Chuck Akre (Trades, Portfolio) was the keynote speaker of this year’s GuruFocus Value Conference. During the Q&A session, somebody asked Akre what investor should do if the valuation of a great compounding machine becomes excessively high. Akre’s answer inspired me to write this belated article. In his experiences, it has almost always been a mistake to sell the great compounding machines, even when the valuation seems high.
Why is that?
Everybody may come up with different answers. I’m not sure I have found the perfect answer but I did a little exercise myself, which showed mathematically and logically why it makes sense to hold the truly great compounders for a long time.
In this simple exercise, I calculated the after-tax compounded rate of return under a few different scenarios using the price, valuation and fundamental data of Markel (MKL, Financial) for the past 15 years. Undoubtedly, there are limitations and drawbacks of the study. However, I think it provides me with a good mathematical framework to figure out the issue at hand.
Scenario 1: Buy Markel on the last day of 2002 and hold it until the last day of 2017 (buy and hold for 15 years).
Scenario 2: Buy Markel on the last day of 2002, sell at the exact high of 2007. Buy again at the exact low of 2009, and sell it at the exact high of 2017 (perfect timing).
Scenario 3: Buy Markel on the last day of 2002 and trade in and out every five years by selling at 10% below the high price of the fifth year and using the proceeds to buy Markel at 10% above the low price of the next year. The transactions under this scenario are as follows:
- Buy Markel on Dec. 31, 2002, at $205.50 per share.
- Sell Markel at 10% below the 2007 high of $545.50, or $491 per share, and pay long-term capital gain of 15%.
- Use the net proceeds to buy Markel at 10% above the low of 2008 of $245.30, or 269.80 per share.
- Sell Markel 10% below the 2012 high of $500.70, or $460.60 per share, and pay long-term capital gain of 15%.
- Use the net proceeds to buy Markel at 10% above the low of 2013 of $433.40, or 476.80 per share.
- Sell Markel 10% below the 2017 high of $1147.10, or $1032.40 per share, and pay long-term capital gain of 15%.
Scenario 4: Buy Markel on the last day of 2002 and trade in and out every five years by selling at 15% below the high price, using the proceeds to buy Markel at 15% above the low price of the next year.
The transactions under this scenario are as follows:
- Buy Markel on Dec. 31, 2002, at $205.50 per share.
- Sell Markel at 15% below the 2007 high of $545.50, or $463.70 per share, and pay long-term capital gain of 15%.
- Use the net proceeds to buy Markel at 15% above the low of 2008 of $245.30, or $282 per share.
- Sell Markel 15% below the 2012 high of $500.7, or $425.6 per share, and pay long term capital gain of 15%.
- Use the net proceeds to buy Markel at 15% above the low of 2013 of $433.40, or 498.40 per share.
- Sell Markel 15% below the 2017 high of $1147.10, or $975 per share, and pay long-term capital gain of 15%.
I will go straight to the results:
Scenario 1: 12.1% CAGR.
Scenario 2: 17.8% CAGR.
Scenario 3: 13.8% CAGR.
Scenario 4: 12.05% CAGR.
Obviously if you dance in and out at the exact low and high of 2009 and 2017, you had better to that. But we know that is almost impossible.
If you are very good at timing the low and high, as in Scenario 3, you will also beat buy and hold.
If you are relatively good at timing the low and high, as in Scenario 4, you are better off not dancing in and out.
You may think that it looks like it’s worth trying to time the low and high.
There is one major caveat: There is no dependable yardstick to tie the low and high to a specific valuation level. In other words, historic valuation level offers little guidance. Prior to 2007, the low price-book ratio for Markel was 1.38 times. Between 2008 and 2014, the low price-book ratio was between 0.91 and 0.99 times (except in the exactly low of 2009 when it got to 0.75 times). And during the recent two years it has been 1.3 times.
Similarly, the high price-book ratio was roughly 2.0, 1.2 and 1.65 during these three time periods. Again, there is no dependable yardstick, which is understandable given there are so many factors influencing short-term and medium-term valuation levels. Notice the high price-book ratio during the second period is lower than the low price-book ratio level during the first period.
What are the likely consequences if you apply a historic valuation method, which is commonly used among value investors? You may have bought Markel at 1.38 times book value during 2003 to 2007, only to see it go down to less than 1 time book. And then you wanted to buy it at one time book value during 2015 to 2017, only to miss out on the compounding.
And the psychological biases are not working in your favor. Once you have sold something at X, it is harder to buy it back at prices higher than X due to anchoring and contrast (how many investors sold Berkshire’s A shares in the early years for a few thousand dollars a share and never bought them back?).
In reality, most people may have done worse but because they may have played the valuation games multiple times during a 15-year period, somehow they may feel like they have achieved betters returns trading in and out every few years compared to buy and hold.
Considering all of the above, I think the odds for anybody to successfully play the valuation fluctuation game on Markel are incredibly unfavorable. However, if valuation reaches extreme levels either on the high end or the low end, it may make sense to either trim a little or buy a little more. By definition, extreme valuations are a rare occurrence.
Disclosure: Long Markel.
