The Rules, Part XLIX

by: David Merkel, CFA

In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.

I’ll tell you about two former bosses that I had. They are both good men, and I respect them both. The first one taught me about bond management. He had a difficulty though. Typically, he did not like to trade. When I stepped into his role, but with far less experience, I traded a lot more than he did. Because I traded more, and liquidity in the bond market is sporadic, I came up with the rule listed above.

The boss had an interesting insight, though: he suggested when you get to large sizes, stocks and bonds are equally illiquid. I tend to agree. In my days, I have traded stocks and bonds where I was a disproportionate holder of them, more so with bonds than with stocks. If you want to learn the microstructure of markets, there is no better training ground than with illiquid securities. And if you hold a lot of any security, the position is illiquid.

Once you are big, it is hard to trade in and out of positions rapidly. You have to scale in and scale out, and do it in such a way that you don’t tip your hand to the market, which would then move against you. Now, it would be easy if you had a fixed estimate of value for the securities, so that you knew whether a proposed buy or sell made sense, but corporate bonds and stocks improve and deteriorate.

Imagine for a moment that you hold five percent of a company’s bonds, and to your surprise, the situation is deteriorating. Bid prices are falling. What do you do? First question: are the bonds money good? Will they pay off, with high likelihood? If so, bide your time, and maybe add some more if you have room. If not, the second question: so what are the bonds worth? If less than the current price, start selling, but avoid the appearance that you are desperate. You have a lot of bonds to sell. For the market to absorb them all will be a challenge. I would say to brokers, that I was willing to sell small amounts of bonds at the current market, but if someone wanted to buy my full position, I might be willing to compromise a little. Then you can have negotiations.

More often, in a deteriorating situation, you sell in dribs and drabs as the price of the asset falls. There is psychological pain as you sell lower, but a good manager dismisses it, forgetting the past and focusing on the future.

Then there was the other boss. At the interview he asked me, “What is one of the hardest lessons you have learned?” I said, “In institutional portfolio management, the two hardest things to do are to buy higher than your last buy, and sell lower than your last sale.”

He appreciated the answer, though he had a hard time applying it personally. He had a tendency to look to the past more than me. Over the years I have learned to be forward-looking and try to analyze what securities will do the best, regardless of my cost basis.

I got the largest allocation of the Prudential “C” bonds when the deal was done. but I bought an equal amount 10% higher in price terms when it was a great deal in relative terms. It was tough to buy more at a higher price, but it was still a great yield on a misunderstood bond.

Regret is native to mankind, but you can’t change the past. You can try to estimate the future. Don’t think about your cost bases. Rather, think about what an asset is truly worth, and its trajectory, and manage your buys and sells relative to that.

Forward-looking management wins. Look forward, and avoid regret.

PS — On Scottish Re (spit, spit) we went through this process. We bought and bought more as it went down. I erred in my judgment. Had I looked at the taxable income, I would have realized that a lot of the profits weren’t real.

Before the company announced its reorganization plan, we doubled our position at a very low price, but then sold the whole thing into an astounding rally when the company announced its plans. That cut our losses considerably, and we didn’t buy it back. Eventually, it was worth nothing. Focus on the future; ignore the past.