#Good company gets inexpensive, how much to buy?
When an
understood, good company gets inexpensive, we
buy its stock. But how much?
(1) Enough uninvested cash (CASH)
My rule is simple. Provided that I have
enough uninvested cash, I put
10 percent of the portfolio in it. I’ve seen other good investors use infinitely
more complicated guidelines, but none that I’ve found to be more practical.
I
f I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.
(2) Strong conviction (COURAGE)
A
strong conviction is important in part because
right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low.
Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.
Correspondingly,
I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to
take advantage of other opportunities that emerge.
#Buying is one aspect of portfolio construction. Another is selling.
There are
two problems with selling.
1. The first is taxes.
The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.
Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.
Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.
Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.
Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.
By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:
http://www.goodstockscheap.com/17.1.xlsx
Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the
toll that frequent selling takes.
2. The second problem with selling is alternatives.
Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement,
each stock sale mandates a hunt for the next opportunity.
#When selling makes sense
Even with these problems, selling does makes sense in some instances. I see four.
(a) The first is when price flies past value.
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.
(b) The second instance is when a company that originally registered as good turns out not to be.
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.
The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.
(c) The third instance is when one is bought out.
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.
I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.
(d) The fourth instance is when cash is needed to make an investment that’s clearly better than one already held.
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.
#When selling makes no sense
Two commonly cited reasons for selling puzzle me.
1. One is rebalancing.
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.
Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side,
I’ve never seen the merits of this practice.
It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper.
But on the sell side rebalancing looks to me like the anchoring bias in action.
2. A second common reason for selling is to prove that an investment was a success (taking profits).
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.
It’s not.
Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.
Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to
institutional portfolios, like hedge funds. It’s about compensation.
Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to
pretax returns. It’s blind to taxes. For this reason
professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.
One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also
triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.
When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.
#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.
1. The first is through acquisitions, as mentioned earlier.
2. The second is through dividends.
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.
Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.
When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was
closer to 10 percent. Dividends had gone up over time, but my cost hadn’t.
That’s how dividends can become a booming cash source underappreciated by all but those who get them.
#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is
concentrated. It contains
no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.
1. Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed
over time that good, focused stock portfolios outperform diversified stock portfolios. This is because
diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.
2. Bad focused portfolio versus diversified portfolio
Of course a
bad focused equity portfolio can certainly
lag a diversified stock portfolio.
Concentration isn’t enough to assure outperformance. But if it’s
purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.
#Sequestered Cash outside of the equity portfolio for ordinary expenses
While I don’t diversify within my equity portfolio, I
do diversify outside of it. I always
keep enough cash on hand to cover expenses for a few years. As I
get older, I expect to
increase this number of years.
1. In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s
cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than
cash or
spent.
Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.
Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.
Because
the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.
2. In same currency as one's expenses
Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.
As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.
To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a
currency investment.
#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.
1. The first is certificates of deposit, or CDs.
Outside of the United States they’re commonly called time deposits. They
offer higher interest rates than do regular bank accounts. Money must stay in them for a
predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.
If the CD interest rate is much higher than the regular interest rate, one
could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which
shouldn’t be needed for the duration of the lockup period.
That said, I don’t use CDs. Since the
timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on
costless accessibility.
2. The other repository is cash-like funds (commercial paper).
They too offer
higher interest rates. An example is a fund that invests in commercial paper.
Commercial paper is short-term notes issued by corporations.
Such cash-like vehicles
usually behave like cash.
One can pay bills with them. But I’ve seen instances when they don’t.
During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had
temporarily halted withdrawals from such a fund. She couldn’t make payments with it.
This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.
#Problems with cash
Cash has its own problems, of course.
Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in
government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.
Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense
- price flies past value,
- when a company thought to be good turns out not to be,
- in buyouts, or
- when a clearly better opportunity emerges.
3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include
- rebalancing,
- memorializing success, and
- industry compensation.
5. Equity portfolios can generate cash without active selling through
6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.
Reference:
Good Stocks Cheap by Kenneth Jeffrey Marshall 2017
