Historical Results and Commentary
August 11, 2001
Holdings
|
|
Aug-01 |
|
1 |
PFE |
|
2 |
UN |
|
3 |
YHOO |
|
4 |
NKE |
|
5 |
LLY |
|
6 |
MMM |
|
7 |
JDSU |
|
8 |
CAT |
|
9 |
JNJ |
|
10 |
NSM |
|
11 |
CA |
|
12 |
FNF |
|
13 |
MSFT |
|
14 |
BRK-A |
|
15 |
HMC |
|
16 |
WMT |
|
17 |
X |
|
18 |
AAPL |
|
19 |
P |
|
20 |
WB |
Performance of Individual Stocks For last 3 months:
|
Aug-01 |
|
|
FNF |
17.28% |
|
P |
-1.98% |
|
CAT |
1.50% |
|
NKE |
23.88% |
|
LLY |
-6.87% |
|
MMM |
-5.93% |
|
JDSU |
-57.61% |
|
BBV |
-10.48% |
|
JNJ |
13.54% |
|
NSM |
29.23% |
|
CA |
18.75% |
|
PFE |
-4.16% |
|
MSFT |
-5.59% |
|
BRK-A |
1.97% |
|
AMGN |
0.83% |
|
WMT |
-0.78% |
|
X |
0.89% |
|
AAPL |
-16.80% |
|
UN |
6.50% |
|
WB |
18.85% |
Total Increase (Decrease) since last quarter: 1.15
Additions: YHOO, HMC
Subtractions: BBV, AMGN
Commentary:
My commentary this quarter regards stock selling principles:
Stock Selling Principles
Everyone wants to sell at the peak of a stock’s price at the very instant before the stock starts to fall. It just feels good. However, from a mathematical point of view, this is a silly ambition. Stocks should be most coveted during their phase of most rapid price growth. In simple calculus terms, it is the timing of purchases and sales relative to the 1st and 2nd derivative of the growth curves that should play more of a role in our ego boosts than the absolute price of the stock purchases and sales. In other words, stocks are most valuable when their price is increasing the fastest rather than when they are at their highest.
Having said that, I have no useful tips for suggesting how to time the peak of a stock’s short term price peak, nor do I know how to forecast rapid advances in price movements, slowdowns, or declines. I strongly urge value investors not to get mixed up in this business, nor to let themselves feed their egos with praise when a good timing play is made. Time is the universal antidote to luck, and an investor that takes pride in a few lucky timing plays is doomed to eventual disappointment.
Asset Substitution
Rather than paying attention to timing for an individual stock sale, it is better to use the defensive posture of substitution to create a higher margin of safety for the portfolio when deciding when to sell a stock1. In other words, a sale of stock is not made for its own sake, but rather in the context of its sale and the subsequent acquisition of another security (or other type of asset, possibly cash). Ultimately, the investor will look at two stocks (or assets), one he or she owns, and one that is under consideration for acquisition. If the case is stronger for the acquisition of a new stock, the change should be made. In this process, an investor comes to face the great human characteristic of attachment to individual decisions. For most, our stock portfolio becomes a source of pride – our good picks vindicate our talent as successful investors, and our bad picks represent good picks that just haven’t appreciated in price yet. Attachment to our portfolios is the great folly of investing. Just because you happen to have owned a stock for a given period of time does not make it safer or better than a stock you just learned about yesterday. Just because it has gone down during your tenure as shareholder does not mean it will come back up, and vice versa. Holding a stock does not make it better or worse. It just makes it more familiar. Familiarity is not an adequate substitute for analytical logic.
It is worth mentioning that the test I often use in managing my portfolio is what I call the ‘acute amnesia test.’ Suppose you hold a portfolio of 40 stocks and then magically came down with a case of acute amnesia where you forgot which stocks you owned. Starting from scratch you then select a new portfolio of 40 stocks based on the principles of value investing. Then you compare your old portfolio with your ‘new’ portfolio. Any stocks in the old portfolio that are not in the new portfolio should be considered candidates for substitution with members of the new portfolio. It is useful to do this test at least once per year, if not once per quarter.
Even the best investor cannot fully overcome personal attachments to certain stocks. This is why I advocate asking the opinion of others when considering making a stock substitution. If a value investor can find a friend or colleague who shares the same principles and attitudes towards investing, it if often worth asking and listening to his or her advice when considering making a stock substitution.
There is one final consideration that an investor must make when considering making an asset substitution. This is the role the change will make on the composition of the overall portfolio. Every value investor needs to adhere to the principle of diversification to some degree. Since members of the same sector often fluctuate together in their attractiveness to the value investor, there are times when many members of the same class of business activity become alluring at the same time. An investor needs to be sure that he or she maintains an adequately diversified portfolio when considering making an asset substitution.
Having said this, one must also understand that the high turnover of stocks in a portfolio is rarely a good strategy for a long-term value investor. Therefore, one cannot consistently apply the ‘acute amnesia’ test every few weeks, or else the turnover rate would be extremely high. I suppose the best posture is a happy medium where no attachment is made to previous decisions, but stocks are still held for a long period of time. I know this is somewhat of a contradiction, but most good advice has some contradictory elements in it.
The Process Of Selling
Once an investor has made the decision to make an asset substitution, he or she is confronted with the mechanics of performing such a swap. In doing so, the successful investor often makes a decent into the murky and terrible world of the speculator.
It is often the case that a value investor will choose to sell a stock during a period of speculative enthusiasm for the underlying company. During these periods of upward momentum, a stock is often pushed to a P/E ratio and Price/Book ratio that warrants its exclusion from the portfolio of a value investor. This raises an ironic yet important question: during periods of market enthusiasm, can the value investor profit from the irrationality of the speculator? I don’t know the answer, but the temptation to play such as game is often such that even the most seasoned value investor will briefly try his or her hand at this dangerous game. There is nothing wrong with this, so long as the value investor sets rigid guidelines of protection.
I recommend setting a minimum price floor in the following way: If the price of a stock to be sold is currently rising at a higher than normal rate, an investor can set a price limit of 7 percent below the current price of the stock. If the stock falls to this limit, it must be sold. However, if the stock continues to rise, the investor can recalculate the 7 percent price floor from the new high price. In this way, an investor can piggyback along a rise in prices. This acknowledges the fact that market prices often move in spurts, and momentum in the short term is an important factor to consider. It is recommended that if a stock continues to rise, the investor tighten his floor (say, but recalculating the new price floor as being 5 percent below the new high rather than 7 percent). The drawback of this technique is that the seller is always selling at a price that is 7 percent (or 5 percent or less depending on the austerity of the floor setting technique) less than it was only a few days ago. Of course, an investor can always opt out of this method and just sell at the market price2.
The timing of a sale should also be considered relative to the price of the asset for which the stock will be substituted. Say an investor has decided to sell his shares in GE and purchase shares in Citigroup. The success of the timing of the GE sale is dependent on the relative performance of GE vs. Citigroup. If GE continues to rise and the investor uses the price floor method to retain holdings in GE, this can be considered successful only if GE rises at a faster rate than Citigroup. If Citigroup rises faster, even though the investor will have made money from holding on to GE longer, he or she will have lost the opportunity to have made more money by switching earlier to Citigroup. It is human nature to pay far more attention to what we currently own than it is to what we could own. This is a weakness from the perspective of the value investor.
Finally, one has the option to make a partial sale, whereby only a fraction of the total shares in a company are sold. It is my opinion that partial sales are usefully only if they make sense from a diversification standpoint. If an investor has seen a meteoric rise in the price of one company, and assuming this company is still a logical company to hold from a value perspective (ie, there are no better companies out there), it may still make sense to sell part of that company if it now represents too large of an exposure to one class of risk for the portfolio as a whole. However, partial sales are far more common when an investor has a strong emotional attachment to a stock that has done well and is continuing to rise. The investor realizes that it makes sense to make an asset substitution, but is wary of losing out on the future appreciation of this ‘darling’ stock which has performed so well. This is folly and the first step on the road to perdition! The investor has essentially become a momentum speculator. Furthermore, it is often the case from a value perspective that stocks that fall in price become more attractive while those that gain lose their shine.
1 It is painfully obvious that I am not taking my own advice right now. While Honda does represent good value, Yahoo does not. Yahoo is not profitable right now, so clearly this is a speculative play on Yahoo’s future profitability, and the belief that Yahoo is extremely cheap right now. Is this a bad move? Most of the times yes, but I feel the upside for Yahoo is so great now, that even if 75 percent of such bets go bad, the possibility of this being a successful strategy is still good. I feel that throwing at stocks that have rapidly fallen from grace is a lot better than pumping money into ‘hot’ stocks that everyone wants. But….to be perfectly honest, I should probably do a lot my thinking and studying before making plays like this one.
2Since I only modify the Bandy 20 index every 90 days, I cannot use this method in this particular portfolio. However, this is the method I use in my personal portfolio (or at least I try to).
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