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"Be Patient" - When Buying AND Selling
Posted by: The Science of Hitting (IP Logged)
Date: July 25, 2013 10:16AM

Equity markets are currently in a position that has been absent for much of the last five years: high-quality names are starting to look quite expensive. Across the board, the Johnson & Johnson (JNJ) and Coca-Colas (KO) of the world are starting to grow into earnings multiples above 20x, implying levels of growth that in some cases exceed what they’ve managed to put together in the previous decade. At the same time, long-term bonds continue to be priced for limited real returns, which has irked individuals who have watched equity markets continue to run higher.

Collectively, that leaves us with few good alternatives; what is an investor to do in such times?

Luckily for us, James Montier of GMO recently penned an article in the firm's second quarter letter that addressed this; while he offered four potential paths that one could follow, I would like to focus on the fourth option - Be Patient:

This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.

Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a re-pricing (witness the market moves in the last month). Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”

This idea is so logical, which is probably why it’s hard to follow when markets move into a territory that approaches absurdity; as foolishness continues to grow and market valuations consistently breach new levels (with commentators there to justify this new found optimism), the fear of being left behind becomes overwhelming. We see this exact phenomena with Isaac Newton during the South Sea Bubble (as captured in a 2009 article by MIT professor Thomas Levenson):

Starting at £128 in January, the price for South Sea securities rose to £175 in February and then £330 in March. Newton kept his head - at first. He sold in April, content with his (quite spectacular) gains to date. But then, between April and June, share prices tripled, reaching over £1,000 ... which is precisely when he could stand it no longer. Having "lost" two thirds of his potential gain, Newton bought again at the very top, and bought more after a slight decline in July…

The bubble burst, and South Sea share prices collapsed to roughly their pre-bubble level. Newton's losses totaled as much as £20,000, between $4 million and $5 million in 21st century terms…

After the disaster, he could not bear to hear the phrase "South Sea" mentioned in his presence. But just once he admitted that while he knew how to predict the motions of the cosmos, "he could not calculate the madness of the people."

I have a solution for dealing with the madness of people, and my conclusion won’t come as a shock to Gurufocus readers: Continue to be patient if you cannot find securities that meet your criteria. Although it appears that cash becomes an increasingly expensive alternative to equities as markets roar higher, the reality is the exact opposite; future rates of return are being sacrificed for current gains, a trade-off that acts like a rubber band as its stretched further and further from equilibrium (only to come shooting past balance to the other extreme at some point down the road). Those who fail to recognize this undeniable truth are most susceptible to becoming its ultimate victim.

Johnson & Johnson provides an interesting example: When Johnson & Johnson (JNJ) was trading at a low-teens multiple of free cash flow for the better part of the last five years, the constant barrage of short-term issues promulgated by the analyst community (and the financial media) were more than priced in. With the stock more than 50% higher than where it traded 24 months ago, the analysts are now lining up with “buy” ratings, proclaiming that the Medical Devices & Diagnostics segment is now out of its doldrums because of “solid growth” attained in the most recent quarter (which was a paltry 0.5% after accounting for the addition of Synthes), and that the Consumer segment is finally getting closer to something resembling normal operations (which was never particularly important to JNJ even during the good years, at roughly 10% of the company’s total operating income).

To be clear (for those who will question this once they come across the disclosures at the bottom of this article), I still own some Johnson & Johnson; this is the other side of “be patient” that receives less attention than it should. Many people live in a state of absolutes marked by decisive – and what I consider to be extreme – action: It often comes in the form of metrics (like a P/E or EV/EBITDA multiple) which are cut-offs that dictate when investors buy and sell (lately, leaning towards the latter). The result, as I see it, is often a narrow window (if we view market movements over a period of years) that rigidly dictates frequent activity.

While this approach is intellectually pleasing (in theory), I don’t think it meshes with reality; one major shortcoming of this rules-based strategy is a failure to look at the whole picture (when I say failure, I don’t mean by construction; it comes from the biases that individuals bring into the picture, which must be considered). Portfolio decisions must be made with an eye on one’s financial situation, in addition to one’s current holdings.

To use myself as an example, I’m young and will be a net saver for decades to come; every month or so I add about 2% in my portfolio in the form of cash (savings), which will be moved into equities once I’m given the opportunity to do so. Year to date, those opportunities have been nonexistent. I have not bought a single share of common stock, and as of today have no plans of doing so in the foreseeable future. As a result, my cash balances have built up a bit; I have plenty of dry powder at my disposal despite the fact that I was fully invested a few months ago.

With that said, I have not sold a single share of stock; I continue to hold JNJ and PepsiCo (PEP) in full, despite the fact that their future returns have been diminished by their recent moves higher. When would I sell? That’s a tougher decision, but it’s one I’m increasingly comfortable making as prices move beyond their current range; in order to part with businesses that I consider above average, I demand a price that adequately captures that fact (as well as the consideration that realized gains and the subsequent tax bill diminish the attractiveness of the alternative); for people with a short term view, who’s returns are solely dependent upon revaluations from Mr. Market (and account for a large percentage of daily market volumes), this isn’t a consideration.

With a view extending more than 10 years, a 20% to 25% move in the equity indices higher or lower is inconsequential; patience should require investors to think in this manner when adjusting equity allocations as individual names (particularly those of above-average companies) move to levels that point towards undue optimism. As Montier’s grandmother used to say, good things come to those who wait. For investors waiting with businesses that consistently generate outsized returns on invested capital, I believe good things justify waiting longer than may seem prudent otherwise.


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Re Be Patient - When Buying AND Selling
Posted by: gurufocus (IP Logged)
Date: July 25, 2013 01:42PM

Excellent! Thank you!

Just it is so hard to be patient watching the market going higher. John Hussman described the hard feeling in one of his recent letters.

In hindsight it would be easy.


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Re Be Patient - When Buying AND Selling
Posted by: The Science of Hitting (IP Logged)
Date: July 25, 2013 03:59PM

Gurufocus,

Agreed! Investors must develop the right mindset to account for the fact that pain, from losses or missed gains, cannot enter into your decision making; acting based on emotions is a sure path to long-term underperformance.

Thanks for the comment!



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Re Be Patient - When Buying AND Selling
Posted by: iamjvc3 (IP Logged)
Date: July 25, 2013 04:54PM

Great article! I just recently reread "The Warren Buffett Way" by Robert Hagstrom. Your comments reminded me of the wonderful insights in chapters 10 & 11 on focus investing (patient portfolio turnover) and the temperament of a true investor (calm, patient, and rational). Your username reminds me that great baseball hits come after waiting for the right pitch to sail into the strike zone. Same with investing - great businesses selling below intrinsic value! Thanks.


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Re Be Patient - When Buying AND Selling
Posted by: gurufocus (IP Logged)
Date: July 25, 2013 05:08PM

Prem Watsa averages down when buying, and averages up when selling.

He is fully hedged and has lost billions on them. It is even harder than sitting on cash!

Talking about conviction...


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Re Be Patient - When Buying AND Selling
Posted by: The Science of Hitting (IP Logged)
Date: July 25, 2013 06:45PM

Iamjvc3,

Glad you liked the article - and also a fan of Mr. Hagstrom's book! Hope to see you commenting on more articles in the future; thanks!

Gurufocus,

I can understand doing that in certain cases, but up to a limit; as an example, I've stopped doing it with JCP because it's not a business I love (to date, as you know, it's been a disaster). There are many ways the investment could end very poorly, or I could be waiting years without any value being created (or even more being destroyed). On the other hand, I would act much differently if a company like Coca-Cola or PepsiCo was going through a similar period of difficulties.

In regards to Prem, he hasn't lost as far as I know - he simply has not matched the indices gains; Fairfax's portfolio is fully hedged, not 100% short or anything like that (correct me if I'm wrong).

Thanks for both the comments and for keeping the discussion alive!



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Re Be Patient - When Buying AND Selling
Posted by: Cornelius Chan (IP Logged)
Date: July 27, 2013 01:24PM

in order to part with businesses that I consider above average, I demand a price that adequately captures that fact (as well as the consideration that realized gains and the subsequent tax bill diminish the attractiveness of the alternative)

Well, JNJ has indeed risen up from range-bound since 2008 ($60). The recent, rapid price gain of shares based on fundamentals is interesting. For example, revenue has been growing steadily the past 4 years. The net income has been uneven, but still growing. Book value is increasing steadily. Especially the return on equity is intriguing. Because this company has been such an incredibly above-average ROE since the early 2000's, but has fallen into a new, lower plateau coming into the high 16 percentile in 2011 (down from mid-high 20's in the 00's). Now back up to the high 20 percent latest quarter. So the price move we see lately is curious. Why now?

Correct me if I'm wrong - the recent flight to safety in stocks propelled a lot of capital into the best blue chips. JNJ is definitely perceived as one of those safest of the safe stocks. Your point about bubble is well taken, because when there is a stampede into one type of stocks then there will be a bubble there. Just the opposite, recently there was a stampede out of certain stocks (gold miners) and we see record lows as a result.

Patience should reward you in the long run. 10 years from now will JNJ be higher or lower than now?

lamjvc3: thanks for bringing up Hagstrom's title. I still have to read that one, now I will hunt it down and do so... been meaning to for a couple years : /


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Re Be Patient - When Buying AND Selling
Posted by: The Science of Hitting (IP Logged)
Date: July 28, 2013 03:06PM

CWR,

I think your point on JNJ, namely will it be higher ten years from now, should be put a bit differently; I think the question should be, for an investment with comparable predictability, what type of returns would I expect for a 10-year holding period? Holding onto my position in JNJ offers a material benefit in that the starting value is larger than the alternative due to the continued benefit of unrealized gains; however, that does not mean it will be the clear favorite in all scenarios. Higher alone isn't good enough; it must outpace the (ex-ante) opportunity cost offered by the next best alternative.

Thanks for the comment!



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