The buy, hold, sell investment strategy review

In analyzing an investment strategy, a simple but useful thing that I like to do is apply my "three boxes" test to it. In itself, the 3 boxes test is quite simple, but it has some key concepts that quite a number of people that I have tried to explain this to find difficult to grasp. The 3 boxes are "buy", "hold", and "sell", and I tick the box if the strategy tries to make money in that particular action.

Not everyone accepts that there are 3 opportunities to make money in every investment.  You will often here the quote "It's only paper money until you've locked in your profits", and hence there is only one opportunity to make money - and that is when you sell and lock the profits in.

This line of thinking comes from 2 main sources.  Firstly, there is the accountants view, that says that until a "capital gains event" has triggered, you can't actually book your profits.  Similarly, the day-traders focus on market price, that zigs and zags so often that a particular zag is meaningless unless you sell, because it could zig in the next minute, wiping out you profits, and therefore, if you don't sell to lock in your profits, they could disappear in a puff of smoke.

I think that this view is very limited, and that it is for more useful to consider the 3 opportunities.  So, how do you make money in each of the buy/hold/sell opportunities?  Let's look at each individually.

To make money when you "buy" something,

The little book that beats the market - still

I've just finished reading the little book that still beats the market, by Joel Greenblatt.  It's written in a very unique and quirky style that resonates well with me.  The magic formula that he documents is a value investing strategy worthy of review.  He very eloquently describes it as "systematically finding above-average companies at below average prices".

The essence of Grenblatt's magic formula is to rank each company by 2 criteria. The first criteria is "quality", for which he uses return on capital, and the second criteria is "cheapness", for which he uses earnings yield.  As point of detail, for return on capital he uses EBIT/(Net Working Capital + Net Fixed Assets), and for earnings yield he uses EBIT/Enterprise Value.

The challenge of changing one's investing model

Models are hard to build.  Not only that, if your model is built upon poor foundations, it may be forever doomed to be a poor performer, and no amount of tweaking will ever resolve this.  Emotionally, it can be very difficult to throw out an entire model and start again.

This is the biggest difficulty I encounter when trying to explain value investing to people.  It contradicts so much of what they know about investing that it initially very difficult to accept.  This difficultly is worsened by the amount of "experience" that the person has.

Measuring Portfolio Performance

It sounds like a simple topic - measuring portfolio performance - so why do so few investors, both amateur and professional, do it so poorly?

The answer should be simple: The way to measure portfolio performance is annual compounding rate of return.

So, how (and why) does it get complicated?

Firstly, many investors are not proud of their performance, and will therefore try and mask their poor performance.  This comes in many forms:

• Reporting only the highlights:  "Fund manager of 2010".
• Reporting over a shorter time-frame than the fund has existed: "20% last year"
• Reporting cumulative results rather than annual results: "80% over last 10 years"
• Erroneously averaging yearly results.  Eg, +20 and -20 does not average 0.
• Reporting "relative" performance, rather than actual: "Outperformed market (-15%) by 3%"
• Reporting without consideration to inflation.

Gambling

I have briefly written about definitions before, and how it is silly to argue over them.  Yet, I can't help but get into arguments about the definition of "gambling" with people.

My definition is gambling is fairly broad, and, using this definition, people gamble all the time.  Thus people that believe that they "don't gamble" struggle to accept my definition.  In fact, it was a former colleague refusing to enter to the work footy-tipping competition (for which there was no entry fee and no prize money) because she "didn't gamble", that got me thinking about this in the first place.

This struck me as flawed thinking for two reasons.  Firstly, because no money was changing hands, and secondly, because I didn't think it was possible to "not gamble".

Summary: A top down look at the year ahead, Saul Eslake

Here's a quick summary of the following ASX Investor hour presentation.

Topic:  A top down look at the year ahead, Saul Eslake, Grattan Institute

Australian Economy:

• Linked to mining, which is linked to China.
• Australian is the only country to supply 3 main China commodities: Iron Ore, Coal, Gas.
• Strength to continue for a number of years.
• Low government debt compared to other "Advanced" economies.

Housing:

• Does not see much growth in 2011
• But does not think that a crash is likely
• Will see growth beyond 2011.

Inflation:

• Does not see inflation in the near future as a major problem. 

Interest Rates:

• Thinks they will remain constant for 6 months
• Maybe 1 or 2 rises later in 2011.