Experimental feature

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Experimental feature

As I discussed in a prior column, successful investing in the stock market requires answers to two simple questions: “what does it cost?” and “what is it worth?” If you know that a \$30 stock is actually worth \$50 a share, you should consider buying the stock. And if you know that a \$30 stock is only worth \$15 a share, you should avoid the stock.

Investors who are capable of doing the analytical work necessary to answer both questions can stop there. Nothing more is required to be successful in the stock market. The problem, however, is that many investors do not stop there. They needlessly add another variable to the equation.

That variable is time. Rather than leaving the investing equation to a cost versus value analysis, investors allow time to become a factor. The time variable might be a function of the investment, such as a call option that expires after one year.

The time variable is often an artifice created by investors, such as when they require an investment to work out quickly. Even when some investors accurately identify and buy a materially undervalued stock, they will abandon the position if the stock price fails to rise in the short term.

When the time element is an artifice interjected into the equation by an investor, it is frequently introduced after the fact. For example, an investor diligently works to find a bargain-priced stock. The investor is not thinking about the time variable during the search. After finding and buying a \$30 stock that is thought worth \$50, the investor suddenly thinks about time. A few weeks or months later, when the \$30 stock fails to move toward the \$50 calculation of value, that investor runs out of patience, sells the position and moves on to something else.

For this investor, there is a distinct asymmetry in the decision-making process. The investor buys because of the analytics – the \$30 cost versus \$50 value calculation. But the investor sells because of something other than the analytics – because of the arbitrary time requirement.

Investors in options are forced to factor in the time variable. While a long-term owner of stock can wait patiently, holding fast to the analytics, an investor in a stock option cannot. Even if the analytics point to an undervaluation, the investment in the option may fail because time runs out.

Consider the probability of making a mistake when time is a variable in the equation. Let us assume you have a 75 per cent probability of being accurate when you calculate that a \$30 stock is really worth \$50. If you are a long-term investor in the stock, you can stop there. You have a 75 per cent chance of being right. If, instead of buying the stock, you buy a one-year call option on the stock, time becomes a critical variable in the equation.

You have control over the analytical process. The better you are at gauging the value of companies, the better your chance for success. You have no control over time. It is a guess. If we put the odds of getting the timing right on the option at 50 per cent, we can now calculate the probability for success for the option investment. It is 75 per cent x 50 per cent, giving us a 37.5 per cent chance of success.

Admittedly, this example is an oversimplification. Depending on the size of the reward, it is possible that a 37.5 per cent probability of success is reasonable. The point of this example is to illustrate a core investing concept. That is, to the extent you introduce additional variables to the investing equation, the probability for success declines. To phrase it differently, the more things you need to go your way, the less likely it is that you will get the desired result.

It is important, also, to recognise that stock values are not static, but constantly changing. The long-term investor seeks to buy stocks that are at a discount and growing in value. Let us assume a long-term investor pays \$30 for a company’s stock that is worth \$50. Let us assume the company is growing in value by, say, 10 per cent a year. Here you can see how the time variable does not skew the decision-making process of the long-term investor. This investor knows there is a chance that the \$30 stock purchase will be rewarded quickly – that the stock quote will rise in the short term to mirror the \$50 value.

The long-term investor also recognises that there is a chance it may take a long time for the stock quote to catch up to value. But this investor does not mind waiting. That is because the value is increasing by 10 per cent each year that the investor has to wait. If the investor has to wait three years, for example, the stock value will have risen from \$50 to nearly \$67.

To the long-term investor who is skilled in the cost versus value calculation, the only time-related risk is that of being early. For an option investor, or other investor with a time requirement, being early can result in the forfeiture of gain. For the long-term investor, though, being early simply results in the deferral of gain, not the forfeiture of gain.

Arne Alsin is a portfolio manager for Alsin Capital and the Turnaround Fund arne@alsincapital.com