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Value Trading – Does It Ever Make Sense?

Article by DAVE ROTTMAN

I would like to discuss and elicit feedback from our community on the topic of value trading. What I mean by value trading is the purchase and sale of stocks in a shorter time frame than traditional long-term investing, where the buy and sell decisions are driven by the exact same fundamental analysis, margin of safety standards, and owner’s mentality that traditional long-term value investors utilize. In other words, I would like to discuss the idea of a business-oriented investment strategy coupled with the willingness for a short investment holding period in certain situations.

Theory

To start, I will simplify the investment landscape by categorizing all stocks into two buckets: slow growers and compounders. Slow growers are businesses where the intrinsic value does not grow especially rapidly, and compounders are businesses where the intrinsic value does grow rapidly. All things equal, purchased at an equivalent price to value (P/V) ratio, compounders should outperform slow growers over long holding periods. This makes intuitive sense, because a large portion of the return in investing in slow growers is the narrowing of the P/V gap, whereas the large portion of the return in investing in compounders is the value itself actually increasing. This is what Charlie Munger is getting at when he said:

“Over the long term it’s hard for a stock to earn a much better return than the business that underlies it earns. If a business earns 6% on capital over forty years, you’re not going to make much different than 6% return, even if you buy it at a huge discount. Conversely, if a business earns 18% on capital, you’ll end up with one hell of a return long term, even if you pay an expensive looking price.”

With that in mind, all things equal it makes sense that an investor would prefer the P/V gap to close as quickly as possible for slow growers more so than for compounders. Further, an investor who is open value trading would be more likely to trim or sell investment in slow growers rather than compounders, because with compounders there is a higher risk of selling too early, not getting back in, and missing out on the value creation that occurs for years to come.

This brings me to the practical considerations of value trading. If, as value investors, we buy businesses whose shares are available at large discounts to intrinsic value, and those shares subsequently rise quickly in price, should we hold onto those shares until the gap narrows further, or should we consider selling (at least some of the investment) and reallocating the capital to other attractive businesses with a larger price-value gap, assuming we can find such businesses? Do long-term buy and hold investors at times hurt their returns by simply holding stocks that bounce up and down, with the P/V gap narrowing and widening over time, even as the value may march steadily upwards?

I suggest that in some situation we should be willing …

Efficiency vs Reliability

Friday, May 25th – Pandora A/S (PNDORA) by LUKE ELLIOTT
Friday, May 25th – GameStop (GME) by VETLE FORSLAND
Sunday, May 27th – “Value Trading – Does It Ever Make Sense?” by DAVE ROTTMAN
To Focused Compounding members:
Two different Focused Compounding members are to blame for this week’s memo. One is Dave Rottman who wrote an article entitled “Value Trading – Does it Ever Make Sense?”. The other is someone I was talking to this week on Skype. The discussion on Skype centered on the idea that I had said somewhere before that I thought it was possible to achieve 30% annual returns. What I think I meant by this – because I’ve said it elsewhere – is that an investor who puts together a run of 30% annual returns is like a Major League player batting .400. Over a career length period of time 30% annual returns are the highest you’re likely to see. Warren Buffett roughly did it over the years he ran his partnership. Peter Lynch roughly did it over the years he ran Magellan, and Joel Greenblatt did even better at Gotham from 1985-1994. A period of 10-15 years is basically the length of a professional athlete’s career. So, we could say Buffett, Lynch, and Greenblatt were 30% annual return career hitters.

Imagine that you – a very good, but not a truly great value investor – are running a portfolio that has chugged along at 20% a year for the last 15 years. You know that other investors at other times – Buffett, Lynch, and Greenblatt – ran portfolios that chugged along at 30% a year for almost as many years as you’ve been going at this. So, you know your portfolio is running at only two-thirds of its optimal efficiency. Where is the “waste” so to speak? Why aren’t you doing 30% a year? I can think of 4 possible reasons. One, you are making mistakes they did not. Two, you are using less leverage. Three, you are putting less into each stock you own. And four, you are owning each stock longer than they did. A portfolio running at optimal efficiency would be: 1) Free from human error, 2) Leveraged, 3) Concentrated, and 4) Have a high turnover. Why would it have a high turnover? Because the portfolio manager would have more ideas than money. This is also why it would use leverage. The question of leverage brings us to the difference between efficiency and reliability. An investing system that is maxed out for efficiency will – in any given year – achieve the highest return. On the other hand, an investing system that is maxed out for reliability will last the greatest numbers of years. Compound results are a combination of efficiency and reliability. The article published this week on Focused Compounding argues that – if a value investor has enough good, reliable businesses to invest in that he knows very well – he should (like Allan Mecham does) constantly be …

Human Nature is the Ultimate Hidden Fee

Tuesday, May 15th – Box (BOX) by Jayden Preston
To Focused Compounding members:
In an interview this week with Barron’s, Vanguard founder Jack Bogle cited stats that showed the average investor’s annual return from index funds was 8.4% from 2005 to 2017, from actively managed funds it was 7.2%, and from ETFs it was just 5.5%. ETFs and index funds are invested in much the same things. So, investors are charging themselves a 2.9% annual fee in the form of bad timing. The same Barron’s article quotes BlackRock’s Larry Fink as saying: “..long-termism is better than short-termism. But people need financial instruments for different reasons.” This is the common argument for the existence of ETFs, long-short hedge funds, etc. But, it’s wrong. We’re talking about a drag of 3% a year between investors staying in a representative sample of U.S. public companies and investors trading in and out of those same assets. This past week, Andrew and I announced we’ll be handling managed accounts. People who have called in have mostly wanted to talk about the fee. I like a 2.5% fixed fee because the math that matters is easy for me to do in my head. We should only accept money when we feel we can still beat the market by more than 2.5% a year after taking on that sum. Different kinds of investment vehicles have different kinds of hidden fees. These fees often add up to more than the amount you’re actually being charged. I spent a good part of last week warning Andrew about the performance drag we’d experience if we either: 1) Held more stocks or 2) Managed more assets. Both would create big performance drags. For ETFs, the hidden fee is bad timing. Investors want the freedom to trade in and out of an ETF. And that freedom costs them 3% a year. For accounts like Andrew and I will be running – the hidden fee is size. I guarantee you you’ll be better off when we are running $1 million instead of $10 million or $10 million instead of $100 million. Andrew and I won’t be better off. But, you will be. Here’s the thing. When money managers charge a percent of profits, they like to say their interests and their clients’ interest are aligned. But, the truth is that the manager’s interest and the client’s interest are never aligned on the one question that matters most: “Should we gather more assets?” The bigger a fund gets, the worse its performance will be. The more an investor trades in and out of ETFs, the worse his performance will be. Hidden fees like these often add up to more than the actual fee you’re charged. Whatever fees a fund is charging you, it’s going to be very hard to overcome the hidden cost of either high turnover or a large amount of assets to actively deploy. Small, active funds can work well. And giant, inactive funds can work well. Everything in between that tends …

Goodness vs. Soundness

Tuesday, May 8th, Industrial Logistics Properties Trust (ILPT) by George Baxter
To Focused Compounding members:
Ben Graham wrote: “Confronted with a…challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY…all experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds.”

Note the word I bolded: “sound”. As I sat down to write this memo, I thought immediately of chess. Can a good chess move be an unsound chess move? Can you win a game because you made a move that actually gives you a negative margin of safety? We know you can. After playing a game of online chess, humans often have a computer chess engine analyze their game. At each point along the way, the computer evaluates the position and states the advantage for black or white in terms of hundredths of a pawn. The computer can also suggest “lines” – or series of moves – where the game would have worked out differently. So, a computer can tell you what move your opponent should have made and whether or not you had a real advantage under “best play”. A move that wins against a human with limited time to think but would fail against a computer with infinite time to think may not be a bad move – but, it is a speculative move. The English word speculation comes from a Latin word – a language Graham knew well – that basically means “to look out for”. A speculation is future focused. It depends on stuff you have to look out for. In chess, to judge whether or not your speculative move was a good one you can look at the result of your game. However, to judge whether or not your speculative move was a sound one you have to sit down – perhaps with a computer, but certainly with a lot of time – and analyze what would have happened had a different move been played in response. Perhaps Graham’s most important quote on the topic of margin of safety is this one:
“The function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.”
A sound move is one that works well enough whatever your opponent plays. A sound investment is one that works well enough whatever the future holds. But, just as some “unsound” chess moves work more often than not when playing against a human – some speculations have awfully good odds.

This brings us to Entercom (ETM). Last week, this minnow that swallowed the whale called CBS Radio was the subject of an excellent write-up by Vetle Forsland. A lot of members have asked for my comments on the stock. And a lot of members are clearly excited by the opportunity. Here’s the thing: If I had to come up with one and only one “line” that is most likely to be played out over the next few years, it …

An Illiquid Lunch

To Focused Compounding members:
There are a couple sayings every modern investor and econ student has had drummed into him over and over again. One is: “there’s no such thing as a free lunch.” It sounds like the kind of thing an economist would come up with. Though it’s not. In the 1970s, an economics writer (Milton Friedman) took the saying from a science fiction writer (Robert Heinlein) who had – in the 1960s – simply transplanted an old 1940s saying to the moon. The actual marketing ploy of giving a free lunch dates back to 1800s America. Some bars in the U.S. offered a free lunch to new customers as a loss leader to drive sales of booze. The marketing ploy has long been forgotten. But, modern economists have embraced the saying, with Gregory Mankiw – in a textbook that has, no doubt, earned him tens of millions of dollars in royalties – describing the principle as: “To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another.” That’s not as catchy as saying “there’s no such thing as a free lunch.” But, it’s a lot more honest. Because, there is – of course – such a thing as a free lunch. It’s called trade. Two centuries back, David Ricardo explained comparative advantage, a concept which basically boils down to the maxim that: “if two parties can trade with each other, it’s best for each party to focus on the thing they themselves do best.” The thing you should train yourself to get best at is learning to hold illiquid stocks. I know of no simpler way to improve your lifetime rate of compounding than to accept lower liquidity in exchange for higher returns. Lucky for you, there’s always someone willing to take the other side of that trade. In a 1990s episode of a series in the Star Trek franchise, a character from a very capitalistic species of alien traders explains his people’s belief that:

“…there are millions upon millions of worlds in the universe, each one filled with too much of one thing and not enough of another. And the Great Continuum flows through them all, like a mighty river, from ‘have’ to ‘want’ and back again. And if we navigate the Continuum with skill and grace, our ship will be filled with everything our hearts desire.”

Well, there are millions upon millions of traders out there looking to buy and sell many of the same stocks you are looking to buy and sell. And the one thing they all want – and you’ve got – is liquidity. Like the case for trade, the case for investing in illiquid stocks is backed up by the historical record. Those of you who follow me on Twitter (@GeoffGannon) saw me retweet a table of historical returns from the 1970s through today which showed that even within each market cap size – …