Market Timing, Valuation, and Systematic Purchases
I have a lot of work to do but I’m sitting at my desk, the snow is on the ground outside, I have a fresh cup of coffee in front of me, and I don’t really feel like diving into my task list quite yet. This is going to be one of those more rambling posts; no real point, just me thinking out loud about some of the things I’ve encountered recently as it pertains to observing other people handling their investment management process.
I’ve mentioned it a few times in the past, both here and at Investing for Beginners, but really, there are only three ways most people build a portfolio: systematic purchases (or formula investing as it used to be called), valuation, and market timing. The first two have made a lot of people very rich. The last is a form of speculation that can’t be repeated indefinitely and often leads to wipeout (a single big blow up and you have to start over from scratch) though the temptation to do it, especially with other peoples’ money and leverage, is too strong for some to resist.
The short way to remember this is as follows:
- Systematic Purchases = Buy or sell methodically through regularly scheduled transactions regardless of market or economic conditions.
- Valuation = Buy or sell based upon the relationship between market price and the after-tax, inflation-adjusted, discounted free cash flows of the asset; e.g., with partial ownership of a company through common stocks, what it should be worth to a strategic buyer in a private transaction who planned on holding and operating it indefinitely.
- Market Timing = Buy or sell based upon whether you think a security will increase or decrease for any reason other than its valuation.
For most investors of relatively modest means, who don’t have a lot of complex needs such as wanting to protect assets from creditors or get around the estate tax limits, who have no interest in learning about business, finance, accounting, and portfolio management, systematic purchases are the best way to go. You setup a diversified portfolio that you regularly acquire over the years through thick and thin, staying the course during booms and busts because you have neither the experience, interest, nor time to do it yourself. An excellent example of this strategy is signing up for your 401(k) at work, picking a low-cost index fund, and maintaining your contributions no matter what happens to the stock or bond markets. Sure, you pay extraordinarily stupid prices for trash assets at the height of periods like 1999 but you also get a lot of really great quality for next to nothing during collapses such as 2009, the hope being that they will continue to offset each other in the future as they have in the past. Alternatively, another form of systematic purchases would be regularly putting several hundred dollars a month into multiple direct stock purchase plans so you end up with a portfolio of directly held blue chip companies pumping out ever-growing dividends. Many “millionaire next door” types are spawned this way. You hear about them when they pass away and their stealth fortunes are uncovered.
The next methodology, valuation, is ultimately the mean to which market prices revert. Regardless of what investors do in the short-term, valuation always wins on a broad basis over the long-term because reality can only be ignored for so long. It doesn’t matter how ebullient investors get during periods like the 1920’s or how despondent they grow during spans like 1973-1974, ultimately, the economic power of a business – and the cash it can produce for owners, who can then use that cash to expand their portfolio, go on vacation, buy new cars, renovate their homes, or put their kids through college – warps everything around it like gravity. It almost all comes down to owner earnings. People who focus on that metric can largely ignore quoted valuations entirely except as something to be taken advantage of when and if it suits them.
This is the reason that sophisticated, professional, and wealthy investors overwhelmingly tend to fall into the valuation camp. Done correctly, this is where the sustainable, outsized, multi-generational fortunes are accumulated and preserved. While the actual mechanics of valuation aren’t particularly difficult, there’s about a ten-year learning curve to truly master the necessary inputs, ranging from GAAP to tax regulations, corporate finance to industry-specific operational quirks.
There are many different sub-sets of value investing. I was able to reach financial independence at a young age in no small part by practicing a very specific, niche version I created by modifying and synthesizing, reworking, and introducing my own unique twists, on the works of people like Benjamin Graham, Philip Fisher, Peter Lynch, Christopher Browne, Charles Munger, and perhaps two dozen others. My own personal version of global, long-term, highly passive, tax-efficient value investing is not at all appropriate for a beginner or intermediate investor to attempt on his or her own but for the sake of explanation, it basically comes down to:
- A strong preference for passivity over what most people think of when they use the phrase “active management”. The sort of behavior demonstrated by the “investor” in this post is something that is anathema to me. There are some years when my turnover rate is lower than the major index funds; even times when it is quite literally zero, as in not a single position was sold. In the core portfolio, most turnover happens due to risk-adjustment and diversification needs. As a result, when turnover happens, it usually tends to come all at once and appear fairly substantial. At a sort of absolute minimum guideline, absent other considerations already discussed (portfolio needs such as diversification or risk management will always take precedence), I expect to hold the position I acquire for many, many years; perhaps even decades or until death. I enjoy long-term holding so much that I have my primary custody agent use a modified account statement template for me that shows the number of days each lot or each security has been held so I can specifically track it.
- A constant attention to tax efficiency through strategies like asset placement, the use of certain conservative derivative practices under specific circumstances, and an understanding of the tax code itself. It’s an intellectual thrill to me, like playing a real life game of Monopoly. I don’t understand how people can find it so boring because it’s no different from plotting in Civilization V or designing an urban grid in Cities Skylines. I spent some of my leisure reading last week analyzing how to structure purposely defective grantor trusts to take advantage of an IRS ruling that allows the donor to effectively pick up the tax bill for his or her beneficiaries, with the tax bill not being counted as an additional gift, resulting in the net consequence of moving more money out of the estate and into the hands of those beneficiaries than would otherwise be possible, while, at the same time, avoiding potential liquidity problems with carefully-crafted safety provisions given to a so-called “trust protector” who could operate as an escape hatch without causing the tax authorities to disqualify the trust … just because. I like having that sort of thing in my mental toolbox. Breaking it apart, understanding it, figuring out how it can be exploited … that, to me, is better than a John Grisham novel. Even writing this, it quite literally makes my pulse quicken. I enjoy optimizing outcomes and this is merely another variation of that. (If you want a simplified two-minute overview of how such a structure would work, Northern Trust has a good white paper on it, which you can read in this PDF.)
- A dedication to maintaining a reasonable cost structure, including custody fees, brokerage execution, and foreign currency transaction expenses. It should be said, in the final analysis, I practically never take the low bid when it comes to hiring advisors such as accountants, attorneys, etc. I’m more interested in getting it done right, and having the risk reduction in place, than I am my compounding rate. Protecting what I have takes precedence even if it means regularly opening the mail to find large bills.
- A heavy preference for the acquisition of higher quality operating assets that have certain characteristics or advantages protecting them from competition and technological changes while simultaneously causing them to generate excessive amounts of free cash flow relative to tangible invested capital. I’ll pay fair value for an asset like common shares of McCormick & Company over getting a 20% discount on an asset like common shares of Carnival Cruise Lines even if the latter may be a better short-term trade (though there are situations in which I may acquire the latter).
- A constant scrutiny of the structure; the terms on which I am acquiring or selling. There are times, and ways, to get assets through much more favorable arrangements that give you more upside, less downside, or even some de facto forms of leverage that don’t involve borrowing money. There are certain ways, under certain circumstances, to generate “enhancements” of sorts that can add a bit to the compounding rate.
- An ever-running series of questions that get applied to each holding, specifically, as well as the portfolio as a whole. What could go wrong? Is there permanent wipeout risk anywhere? If so, what are the probabilities of it manifesting? What countermeasures can be taken? What are my assumptions? What are the correlated risks, including correlated input costs? What are the political considerations? What could I do to make this portfolio safer on a long-term basis (as measured by after-tax, inflation-adjusted purchasing power increase not year-to-year quoted market value or nominal dollars)? If I viewed my portfolio as one giant company, what are the underlying economic characteristics – returns on capital, valuation, debt-to-equity, dividend growth rate, etc. relative to the stock market as a whole?
Our in-house valuation approach was and is essentially an extension of entrepreneurship in that Aaron and I think of ourselves as being in the business of acquiring risk-adjusted cash flows. Aside from moral and ethical considerations (you may decide you don’t want to own shares of a certain business regardless of the potential profit because you don’t want to engage in a specific type of conduct), it doesn’t much matter where or how those cash flows originate, be it ownership in businesses (publicly traded stocks, privately negotiated partnerships, or private equity), debt (bonds, directly underwritten mortgages, peer to peer loans), real estate (houses, apartments, office buildings, industrial warehouse, storage units), intellectual property (copyrights, patents, trademarks); it’s all the same. An after-tax, unrestricted free cash flow dollar is a dollar is a dollar.
The implications of this thought process – a dollar is a dollar is a dollar – are difficult to overstate. To put it more starkly, despite our preference for passivity, there is a limit at which the trade-offs, especially adjusted for deferred tax consequences, become too great to bear. If we entered some period of time where stocks were quoted at 50x core economic earning capacity and real estate was offering 10% cap rates, most of our personal net worth would end up in real estate depending on the length of time the situation persists and the efficiency with which I can make the allocation shift. (That’s not the case at the moment. We’ve come very close, several times, to seriously looking to acquire property in Southern California since there’s a decent chance that is where we end up long-term but I cannot accept the current absolute or relative returns compared to the risk because the only way it makes sense is if 1.) the investor utilizes borrowed funds rather than 100% equity, and 2.) we go into an inflationary environment, de facto reducing the purchasing power outlay future debt repayments represent rather than a Japanese style-deflation, which seems equally as probable; a bet that isn’t necessary with certain other, higher returning, more predictable assets at the moment such as shares of The Hershey Company. Despite its artificially high p/e due to some temporary accounting quirks, Hershey is sitting there, in plain sight, at a price that should almost guarantee (as much as one can be certain about these things in an uncertain world; crazy things happen, which is the reason diversification exists) double-digit total return for owners over the coming 25 years. Even if we go back into a 2005-2009 meltdown where the stock is at $40 tomorrow, it shouldn’t matter as time irons out the volatility. It’s so clearly in the “intelligent things to do” pile at the moment, why bother with an office building in Orange County? Of all the ways to get rich slowly, it is one of the least risky in the S&P 500 at present if an investor is willing and able to hold onto it like a pit bull even if we go into a full blown Great Depression tomorrow and the losses look horrific. Of course, if you run a mutual fund or hedge fund, you may not have investors who share your time horizon so you don’t buy it because you could lose your job. The whole system, twisted by incentives caused by investor irrationality and ignorance, is almost comical in its nonsensicality. Almost once a day, I come across something that makes me feel like I’m peering through the looking glass.
In other words, “buying profits and assets”, as I like to say, is really the gist of it. I want to sit at home and have money come in from all directions, at all hours of the day, without me having to go out and sell my time. It gives me freedom. (Yesterday was an excellent illustration. Aaron and I woke up, it was snowing, we stayed home, ate ice cream in our pajamas, watched a Korean drama, and only finally became productive around 3:30 p.m. when we wanted to get some work done – even then, it was largely spurred by the fact he had a hair appointment so I figured I might as well check items off my task list. Nobody can say anything about it. Nobody can fire us. It’s possible for us to behave this way, among other reasons, because while we were sitting by the fireplace laughing at the exploits of 오 마이 비너스, customers were shoving cash into the coffers of our private businesses; people around the world were drinking Johnnie Walker, snacking on Reese’s peanut butter cups, taking out student loans from Wells Fargo & Company, using the hydrocarbons drilled, refined, transported, and sold by ExxonMobil, picking out wedding rings at TIffany & Company, flavoring their food with McCormick spices, buying their insurance through GEICO, sipping on Coca-Cola, brushing their teeth with Colgate, negotiating the purchase of escalators, elevators, and jet engines from United Technologies, etc. Each year, we aim to use our cash flows to acquire more productive assets so more and more torrents of cash arrive without us having to do anything.)
How that is done depends upon the person. In his 1949 edition of The Intelligent Investor, Benjamin Graham observed that most investors, under most circumstances, (those he deemed “defensive investors” who weren’t professionals) shouldn’t worry about trying to get the best price:
It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, the loss of considerable dividend income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever present bargain opportunities in individual securities.
History has proven he was right, especially for truly excellent businesses; stretch the ownership period out long enough and even the Nifty 50, which traded at utterly obscene valuations in the 1960s, ended up beating the S&P 500 a quarter-century later despite several bankruptcies of components, such as Eastman Kodak, along the way. Even such an occasional failure on the journey, the success of the survivors not only made up for it, but mercilessly crushed the competition. You can probably make an argument that, as long as you’re not dealing with a greater than 2% to 5% portfolio weighting and you truly, honestly, will hold for 25 years even if we go into a 1929-1933 catastrophe (which few people are emotionally or financially capable of doing), there is probably never a bad time to buy Coca-Cola or PepsiCo, Johnson & Johnson, Hershey, Procter & Gamble, Colgate-Palmolive, McCormick, and a handful of other businesses. With each passing year, you want to be like Rockefeller when asked how much he hoped to accumulate: “Just a little bit more”.
And, really, this was true for businesses as a whole, mediocre ones included, provided you were sufficiently diversified. Though the past is no guarantee of the present – it would be almost unthinkable given our cultural preference to destroy the entire Earth along with us through a nuclear holocaust were we to ever be attacked in a full-scale onslaught, but the United States could suffer some sort of catastrophic wipeout on par with the Austrian or Chinese stock markets in the 20th century wherein equity values essentially go to zero and the nation is conquered or obliterated – assuming life goes on as it has, there’s never been a single 25-year rolling period in the modern era where stocks haven’t generated a positive return for U.S. investors. To think that the future will somehow be different from the past requires explaining the reasons, especially given the enormous economic, political, cultural, and military advantages we have over so many other places on the planet.
As I’ve gotten older, there are times I’ll buy an excellent business at fair value simply to add to the permanent collection; certainly, with family member accounts, which I run far more conservatively than my own, such as the very personal explanation I gave for buying shares of Colgate-Palmolive in my father’s accounts. I run one of my brother’s accounts in a way that, were I to die, he is to immediately seal it and make no changes for the rest of his life. While I’m around to manage it, it is another pool of capital but I do it in a way that at any moment, without notice, it could become a so-called ghost ship or coffee can portfolio and do fine. In a very real way, I think of myself as a collector. Only, instead of things other Americans collect, such as decorative plates from The Franklin Mint, I collect cash flow. Sometimes, I really do pick up a bit of ownership, put it on the shelf, and say to myself, “You go there. I will watch you and enjoy you for the rest of my life.” even if it isn’t necessarily the highest returning asset on my desk at the moment.
Most of the time, for a vast majority of the dollar-weighted invested assets Aaron and I have accumulated, I behave more like a sniper or a Disney villain. Though it may seem comical, there’s a real parallel between a hunter waiting in the wild looking down the barrel of a long-rang weapon, Ursula plotting her takeover of the seas, and a value investor of our particular variety acquiring holdings. I’ve used the Ursula illustration before when discussing writing cash secured equity puts but it holds here, too, so let’s use it for the sake of illustration.
First, you identify what it is you want to own, valuing it using your knowledge of accounting rules, corporate finance, tax laws, and operating experience; identifying a probability range of earnings estimates under different scenarios which, then, allow you to say with a degree of relative certainty that a given price is likely to lead to your minimum satisfactory outcome or not. (This is partly what I refer to when I say I’m in the job of tilting, and exploiting, probabilities.) This process includes building models so you know how you’d want it to fit into your overall portfolio weighting for a risk/return analysis.
Then, you wait, plotting, bidding your time … your cash reserves grow, your dry powder accumulates.
At this point, it’s useful to once again paraphrase Benjamin Graham who observed, when addressing the enterprising investor serious about money management, that if you’re patient enough, you’ll usually (not always so be emotionally willing to let a few get away from you) get your price. Sometimes it happens suddenly without warning, like the crash in October of 1987, other times, it’s the result of a long, cold neglect, but the odds are okay that you’ll be able to get your hands on ownership at an outlay you consider reasonable. A business, piece of land, building, or copyright that you may have wanted to own for years is suddenly within striking distance of a level at which, if acquired, is almost certainly going to lead to good long-term results, especially on an overall-portfolio basis as it is merely one component in the bigger money-printing machine you are designing and constructing.
Finally it happens. You enter the bid. The counter-party, for reasons that are largely unknown to you – they could be facing a margin call, they could be selling off assets to pay for a new swimming pool, they could be liquidating an inheritance they received from a parent or grandparent, they could be raising funds to meet investor redemptions, they could be shorting the stock, they could be raising cash to open that dream restaurant they’ve always wanted to start – signs over their stock certificates, promissory notes, or other property, entitling you to the cash flows from the asset.
Triumphantly you grasp your equity: “You belong to me“.
Even if the world is falling apart around you and the economic maelstrom raging, you can’t help but rejoice. Your patience has paid off in the end. While you sat on the sidelines, mocked by the speculators who had treated assets like lottery tickets, paying whatever they “felt” its price should be rather than basing it on a cold, objective analysis of the numbers, now it’s your turn. If you’ve done your analysis correctly, someday the same fools who wanted nothing to do with the holding when it was temporarily unpopular will come banging down your door to try and buy it back once it is again en vogue. Meanwhile, you sit back and collect the cash flows, which should be sufficient to result in a satisfactory outcome even if you never sell the holding for the rest of your life. Frankly, that’s the preferred outcome. Up until you hit the estate tax exemption of $10,900,000 for a married couple, you quite literally want your heirs to take it from your cold, dead hands so they enjoy the stepped up cost basis loophole, which allows all of the capital gains taxes that would have been owed to be forgiven.
You, in other words, get richer by doing what Charlie Munger advocates: “Sit[ting] on your ass”. While a small contingent of investors may be able to value assets like an executive or professional, fewer are able to control their emotions and honor this commandment. I’ve talked about it in recent years – you get some minor 15% or 20% fluctuation and everyone suddenly acts like it’s a big deal. It’s not. Most of your holdings could very well increase or decrease peak-to-trough or visa versa by at least 33% every 36 months. That’s normal. If you buy a $100,000 block of some great business as part of a diversified portfolio, and you paid a good price for it, it shouldn’t cause even an eyebrow raise if you wake up to find it quoted at $67,000. If anyone tells you this is outside the realm of possibility – be it a financial advisor, portfolio manager, or friend – realize that you’re dealing with someone who is out of their depths. In a handful of specialty cases, such as the oil majors, much larger fluctuations are to be expected. If you own ExxonMobil over a 50 year period, you’re probably going to get obscenely rich from it but you’re going to find yourself down 50% or more from time to time. Though I’ve said it in the past, I don’t want you make light of what I’m about to tell you: Deal with it. It is part and parcel of the process. If you can’t accept it, that’s fine – you don’t have to own stocks to become wealthy – but understand that you neither deserve nor entitled to the returns that equities provide. Never forget that no matter how good a price you get on the buy or sell side, you will almost never capture the bottom or top; don’t even try. Be sure that your price is good.
It is difficult to emphasize the importance of passivity enough. Since I just quoted Munger, look at the length of time the assets that made Charlie rich were held in the equity portfolio of Berkshire Hathaway. Most of the real money came from trees planted more than a quarter-of-a-century ago. Shares of the largest position, Wells Fargo, were first acquired 27 years ago in 1989 and subsequently added to any time there was a banking crash. The Procter & Gamble stake can be traced to privately placed convertible preferred shares in Gillette, which P&G later acquired, that same year. The Coca-Cola shares were bought 28 years ago in 1988. The American Express shares can be first be traced to a privately placed convertible preferred issue from 25 years ago, back in 1991. Plus, these stakes have generated billions upon billions in after-tax dividends that funded other, newer investments. It’s even more extreme with the wholly owned subsidiaries, which he and his business partner, Warren Buffett, won’t part with at any price, some of their holding periods now approaching and surpassing the 50 year mark. It’s a lesson that Buffett has had to learn the hard way. Had he held on to shares of The Walt Disney Company from his 30’s, he’d be sitting on an extra $12+ billion from an initial $5 million investment back when he was running the investment partnership. Buffett became so passive in his later years, he sometimes took it to extremes, finally admitting at the 2005 shareholder meeting it had been a mistake not to sell Coca-Cola when it was at 50x earnings (the overvaluation has since burnt off and, true to form, it’s going to work out beautifully so passivity-as-a-matter-of-course once acquired makes the ghost ship approach quite appealing. I still think SunTrust was insane for selling its Coke when it did at the price it did; a decision that elevated accounting considerations above economic reality, that has cost it dearly, and that will ultimately end up causing owners to be far poorer than they otherwise would have been.).
The interesting thing about the valuation-based approach is that investors who utilize it tend to develop certain areas of expertise around which they excel and focus their attention even within certain asset classes. Now referred to as a “circle of competence”, the concept is largely credited to the legendary founder of IBM, Tom Watson, Sr., who said, “I’m not genius. I’m smart in spots – but I stay around those spots.” You may be great at running a chain of tire shops or beauty parlors, able to earn jaw dropping returns on capital that you couldn’t get anywhere else because you’re simply that good at it. You may become an expert in analyzing the oil and natural gas industry. You may become highly proficient in understanding pharmaceutical firms. You may develop new construction projects from the ground-up turning once-vacant plots of land into thriving communities. You may buy old, promising restoration candidates and return them to their former glory. You may buy song rights in bankruptcy auctions (a couple of years ago, I came close to working with a reader of this blog in bidding on the rights to some of Toni Braxton’s royalty streams in her most recently bankruptcy court hearing. He had done the homework, brought them to my attention, wanted me to put up the money, and split the proceeds in an equitable way as a reward for uncovering it. I was seriously considering pulling the trigger but the judge was conducting the whole affair on a black box basis so there was no telling what the actual underlying copyrights were, only the past cash flows, which wasn’t specific enough for me to write a check).
A small percentage of investors seem to take a hybrid approach between systematic purchases and valuation so it’s not an all-or-nothing deal; e.g., engaging in valuation on the margins of their portfolio while sticking with systematic purchases for the core. For example, a lot of investors who ran down to the HR department during the 2008-2009 collapse and significantly increased the amount they were putting into their 401(k) because they knew that the stock market had fallen to a level that made it objectively cheap by historical, relative, and absolute standards were making a valuation determination. They were still regularly purchasing their mutual funds through payroll deductions, pay period after pay period, dollar cost averaging, but they de facto ended up accelerating their own recovery time by dragging down the cost basis of their portfolio a lot faster than otherwise would have been the case.
The same is true in reverse. I’ve used it as an illustration of intelligent behavior in the past but there was a period during the dot-com boom when Vanguard’s founder, John Bogle, liquidated something like all but the last 25% of his stock and equity index fund investments, putting it, instead, in cash, Treasury securities, and bonds, which were offering nearly 3x the yield relative to the earnings yields on stocks. The valuation gap had become so large, he talked about it being a once-in-a-generation disconnect that he could no longer ignore so he threw the “stay the course” mantra of systematic investing out the window. There was no way stocks could live up to the promises that were baked into their valuations, which he knew from simple math.
In contrast to all of this is market timing. As previously explained, a market timer decides to buy or sell because he thinks the asset will increase or decrease for any myriad of reasons, none of which is necessarily tied to intrinsic value (though exceptions to that last exclusion exist – e.g., if you purchase a non-hedged put option as a way to leverage a bet that a certain enterprise is going bankrupt due to cash flow problems, although the underlying thesis is based upon valuation, the fact that you’ve introduced a time-decay factor with a $0 end value as a result of the presence of option expiration means that you are engaging in market timing because you need the end result to manifest within a fairly specific period; an entirely different thing that cannot be done with any degree of accuracy on a widespread, repeatable basis. It’s a fuzzy line here, though, because the degree of time remaining prior to expiration heavily influences the degree of market timing speculation inherent in the position).
Mutual fund investors are perhaps the worst when it comes to market timing. You look at the returns they earn on a dollar-weighted basis and it is pathetic (note: As defined, I have some serious real-world reservations about dollar-weighted calculations so take them with a grain of salt as the metric currently measures total cash flows rather than the actual experience of the median investor in the fund, the latter of which cannot be calculated from external data despite being the far more relevant consideration). Even when someone pulls it off successfully for awhile, the type of people attracted to the strategy don’t necessarily benefit from it because of their own shortcomings; e.g., one of the earlier links I included in the body of this post talks about the CGM Focus Fund, a speculative market timing fund that generated 18% compounded rates of return over the past decade while the stock market as a whole did far worse. Despite this stellar performance (which was achieved with extreme risk and is not a way I’d want my own money put to work – I quite literally mean it in the strictest sense of the word when I say that, given the choice, I’d have rather owned 10-year FDIC insured certificates of deposit), the typical investor in the fund didn’t earn the positive 18% per annum return they should have but, rather, a negative 11% return per annum. When the fund went up, they bought more because it had increased. When the fund went down, they sold shares because it had decreased.
The whole thing is bonkers. An asset isn’t necessarily cheaper when the price declines if the intrinsic value has somehow been impaired. Likewise, an asset isn’t necessarily more expensive when the price increases if something has happened that indicates the intrinsic value is a lot higher than previously realized. They keep looking to the market price to inform them of intrinsic value when that’s not what it is there to do at any given moment in time – it’s there to be exploited or ignored. As Graham put it in the aforementioned 1949 edition of The Intelligent Investor:
The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which we would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.
Passivity is just so much more effective when it comes to accumulating wealth. You only have to make two correct decisions – which asset to acquire and the price you want to pay for it – then sit back and enjoy the fruits it produces decade after decade. You have a couple of good ideas every few years and you’re set for life. People can’t do it, though. After all these years, I accept but it but I don’t like it. A perfect example is the recent drop in equity prices on Wall Street. We’re in the middle of the quiet period so a lot of companies aren’t able to use share buybacks to support the stock price, leading to greater volatility. The strong dollar caused a lot of earnings reports to look far less attractive than they should have been (it’s gotten so absurd, that some countries enjoyed double-digit increases in operating results but got reported as substantial decreases on a percentage basis because the greenback has been driven up relative to other fiat). The economy is mediocre in most respects. Certain hedge funds and sovereign wealth funds are redeeming positions. Everyone’s worried about China. Crude oil has collapsed to the lowest price in 12 years, hitting the $20’s. It’s nothing new. This is life.
Look at Tiffany & Company. When I wrote about it during the first week of this month, I mentioned that it appeared to be a good long-term opportunity relative to intrinsic value, both absolutely and relative to valuation five years ago. The stock was $76.04 per share. In the mere two weeks since that time, the price has declined by $14.24 per share, or 18.73%, down to $61.80. Christmas sales were a bit worse than expected (though still highly profitable and objectively good) so analysts began downgrading it. Reports were put out by places like Zacks Equity Research, saying that it may not be “rational” – I kid you not – to own Tiffany & Company because the price had fallen. The exact quote, “With Tiffany’s share price tumbling and estimates witnessing downward revisions, it would not be prudent to keep the stock in your portfolio, at least for the time being.”
It’s almost a perfect summation of what is wrong with Wall Street, the investment business, professional and individual investors. Trying to predict what Tiffany & Company, or any firm’s, stock price will do in the short-term (market timing) is idiotic because it cannot be done. Whether the stock is at $20 or $120 tomorrow doesn’t matter much if the underlying business hasn’t suffered some massive, unlikely, change in its earnings capacity. The only intelligent courses of action are making sure your purchase price is backed by a sufficient margin of safety so it is likely to lead to a happy outcome over the years (valuation) or regularly buying throughout your lifetime (systematic purchases).
This whole thing is not complicated. It’s really not. When I wrote that I believed Tiffany & Company was [and, at present, remains] a fair opportunity for someone with a long-term horizon when it was in the $70s, and that there was a point in the $50s at which I would be convinced the probabilities tipped to such a degree that it would result in some major allocation shifts so I could get my hands on a meaningful amount, I never dreamed I’d get lucky enough that we’d be flirting with it in a period of fourteen days. You cannot predict these things (which is the reason I’m not a fan of market timing, instead advocating for systematic purchases for typical investors and, in rare cases, a valuation approach for the experienced). I bought more in the $60s for several family members and, if the current price or better is maintained, plan on gifting some to my nieces and nephews in the near future. Why? Relative to the economic engine under most economic scenarios, a 25-year holding period should be highly satisfactory at the prices we paid. That’s really all I care about in the end. I repeat it so many times it gets exhausting but it seems like so few people get it. Folks make things much harder than they are. If you bought a rental duplex in the suburbs of Kansas City for $300,000 that was pumping out $30,000 a year in net rents, then the next day someone showed up and offered you $210,000, is it going to cause you any distress? Are you going to be upset or think about it too much? No! You’re measuring your results by the underlying cash being produced by the asset. You’d thank them for the interest but say you’re not interested in parting with it.
As nuts as it drives me from time to time, I’m not above taking advantage of it. Those covered calls I wrote back in December, part of a series of derivative transactions into which I entered after picking up my proverbial pen for the first time in years, are almost assuredly going to expire completely worthless, much to my delight. (We also didn’t have any cash secured equity puts exercised, either.) That means we had piles of fresh, pure profit liquidity for me to buy more of the things I want for the portfolio. The pricing was such that I would have been happy no matter what happened – the reason it caught my attention – but there’s something particularly satisfying about watching speculators’ funds end up in our accounts, keeping our shares, and using their money to pick up a stake in a business I’ve been acquiring aggressively lately (it’s too small, and the economics too good, to discuss on the blog given that we very well may be buying it indefinitely, perhaps for years).
I’ve been sitting here too long. I should go do something. I always hesitate to publish posts like this because there’s really no point to them; no clear, central message, no defining keyword, it’s more of me typing to myself in the same way people think out loud. I’m not sure why anyone would even care to read it since it’s probably not relevant to their personal situation as each of us have our own opportunity costs and considerations that must be taken into account when managing our financial affairs. I suppose it comes down to 1.) buy really good assets, 2.) pay fair or attractive prices for them relative to conservatively estimated intrinsic value, 3.) structure them in a tax and cost efficient way, 4.) arrange your overall portfolio so the risks are tolerable and intelligent, and 5.) sit on your backside, avoiding the temptation to “do something” but all of it has been said before so it shouldn’t be news. The problem is getting people to actually do it.
Still, it’s been a nice distraction so thanks in the off-chance you’ve made it this far – we’re around the 6,700 word mark at this point. I genuinely hope there was at least something useful in it that you can take for yourself and put to work for your own advantage so you’re better able to achieve whatever your own financial dreams and goals are.