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):
“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 (NYSE:BRK.A)(NYSE:BRK.B) acquiring a stake in Coca-Cola (NYSE: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!
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.