VALUE: After Hours (S07 E23): Margin of Safety vs Momentum

During their recent episode, Taylor, Carlisle, and Zeke Ashton discussed Margin of Safety vs Momentum. Here’s an excerpt from the episode:

Jake: One thing that friend of the show Chris Bloomstran does that I always thought was pretty clever, is when he’s selling something, he will leave a small token amount of it still in the portfolio if it’s a business that he likes and wants to keep following it and he just doesn’t really like the price right now, because it is psychologically quite a bit easier to add to half of a percent position than to reinitiate off of zero completely.

There’s something about the human psyche that it’s really hard to get back in after you’ve already sold all of it. It just makes it easier to then ramp it back up if the price comes back to you. So, it’s close to buying, but instead it’s just a holding of a small piece to kind of keep your foot in the water.

Zeke: I love that idea. And I think that would help me, because one of the things I do like is closure.

Jake: Yeah.

Zeke: I like to be able to say, “Hey, we bought this stock in whatever four years ago and we paid 13 times free cash flow. And now, I’m selling it four years later and the free cash flow’s gone up by 50%, and now I’m selling it 18 times free cash flow,” which is fair value, and then, boom, it’s done.

Jake: Right. It feels good to close the book on it, like there’s something– [crosstalk]

Zeke: Yes, it feels great to close the book on it. It’s interesting that you would say that. By the way, I think Chris is a brilliant investor. I’m sure he’s had wrestled with things like that. I’m sure he has come up with that technique in order to overcome some psychological bias that he recognized that he had. But I’m going to actually write that down. If I get a chance to talk to Chris about it, I will ask him about it, because I think that’s really useful. But I’d be curious if either one of you has a psychological wiring to you that you feel like you need a little technique to override like that, or whether you think that–

Tobias: My whole process is built to override my urges to do anything. I’m prevented from doing anything.

Jake: Yeah. Toby’s pretty well tied to the mast. Graham had that idea of two years or 50% up, whichever came first for a net-net, I believe, if I’m recalling correctly, which I always thought was a pretty good idea.

Tobias: It just truncates your winners. The only problem is it just doesn’t work. It’s suboptimal.

Jake: Well, that whole continuous return versus the punctuated, I think it was easier back in the day to keep that motoring return going. You know related to this though, long time ago, I did a little– It was just in an Excel. It was very back of the envelope. But I took all of the studies that I could find, the value studies. These are the tweedy brown magic formula, etc., you’d know all of them. I plotted out all those returns in the year that they were recorded. And then, I went and found as many of the value investing gurus that I could and I plotted out their returns over that same kind of time period. So, it was temporarily matching studies versus gurus.

The finding was that the studies completely trounced the gurus, which is interesting, because the gurus also trounced the market. But my hypothesis as to why the studies did so well was that the gurus participate on that downside irrationality. They’re buying when everyone else is irrationally despondent about a business, and then they sell when it gets up to fair value, as you described, Zeke.

And then, perhaps, the studies were participating on that downside irrationality, because they are buying cheap. And then, they might have captured some of the upside irrationality as well as it moved into a momentum stock. They just didn’t sell, because it was programmatically a timing thing and it was two years later you sell, and that’s just what it did. And then, it is able to get both sides of the humanity being wrong in either direction.

Zeke: Yeah.

Tobias: There’s also that idea that golden rule that humans tend to underperform simple statistical-

Jake: True.

Tobias: -algorithms and simple statistical algorithms outperform the cohort.

Jake: Even when the experts have access to the models. [chuckles]

Tobias: That’s it. That’s it. The theory is that you should apply the model without messing around with it too much. We’ll see.

Jake: Zeke, what do you think about that? Does that ring true for you at all?

Zeke: In terms of models outperforming humans?

Jake: Well, yeah. You were saying that you felt like you weren’t capturing any of the upside irrationality.

Zeke: Yes.

Jake: Enough of it. Yeah.

Zeke: Yeah. I will say too, that I don’t know which is the greater sin. When you’re in a bull market, not capturing that irrational upside-

Jake: Exactly right.

Zeke: -turns out to be a big sin. On the other hand, coming back to the very first topic we talked about, which is the post-value era now, I think that there’s this margin of safety concept that has slowly been getting diluted amongst value investors. The reason is if you’re really focused on margin of safety, you really probably have not kept up with what’s been going on in terms of market performance. You haven’t been able to own some of the big winners. I just think that’s the nature of it.

And so, combining that margin of safety with catching the upside that comes when the narrative has taken a positive turn or simply the momentum of a stock that is going up will likely continue to go up, I do think that is even more magnified now with the passive flows, because as new money comes in, it will go to a stock that’s higher, and then that stock moves higher, and then the next flow will come in and it will go to that stock again higher. And so, I think that the momentum factor may be more durable now than it’s been in the past, if you’re in the– [crosstalk]

Tobias: Statistically that is true.

Zeke: Yes.

Tobias: It has more evidence for it, stronger evidence for it.

Zeke: Whereas let’s say, you are equally weighted between margin of safety and trying to capture upside. I think the margin of safety piece will come in earlier than it would for many and it will truncate some part of your upside. I think value investing probably does truncate some of the upside, because it used to be traditionally value investors really outperformed the market in the down markets.

And in fact, it became a source of capital into the market to prevent stocks from going further down, because they were the ones that had the cash and they were the ones that didn’t participate in the bubbles. I don’t think that’s as true as much anymore either. I don’t think– [crosstalk]

You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:

Apple Podcasts