I love a thoughtful email and this is a good one (see below). John has been doing some thinking and digging and wants to know why we shouldn't buy and hold a wonderful business we buy on sale instead of trading it. Its such a good Rule #1 question, John, that I wrote a whole new book about it. The book is called Payback Time and comes out in March 2010 from Random House.
The short answer is that you are right. Its better to hold a wonderful business that you bought on sale than to trade it. Trading has a transaction cost, can be inaccurate in the short run and will certainly cost you some of your profit. It also has the advantage of getting you out of a stock that is about to take a huge nose-dive. Trading is insurance against screwing up. Its not perfect but it is pretty good insurance and it reduces the amount of effort you have to put into determining whether the business is a good one and whether you got the price/value thing right.
Payback Time presents the buy and hold strategy in a whole new light with step by step instructions for implementation. It starts with the same requirement to get a wonderful business at a great price. But since we're holding, we're not trading, we HAVE to get the price right. So I bring in the concept of pricing from Private Equity that I call the Payback Time Price. Its the price of the business that will be repaid in a very short number of years out of earnings. The Payback Time Price keeps you from screwing up badly.
Imagine you were going to buy a private business for $1 million. The business earns $200,000 a year after tax. It isn't growing. Therefore, in 5 years you have your money back (assuming you don't need any additional working capital to keep it going). Notice that from that point on, you don't have any money in this deal. You are playing with house money. Your money is off the table. Now, if the business goes south, you can't lose money. Once you've got your money out, you are golden.
You have no risk, my friend. Its all good from there. That's ideal.
Of course, with public companies, we're not going to be able to buy the whole thing. But if we buy right, if we use Payback Time as a measure of the purchase price, we should properly expect that the market will properly price the business as time goes along and we will see a profit on our investment. In fact, we might even be able to get our money out of the investment in a short time - a year or two - and what we leave in the deal is all house money. And again, we have no risk.
Doing this right requires a technique I call "Stockpiling". And to jack up our profit, we can add some cool techniques to generate cash flow using Puts and Calls with absolutely zero risk. I know that seems crazy but the whole origin of options was to reduce or remove the risk of owning something scary like a wheat crop.
So, John, my congratulations on your analysis. And I hope you enjoy the book when it comes out. I think you will.
Now go play,
Below is the original email sent to Phil Town
Hi Phil,
Recently, and before I'd ever heard of "Rule #1", I read "The Essays of Warren Buffett". While I found it to be overflowing fundamental wisdom, I was disappointed by its lack of any divulgence of tactics or practical applicability for the small investor. Then, I read a blip about you and your book on MSN.com, bought it because you felt genuine to me, and, to my delight, I found "Rule #1" to be exactly what I was looking for! Great job.
That said, I have to admit, I was surprised to run into technical analysis before the end. In "Grab the Stick" and "The Three Tools", your point that fund managers move the market (ARE the market) and will always have some early information to trade on is inarguably true. However, I'm not able to reconcile the entire argument you make as to why the tools work, and I'd love to hear your thoughts on the following to perhaps widen my perspective.
Regarding "increased or decreased institutional investing" (p. 190), I think that a "decrease in institutional investing" can only mean that money is moving out of the market (or a particular stock) entirely, and not just from one institutional investor to another, and that this can only be represented by a drop in price because the number of shares remains constant, and the collective of institutional investors that make up the market remains constant - whether the shares are owned by institution A, B, or C or whatever combination of the three, there's still X million shares amongst them.
In conjunction, regarding "the price of a stock goes down when [fund managers] sell out" (p. 192), taking a step back from this perspective, I see that stocks are traded rather than only sold. For every seller, there is a buyer. For every mutual fund manager dumping huge blocks of a stock, there is also one buying up huge blocks of it (unless we assume that the specialist is eating all the losses, which can't perpetually be true).
So, speaking from the opposite perspective, we can ask, "What's making the price go down while all these institutional investors are grabbing up the stock?"
For example, C knows something bad's going to happen, so he puts some shares up for sale at a little discount. Neither A or B know about the impending badness and see the shares as a deal at that price, so they buy 'em up - until they start to smell something wrong. Once they all sense it, there's no way out except at a price that they start to believe truly accounts for the badness. And the Three Tools should predict that slide sometime after C gets his news and before A and B catch on.
Yet, I'm inclined to believe that there is no shortage of examples of a stock price moving against the three indicators (refer to the May 12, 2006 blog entry "INFY And The Tools") which I think must then point to disagreement among investors as to what price fully accounts for the future problems. This is what makes some of the big guys stay in the theatre while other big guys are pushing for the door, and in the end, only actual future earnings will determine if those who stay will get burned or see the thrilling twist at the end of the movie.
But because of the uncertainty of the ultimate effect of any "badness", and the inconsistency in opinions on it among institutional players, doesn't trading on these technical indicators violate the "certainty" and "predictability" foundations of Rule #1 investing? And, so wouldn't we rest easier just buying and holding a great company until the market price approaches the sticker price?
Thanks!
John
P.S. Looking forward to providing you with a success story you can post on your site in a few years!
