Mon Feb 08 2016
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Why I’m Moving Slowly as Markets Fall

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With the Standard & Poor’s 500 down roughly 5% in January and continuing to move lower in the early days of February, I’ve noticed an uptick in websites / blogs with authors pitching long-term buying opportunities. While I certainly don’t disagree with their thinking (lower prices improve forward returns), some simple math will help explain why I’m not so convinced yet.

Let’s assume that “ABC” was trading at $ 100 per share at the start of 2016 and fell in line with the S&P 500 for January (to ~$ 95 per share). If you require 15% annualized returns and define “long term” as five years or more, that implies “ABC” will need to be traded at ~$ 191 per share by 2021 to meet your return requirement from today’s levels ($ 95 per share).

Of course, the second part of our calculation – a reasonable estimate of what the company will be worth in five years’ time – did not change as a result of the general market decline of the past month. Said differently, you could have bought “ABC” shares on Jan. 1 for $ 100 – a level that priced in 13.8% annualized returns at our ~$ 191 target price in 2021. The 5% decline has added roughly 120 basis points to your annualized return.

Now that’s nothing to scoff at: over the course of 50 years, that’s the difference between turning $ 10,000 into $ 6.4 million (13.8% a year) and $ 10.8 million (15% a year). However, it is not as significant as the enthusiasm of some authors might lead you to believe.

Here’s the point: if you thought a company was expensive at the start of the year – say, priced for 5% annualized returns – you need a lot more help from Mr. Market before that security will be priced for double-digit annualized returns. A stock priced for 5% annualized returns will go from $ 100 to $ 128 over the course of five years; for that same security to suddenly be priced for 10% annualized returns, it would need to fall more than 20% from where it currently trades.

This is a relevant conversation to have at this time: many value investors have been holding on to growing cash piles for some time. As Mr. Market has shown some nerves early in 2016, it’s tempting to start making additions – and if you can find companies trading at a material discount to intrinsic value, that obviously makes complete sense.

I must admit that I’ve been tempted to start taking action. At the same time, I recognize that most of the stocks grabbing my attention are just starting to cross levels where they meet my return requirements. As I’ve been thinking about this, I started to question whether getting really aggressive makes much sense at the bare minimum of my return requirement. I’m okay with being “all in” when expected annualized returns approach 20%; with this number in the low teens for the ideas that truly have me excited, there’s an argument for moving slower.

It’s worth noting that I’ve struggled with this historically. As a value investor, I feel a real temptation to jump any time Mr. Market gives me an opportunity to buy something for less than I paid previously – even when those declines have only been a few percentage points. Over time, I’ve become more comfortable with sitting patiently when I feel it’s appropriate to do so – while fully recognizing that this could (and will) come at the cost of short-term upside in many cases. That’s a reasonable price to pay in exchange for the benefit of having dry powder in the rare instances when truly wonderful opportunities arise.

Let me share an example: In Seth Klarman (Trades, Portfolio)’s speech at Ivey Business School (link), he mentioned that The Baupost Group held roughly 40% of its assets in cash at the start of 2008. As we all know, the S&P 500 declined by more than 35% that year. To me, that makes this comment from the December 2008 issue of Graham & Doddsville pretty interesting (link):

“After sitting patiently on the sidelines with a mountain of cash — 40% to 50% of Baupost’s $ 14 billion in assets — for several years, the firm’s recent investments have cut its cash stash in half.”

I find it astounding that, as equity prices fell by more than one-third, Baupost still took (what I personally consider) a relatively measured pace when committing new funds. They still ended the year with ~20% of their assets in cash and equivalents.

In the Ivey Business School video, from March 2009, Klarman noted that Baupost still had a large percentage of its fund in cash. As a reminder, the S&P 500 fell more than 25% in the first 10 weeks of 2009. Again, this clearly takes some serious patience. I have a hard time believing I would have had a single penny left to spend by the end of 2008 – let alone by March 2009.

Maybe you can argue Baupost missed an opportunity by continuing to hold cash at the bottom in March 2009 (based on what he said at the time, I think it’s unlikely they put a large percentage of those funds to work in the coming weeks). But as Baupost’s performance has shown, you can make up for many years of underperformance and holding large amounts of cash when you are one of the few investors left to capitalize when markets panic (as highlighted in the Graham & Doddsville article, Baupost generated ~20% annualized returns over its first 26 years).

Conclusion

With a growing cash pile that has hindered relative performance in recent years, I understand why investors would want to jump at the first sign of opportunity; I feel the same way.

But with a long-term time horizon, recent declines are far from noteworthy. From a mathematical perspective, there’s not much reason to put all your chips on the table investing in a company that you weren’t comfortable owning when it traded a few points higher.

With that in mind, moving patiently continues to make sense to me. I’m fine with missing a near-term move higher; in some ways, that’s the price you must be willing to pay if you want to be like Seth Klarman. If you want to be in a position to buy securities when they trade at fire sale prices, you first have to make it to the auction with some cash in your pocket.

As usual, Charlie Munger (Trades, Portfolio) says it better than I can: “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”

I’m starting to see some opportunities that are better than mediocre. I hope this continues. As usual, I’m hoping for lower prices; I plan on having plenty of cash to put to work if that happens.


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