Monday, June 10, 2013

The importance of expectations

I've had a post on a Greek net-net bouncing in the back of my head for a few weeks now.  As I've thought about writing that post I kept reading articles and blog posts where either readers or authors had unreasonable expectations.  It occurred to me that I've never clearly talked about my expectations for investments, and why they are important to the investing process.

This post probably crosses into the life advice category as well, but I've found that most life advice that's good advice is applicable to investing, good advice is universal.

Nothing can demotivate as quickly as unreasonable expectations.  This is just as true in finance as it is in marriage, or in a career.  Twenty-two year old's who expect to be sitting behind the mahogany desk on the top floor in three years are in for a rude awakening.  Individuals who expect marriage to be all bliss will be disappointed.  Investors who dig deep and do a lot of work on ideas and expect them to all go up will be disappointed.

There are two sets of expectations when it comes to investing, the investor's own expectations, and other investor expectations.  I want to talk about both.

Other investors

This is the easiest set to talk about; the expectations of others.  When the expectations of the market don't align with reality an opportunity exists.  Generally expectations are either overwhelmingly negative, or overwhelmingly positive.

An example of positive expectations can be seen when looking at any media darling growth stock.  The stock is modeled to have 15-20% earnings growth from now until eternity.  Simple models like this fail the Peter Lynch test.  Lynch talks about thinking of real world implications.  He mentions in his book reading a growth forecast and realizing that every person in the US would need to buy the product for the forecast to come true.  An expectation like that is unrealistic, and thus the stock is selling with too rich of a valuation.  Think about how many units would need to be sold to make estimates reasonable as a way to test the market.

Where I spend most of my time is evaluating negative expectations.  Many companies I decide to invest in have been left for dead by other investors.  Investors either expect the company to remain dead money, or to always trade in some tight range that's perennially low.

The key to being a successful value investor is determining the expectations the market or other investors are making regarding a stock, and then comparing those expectations to the facts, or the truth.

Sometimes investors have bad expectations because they don't have all of the information needed to make a correct decision.  Missing information leads to an informational advantage for investors with the information.  The better information also allows better estimates for what an investor might expect to happen in the future for a company.

I think too many investors get hung up on getting an information advantage.  Instead investors should aim for creating a patience advantage.  In many value stocks the selling owners are shareholders who've owned the stock since it was a high flyer.  The stock has fallen, the company has deteriorated, and they are finally throwing in the towel.  These are ideal sellers.  I get nervous when I see that most of a stock's ownership basis is value investors, or the only people talking about a stock are value investors.

Our own expectations

Here is a simple life lesson, people will talk endlessly about things that don't affect them.  People will talk about things that affect them if action isn't required.  If there is an issue that affects someone, and it requires the person to act it will be met with silence.

To become better investors we need to face our own expectations.  I've received emails from readers who tell me they're only interested in stocks that will triple, or go up 5x in three years.  Sure, I'm interested in those stocks as well.  If someone can email me where to find only those stocks I will sell everything I have for them.  I've had readers tell me they only want 20% returns, or they only want high quality net-nets.  A high quality net-net is an oxymoron, they don't exist, if a company is trading below NCAV there is a problem, guaranteed.

Why are our expectations regarding returns so incorrect?  I think some can be traced to Buffett, he famously quipped that he could guarantee 50% returns on $1m invested.  This is like Michael Jordan guaranteeing that he could single handedly beat any high school team in game of pick up ball.  With sports we recognize that superstars are naturally talented, and no matter how many hours we practice, 10,000, 20,000, we will never be able to perform at their level.

Yet Buffett seems so simple, he has this folksy wisdom, and he talks about how he just buys these good businesses and somehow he'd do 50% a year.  The sale pitch is enticing, and we start to believe if he could do 50% why can't we?  Just like we're not Michael Jordan, we're not Buffett either.  Knowing ourselves sets the basis for creating reasonable expectations.

Setting reasonable return expectations should lead to better investing decisions.  If my bogey is 25% a year and I'm only able to do 18% I might start to take on extra risks in an effort to juice returns to meet my goal.  I remember seeing a quote that 40% of investments fail, it's keeping the number of failures to a minimum that drives returns, not a few 30-baggers.  It's fairly easy for a company to go to zero, all they need to do is stop selling and spend down all of their cash, default on their debt and setup an appointment with the bankruptcy court.  It's very difficult for a company to double their sales, or triple earnings.

The second area of personal expectation setting is the time frame required for an acceptable return.  A friend of mine sent me a note months back stating that he set up a test portfolio in Yahoo with a number of stocks he had given up on.  He went back and looked at it and they were all trading higher, many at or above his original estimate of IV.  My friend is extremely patient, but no one is patient forever.  The longer we're willing to wait the better chance we have of an investment idea working out well.

I want to take a journey down a tiny rabbit trail for a second here.  I've had a few comments asking why I prefer to invest in profitable net-nets when research shows that the unprofitable ones end up doing better return-wise over the long term.  The reason I prefer profitable net-nets, or profitable low BV companies is because the profit gives me time for the investment to work out.  I can sleep well at night knowing a company isn't frantically spending down their cash pile.  Impending doom can be a motivator, but impending doom is also a stressor.  I prefer investments that might return less, but the tradeoff is I am willing to hold on to them over a long period and be patient.

I've come to appreciate that investments always take much longer than I expected to work out.  This is why investors seek out catalysts, it's an effort to reduce patience.  I'd rather work on my patience skills, because there are a lot more investments without catalysts out there, than with them.

Another pet peeve expectation is liquidity.  I realize that I probably have some readers who are tossing around serious money in the market, this isn't for you.  This is for everyone else who wishes they had a Ferrari, but really only has a Corolla.  It's possible to build, and liquidate positions in illiquid stocks with smaller amounts of money.  The key is patience and having a reasonable expectation.  In the past selling a stock used to involve going to the bank, taking the certificate out of the safe deposit box, driving to the post office, mailing it, and waiting.  Now we click a button on the computer and complain how illiquid a stock is when we don't have a fill in 15m.

We could all use a deep peer into our souls and examine our expectations.  Are we expecting too much, are we expecting too little?  Are our expectations causing us to make bad decisions?  The secondly look at the expectations others in the market have for companies we own.  Are there opportunities to take advantage?

Talk to Nate


7 comments:

  1. Nate:

    An excellent posting as usual!

    One thing I would like to mention is that a lot of investors complain about liquidity. A lot of stocks are not that liquid, HOWEVER, they are liquid enough for us individuals to build positions in. How many of us individuals are taking $25k or $50k or even larger positions? Not too many that I know...

    So I would suggest that individual investors who complain about liquidity frequently use that as a crutch to not take action....

    I've also shared ideas with people who have unrealistic expectations. A friend who is anxious to get into the market asked me for advice. I suggested that they look at CLWY. At the time it was trading for $.80/share. I figured the real estate was extremely valuable and if things go right, the company might be worth $3/share. I figured that this might take 3-4 years. He scoffed at my "foolishness". If he was going to go into the market, he NEEDED HIGHER RETURNS THAN THAT! ALSO, the time frame was WAY TOO LONG. How are you going to make money on dogs like that?

    Well, maybe that is why he has never invested, and probably never will.

    How many others like that are out there? They have unrealistic expectations about how things work, and returns that can be expected.

    If you can consistently earn 20% or so, and live within your means, you will be a rich man in time...

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  2. You will grow rich earning a lot less than 20% a year. Saving and investing at 6-7% will result in a large sum of money. 20% will result in exceptional wealth.

    Nate is correct. The key to investment success is patience. That's really all one needs.

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  3. WOW. fantastic call on CLWY. I love the "time horizon arbitrage" strategy and have experienced some of my best returns from these investments where you strongly believe the stock is worth a lot more than current price but you just have no idea when. In my experience these things tend to reprice sooner than many would expect.

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  4. Well over half of my portfolio is in illiquid securities. I'm not impatient in the sense of being unwilling to wait for the market to come to me. Instead, my problem is that I get very impatient when I have a lot of uninvested cash, which makes me inclined to buy something I can get my hands on right away instead of sitting around hoping to get a fill. There is a real opportunity cost of waiting in cash because there is no guarantee that a seller will ever hit your bid on a security. And since I am trying to get 15+% returns per year, cash today as even more undesirable than usual.

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    Replies
    1. When I have an excess of cash and a lack of compelling ideas, I try to focus my energy on finding and evaluating special situations or work-outs. This is standard piece of Buffett partnership advice.

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  5. The opportunity cost of holding cash with global markets at all-time highs is not terribly expensive. Any reasonable long-term value screen will not produce a plethora of results. Successful long-term investing is often about avoiding losses. Howard Marks said it best, "...if i avoid the losers, then the winners will take care of themselves." Staying fully invested at all times is not true value investing.

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  6. Nate,

    "The key to being a successful value investor is determining the expectations the market or other investors are making regarding a stock, and then comparing those expectations to the facts, or the truth."

    Would you care to write another article on this?

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