Understanding relative value

We’ve talked a lot about calculating the value of a company. That’s what we do when we look at historical adjusted earnings and compare that to the current market value of the stock price. You get a P/E and assuming that earnings growth will continue as in the past (not something you can necessarily assume) then you can get an understandning of whether you should buy. That is based primarily on your view of the future prospects of the business that you are buying and the current value that the market is assigning to the company. You should also consider all of your other holdings to make sure that you maintain a diversified portfolio. For instance, is would not be wise to put all of your money into one industry such as tech.

Now the above is not the only thing to consider when making investment choice. Let’s discuss relative value. Relative value is the value of a company compared to the value of other companies that you could invest your money. How many times have you seen someone post some like “Yeah this or that stock is down but my time horizon is 5 or 10 years so I’m going to hang on.” It may be the right decision to hang on. Or it may be be that that person does not want to admit a loss. Whatever the reason, it is highly likely that this person is thinking only of their stock in isolation (i.e. absolute value) rather in in comparison to other stocks (i.e. relative value). In markets like we are in right now, there may be opportunities to make shifts that can serve your long term financial interests. By considering your investments against your other investments and other potential investments, you may realize that you have an opportunity to exit a position that your weren’t that excited about to buy a new one that you’ve been watching or add to one that’s dropped significantly and that you have a very high conviction on.

Let me give you an example. I bought too much AEYE than I should have. I also had some remaining shares of AFOP that I was looking to sell. For both of these stocks, I was not selling them because they had dropped and I thought further downside was limited. Essentially, I was waiting for these stocks to rebound some before selling. Then many other stocks started selling off hard while AEYE and AFOP retained their value. So while the market prices of AEYE and AFOP did not go up, their relative value compared to many other stocks did go up. Now I could sell them and buy some other stocks that had dropped much more. It was almost the same as waiting for AEYE and AFOP to go back up. Almost but not quite. It was better because by selling low and buying other stocks low I was realizing a tax loss that would reduce my 2014 taxes. There were 2 other reasons why I viewed these trades as beneficial. First, I believe I was reducing my risk by reallocating my money into stocks that I beleive have lower risk. Second, I believe that when the market rebounds these other stocks will rebound more than AEYE and AFOP. We will see if that holds true. Those of you who have been watching Saul may have noticed that Saul thinks in terms of relative value. For example, he often says something like "I sold some of my stocks that that didn’t drop much (e.g. AMBA) and bought some other high conviction stocks like UBNT, SYNA or BOFI. Hope this helps.

Chris

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Chris,

Thanks! Your post was a “lightbulb moment” for me. This board is one of the most educational spots in TMF.

I’ve been struggling with the concept of a fixed portfolio with little or no new cash, and how or when to make adjustments over time. I was thinking greater percentages allocated to those stocks where I have a higher conviction and/or see lower potential risk. But that begs the question of exactly what is the right allocation. One is likely to fall victim to false precision. Now it’s making better sense to sell a little bit of a higher conviction stock to buy other stocks that have become relatively cheaper. I like framing that as a change in risk: the high conviction stock that hasn’t dropped (as much) may now be riskier than it previously was (compared to other stocks), and so it deserves a smaller allocation (and the others deserve larger allocations). Neat.

I’m still wary of trading too much. That leads to increased trading fees, and makes for more record keeping in a taxable account. And it may cause tax implications in a taxable account. I’m still trying to figure out what is an appropriate amount of trading/adjustment.

In my case, my largest position is AAPL*, which has barely moved. That makes it relatively more risky, and a good candidate to sell in order to buy other good stocks that have fallen more severely. I was planning on selling more AAPL, but I have a definite long-term gain, which I was hoping to defer to 2015 for tax purposes. At some point, bargain prices in other stocks will override the tax consequences, and I should sell (at least some) in 2014. I don’t know where that threshold is. I’m going to have to ponder that this weekend.

Thanks again for a great post that’s making me think differently.

-Mark

  • AAPL used to be something like 70% of my overall portfolio earlier this year. It is now down to something like 15%.
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Apple has been flat for a month. It’s up 30% in the last year. I would never sell my shares in the hope that a stock that has been crushed is going to give me larger returns. Doesn’t make sense to me.

Long UBNT

Robert

I would never sell my shares in the hope that a stock that has been crushed is going to give me larger returns. Doesn’t make sense to me.

Hope when investing never makes sense, substitute belief and it can make perfect sense.

They don’t call it rotation for nothing.

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Rotation works for me as well but holding Apple for the last six years has been my biggest winner. Different strokes as they say.

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Rotation works for me as well but holding Apple for the last six years has been my biggest winner. Different strokes as they say.

Thats great Everett but do you think it will be your biggest winner in the next 6 years?

Andy

do you think it will be your biggest winner in the next 6 years?

Like pretty much everything else, it is until it isn’t. Apple has scared me as an investment for quite some time because it depends on them continuing to produce new products, even new categories of products, which excite people enough to maintain their fan base. Meanwhile, despite the number of product categories which they invented … well, not really invented, but succeeded in popularizing … all of these product categories now have competitors and, by and large, it is no longer clear that Apple is actually a real leader … in sales and zeal, maybe, but technically it is much more dubious. So, they have to keep the edge or one of these years they will disappoint. The market popularity will carry them for a bit, but eventually they have to deliver or they become yesterday’s beau. And yet, it hasn’t happened yet.

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OK back to lurking.

Robert

Then many other stocks started selling off hard while AEYE and AFOP retained their value. So while the market prices of AEYE and AFOP did not go up, their relative value compared to many other stocks did go up

That all depends on what you consider the absolute value to be of those companies. If you think AEYE is going to be a 10-bagger from here, then how is it a relatively poorer value compared to some stock that may have gone from a potential double to potential triple due its decline?

It was almost the same as waiting for AEYE and AFOP to go back up. Almost but not quite. It was better because by selling low and buying other stocks low I was realizing a tax loss that would reduce my 2014 taxes

This doesn’t really make any sense. The taxes you’re saving are fractions of each dollar lost. Even if you’re in a crazy tax bracket in a crazy state, you might save 50 cents on the dollar? And for most folks, it’ll be a lot less (and zero for anyone in an IRA). The tax loss is a small consolation prize, at best – don’t let the tail wag the dog.

I believe that when the market rebounds these other stocks will rebound more than AEYE and AFOP

Chris, you may be very good at predicting this sort of stuff, but I am definitely not – and I think even Saul has mentioned before that he’s often surprised by which stocks in his portfolio do well and which don’t over some period of time. For most of us, shifting capital based on something like this is risky.

Personally, I prefer to stay grounded in the realm of absolute value. Stocks can move sharply, and it’s just too hard (for me, anyway) to predict when those moves will be. They seem completely random to me. That doesn’t mean shifting capital isn’t a good idea, but I’m doing it from stocks that I believe are trading well above their absolute fair value to ones that I believe are trading well below their absolute fair value. Even that’s risky, since you’re moving capital away from a proven winner, and perhaps my view of the “undervalued” company is flawed. Some people only add to their winners, and are successful doing that. But assuming my sense of fair value is in the ball park, I’ll at least do fine over the long term regardless of what happens in the short term.

Generally speaking, I think one needs very good reasons to shift capital around – especially if emotions are running high, as they can be during a correction like this. It’s not something to be taken lightly. In your case, you had decided earlier to reduce your positions in those companies due to portfolio risk. That’s a great reason, though I think it makes more sense to act as soon as you make that decision – it’s a coin toss as to whether the stocks will go up or down in the short term, so waiting for a better price is just trying to time the market. Again, maybe you’re good at that, but I’m not.

But those decisions weren’t to sell based on a relative value, but to reduce portfolio risk. Then you redeployed that capital elsewhere.

It’s important to remember: you don’t have to jump on every opportunity and maximize the profit from every situation. It’s impossible to do anyway. All that matters is your long-term performance and whether you’re meeting your goals with acceptable risk: if you are, then you’re successful. Period. You don’t need to beat yourself up over all the woulda-coulda-shouldas.

As humans, we’re susceptible to a lot of biases that can push us into very bad investment decisions. And the more emotional we are, the more likely we are to make a poor long-term decision. I personally think it’s often best to stick with the decisions we made during calmer times unless there’s a really good reason. I’m no longer in Fool One (I tried it for about a week before deciding it wasn’t for me), but I think one of the smartest things Tom G. is doing in his Everlasting Portfolio is locking up purchases for 5 years. Now someone might look at that and think “That’s stupid! What if your thesis is broken? What if X happens? what if Y happens?” and it’s true, of course, that there may be some very good and sound reasons to sell sooner. But that rule also avoids all of the bad decisions to sell, and I think that’s the much larger risk for most of us. I’m willing to bet most of us don’t even measure our sell decisions properly (keeping track of exactly where that capital subsequently went) so that they can even be analyzed years down the road.

So anyway, all of this is a long-winded way of saying that I think your idea – selling over-valued assets to raise cash for buying under-valued assets – makes perfect sense in certain situations, but it’s not as a simple as just looking at which stocks have declined more than others. There are a whole host of other considerations, and I personally believe that one needs to tread carefully and avoid getting caught up in the moment.

Neil

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That all depends on what you consider the absolute value to be of those companies.

Looks like you weren’t clear what I meant by absolute value. I did not mean that absolute value is an opinion of valuation but rather that absolute value is the current market value of a given stock in isolation. Whereas relative value is the market price of a stock compared, individually, to another stock. It might be easier to think of it as an exchange rate. If your idea of the worth of two companies that you own remains unchanged and the relative market price of those two companies changes dramatically then it might be worthwhile to look and making adjustments. Of course, as you pointed out, there are many factors to be considered.

This doesn’t really make any sense. The taxes you’re saving are fractions of each dollar lost. Even if you’re in a crazy tax bracket in a crazy state, you might save 50 cents on the dollar? And for most folks, it’ll be a lot less (and zero for anyone in an IRA). The tax loss is a small consolation prize, at best – don’t let the tail wag the dog.

I agree that the tax implications should not rule decision making but it can certainly be a benefit.

but I think one of the smartest things Tom G. is doing in his Everlasting Portfolio is locking up purchases for 5 years. Now someone might look at that and think “That’s stupid! What if your thesis is broken? What if X happens? what if Y happens?”

I’d agree that it’s foolish to limit yourself to not making changes if you get new information or if prices get too far out of whack up or down. To lock yourself in really says more about either a) a lack of conviction in your holdings or your ability to value companies even crudely, b) or a lack of belief in your own ability to make good investing decisions. I find it useful to think and act incrementally, making small shifts as opposed to radical portfolio shifts. It helps also to accept that mistakes will be made and optimal timing on selling or buying is not the goal.

Chris

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