Friday, November 28, 2014

The Curse of Liquidity

I think it's fair to say that it's never been easier to minimize frictional costs when it comes to investing in stocks.

Transaction costs these days are, at many brokerages, reasonable or better for stocks and ETFs.

Many fine low cost fund alternatives exist.

Yet what should be plain advantage is often converted into a curse.

In this CNBC appearance back in October, Warren Buffett said that "if you are buying a business to own...the idea of what the market does on any given day, it's just meaningless. What you really have to look at is where you expect the business to be 5 or 10 or 20 years from now."

That's how most will think about businesses that aren't traded daily but, because stocks are quoted so frequently, behavior is changed for the worse.

 "...you can look at stock prices minute by minute. And that should be an advantage but many people turn it into a disadvantage."

Buffett wrote something similar earlier this year:

"Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of 'Don't just sit there, do something.' For these investors, liquidity is transformed from the unqualified benefit it should be to a curse." - From the 2013 Berkshire Hathaway (BRKa) Shareholder Letter

Low frictional costs and the convenience of buying and selling creates a temptation to try and be in and out of certain things at just the right time. What then usually happens is -- as a result of this behavior -- not only is the low frictional cost advantage lost or reduced, unnecessary mistakes get made. Making judgments about how price compares to value is far from easy, but it can be done. Mistakes occur when attempts at timing is added to the equation. Stocks move unexpectedly. Timing when to buy or sell, if not impossible, is difficult to do reliably well. Nor is it necessary. What matters far more is a reasonable appraisal of business value combined with patience and price discipline. Get that right and, in the long run, good things are more likely to happen.

Attempts at timing are more likely to subtract or, at a minimum, distract from what really counts.

So that means the relationship between price and value -- along with opportunity costs -- should primarily dictate action; timing should not.

Part of the problem is that some behave as if the mistakes will only be made by the other participants. Morgan Housel explains this tendency -- what's known as the bias blind spot -- the following way:

"People love reading about flaws people fall for when handling money. But few of them admit, or even realize, that they're reading about themselves."

He adds: "We're blind to our blindness."

Some think they can be in the right stock (or stock fund) at just the right time. What happens instead is they end up just compounding mistakes and incurring unnecessary costs when much less activity would have yielded a vastly better outcome.

Liquidity is much overrated. It can be an advantage, of course, but only up to a point.

"A modest amount of liquidity will service the true needs of a civilization. A large amount of liquidity will bring out the worst in human nature." - Charlie Munger at the 2008 Wesco Financial Shareholder Meeting

The risk that a stock or fund that's been bought might drop substantially gets most of the consideration. Loss aversion contributes greatly to this. Yet the risk that what can be bought sensibly today may at some point not be available at attractive prices -- though not in a predictable manner as far as timing goes -- deserves at least equal attention.

"Since the basic game is so favorable, Charlie and I believe it's a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of 'experts,' or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it." - From the 2012 Berkshire Hathaway (BRKa) Shareholder Letter

Those who try to "dance in and out" aren't giving due consideration to the risk of not participating sufficiently. They think they'll be in and out at the right times. Somehow, they'll consistently avoid the downside while capturing the upside. Easier said. If the share price of a lousy business drops that, of course, can be a real problem. On the other hand, for those who feel comfortable judging prospects and value, if the share price of a sound business temporarily drops that's far from a problem for the long-term investor.

More from Buffett's CNBC appearance back in October:

"I don't know how to tell what the markets going to do. I do know how to pick out reasonable businesses to own over a long period of time. And a lot of people do, incidentally."

It's, in fact, an opportunity when prices fall.

"The stocks I was buying yesterday I hope go down today. Put it that way. And I hope they go down next week, and I hope they go down the week after. Nothing is going wrong with the companies."

Effectively judging business economics is paramount when buying an individual stock. For some, that's where a good fund might be more suitable.

Many stocks, these days, have become quite expensive or, at least, not cheap. Though there are always individual exceptions, the time to buy with a substantial margin of safety, at least for now, has mostly passed.

Stocks may continue rising, of course, but those gains increasingly will be driven by speculation instead of increases to intrinsic value. When stocks will become broadly undervalued again, and what the cause will be, is always uncertain. Those who still think bull markets are such a wonderful thing might want to keep these things in mind.

Bull markets make it more difficult to accumulate meaningful positions.

Managing risk and reward just becomes more challenging.

Liquidity should be an advantage. Well, at least it should be for those who tend to buy pieces of sound businesses with the idea that gains will come primarily via long-term intrinsic value increases. Returns should mostly driven by the compounded effect of what the businesses produce -- free cash flow generated at high returns on capital -- for owners over the long haul. Too often, instead, the focus is profiting from near-term price action; the focus is on speculative bets on where prices are going.

So, as a result, what ought to be beneficial liquidity morphs into a curse.

Broadly speaking, outcomes likely improve when there's greater emphasis on what businesses -- whether owned as individual stocks or through a fund -- can produce over a very long time.*

To me, there should be much less emphasis on the wonders of liquidity.

As always, what's sensible to buy at one price becomes less so as prices increase.

So buying at least reasonably well (i.e. a nice discount to conservatively estimated value) in the first place naturally matters a great deal.

Investment results ought to be mostly about long-term increases to per share intrinsic value.

They shouldn't be dependent on selling at speculative prices.

Adam

Long position in BRKb established at much lower than recent market prices

* This naturally also applies to owning a business outright for those inclined and able to do so.

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