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.

Paper Money

What is paper money?  And, more specifically what are "paper profits" and "paper losses"?

Recently, I was watching this video, when John, the author, used the term "paper money" to refer to "cash" as well as "contracts", because both were printed on paper.  (Ignore that cash is now printed on plastic).

Now, as I've said before, I'm not one to be picky about definitions, but I do take note when I think that someone is using a definition that seems different to my own, as well as being different to what I believe is common usage.

My understanding of "paper money", and again, more specifically, "paper profits" and "paper losses", is that it refers to unrealised capital gains.  For example, when an asset that you own temporarily doubles in price, you have a "paper profit" of 100%.   The term "paper" is used because a) the asset (eg stock) price, was published in the newspaper, and b) because when you update your personal "paper" balance sheet to reflect the updated market price, you write down the 100% profit. 

In this way, neither "cash" nor "contracts of ownership" are considered "paper" money.

Why is this important?

Because the whole concept of "market value", and, more specifically, the extrapolation of the market value of the most-recently transacted shares to the total value of all the shares, ie, "market capitalisation", I believe to be erroneous.  I hope to cover the details of that belief sometime in the near future.

But for now, in conclusion, thinking that "paper profits" are real is somewhat delusional..

Dividend Reinvestment Plans

There are many companies that offer dividend reinvestment plans.  These are "automatic share buy orders".  Instead of receiving dividends from the company in the form of cash, you will receive shares, generally purchased at the current market price.

I will never participate in a dividend reinvestment plan.  The reason is simple.  To me, a good investment strategy will only buy assets when they are cheap.  Any given "now", without any consideration of price, is not likely to be cheap.  So, you may end up buying shares when they are not cheap, or, at worst, when they are bloody expensive.

So, why then do so many companies offer a dividend reinvestment plan?

Well, I think it is a cheap management trick to pump up the share price.  If a company can cause a continual buying trend, share prices will tend to rise (until the scales tip back towards balancing with earnings).

The problem though, is that management should not be concerned with the price of the company shares.  "Ahhh, but they are!" I hear you say.  And you're right.  Often Executive bonuses are linked to the share price of the company.  This is stupid.  Shareholders should let management focus on the profitability and growth of the company, and then the share price will take care of itself.  If shareholders vote for short-term reward structures, they will get short-term focused management - to the detriment of the long term performance of the company.

The problem with short-term focused management should be obvious.  CEOs that maximize their bonus before walking out the door leaving a hell of a mess behind.  This is definitely not in the interest of shareholders.

So, as a shareholder:

• I will always vote against the introduction of a dividend reinvestment plan.
• I will be wary of any management that suggest the introduction of a dividend reinvestment plan.
• I will always vote against executive remuneration linked to short term objectives, such as share price.
• I will never participate in dividend reinvestment plans.

Until I change my mind..

(KX9UC8U9WVYT)
 

Family Trusts

Disclaimer: I am not a lawyer.  I am not an accountant.  I am not a financial adviser.  The description below is written in layman's terms, by a layman.  It may not be accurate.  Seek professional advice.

At about the same time that I setup my SMSF, at the advice of my accountant, I also setup a Family Trust.

A Family Trust is similar in structure to the SMSF, in the sense that it a legal entity, essentially created by the existence of a deed document.  It can own assets.

So, why setup a Family Trust?

A Family Trust allows me to distribute any income received by the Family Trust to the beneficiaries of the Trust in a discretionary manner.  The beneficiaries of the Trust are the people (generally immediate family members) that can receive income generated by the Trust.

The real advantage of the Family Trust is the discretionary nature by which income can be allocated.  Basically, income can be allocated as required (or, at the sole discretion of the Trustees) as to maximize the net benefit (ie, after tax) to the beneficiaries.

So, in my case, my partner and I will likely alternate being the primary income earner and the primary care giver across a number of years.  Using the Family Trust structure, we simply put the name of the income earning assets into the name of the Trust, and can then (in any given tax year, and changing between tax years) allocate income to primary care giver first, ensure that we maximize our net earnings.

We can also allocate $3,000 per year to each child, without paying any tax on that income.

You should be able to see the effectiveness of the Family Trust structure, in building and maintaining the financial well being of your family.

Setting up the Family Trust...


Setting up the Family Trust was quite similar to setting up an SMSF, in the it consisted of:

• Creating the Trust Deed document, which, amongst other things, contained the list of Trustees (the people that control the Trust), the list of Beneficiaries (the people that benefit from the Trust).
• Getting ABNs and TFNs for the Trust
• Setting up bank accounts in the name of the Trust.
• Moving existing assets into the name of the Trust.

I'm not about giving financial advice, but I would think that the Family Trust structure would be useful to me if I were in any of the following circumstances:

• Had over $100,000 in funds to manage.
• Had family members that were either temporarily or permanently in lower tax brackets.
• Had at least one child, although the more the better.

Actually, that really only covers of the "maximizing net returns" aspect.  I would also consider setting up a Family Trust structure if I had relatives that were incapable of managing their financial affairs, for example, due to illness or general incompetence.  In any case, I would definitely speak to my accountant about the appropriateness of setting up a Family Trust.

The cost of setting up the Family Trust was about the same as the SMSF, ie, a few grand, but it is definitely worth it.  I may be wrong, but I doubt it.  :-)