Assessing Investment Performance

“The performance of investors who add value is asymmetrical.  The percentage of the market’s gain they capture is higher than the percentage of loss they suffer …. Only skill can be counted on to add more in propitious environments than it costs in hostile ones.  This is the investment asymmetry we seek.” — Howard Marks

The end of a calendar year is typically a time for reflection and contemplation for most people, both on a personal and professional level.  If such reflection is to be more than a surface level passing thought, one must bring a certain amount of discipline and rigor to the process.  One year is plenty of time to assess the success or failure of a diet, exercise program, or quitting smoking but it is but a short blip of time in the world of business.  Since all intelligent investing puts the investor in the role of a businessperson, it follows that a single year is not a meaningful timeframe to evaluate investment performance either.

The vast majority of professional investors do not have the luxury of claiming that one year is an insufficient amount of time to evaluate performance.  The incentive structure and culture of most firms make annual performance paramount and the individuals and institutions entrusting funds to money managers often have even shorter frames of reference.  This is why closet indexing, window dressing, and other counterproductive actions are so prevalent.  Fortunately, individual investors do not face these institutionalized pressures.  An individual investor’s worst enemy is likely to be himself and therefore the struggle is internal and mostly a matter of temperament and personal discipline.  In this article, we ignore the pressures facing professional investors and focus on how to rationally assess performance in a way that can be implemented by individuals.

Annual Performance

One year is not a long enough period to assess performance but obviously longer periods are made up of shorter chunks of time.  As a matter of convention and convenience, it is natural for investors to look at performance annually.  This is not harmful as long as these annual periods are viewed in a longer term context.  Most investors probably look at annual performance but it is apparent from reading news articles and comments in venues such as Twitter that, in many cases, performance is not viewed correctly especially relative to benchmarks.

Investors who utilize brokers such as Vanguard or Fidelity can delegate the task of measuring their overall annual performance to the figures presented on annual account statements.  Those who prefer a more proactive approach can easily create a spreadsheet in Microsoft Excel that calculates the internal rate of return (IRR) of a portfolio based on transaction activity during the course of a year.  Such a spreadsheet must include the beginning account balance along with all additional purchases, sales, income received, commissions paid, and the ending account balance.  Depending on the complexity of an investor’s situation, it might be useful to calculate the IRR of sub-accounts such as taxable and tax-deferred accounts separately.  This is particularly useful for sub-accounts employing significantly different investment strategies.

Most United States based investors tend to use the S&P 500 as a benchmark but there isn’t really anything written in stone dictating the use of this benchmark.  Investors employing strategies focusing on very specific niches, such as small capitalization stocks, should probably pick a different benchmark.  It is critical to include dividends in the performance of the benchmark.  Most articles and tables in newspapers present only the price change of an index rather than total return.  This can be meaningful.  For example, in 2015, the S&P 500 had a slightly negative return based on price alone but a slightly positive return when dividends are considered.

Some investors prefer to use an investable benchmark such as the SPDR S&P 500 ETF (SPY).  The argument for doing so is that one cannot directly invest in the S&P 500 and must bear the small costs of an ETF or other index fund to implement a passive investment strategy.  In reality, whether one uses the S&P 500 or SPY is not likely to materially impact the question of whether an investor possesses sufficient skill to actively manage a portfolio.

Once a benchmark is chosen, it is important to not make changes to which benchmark is used except when clearly justified.  It is also intellectually suspect to switch to a different benchmark retroactively in an attempt to make performance look better.  Ultimately, all an individual is doing is fooling himself with such actions.  Benchmarks should only be changed if there is a clear change in strategy that fully justifies the change and benchmarks used in past years should not be retroactively changed.

Multi-Year Performance

If we refer to the quote by Howard Marks at the beginning of this article, it is apparent that skill must be measured over multi-year periods.  But how many years is sufficient to determine whether an investor has skill?

It is not a good idea to refer to a fixed number of years as a sufficient amount of time to measure skill.  Instead, it is important to consider the overall market environment and pick a timeframe that includes both a major bull and bear market.  Why is this the case?  It is very possible, and indeed likely, that an investor with a proclivity for taking huge risks will dramatically outperform a benchmark over the course of a strong bull market.  It is difficult to know whether the investor took these risks intelligently or not without observing performance during bear markets.  It is also possible, and very likely, that an exceedingly risk averse investor will dramatically outperform a benchmark during a severe bear market, but it is difficult to know whether such an investor was uncommonly wise or just inherently incapable of taking intelligent risks without observing performance during a subsequent bull market.

In general, stocks tend to rise over long periods of time.  In the sixteen years since the turn of the century, the S&P 500 had a positive total return in twelve years.  The last year in which the S&P 500 had a negative total return was in 2008.  With the exception of 2011 and 2015, which featured low single digit returns, the S&P 500 has posted very strong double digit positive returns over the past seven years.

Based on the performance of the overall market in recent years, it is difficult to be confident that an investor possesses real skill without looking at a record that spans at least a full decade. 

If we have access to an investor’s record from January 1, 2006 to December 31, 2015, we would be able to observe performance during the tail end of a bull market, through one of the worst bear markets in generations, as well as during the subsequent bull market that is still underway.  An investor who took imprudent risks in 2006 and 2007 would likely have faced ruin in 2008 that more than fully offset the gains of the good years, and reduced the capital base to the point where significant outperformance during the last seven years would be required just to match the benchmark.  An extremely risk averse investor incapable of taking intelligent risks would have been saved from much of the agony of 2008 but would likely have not participated in the current bull market.

This Presents a Dilemma …

Active investing is not without costs in terms of time, effort, transaction costs, and the very real possibility that performance will fail to match totally passive alternatives.  At least in recent history, it is difficult to know whether an investor has any skill without a track record of a full decade.  How can investors with less experience or an investor just starting out begin to determine whether the effort is worthwhile?

For new investors, one of the most important factors to consider is whether the process itself is rewarding and fulfilling.  If reading 10K reports and similar documents is not your idea of a good time, it is exceedingly unlikely that active portfolio management makes any sense.  Investors who outperform must have a passion for the process.  They must find it intellectually rewarding in and of itself without considering the superior returns that might be achieved.  When a passive approach is available at very low cost, why even bother to find out if real investing skill is there if the process itself is not enjoyable?  This is particularly true when anyone earning the median income in the United States can almost certainly achieve financial security with a 10-15 percent savings rate over a long career.  For high income earners in fields outside investing, a passive approach coupled with a healthy savings rate is more than enough to guarantee financial security.

This leaves the question of how to evaluate the performance of an investor who has only been operating during the course of the current bull market.  Many investors with significant skill could very well not outperform during a bull market with this prudence more than amply rewarded during a subsequent bear market.  As a result, simply looking at raw performance numbers over the past few years is not sufficient to make an informed judgment.  If an investor has significantly outperformed in recent years, that isn’t necessarily proof of superior skill either.  It could be the result of luck and blind risk seeking behavior.  The only way to judge performance without a longer track record is to examine individual decisions and try to determine if they were intelligent and well thought out.  This requires that the investor has prepared an investment thesis, or at least an informal note, documenting each decision that was made.  Unfortunately, self evaluation is difficult and some type of peer review may be necessary to retain intellectual honesty.  An investor in this situation might, at least at an intellectual level, hope for a bear market in the near term as it would likely demonstrate whether their skill exists or not.

One Supplemental Measure

The use of a benchmark to measure performance is important but perhaps a more interesting metric is to attempt to learn if you are your own worst enemy when it comes to trading.  A very simple way to do this on an annual basis is to track the performance of your portfolio as if you had made no changes throughout the year.  Measure this figure against the actual performance of the portfolio.  Although a year is not really sufficient to judge the success or failure of a trade, if one finds that trading is consistently detracting from results, it is an important sign that a different perspective could be useful.  Some of the best investors are extremely inactive.  Charlie Munger’s investment portfolio at The Daily Journal has been unchanged for years after he chose to deploy cash very close to the bottom of the market in early 2009.  As Mr. Munger says, “Investing is where you find a few great companies and then sit on your ass.”

Disclosures:  None

 

When to Sell a Successful Investment

“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher

“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks

There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value.  In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio.  This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time.  During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk.  Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.

On the other hand, the decision to sell can frequently be agonizing for various reasons.  If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership.  Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment.  Often times, the best approach is to pull the band-aid off quickly and move on.

The more interesting question, and the subject of this article, is when one should sell a successful investment.  This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common.  In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success.  We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum.  This necessitates careful consideration of when a successful investment has run its course.

Motivations for Selling

There are obviously a number of motivations that would lead an investor to sell a successful investment.  Many of the reasons are somewhat beyond the scope of this article.  It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence.  Such needs may be immediate or on the horizon.  Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short.  In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.

Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment.  This is the more interesting scenario for purposes of this article.  When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?

Assess Prospective Returns

Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail.  It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis.  Investors are subject to both good and bad luck.  When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.

Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level.  For example, a month ago, we posted an article on Markel trading above $800 per share for the first time.  Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article.  As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.

The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years.  Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.

Consider Tax Consequences

Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities.  Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future.  However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities.  Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.

All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities.  For example, consider an investor who purchased Markel shares at $400 approximately four years ago.  Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains.  The current effective top Federal income tax rate on long term capital gains is 23.6 percent.  Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities.  In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.

Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346.  At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.

If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment.  At that rate of return, the new investment will be worth $1,234 in five years.  Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government  resulting in net proceeds of $1,123.

(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads.  We have ignored transaction costs for purposes of simplicity.)

The Hurdle May Be High

As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable.  In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off.  Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower.  Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.

It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account.  In such cases, the tax friction disappears, but the other issues remain.  Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities.  It goes without saying that frequent activity on a short term basis is almost always ill advised.  The same is often true in the long run, as Philip Fisher pointed out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel.  Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares.  See also general disclaimer.

Harness Technology to Stay Informed During Earnings Season

As we move into the height of third quarter earnings season, many investors may feel overwhelmed when it comes to staying on top of earnings announcements for portfolio companies and investment candidates.  Without a solid system for keeping abreast of company filings, it is inevitable that you will either miss a report entirely or only read it several days after it is initially released.  This is particularly true for smaller companies that are not regularly covered by analysts or major newspapers such as The Wall Street Journal.  How can investors confidently stay informed?

We take it as a given that intelligent investors always examine the primary source documents released by companies rather than relying on analyst reports, newspaper articles, and other third party sources.  Public companies are required to file financial information and other material documents with the Securities and Exchange Commission and all of the documentation is available online through the EDGAR system.  In this article, we will discuss an easy way to stay on top of SEC filings using the EDGAR system and Google Reader.

Using the SEC EDGAR Database

During earnings season, most companies will announce quarterly results through a press release that provides management’s summary of the quarter and condensed financial information.  The press release is filed with the SEC as a 8-K Current Report.  At a later point, the company will file a 10-Q report with much more information.  Some smaller companies do not issue press releases and only file the 10-Q.  Investors much keep an eye out for both types of filings.  Fortunately, it is possible to easily automate delivery of such filings.

The image below shows the main company search screen of the EDGAR database.  There are a number of potential options for searches, but we will simply use the ticker symbol for a company that we follow:  Markel Corporation (Ticker:  MKL).  Click on the image for a larger view.

After clicking on the Find Companies button, we are presented with a list of results (click on the image for a larger view):

We are presented with a list of the latest company filings for Markel.  The latest entry is a 13F-HR filing made on August 9 which lists the equity positions held in Markel’s portfolio as of June 30, 2010.  The next entry is the company’s 10-Q report for the second quarter which was filed on August 6.

If we wish to track only 10-Q reports, we can enter “10-Q” in the “Filing Type” text box and hit the search button.  However, if we filter on a specific filing type, we could miss other important information such as 8-K current reports and future 13F-HR filings so we will leave the search results unchanged.  To view the actual filing, click on the “Documents” button and then on the appropriate form.

Using RSS Feeds and Google Reader

While the EDGAR system is a great way to look up company information, it is not practical to look at the database every day for each individual company to see if something new has been posted.  Fortunately, we do not have to constantly check the database because we can create a RSS Feed based on our search criteria.  The image below highlights the RSS Feed icon in the search results area:

After clicking on the RSS Feed link, your browser may allow you to add the feed to a specific RSS Reader or you may be presented with the raw RSS Feed text.  If you are provided with a page allowing you to add the feed to Google Reader, you may do so directly.  If not, copy the RSS Feed URL and save it for use in your RSS Reader of choice. Any RSS Reader will allow you to import a feed if you have the URL for the RSS Feed available.  For example, adding the following URL to any RSS Feed Reader will import the feed for Markel:

feed://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0001096343&type=&dateb=&owner=exclude&start=0&count=40&output=atom

Our preferred RSS Feed Reader is Google Reader which allows for a great deal of customization to suit the reader’s needs.  Feeds can be organized into multiple folders, individual items can be “starred” for later reference, and useful statistics are available.  The following image shows the Markel RSS Feed within Google Reader (click on the image for a larger view).

To view the actual filing, simply click on the link that appears in Google Reader (for example, the 13F-HR report can be viewed by clicking on the link shown above).

As you can see, there are numerous other folders that have been set up to categorize industries, portfolio companies, and other types of content such as blogs and networking posts.  Google Reader can manage any content that is available as an RSS Feed.

Once Google Reader, or any other RSS Reader, is set up with the SEC EDGAR feeds for your portfolio companies and candidates, it is simple to check Google Reader once or twice a day to keep abreast of all filings that have been made by company management.  Many companies also offer email notifications and other ways of staying informed but by using RSS feeds, all of this information can be available in one place which greatly increases efficiency and avoids the risk of missing a filing when a flood of earnings reports come in.

So while there are no easy ways to decipher creative accounting, at least you’ll be up to date on the filings!

Disclosure:  No position in Markel Corporation which was just used as an example for the article.