Method to improve entry price

A while back, Jim shared a very interesting approach of the nature of: if you have to sell periodically anyway for living expenses, the 3% rule (waiting for a 3% drop) following a major run-up has historically made for a decent rule to improve long run results. Being in the accumulation rather than distribution phase, still working for a living and adding to my investments, I’d be very interested in the converse. Any ideas on an approach to improve average entry price by delaying investment of new funds until more opportune times for someone in the accumulation phase who regularly has new funds coming available to invest? I gathered historical data and ran some initial backtests on delaying investment of new funds (holding them in cash) until P/B had reached various values (IE: 1.1 to 1.6), but surprisingly, that approach didn’t seem to produce much benefit in terms of boosting total return.

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Being in the accumulation rather than distribution phase, still working for a living and adding to
my investments, I’d be very interested in the converse. Any ideas on an approach to improve average
entry price by delaying investment of new funds until more opportune times for someone in the
accumulation phase who regularly has new funds coming available to invest? I gathered historical
data and ran some initial backtests on delaying investment of new funds (holding them in cash) until
P/B had reached various values (IE: 1.1 to 1.6), but surprisingly, that approach didn’t seem to
produce much benefit in terms of boosting total return.

The problem is that you don’t know how low the evaluation multiples will get, nor how long it might take to see them again.
All the while, the value per share is slowly rising, so the longer you wait the more value growth
you miss out on and the less likely it is you’ll get your target entry price.

But, here are two ideas:

Write cash backed put options, repeatedly, till one is assigned.
If they’re at the money (strike price near current stock price), you’ll get the maximum time value and,
assuming the stock is at a somewhat typical valuation level, the odds of you getting the stock in that round are very close to 50/50.
A pinch lower strike price gives a pinch lower chance of getting the stock each time and vice versa, so you can tune your likely wait period.
It might take a while till you get the stock assigned to you, but you’re earning a not-too-bad
return in the mean time, so you aren’t really missing out on the value growth of a share.

In fact, it’s fairly likely that the rate of return might exceed the rate of return on the stock by a whisker.
For a while I did this, and whenever the stock was assigned I just turned around and s old it again and wrote more puts.
The rate of return was not great–Berkshire is pretty steady so option premiums are not high–but it
was
about 2%/year better than holding the stock, kind of like adding a dividend on top of your ownership.
Of course, depending on your tax situation that might not be enough to make it worthwhile.

A random example:
Berkshire stock closed at $312.90 on Friday. March $310 puts were bid $8.75 at close, though you would likely get about $9 with a limit order.
If you wrote one of those puts for $8.75, the two possible outcomes would be:

  • Slightly less than 50% chance you end up with the stock at a net entry price of 301.25, which is a 3.7% discount to the stock price at the time.
  • Slightly more than a 50% chance you end up with a cash income.
    You had to start with 301.25 in cash, and you got an income of 8.75 = 2.90% on cash tied up in 49 days = 21.6%/year rate of return.
    (the return is not usually that good…volatility was high the last few days, so option premiums were high).
    If you get the cash and the option is never assigned, you just repeat the exercise with another, later strike price.
    Since note: rather obviously, don’t do this when the stock is cheap, just buy the stock.

Another idea:
Pick a valuation multiple that seems to happen relatively regularly, and set that as your target entry price.
For example, since 2008 there has only been one stretch over a year long that the price hasn’t been below 1.35 times peak-to-date published book per share. (the wait was about 1.5 years if you started Nov 2016)
Accumulate cash till that target valuation level happens.
BUT…each day, increase that target multiple by a tiny amount–the longer you wait, the more modest the price you’ll settle for.
This ensures that you’ll do your next purchase without too much delay, while also ensuring that at least it’s one of the best multiples that was available during your waiting period.
Since you’re quite sure there won’t be too much delay, you’re quite sure there won’t be too much “missed” growth in value per share.
I haven’t tested this, but I have tested approximately the reverse for a periodic selling strategy.

I don’t have a periodic income, but I do have a cash pile at the moment.
I’m waiting for a good moment to pounce and load up, with the hope that it will happen before I lose patience.
But I’m pretty patient.

Jim

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Don’t worry too much about the entry price. Berkshire Hathaway’s stock price is usually unaffected by the irrational exuberance that affects other stocks and the market in general. I wish that Berkshire Hathaway stock offered clear opportunities to take the money and run, but that would require drawing in suckers to overpay.

If you really want to be picky, buy Berkshire Hathaway stock only when the price/book ratio is at or below historic averages, and wait if the price/book ratio is above historic averages. Don’t be concerned about when the low point will be. If it’s a good value, the biggest risk is letting the stock run away from you.

I know that my solution is rednecky, but it’s so much cheaper and simpler than dealing with stock options to hedge.

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For example, since 2008 there has only been one stretch…

You’ve mentioned this cutoff date a lot when writing about what berkshire’s ‘normal’ valuation. Is it just a convenient measuring point, it being a market crash, or is there more to it? The other thing that happened close to that time period is the purchase of BNSF with all its physical assets. I’m basically wondering if we have good reason to give up on higher valuations of the pre-2008 period.

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The mean price to book ratio of the S&P 500 from the year 2000 to now is 2.89.

https://www.multpl.com/s-p-500-price-to-book

If we apply the same ratio to the operating businesses of BRK (which arguably are higher in quality, compared to the S&P 500), and because the operating side is roughly half of BRK’s book value, then the operating side alone accounts for around 2.89/2 = 1.44 x book value, with the investment side thrown in for free.

Could this be one of the reasons why Mr. Buffett has been buying BRK stock, even at P/B multiples of 1.44, when he has also stated that he will not buy the stock unless it is trading at a significant discount to book value, conservatively calculated?

Of course, one can argue that the S&P has been significantly overvalued during the last 20 years. If so one can apply a desired haircut to the price to book multiple, but the overarching conclusion still does not change that BRK deserves a much higher multiple.

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You’ve mentioned this cutoff date a lot when writing about what Berkshire’s ‘normal’ valuation. Is it just a convenient measuring point, it being a market crash, or is there more to it?

No deep reasoning about it–
Berkshire’s valuation level was much higher before the credit crunch than it has been since then.
One can speculate about the reasons, but after ~14 years it seems reasonable to assume the “new era” valuations are what’s to be expected for now.
That could change, but we can’t predict the change, only make a best guess based on the situation we see.

So…any observation about average valuations, or how long a wait it might be to get a low multiple,
or how long a wait it might be to get a high multiple, should probably ignore pre-crunch observations.
We just don’t seem to see Berkshire at high valuations much any more, and see pretty good ones relatively frequently.
For simplicity, and absent better information, I assume that will remain roughly true for the foreseeable future.

1996-1999, average P/B 2.08, 10th percentile 1.70, 90th percentile 2.50
2000-2008, average P/B 1.62, 10th percentile 1.46, 90th percentile 1.81
2009 to date: average P/B 1.34, 10th percentile 1.16, 90th percentile 1.48

So far, my reasonably fancy valuation metrics continue to track a fixed multiple of book pretty well.
That is, P/B (for now) works about as well as it ever did as a value yardstick.
Not perfectly, especially when there are big gyrations in the valuation of the big stock positions, but not too bad.

Jim

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If so one can apply a desired haircut to the price to book multiple, but the overarching conclusion still does not change that BRK deserves a much higher multiple.

Though Berkshire might be a great deal, I wouldn’t put much weight on that specific line of reasoning.
The bulk of the firms in the S&P 500 that trade at high multiples of book are firms that built up those assets themselves.
They spent the money to build the factories, and so on.

At Berkshire, a lot of the big units were acquired for a multiple of book. BNSF, several utilities.
So, they already have their multiple: they’re on Berkshire’s books at a multiple of tangible assets.
As an example, Berkshire’s book value for the railway just after acquisition is higher than BNSF’s book value of the assets was the day before.

Any big acquisition continues the trend of Berkshire being worth a low multiple of book.
(if it were 100% fresh acquisitions and financial securities, it would be worth 1 times book).
Conversely long stretches without a big acquisition will cause the fair P/B to drift upwards slowly
as a larger fraction oft he assets is made up of slow organic capex.

To the extent that Berkshire is always going to be an acquisition machine, the fair mulitiple of
book (even for the operating side) will always be lower than the fair multiple for a typical stand alone operating business.

Jim

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But, here are two ideas:…

Here’s a really simple approach.

(a) If the valuation multiple is not unreasonably high, just invest any saved money immediately.
(b) If it is unreasonably high, wait till it is, letting the cash stack up for a while.

It’s up to you to decide what constitutes “unreasonably high”.
But FWIW, since the credit crunch, the average one year stock price return has been negative in real terms on purchase dates at or above 1.54 times peak-to-date published book per share.
The average one year forward return starting from P/B 1.50 has been inflation + 1.88%.

Jim

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For the P/B spectators… do you find this site reliable or calculate by hand:

https://ycharts.com/companies/BRK.A/price_to_book_value

For the P/B spectators… do you find this site reliable or calculate by hand:

By eyeball, it doesn’t match mine. Generally yes, but in the finer details no.
At a guess, it seems (?) they are using P/B at (say) Dec 31 2019 being the book value on that date, even though it wasn’t known till a couple of months later.

Personally, I track “published book”: the most recently published figure known on a given date.
Technically speaking, book value is something that exists only on a day that a set of statements is prepared.
And knowable only after that team tells you that result.
This isn’t just price changes in the equity portfolio…there are many accounting adjustments that are done only when a set of books is prepared.

Jim

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For the P/B spectators… do you find this site reliable or calculate by hand:

https://ycharts.com/companies/BRK.A/price_to_book_value

I look at them and 2 other sites. They are all fairly consistent. Although ycharts tends to show a bit higher.

********************************
Fri 28 Jan 2022 05:13:06 PM CST
From ycharts: P/B 1.475 for Jan. 28, 2022

From alphaquery: P/B 1.43 Price: [/static/img/loading.svg]

From microtrends: P/B 1.43 January 27, 2022

Here’s a really simple approach.
(a) If the valuation multiple is not unreasonably high, just invest any saved money immediately.
(b) If it is unreasonably high, wait till it is, letting the cash stack up for a while.

Jim, thanks for the thoughtful responses. I plan to study the option strategy you suggested further. In the meantime, I did some additional backtesting of the approach you stated. I tested two flavors, but unfortunately both seem to be flops. Any thoughts on why that may be? What you state makes logical sense, but I struggle to reproduce a consistent advantage in backtest. I assume that’s because the missed opportunity during periods where P/B remains stubbornly high offsets the advantage by holding cash during these periods and buying in at lower P/Bs. (Note: I haven’t tested your other idea yet of gradually ramping up the P/B thresholds as time passes)

  1. Pick a single P/B threshold, say 1.5. Invest any newly available funds immediately at any P/B below this, and hold onto newly available funds in cash at any level above this, investing the lump sum the first time P/B reaches that 1.5 threshold . I ran this through solver to analyze P/B values from 1.00 to 2.00 from Y2000 and again from Y2005 to date. Surprisingly, this showed negligible total return benefit even with the best parameter: the best produced around 1.5% advantage -total- from 2005, not annual.

  2. Pick two P/B thresholds, say 1.2 and 1.5. Invest any newly available funds immediately at any P/B below 1.5. But if P/B is above 1.5, hold the funds that would have been invested in cash until it reaches 1.2 or below (although future funds would still be automatically invested in the < 1.5 range). I again ran this through solver to analyze all P/B values from 1.00 to 2.00 for each threshold from Y2000 and also from Y2005 to date. The 2005 to date produced a max total return around 8% higher than the baseline for the two optimal P/B thresholds. Still not much of an advantage, but something (+0.4%/yr). I also plotted all runs on a surface in excel to look for the largest cluster of groupings (trying to avoid picking an outlier) - these two special P/B thresholds fell within that. But to stress test the idea, I then ran the same backtest on Y2000 to date data and ended up with very different results. That advantageous P/B from Y2005 to date yields worse results than the baseline from Y2000 to date. This shakes my confidence in the approach, but welcome thoughts on why it should not.

I struggle to reproduce a consistent advantage in backtest. I assume that’s because the missed opportunity during periods where P/B remains stubbornly high offsets the advantage by holding cash during these periods and buying in at lower P/Bs.

I expect that’s the case. Berkshire is a stock that generally doesn’t go through a lot of gyrations, and the company is always piling up value, so going ahead and investing at first opportunity is basically as good as the valuation based schemes being proposed.

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