) plans or Roth IRAs.
The fact that you mainly invest through Roth IRAs and 529 accounts means, for all intents and purposes, this shouldn't have much, if any, consequence for you. Those embedded gains, if triggered, will be moot since you don't have to pay taxes on that sort of income within either of those two account structures. If assets are below $500,000, you don't want to think about it, it makes life more convenient, the trade-offs are still probably worth the benefits of dumping it into one of the indices and forgetting about it. The big takeaway is, I probably wouldn't be holding any of these things outside of tax shelters.
(This is a good introduction to the topic of ETF taxation if it's something you'd want to study.)
That said, here's the part I'd tell you behind closed doors: If changes in methodology are important to you, you'll find the VTSMX little better. Vanguard can't make up its damn mind about the holding rules it wants to use. In 2005, the fund was modeled after the Wilshire 5000. They then changed it to the MSCI Broad Market Index. Now, they recently decided to throw that out the window and change the index to the CRSP. I actually think it's a slight improvement though it still has the downsides of things like float-adjustment which were introduced to the S&P 500 index which, I think, will all but guarantee rich insiders benefit over mom and pop investors the next time we have a great bull market with lots of IPO activity and rapid growth for reasons we've discussed in the past. (If you're curious, check out the CRSP index construction methodology in this PDF disclosure.
How many times do you see people talk about this? Hardly ever. It matters, though, because of what I've told you: There is no such thing as an equity index. There are only individual stocks. Everybody invests in individual stocks. Period. It's only a matter of how those stocks are chosen. The index is simply the list of rules used to buy the individual stocks. Someone, somewhere is making the decision about how that list is put together. Someone, somewhere is making a list of which firm is hired to do it. People outsource this job so they don't have to think about it but it's dangerous to think there is somehow a difference between owning individual stocks and a pre-packaged group of individual stocks. What counts is your methodology: Tax-efficiency, low turnover, diversification, disciplined adherence through market volatility, etc. Or, alternatively, you could use some sort of annual re-balancing equal-weight approach if you were more interested in safety and stability; willing to sacrifice (potentially) a bit of return for the peace of mind.
J. Dias
October 26, 2015
Replying to Joshua Kennon
Thanks for generously explaining this to me. It’s an eyebrow raising topic, because as you stated, 95%+ of people who own mutual funds never consider what they actually own, how they own it, and what the rules are in outlier scenarios. It does however make me feel better that the U.S. retirement and college savings system avoids the embedded gains tax. The overall system is not perfect, but damned if it isn’t pure joy to have won the lottery when it comes to being born in the U.S. during such an advanced time when so much knowledge is available, such as your blog.
Craig Koza
October 23, 2015
"It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost."
The sentence above is so powerful and succinct. Sums up what many of us have been trying to do, in my case for decades. Unfortunately, most of us are not equipped to do this well so we buy and hold index funds. I look forward to becoming a client of the soon to be Global Asset Management Firm @joshuakennon:disqus
Savvy Buck
October 28, 2015
Hi Joshua,
How do these big blue chips grow these days?
I'm talking about blue chips like Mcdonalds, Coca Cola, Home Depot, Walmart.
Yes, I know each year they earn billions in profit, but it seems like they have plateau'd.
Last year perhaps they earn $70 billion, and this year perhaps they earn $75 billion....
How exactly will McDonalds grow? There's only X number of people eating Micky Ds every day. It seems the only way is to get everyone on the planet to eat a Big Mac everyday in order to grow. And then what? Then this company will be totally saturated!
Same deal with Coca Cola, the only way for it to grow is to get people to drink more soft drinks every day. And no, introducing new line of coke will not bring in more profits ([b]in the overall picture[/b]). Basically if you are buying Dr Pepper for Canada Day, then you probably aren't buying its signature Coke.
Tyler Phillips
October 29, 2015
Replying to Savvy Buck
Joshua wrote a great article that might answer some of your questions:
https://www.joshuakennon.com/determines-rate-return-investment-will-generate/
lnt90
November 4, 2015
Replying to Savvy Buck
Taking Coke as an example there are plenty of ways it can grow! Lowering costs and becoming more efficient, stock buybacks like Exxon & Autozone, Acquisitions, and of course just organically selling a little more beverages every year than the year before. Also raising the price can result in more as well.
People thought McDonalds couldn't grow anymore 25 years ago. And look whats happened, my take is this, find a company that has high barriers to entry and would almost be impossible to take out of business long term, that automatically eliminates 80-90% of companies, than look at those 10% or so of companies and figure out which are the best of the best by the quality of the assets they own and buy them and only buy what you understand. I know I.B.M. & Wells Fargo have many traits great businesses have but they have a lot of parts that goes beyond my understanding so I don't bother with them. But that's fine because I get Coca-Cola, ExxonMobil, and Johnson&Johnson because I fully understand what makes the business go and how good these firms are. Your buying the best of the best, they'll figure out a way to grow.
dave (nestle)
November 3, 2015
Just saw a nice interview with Carl Icahn.
some of his thoughts, paraphrased:
-he tried the hedge fund business for a short time and got out, and found:
1. You need capital
2. You need a permanence of capital
3. There will be cycles (because of this you need both numbers 1 and 2)
4. Donald Trump is the only candidate that can fix Washington (read: Make America great again)
(hint: I would love to see a case study (and personal thoughts) of Mr. Icahn someday.)