I figured now is as good a time as any to take stock of the things I've been pondering. Up to this point, I've had a few of my questions answered, but several that have gone unanswered. Furthermore, having skimmed the remainder of the book and the book's index, I am fairly certain that my unanswered questions shall remain unanswered. Let's have a look.
Questions Answered:
Q: According to Graham, when is a stock cheap enough to call a bargain?
A: When its current price is at least 2/3 of the intrinsic value.
Commentary: This fascinates me. Buying a stock for, at most, 2/3 its intrinsic value implies that my long-run expected return on any of my stock choices should be at least 50%! Not that the market can be timed, but if I wanted to achieve 15% annual returns, I'd need every stock I choose, on average, to realize its true value in approximately 2.9 years, or a little less than 35 months. This calculation ignores reinvestment if stock price drops and also assumes that every stock is purchased at the maximum 2/3 threshold.
Q: Graham, as well as many other value investing experts, recommend seeking out smaller stocks, or "secondary issues", since they are often ignored by large institutional investors and frequently trade at values well below their intrinsic values. If these stocks go largely ignored by the biggest buyers in the market, why should I believe that such an investment will ever realize its potential?
A: In short, Graham recommends that we simply accept that such stocks trade below value. As such, in finding a bargain, it has to be a tremendous bargain since you can and should only hope to realize a portion of its intrinsic value. In other words, buy them at a bargain price relative to what a private owner might pay.
Commentary: Technically, my question is answered but it spawns so many more that it is very nearly not. Graham has famously said, "markets act like voting machines in the short run, and like weighing machines in the long run." Fair to say, but if I'm supposed to simply "recognize" that certain issues will be perpetually undervalued, then by how much will it fall short of its intrinsic value? How can I ever know for sure that I'm buying a bargain if I can't even set a baseline for my margin of safety?
Furthermore, how and when will such stocks begin to appreciate if they are largely ignored by the biggest players in the market? According to this article, retail trading (i.e. yours and mine) makes up 11% of the total trading volume; the rest are hedge funds, institutional investors and market makers.
So when it comes to value investing in small, largely ignored stocks, am I to rely on that 11% to identify my undervalued position? Who else is out there and how long will it take them to bid up my position?
Questions Unanswered
Q: In a concentrated portfolio of 5-10 stocks, how do I choose my allocation to each stock?
Commentary: Graham is disappointingly silent on this topic. If I choose 5 stocks, how do I allocate my investable funds? Shall it be 20% into each, or should it vary according to some measurable parameters?
I've considered the standard business school process, Modern Portfolio Theory. Though MPT appears to be among the best asset allocation models we've got, it is woefully inadequate for a litany of reasons. Returns are most definitely not normally and jointly distributed; even if they were, that is definitely not how we as investors measure risk. Also, a value investor not only shrugs off the notion that past returns and volatility are an indicator of future stock behavior, but fundamentally relies on that assumption. If long-run stock returns could be statistically modeled, then it would be futile to buy cheap stocks since their future returns would be nothing but a probabilistic average (at any price)! Indeed, many academics and passive investor proponents agree that this is, in fact, the case.
I've also entertained Post-modern Portfolio Theory, which seeks to address some of MPT's deficiencies. It mostly fixes issues with jointly and normally distributed returns and the implicit assumption risk also includes "upside" risk. I was intrigued with PMPT at first, but ultimately PMPT must lean on past performance as some indication of future returns. No matter how sophisticated you make a statistical model, it will always be flawed in the eyes of a value investor because of the aforementioned reasons.
I have no choice but to continue thinking about this.
Q: At what point should I begin selling my position?
Commentary: Graham is unclear on this. Should I begin selling as I achieve my target return? Do I sell when the stock hits the intrinsic value I've computed? Or do I let the investment ride until it drops by some predetermined percentage or absolute value?
I partially understand why Graham is unable to offer hard and fast rules on this. Much of it depends on your general risk tolerance and ultimate financial goals. However, I am a little frustrated that there aren't tighter guidelines on this.
For now, I believe I must operate on two basic tenets:
- Allow the stock to ride until it sustains a sufficiently large downturn. In other words, put a stop-loss order on the position once it approaches the intrinsic value.
- Be on the lookout for better bargains. If the remaining upside I can conservatively expect from an existing position is less than the upside from a new bargain stock, it serves to exit the position in order to enter the new one.
All the same, these tenets require a great deal more refinement. For example, should I base my stop-loss order on a percentage loss or an absolute dollar loss? What if the upside potentials are approximately the same? What about tax considerations? This is but a fraction of the questions I need to hash out.
Main Takeaways So Far
Graham distinguishes two types of investors, the "defensive" one and the "enterprising" one. A defensive strategy is much like the one my financial advisor follows. I will cover this in more detail later, but suffice it to say for now that a defensive posture mostly adopts a passive investing approach, deriving the bulk of returns from dollar cost averaging. The enterprising strategy involves the active search, analysis and management of a (usually) smaller set of stocks. There are two approaches to enterprising: the negative approach and the positive approach. The negative approach is more like a defensive-plus posture: invest in a market portfolio but actively avoid crappy stocks. The positive approach involves uncovering gems through diligent research.
I prefer positive-approach enterprising investing. It's more or less the Magellan Fund's strategy and the only one I believe can achieve appreciable returns in excess of the market.
No comments:
Post a Comment