Selling cheap to buy cheaper

I apologize for the lack of recent posts, in many ways it' a bit unusual.  I started this blog in 2010 and became serious about blogging during 2011.  Since then I set a goal of posting twice a week.  If you look at my post history you can see a giant gap over the last few weeks.  We took a nice long summer vacation and I decided to abstain from posting while away.

We drove from Pittsburgh down to New Orleans to visit my brother, his wife and our new nephew. Then we headed over to Pensacola for some time at the beach.  Before this trip I hadn't spent any time in the Deep South.  It was really nice, we had a great experience.  We had some good food, relaxing days, and I was even able to meet up with a reader for coffee, which was awesome.  While away my inbox filled up and I kept my eyes off the market.

Now that I'm back I want to get back into my two posts a week routine; here's to starting!

A friend emailed me recently musing about buying when the market is falling.  It might sound like a strange topic to discuss when markets are soaring higher, but it's always good to be prepared.  My friend asked my thoughts on selling cheap stocks to buy cheaper stocks in the midst of a downturn.  In his view this is the ultimate act of a investor.  The ability to ignore emotions and sell stocks that at other times would be considered extremely attractive for stocks that one deems are even cheaper.

If an investor wants to have the ability to sell a cheap stock and purchase a cheaper one they must have some sense of potential value.  Is a stock at 50% of book value cheaper than a stock at 60% of book value?  Not necessarily.

Some investors (the disciplined ones) keep spreadsheets of all of their holdings and what they feel is the discount to intrinsic value of each holding.  The investing cowboys, of which I am one, tend to play it a bit more loose.  No spreadsheets are necessary, just a rough gut feel of when a stock is getting a bit frothy.  My own process works as follows.  I will initially research a stock and often will write a post about the stock.  The purpose of the post is to help formulate my thoughts on an idea, and to preserve a record of my initial thinking.  If I like the stock I make a purchase and usually forget that I even own it.  I don't follow the news for stocks, or set alerts.  I will check my entire portfolio on  a semi-regular basis.  I check each stock for news or activity and then go back on ignore mode.  If during my check I notice a stock that's run up significantly I will look for news, and evaluate if I need to sell out of the position.

When considering my investments against each other I like to look at what I consider their potential value.  This is the stock's undervaluation plus their business value.  In Security Analysis Benjamin Graham discusses selling a stock after three to five years if it hadn't reached intrinsic value.  I want to walk through an example of how I calculate potential value.  Let's take a stock at 60% of book value that's earning 3% on equity.  Many readers bash stocks I pick with low returns on equity, but maybe understanding how I view things will help to clarify why some of these low ROE companies can be good investments.

Take the example of a stock that has a book value of $10 and is selling for $6.  The company earns $.30 a year, or 3% on equity.  If the stock reaches its intrinsic value in five years, our maximum holding period, the investor would earn 19% a year.  Between year one and five the company grew their equity at a paltry 3% a year.  Five years of 3% book value growth equals $11.59 in book value at the terminal date.  If an investor held the entire five years, and the stock rose to book value they'd realize a gain of 93%, or 19% a year over their holding period.

The above example shows how even poor companies that don't earn their cost of capital can result in significant gains if the company's market price eventually reverts to intrinsic value.  Of course nothing is guaranteed, and not all investments drift up to what a reasonable investor might consider intrinsic value ever.  At times management is directly opposed to shareholders and works to keep the value of the company low.  Other times there are structural factors that keep the value of a company low forever.

If one believes in the concept of mean reversion then this theory holds.  The key variables to the equation are the company's intrinsic value, and the time period of the holding.  If a short time period is used then potential returns increase.  If a longer period is used then potential returns decrease.  There are a few investments I hold where I've figured that even with a 10-15 year holding period my potential returns could be well above 15% a year.  It's situations like that where I'll potentially hold a stock for a decade or more.

So what does the idea of potential valuation have to do with selling cheap stocks to buy cheaper stocks?  It's the only way I can think of that one can rationally rank investments in a way that lets them compare two potentially cheap investments.  I mentioned above that a company at 50% of book value might not be cheaper than one at 60% of book value.  If the company at 60% of book value is earning 8% on equity and the one at 50% is earning 2% the company selling at the initially higher price is cheaper overall over the same holding period.

When a stock appreciates towards what I might consider a fair value I will go through this exercise to determine out what the potential return is for the stock going forward.  My personal hurdle rate is 10-15% a year.  My hurdle probably seems low for most readers, but if I can earn between 10-15% a year for the next 30 years I'd be extremely satisfied.

In a downturn an investor could use the above system to classify all of their investments.  Then evaluate new investments against the set of current investments.  A company with a potential return of 20% a year could be sold to purchase a company with a potential return of 30% a year.

The caveat with this system is that in a downturn it's hard to know what past numbers could be repeated in the future, and secondly you need to invest in companies that will survive.

I want to come full circle and answer my friend's question.  I agree that selling what's cheap to buy what's cheaper is the ultimate test of emotions.  An investor in that situation is facing a portfolio that's  losing value, and they are out of cash if they're in this situation.  They need to ignore their gut and trust the numbers, sell companies with low expected returns and purchase ones with higher expected returns.  I don't know what different in potential return is meaningful, but I think it's an individual preference.  Based on the potential error from estimated time ranges I wouldn't be exchanging stocks for a few percentage point differences in potential returns.  But I would exchange something with a 15% potential annual return for something with a 30% potential annual return.

In my own portfolio I like to keep 5-10% in cash at all times.  I feel this gives me the ability to act quickly on a new investment idea should I come across something attractive.  I haven't found my cash levels to be correlated with the market levels in generate.  I'm currently floating closer to the lower end of my cash cushion, whereas a year or two ago I was closer to 15% in cash.  As opportunities become available I take positions.  And if the opportunity has a potential annual return of 10-15% I will seriously consider a place for them in my portfolio.