The value investor's schizophrenia

Superstar investor Warren E. Buffett is widely quoted as having said, “The best time to sell a stock is never.” But Mr. Buffett, though a proclaimed disciple of Benjamin Graham, the “pope” of value investing, was later just as much influenced by Philip Fisher, the recognized “pope” of growth investing. In fact, it was Mr. Fisher who, in “Common Stocks and Uncommon Profits” (Harper, 1958) wrote that the best time to sell a stock is “almost never.” I never met Mr. Graham and haven't met Mr. Buffet. But I did meet Mr. Fisher, who invited me to visit a company with him after reading one of my papers sometime in the 1980s. Without even a stock quote machine in his office, he was a voracious reader of company financials but also a compulsive evaluator of corporate management. Mr. Fisher wanted to know and talk to everyone he could in a company, from the chief executive to operations personnel. And once convinced that a [company's] management was among the best, he was willing to pay almost any price for the shares. If Mr. Fisher overpaid, his logic went, the company's earnings growth would make up for it over the ensuing years. It isn't clear that Mr. Buffett puts the same premium on superior management. In a May 20, 2008, statement to the Associated Press, he even advised, “Buy into a business that's doing so well an idiot could run it, because sooner or later, one will.” This, by the way, was probably inspired by a similar comment from legendary growth investor Peter Lynch in his 1989 book, “One Up on Wall Street” (Simon & Schuster, 2000), so the feeling doesn't belong only to value investors. Clearly, Mr. Buffett has retained a great sense of value. But nowadays, his philosophy — probably imposed in part by the trading and liquidity restrictions of a very large portfolio — seems closer to that of Mr. Fisher, as exemplified by this quote from his 1989 Letter to Berkshire Hathaway Inc. shareholders: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” I am still more at ease with the value discipline of investment. I feel more comfortable estimating a company's reasonable worth than putting a dollar value on the quality and future achievements of its management. In addition, the contrarian bias of value investing also pleases me, since it means seizing occasions when the price that the investing crowd is willing to pay for a stock is well below its value. In case you forgot the difference, Mr. Buffet reminds us, citing Mr. Graham in his 2008 letter to Berkshire Hathaway shareholders, “Price is what you pay; value is what you get.” The inherent contradiction in value investing lies in the fact that, as investors relying on fundamental analysis (balance sheet, income and cash flow statements, plus some sector economics), we think of ourselves as long-term investors. In fact, over short periods of time such as a few months or even a year, a company's fundamentals don't have time to change materially, so in-depth, fundamental analysis is superfluous. At the very least, therefore, we have to work within a time horizon credibly compatible with changes in businesses' fortunes (economic cycles, strategic plans or initiatives, etc.). On the other hand, however, the ideal mentioned earlier of “never selling” is appealing but not realistic, especially when a value discipline implicitly mandates that one sell a stock once its price has gone above one's appraisal of the company's worth. As I recall, Mr. Graham, in his classic “The Intelligent Investor”(Collins Business, 2003), recommends selling a stock after one year or when it appreciates 50%, whichever comes first. Frankly, this seems less intellectually satisfying than his well-articulated value -buying discipline. All this is further spiced up by the fact that over the short or medium term, the stock market is influenced more by crowd psychology than by fundamentals. As crowd psychology typically oscillates between euphoria and depression, stocks rarely go from undervalued to merely fairly valued. Momentum usually carries them well into overvalued territory before the next fall. So there definitely is an opportunity cost in selling too early, and it is painful to forgo at least some of those “speculative” gains. The value investor's conundrum came into newer focus for me recently as a result of two separate developments. After much internal debate between the pros and cons on our research team, we recently bought shares of a nameless stock, which seemed overly depressed. We figured that within three or four years, our typical time horizon, the stock might double as a result of continuing earnings progress and a higher price-earnings ratio when the investing crowd's perception became more optimistic. As it happens, the stock actually multiplied by 2.5 in just three months. Here I should point out that this is very atypical of the value approach to investing. Usually, we buy stocks on the way down, and they tend to decline some more before recovering. In fact, if we continue to be comfortable with the business, we usually view the further price declines after our first purchases as an opportunity to add to our initial positions, often at lower prices. Further, mentioning selectively some investments, even old ones, can be construed as a recommendation, resulting in burdensome compliance requirements and lengthy disclaimers. So let's be clear: The examples cited here are not recommendations. They illustrate exceptions much more than the norm in our investment process. The choice in this example was either to sell like a short-term trader or to hold on to the stock. We still liked the company, and nothing had changed in its fundamentals, but we were fully aware that what crowd psychology gives, it can also take back. From today's higher valuation level, a three-year horizon no longer promised exceptional returns. On the other hand, for the moment, the momentum was with the stock; and to complicate the problem further, for American taxpayers, the tax on a realized short-term capital gain (less than one year) would be twice that on a long-term gain. In this kind of situation, we often adopt a compromise solution — and we did, by selling some of our holdings. At the other extreme of this example, we have a client who, for various estate reasons, would rather not realize capital gains in his portfolios. This has been a constraint for a number of years. In view of the heavy capital gains taxes that would have needed to be paid if we sold some old portfolio positions, we have held a number of them, even though similar positions were sold long ago in other portfolios. The humbling thing is that some of the stocks in this particular portfolio have been star performers over the longer term. Here are some no-name examples (again, please see the disclaimer above): • Stock A, bought in 1967, was recently up 3,300%, versus 1,500% for the S&P 500 over the same period. • Stock B, bought in 1998, was recently up 630%, versus 28% for the S&P 500. • Stock C, bought in 2004, was recently up 370%, versus 30% for the S&P 500. • Stock D, bought in 1967, was recently up 6,550%, versus 1,500% for the S&P 500. Figures are rounded, and dividend income has not been included. There are a few more similar examples in the portfolio in question, and though I don't remember when these stocks were sold in our other portfolios or exactly at what price, the vastly superior performance of these few against the market almost guarantees that our own performance would have been enhanced had we not sold them. In investing, even the best long-term performances (encompassing several major market cycles) are littered with occasional missteps. When these happen, the best attitude is to learn a lesson (if there is one to be learned) and move on. Looking back is not a productive investment attitude. When following a value investing discipline, we are faced with two major factors: 1. Our discipline always will lead us to sell too early. So what? The original Baron de Rothschild reportedly claimed that he had made his fortune by selling too early. 2. Value tools are more effective and more flexible for buying than for selling. The conclusion we have drawn from this is that the time to sell is when one has identified a significantly better value idea than the stock owned. Simplify! Francois Sicart is the founder and chairman of Tocqueville Asset Management LP.