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Jack of All Trades, Part 2
Posted by: The Science of Hitting (IP Logged)
Date: September 25, 2013 11:16AM

In a recent article, “Jack of All Trades, Master of None” (here), I talked about the importance of being selective; I made the point that you don’t need to have an opinion about every stock in order to do well over time. I suggested getting to know the best companies that you can find intimately, and then waiting patiently to buy those names when given the opportunity to do so.

I received a bit of flak for a statement I made in the comment section; to be clear, I thought the reader made a fair point, and I completely understand where he is coming from. Here’s the paragraph that the reader pointed to (bold added for emphasis):

“And on JCP I have not sold a single share; at the same time, I haven't bought any either, and will not be doing so (with all but 100% certainty). I made a commitment to be a business owner when I bought the shares and am seeing it through; I'm hoping painful lessons are more likely to be remembered....”

Like the reader, you may find that statement a bit odd. Why would you willingly give up the option to use the liquidity offered by publicly traded equities? Shouldn’t you dump a stock when it approaches intrinsic value or if you realize you’ve made an error – whether it’s been three weeks or three decades?

I’ll leave that unanswered for a minute. I think there’s a statement from my most recent article, “The Real Definition of Intrinsic Value,” that’s related in many ways. From the article:

“At times, waiting patiently can be disheartening, or even boring (three-quarters of the way through 2013, I’ve yet to place a single buy or sell order). But eventually, the tide will turn.”

That nine-month period is the longest I’ve gone without placing a single trade since I first started investing; take a second to think about the longest you’ve gone between trades in your career, and how long you’ve waited on average. I think that for most people (including myself – I’m way ahead of pace assuming I’ll be an investor for decades to come), this likely clashes with Warren Buffett’s “20-Hole Punch Card” idea in a big way; if you’re buying a stock every quarter and invest for a few decades, it’s easy to eclipse your allotted punches by a factor of 10. The point isn’t to focus on the number, but what it suggests about the due diligence required for sound decision making.

I was reading through my investment journal this weekend, and came across an applicable quote from “The Snowball” (or so I believe - I didn’t note the source at the time): “After the Cap Cities deal, in 1985, he [Warren] went for three years without buying a single common stock.”

Again, ask yourself – what’s the longest you’ve gone with doing nothing? The investment that followed that 1,000-plus day waiting period has become the most well-known investment of Buffett’s career; it’s amazing that this preceding fact is an all but forgotten part of the story.

Here’s what Buffett said about their inactivity in the 1987 shareholder letter (written February 1988):
Quote:
“Whenever Charlie and I buy common stocks for Berkshire's insurance companies (leaving aside arbitrage purchases, discussed later) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: A prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total

We really don't see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as these. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price….

At Berkshire, we have found little to do in stocks during the past few years… However, Mr. Market will offer us opportunities - you can be sure of that - and, when he does, we will be willing and able to participate.”

(Mr. Market presented an opportunity shortly thereafter – with Berkshire (BRK.A)(BRK.B) acquiring a stake in Coca-Cola (KO) with a cost basis approaching $600 million over the next 12 months.)

That’s an amazing admission: “We do not have in mind any time or price for sale.” I made a comment a few weeks ago that suggested the same thing for Phil Fisher. In reading through “Common Stocks and Uncommon Profits,” one thing jumps off the page: When Mr. Fisher talks about selling, he doesn’t even address the idea of a stock increasing beyond some measure of fair value (No. 3 and No. 6). He seems to be focused on buying the best companies with serious growth ahead – and then holding on tight. That’s so foreign to what we hear today – with analysts being, as usual, the most prominent example of the short-term mindset that encapsulates many market participants.

Why do Buffett, Munger and Fisher take such an approach? An argument can certainly be made that Warren’s talking his own book: Berkshire is so large (at this point) that it cannot realistically move funds without incurring huge costs (of course leaving taxes unrealized is part of the rationale for such an attitude as well); it’s simply too difficult to take any other approach.

I think such an approach makes sense because it completely changes your viewpoint; you’re not going to care much about short-term fluctuations if you plan on staying put for years to come (more often than not, I find myself rooting against my investments – so I can buy more).

I made a multi-year commitment when I purchased a stake in J.C. Penney (JCP), and I will see it through; at the same time, it’s really opened my eyes to just how difficult retailing can be. I’d hear it many times before, and knew well about Buffett and Munger’s time as the owners of Hochschild Kohn – but apparently that wasn’t enough to stop me. I looked at the company’s financials early on and believed that it would not take too long for customers to return if the new concept was abandoned, with historical profitability returning shortly thereafter. That assumption has proven to be far too optimistic. By the way, this doesn’t fall on the shoulders of Ron Johnson, Bill Ackman, Steve Roth or anybody else; that is my own error.

Looking forward, what effect will such an approach have on my investment results on average? As one’s time frame is extended, changes in market multiples matter less and less; the returns of the underlying business and its staying power becomes increasingly important (spotting an impeding change can be an arduous task). Why does this matter? I believe there’s a limited subset of market participants who think about stocks in this manner; from analyst reports to blog posts, there seem to be very few people that focus on those underlying returns.

Again, I want to reiterate – I completely understand how others view this differently. I do what works for me, and others should do what works for them. I want to buy great businesses when they are undervalued and watch my returns match (or exceed if purchased cheaply enough) the underlying returns of the business in question.

The temptation to stray from this approach is prominent; it’s so easy to get caught up in the noise and fall prey to the liquidity discussed earlier. When every tick starts to look like a reason for euphoria or despair, fair value estimates (amazingly) start to converge closer and closer to current market prices. Before you know it, buy and sell prices are within spitting distance of one another – implying a level of knowledge about the future that is, for lack of a better word, laughable (assuming one believes intrinsic value is based upon discounted future cash flows).

It’s much easier to say you’re an investor than to actually act like one (how many stocks in your current portfolio would you happily own if the market closed for the next five years?). By the way, trading pieces of paper works for some; more power to them (in the words of Charlie Munger, “Someone will always be getting richer faster than you. This is not a tragedy.”).

I take a different view - in a world of traders, I believe that thinking long term is a clear advantage over the competition; I’m looking at factors most market participants never think about (not because I’m any smarter than them; just like I don’t look at the technical indicators, traders would find no value in thinking about the long term trend of ROA or market share).

Most importantly, I think this approach can narrow the core questions down to a handful - is the underlying profitability of this business protected by a moat with room to grow over time; how does management’s capital allocation stack up over time; and does the valuation understate conservatively expected results by a wide margin? If you can answer those two questions, I don’t think you need to worry about Fed tapering, the current Schiller P/E for the S&P 500, or the impending government shutdown. With enough patience – which can mean years of waiting – I don’t have any question that Mr. Market will eventually give you an opportunity to act.

This all comes down to selectivity. It reminds me of what Charlie Munger says about ethical behavior: When there’s a big whirlpool, you don’t want to come within 20 feet and just barely miss it – you want to go around by 500 yards. I don’t want to play a game where I’m tempted to invest in a stock at “X” and start judging my success a month later when “X” is at 95% or 105% of its original value. I don’t think it is naturally for human beings to take the vicissitudes of the market lightly; remaining level-headed as stocks start moving is easier said than done. I don’t want to see if I’m capable of playing this game – I want to completely avoid it if possible. I don’t want to nibble on the edges of dozens of stocks, buying at 16x earnings to dump at 18x.

I want to find a handful of companies that I can own for years. When they’re cheap, I want to accumulate shares in a big way. If I'm not comfortable with an investment being 10% of my portfolio, I don't see a clear reason why I would want it to be 1% either. I'd rather wait for something better if that's the case. In the words of Charlie’s grandfather, “When you find one, my dear grandchildren, and you can clearly recognize it, seize it boldly and don’t do it small.”

As always, I’m happy to hear from readers who think differently than I do; thanks for reading!


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Jack of All Trades Part 2
Posted by: swnyc2 (IP Logged)
Date: September 25, 2013 11:06PM

BRAVO!

(But, by the same logic, if you realize your original thesis was in error, and you no longer believe you are holding stock in a company that has favorable long term economics, you should sell the stock.)


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Jack of All Trades Part 2
Posted by: aagold (IP Logged)
Date: September 26, 2013 12:23AM


Science,

I just noticed this from your "about the author" description:

"On the sell side, I'll generally spread my sells over a few trades at 5-10% intervals as I approach my estimate of fair value; with the truly great businesses, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of outsized returns and time on intrinsic value."

Ummm.... isn't this a bit inconsistent with what you wrote in this article? It seems to me you're really struggling to justify this arbitrary constraint of holding on to any stock you've bought for at least a few years, regardless of what new information comes to light. Isn't that just an excuse to bury your head in the sand when things change and engage in "thumb sucking", as Warren calls it?

I really wish Warren Buffett was willing to read our discussion about this issue and tell you what he thinks, because I'd be willing to bet a lot of money that he'd disagree with what you're saying here. Yes, of course it makes sense to think long term and to avoid the types of meaningless short-term noise so many traders get caught up with. And yes, it's also true that years can go by without an intelligent investor taking any action whatsoever - that makes perfect sense in certain circumstances. But to say that you're going to have an iron-clad policy of never selling a stock you've bought unless you've held on to it for a few years, regardless of what new information comes to light, or how the current price compares to a conservative estimate of *long term* intrinsic value, or what other opportunities are out there - I'm sorry, but that just makes no sense (sorry to be so blunt).

- aagold



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Jack of All Trades Part 2
Posted by: sapporosteve (IP Logged)
Date: September 26, 2013 07:14AM

Science,

I can understand you wanting to hold for a longer period than most, but given JCP dropped 18% yesterday and is down another 8% in pre-market due to a Goldman Sachs credit assessment, this brings the year to date decline to 46%. Now if you bought in around $20, then you need JCP to more than double just to get back to your starting price (I admit I dont know what you bought at).

Even the great Buffett bailed out when he believed after a rational assessment that he had made a mistake.

I think retailers will bounce back and respond to online sales etc but I think they may be a lousy investment for a while yet.

I noted you said you would not be buying any more, but at what price would you need to consider that your thesis is wrong and maybe get out? Even a business owner realises that there are times to sell and move on.

regards
Steve


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Jack of All Trades Part 2
Posted by: The Science of Hitting (IP Logged)
Date: September 26, 2013 10:03AM

Swnyc2,

That's certainly true; I think the point is to try and get to a level of preliminary analysis that would result in that happening on all but the rarest of occasions. If buying the type of companies I'm talking about, there really shouldn't be anything that can pop up in a short period of time (say, one year) that wasn't present or worth consideration prior to purchase. The mixture of a truly great business and sound analysis prior to purchase should eliminate most of these situations (two things I'm continuing to work on); thanks for the comment!



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Jack of All Trades Part 2
Posted by: The Science of Hitting (IP Logged)
Date: September 26, 2013 10:35AM

Aagold,

The part you highlight is really the main question: do I go into a purchase with an exit price (estimate of fair value) in mind? We can see Warren's quote from above, and I added my two cents on what I drew from Fisher's writing (others may disagree). I'd say that in the past, I was much more focused on determining fair value, and selling as the stock approached that level; I'm slowly moving towards an emphasis on buying great businesses and holding on for a long, long time (I will change my bio).

Does that mean set it and forget it? Well, we saw what Warren did in the early 2000's with KO, as it approached a price that many would consider quite expensive. Again, he has to deal with the size issue; in addition, he was on the board at the time, which would've made liquidating such a huge stake in the company uncomfortable, to say the least. He's labeled a few holdings as permanent, and so far has kept his word regardless of swings in the market; his approach seems to be to sit still when they get expensive, not to sell or seek other opportunities (as you suggest).

I'd like to address your last point:

"But to say that you're going to have an iron-clad policy of never selling a stock you've bought unless you've held on to it for a few years, regardless of what new information comes to light, or how the current price compares to a conservative estimate of *long term* intrinsic value, or what other opportunities are out there - I'm sorry, but that just makes no sense (sorry to be so blunt)."

I don't want get locked into an iron-clad policy (as you call it); these articles shouldn't be read as a proclamation of policies from which I will never stray. I use this as a sounding board in what I consider an evolving investment approach, one which is greatly improved by reader comments (like your own). I don't have all the answers, and am working like everybody else to find something that fits.

I'm simply saying that one should not take partial ownership in a company if they are not comfortable with the prospects for that business over a period of years to come. Some (most) people don't agree with that; they trade pieces of paper day after day. More power to them; but I have no interest in playing that game. The best way to not play it - and to avoid thinking as such - is to eliminate it entirely.

I might miss some opportunities to make money over the years with such an approach, which is fine; I think it will keep me out of trouble, and it's an approach to investing/business ownership that works for me. We have a good idea of what Warren thinks from his own activity in BRK.A, KO, and others. Certainly he's considered new information as it's appeared; but he has not bought or sold (in the case of KO) for many, many years - and in the case of BRK.A, he went many decades (with current selling tied to philanthropy). With See's, he has said he wouldn't sell it for multiples of what it is worth; he doesn't seem to keen on doing what you're talking about.

Straddling the line, as you discuss in your final paragraph, is easier said than done. I think the best way to go about it is avoiding the line entirely and staying as far to the long side - and away from the herd -as you can. Again, your approach may differ.

Thanks for the comment!


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Jack of All Trades Part 2
Posted by: The Science of Hitting (IP Logged)
Date: September 26, 2013 10:43AM

Sapporosteve,

Forget the movement in the price of the stock (or JCP in particular); the point is that I'm making investments with the plan on being an owner for many years. I committed to doing so with JCP and am sticking to that commitment.

Now the question becomes, what happens if things change? As we see with JCP, the situation has changed dramatically in a short period of time; the business was never very good to begin with, and has got materially worse in the past eighteen months.

What is the lesson to be learned? I think it is to avoid company's like JCP; throw it in the "not interested" pile and move on. There will be somebody to buy it, and maybe they'll make a ton of money; this is not a tragedy.

I personally want to focus on companies where the underlying fundamentals will not change so drastically - as they've done with JCP - in such a short period of time. I think the rest of my portfolio is a better reflection of that approach.

"Even a business owner realizes that there are times to sell and move on."

I don't want to be in situations where that's the case, especially in a period of months/quarters; I want to own great companies and stick with them for years or decades to come. That will undoubtedly limit my opportunity set; that's a trade-off I'm happy to make. Thanks for the comment!


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Jack of All Trades Part 2
Posted by: aagold (IP Logged)
Date: September 26, 2013 02:37PM


Science,

I'd like to point out a few relevant points:

1) Buffett makes a clear distinction between Berkshire-owned subsidiaries vs. marketable securities when it comes to owning a business "forever". He's made it clear that as long as a Berkshire subsidiary isn't losing money he won't shut it down or sell it, but that's not the case for marketable stocks (i.e., partially owned businesses).

2) Besides the difficulties you mentioned, such as selling KO when he was on the board or the difficulty in selling a huge number of shares, there are tax constraints he's under as well. As Munger put it once, Berkshire isn't structured correctly to actively trade stocks. There would be too much double taxation - corporate income tax paid on capital gains if Berkshire sells at a profit, and then shareholders would have to pay capital gains taxes again when they sell their Berkshire stock. As a result, he's almost forced to hold stocks "forever" unless they become clearly too risky.

3) Stocks don't have feelings. If you sell one it won't feel bad. In fact, it won't even know. I'm always having to tell my sister this when I sell a stock in her account that's done well for her.

4) I'd like to point out a subtle distinction between "being prepared to own a stock forever" and "owning a stock forever". When I buy an undervalued stock, I'm *prepared* to own it forever. As long as management is operating the business correctly, and is allocating capital correctly (which includes buying back their own shares if that's the best use of company cash), then if the stock price stays low for a really long time I don't care. In fact I'd probably use the opportunity to keep buying more. But that's a whole lot different than saying I *commit* to owning it forever (or a very long time). Why? Because if Mr. Market becomes manic instead of depressive very quickly, so my stock quickly moves from being underpriced to being overpriced, I'll dump it immediately and make a huge IRR. And so would Buffett, absent the constraints talked about in #2 above. So there's a huge difference between being *prepared* to own a stock long term and *committing* to own a stock long term.

- aagold



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Jack of All Trades Part 2
Posted by: The Science of Hitting (IP Logged)
Date: September 26, 2013 04:31PM


Aagold,

Glad you're keeping the discussion lively! Hopefully others are reading and not just us going back and forth :)

1) That's true - and he's also made the point that there's no difference, i.e. both are ownership in that business. I'd be curious to know what was the shortest period of time Warren held a stock within the past 20-30 years; would you think it's over/under one year? What do you think that answer is for most people? That's the point I'm getting at...

2) Very true, and that's why I mentioned those difficulties (want to be fair / honest); of course, we have our own tax implications to consider as well. I'm not there now, but at some point I plan on being in the higher tax brackets, and it's probably safe to bet that they won't be 15% forever. Every investor, not just Warren Buffett, must consider the tax implications of their action, regardless of if the rate is 5%, 15%, or 50%.

3) True again. As an example, I don't own PEP because I think it's happy I've been it's friend for so long; I'm more concerned with the attractive ROA & ROE that it's put up year after year after year (the unrealized gains you mentioned above play a role as well).

4) Many people say that; then there's the important question: how many of your current holdings is that true for? Buffett hasn't pursued the in/out method you describe, and has done just fine. That's not to say you're wrong; I simply prefer his method and believe I can act more rationally taking that approach.

Thanks for your comment; look forward to your response!


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Jack of All Trades Part 2
Posted by: batbeer2 (IP Logged)
Date: September 26, 2013 04:38PM

Hi aagold

>> I'll dump it immediately and make a huge IRR

Dumping it is not what gets you the huge IRR.

Lets say I offered to sell you either a bank account with $10 000 and a 5% interest or a bank account with $3 000 and 15% interest. In each case, I want $ 7 000.

In real life, most people would choose the former, liquidate the account and claim an indecent IRR.

BUT

If you chose the latter, you'd do a lot better in the long run. If you're comfortable that the 15% is sustainable for many years, would you sell that asset to anyone else even if they offered you $20 000?

If you don't sell, it means you're hanging on to an asset with a p/e of 20 000 / (0.15*3 000) = 44 !

It depends on your horizon. That's subjective.


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