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Paradox of value investing
- Thread starter Cutten
- Start date
Quote from Rona1d:
the object is NOT to buy low and sell high. That is a very speculative approach and would be the same as flipping a coin!
"The Intelligant Investor" is the best book to read about value investing, and about investing in general.
???
Value investing is trying to buy something currently priced for less than you believe it is worth (buy low, sell high). I think you are giving my "buy low, sell high" some other meaning that I did not intend.
Joe.
Quote from Cutten:
Thanks tyrant for "getting it".
The real nub of the paradox is this - how can it be rational to own at $41 on the way up, if it was not rational to own at $41 on the way down?
Cost basis of $40 is irrelevant (except for tax reasons - let's assume a zero tax entity such as a pension fund, to make things simpler). Cost basis has no impact at all on what the correct decision at $41 is. Otherwise, it would be rational to own if you already owned from $40, but irrational to own if you were flat. An investment cannot be both a buy and a sell at the same price for two people identical in every respect except their cost basis or lack therefore. If you bought at $40 and it's now $41, you have $1 profit per share. You are in an identical position as someone who is flat and just bought at $41, but had $1 per share profit from some other investment. You can't say the first person should be long and the second shouldn't be long. Cost basis has no impact on investment decisions at the *current* price.
Cutten:
I don't think you're getting it.
If I'm a value investor, and if I think a stock is a buy at 40, I'm not willing to pay 41. What is paradoxical about that? Why does the fact that I'm not willing to pay 41, mean I have to sell it at 41 if I just bought it at 40?
Assume that I think fair value is 80....and I think 40 is where I have to buy it. If I buy at 40, the fact that it goes to 41 doesn't change what I bought it at. This seems to be what you are missing. The idea that it goes to 40, then goes up to 41, only means that 1) I no longer think it is a "deal" for buying and 2) I'm content to hold my position at 40 because at 40, is was a deal, it's still a deal when the stock trades at 41, or 50 for that matter. You seem to be confusing the price I'm willing to buy at, with the price I'm willing to sell at.
And by the way, if it goes to 41, and then goes to 80, oh well...sometimes the market is like that. Does that mean I have to second guess myself when it gets to 41, and wonder whether it will bottom there and go on up to 80? C'mon fellas, this is a standard plight of trading everyday. We make a decision that the market will later prove was right or wrong.
Either way, assume that I bought at 40 because it was a large discount to fair value which I calculate as 80. Provided nothing changes in the company that changes that 80 dollar figure, there is nothing that changes whether 40 is still a bargain for me. If it goes to 41, my purchase is still a deal, I would no longer buy at 41 because it isn't cheap enough, but I would not sell because it is not what I calculate to be fair value. Why is that a paradox???
OldTrader
By the way, I'm what I would call a value investor in real estate. I only buy real estate based on how big a discount it is to what I determine to be fair market value.
Once I have determined fair market value, I then calculate a maximum price I would be will to pay for a property. I'm not will to pay a dollar more so to speak.
But once I've bought, I'm not willing to sell to the next guy who might offer a dollar more either.
I was involved in an auction a few months back on a property. After looking at the property, I decided it might be worth $100K after some work was done to it.
I also determined that to be worth that $100K, I might have to have about $20K worth of various work done to the property.
Based on that, I decided I would be willing to pay up to $40K for the property. I felt like this gave me plenty of room to do repairs, even if they came in higher than I anticipated, to pay a realtor and closing costs, to pay carrying costs like taxes, utilities, insurance, etc, allow me to discount the property to under fair value if the weak market dictated I would have to do this to sell, and then to allow me a generous profit for the time, effort, and risk I would be taking.
As it turned out, another guy ended up bidding $60K, so I didn't get the property. It will be interesting to see how he does with the property. In the meantime, I knew what I though was a value for me. I have no problem how well he comes out. And had I bought it for $40K, I wouldn't have sold it for $41K, nor would I have paid that for it.
Paradox? Hell no.
OldTrader
Once I have determined fair market value, I then calculate a maximum price I would be will to pay for a property. I'm not will to pay a dollar more so to speak.
But once I've bought, I'm not willing to sell to the next guy who might offer a dollar more either.
I was involved in an auction a few months back on a property. After looking at the property, I decided it might be worth $100K after some work was done to it.
I also determined that to be worth that $100K, I might have to have about $20K worth of various work done to the property.
Based on that, I decided I would be willing to pay up to $40K for the property. I felt like this gave me plenty of room to do repairs, even if they came in higher than I anticipated, to pay a realtor and closing costs, to pay carrying costs like taxes, utilities, insurance, etc, allow me to discount the property to under fair value if the weak market dictated I would have to do this to sell, and then to allow me a generous profit for the time, effort, and risk I would be taking.
As it turned out, another guy ended up bidding $60K, so I didn't get the property. It will be interesting to see how he does with the property. In the meantime, I knew what I though was a value for me. I have no problem how well he comes out. And had I bought it for $40K, I wouldn't have sold it for $41K, nor would I have paid that for it.
Paradox? Hell no.
OldTrader
Quote from makloda:
Maybe a good analogy is the buying decision process you would go through when buying a brick and mortar private business, say a fast food restaurant.
Say a good friend of yours if retiring and offers you his sandwich shop. Say it makes 45k per year net after all wages and costs, depreciation of appliances and inventory and all taxes. Say you personally would consider 8 years net profit as your personal 'fair value' goal of a business. 8x45k = 360k. Now say you look for a safety cushion and are only willing to pay 80% of what you would usually consider 'fair value' in order to protect against unseen risk. That's 288k.
Your friend offers you the restaurant for 285k. Do you 'have' to buy it if you're a value investor? And then, what if you buy it for 285k and somebody offers you 365k (i.e. more than fair value) two years later? Do you 'have' to sell it now because you're a value investor?
I think most value investors look at value investing in public companies as owning parts of an actual business, not as a mechanical regime that forces them to buy and sell a piece of paper religiously at certain price points.
But *why* are they owning parts of a business? To make a profit. Hence they must consider bids and offers, and accept them if they will result in a more profitable outcome than holding or sitting flat.
Let's extrapolate your argument to its logical conclusion. If the business is limited liability, and is offered to them at 1 cent, do they have to buy? If they are motivated solely by profit - which all investors should be - then yes, they do have to buy. Let's say someone offers them $1 billion a day later, do they have to sell? Yes.
Now, at one point do the forced buy at 1 cent and the forced sell at 1 billion become no longer obvious? That's the point at which a profit-motivated investor can rationally hold onto the business.
Going back to my initial proposition - assume i) perfect ability to value the business ii) stable valuation iii) perfectly continuous security prices. How can a profit-maximising value investor stay flat at 1 cent below fair value, or fail to sell at 1 cent above fair value?
The only circumstance I can think of is if there are competing businesses that are even cheaper. But let's say that is not the case - I don't currently see how value investing methodology can let you do anything other than buy at 79.99 and sell at 80.01 (or 40 and 40.01).
Quote from OldTrader:
By the way, I'm what I would call a value investor in real estate. I only buy real estate based on how big a discount it is to what I determine to be fair market value.
Once I have determined fair market value, I then calculate a maximum price I would be will to pay for a property. I'm not will to pay a dollar more so to speak.
But once I've bought, I'm not willing to sell to the next guy who might offer a dollar more either.
I was involved in an auction a few months back on a property. After looking at the property, I decided it might be worth $100K after some work was done to it.
I also determined that to be worth that $100K, I might have to have about $20K worth of various work done to the property.
Based on that, I decided I would be willing to pay up to $40K for the property. I felt like this gave me plenty of room to do repairs, even if they came in higher than I anticipated, to pay a realtor and closing costs, to pay carrying costs like taxes, utilities, insurance, etc, allow me to discount the property to under fair value if the weak market dictated I would have to do this to sell, and then to allow me a generous profit for the time, effort, and risk I would be taking.
As it turned out, another guy ended up bidding $60K, so I didn't get the property. It will be interesting to see how he does with the property. In the meantime, I knew what I though was a value for me. I have no problem how well he comes out. And had I bought it for $40K, I wouldn't have sold it for $41K, nor would I have paid that for it.
Paradox? Hell no.
OldTrader
Yes but in your case, there is a clear reason for you not to buy at $99k - you would lose money because it takes time, cost, and effort to buy and fix up a property. We are talking about a pretty much costless transaction of buying a stock below fair value.
Quote from OldTrader:
If I'm a value investor, and if I think a stock is a buy at 40, I'm not willing to pay 41. What is paradoxical about that? Why does the fact that I'm not willing to pay 41, mean I have to sell it at 41 if I just bought it at 40?
OldTrader
Very simple question - what was it about the valuation at $41 that made it not worth owning the stock? Was the price too high?
Whatever the reason - does that reason not still apply once you have bought at $40 and it then returns to $41?
Put simply - if it was not worth owning at $41, how can it be worth owning at $41?
Quote from OldTrader:
If it goes to 41, my purchase is still a deal, I would no longer buy at 41 because it isn't cheap enough, but I would not sell because it is not what I calculate to be fair value. Why is that a paradox???
OldTrader
The paradox is that in the first statement ("My purchase is still a deal") you are saying you want to be long at $41, and in your second statement ("it isn't cheap enough") you are saying you don't want to be long at $41.
At $41, you either want to be long or you don't. You cannot want to be long AND flat at the same time. Yet in the space of one sentence, you said you want to be long, and you don't want to be long.
That's the paradox.
Quote from FerdinandAlx:
You seem to forget that the equity you build up in a position acts as a margin of safety just as well.
You also seem to forget that the decision to sell is based on the company reaching its intrinsic value. It doesn't come up at any other price level except if a better investment opportunity presents itself.
Equity you build in a position does not act as margin of safety at all. You have already made that money - if you lose it, that is a loss of capital that is yours.
To demonstrate - let's say you have a net worth of $1000, and invest in a stock. You have found the next MSFT and it eventually rises 1000 fold, giving you a net worth of 1 million dollars. Are you claiming that if the stock then plummets 99.9% back to $1000, that you haven't lost any money? Obviously that's ridiculous - you have just lost $999,000, a catastrophic wipeout of your net worth. Therefore equity in a position is not margin of safety, it is your money and any loss borne by it is just as real a loss as losses suffered on your initial investment.
I did not "forget" that the sell decision is based on the company reaching fair value - I challenge you to find where I ever said that. What I claimed is that if you did not think the stock was worth owning at $79 in the first place, why do you suddenly think it is worth owning at $79 now?