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Daryl Davis
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Daryl is quick to point out he is simply a Buffett hack. As such, and because there is a distinct absence of commas in his net worth, he could be called the poor-man's version of Mohnish Pabrai. After winging it through college studying philosophy and religion, Daryl has since pursued his... More
  • More on Longs; Selling 1 comment
    Dec 21, 2009 8:34 PM
    Earlier this year, I wrote a series on the home healthcare industry in which I recommended a buy-and-hold strategy for AFAM, AMED, GTIV and LHCG (“hold” being defined as “at least several years, and possibly forever”). The reader should not have left that series with any expectation of further communication from me on when to sell.
     
    Three weeks ago, I posted an article (“A Leverage-Wary Partridge in a Pair Tree”) regarding pair trading that contrasted with the earlier series due to its focus on market technique rather than business fundamentals. Missing from that detailed recommendation —offered only to a select group of readers— was the following very important communication: For record-keeping purposes as well as to benefit anyone who followed that advice, I will communicate when I exit my pairs by commenting on that article.
     
    With that omission now rectified, we can use this opportunity to discuss exit philosophy.
     
    Marginal Discussion
     
    First, we need to clearly understand the terms “margin” or “marginal” in whatever context they are used. “Margin Account” is likely the most easily understood term: These are brokerage accounts wherein a trader is able to borrow against the equity of her securities, as well as execute short sales. Of course, when she gets a “margin call,” she is required to shore up her margin account to her broker’s mandate (either by adding assets quickly, or selling the extant assets within the account).
     
    “Marginal Opinion” determines the price at which a security most recently traded. On page 12 of The Theory of Investment Value, John Burr Williams writes: “Both wise men and foolish will trade in the market, but no one group by itself will set the price. Nor will it matter what the majority, however overwhelming, will think; for the last owner, and he alone, will determine market price. Thus marginal opinion will determine market price.” Williams goes on to give an admittedly oversimplified example of how marginal opinion is formed by a relatively small group made up of the most pessimistic owners and the most optimistic non-owners of a security.
     
    The “Marginal Traders” in any given security are made up of that unfortunate group of less-competent souls who—against their will— transfer portions of their wealth to the more successful investors and traders in that security. These traders are the patsies who do not realize they should stop playing the game. Usually, marginal traders are intelligent —at least in that word’s conventional sense. Even the most intelligent person in the world could step into this category, if, in trading, that person stepped outside of his/her circle of competence. Isaac Newton once commented on the market, “I can calculate the movement of the stars, but not the madness of men.” 
     
    With these clarifications in place, it is easy to see how market prices —determined by a frequently small group of optimists and pessimists —can be so volatile. When transactions from this marginal opinion emanate from margin accounts, the results can be incredible. When marginal traders determine the marginal opinion by transactions within their margin accounts, the results are often ridiculous. 
     
    Sleeping Well
     
    Mohnish Pabrai—a self-proclaimed Buffett follower —wrote that “selling a stock is a more difficult decision than buying one” (p. 147, The Dhandho Investor).   I disagree.* Understanding a company within an industry within the economy is quite difficult. Competently engaging that company’s marketable securities presents a whole new set of challenges.  Selling is far from easy, but by the time you get there, most of the heavy lifting has been done. Further, a great purchase decision trumps all cards— and may even eliminate the need to sell.
     
    Within the Buffett system, the two preeminent issues to contemplate regarding a potential sale are: 1) the prospects of the currently owned security; and 2) other available options. There are additional subtleties, and to understand when to exit a position, one need only read Berkshire Hathaway’s shareholder letters —with focus on those from 1986, 1987, 1988, 1993, and 1997. For our purposes in this brief discussion, we can identify one easy negation: Because markets and companies evolve, there is no benefit to a rule requiring the determination of a specific exit point prior to the establishment of a position.
     
    For example, if a trader purchased AFAM at $21 on April 8, 2009, with a pre-determined exit price of $26 and a stop loss at $15, then he would have logged a 24% profit just 26 days later, while never having to even sniff $15. Admittedly, it would be difficult to interrupt his celebrating, but a sale as of today would log an 86% gain. A sale three weeks from now might log a 2% loss. The author would be unmoved by any of these outcomes in and of themselves. While I can speak somewhat intelligently to the future prospects of AFAM, I do not know what other options that hypothetical trader has or had available (and there were hundreds of great choices on the table in early May).
     
    Over the next 20 years, that original and untouched investment in AFAM will net a result superior to that of the overall market, which is why I can, with a clear conscience, leave that recommendation uncoupled —that is, without any sell advice.
     
    The pair recommendation is quite different. A pair cannot be held forever: “till death do us part” would be a ludicrous approach. In his 1988 Letter to Shareholders (http://www.berkshirehathaway.com/letters/1988.html), Buffett goes into detail about arbitrage. While a pair trade does not fit within the description of a true arbitrage trade, they are related and it is helpful to understand arbitrage as explained by Buffett in the context of this covered pair trade.
     
    The need to rectify my aforementioned omission was made clear to me almost immediately after the article posted, as two stars lined up for the perfect, though unlikely, scenario to unfold. The most startling market statistic regarding AMED is its short interest. With about half of the shares currently on loan (a value approaching three-quarter of a billion dollars at today’s share prices), it is all too easy —and unhealthy— to expect a major short squeeze. But it would take several stars to line up for such an occurrence: the sophisticated bears entrenched around AMED have plenty of fat stored up to avoid being exposed —especially at this time of year. However easy it is to imagine picking off these ostensibly docile and vulnerable bears, rest assured they are actively protecting themselves and their kin. But we are a bit ahead of ourselves.
     
    Because of the risks inherent in any short position, traders should be extremely diligent when considering a pair trade. To avoid getting into serious trouble, many pair traders must be very alert with the daily goings-on of the market. Volatile stocks demand special attention, as a surprise upside-down position can cause a margin call, or even “blow up” a trader. To avoid this, some traders set automatic trigger points to exit a position. Of course, such triggers can occur at the worst times. For example, had our hypothetical trader purchased AFAM at $21 on February 27 (just 38 days prior to the first example) with the same exit price goal of $26 and stop loss at $15, he would probably still be licking that self-inflicted wound (a 29% loss in just 10 days) and not have the option of selling for an 86% gain. 
     
    Determining where, when, how and why to set such trigger points requires one to attempt to understand a psychotic and neurotic market.  Some traders attempt to solve this issue with bigger, badder and faster hardware —but emotionless computers have not yet mitigated the market’s psychotic behavior. Other traders, still required to monitor their equity ratios daily, or even hourly, may approach things with less rigidity or logic, but are in constant danger of broker mandates, continually adjusting their assets.
     
    What I recommended three weeks ago takes all of this anxiety off the table. By covering the short portion of a pair trade with an unfettered pre-established long position in the same brokerage account, there is not a point where the short position can cause a margin call. Therefore, an investor can still regularly reflect on the intrinsic value of these companies, rather than focus on erratic and inefficient stock market quotations in the short term.
     
    None of this is meant to imply that a multitude of other trading methods are not successful. In fact, two trading teams can sit on opposite sides of the table and both come out ahead. Team Right, relying on business fundamentals and acknowledging a whimsical market, might go long on a stock and focus on a market outcome which could take a couple of years to develop, or occur immediately. Right’s investors are entitled to ignore wild price swings as long as they are not leveraged. Team Left might short that same stock, relying on market perception only. Because stock prices are so frequently determined by a smallish group of skittish buyers and sellers, Left’s traders could even achieve their short-term goals by manipulating those marginal opinions —directly or otherwise.
     
    One relatively small short hedge fund could easily and quickly wipe out the buy orders of dozens of optimistic bulls and then pummel the stock with additional short sales, turning the less-optimistic marginal traders into pessimists wondering if the shorts know something they don’t. Left’s team may facilitate the writing of an unfavorable article or two. They might go as far as to allege a smoking gun, which will certainly scare away potential owners of the stock, allowing Left’s traders to clear profits more easily. 
     
    Timing can also be quite important, as some trading dates carry more importance than others. Left’s team may call in a favor with an analyst to delay an imminent buy recommendation on the stock.  January 2, for instance, is a critical day for many money managers who have every reason to do what they can to get a stock price to a certain level by that date. To achieve the right incentive, Left’s traders could do any number of things in the short term.
     
    Right’s traders do not have to pay attention to any such dates, but reserve the right to benefit from attractive outcomes.
     
    Left’s traders will likely do just fine, as will Right’s. 
     
    It should be noted that Left’s traders could just as easily be focused on fundamentals: In the above example, they may have shorted the stock because they believed it was overvalued. Of course, in that case, there would be no need to attempt to shape marginal opinion.
     
    With respect to my most recent recommendation, I hold hopes for the perfect scenario to unfold—but I do not expect it. I expect all four stocks to have closer valuations on multiple occasions over the next couple of years. Exiting those positions today after three weeks would log more than adequate returns —again, especially considering the profits were generated off someone else’s assets. However, I will wait— fully expecting some market craziness on any given day.
     
    Ghost of Christmas Past
     
    We will conclude this discussion with an exclamation point of sorts. December 22, 2009 marks the three-year anniversary of an interview that some hedge fund managers find very regrettable. It speaks for itself:
     
     
    Professional money managers frequently, and sometimes unethically, attempt to shape marginal opinion. This author will attempt to focus on fundamentals, avoiding the anxieties that accompany leverage, but fully prepared to take advantage of irrational and unpredictable marginal opinion.
     
    *Selling is, obviously, a critical part of the investing equation, and, in fairness, Mr. Pabrai went to great lengths to point out some of the complexities and varied perspectives one can take in contemplating the sale of any security. Although I quibble with Mr. Pabrai on this point,  I highly recommend his book.


    Disclosure: Disclosure: Long AFAM, AMED, GTIV and LHCG; Short AFAM and GTIV
    Themes: Home Healthcare
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    From: Davis, Daryl R
    Sent: Wednesday, December 23, 2009 7:59 AM
    To: [Editor]
    Subject: RE: article

    [Editor],

    Hello, again, and thanks so much for your response. The reality is, your response is much more gracious than I expected. In fact, I have submitted a few articles in the past with full expectation that they would not be published. Speaking of previous articles, and I don’t expect you to remember this: An objective observer would likely deem my ability to research and communicate fundamental analysis as superior to the vast majority of SeekingAlpha’s contributors.

    With that being said, you are right. My most recent submission has virtually no fundamental information or analysis. So, your rejection is not altogether surprising. However, I could easily overcome that deficiency.

    From a broader perspective, though, I don’t know if that would serve our purposes. My target audience is quite different than my current readership—which is tiny—on SeekingAlpha. The Instablog has been posted and time stamped…that is the most critical part of the equation for me. With respect to publishing it, that article could easily be deemed controversial with limited upside for SeekingAlpha. If I were you (2nd person plural), I would reject it for more than the valid reason you have offered. As I barely cloaked an attack on Andrew Left (exponentially greater readership and pull), and highlighted a YouTube interview with Cramer that he would likely prefer to forget about, I don’t see enough reward for SeekingAlpha to publish something that presents this significant downside. Again, if I were you, these would be things that would augment the “lack of fundamentals” reason you have offered. I write all of this with sincerity, with no malice at all towards SeekingAlpha. My goal here is to communicate that I don’t expect you to request me to alter the article…though if adding 600 more words worth of fundamental analysis is desirable for publication, I can do so in a matter of hours.

    The value SeekingAlpha offers is incredible, and I truly appreciate that I can “contribute.” I have zero problem with the rejection, and look forward to future opportunities with you guys.

    Hope you have a great 2010!
    27 Dec 2009, 11:15 PM Reply Like
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