Monday, March 31, 2014

When Second Best is Better - The Case for Patient Quality Over Bravery (if you have a job)

Having a job is great, but its good to have extra income sources as well. A common one is to buy some rental property, but they have always seemed like a hassle to me. For one thing I do not have the handy man skills and for another my friends who do own these properties constantly lament the calls that come in at the most inopportune times - Friday evening boiler goes out, Thanksgiving plumbing problems and so on. On the other hand, I guess there's always stocks.

John Authers posted a follow up video to his excellent article - "Be brave, and patient, to make a fortune in value investing." In it he uses some research by Andy Lapthorne of SocGen to explore two schools of value - quality and value. You can think of these in terms of patience (quality) and bravery (value).

Both quality and value have a lot to recommend them in terms of beating the market.

Being brave and buying the cheapest stocks and holding them until their prices reflect true value is clearly the way to earn the best returns. You have to have the stomach for it, because events like 2008-9 will really come a cropper. That level of volatility is enough to ensure that most people will not get the results out of a deep value strategy, because they will sell out in March 2009 instead of buying more.

I enjoyed the buying opportunities of 2008-9, buying companies for 50 cents on the dollar was a memorable experience. I still like bargains, but  I have come round to another reason why quality is preferable even when you can stomach the value volatility and that's this - a job.

As the disclaimer says I am not a finance pro, I do not do this for a living. Many times I am busy at work and do not have time to check in on stocks every day or every week. In a deep value strategy a lot of the companies are under pressure, the companies face all kinds of risk. in theory you can buy cheap and forget about it. But in reality, decisions can come your way at very unpredictable times - operational issues, earnings misses, and events of all kinds. These kinds of events can whack double digit percents off the stock price, which may be a great time to buy more. Or maybe run for the hills if the event is very serious. Or maybe hold and do nothing. If you have a portfolio stuffed with a bunch of lower quality companies, there is a lot of news and movement to digest and react to.

Don't get me wrong I enjoy this decision making process, its just that I do not always have the time to 1) gather and absorb the information 2) come to a conclusion and 3) act on it. If things are busy at work then many weeks can go by and a good time to buy or sell can be lost. I suspect this is the case for the majority of people who are not full time finance pros.

That's where the quality focus comes in. The real benefit to this approach is the pace of decision making. Its pretty unlikely that Coke or General Mills or Kimberly Clark is going to bombard you with many time sensitive decisions in a given year. Just the opposite, these are companies that put you to sleep just thinking about them - ahh...paper products....For someone with a full time job, being a part owner in this kind of low maintenance business is a dream come true.

Let's take a real world example, Russian stocks are selling for low single digit P/E. Cheap, cheap, cheap.  Would it make sense to hold your nose and buy these stocks? At the same time, you do not really own these stocks, the government does. So you're not an equal partner. Beyond that, there is all manner of geopolitical and market risk. At a low enough price you are compensated for taking those risks, but you still have to deal with wide array of events at wildly unpredictable times. Compared to that the evergreen nature of quality companies, like say, a Coca Cola look pretty good.

Its not that the investing opportunity in the abstract is superior for quality over value, rather its the individual's ability to extract the most from the opportunity. And that comes down to decision making process and the pace at which those decisions need to be made. A good goal for an individual investor is to align as much as possible the relative expected amount of decisions with the time that you have to put into analysis. For most investors this is as low as possible, because there are lots of other things to do in this world.

So all else equal I would rather own boring quality than potentially higher rewarding deep value. I do not want the Friday evening call with 3 decisions to make when I am busy with something else. I am perfectly happy to let the plow horse plod along. Second place is not such a bad place to be in this game. When I look at the SocGen indices, I think its hard for most individual investors to replicate the Value index, but the Quality Income strategy is one where the individual in the proper going in mindset is well situated to earn returns that match the Quality Income index.

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