Paradox of value investing

[Cutten]

Quote from FerdinandAlx:

Equity builds up as the shareprice increases, maintaining the margin of safety. Stop trying to turn this into a financial version of Zeno's paradox.

You ignored the part where I said "assuming the intrinsic value stays the same". Profits on the open position of course do not provide a margin of safety, since they are identical to someone in a similar position who simply adds an equivalent amount to their account from other sources. Open profit is the same as initial capital - it buys the same amount of goods, has the same economic value etc. I proved this using the MSFT-style example - rather than respond, you are just repeating your initial assertion.

This isn't equivalent to Zeno's paradox. Please don't insult me by assuming I am just trying to play a logic game - I am actually trying to get to the *true* reasons for rationally holding during a large price move.

As evidence of sincerity, consider that firstly I'm admitting some discrete profit margin (1 or 2 ticks). Second, I am not saying holding for a large price move is irrational. I'm simply saying that an assessment of valuation alone does not seem to give any reason to wait for a large dip, then hold all the way back up. The valuation argument alone only seems to allow buying a tick below your desired entry point, and selling a tick above it. There must be some other rationale for holding further - I want to know what it is, and am hoping that a value investor either provides it (not seen that yet), or admits they don't just use valuation and in fact use some other rationale for holding for such a long time.

I started this thread, hoping that a sincere debate and intellectually honest enquiry could result in myself and others gaining knowledge. So far, at least one poster has indulged in point-scoring and other politician-style debating tricks. Please do not emulate him.

 

[Cutten]

Quote from Rona1d:

There is no correct way of finding the actual value of the company. THere are to many unknowns. THerefore, each persons evaluation in a company might be different than yours.

I'm well aware of that, however it does not alter the fact that value investors i) claim they can value companies with some certainty - at least, they claim they can arrive at a lower boundary for valuation, such that the stock is objectively "cheap" below this price; ii) even if the valuation is inaccurate, the value investor still invests based on their assessment. They still face the same problems of rationale, *even if their valuation is wrong, or unclear*.

In any case, to avoid confusing the issues, I stipulated earlier in the thread:

"2) Let's assume we are perfect analysts and can arrive at the exact fair value for the stocks we buy (if we can't, then we pass on them). That's fine and doesn't affect my point."

So - let's assume for example that the stock is a company that just owns $1 million in T-bills. Pretty uncontroversial valuation there, isn't it? So, how does a value investor justify not buying at $999,999? Why would they wait for $500,000, and not buy at $501k, 502k...998k,999k?

 

[Cutten]

I think in my last post I've stumbled on a way to make this paradox much more clear to some of you. Let's say you have a company with a market cap of $1 million. It owns T-bills, the amount is not entirely clear, but your analysis tells you that it's either $900k of T-bills, or $1 million of T-bills, and you estimate the probability at 50:50 between the two possibilities. Your estimate is not 100% reliable but you are pretty confident in it.

As a value investor, could you answer the following questions please?

1) tell me the price at which you would buy the company, and give your rationale

2) If immediately after purchase, you got an offer for the company, at what price would you sell?

3) If you would sell at a price of X or higher, why would you not buy at a price of X minus 1 dollar? Assume no transactions costs or taxes for the purchase or sale - the entire process is essentially effortless.

I look forward to your replies.

 

[FerdinandAlx]

The rational for holding further is that there is an expectation that share price and intrinsic value will continue to contract.

The reasoning is thus that a stock trading at 50% of intrinsic value will increase more than a stock trading at 99% of intrinsic value, as well as providing a greater margin of safety.

In theory, this provides the investor with less risk and greater reward.

 

[Cutten]

Quote from FerdinandAlx:

The rational for holding further is that there is an expectation that share price and intrinsic value will continue to contract.

The reasoning is thus that a stock trading at 50% of intrinsic value will increase more than a stock trading at 99% of intrinsic value, as well as providing a greater margin of safety.

In theory, this provides the investor with less risk and greater reward.

Would this imply then that the value investor should scale in to the stock, rather than buying all at one price?

Even then, there's the slight problem of how to scale out. We might end up with 40 scale in buys, and then be compelled to scale out 1 cent higher The same problem as before, just multiplied many fold. If the risk/reward is not so good at $79 as at $40, then I would assume the investor wants to own much more at $40 then he does at $79.

 

[u21c3f6]

Quote from Cutten:

I think in my last post I've stumbled on a way to make this paradox much more clear to some of you. Let's say you have a company with a market cap of $1 million. It owns T-bills, the amount is not entirely clear, but your analysis tells you that it's either $900k of T-bills, or $1 million of T-bills, and you estimate the probability at 50:50 between the two possibilities. Your estimate is not 100% reliable but you are pretty confident in it.

As a value investor, could you answer the following questions please?

1) tell me the price at which you would buy the company, and give your rationale

2) If immediately after purchase, you got an offer for the company, at what price would you sell?

3) If you would sell at a price of X or higher, why would you not buy at a price of X minus 1 dollar? Assume no transactions costs or taxes for the purchase or sale - the entire process is essentially effortless.

I look forward to your replies.

Please remember that I am answering in context of the given variables. One of the items missing in the example is time frame so I will add it.

First, I am conservative so I would use the $900K estimate. Next I will assume that it takes an average of 1 year for the market to "agree" with my valuation. Using these variables assuming no other costs or losses, 15% per annum would be an acceptable return to me. Therefore I would purchase at $782K.

I would sell at $900k less risk-free interest rate if offer is made in less than a year.

I would buy at any price that would give me at least a 15% per annum return based on the valuations.

Joe.

 

[QuadLaser]

Cutten,
You have come up with a very clever paradox to which there is no rational basis to defend value investing. The truth is that all value investors ARE forecasting. They are forecasting that the stock will reach their idea of fair value. That is why they can hold through $41 on the way up.

There are also costs to transacting in the real world. Commissions and finanacing of positions have a very real cost on trading, and buying and selling for a 2 cent profit is simply not possible for most investors.

If there were a synthetic trading game, where complete true value was 100% defined for a company, the market for this company would be FV - 0.01 bid, FV + 0.01 offered, and it would never fluctuate. This would satisfy your arguement. But we don't know fair value, and we have costs, emotions, financing, other opportunities, and a myriad of outside forces that make your ideal value investing scenario unrealistic.

 

[Cutten]

Quote from u21c3f6:

Please remember that I am answering in context of the given variables. One of the items missing in the example is time frame so I will add it.

First, I am conservative so I would use the $900K estimate. Next I will assume that it takes an average of 1 year for the market to "agree" with my valuation. Using these variables assuming no other costs or losses, 15% per annum would be an acceptable return to me. Therefore I would purchase at $782K.

I would sell at $900k less risk-free interest rate if offer is made in less than a year.

I would buy at any price that would give me at least a 15% per annum return based on the valuations.

Joe.

Ok, thanks for explaining. I agree that the time value and risk preference is important. I would point out that buying at 900k here is essentially a riskless investment. So paying anything less than 900k minus t-bills return is basically turning your nose up at a risk free return in excess of t-bills. Why would you keep your money in cash, when at the T-bills equivalent minus $1 valuation, you can buy and guarantee to earn a higher return than your cash in the bank?

Also by saying you are risk averse, you are saying that you will not risk 1 dollar for a 50/50 chance of making $100,000. In that case how can you ever buy a stock, since you will never get a 50,000:1 payoff in the stockmarket.

 

[u21c3f6]

Quote from Cutten:

Ok, thanks for explaining. I agree that the time value and risk preference is important. I would point out that buying at 900k here is essentially a riskless investment. So paying anything less than 900k minus t-bills return is basically turning your nose up at a risk free return in excess of t-bills. Why would you keep your money in cash, when at the T-bills equivalent minus $1 valuation, you can buy and guarantee to earn a higher return than your cash in the bank?

Also by saying you are risk averse, you are saying that you will not risk 1 dollar for a 50/50 chance of making $100,000. In that case how can you ever buy a stock, since you will never get a 50,000:1 payoff in the stockmarket.

I don't agree that buying at 900K is "riskless". Remember, we are buying stock. The market determines the price. There are many companies whose stock sells for less than their "value" but until the market recognizes that value and prices it accordingly, you may be holding on to a stock that just stands still or even goes down.

Joe.

 

[FerdinandAlx]

Quote from Cutten:

Would this imply then that the value investor should scale in to the stock, rather than buying all at one price?

Even then, there's the slight problem of how to scale out. We might end up with 40 scale in buys, and then be compelled to scale out 1 cent higher The same problem as before, just multiplied many fold. If the risk/reward is not so good at $79 as at $40, then I would assume the investor wants to own much more at $40 then he does at $79.

Well, a value investor could begin scaling in when his requirements for a margin of safety have been met. He could also choose to buy all at once, as he would rationally expect the stock's price to contract towards its intrinsic value rather than continue its decline. A principle of caution is valid though, since the value investor can't claim that markets work completely efficient in the short term. Doing so would invalidate his method.

The investor could start scaling out once intrinsic value is reached.