Tuesday, June 27, 2006

Investing Myth: Buy and Hold is the Best Investment Strategy

I am a contrarian. Since my goal is to have serious money and since most people are poor (see the Pareto rule), I want to avoid following the mistake of being conventional.

One of the most common conventions in investing is that you should "buy for the long term". Advocates of this position cite a few major reasons for doing so, namely, that you minimize taxes and transaction fees. Taxes and fees can indeed be large drains on investing portfolios. Warren Buffett, who is famous for saying that his favorite holding period is "forever", took substantial pains in his latest letter to shareholders (pg 17 "How to minimize investment returns") to explain how the financial services "seduced" Americans into trading assets, and paying for the privilege. In fact, Buffett, arguably the greatest investor of all time and one of the people whose approach to investing I study carefully, is often cited by the "buy and hold" crowd as proof that buy and hold is the best strategy.

Looking a little closer, however, we can see that, in fact, buy and hold, for all its apparent tax and transaction cost advantages has a great many weaknesses.

First, most retail (small) investors do so inside of tax-advantaged savings plans, where most of the tax advantages of holding are wasted. Since taxes on earnings are already deferred until withdrawal, what tax benefit does long-term holding really offer? In fact, if you are investing in a 401(k) or IRA that is not a Roth (e.g. traditional or SEP-IRA), even the benefit of lower capital gains and dividend tax rates is lost, since all withdrawals are taxed as ordinary income - the same tax rate that short-term traders pay on their gains. (Gains in a Roth are tax free, which is the main reason that the Roth is the best savings vehicle the US government ever devised, at least from a tax perspective).

What if you aren't investing in a tax-advantaged vehicle? Well, depending on what you are doing, you can often defer taxes indefinately through use of a 1031 exchange, which is a tool to help people swapping a piece of property for a "like-kind" property. This does not only apply to real-estate, it can also apply to business assets, though, unfortunately, not to common stocks, which nevertheless, qualify for beneficial tax treatment after only one year (cap gains), or even less (dividends requires 90 days). This hardly represents a "forever" holding period.

Second, buy and hold fails to protect you against downturns in the market. If you purchase the diversified mutual fund, and buy, hold and pray, you are exposed to significant amounts of market risk (which peversely has people worried about how "the market" is doing and not how their investments are doing). "The market" has historically had huge drawdowns, from which you have no protection. While the long, long-term trend in the market has been upward, you can find at least two occasions in the past 80 years where "the market" has failed to increase in value for decades. It took until 1954 for the Dow to surpass the high of 383 it set on September 3, 1929: 25 years, and again between 1964 and 1981 the Dow remained flat (with plenty of volatility). Sure, if you held, you got your dividends, so you got even before the Dow did, but what if you were forcibly "retired" in 1930 or 1973 due to the downturn and needed those assets to provide for your livelihood? Are you investing to be able to live off the dividends alone? Forced to sell in an unfavorable environment you could be wiped out before a market recovery.

In fact, no real investors have become rich by simply "buying and holding", not even Warren Buffett. When asked at an annual meeting of Berkshire if he agreed with Phil Fisher, Buffett admitted that when he was younger he would sell, when something better came along, but now that he had more money than ideas he stood pat.

This is a key insight: neither I nor you are Warren Buffett. An investing strategy for becoming wealthy is quite different from an investing strategy for when you are already wealthy. Why use the wrong one?

One of Buffett's main reasons for holding forever is the fact that with over $100 billion in assets, it is actually difficult to find investments that are both good and meaningful. In his case, the transaction costs involved in moving such large amounts of money in and out of securities would eat most of his additional gains (after all, he can seriously influence pricing of a stock). Unlike you or I, Buffett has another reason for sticking to his policy: it helps him purchase the businesses he wants.

Buffett looks to become a controlling shareholder of a business. One of the reasons that he can avoid overpaying, is that he offers something really unique among buyout firms: he allows management to retain control of the busienss after they sell it. If management suspected that Buffett would resell the business anytime a better investment came along, they would ask for much larger control premiums, because they would know that Berkshire might sell its stake to another, less management friendly, shareholder.

Again, if you aren't purchasing control, why would you assume that the best strategy is simply to copy what Buffett does now?

So, if buy and hold isn't such a clear-cut winner, why is it so often followed? I think the first reason is emotional. It feels good to think that you made a "good purchase" and then, like a favorite piece of furniture, or a home, stay with it for decades. Second, most of us are purchasers, not sellers. We are consumers first, we rarely go through the process of selling. We sell our labor, or our home, and the sales pitch is a stressful, once in awhile activity. Given our inexperience and our general inclination to shop, buying is simply our natural mode.

Contrast that with what rich people do. Rich people are selling all the time. They are selling securities (to the public), selling real estate (to emotionally charged homeonwers), even selling themseves (their latest book). Strategic investors know how they are getting out, before they get in. That is why they are investors (and strategic), not savers looking for a better savings account.

A much better strategy is to do what Buffett did on his way to becoming rich - analyze the value of your investment, and when it becomes fully or overvalued, sell. Set this price when you purchase the investment, so that you do not become emotionally attached. It is so easy to tell yourself that that winning investment has another point in it, and then watch it tumble.

Always be watching out for a better idea. Keep most of your money in your 1st and 2nd ideas. If you have lots and lots of ideas, either you have a very favorable market (possible), or have difficulty descriminating between ideas. Force yourself to narrow your focus and decide, even between good options.

Just remember, most of the people who are telling you that you need to buy (and right now!) are selling securities. If they represent such a great value, how come they are not suggesting to the people who are selling the securities that they should hold out for another day when prices are more favorable? Perhaps they are.

Sunday, June 11, 2006

Charlie and the Money Factory

The 80/20 Rule (Pareto's Principle) suggests that 20% of your ideas will produce 80% of your investment returns. Actually, there is an argument that says that 20% of your ideas produces 120% of your returns, and the other 80% cost you money.

Assuming that you can evaluate businesses, your best ideas (the 20%) are a money factory. They will multiply your wealth over and over again. Why would you put money in something else, if you can put it to work in your best ideas?

Well, my obsession with focus investing is well known but why take my word for it, when you can get it straight from one of its most successful practitioners, Charles Munger, Vice-Chairman of Berkshire Hathaway?

In the Question and Answer portion of the 2006 Berkshire Annual Meeting, (read the notes here), the following question came up:

If you were starting with $1 Million today, what strategy would you follow?

And Munger's response:

CM: Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, then you compare other opportunities with that. And you only invest in the most attractive opportunities. It’s all about opportunity cost. The game hasn’t changed at all. That’s why modern portfolio theory is so asinine.

If Warren were starting today, he’d put together a concentrated portfolio. Your 1 or 2 best ideas are way better than the rest. So when you act, you’re thinking about how the alternatives compare to your best idea. But you don’t want to own your 10th-best idea when you can use that cash to invest in your best idea.

Focus on your best ideas. They will mint money for you.

Saturday, June 10, 2006

The Infidel: Herb Greenberg takes on True Religion

Herb Greenberg has a long-standing campaign against True Religion. He hates the company. One has to wonder why he hates it so much - did he feel slighted by something the company did, like refusing to comp him some test merchandise? Did he discover he can't fit in them? I don't know.
At his blog, Gualberto has done a good job of documenting Greenberg's take on the company.

Gualberto also takes the opportunity to show how some of Greenberg's other personal crusades have turned out. Read the comments to the post. Incidentally, unlike blogger commentators, Greenberg doens't actually own any stocks (except his employer's) according to the WSJ, which owns DowJones MarketWatch, where Greenberg is a senior columnist.

The column, which appears on pg B4 of today's (Saturday 10 June) WSJ, has this to say about TRLG:

Blue Jeans Lady
Whenever a brand claims to be hot, proff that it's not - or possibly not as much as it once was - is when its products start showing up at discounters.

Enter True Relgion Apparel, know for its pricey jeans. Until recently, the company insisted that the only place you can find its "damages," at discount prices, was Nordstrom Rack, the discounting arm of the upscale department store. In response to a questioner on its most recent earnings call, [CFO] Charles Lesser said that if the heans can be found elsewhere, 'call me immeidately so I can, in fact, get the New York Police Department on them.'

That's just what [Greenberg] did several weeks ago when [he] heard the jeans were showing up in New York's Century 21 department stores. Mr. Lesser told me the company had indeed sold some "voerstock" items to Century 21 - and that Century 21 and Nordstrom Rack were the only two discounters buying directly from True Religion. He said that if I could find them elsewhere, they're likely to be counterfeit.

So [Greenberg] called him again, this time asking about those True Religion jeans at a few BJ's Wholesale Club stores in New York and Mass. ...

If they are legit, how would they have gotten there? Probably by way of some small retailer that, if found, won't be a retailer for long, [Lesser] says. ... The question, of course, is why would a retailer have a hard time selling something that's supposedly in such high demand? Good question.
So, who's right? It is, of course, possible that the brand or the product category, could suffer a setback. I am not really an expert on fashion, which is why I generally avoid the category, but the company's overall earnings and revenues are very small relative to the categories in which they compete. They have room for growth but the key thing is, even if they had little topline growth, the stock would still be reasonably priced! You would have to assume a complete collapse of the brand, which I think unlikely. If, in fact, they couldn't hold their high pricepoints, they could always take their product downmarket, in terms of price point, and add huge volume.
Until management demonstrates that a)they are abandoning their strategy, or b) that they cannot deliver what they promised, even while following the strategy c) the company is sold, or d) the price rises about $22, the stock will remain among my investments.

Management Faith in True Religion

TRLG is a volitile stock. Certainly, it is the most volitile of my investments. Yesterday, it was up $1.25 in NASDAQ trading, on a report that management is putting the company up for sale. More accurately, they are looking to do a deal and take the company private, so they would be selling to themselves, too. They have retained Goldman, Sachs to advise them on a potential private equity takeover.

With no actual offers on the table, we have to conclude that much of yesterday's action was short covering (though there was probably also some risk arbitrage). Yesterday's volume of 1.587 million shares, 150% of the average day, no doubt involved quite a few short covers, but with 5.19 milion shares short as of May 10th, there is still plenty of short interest, even with gradual covering over the last few weeks as the stock has risen.

We have no idea what price tag would be put on the company, but as I have said before, the numbers at this company are just tremendous. Even at $21-22 is a fair valuation, with a control premium on top of that. But with other good values emerging from the recent market meltdown, I hope that a sale at a favorable price is announced and quickly, offering an opportunity to redeploy the capital I have in this stock.

Friday, June 09, 2006

Evangelism at True Relgion

TRLG announced today that it has entered into a licensing agreement with InGroup, a leading product licensing firm. (Read the press release). This step is a logical one in the company's desire to expand the brand beyond premium denim. Lubell is a jeans expert and developing appropriate products in other fashion categories (e.g. fragrances, shoes, etc) means working with experts in these fields and this is what InGroup is expected to do.

What this means for shareholders of TRLG is that we have found another way to capitalize on the brand with little or no additional capital tied up in producing the products. I am not sure how this licensing arrangement will work exactly (will TRLG distribute or a 3rd party?) Gualberto has had some discussions with Charles Lesser, and the licensing is definately part of their 2007 strategy. The only real risk I see at this point is that of overexposure, but I consider this a remote possiblit at this time, at least not yet.

So, the evidence suggests that the licensing agreement is part of an overall corporate decision to grow rapidly, and with a minimum of capital investment. Given management's ability to deliver results thus far, I see this as very bullish. If we see any further weakness in the stock, I will look to add more stock to my position.

Tuesday, June 06, 2006

CL - Colgate-Palmolive Update

In my last post about Colgate-Palmolive, I discussed whether it was time to sell, as the stock has enjoyed a nice run. It has held its position, even as the markets have melted down, mostly because at the same time the stock market has melted down, the dollar has fallen, which is leading to expectations that the company's results will continue to be strong.

Over at the AntiBrokers, they have analyzed the chart for CL, and have concluded that the stock's current run is not done, and if it can break out of the 60-65 range, we should expect further bullishness.

Until I find an investment I like more, I will continue to hold

Thursday, June 01, 2006

Technical Analysis - Redux

In my first post about Technical Analysis, I admitted that it is not a tool that I use very often. I tend to stick to the fundamentals, and look to purchase at a discount to intrinsic value.

So I appreciate Nick's heads up. He referred me to The Anti Brokers, a site dedicated entirely to Technical Analysis. Rather than talk about technical analysis, it just relentlessly breaks down the charts, security after security, with some really interesting observations.

Add it to your regular reads. I've added it to mine.