Can you go wrong taking a profit?

[berkshire101]

I’ve been thinking about this a lot lately.  Maybe it’s just because we’re in a bull market.

 

Let’s say your goal is to compound capital at 15% annually.  The GARP model seems to work.  But finding businesses that can grow at that rate can be a difficult thing to forecast.  Another method is rotating in and out of stocks trading below intrinsic value.  But that process comes with higher fees and taxes.

 

Let’s say the second method generates 30% annual returns before taxes and fees.  After your expenses, the returns would be 15%.  Would you still go down this route or stick with the long-term approach? 

 

Are there any research papers showing how taxes and fees effect returns and by how much?  In some countries, there aren't any capital gains taxes.  Does anyone know the returns of investors in those countries?

 

Thanks.

[Pretium]

This might be of interest

Thornburg_-_Real_Returns.pdf

[KCLarkin]

Rob Arnott has a couple good articles on this:

http://www.riabiz.com/a/5814459/is-your-alpha-big-enough-to-cover-its-taxes-a-classic-journal-article-revisited

[netnet]

It depends.

 

You alluded to the analytical problem: Are you sure the compounder is not  Enron. That is not really factitious answer, you have to be sure that you have a high quality compounder (that is not totally over valued, say Coca Cola in 2003).  You can do a blended strategy, which is sort of what Buffett did in his partnerships. 

 

Better than an academic study, when asked, Buffett said both strategies are good. (at least for small amounts of capital)

[Guest Schwab711]

First, going in with a goal for actual returns seems likely to lead to a lot of mistakes. I think aiming for a level of expected returns and being disciplined will limit some of those same mistakes (no different than a discipline company only spending when expected ROIC hurdles are met). Nit-picking but it's about approach!

 

Completely agree with netnet. Quality companies can be very expensive traps if you are wrong about quality (obviously). Cloning will only tie your destiny with others. I think this strategy works best if you are the broad knowledge base-type. Being well versed in various types of history disciplines seems absolutely necessary. I wouldn't even venture outside the areas of history you know well (don't buy a cheap quality German company if you know nothing about the area and laws?).

 

As to trading in-and-out of equities trading at a discount to projected IV, I think everyone does this to some extent. The deep-value guys make a living off of price-multiple appreciation. Ultimately, when you go long an equity, your total returns = (1 + ME) * (1 + OR)^N.

ME:= Multiple Expansion

OR:= Operating Earnings Growth

N:= Years investment is held

 

There is no way around this formula when explaining your capital gains! I wouldn't call the 2nd method trading but you should at least be aware that you are investing off of the weak-term in the formula (Sad I don't know the correct math terminology for strong/weak term in a formula, I was briefly a PhD candidate in math after all until I chased $ now! Does anyone know it?). Your results will be proportional vs exponential. Do you really think you can re-invest your entire portfolio annually in low-to-no growth securities whose Price Multiples will increase 30%? That is essentially your strategy.

 

If investing was like fishing, the QCs with high EG vs. LQ LG companies is fishing with friends vs. by yourself in the rain. Similarly, PM expansion is like catching a fish relative to the fun you will have, it's a great bonus but not necessary. The higher expected fun for the trip is with friends. The risk of identifying real friends! :)

[berkshire101]

Thanks for the replies and links guys.  I guess the reason I asked this is because you see hedge fund guys like Ackman, Tepper, Loeb, etc. have great track records.  Some above 20% net of fees.  How do they do this?  Well, they're billionaires for a reason.  But are those gross or after-tax returns? 

 

I've had success with buying (through a virtual account) concentrated positions in these GARP companies when they're out of favorite.  CLB, ROST, and PETM were a good recent examples. 

 

So I was thinking maybe do a blend of GARP and Net-net.  If it doesn't work out then I'm stuck holding onto a pretty high-quality business (assuming it's high-quality to begin with).

[Guest Schwab711]

Thanks for the replies and links guys.  I guess the reason I asked this is because you see hedge fund guys like Ackman, Tepper, Loeb, etc. have great track records.  Some above 20% net of fees.  How do they do this?  Well, they're billionaires for a reason.  But are those gross or after-tax returns? 

 

I've had success with buying (through a virtual account) concentrated positions in these GARP companies when they're out of favorite.  CLB, ROST, and PETM were a good recent examples. 

 

So I was thinking maybe do a blend of GARP and Net-net.  If it doesn't work out then I'm stuck holding onto a pretty high-quality business (assuming it's high-quality to begin with).

 

You probably won't find quality in net-net land but you can certainly find good stuff that's undervalued on a purely fundamental basis.

 

A lot of the investors you mention are somewhat activist investors that can force catalysts. I don't think this is anywhere near as easy of a skill is it may appear but it really expands your pool of potential investments and can increased returns by shortening time. Pretty sweet advantage over the small capital guys. Small capital may be able to earn higher returns but more money vastly decreases risk. I probably wouldn't be so strict with my investment criteria as I am now if I had more capital. Investment strategy should be extremely flexible based on capital, skill/expertise, income/capital, and more. There is no WAR metric for investing like with baseball, this game is unimaginably complex to model.

 

As to the best strategy, I thought the most logical method to find the strategy that works best for me is to attempt to physically calculate the expected returns for a potential investment over various time periods. Come up with IV ranges for each period. Do enough of these reviews to get a large enough sample size. Classify the potential investments by similar characteristics and compare groups. At least look at these stats while eliminating outliers too. This gives you an idea of the best strategy based on the investments you are capable identifying. What use is it trying to read white papers outlining expected returns of complex derivative or FX strategies if you can't identify potential investments for those strategies? You should probably continue to do this throughout your life to see how things evolve with more data. As your knowledge base expands over time the types of potential investments you identify will expand as well.

 

I'm positive that when Buffett says he doesn't use spreadsheets it doesn't mean he doesn't agree with their validity. He has modeled so many investments over decades that he is pretty accurate in his estimates of the IV range as he tinkers with growth rate (and discount rate if you like extra variables). For most on this site with less than 10 years experience, we should probably show our work.

[thepupil]

berkshire, you mentioned on another thread you spend $7K / year and save 80% of your income. Solving that math problem means you make around $35K.

 

why on earth are you worried about taxes on what you make from investments? You are not tax particularly tax sensitive at your level of income (and I'm guessing assets).

 

With regards to "higher fees", I'm assuming you mean commissions. Interactive Brokers has very low commissions and I see promotions to sign up for places like Chuck Schwab and Merrill Edge and get 100 or 200 free trades all the time. You have to fiendishly turnover your book for commissions to matter as a non-professional; professionals actually still pay a good amount in commissions.

 

I would ignore taxes and commissions for now and focus solely on investing. When you're making $200K living in high tax state and paying a 50% all in tax rate on short term gains, then maybe you should worry about taxes.

 

Generally returns you see for guys like Ackman and Loeb are net of fees, gross of tax. No one pays the same tax rate so it would be impossible to show after tax returns.  Lots of investment $ don't pay or care about tax (including our personal pensions like 401ks and IRA's).

[thepupil]

all that being said, it is likely that tax efficiency and low costs will be a side affect of a reasonable approach to investing.

 

But they shouldn't be the goal, at least until you are making/have a lot of dough and don't have any in accounts with no tax friction.

[oddballstocks]

all that being said, it is likely that tax efficiency and low costs will be a side affect of a reasonable approach to investing.

 

But they shouldn't be the goal, at least until you are making/have a lot of dough and don't have any in accounts with no tax friction.

 

+1

 

My style of investing is more similar to Graham or Schloss with lots of cheap stocks that I sell once they hit IV.  I'm always on the hunt for something new, and quick to sell.  This strategy is stereotyped as terrible for taxes and fees.

 

I turn over about 10-20% of my portfolio a year at the most.  For example I turned over less than 10% of my portfolio in 2014.  Taxes aren't really something I'm focused on, I don't let the tax tail wag the dog.  Most investments even cheap small stocks take more than a year to appreciate to IV.

 

There is this myth of buying net-nets or low P/B stocks and recycling them every few months.  In my experience the reality looks more like this: buy net-nets or low P/B stocks and sit and wait forever as the price never moves.  Then suddenly a year or two later the price appreciates in a single day or two without warning and you sell.  The strategy works, but it's boring.  There's a reason no one is doing this, it's like watching paint try.  It's much more exciting to analyze managements or find compounders, but the strategy is sound, boring but sound.

[Jurgis]

It's much more exciting to analyze managements or find compounders

 

This might be off topic in this thread, but compounders are also boring to tears. Especially for active investors such as people frequenting this forum. There is no action - you just buy and hold. And hold. And hold.

 

That's why very few people ever held BRK or FFH (or for that matter MSFT, GOOGL, WMT, JNJ, IBM ) for 20+ years. And most of the people who did that are not "investors", but rather employees or in case of BRK old ladies from Omaha. ;)

 

Even most self admitted Berkheads or Fairheads on this forum have traded in/out of BRK/FFH more times than they casually admit. Or at least kept a non-trivial amount of their portfolio in companies that were sold much more often than compounding would call for. ;)

 

Unfortunately action is a drug. A very difficult drug to kick for active investor.

[netnet]

It's much more exciting to analyze managements or find compounders

 

This might be off topic in this thread, but compounders are also boring to tears. Especially for active investors such as people frequenting this forum. There is no action - you just buy and hold. And hold. And hold.

 

That's why very few people ever held BRK or FFH (or for that matter MSFT, GOOGL, WMT, JNJ, IBM ) for 20+ years. And most of the people who did that are not "investors", but rather employees or in case of BRK old ladies from Omaha. ;)

 

Even most self admitted Berkheads or Fairheads on this forum have traded in/out of BRK/FFH more times than they casually admit. Or at least kept a non-trivial amount of their portfolio in companies that were sold much more often than compounding would call for. ;)

 

Unfortunately action is a drug. A very difficult drug to kick for active investor.

 

Indeed, to quote Munger, quoting Pascal:" All of humanity's (or, in this case, an investor's!) problems stem from man's inability to sit quietly in a room alone."

[berkshire101]

It's much more exciting to analyze managements or find compounders

 

This might be off topic in this thread, but compounders are also boring to tears. Especially for active investors such as people frequenting this forum. There is no action - you just buy and hold. And hold. And hold.

 

That's why very few people ever held BRK or FFH (or for that matter MSFT, GOOGL, WMT, JNJ, IBM ) for 20+ years. And most of the people who did that are not "investors", but rather employees or in case of BRK old ladies from Omaha. ;)

 

Even most self admitted Berkheads or Fairheads on this forum have traded in/out of BRK/FFH more times than they casually admit. Or at least kept a non-trivial amount of their portfolio in companies that were sold much more often than compounding would call for. ;)

 

Unfortunately action is a drug. A very difficult drug to kick for active investor.

 

Indeed, to quote Munger, quoting Pascal:" All of humanity's (or, in this case, an investor's!) problems stem from man's inability to sit quietly in a room alone."

 

The spread between 15% to 20% is the difference between millionaire and billionaires haha.  So that's why it's difficult to sit quietly and do nothing.  Pretty sure Buffett and Munger weren't sitting quietly in their early days.

[Jurgis]

The spread between 15% to 20% is the difference between millionaire and billionaires haha.  So that's why it's difficult to sit quietly and do nothing.  Pretty sure Buffett and Munger weren't sitting quietly in their early days.

 

Yes. But very few people generate 5% annual alpha spread by acting vs sitting. Are you one of them? ;)

[berkshire101]

The spread between 15% to 20% is the difference between millionaire and billionaires haha.  So that's why it's difficult to sit quietly and do nothing.  Pretty sure Buffett and Munger weren't sitting quietly in their early days.

 

Yes. But very few people generate 5% annual alpha spread by acting vs sitting. Are you one of them? ;)

 

No  :-[ :'(

[AzCactus]

The spread between 15% to 20% is the difference between millionaire and billionaires haha.  So that's why it's difficult to sit quietly and do nothing.  Pretty sure Buffett and Munger weren't sitting quietly in their early days.

 

Yes. But very few people generate 5% annual alpha spread by acting vs sitting. Are you one of them? ;)

 

I think you can of course go wrong taking a profit especially in retrospect.  Also, those expecting Berkshire to generate 20% or even 15% per annum will likely be disappointed.  Size is the anchor to performance and to me Berkshire doing between 11-12% per year is more likely.   

[KinAlberta]

It's much more exciting to analyze managements or find compounders

 

This might be off topic in this thread, but compounders are also boring to tears. Especially for active investors such as people frequenting this forum. There is no action - you just buy and hold. And hold. And hold.

 

That's why very few people ever held BRK or FFH (or for that matter MSFT, GOOGL, WMT, JNJ, IBM ) for 20+ years. And most of the people who did that are not "investors", but rather employees or in case of BRK old ladies from Omaha. ;)

 

Even most self admitted Berkheads or Fairheads on this forum have traded in/out of BRK/FFH more times than they casually admit. Or at least kept a non-trivial amount of their portfolio in companies that were sold much more often than compounding would call for. ;)

 

Unfortunately action is a drug. A very difficult drug to kick for active investor.

 

It's like playing a lot of games, cards, gambling, etc.  The people don't play to win, they play for the thrill. I'm always amazed at people that can't hold index funds, mutual funds and efts, finding some excuse to avoid them completely.  Instead they adopt the view that they must be 100% into individual equities and this puts them in a precarious, fearful position when the market starts to move against them. 

 

We have evidence that index funds are near impossible to beat so it makes sense to allocate a good proportion one's invested assets and proportionate regular contributions into them.  Then if you are any good at investing you will soon overwhelm those indexed investments and can totally ignore them (like the savings invested in a house - you just let it ride through thick or thin.  Do the same with half of your savings) - index and forget.  If you aren't any good, or are just mediocre you will see the indexed funds move ahead of your own picks.  All along the indexed funds will serve as both a benchmark and as an insurance policy.

 

So, with index funds, unless they are in some booming sector I say never take profits. Commodity, tech, precious metals indexes I say take the profits. Individual companies like tech (or anything that lacks recession survivability I say take the profits.  You don't want to own something that turns from a good underpriced value at the start of a recession into an technologically obsolete value-trap before a protracted 5-10-15-20 year recession ends.

 

Companies that have a long history of surviving recessions, maybe even growing through recessions, I say buy and hold.  (I've held BRK for 20+ years.)

 

[Jurgis]

those expecting Berkshire to generate 20% or even 15% per annum will likely be disappointed.  Size is the anchor to performance and to me Berkshire doing between 11-12% per year is more likely. 

 

Nobody said that Berkshire is going to grow 20% or 15% going forward. The reference was to early Buffett/Munger years when they did trade more and generated 15-20% returns.

[Jurgis]

Good post KinAlberta. +1

[KinAlberta]

Note that in 2008 Buffett had $600 million in cash and short term investments in his personal account*.  Something makes me think he saw fit to take some profits. (I believe a couple years earlier, maybe about 2005, or 06 he had said in some interview that he was mostly in treasuries because he couldn't find anything cheap.)

 

In the early 1970s he said he got out of the markets (closed his partnerships) because he didn't want to end up with 'mediocre returns'. (Per the footnote in a Fortune article of the day.)  Again, he took profits. Still even then he continued on his own investing a bit and owning companies. So he never totally left the market.

 

 

*It's so cool that the guy has probably become a billionaire twice, though two different routes, first via BRK by never selling a share, and secondly via his personal account doing who knows what.

[KinAlberta]

Good post KinAlberta. +1

 

I have to add a huge qualifier:

 

Unfortunately I have found it incredibility hard to stay partially indexed myself. Sometimes to my financial detriment though importantly I have no compulsion to match or beat any arbitrary market index (which are just stupid artificial self-imposed goals uncorrelated to one's own circumstances, needs and risks) - I prefer sleeping at night.  Rebalancing between fixed income and equity indexes would have been a better process. Taking profits and holding cash - is something I've long questioned even though I'm again in that position myself.

 

However, I've long held BRK and added to my position and used it as a market proxy and a benchmark for my own performance. (Have traded FFH for 20 years and held for years too.)

 

I sold out of my indexed funds in the early 1990s because of market fears (and did well in the short collapse) but didn't jump right back into them - that was a mistake. 

 

Then again when Nortel became an obscene amount of the Cdn index in the tech bubble I bailed again (sold a lot of Nortel too but because I never understood its extremely high prices, I watched it fall by half before I started to bail at about $65/sh. I should have been indexing the Nortel gains on the way up because the indexes did better on the downside.) 

 

Then I did minimal indexing for 8-10 years finally put most of my portfolio into indexes and etfs a few years ago - only to sell because this market has been supported by government/fed intervention and nothing close to free market valuation practices. That scares the heck out of me about the future. (I'm re-reading materials on the 1920s to bone up on possibilities.) Nonetheless, my plan it to get out of holding as much cash and direct share positions as I am now and just lock 80% or so into index funds and forget about them. Then taking profits would be bad.

[Liberty]

Good post KinAlberta. +1

 

Yes, good post.

 

There are times when I wonder if I should just index everything and forget about it. I'm already mostly just holding high-quality companies for the long-term, so it's not like I'm trading a lot and puffing and discarding cigar butts with a big churn, but there's something about it being "out of your hands" that reduces stress even if ultimate results aren't as good. It's more about psychology than anything else.

 

Not intending to do anything like that, but it's a thought that crosses my mind once in a while...

[innerscorecard]

We have evidence that index funds are near impossible to beat

 

It's not correct to give the statement like this. Market-cap weighted index funds are very hard to beat for mutual fund managers, net of fees and costs. The considerations are different for disciplined, trained and skilled individual investors.

[Liberty]

We have evidence that index funds are near impossible to beat

 

It's not correct to give the statement like this. Market-cap weighted index funds are very hard to beat for mutual fund managers, net of fees and costs. The considerations are different for disciplined, trained and skilled individual investors.

 

Indeed. The question is always, will I find out too late that I'm not a disciplined, trained, and skilled investor, but am actually just a schmuck pretending to be one? Heh.

[vinod1]

Let’s say your goal is to compound capital at 15% annually. 

 

I would suggest caution against setting return targets, every very reasonable ones. Buffett, Munger and Klarman, all warned about this very same point. I used to have a return target as well one time, but very quickly realized my mistake before it cost it me too much.

 

Setting a return target is individual equivalent of the Corporate Strategic Plan. It not only does not work but triggers so many other behavioral biases that it would hurt your portfolio.

 

Basically when you target return, you would be focusing on the upside ignoring risk. Of course, you would tell yourself that you would do no such thing. Since investing is not like working in a factory where you can decide to put in an extra 20% more time and make proportionally higher income. You get the returns that are available in the market. If your target returns are not available, you would be tempted to load up on risk to make it up.

 

Vinod

 

Vinod