The best time to sell a stock is when your opportunity cost is higher than the expected return of owning the stock.
If you are asking yourself this question, you are asking yourself the wrong question. At the very least, I would propose you implement a minor tweak to it: How would Warren Buffett be investing if he were in your shoes?
The thing is that the investing style of Warren Buffett has changed immensely over time. That’s just because he is extremely smart and extremely adaptable. And you wouldn’t want to mimic Buffett’s investments today, for the simple reason that he is severely disadvantaged compared to yourself.
If Buffett were in your shoes, he most definitely wouldn’t be looking at Berkshire Hathaway for copycat ideas. You see, one of the things that is not talked enough about, when people are discussing Buffett is that he has been extremely adaptable.
There are assets worth a total of $788 billion on the Berkshire Hathaway balance sheet. If the company would want to deploy 1% of its assets base to one investment, that investment would have to be valued at $7.8 billion. By comparison, the smallest company in the S&P 500 index has a market cap of $1.5 billion.
Therefore, if Buffett wants to make an investment that actually moves the needle today, his universe of available investment opportunities is actually tiny.
The Buffett Partnership
So, how did Buffett invest early in his career, when he was a much smaller fish in a much bigger pond? This question brings you to the the Buffett Partnership, which Buffett managed from 1956 to 1969. When Buffett dissolved the Partnership in 1970, he kept his stake in Berkshire Hathaway, which the Partnership had had a controlling shareholder in. The rest is history, I guess.
First of all, during the Partnership years, Buffett invested in smaller, less liquid companies. Secondly, Buffett was a relatively concentrated investor, focusing on a few high conviction ideas. Nonetheless, this does not mean he didn’t try to diversify the Buffett Partnership Portfolio. The way he did it was not through quantity of exposure, but through the quality of exposure.
By quality, I don’t mean that the stocks he chose were of higher quality than the stocks in the general market. But rather that he managed the stock portfolio by allocating its capital into three buckets that each had exposure to qualitatively different factors.
The Three Arrows of Buffett’s Capital Allocation
His objective, as I understand it, was to be able to keep his options open and be flexible under different market conditions. For example, if the overall market went up, he would be able to allocate capital to the bucket of stocks that were not driven by the overall market, and vice versa if market sentiment was overly pessimistic.
But you don’t have to take my word for it. Here is Buffett’s explanation of the three qualitative areas that he allocated capital to. The following is taken from the 1961 Buffet Partnership Letter Shareholders:
Our Method of Operation
Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.
The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.
The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.
Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies.
This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.
I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.
The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.
These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.
In this speech by Peter Thiel, he says the following when talking about how to detect patterns when trying to recognizing entrepreneurs as a venture capitalist:
“You always want to invest in the ones where they speak in definite future tense. You sometimes have to be careful they’re not totally crazy people, but that’s the sort of person you want to invest in. You do not want to invest in people who are talking too much about probabilities or risks or things like that because my experience has been that the people who think they’re involved in some sort of lottery ticket-like dynamic are already setting themselves up to already somehow get the probabilities wrong and invariably lose.”
“There is a similar version of this that I experience as an investor in these ventures. There’s always this very tricky question of the role of luck and chance in these things working. There certainly is this external truth perspective that there is a certain amount of luck that is built into the nature of the universe and you try to model it. You try to account for it. You try to get the probabilities right, as you assess these things. So, when people say that luck is involved, this is a statement about the deep nature of our universe.”
“And then there is this sort of internal truth version. Whenever we have thought that it is a matter of work. Psychologically I can say that this has often been a very bad sign. Where you say, “well, we don’t know if this is going to work. Maybe it works. Maybe it doesn’t. So, let’s just invest a slightly smaller amount for our lack of knowledge.” And as a pattern, I would say, those are investments that have generally gone very badly wrong.”
“If I had to sort of explain why. When you think you are multiplying a small probability by a big payoff, you sort of psycho yourself into playing the lottery and you psych yourself into losing. Because you somehow are being sloppy and not doing that much work.”
I think these thoughts do a great job of highlighting the inherent differences between entrepreneurs and investors. The entrepreneurs Peter looks for speak of the future through a deterministic mindset. They have a clear sense of the future and how they are going to shape it. Peter himself, on the other hand, as a venture capitalist does not invest his all his funds in one company. In his role he needs to have a more probabilistic mindset, even though he bets big once he has a high conviction on particular investments.
The World According to…
|The Entrepreneur||The Investor|
|Deterministic mindset||Probabilistic mindset|
|Risk is endogenic||Risk is exogenic|
|High Conviction||Risk Management|
One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.
Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.
The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).
Analytical vs Statistical Approaches
For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.
The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.
The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.
The Limits of History
But what is data? Data is history.
Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.
The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.
I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.
We don’t seem to ask ourselves how we come up with these number, do we?
Do We Even Know What Inflation Is?
The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”
In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).
If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?
How to Measure Inflation?
This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.
Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?
What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches?
And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.
So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.
Value Investing is seductively easy. Summarized into one sentence, Value Investing is the art of picking stocks that are undervalued, a.k.a. buying a dollar for 50 cents.
The big problem – paraphrasing what Johan Cruyff said about football – Value Investing is a simple concept, but it is extremely hard to invest with simplicity.
How Value Investors Buy Books
Consider the following analogy:
Put yourself in the shoes of a Value Investor in a book store. Having a natural inclination to buy stuff that is undervalued, you will automatically be drawn to the table with a big sign saying:
- Books 50-80% OFF!
…and therein lies the problem.
Buying a book is a bet with an asymmetric outcome. The downside is that you will buy a book and it might turn out to be a waste of your time, plus the $10 to $30 it cost to purchase it. The upside, however, is close to infinite. A good book can fundamentally alter your life.
Coffee consumption is another good example. If you could only drink one cup of coffee a day, you would probably not drink the first cup of joe available to you. You would be more selective. You might even be willing to pay more for the right one.
Mistakes of Omission
Most of the books on the discount table are crap. They are there for a reason.
The Value Investor, focused on the table of discounted books, might end up finding a book that is good enough to be worth the purchase.
At the same time, his attention is turned away from the books that can truly alter his life.
Do you disagree? Let us know in the comments below!
In the world of startups and new ventures, the central theme seems to gravitate towards growth and scaling.
When it comes to growth and scaling, learning how to manage an organization that is constantly getting bigger becomes the biggest challenge.
However, when you look at the oldest companies in the world, these are all small operations in industries that have hardly changed much throughout the lifetime of those companies.
Build to Last
Two of the oldest companies in the world are a:
- Japanese Ryokan
- German Brewery
When founders start new companies, most of the time their vision is to disrupt an industry.
But what if the objective would be to create something that was built to last? If you want to build an impenetrable fortress, you don’t want it to be ever-expanding, would you?
So, here’s a question: What if you were asked to build a company and there would only be one constraint: The total size of the organization would not be allowed to exceed 8 people.
What would you build?
The Scuttlebutt method of investing is fathered by the legendary investor Phil Fisher. Fisher is likely most known for his bestselling book Common Stocks & Uncommon Profits.
Scuttlebutt investing, as the name indicates, begins with a story or some other anecdotal data point, that triggers interest. It might be a product you love, a competitor you hate because of her competence.
How to Practice the Scuttlebutt Method
This is just the starting point, though. You have a hunch. You might be on to something, but what’s the next step? Do you check the performance of the stock price, do you download the financial statements and start crunching numbers?
If you are a Scuttlebutt Investor, your research would be very hands-on. You might visit retail locations or even manufacturing facilities. You would get feedback from customers, resellers or even competitors. You would try to understand the competitive dynamics of the market, performing the Silver Bullet Test on the people you would talk to.
Following up with Fundamental Research
The Scuttlebutt Method is great to validate investment ideas and building an intuitive understanding of the operational and brand-related qualities of a potential investment. Nonetheless, once you have strengthened your conviction about a certain stock, what you want to do is to cross-validate your finding with a fundamental analysis of the financial statements of the company.
This will give you a clearer picture of the business model and allows you to compare your scuttlebutt data points with the overall financial and valuation picture.
- Rouey Research works with investors in a collaborative and constructive process to provide fundamental equity research reports that compliment your scuttlebutt efforts.
One way to value a stock, especially those of companies that own various subsidiaries or a portfolio of assets, is by analysing the company’s discount (or surplus) to Net Asset Value.
Conglomerate Discount – The Case of Exor
We recently took a close look at Exor N.V., the holding company that controls such publicly traded companies as Fiat Chrysler Automobiles, Ferrari and CNH Industries. Conglomerates like Exor are interesting to analyse as they tend to trade a steep discount on the mark-to-market Net Asset Values (or market-adjusted book value).
In the case of Exor, the company trades at about a 30% discount on the market value of assets on the balance sheet.
- Read our Fundamental Analysis of Exor
Point of Maximum Pessimism – The Case of Dundee Corporation
If you are a Contrarian Investor, you are trying to go where other investors feel extremely uncomfortable to be. You are trying to go where others are running to the exits, but at the same time, you don’t want to be too early.
One of those situations is materializing at a Canadian Asset Management Company called Dundee Corporation. After a series of unfortunate events (and decisions), the market capitalization of Dundee is gone from about a billion dollars to about $74 million.
The company trades at a steep discount to book value, but for good reason. The company has been haemorrhaging money as failed investments have sucked up cash and destroyed shareholders’ capital.
But investors may have overreacted. Even though the company is taking drastic steps to turn the business around, Dundee’s stock is trading at about a 70% discount to book value. If the company manages to stop the bleeding, a significant re-rating might be in the cards.
- Read our Fundamental Analysis of Dundee Corp
The whole point of fundamental research or value investing or whatever you want to call it is to get an edge by looking a little deeper than others are looking. This is why you won’t get very far by using stock screeners.
Stock Research on Onverstock.com
We recently published a stock report on the Fundamental Finance Playbook about Overstock.com. The article is a deep dive into the current status of the company’s online retail business. We try to figure out if the business is, in fact, in a turnaround as management claims, or if the company is at risk of running out of cash.
Previously, the management had stated that they were trying to sell the online retail business but so far nothing has materialized. During our research phase we noticed that during the last quarter, consulting fees on the corporate level had increased significantly. By corporate level, we mean not connected to the operations of the online retail business nor the blockchain ventures.
Overstock engaged Guggenheim in 2018 to explore strategic options for the retail business and find possible buyers. If the consulting expenses are mostly in the “Other” business segment and neither in the retail operations nor the tZero operations, it is plausible that Overstock is already in advance negotiations with potential buyers through Guggenheim.
What that indicated to us, was that there was a possibility that Overstock was already working with Guggenheim Securities, the company that Overstock employed to find buyers, on advanced negotiations with possible buyers. These kinds of transactions usually require heavy due diligence, so it would be quite plausible that costs would ramp up like this.
Two Potential Acquirers
A week after we published, Patrick Byrne, Chairman and CEO of Overstock said in an interview with CNN that the company was in negotiations with two potential acquirers. It remains to be seen if anything materializes from this, but it goes to show that sometimes the fundamental facts are buried in the footnotes.