I know that much of the money management business sets target prices for buying and selling, particularly value managers, and sell-side analysts. I don’t set target prices. Why?
Think of what a target price means. It says that at a certain price you are willing to exchange securities for cash (sell), or vice-versa (buy). The trade-off between an individual security and cash is difficult to calculate. Even if you have a really good dividend discount model, the target prices are very sensitive to model inputs. I think the question of whether I would rather have cash or an individual stock or bond is a difficult question.
So why don’t we focus on easier questions? It is simpler to rank stocks versus other stocks at least in broad, and bonds versus bonds. I am not saying that you have to optimize. You can’t be exact in ranking the desirability of stocks or bonds, but if we can’t identify a group of stocks outside the portfolio that are better than a group of stocks inside the portfolio, there is not much sense in trading. Same for bonds.
With bonds, the tradeoff is more obvious, because you can consult yield relationships, and make all of the adjustments necessary to decide whether a trade is a good one or not. Even then, there had better be a good yield advantage after all adjustments, or the trad will not make sense. As an example, back in the first half of 2002, I engaged in a wide number of trades that gave up some absolute yield, but improved the portfolio’s credit quality dramatically at a time when credit spreads were narrow. Though overall yield went down, the portfolio was in better shape. This was the opposite of what we did after 9/11 — buy distressed bonds while spreads were very wide, accepting more credit risks when it paid to do so.
Thus, most of my portfolio management is not so much “Aim for the best.” I’m not sure I can do that. “Aim for something better than what I currently have” is achievable. In cases where I can find no clear improvements, sitting on my hands it the best strategy. After all, time is on the side of a portfolio representing great relative value.
This is not to denigrate those that are better than me, like Seth Klarman. He has a strong sense of when he would rather hold cash versus taking any risk, and so he manages value in an absolute sense, even giving back money to clients when he doesn’t have anything to do with it.
I’m still finding some attractive assets to buy, though not many. Later this month, I will do my formal quarterly reshaping of the portfolio, where I will trade away a few stocks I like less for those I like more. And if I can’t find any that I like more, I don’t have to do anything, because if I’ve got a really good group of stocks, doing nothing may be the best idea of all.
PS — If you want more, some of the details are in Portfolio Rule Eight.