Compounding Life

I enjoy reading old finance and investing books for many reasons. Most of the time the enjoyment is derived from the history lesson or seeing folly from the past that we continue to repeat in the present. Ocassionally there are some very entertaining gems like the one I found in “The ABC of Options and Arbitrage” (free download from archive.org) by Samuel Armstrong Nelson, published in 1904.

As most of the readers probably know the main difference between American style and European style options contracts is when they can be exercised by the buyer. European style options can only be exercised on the expiration date where as American style options can be exercised any time before expiration.

Why might it be that this difference exists? Samuel proposes one answer:

The London buyer of options is accustomed to “trade
against his options” to a much greater extent than the
New Yorker, and trading of this character calls for quite
complicated calculations that would puzzle and confuse
the average American stock speculator who wants a sim-
ple, rather than a complicated proposition, and who prefer-
ably always demands a quick, rather than a slow decision.
The English stock speculator apparently is slower, more
patient and willing to work harder to secure a profit than
his American contemporary, who despises small profits, and has a world-wide reputation among financiers for his
failure to give proper regard to his interest account.

At CGI Las Vegas I listened to presentation by John Del Vecchio from Ranger Alternatives. John manages the Ranger short book and has a strong background in accounting forensics. Specifically finding companies with low earnings quality before the market does and building “short” positions based on that information.

In his presentation he referenced some stats from a Blackstar Funds paper on the Russell 3000 index between years 1983-2006.

Russell 3000 stats 1983-2006

39% of stocks were unprofitable investments

18.5% of stocks lost at least 75% of their value

64% of stocks underperformed the Russell 3000

25% of stocks were responsible for all of the market’s gains

Well obviously an enterprising investor after reading this would be diligently researching looking for the %25. If you only invest in those companies you are sure to outperform the market. Well not always…

What a difference a day makes

The paper also gives us a sampling of some of the best performing stocks during that time period and their performance after the peak:

Thoughts

It would be interesting to see of the %25 that made up %100 of the gain in 1983-2006, how many companies would still be worth owning today. Looking at that list there are a couple. Of course there are some that would have resulted in a permanent loss of capital and some that are not permanent losses yet but for which the immediate future is not bright. Lets take a quick look at a couple…

GE

If you had bought GE on 01/03/83 at its closing price of 91.75, split adjusted (48:1) each share would be worth around $670 today. I figure thats about %8.3 compounded annual gain. If you had sold that share before the market drop you would have approximately 3x that amount somewhere around %12.5 compounded annually. Not including dividend payments. While GE is a mess today, its fair to say you could of done worse things than buying a share of GE in 1983.

MSFT

If you had bought MSFT when they went public on 03/13/86 at $28, split adjusted (288:1) each share would be worth around $8000 today. Around %29.3 compounded annually. Not including dividend payments.

Conclusion

This data reinforces a couple of points that I sometimes temporarily forget.

1. If you own a sub par company because it was undervalued when you bought it, sell it when it reaches intrinsic value and take your profit. There is no reason to hold it afterwards because it is likely to fall into the %64 that under perform the market. If you sell it and move on to the next value you will be on your way to out performing the market.

2. Paying a little bit of a premium for a a great business with a great moat and great management can pay off big time.

3. I think people should really call “buy and hold” “due diligence, buy and due diligence hold, rinse repeat”.

Paul Graham is well known in the start up world, probably not as much in the value investor world. Paul has a bunch of great essays on his site. One that I really enjoy is “How to do what you love” .

While they are all good this post was inspired by reading “How to Fund a Startup”. I think this essay is very informative on a couple of different levels.

Value investors are generally not interested in Initial Public Offerings of startups, for good reasons. I still think its important though to understand the process that most startups go through in their quest to get acquired or go public. Not to say that either of those two are the goal of all startups but in a lot of cases that is the exit plan. Its also interesting to note just how early on the differences between company managers and investors start to manifest. Of course in these early stages the founders usually do have a major stake so they are of course shareholders as well but not always “investors” meaning they do not have as much capital in play.

A great quote from the essay:

I don’t mean to suggest that our investors were nothing but a drag on us. They were helpful in negotiating deals, for example. I mean more that conflicts with investors are particularly nasty. Competitors punch you in the jaw, but investors have you by the balls.

I find this comical because in a lot of cases after the company has gone public and the original investors have cashed out the tables can be turned rather quickly to a situation where people running the company can have the investors “by the balls”.

Lately I have been reading the quarterly and annual reports from the “Oak Value Fund”. Not because I am interested in investing in their fund but because they are well written reports that summarize the market weather from the perspective of a value investor and they go into good details about their holdings and their reasons for buying or selling their positions.  

The Oak Value reports are reminiscent of the Berkshire Hathaway annual letter to shareholders but offer yet another perspective because they do not buy entire companies and they will open and close positions more often.

I reiterate, I have no intentions of investing in this fund nor do I make any recommendation that any one else does. I just feel there is some good reading in their reports.  One interesting note is that OAKVX is a fairly small fund with only around 58 million is assets.