GADR: All Stocks, All The Time? (1/3)
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*Graham and Doddsville Revisited* -- "The Intelligent Investor in
the 21st Century" (12/24/98)
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"The underlying principles of sound investment should not alter
from decade to decade, but the application of these principles
must be adapted to significant changes in the financial
mechanisms and climate." (Benjamin Graham)
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[A query regarding famed Contrarian David Dreman's newsletter
(see: Message 6366543
gave rise to a lively exchange about the merits, and demerits, of
holding an all-stock portfolio, all-of-the-time. These postings,
and other comments, have been edited to give the appearance of a
virtual conversation among Wayne, Berney, Wren and Reynolds.]
Dreman's Newsletter
-----------------------------
Wren: I recently received a package advertising the David Dreman
Value Stock Report. Dreman was on Wall Street Week recently. He
has written a column in Forbes for a number of years, and manages
money. The Kemper Dreman mutual fund has a very good record. Has
anyone had experience with Dreman's newsletter?
Reynolds: The track records of Graham and Buffett are the only
ones I have taken much note of. Readers familiar with the record
of Dreman's newsletter are invited to share this information.
What I recall mainly from Dreman's appearance on WSW was his
advice that investors hang in with 100% stock portfolios, not try
to time the Market. And, if I recall correctly, he likes Boeing.
Bargains Aren't Always Available
---------------------------------------------
Wayne: I have problems with an all-stocks, all-the-time
investment strategy, even though you can justify it, if you want
to, by looking at multi-decade studies of stock vs. the
alternatives.
Reynolds: Well, that's a pretty good beginning for justifying an
investment strategy.
Wayne: [But,] it implies that you can always find stock bargains
that will produce greater returns than the alternatives at any
snapshot in time. This is simply not true.
Reynolds: In an absolute sense, that's correct. But, there are
always relative bargains in the stock market -- that is,
bargains relative to other stocks. As long as you buy stocks
that are undervalued relative to other stocks, there are very few
real-life, long-term scenarios in which there would be higher
returns from trying to time your way back and forth between the
stock market and cash, bonds, real estate, precious metals, etc.
Wayne: [Also,] it leaves you in a situation where you can't take
advantage of the truly great bargains that pop up during
corrections and panics, in either the overall market, or in a
particular sector.
Reynolds: That's true. And, some of Buffett's greatest gains
came from getting out of the stock market before the Bear Markets
of 1973 - 1974 and late-1987, and aggressively getting back in
afterwards. But, as Graham pointed out, for the average
investor to do so is as likely as finding money growing on trees.
Nonetheless, I must admit that Graham would have agreed
with you on this. One of the major disagreements between himself
and Buffett was Buffett's belief that if prices were low enough,
an all-stock portfolio would be justified. Graham couldn't
accept this. So, he certainly would not have accepted Dreman's
conclusion that an all-stock portfolio is the safest course --
regardless of price.
Currently, Stocks Have Lots Of Downside Risk And Little Upside
Potential
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Wayne: For example, one could argue that stocks are presently
discounting returns of between 5.75% - 7.5%, with the lower range
being the more likely in my view. Furthermore, a PE contraction
is a distinct, profit-erasing possibility.
That means that an investor is surrendering returns of 1% - 2%
annually by staying in bills and notes. Even during this
relentless rise in the market, there have been 3 sharp pullbacks
in the last year or so that provided opportunities to buy some
stocks at levels where the discounted return was much higher and
a P/E expansion was a very good possibility. This more than
makes up for losing 1% - 2% over a period of even a couple of
years, and it avoids facing the risk of a P/E contraction that
would more than wipe out that 2%.
Reynolds: You make a very persuasive argument, in the best
tradition of fundamental analysis. But, couldn't the same
argument, with basically the same numbers, have been made 3 or
more years ago? And yet, as things have turned out (at least for
now), money sitting in cash and bonds for the past 3 years would
have left on the table a total of around 100%.
It is true that even more money could have been made by getting
in and out at just the right prices. But, getting in and out of
stocks requires subjective judgments that are most likely to be
overly pessimistic when it is time to buy, and vice versa. I
believe that this is at the core of Dreman's case, and I am
inclined to agree.
Wayne: ... There have been periods where the gap between stocks
and bonds/cash has been as high as 8%. A 100% investment
strategy would certainly been appropriate at that time.
Reynolds: No doubt about it, I wish the Market's P/E were 10
rather than 30.
Taking Advantage Of The "Spread" Is Not Timing
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--- Wayne: What I'm describing may seem like market timing, but
it isn't. It is setting the standard for investment at a level
where the spread between the expected return on the stock and its
alternative is high enough to cover all the associated risks.
This includes the risk of missing opportunities like we had just
a few weeks ago. Some companies I am familiar with were selling
at 30% discounts to their values on a long-term normalized basis,
and an even greater discount if you think low interest rates and
inflation are a permanent state of affairs. This more than made
up for losing a couple of percent for awhile, and gave me a P/E
expansion pop because the market recovered so quickly.
If Certain Times Are Chosen, But Not Others, It's Timing
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Reynolds: The Value Investing fraternity can call it
whatever it wants. But, as language is normally understood,
choosing to buy or sell at certain times and not at other times
is timing.
Wayne: So, your position is that selling an overvalued
security is market timing unless the proceeds are immediately
placed back into the market?
Reynolds: Right. When you get down to it, there are only two
ways to completely avoid Market timing: 1) buy whenever the
funds to do so are available -- and hold forever; or 2) never get
into the Market at all.
A famous example of the first category is the Lexington Corporate
Leaders mutual fund. Founded in 1935, the fund began with 30 of
America's leading corporations. None of the original holdings
have been sold, and no new stocks have been added to their
portfolio. Yet, the fund has a very respectable track record
over that period -- even compared to Indexing (which didn't
become feasible for the small investor until 1974). Naturally,
this fund hasn't outperformed the combined track records of
Graham and Buffett over that span. But, I believe it has
outperformed the average mutual fund, or the average individual
investor who has been moving in and out of stocks, regardless of
selection criteria.
No One But Reynolds
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Wayne: I don't know anyone besides Reynolds that holds that view
of what Value Investing is [i.e., that Value Investing is a form
of timing] .
Reynolds: True, which is a reason I feel this is worth
emphasizing: Value Investing does not solve the problem of
timing. It ignores it -- which is not the same as solving it.
Wayne: In every other discussion I have had on the subject,
market timing was always considered to be the act of buying or
selling based on where the investor thought the market or
security price was heading. Bull Market/Bear Market, etc.
Reynolds: Everyone buys and sells securities based upon
where they think the security's price is ultimately going. Even
in the case of a pure dividend play, no one purchases with
indifference to a permanent decline in share price.
Wayne: When I sell, I always assume what I sold will continue
going up. It's just that I expect to get a better rate of return
over the next 5 - 10 years on the alternative investments where I
place the proceeds.
Reynolds: Interesting -- when I buy, the stock always keeps
going down! But, this is just another way of saying that no one,
regardless of investment criteria, can reliably get in at the
very bottom and out at the very top. When a stock is out of
favor, and thus undervalued, it's likely to remain out of favor
for a while -- until Mr. Market gets around to recognizing its
value, and repricing it accordingly. Likewise, selling an
overpriced stock doesn't mean it won't become more overpriced.
But, by choosing to buy at a time when a security is underpriced,
and to sell at a time when it is overpriced, one is still
timing.
Graham Called It "Pricing"
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Berney: In The Intelligent Investor (p. 95), Graham
writes:
"Since common stocks, even of investment grade, are subject to
recurrent and wide fluctuations in their prices, the intelligent
investor should be interested in the possibilities of profiting
from these pendulum swings. There are two possible ways by which
he may try to do this: the way of timing and the way of
pricing. By timing we mean the endeavor to anticipate the
action of the stock market -- to buy and hold when the future
course is deemed to be upward, to sell or refrain from buying
when the course is downward. By pricing we mean the endeavor to
buy stocks when they are quoted below their fair value and to
sell them when they rise above such value. A less ambitious form
of pricing is the simple effort to make sure that when you buy
you do not pay too much for your stocks. This may suffice for
the defensive investor, whose emphasis is on long-pull holding;
but as such it represents an essential minimum of attention to
market levels*....."
"*Except, perhaps in dollar-cost-averaging plans begun at a
reasonable price level."
Reynolds: Every discipline has its own vocabulary and, in
certain cases, uses words in ways that vary from their common
meanings. Value Investing is no exception. But, I try to use
ordinary language in discussing investment concepts. I feel that
if I haven't expressed a concept using words according to their
everyday meaning, then I still haven't made it clear to myself.
In the passages Berney cites, Graham explains the meanings he
attributes to the words "timing" and "pricing". It may appear
that the two are mutually exclusive categories -- that one is
either timing or pricing, but never both. But, in the way
language is normally used, the distinction between "timing" and
"pricing" is similar to the distinction between "sex" and "oral
sex" (an analogy Graham would have appreciated). The former is
not necessarily a case of the latter ... but the latter is
invariably an instance of the former. I think it is important
for me to bear this in mind to avoid deceiving myself into
thinking that I have solved the problem of timing just because I
am seeking out bargains.
Pricing = Long-Run Timing
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I understand Graham's distinction to be the difference between:
1) shorter-term timing based upon the momentum of, for
example, earnings, price, volume, etc.; and
2) longer-term timing based upon, for example, low
price-to-book value, low P/E, etc.
Whether the criterion is technical, like price in relation to
volume, or fundamental, like price in relation to book value or
earnings, both are systems for buying, or selling, at some times,
rather than at others. But, I agree that the distinction Graham
is making is a valid and important one. For, although both
methods employ timing, each looks at the problem from opposing
perspectives. The so-called timer asks the question, "Is this
the right time to buy?", and assumes that if so, the fundamentals
will take care of themselves. By contrast, the Value Investor
asks, "Are these assets and earnings available for a bargain
price?", and assumes that if so, the timing problem will sort
itself out. These two approaches exemplify Graham's famous
dictum: In the short run the Market is a voting machine, and in
the long run it is a weighing machine.
In my view, neither is necessarily superior to the other.
Usually investors are temperamentally more or less suited to one
or the other, though in some cases they are comfortable with both
approaches. Presumably, most of us are here because we're more
confident in our judgments about a company's long-term
fundamentals than in trying to closely time Mr. Market's
moodswings. But, unless we just buy-and-hold forever (as Buffett
does with his core holdings), none of us completely escapes the
problem of timing.
Berney: Elsewhere (p. 98), Graham states: "We are convinced that
the average investor cannot deal successfully with price
movements by endeavoring to forecast them." In fact, in numerous
references, he refers to the act of trying to forecast price
movements (market timing) as speculating.
Wayne: Thanks, Berney ... there's something unsettling
for me about being classified a "timer" when I have no idea
what's going to happen next!
Reynolds: That's another reason why I'm making so much of an
issue of this -- because none of us can really know
"what's going to happen next". Therefore, there is always timing
risk. Calling timing something other than "timing" does
not remove the risk. Value Investing seeks to finesse the
problem by focusing on price, and letting the timing take care of
itself. But, the problem of timing doesn't go away. Value
Investing's response is to say: This stock is so cheap that even
if goes it down tomorrow, or the next day or the day after that
-- nevertheless, it will eventually go up at some point in the
future that will justify having purchased it at this time and at
this price.
This is a proposition that I find "unsettling", though, as
a Value Investor, unavoidable. Peter Lynch likes to say that he
makes the most money in the 3rd, 4th, and 5th years of an
investment. But, this is another way of saying that investing
based upon fundamentals typically gets the timing wrong
for the first year or two.
It is axiomatic that a Value Investor must have confidence that
he or she is right about an out-of-favor stock, and the patience
to wait for Mr. Market to eventually agree.
But, it is also axiomatic that no one is right all the time. This
places the Value Investor directly upon the horns of a dilemma:
An investor unwilling to wait for Mr. Market to confirm his
valuation of a company's stock does not have the temperament for
Value Investing. Yet, someone who waits the 3 to 5 years that
Lynch found necessary for his investment judgments to achieve
their greatest payoff will fall way behind the 8-ball when those
judgments are mistaken, as they inevitably will be at times.
Further, the judgment may have been correct when originally made.
But suppose that a couple of years after the purchase has been
made, "the facts change", as Lynch would put it. Nowadays, 2
years is plenty of time for facts to change. In this case, the
Value Investor should sell. But, this leaves the investor with
an investment that has been underperforming for 2 years.
Clearly, price notwithstanding, it was the wrong time to buy.
By contrast, the so-called "market timer", if adhering to his or
her discipline, will quickly retreat from a losing position,
rather than spending years hoping to be proven "right", perhaps
fruitlessly.
Further still, the Value Investor might turn out to have been
right all along, yet still underperform Mr. Market. Suppose a
stock is selling for 30% less than its net tangible book value.
In theory, this is a no-lose bet, since even in bankruptcy the
company's net assets can be sold off for more than the company's
current market price. Yet, though this company loses as much
money in bad years as it makes in good years, it manages to keep
its doors open through occasional, but recurrent, sacrifices by
workers, management, suppliers, creditors, and even the taxing
authorities. Thus, the company remains "undervalued"
indefinitely, at least as measured by asset value. This is
exactly what happened to Buffett with the original Berkshire
Hathaway textile makers.
Finally, suppose a Value Investor correctly calculates that XYZ
Corporation, a textbook publisher, has an Intrinsic Value of $60,
though its share price is $40. The investor purchases shares of
XYZ accordingly. Nine months later, due to Mr. Market's
continuing pessimism regarding its short-term prospects, XYZ's
price has sunk to $30. While our investor is pondering whether
to load up on more shares of XYZ, a wildly overpriced wireless
e-commerce company, WebCell.com, acquires XYZ in exchange for $35
worth of its stock. Our investor wants no part of WebCell.com's
stock, and sells his shares of XYZ for just under $35. As the
years pass, WebCell.com eventually shuts down its money losing
wireless e-commerce operation, but continues to mint money from
its textbook publishing subsidiary, XYZ. Our investors "pricing"
was correct, but his timing was wrong.
Graham, of course, was not unaware of these difficulties. They
have no simple solution.
Berney: Wayne, I believe there is a fine line between "timing"
and only investing when the valuations are reasonable. Certainly,
Graham was not advocating a buy and hold strategy -- and clearly
stated this. He noted that one should buy when valuations were
reasonable and sell when valuations were unreasonable....
However, as Wren pointed out, emotions frequently get in the way.
It was not until July 1997 that IBM exceeded the high set in
August 1987. Wal-Mart is my favorite. It is in a small group of
20% of the S&P that has done everything that could be expected.
They have achieved revenue and EPS growth for 6 straight years.
Nonetheless, the stock closed at $32 in December, 1992, and did
not see that valuation again until June 1997. I could cite
numerous other examples of quality companies whose stock became
overly valued and it took years to recover.....
Reynolds: Let's look at IBM in 1987 and Wal-Mart in 1992 as two
examples of dollar-cost-averaging with the worst possible timing
and pricing.
[cont'd in next posting] |
