On Bad Academics & A Good Academic Argument for Concentration
I can’t vouch for much of academic finance. When it comes to this field, academics tell us all about beta, risk adjusted this and Sharpe weighted that. Though the reality of the situation is that finance and economics are not easily definable subjects with physics-like rules, academics try to prove otherwise, I guess because they’ve been trained so well to use statistics and complex math they feel it is necessary to use those skills.
Thus, you get nonsense like the Capital Asset Pricing Model. Now, you might say, CAPM is used to calculate Cost of Capital! That’s the basis for picking discount rates, and determining the value of a franchise, which even value investors use!
The nonsensical part is this: one major input of the CAPM equation is beta. Beta measures the “riskiness” of a security generally by its past volatility relative to the market as a whole. A stock that goes from 80 to 40 back to 80 in a few weeks has a high beta as compared to the stock market. Wal-Mart, who barely moves more than a few percentage points here and there, generally making moves with the market, has a beta much closer to 1. (the market is 1, if you move less than the market you are less than 1, and if you move more than the market you are 0-1)
This is the CAPM equation: % of debt*(Cost of Debt*(1-tax rate)) + % of preferred*(cost of preferred)+% of equity * (cost of equity)
What’s cost of equity? Basically:
(Beta for the firm * Market Risk Premium)*Risk free rate = CoE
I’m sure someone will squabble with that, but there are the basic equations. How much debt, preferred, and equity are in your capital structure, and how much do they “cost.” Added ‘em up and boom, Cost of Capital.
I won’t take issue with the first equation. Cost of debt and preferred are simply the interest rate you pay, with taxes taken into account. Easy enough.
However, it is this computation of the “cost of equity” in CAPM that drives me up a wall. If your firm has a higher beta, CAPM says your resulting cost of capital is higher. Although it has been well proven that beta measures, well, nothing in the long run, this number can affect millions of investors’ calculations, from intrinsic value (discounted cash flows) to competitive advantage (as measure by the amount ROIC > COC).
Imagine this. You are American Express (AXP). A large, well-known firm with a massive “moat” and competitive advantages up the wazoo. People covet your card, love your card, and merchants are willing to pay you big fees to have your card used in their stores. A great company. Your stock sits at 70, and your current Cost of Equity is 10%.
Now, your stock drops by half, because war started in Russia or interest rates dropped a quarter-point or something else marginally important to your company occurs. Mr. Market overreacts anyways, and sends you tumbling.
Now, because your stock is now at 35 in a matter of minutes, your beta goes up. You’re much more volatile than the market. Because your beta went up, your cost of equity went up. Because your cost of equity is now higher, your cost of capital is higher. Because your cost of capital went up, your firm is now worth less!! (because you use the COC to discount the firms future cash flows. Higher COC, lower value).
This notion of “cost of equity” is saying that, no matter what happened, since the stock dropped so much you must be worth less. It doesn’t matter if some irrational seller came on line and dumped stock left and right, your stock just became more volatile so you are worth less. Do you see where this nonsense takes you?
Now, I’m not saying all investors believe this crap. They don’t. But many, many people do and this is taught in finance classes, even today. These are “post efficient market” type finance classes that still teach a concept that lies on efficient markets called beta. They do all kinds of security analysis, credit analysis, moats, they teach about Warren Buffett, and then, BAM, they ask you do to discounted cash flows based on a CAPM input, cost of capital. D’oh.
I can assure you that Warren Buffett, Charlie Munger, Joel Greenblatt, Eddie Lampert, and Seth Klarman don’t use these nonsense equations to invest and they’re all wealthy, successful investors. Cost of capital is not a definable, mathematic, concept like academia wants it to be.
Capital is an ever flowing, ever changing input with no easily calculable value. Especially cost of equity, whatever that means. By trying to compute cost of equity as academia wants you to, you are now liable to be precisely wrong, rather than vaguely correct. This false precision causes overconfidence, an egregious error leading you down a path to big mistakes.
Academia can even say “well, the equation is just in theory, we wouldn’t have you making specific decisions based on the numbers.” What the hell good does that do for your theory? What’s financial theory if it creates nonsensical results in real life?
Part deux
That said, I did come across a solid academic paper today, via Abnormal Returns. The paper comes from a University of Toronto Professor named Lukasz Pomorski.
The paper is entitled: Acting on the Most Valuable Information: ‘Best Idea’ Trades of Mutual Fund Managers.
What Pomorski (and the rest of us, I might add) wants to know is if mutual fund managers do have the skill to outperform, taking out the elements of investment management that cause chronic underperformance: benchmark hugging, quarter painting, and peer envy.
What he did was to define the “best idea” of a particular manager (or investment organization) by saying: “OK, if a mutual fund family runs many funds, all having access to the same research, then logic dictates that the ‘best ideas’ will be ones bought by many of their funds at the same time.” This seems a decent way to determine what a “best idea” is without taking years to ask each manager what their “best idea” is, and then measuring from there on out how the results were. Quibble as you like, but that’s his assumption.
So, he took that definition and measured it over 25 years of data, to see if those “best ideas” outperformed the relevant benchmark on a sustainable basis.
The results were quite interesting: those ideas bought by 2, 3, or 4 of the funds in a fund family outperformed the relevant benchmarks by up to 4% per annum. Here is the relevant conclusion made the paper, one to take to heart:
“In line with this idea, I find that trades made by more than one fund beat the benchmarks by up to about 0.3% per month in the quarter subsequent to when funds trade. Moreover, such trades outperform trades made by single funds by even higher margins. Abnormal returns do not revert in the next six quarters, which suggests that the result is not driven by transitory liquidity e®ects. Interestingly, the value of \best ideas” is higher when they involve companies that did not experience large revisions in analyst EPS forecasts. It is thus possible that fund managers are able to obtain new information earlier than sell-side analysts.”
I’d say an extra 30 basis points, per month, is pretty statistically significant in terms of materiality. Not only were these “best ideas” outperforming the benchmarks, but they were outperforming the lesser ideas as well!
Now, lastly, the practical argument for investment concentration, based on academic results:
“While managers correctly evaluate what information is the most valuable, they do not limit their trades to the \best ideas.” In fact, for the average management company, only about 30% of dollar volume represents trades that, according to the proxy proposed here, managers are particularly excited about. There is no evidence that the remaining trades mutual funds make beat the benchmarks. Even if the standard errors are disregarded, the average characteristic-adjusted monthly return on trades that are not \best ideas” is only about 0.2-2.3 basis points. Once transaction costs or other fund expenses are accounted for, these trades will likely turn out to waste investors’ money.” (emphasis added)
What he’s saying is that the best investments, the real no brainers that the whole organization wants to buy, outperform handily. Those “best ideas” give support to the argument that investment organizations indeed have the skill to “out-analyze” the market.
…And then they dilute the hell out of it by buying a dozens and dozens more stocks in an effort to stay conventional. In the end, the funds in aggregate perform below the indexes.
My Take
By finding your best ideas, the ones where you can’t lose and are likely to make a lot of money, and backing up the truck when they come, you can beat the markets and beat the pants off of most institutions. Concentrate on the no-brainers, and your results will come. Just make sure you know what a no-brainer looks like and have the courage to buy it when it’s hated and sell it when the value is no longer there.
I finish with a quote from Buffett:
‘Wide diversification is only required when investors do not understand what they are doing.”
I like this idea to get gutsier on those calls that you feel confident about - the “no brainers” - however this must have some limit in terms of risk of loss. Call me old fashioned, or call me a father with 2 kids to feed, or whatever, but even when you’re convinced that something is a no brainer, there are a couple things that could work against you: 1) you are wrong or your logic or analysis was misguided; 2) something changes (black swan) or 3) you are right, but the enough of the rest of the market sheep are wrong, and therefore your share price is swamped by the herd selling.
Because there is no such thing as being 100% sure that your shares will rise, I still think you need some decent level of diversification with your portfolio. However I have been thinking along these lines in terms of what % of ones portfolio is reasonable when “backing up the truck”, for if on balance you are right more than you are wrong, and when you’re right, you’re really right, then making appropriately large bets can be a life changing proposition (financially at least).
In my case thus far I’ve subscribed to the Vanguard philosophy of getting market exposure as cheaply as possible, sticking to asset allocations, and then carving off some “risk money” to work with my single situation picks. As one gets some confirmation on their picking ability, one gets more emboldened to increase that risk money portion of the portfolio vs all those boring index funds…..
Thanks for the timely article
Hogan,
“Fortune’s Formula” by William Poundstone is the go-to book when thinking about how much one ought to back up the truck. Here’s a shortened link to the book at Amazon:
http://tinyurl.com/5k5xpv
Hogan,
You’re 100% correct.
I guess I should add a qualifier that this is for 100% active, entrepreneurial, investors looking to build wealth. The lesser ideas dilute away your better ones.
I also agree that some level of diversification is needed. Beyond 8-10 companies, though, I think you’re getting into territory where you are throwing money away owning lesser ideas. The examples above show that most mutual funds are doing just that.
Linc is right on point: if you look at the Kelly Formula you’ll see that if you make a bet that’s wildly in your favor, putting 3-5% in it is nonsense.
For a father with 2 kids who isn’t a full time investor, I would recommend everyone to do exactly what you do. Buy the market cheaply over time.
Hi Jeff,
I think a major flaw in Professor Pomorski’s study is that he assumes the primary motive of a fund manager’s investment decisions to maximize the return of all of his funds. That’s not the case.
A fund manager offers many funds for investors to select from. It’s similar to that a mobile carrier (as in Australia) offers many different plans. Some economists use the term “confusopoly”. The aim is to confuse consumers enough that they cannot easily do an apple-to-apple comparison of the value. In the case of the fund manager, he just needs to make sure some of his funds outperform the market for some years so he can sell investors something. A few years later, when the tide changes, he can get the investors to switch to a different selection of funds which give better performance. As long as he has something to sell, he doesn’t really care if he has some funds underperform the market. As you can see, he has incentive not to hold the same assets across too many of his funds.
I’m not sure I agree.
The primary motivation of a fund varies, obviously from fund to fund. Pomorski’s doesn’t assume, though, that maximal growth is the prime goal. Indeed, he admits in the paper that often times what holds most investment managers back is that they focus on other things. One of his conclusions was that, in aggregate, funds underperform due to these other factors: window dressing, benchmark hugging, etc. These things are closely rlated to what you call ‘confusopoly.’ As long as they are doing what others are doing, they can offer lots of different funds to appease various investment appetities. The Prof recognizes this.
His purpose, knowing this, is to take those variables out and say, OK, what do they do that might really reflect pure investment skill versus all of this extraneous “business” nonsense that causes general underperformance. You saw the results.
Jeff,
I agree with you in general - too much of what I learn in finance has little practical application. One time, I was talking with a professor about structured finance and arbitrage opportunities when I brought up the practical application of that… how one might actually profit. His response? “Oh, I don’t know anything about making money in the stock market.”
Here specifically, I think you’re a little to hard on cost of equity - it doesn’t matter most of the time (namely, until/unless a firm needs to raise capital), but when that does occur it’s useful to know how much borrowing costs might have gone up. Consider: http://blogs.wsj.com/marketbeat/2008/08/15/blue-chips-facing-growing-funding-costs/
Who would have thought that American Express would need to price debt at 400 bps above Treasuries? If you’ve been tracking AmEx’s stock price, though, you’d know that a capital raise would be costly. See also: investment/lending banks.
The real thing I think you’re after is to find a better measure of “risk” than beta - join the club. The appropriate question to ask is what return you require given business risk. Using beta can give you a fair approximation, which is really all you’re after. An alternative is to simply use a long-duration Treasury, under the thought process that you would be planning on owning the business for X number of years, so it must have sizable-enough competitive advantages that you aren’t incurring a whole lot of risk… thus, the “risk-free” rate.
This is all interesting stuff - but at Univ of Chicago MBA I was taught that active managers cannot generally beat the market consistently. Of course with the law of large numbers you will have some who are able to string together 2,3,4 or 5 years of outperformance. But you start to get out on the bell curve if you can find someone who can do it over 5,10 or 15 years.
Perhaps this article suggests that if managers were free to focus on only their 5 or 8 best ideas, that they could outperform consistently? Or perhaps those “smart” people are running the successful hedge funds, and not working at Mutual Fund XYZ.
Applying this to the life of an individual investor, I must question whether it is wise to not gain exposure to the market thru cheap index funds, and assign a portion of your portfolio to your own “best ideas”. If it has been shown that few if any professionals doing this full time can consistently beat the market over time, then I would think any individual investor should question whether they have the firepower to consistently uncover, and properly time, the best opportunities from a global market with 1000s of securities.
Perhaps one might retort that one doesn’t need to find all the best opportunities, but just enough big winners even if you missed some even bigger winners elsewhere.
Concentration can be taken too far. Excellent companies can be, and have been, caught up in economic events completely beyond their control. I had a position in an excellent financial company that had no credit risk whatsoever and made up 20% of my portfolio, yet still managed to suffer a 90% loss in that position when the securitization market froze. Some events are not predictable. Staking everything on a single position is just hubris.
For long-term buy-and-hold investors, I think that a minimum of 10 stocks is required for safety, unless you meet one of the following conditions : 1) you have a very big stake (e.g. like Buffett or Lampert) and can assume operational control of the company, 2) your position is less than 2% of daily trading volume and is instantly saleable, and you are willing to watch the position like a hawk and quickly liquidate at the first sign of problems (i.e. you’re a trader-investor hybrid).
Concentration brings spectacular gains …. when it works. All academic studies about concentration should be rigorously examined for survivorship bias.
Jeff,
Care to share your top 8-10 stocks?
James,
What I’m saying about cost of equity, under the CAPM model, is that large stock movements, regardless of purpose, make a firm “worth less.” That is the conclusion you arrive at. The conclusion is, of course, nonsense. Stock movements and equity costs are often correlated, but CAPM makes them causative, which they are not. (more movement = more cost).
“it doesn’t matter most of the time (namely, until/unless a firm needs to raise capital)”
Not if you’re looking to optimize your capital structure. Equity always has an opportunity cost called debt. If you have 100% equity and no debt in a non-cyclical industry, you’re probably not running a great cap structure, and you can issue debt to buy back equity. The cost of equity is ever present but using stock volatility to determine its value is nonsense.
Thus I refuse to use a model where I know that the output is garbage. Most of the time, it might be a decent approximation. But most of the time isn’t what I’m looking for. There are lots of incredible and unusual events happening all of the time. Those events will skew the hell out of any CAPM model.
By instead focusing on prevailing long term treasury rates and various opportunity costs, I get a better picture. “OK, treasuries are yielding 6%, I can buy American Express which has a sustainable 8% yield, and growing. Or, I can buy Primus Guaranty for a 40% yield that’s growing very slowly, or, etc…” It’s a very rough structure but CAPM gives a false precision and creates nonsensical results. I can’t subscribe to its use. I choose a traditional opportunity cost model and a “common sense” model instead.
Hogan,
True. As a whole, active management largely is the market. The market can’t beat the market, and after costs and fees will, in fact, underperform. It doesn’t take a genius to figure this out.
However, beating the market or lack thereof has many inputs. This study shows to me that these guys do have some great ideas but choose to own a ton of stocks instead of running a portfolio focused on their best ideas. There are dozens of reasons this is true, but nonetheless it is.
A small, concentrated investors has a good chance of beating an index if he or she knows what they’re doing. If you own 5-10 stocks, all of them cheap and all of them safe from going to zero, you’ll beat the market over time. There are so many managers, both known and unknown, that have done this. There is no risk in buying an excellent, cheap company that you know very well. Making a bunch of great risk/reward bets simultaneously, without considering of index weighting, peer performance, relative nonsense, or the emotional stock market will lead to success. But you have to put a lot of time into it, and if you’re not willing to devote a significant amount of your time or make it a career, active management won’t help. In that case, I agree that indexes are best.
“Perhaps one might retort that one doesn’t need to find all the best opportunities, but just enough big winners even if you missed some even bigger winners elsewhere.”
Ding, ding, ding.
VG,
You’re right, there’s some risk. But, with your financial company, you didn’t properly consider the customer concentration risk you were taking. As I wrote before, the market is your customer when you’re a securitizer. If it goes down, you do too. I’m not saying this to be mean, I did the same thing (First Marblehead) as you did and lost a chunk of money.
Concentration is, as you said, a two headed dragon. If you do it correctly, you build wealth. If you don’t, you lose money. You have to be extremely atuned to risk. All risks. Business risks, financial risks, market risks, customer risks. If you properly appraise your risk, you can take huge bets. But in the case of a company reliant on securities markets properly functioning, there is a massive risk inherent that can send them to zero. I found this out firsthand. If you’re going to put a third or a half of your port. in a company, it cant have any chance of going to zero. If you use leverage, you will go to zero.
You have to be comfortable with your level of concentration, also. Most people can’t stomach owning 5 or 6 companies, so they don’t. That’s fine! Even if you own 10-12 stocks, you still get most of the benefits of concentration. On average, every position I take is about 10-12%. But there come times when putting 10% of your portfolio in a “no-brainer” idea that is nonsensical. Once in awhile, if you’re paying attention, risk/reward bets with massive skew and little realistic downside (think hard assets, liquid assets, or a massive moat) come along and putting 30-40% of your portfolio in it is totally rational. It’s not hubris, but proper risk reward attitude. If there is leverage inherent in either your buy or the investment itself, you can blow up. If you take away the leverage and own good cheap companies, you’ll avoid the blow-up.
If you know what you’re doing and can properly appraise risks, concentration is advisable. Margin of safety must be #1, though, and you must be patient enough to wait for the best opportunities.
Dave,
I don’t really do that kind of thing. Peruse the blog for companies I’ve written about and you’ll get a sense of what I like.
“A small, concentrated investors has a good chance of beating an index if he or she knows what they’re doing. If you own 5-10 stocks, all of them cheap and all of them safe from going to zero, you’ll beat the market over time. There are so many managers, both known and unknown, that have done this. There is no risk in buying an excellent, cheap company that you know very well. Making a bunch of great risk/reward bets simultaneously, without considering of index weighting, peer performance, relative nonsense, or the emotional stock market will lead to success. But you have to put a lot of time into it, and if you’re not willing to devote a significant amount of your time or make it a career, active management won’t help. In that case, I agree that indexes are best.”
I seem to remember that “value” stocks have indeed outperformed other styles over the long run. If you can indeed generate a continuous supply of “great risk reward bets” and also be recycling old ones that have performed into the newest, greatest, then yes you will do well.
I don’t think you actually meant this, but when you say there is “no risk” in that, obviously that is not true. In your opinion, these are compelling potential trades. But the point of diversification is a realization that one doesn’t have a crystal ball, and therefore there is a decent chance that the trade doesn’t unfold as we expect. Otherwise, it would be optimal to go 100% in your “best of the best” idea at all times. As the market is nothing more than an amalgam of all the other great minds out there, you’re always at the mercy that you could be “right” yet wrong solely because a majority of others see it differently and trade accordingly.
I could be wrong on any investment, that is correct. Of course I didn’t mean “none.” Anything can happen, and I’m not an ego monster who believes I know better. I understand this.
But if you really understand a business and what factors drive it, a minimal level of diversification is needed. I’m not saying I can go find the greatest investments out there. What I can do is scan around and drill deep if I find one I can understand very well with very little risk and a high potential return. If I buy a company for its cash value and get a good, solid, profitable business for free, and run by intelligent, owner managers, where’s my (material) risk?
I like Munger’s example:
If you went into some city and bought a half interest in the 3 best businesses in the city would anyone call you crazy? No, it’d be stupid for you to continue “diversifying” into a bunch of worse off or crazy expensive businesses.
What I went in and bought an interest in the 3 best buildings in the city for a song? Who would call me crazy? I don’t think everyone would complain that I didn’t own an interest in 20 buildings. I picked 3 great ones!
So, whatever the number you call “concentrated,” that style is the way to go for an entrepreneurial investor.
Indeed the market is a collection of heads. Millions of them. However those heads are subject to contraints and irrationality that we (as intelligent value investors) stay away from. I don’t have to think about my benchmark. I don’t have to appease irrational clients. I have no one giving me a list of acceptable stocks. I don’t have to sell if the price drops below $5/share. I don’t have concentration limits. I don’t buy because prices are going up or some talking head tells me to. I don’t sell because prices are going down or some talking head tells me to.
What I’m painting, using I, is the intelligent, rational, value investor. If you rid yourself from irrationality and constraint, leaving yourself to flexibility to own anything at any price, with the only caveat that you understand what you’re buying, I don’t see it as a remotely risky strategy.
Everything entails risk. But the best way I know how to minimize that risk is to own a handful of things I understand best and not stray from my circle of competence. If I lose my shirt, it will be because I don’t understand what I’m buying.
I don’t have a crystal ball but the purpose of a large margin of safety is to render an accurate view of the future unnecessary.
“Otherwise, it would be optimal to go 100% in your “best of the best” idea at all times”
There are times this is not irrational. Would it have been irrational for Buffett to put his entire net worth into Washington Post in 1973- a best of breed company run by exceptional managers trading at a price not greater than 1/3 of its liquidation value? I don’t think so. If you are so risk averse that you can’t load up when you find a 1 in 10 year no brainer, I’d ask if you should be actively managing at all.
In August 2007, Mark Sellers wrote a terrific article for the “Financial Times” about why mutual fund managers overdiversify and underperform. He pointed out that their biggest risk is not the same as your biggest risk: yours is losing money; theirs is losing their jobs and/or assets under management.
So despite their status as active managers, they actually strive to nearly match their benchmark index in order to preserve their own livelihood. Just another example of the many conflicts of interest inherent in the financial industry’s “Helpers.” Here’s an excerpt and link:
“I am amazed that someone who gets paid $1m or $2m a year is holding 50 or 100 stocks in the portfolio. The reason for holding so many stocks is that you feel you cannot understand any single company well enough to assess the risks, and so you are going to hold many stocks to minimise the risk of being wrong on any single one. You stand a small chance of dramatically underperforming your benchmark if you do this, and so have a high chance of keeping your job.”
http://cachef.ft.com/cms/s/2/b5dc62d4-524c-11dc-a7ab-0000779fd2ac.html
“Otherwise, it would be optimal to go 100% in your “best of the best” idea at all times”
“There are times this is not irrational. Would it have been irrational for Buffett to put his entire net worth into Washington Post in 1973- a best of breed company run by exceptional managers trading at a price not greater than 1/3 of its liquidation value? I don’t think so. If you are so risk averse that you can’t load up when you find a 1 in 10 year no brainer, I’d ask if you should be actively managing at all.”
I agree with your philosophy and with intelligent value investors in general. I’d like to be one. I do agree that when you spot a 1 in 10yr no brainer you need to load up. Its like if you’re counting cards and you get a double down opportunity - even if it is gut wrenching, you need to make that bet. That said, everyone has a risk tolerance and I don’t know that it is ever wise to be 100% in one thing, unless you are 100% positive you can’t lose your money. I guess if you can be 100% positive of that, then so be it, but is that really possible? It also depends on your situation. If you are in college and working with a relatively modest sum (no offense here and perhaps you are working with more than I think…) plus you are single and have your whole working life ahead of you, then I guess worst case is you crap out and learn a lesson and start over. Of course lets look at a 65 year old (not me) with $5.0mm in various retirement savings, who spends his newly retired days engrossed in value investing - surely this person would think long and hard before committing 100% of that 5.0mm to one idea, no matter how “sure” he was. The price of being wrong there, even if the % is de minimis, is too high…..
Again thanks for the good discussion and your blog - I am determined to take better advantage of some of these situations, as I am a sub-40yr old fortunate enough to have a nice income - I can recover from a hit - but I want that wealth creation that comes with being right, and more importantly having the conviction to put the money on the table. Not much point in spending the time, doing the work, uncovering the opportunities, only to wager 1.10th of a percent of my portfolio….but likewise you won’t see me 100% in anything….ask those Enron employees about that….
Hogan,
I really appreciate the intelligent give and take. Thank you.
Regarding what I said, I’m not trying to make the argument that you should be 100% in anything. I never have been and probably never will be.
All I’m trying to say is the concentration is not as scary as it sounds. For professional, entrepreneurial investors who know what they are doing, concentrating your invesments beyond what’s considered “conventional” out there is something I’d highly advise. For most, 99.9% of the population, this is not the case. They can’t put the time in, or the effort, or whatever it might be. But institutional investors act irrationally, an investing sense, by doing what they do. They might be rational from a “lets build up our AUM” perspective, I don’t know.
I agree with you also, that it depends on your situation. If you’re 65 and retired, living off of your money, the volatility could kill you so I wouldn’t advise.
I think your strategy of slowly easing into active mgmt, versus indexing, is an excellent one, considering your situation. I assume you have a job outside of investing, so in that case, mostly indexing but buying your best ideas is a good way to go about it.
Hi Jeff,
Just stumbling across this today. Here’s my view, which is in agreement with yours, I think.
CAPM:
Beta assumes risk = volatility. But it ain’t so. It’s the same false logic as in any model that confuses price with value, like PEG. As a value investor I’m looking for divergence of price and value, so it makes no sense to try to define one (value) in the context of the other (price as input to beta).
Volatility represents opportunity, not risk. It’s what causes the price/value skew. Without that skew, there’d never be a bargain, never anything on sale.
I use a vaguely defined method similar to yours for determining cost of equity. I start by using the whole CAPM formula, but replacing beta with my own factor, based on how I subjectively see the overall risk of this company. Granted it’s subjective and vague, but using the rest of the CAPM / cost of capital structure helps me to focus on the variable of “risk”.
Finally, these academics that say active doesn’t work always discount Buffett as a fluke. That’s the problem with models, heh.
Concentration:
I hadn’t read that Munger perspective, but I’ve always used that thought experiment myself. I guess I can more readily relate to buying a small business in my town - something very concrete. Would I want to be an owner of just one or two wonderful little businesses or some vague basket of most of the businesses in the town? You can be sure it’s the former, and before I buy, and as an owner, I’ll dive in and develop a deep understanding of these few holdings.
On a related note, while sometimes it seems tedious to develop a detailed model for a DCF - future revenue and margin estimates, etc. - I find I get as much out of the process as the result, as it requires really thinking through how the company actually makes money, and the forces affecting them. It’s the kind of analysis I’d do if I was plunking down my life savings to purchase 100% of a local business.
Regards
-joe
Joe,
I agree with your conclusions above. Indeed, building a DCF should be more about process than the results. I believe most users take the result as a conclusion in and of itself, using the numbers with “physics like” accuracy. The process of looking at what might drive future profitability is a very good one.
The way you go about using a discount rate seems like a good one to me, using a subjective estimate. It’s about all you can do to look at your opportunity costs, interest rates, and true business risk and determine what those future cash flows might be worth. Art not science.