The reality of models

Models are useful abstractions of reality.  The "correctness" of a model is simply is usefulness for a particular purpose.

Instrinsic Value and Target Prices

When I was recently reviewing Empire Investing, I luckily stopped at the "value" step of their investment strategy, as this gave me time to reflect on a couple of things.

The first is the concept of intrinsic value, which most value investors will know well, as the traditional texts of Benjamin Graham and Warren Buffett refer to it often.  I, however, don't subscribe to it.  I simply don't believe that anything has an "intrinsic value" - the only "value" that can be placed upon something is someone's desire to have it.

A long term investor will value certain properties of a company very differently than a short term investor would value those properties.

Consider the example of a house.  I could describe a house as "2 bedrooms, 1 bathroom, modern and in a nice suburb" to a room full of people, and ask each of them to create a baseline valuation of this house.  It doesn't matter what valuation they come up with.  I could then ask "and what is the change in value if I add a double-car lock-up garage on".  To some people, this might de-value the house, (if for example they didn't have a car, didn't want one, and didn't need the storage space) and to others, like myself, it would add value to the house.  So, what is the "intrinsic value" of the garage?  It doesn't make sense.

So, what Buffett et al are referring to when they refer to intrinsic-value is actually value-to-them, as long term investors.

Empire Investing Strategy Review - Part 1

This blog is supposed to be about investing strategies, and to date, I haven't spent too much time talking about them (other than the magic formula).  Luckily for us, there is an investment company called Empire Investing that publishes their investing strategy, and so today I'd like to review it. 

Let me start by saying that I have no affiliation with Empire or any of it's staff, other than that The Prince has chanced across this blog before.  Not that it matters though, as it seems that they are not currently accepting any new clients or funds.

So, to start off, I'd say that one of the reasons that I'm looking forward to this review is that their investing strategy is quite similar to my own, but with some interesting differences.  Let's look at their strategy in a nut shell:

The stock market side pot

Here's another thought experiment for you.

Suppose the government (or the stock exchange) changed the rules on investing to ban short-term trading.  The mechanism for how they do this is not important, but it could be implemented, for example, by changing the capital-gains tax rules to tax short term trades at 100%, making them pointless.  Let's say that they effectively prevented anyone from owning stocks for less than 3 years.

What would happen to the market?

Friday on my mind - continued

I hope that you've had some time to think about the original thought experiment.  Please read it if you haven't, or else the rest of this post will make no sense whatsoever.

Friday on my mind

Here's a thought experiment for you.

Suppose that you own a regular house in a regular suburb.  One Sunday, you wake up, and you think to yourself - "I like this house, I think it's worth $500,000.  Yes, I wouldn't sell it for any less than that."

On Monday morning, for whatever reason - it doesn't actually matter why - your next door neighbour, who's house is practically identically to yours, comes over to your house and says "Today I am leaving, and I'm giving you my house. Here's the title.  It's yours".

On Tuesday morning, a man appears at you door, and offers you $500,000 for your house.  You seriously consider it, and tell him that you'll think about it, and get back to him.  You also point out that you own the house next door.  He leaves you with his offer.

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.