Sunday, 22 September 2013

A crucial investing question: Do you know your time frame?

by Barry Ritholtz 

Do you suffer from time frame confusion?
That question came up recently when I was asked about a specific stock. Although we did not own that stock, I discussed why its sectors (health care and biotech) had been doing well in recent years — and would probably continue doing well. It has been part of our long-term view that these industries will thrive in the coming decades.
But this particular name had just run straight up, Apple-like, and I mentioned that in the short term, it might be due for an Apple-like pullback as well.
Subsequently, an investor asked, “You mentioned the stock was overbought and could pull back, so how does that square up with your long-term view that this stock and sector can do well?”
Short answer: It doesn’t.
Longer answer: Never confuse investing with trading. The short-term swings in prices are mostly noise; volatility is often a reflection of traders’ emotions. Longer-term price changes reflect earnings and valuation.
Hence, if you are saving for retirement, the fast in-and-out trading is irrelevant. Our clients’ investment profiles are typically looking out many years and decades. What a stock does over the next 30 days is essentially a trading question, and irrelevant to them.
Whenever you hear a discussion about the short-term swings in any given stock’s price, your immediate thought should be whether it matters to why you are investing. Consider what your time frame is and you will figure out what your answer should be. Indeed, much investor confusion and quite a few investor errors involve making the mistake of investing for one time frame and behaving in another.
Perhaps a few examples of shifting time frames might help illustrate this.
A classic trading rule: “Never turn a trade into an investment or an investment into a trade.” A trader’s goal is to take advantage of the volatility of daily price fluctuations to earn a short-term profit. This is a defined holding period (i.e, before the market closes that day; 48 hours, etc.). A trader who extends this into a longer frame — usually because the trade went against them — is making a classic time frame error. How many traders who shift a trade into an investment have done all of the requisite research, thinking and planning for a longer-term hold?
This reveals the shifting of time frames for exactly the wrong reasons.
Investors can make a similar mistake. They own something with an expected multiyear holding period, only to bounce the stock on some very short-term news — a critical review of a product, a negative research report, a 5 percent price drop. I doubt any of these investors has in their long-term plan “I will sell XYZ if an analyst downgrades the stock.” Yet that is what they do all the time.
Good investors must learn to contextualize the daily background noise. That is my phrase for the never-ending proliferation of economic news releases, media broadcasts, technical updates, and cable TV shows that are mostly meaningless time fillers. Television and radio have 24 hours a day to fill — does anyone believe that all of that content is meaningful? The Internet has an infinite number of pages to fill — guess how many are truly valuable?
Minute-to-minute: A very noisy and constant flow of prices, rumors and chatter about stocks; this is the realm of day traders, Twitter and institutional desks. If you are an investor, nothing is more meaningless to you than this time frame.
Hourly: Similar to minute flow, only now we can add how the stock opens or closes. Traders can be heard to say things like “strong open in XYZ” or “I hate the way the ABC closed.”
Daily: Filled with random gains and losses, driven mostly by the overall market (my guess 35 percent) or the equity’s sector (about 30 percent). News flow often pushes prices in one direction, only to quickly reverse after a short period. Still reflects economic and other noise overall.
Weekly: Informative charts: Overall trend begins to show. Begins to smooth out the random movements. Noise factor considerably less. Good way to think about cyclical markets (i.e., two to five years).
Monthly: Provides a window into longer term, decade-long secular cycles. Most traders ignore the monthly charts — too slow, they say — but these can give you some insight into real (vs. false) reversals.
Quarterly: Valuation data comes into focus via earnings. A longer-term view allows potential mean reversion to be taken advantage of (via rebalancing).
Annual: For retirement planning and life events. Yearly data put the rest of the noise into perspective. Most of the weekly or monthly random up-and-down movements get smoothed out. Ultimately, this is where long-term investors should be focused.
Decades: The market historian’s friend.
What’s your time frame like?

How To Improve Your Value Investing Returns

Do your value shares go higher after you've sold? Here's what to do.
I'm a dyed-in-the-wool deep-value investor and have noticed two things about my strategy:
1. It works more often than it doesn't, and;
2. When it works well, the shares often go on to far greater things after I've sold.

Regarding the first point, remember; my strategy doesn't -- and can't -- work every time. In my experience, my approach simply works far more often than it doesn't, and I gradually come out well ahead.

As for the second point, we all have to learn to accept it as an inevitable part of being a bargain-value hunter. You will see recovery situations go on to greater things after you've seen the basic value 'come out'.

What to do
But there are a few actions to take that may help maximise your returns.

First off, if your bargain-value selection offers the best of all worlds; i.e. if there's some simultaneous excitement from a little growth potential, then be patient.

Often, value shares that are successful turnarounds become growth stories, or 'GARP' shares (growth at a reasonable price). In these situations, it may be wise to wait.

If you're unsure about what to do, but the basic value has come out, then selling enough to retain your original stake and letting the rest run for free can be a good tactic.

Selling too soon?
Personally, I usually sell too soon. You may have heard the phrase 'leave something for the next guy' from value investors. What they mean is that, when the basic value is out, it's out -- so let the future price do what it will. If it goes on to a 'fuller' value, then so be it.

You will rarely be able to buy at the bottom or sell at the top. Buying at a level you perceive as cheap and selling at a more reasonable value is what my deep-value approach is all about.

But I've realised that as a value investor, I can be too pessimistic about future prospects, just at the point of turnaround.

Run the winners longer
Consequently, I've resolved to run my winners longer. The value in deep-value shares can come out over days, weeks or months, but more usually it takes years. So a resolution to be patient and not to be tempted into too short term a profit, and to allow for a modicum of optimism should help not leave too much in for the next guy!

Don't stop loss
Stop-losses may be a useful tactic in certain situations. But on the whole, they don't work. They certainly aren't appropriate for value investing in my opinion. If an investment declines by 10% in a company which you perceived as undervalued, and there has been no fundamental change in the value metrics, then why would you sell?

The answer is that you wouldn't. If anything, have the courage to average down your purchase price.
A stop-loss can be helpful if you think the shares have further to go as they begin to enjoy a growth rating.

Be sure about your safety margin
In order to be confident about averaging down, though, you need to be sure about your safety margin.
The three most important word's in Benjamin Graham's lexicon were 'margin of safety' -- the price at which a share can be bought with minimal downside risk.

A substantial margin of safety exists when a share is available at a big discount to its 'fair' value. By building a substantial margin of safety into your investments on the basis of well-researched factual information, you will help protect the downside.

Being as sure as you can be about the safety margin in the first place will give you the confidence to average down. You will also have the information you need to set something like a fair price target, however long it takes for that price to be reached.
But even with this strategy, there will still be ones that go wrong.

Don't try to time it
Don't try to time the market. There's an army of people out there with endless data. Why would you know better?
Instead, try to find companies trading at historically low prices and on historically low ratings with strong balance sheets and wait for the value to come out.
As Ben Graham said "[investors] … should rarely buy [shares] when their short-term prospects look bright."

Don't over trade
And finally, a reluctance to trade will help you maximise your value investing returns. Remember, trading costs and most frequent traders lose money.

By David Holding