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Geoff Gannon
Geoff Gannon
Articles 

How to Be More of an Investor and Less of a Trader

A list of questions you can ask and answer that will increase the average holding period of the stocks in your portfolio

November 04, 2016

A lot of people reading this consider themselves value investors. There are two parts to that designation: the “value” part and the “investor” part.

I want to talk about the “investor” part. What is the difference between investment and speculation? Ben Graham answered that question 82 years ago. See “Security Analysis.” That’s not the distinction I’m worried about here. Some of what Warren Buffett (Trades, Portfolio) has done would be considered “speculation” by Graham. But it would still be considered “long term” by everyone.

So Buffett is an investor in the sense that he is not a trader. What is the difference between “investing” and “trading”? Time. The difference is time. A trader has an exit strategy. A trader wants to flip his position. An investor wants to hold. An investor has lower turnover in his portfolio. He has a longer average holding period.

What is your average holding period? I’m sure you don’t know. I don’t know. But we can start with a pretty simple test. Look at your portfolio as it exists now. Go into your brokerage account and find every single position you have. Print out the “Portfolio Holdings” page if you have to.

Then do a little research on your own past behavior. Look up when exactly you bought each of those positions. That won’t give you a true measure of the average holding time for you as an investor. Obviously, you aren’t selling all those positions today. But it will give you a minimum. If you have 20 stocks in your portfolio and the 10th-longest held stock was bought back in 2013, then you tend to hold stocks for three years or longer. Is that investing? Or is it trading?

I’d call three years trading. There’s a logic to this which I’ll explain in a second. But I want to stop here and say that, of course, it doesn’t matter what I call investing and what I call trading. You define it however you want to define it. This article is about how you can – if it’s something you’re looking to do – extend your average holding period. This article is for people who think of themselves as long-term “buy and hold” type investors in theory but then find they are more like “value traders” in practice. They buy a stock at a low price-earnings (P/E) or price-book (P/B) or EV/EBITDA ratio or whatever and then they sell that stock when it hits a high P/E or P/B or EV/EBITDA ratio. They are trading on a multiple expansion. They aren’t making their return from owning the stock. How can people like that become more investorly and less traderly in their approaches?

I have a six-part investment process that might help. There’s nothing special about these six steps. You can find a better set of six that work for you. But these six will start you thinking the right kinds of thoughts. What we are focused on here is practice. We are thinking practical thoughts – talking habits – rather than theoretical thoughts.

Okay. What are these six steps?

  • Question One: “Is this a business I’m comfortable owning forever?”

If your answer is “No,” then you eliminate the stock from consideration right there. For me, this eliminates about 95% of stocks. If I read a 10-K a day for about three weeks, I come across one idea that passes this test. It’s about a 1 in 20 sort of business that is going to pass this first test for me. For you, it might be different. Maybe it is 10% of all stocks. I’d believe that. Could it be 20%? I guess. Could it be 50%? No. It can’t be 50%. Most people are not comfortable owning most businesses forever. So, if you read a 10-K a day for three weeks and you find that 12 of those (12 out of 21) are businesses you’d be comfortable owning forever – you’re probably lying to yourself.

If your answer is five out of 21 or three out of 21 or one out of 21 – you’re probably being honest with yourself. Or at least you’re being more honest with yourself than most stock pickers are. So, let’s start with that. I could list a ton of businesses I’d probably be comfortable owning forever. For example: I’d be comfortable owning Omnicom, Frost, Grainger, Hunter Douglas and John Wiley forever. What do these businesses have in common? They tend to have high rates of customer retention. Frost is a little over 90% customer retention. Omnicom is – like other major advertising agency holding companies – probably in the 95% to 99% of major accounts range. Grainger is an MRO distributor. That industry – especially among large accounts, on which Grainger focuses – has a high customer retention rate.

In Wiley’s journal publishing business, it tends to retain university library clients indefinitely. In fact, when I was researching Wiley I spoke to one buyer of Wiley’s journals – and Elsevier's and Springer's and so on – and asked what would happen if a company like Wiley raised prices on him. He said he’d stop buying a competitor’s journals. I said, “Wait, what? A competitor’s?” And he said, “Yeah, when one of the top three or four or five publishers with their bundles of top journals raises their prices I have to eliminate smaller journals from smaller publishers. How it works is I have a list of all the journals I want to subscribe to. And I have a budget. The ranked list doesn’t change. And my budget doesn’t change. So when the top journals cost me more – I cut the bottom journals.”

In other words, he doesn’t switch providers because of price. Likewise, Omnicom’s clients aren’t going to switch to another ad agency because of price. And Frost pays much, much lower interest on its accounts than many banks yet its customer retention rate is higher than the banks that pay more for their deposits. That is the kind of business – the kind of industry – I’d be most comfortable investing in forever. For me, personally, I don’t want to own a business forever in an industry where price is a reason customers switch providers. I want to be in an industry where customers either don’t switch providers or where customers switch for reasons other than price. But that’s me.

You might feel comfortable owning a business with real, hard assets forever. Maybe you want to own ExxonMobil or U.S. Lime or Southern Copper or Union Pacific forever. You’re looking at the supply side instead of the demand side. You’re asking: Who is ever going to build another railroad in the U.S.? Answer: no one. Or how much does it cost to find, develop and exploit a new source of oil? Or get the permits and so on for a new limestone quarry. That isn’t usually my kind of thinking. But it makes sense to me. It’s rational. I wouldn’t think it odd if people said they were comfortable owning a business with a limited supply situation forever. We have businesses where clients don’t switch providers or when they do switch providers they don’t switch because of price. And we have businesses where competitors can’t enter the business on the same terms that the existing players did.

Then we have Buffett’s favorite businesses. We have “habit” type businesses, businesses with mindshare. We are talking Gillette and Coca-Cola and See’s Candy and Wrigley. They may have other advantages too. Obviously, Coke and Gillette have some pretty impressive distribution systems over the entire globe. But they also have the advantage that when you are in a restaurant and the waiter comes up to you, you say, "I’ll have a Coke." You never say, "I’ll have an RC." Mindshare.

There are three examples of classes of businesses you might be willing to hold forever. This first step is the most important. “Am I comfortable owning this business forever?” is the most important question a long-term investor can ask. It makes up most of what being a long-term investor is all about.

Next, let’s look at question No. 2.

  • Question Two: “What will this business look like in five years?”

To me, this is the question that separates the value investor from the value trader. There is nothing wrong with being a value trader. But that’s not what this article is about. A value trader looks at a stock that is cheap right now. The P/E is 11 or the P/B is 0.9 or the EV/EBITDA is 6. He compares these figures to peers. Is this stock cheap on an absolute basis? Does it have a low P/E, P/B, EV/EBITDA, etc.? And then: Is this stock cheaper than those public companies that are most like it?

Say we are looking at Southern Copper. We would ask how much does Southern Copper trade for in the stock market per ton of reserves. And then we’d ask if other copper miners trade for more or less per ton of copper reserves. It is easy to do these kinds of comparisons. One of the appealing aspects of Frost – for me – is how cheap that bank is in terms of price to deposits. The market cap of that bank is low per dollar of deposits. It’s not low on a P/E basis. But it is low on a price-to-deposits basis. If interest rates were at a different level – just as if copper prices were at different levels for Southern Copper – the earnings picture would be different. This is a short-term – or I guess most people would say medium-term – speculation. It’s just a bet on higher copper prices or higher interest rates or something like that. It’s different from believing Frost will be able to grow its deposits per share, per branch, etc., at a good pace for the next decade.

Buffett is thinking more in those terms. He is asking: how quickly can Wells Fargo grow its share of wallet with customers, its deposits per branch, its deposits per share, etc., over the next 15 years? He’s not just thinking about how much Wells would be making in 2020 if the Fed Funds rate was 3% by then.

  • Question Three: “What would that business be worth in five years?”

This is about pricing the future business instead of the present-day business. Let’s say I think that through a combination of interest rate increases and organic deposit growth, Frost could grow EPS per share by 10% a year over the next five years. Then, what I do is I look at the business as it exists today and take Today’s EPS * 1.10 ^ 5. That is the business I think about. The tomorrow (five years from now business) rather than the today business. This is part of what separates the investor – who intends to hold the business for the long term – from the trader who might be selling in just three years’ time. I don’t care what the business looks like today. I’m not selling the stock today. If I’m an investor – I’m not even going to be thinking about selling for five years. So, what matters is what the business looks like in five years. What it looks like today doesn’t matter.

  • Question Four: “How much am I paying today for that?”

This is the value part of “value investor.” But it’s a little different than looking at P/E ratios and P/B ratios. It is a DCF-type approach.

Let’s say I have a stock today that is earning $1 per share. But I think it will grow more than 10% a year. It will be earning 65% more per share within five years. Then we aren’t going to compare today’s price to the $1 EPS today. We are instead going to compare what we are putting down today to own a business making $1.65 per share in 2021. Now, I don’t think any sort of actual DCF type approach is needed here. Instead, a purely relative approach can work. Put taxes aside for a second. We can ask how much do I have to invest to have $1.65 in earning power in 2020.

If a stock is trading at $15 per share today and will produce $1.65 per year in EPS in 2020, then we can say it costs me $15 per share today to have $1.65 per share in EPS In 2020 when I invest in this stock. Another stock may be trading at $10 per share and producing $1 in EPS. Then the question becomes how much does it pay out in dividends. And how can I reinvest those dividends to get that same $1.65 in EPS In 2020?

It can be a simple comparison between different alternatives. But it must be future focused. You must pick a time in the future. I suggest five years as the minimum. Any investment you hold for at least five years is going to be considered long-term by most people. Starting with comparisons that use five years as the time frame you are measuring will put you in an investor’s mindset.

If stock A is cheaper in years 1, 2, 3 and 4 but falls behind the EPS production of stock B (for the same initial cash outlay on your part), then stock B is the better investment for you because you are an investor. Note that stock A is the better trade for the trader. There is no objective answer to which stock is the better “value” stock. It depends on the reference frame. In the trader reference frame, stock A is cheaper. In the investor reference frame, stock B is cheaper. It’s relative. You pick a different frame and you get a different answer.

Here, we are concerned only with the subjective reference frame of “investor.” We are discarding the trader frame. To do that, we are disregarding how much more earnings an investment will produce per dollar of your money in years 1, 2, 3 and 4 and just asking which stock will be ahead in terms of earning production starting in year 5. This keeps you focused on the long term.

  • Question Five: “What’s the best stock I don’t own yet?”

Let’s say I like Hunter Douglas, but I don’t own Hunter Douglas. But I know that if I had to buy something today – if you put a gun to my head – that something would be Hunter Douglas. That’s my opportunity cost. That’s what we compare the stock we’re considering to. It must clear the “Hunter Douglas” hurdle.

  • Question Six: “Do I really think this is the best opportunity I’m going to get all year?”

We’ve cleared the opportunity cost hurdle. We know the stock we’ve found is the best thing we could buy right now. But should we buy something right now? Answer: usually not. On most days, we as investors don’t want to be doing anything at all. How do we build inaction into our selection process? We can use a modified sort of form of Buffett’s “punch card.” He said if he gave you a card with 20 punches on it and each time you bought a stock, you used up one of your punches and that card had to last you the rest of your life – that limitation alone would improve your stock selection process. I agree.

But how do we build that into the here and now instead of lifelong thinking? We limit ourselves to one stock purchase per year. You can only buy one stock this year. If you buy this stock, you aren’t allowed to buy any other stock this year. This will reduce your turnover rate. And a lower turnover rate will lead to a higher average holding time in your portfolio. It will make you more of an investor and less of a trader. So, limit yourself to one punch per year.

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About the author:

Geoff Gannon



Rating: 4.4/5 (11 votes)

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Comments

rrurban
Rrurban - 4 years ago    Report SPAM
Wonderful article! Really insightful and simple solutions to the complexity of stock market investing

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