Buy Right and Sit Tight
What investing should be, and what it has always been intended to be, is a means of providing needed capital to productive businesses. Unfortunately, many have tried to undermine the fundamental purpose and principals of investment by participating in speculation and calling it active management.
Jack Bogle, founder of the Vanguard Group, is probably the most well-known proponent of the buy-and-hold strategy. Over the years Mr. Bogle has repeated various versions of the same argument for what is generally known as the Efficient Market Hypothesis.
The Cost of Trading
When most investors consider the cost of trading they consider factors such as commission fees and capital gains taxes and probably stop there. I want to elaborate on what I consider the true costs of trading, and why buy and hold outperforms active strategies, by detailing an example from my current portfolio.
Case Study - 100 shares of MO
I currently own 100 shares of Altria Group (MO) which I acquired in 2007 at the split adjusted cost of $19.93 per unit, after accounting for the spin-offs of Kraft (KFT) and Philip Morris (PM). I currently have an estimated fair value ((EFV) for MO of $27 per share. Let’s say that I could sell my shares at $28 per share, a slight premium to my calculation of EFV. How do I calculate the cost of this trade?
If I were to sell my shares at $28 I will realize a profit of $807, which results in $645.60 after capital gains tax. That $161.40 in taxes is part of the cost of my trade, but if you stop there you’re not seeing the bigger picture.
Let’s assume that in 12 months the price of MO will revert to my assessment of fair value. The expected 12-month cost for my trade is equal to the cost of capital gains plus expected dividends minus the premium to fair value per share. The present annualized dividend rate is $1.64 per share. In this instance I will pay $161.40 in taxes + $164 in lost dividends - $100 premium to fair value. So my expected 12-month cost is $225.40.
The expected cost of my trade divided by the net proceeds from the sale reveals the rate at which I will have to be able to reinvest the proceeds in order to break even on the transaction over that 12 months time. I call this break even point the hurdle rate, because it is the benchmark I must clear to earn back the cost of the trade. My sale of 100 MO at $28 will have netted me $2,800 minus expected cost of $225.40, or $2574.60 in net proceeds. In order for me to break even on this transaction I will have to be able to reinvest that money at 8.75%. Remember, that’s the rate of return I need to break even within the first 12 months. I didn't include taxes on dividends so maybe my hurdle rate is just a touch lower.
Calculating The Hurdle Rate
Expected cost = (capital gains tax + expected dividends) - premium to EFV
Hurdle rate = expected cost / net proceeds of sale
Historical data shows that stocks made 9.2%, bonds made 4.4%, and cash returned 4.1% in the 20th century, with all dividends or interest income reinvested. [2] Since I'm an infallible value investor and all of my investments beat the market averages, the odds are in my favor that I can reinvest the proceeds from my sale of Altria at a small profit in the first year (tongue firmly in cheek). If the hurdle rate were greater than the historic return of the market then I would statistically be likely to lose money on the trade.
In my case, MO has a strong record of increasing its EFV through growing EPS and increasing dividends, and is likely to continue to do so. So even though the price is currently above my estimation of fair value, it is still important to calculate the hurdle rate to make sure that I have a reasonable expectation of reinvesting that capital at a rate that compensates me for the cost of trading. In this instance we anticipate that I need to realize a 12-month return of 8.75% just to break even on costs. The hurdle rate is often much higher than investors anticipate.
The important point to focus on is that even though I think MO is slightly overvalued, if shares trade down to my EFV over the course of a year, I will in all probable circumstances break even holding my shares versus trading, after accounting for costs.
Good Reasons to Trade
Remember Bruce Berkowitz’s quote, "Sell that which is cheap to buy that which is cheaper”? [3] The hurdle rate also allows you to calculate the return you would need to break even selling a stock that is below your EFV by simply adding the discount to EFV to the Expected Cost.
Trading isn't inherently bad if you can earn back the cost of the trade. Here is a partial lists of good reasons to consider a trade:
1) You can invest above the hurdle rate.
2) Broken thesis.
3) Broken business.
Don't confuse trading with selling. There are lots of reasons one might sell a stock that having nothing to do with trading, such as paying off an unexpected medical cost, or simply enjoying retirement
Why Buy and Hold Outperforms
The Oracle of Omaha summarized his buy and hold philosophy in his 1996 letter to shareholders. It contains one of my favorite Buffett quotes:
The most overlooked value of buy and hold may ultimately be the most important. Opportunity cost. How else could you have invested the time you allocated to active management strategies? What is your time worth to you? According to the Bureau of Labor Statistics you are worth approximately $23 an hour. [5] How many hours a week do you spend studying and researching investments? Herein lies the real reason to “buy right and sit tight.” If you add the opportunity cost of your time into the formula, the hurdle rate for all your trades will almost certainly dwarf your expectations.
Sources
1) http://www.morningstar.com/cover/videocenter.aspx?id=295081
2) http://www.investmentu.com/2002/December/20021219.html
3) http://www.morningstar.com/cover/videocenter.aspx?id=324904
4) http://www.berkshirehathaway.com/letters/1996.html
5) http://www.bls.gov/eag/eag.us.htm
What investing should be, and what it has always been intended to be, is a means of providing needed capital to productive businesses. Unfortunately, many have tried to undermine the fundamental purpose and principals of investment by participating in speculation and calling it active management.
Jack Bogle, founder of the Vanguard Group, is probably the most well-known proponent of the buy-and-hold strategy. Over the years Mr. Bogle has repeated various versions of the same argument for what is generally known as the Efficient Market Hypothesis.
As a group, we investors buy and hold. All of us together own the entire stock market and we hold it. We are trading back and forth within the market with each other, and we are each trying to gain an advantage over somebody else. It is a market system that pits one investor against another. But as a group we are buy and hold investors.”I’m an adherent of the “Mostly” Efficient Market Hypothesis. In other words, markets are never perfectly efficient but they tend to produce “mostly” efficient price results over longer periods of time. Thus, I argue for buy and hold based on cost. Costs are incurred on all transactions. Since buy and hold involves the fewest transactions and since markets are mostly efficient in the long run, buy and hold investors have a cost advantage over the average market participant.
“Indexing, which is the ultimate buy and hold strategy, is going to still beat the average active manager, because the average active manager owns the entire market just like the index fund does when you add all the managers together. [1]
The Cost of Trading
When most investors consider the cost of trading they consider factors such as commission fees and capital gains taxes and probably stop there. I want to elaborate on what I consider the true costs of trading, and why buy and hold outperforms active strategies, by detailing an example from my current portfolio.
Case Study - 100 shares of MO
I currently own 100 shares of Altria Group (MO) which I acquired in 2007 at the split adjusted cost of $19.93 per unit, after accounting for the spin-offs of Kraft (KFT) and Philip Morris (PM). I currently have an estimated fair value ((EFV) for MO of $27 per share. Let’s say that I could sell my shares at $28 per share, a slight premium to my calculation of EFV. How do I calculate the cost of this trade?
If I were to sell my shares at $28 I will realize a profit of $807, which results in $645.60 after capital gains tax. That $161.40 in taxes is part of the cost of my trade, but if you stop there you’re not seeing the bigger picture.
Let’s assume that in 12 months the price of MO will revert to my assessment of fair value. The expected 12-month cost for my trade is equal to the cost of capital gains plus expected dividends minus the premium to fair value per share. The present annualized dividend rate is $1.64 per share. In this instance I will pay $161.40 in taxes + $164 in lost dividends - $100 premium to fair value. So my expected 12-month cost is $225.40.
The expected cost of my trade divided by the net proceeds from the sale reveals the rate at which I will have to be able to reinvest the proceeds in order to break even on the transaction over that 12 months time. I call this break even point the hurdle rate, because it is the benchmark I must clear to earn back the cost of the trade. My sale of 100 MO at $28 will have netted me $2,800 minus expected cost of $225.40, or $2574.60 in net proceeds. In order for me to break even on this transaction I will have to be able to reinvest that money at 8.75%. Remember, that’s the rate of return I need to break even within the first 12 months. I didn't include taxes on dividends so maybe my hurdle rate is just a touch lower.
Calculating The Hurdle Rate
Expected cost = (capital gains tax + expected dividends) - premium to EFV
Hurdle rate = expected cost / net proceeds of sale
Historical data shows that stocks made 9.2%, bonds made 4.4%, and cash returned 4.1% in the 20th century, with all dividends or interest income reinvested. [2] Since I'm an infallible value investor and all of my investments beat the market averages, the odds are in my favor that I can reinvest the proceeds from my sale of Altria at a small profit in the first year (tongue firmly in cheek). If the hurdle rate were greater than the historic return of the market then I would statistically be likely to lose money on the trade.
In my case, MO has a strong record of increasing its EFV through growing EPS and increasing dividends, and is likely to continue to do so. So even though the price is currently above my estimation of fair value, it is still important to calculate the hurdle rate to make sure that I have a reasonable expectation of reinvesting that capital at a rate that compensates me for the cost of trading. In this instance we anticipate that I need to realize a 12-month return of 8.75% just to break even on costs. The hurdle rate is often much higher than investors anticipate.
The important point to focus on is that even though I think MO is slightly overvalued, if shares trade down to my EFV over the course of a year, I will in all probable circumstances break even holding my shares versus trading, after accounting for costs.
Good Reasons to Trade
Remember Bruce Berkowitz’s quote, "Sell that which is cheap to buy that which is cheaper”? [3] The hurdle rate also allows you to calculate the return you would need to break even selling a stock that is below your EFV by simply adding the discount to EFV to the Expected Cost.
Trading isn't inherently bad if you can earn back the cost of the trade. Here is a partial lists of good reasons to consider a trade:
1) You can invest above the hurdle rate.
2) Broken thesis.
3) Broken business.
Don't confuse trading with selling. There are lots of reasons one might sell a stock that having nothing to do with trading, such as paying off an unexpected medical cost, or simply enjoying retirement
Why Buy and Hold Outperforms
The Oracle of Omaha summarized his buy and hold philosophy in his 1996 letter to shareholders. It contains one of my favorite Buffett quotes:
“If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.” [4]Why do I think buy and hold outperforms? It is all about costs versus compounding. As your portfolio’s aggregate earnings march upwards over the years the law of compounding returns takes over. In my example involving MO, we demonstrated how just one trade could set me back 8.75% over 12 months. If you aren’t able to recoup that cost quickly, the difference in value will compound over time as well. Instead of fighting what Einstein once called "the greatest force in the universe," buy high-quality compounding machines and let them work for you. (Academic sources claim Einstein didn't actually say that.)
The most overlooked value of buy and hold may ultimately be the most important. Opportunity cost. How else could you have invested the time you allocated to active management strategies? What is your time worth to you? According to the Bureau of Labor Statistics you are worth approximately $23 an hour. [5] How many hours a week do you spend studying and researching investments? Herein lies the real reason to “buy right and sit tight.” If you add the opportunity cost of your time into the formula, the hurdle rate for all your trades will almost certainly dwarf your expectations.
Sources
1) http://www.morningstar.com/cover/videocenter.aspx?id=295081
2) http://www.investmentu.com/2002/December/20021219.html
3) http://www.morningstar.com/cover/videocenter.aspx?id=324904
4) http://www.berkshirehathaway.com/letters/1996.html
5) http://www.bls.gov/eag/eag.us.htm
