Do I trade too much?

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Buffett: Hold Stocks Forever

One of the most common criticisms I get from other value investors is that I trade too much. This is mainly because value investing has come to mean whatever Warren Buffett says it means.

Buffett recommends that the best holding period is forever. Buy a great business at a fair price and hold onto it for decades. This has become the commonly accepted wisdom among value investors.

Buffett’s views on holding periods is best summarized by the below quotes:

Our favorite holding period is forever.

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years

My activity is entirely inconsistent with this philosophy.

I argue that Buffett’s approach is only one method of value investing.

It is a perfectly valid approach. But it’s not the only valid approach.

Graham: Two Years or 50%

Graham had a different view. It is also one that makes more sense to me. Graham’s view was that an investor should calculate a stock’s intrinsic value, buy below that intrinsic value, and then sell when it reached that intrinsic value. In other words, Graham believed in simple, easily comprehensible, rules-based value investing.

This is different from holding onto stocks in great businesses for decades on end no matter what.

Graham explained his rules in the following interview:

Q: How long should I hold onto these stocks?

A: First, you set a profit objective for yourself. An objective of 50 percent of cost should give good results.

Q: You mean I should aim for a 50 percent profit on every stock I buy?

A: Yes. As soon as a stock goes up that much, sell it.

Q: What if it doesn’t reach that objective?

A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.

In other words, Graham recommended that an investor should sell a stock after a 50% gain or after holding for two years, whichever comes first.

This view makes sense to me.

I estimate what I think something is worth, then I sell when it hits that value. I don’t think I’m capable of figuring out which stocks among the thousands available in the investable universe will overcome the odds and compound for decades on end. I do think I’m capable of identifying a bargain and selling when it is reasonably close to its intrinsic value.

There are drawbacks to this strategy. I will never own a stock that compounds throughout the decades. I’ll never buy and hold Nike for 40 years. I’ll never become a millionaire by investing in the Amazon IPO.

I also don’t care. I can achieve perfectly satisfactory results without trying to buy these lottery tickets.

My approach is a high turnover approach, which increases costs and taxes. This is a big deal for someone like Buffett and not so much for me. Buffett is a megaladon and I’m a gnat in the belly of minnow. My trading account that I track on this blog is in an IRA and brokers don’t charge commissions any longer. I have miniscule sums of money and I can’t influence the price of a stock.

My strategy isn’t scalable, either. At least, it’s not scalable to Warren Buffett’s level. Warren Buffett commands the one of the largest pools of investable cash (that is constantly growing!) in global markets. He can’t nimbly move in and out of stocks. It’s like an elephant trying to nimbly move in and out of a swimming pool.

Buffett’s strategy is entirely valid, but it’s not the only valid strategy.

What’s a Wonderful Business?

Buffett recommends buying wonderful businesses. Well, what’s a wonderful business?

A wonderful business is a business that can earn high returns on capital over long periods of time.

This is extremely hard to do. It’s extremely hard to do because we live in a capitalist economy with a lot of competition. If someone has a business where they can earn high returns, other businesses are going to swoop in and do the same thing, which will reduce those returns.

This is why Warren Buffett focuses so much on the concept of a moat. Those high returns on capital can only be sustained if there is something about the business that helps it resist competition.

Where do moats come from? They can emerge from a lot of places. Some businesses might have a geographical moat, like a toll bridge. Others might have a regulatory moat, where government policy helps sustain their advantage. Brands are another form of moat. Are you willing to pay a premium for a Nike swoosh? You likely already have, many times over.

Buffett has identified many moats in good brands. After successes with other wonderful businesses such as American Express and Disney in the 1960’s, Buffett recognized the power of a moat through his investment in See’s Candy in the early 1970’s.

See’s Candy can earn high margins because it has a recognizable and enduring brand. Munger explains the moat below:

“When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”

People are willing to pay a premium for See’s because of the enduring quality of the brand. That’s not something that an upstart competitor can easily disrupt.

The same is true for Coca-Cola. Coca-Cola has a strong brand. If you face a choice between a store brand Cola and Coke, you’re going to pick Coke.

It won’t make much of a difference in your personal finances or grocery bill if you pay 40 cents a can versus 30 cents a can. Why wouldn’t you chose a marginally more expensive quality brand that you’re familiar with over one that you have no familiarity with? Meanwhile, that small difference in price creates large profit margins that are sustainable over long periods of time.

Moats Are Hard to Find

Situations like Coke and See’s sound deceptively easy to identify.

A key problem is that moats are much harder to identify than we realize.

The concept of moats was popularized by Buffett, but it is rooted in the ideas of Michael Porter.

The ideas of Michael Porter have been widely disseminated throughout business education programs. In the 1980’s, it was first taught at the Ivy Leagues. By the 2000’s, it was disseminated and understood far and wide.

My MBA is about as far away from the Ivies that you can go. I earned my MBA at a cheap state school, but even I was taught the gospel of Michael Porter. Much like the efficient market hypothesis, which was drilled into my head during my Finance undergrad degree, Porter’s ideas were treated as gospel truth.

There’s a problem with the ideas of Michael Porter: there isn’t any proof that any of it is true. Dan Rasmussen explains much better than I ever could in this excellent article in Institutional Investor. Rasmussen explains:

Porter’s logic suggests that firms with competitive advantage would earn excess profits, so profitability margins should be a guide to which firms have the most-sustainable profit pools. Yet profit margins have no predictive power in the stock markets. In fact, academic research suggests that margins are mean-reverting and provide little information about future profitability. The implicit certainty of Porter’s view of the world — that margins are persistent, that competitive advantages result from permanent structural features of industries, that “excess profits” come only from distortions in market structure — could lead investors to overpay for current performers. The theory leads not to an investing edge, but to the most common of investing mistakes.

It’s harder than hell to distinguish between a business that is enjoying a temporary edge between one that is an economic franchise.

It’s also hard as hell to figure out if an economic franchise which has endured for decades is about the completely fall apart. One of the best examples of this is Kodak. In the 1990’s, Kodak looked like it had an impenetrable moat. Then digital cameras came along.

Morningstar has put significant resources and intellectual depth into identifying moats. As highlighted in this excellent article by Rupert Hargraves, companies christened as “wide moat” don’t outperform over the long run like they theoretically should. Are you a better analyst of a moat than the talented people at Morningstar who have devoted themselves to solving this problem?

The same phenomenon is also highlighted by Tobias Carlisle in Deep Value. Carlisle cites Michele Clayman’s analysis of Tom Peter’s book “In Search of Excellence” as an example.

In the early 1980’s, Tom Peters identified key attributes of “wonderful” companies and assembled a list of truly wonderful companies. These were companies with high growth rates and high returns on invested capital.

In 1987, Michele Clayman analyzed the stock performance of these “excellent” companies. The portfolio underperformed the S&P 500.

Adding insult to injury, Clayman also assembled a list of companies with the opposite characteristics of excellence – bad returns on capital, low growth rates. Guess what? The unexcellent portfolio outperformed both the S&P 500 and the “excellent” portfolio by a wide margin.

Of course, a modern value investor would argue that they weren’t really excellent companies because they didn’t have a moat to defend those high returns on capital.

These investors would say that the companies that they are purchasing today actually have a moat. Okay. What’s more likely? That these investors have found a moat or a business enjoying a temporarily good situation that will ultimately be eroded by competition? I would say that the evidence suggests they are unlikely to find a moat.

Coca Cola: A Case Study in Moats

The Moat

Buffett gobbled up Coca-Cola shares after the stock market crash of 1987. He knew Coca-Cola was one of the ultimate American brands and had a strong moat which allowed it to earn high returns on invested capital.

A key source of Coke’s moat was its long and successful marketing campaigns. Coke was everywhere for 100 years. Baseball games. Logos printed on every billboard. Indelible images pounded into the American psyche, like Santa Claus drinking an icy cold Coca-Cola and smiling.

The success of Coca Cola’s marketing was best demonstrated during Coca-Cola’s debacle with New Coke. In 1985, Coca-Cola tried to change their formula. They tested out their formula in taste tests and people preferred it.

Once the new flavor was released, the public hated it. Coke executives quickly realized that Coca-Cola’s success had nothing to do with the actual taste: it had to do with the public perception of the Coca Cola brand, which Coke spent decades establishing. The people associated messing with Coke’s flavor with messing with a part of Americana itself. Coke ultimately relented and brought back the old flavor in the form of “Coca-Cola Classic.”

This is a great documentary from 2003 on the debacle, the People vs. Coca-Cola.

I grew up on a steady diet of Coke marketing and Coke products. Coke’s aggressive marketing has made me associate that brand with an image of America itself.

The sugary sweetness was an immediate appeal. The sugar and caffeine high that came afterwards made me feel good. It was usually served to me at happy occasions: family events, movies, birthday parties. My mind quickly associated the taste of Coca-Cola with good times and good feelings.

Generations of children had the same experience. This made for a hell of a moat, probably the ultimate moat in the history of business.

A Wonderful Business at a Fair Price

Modern value investors are obsessed with identifying Coke-like businesses. They want to identify these wonderful businesses at fair prices and hold onto them for decades of compounding success, following Buffett’s example.

As justification for their frothy purchases, they cite Buffett’s transformation from buying stocks below working capital to buying wonderful businesses at fair prices.

Of course, the price of Buffett’s Coke purchase was hardly modern compounder territory. Buffett bought Coke at a P/E of 12.89 in 1989 and 14.47 in 1988.

Furthermore, I think that Buffett holding onto Coca-Cola for decades was a mistake. He should have sold it in the late ’90s.

Coca-Cola has treated Berkshire exceptionally well. Coca-Cola has compounded at a 13% rate since 1986 in comparison to the stock market’s rate of 10% during the same period. In other words, Coca-Cola turned a $10,000 investment into $660,653. The US stock market turned the same $10,000 into $270,528.

What is missing from the raw CAGR is the sequence of these returns. From 1986 to 1998, Coca-Cola grew at an astounding CAGR of 27.68%. However, from 1998 through 2020, Coke has only appreciated at a CAGR of 4.74%. 10 year treasuries have returned 5.31% with a lot less stress.

An investor would have been better off investing in 10-year treasuries in 1998 than investing in Coca-Cola.

Did Coca-Cola’s business change? No. Coca-Cola has continued to be a great business since 1998, growing earnings and earning high returns on invested capital. It didn’t matter for the stock.

What changed was the price. Coca-Cola got up to a P/E of 40x in 1998. The price grew faster than the fundamentals.

The valuation mean-reverted in the 2000’s despite the performance of the underlying business, causing the less than satisfactory result.

Buffett should have sold Coca-Cola in the late ’90s, but he didn’t.

Why didn’t he?

It could be for public image reasons. Berkshire had become so closely associated with the company. If Buffett sold, it would be a blow to the public image of Berkshire and Coke.

He also couldn’t nimbly move out of it, as it had grown into a massive portion of the Berkshire portfolio.

In fact, it’s quite possible that Buffett realized Coke was expensive, couldn’t sell for the public image reasons, and this may have been a major reason that Berkshire purchased General Re, which helped dilute Coke as a percentage of Berkshire’s holdings.

I’d also argue Buffett was in love with the business and couldn’t bring himself to sell.

Problems with Wonderful Businesses

Coke’s price run-up in the ’90s and Buffett’s mistake by holding on outlines a major problem with buying wonderful businesses.

If the business is indeed wonderful, how can an investor bring themselves to sell when the price gets ahead of the fundamentals?

Another major problem with moat investing is that moats are ridiculously hard to identify. I would argue that even Coca-Cola’s moat isn’t certain to persist into the future.

While it was socially acceptable to give children sugar water when I was a kid, that dynamic is different today. Coke has tried to get away from this problem by diversifying into other products. Still, I find it hard to believe that Dasani will have the same marketing grip over future generations that Classic Coca-Cola had over previous generations.

If Coke’s moat is uncertain, then what moats are certain?

If it’s possible that Buffett – the greatest business analyst of the last hundred years – is making a mistake by holding Coke, then what are the odds that you going to make a mistake by buying the business that you think has a wide moat? I am certainly not a business analyst that’s as good as Buffett.

It is also increasingly difficult to acquire these businesses at “fair” prices. Investors fall in love with wide-moat businesses and bid them up to prices which are likely going to create disappointing future results.

For example, modern value investors are buying things like Visa and Costco because they are wonderful businesses with moats.

I certainly agree that, on the surface, Visa and Costco have incredible moats. Visa controls a significant portion of the global payment system and it’s unlikely that a competitor can disrupt that. Costco controls an ever increasing portion of America’s retail spending habits and maintains that by maintaining low prices and locking in consumers with memberships.

Neither of these businesses can be acquired at the kind of “fair” prices that Buffett acquired companies like See’s and Coca-Cola.

Look at the current EV/EBIT multiples of these wonderful businesses:

Coca-Cola – 24.14

Costco – 19.91

Visa – 23.42

Additionally, Buffett didn’t buy Coke and See’s at crazy, or even slightly high, prices. They were incredible bargains!

As mentioned earlier, for Coke, Buffett bought it at a P/E of 14 and 12. The enterprise multiple was likely much lower than that raw P/E suggests. See’s was purchased for $25 million. Sales were $30 million the year that he bought it. Profits were $4.2 million.

Buying a company for less than its annual sales and at a P/E of 5.95 is nothing like buying today’s compounders at EV/EBIT multiples over 20.

Yes, See’s wasn’t a net-net, but it was hardly a situation where Buffett and Munger threw caution to the wind and paid a sky high valuation for a great business that compounded over time.

Do I Trade Too Much?

Let’s return full circle to the question I asked at the beginning. Do I trade too much?

I don’t buy wonderful businesses and hold them for all the reasons described above. I buy cheap stocks and then get out when the fundamentals deteriorate or they get close to intrinsic value. I certainly trade more than the Buffett-style compounding value investors, who would waive a ruler at me like a nun in Catholic school for betraying the faith.

I went to Catholic school and this was a frequent occurrence.

I trade even more frequently than Graham’s rules recommend.

Not only do I sell at intrinsic value, I often sell at mere 52-week highs. I’ll also sell if I notice a deterioration in the performance of the business, often relatively quickly after I buy them.

A major reason I sell so quickly is because I know I’m not necessarily buying wonderful businesses. I’m buying businesses at what looks like a bargain price regardless of its underlying quality. I get out when I see signs of a deterioration in the business, which helps me avoid value traps.

I’d argue that the approach works, even though I’ve lagged the S&P 500.

As with all things, I like to look at the evidence and not the dogma.

Here is a comparison of stocks I’ve sold, comparing my sale price to the current market price.

price1

2

sells

selling

I’m not following the Buffett scriptures, but it seems to me like I’ve made some pretty decent sell decisions.

I think I will continue to follow my own path instead of sticking to an investing religion dogmatically.

Summary

  • Buffett believes in long term holding periods. Graham recommending shorter periods. I agree with Graham.
  • Wonderful businesses with moats are extraordinarily hard to find. It’s also hard to find in any quantitative sense.
  • There isn’t any empirical evidence that proves that wonderful businesses outperform over long periods of time. In fact, the opposite is true.
  • I get criticism for trading too much, but it seems to be working out for me. I’m going to chart my own path and not stick to an investing dogma like it’s a religion.
  • You do you. There isn’t any one true faith in investing.

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