Even if an investor has the perfect valuation-driven asset allocation model, there is still scope for error when it comes to execution. One of the key elements that any investor must consider when managing a portfolio is when and how frequently to ‘re-balance’ back to ‘target’ weights. While this subject is both important and hotly debated, we have found no academic work to support the view that there is an optimum rebalancing period. Therefore, while we remain open to the discovery of a reliable systematic approach to rebalancing, we believe that rebalancing requires significant thought and a best execution policy should be open to change.
Rebalancing Principles and Warren Buffett
The key element of a diversified portfolio is the fact that asset prices move in different directions, especially when allocating between negatively correlated assets such as equities and bonds. This aspect of capital markets can help reduce the volatility of a portfolio that is broadly spread across asset classes, although does reduce our exposure to our best ideas. By virtue, this can lead to a misalignment between the desired asset allocation and reality.
Rebalancing is therefore an essential part of a valuation-driven philosophy. Left unchecked, our exposures will not resemble our best ideas. Yet, executed too aggressively or regularly and we expose the portfolio to unnecessary turnover, such as taxes and fees, and the potential for drag. We have witnessed this in practice, with Warren Buffett a master but countless others failing miserably as they seek to top-up positions that are in structural decline.
Averaging Down: Simple but not Easy
The subject of averaging down is one of the biggest challenges for valuation-driven investors to tackle. In essence, it is the art of obtaining the lowest cost base possible. For example, say an investor buys an asset today and it falls by 40% tomorrow. Should they buy more of it? For value investors, the general wisdom is that you should definitely buy more so long as their conviction in the long-term fair value of the asset remains. It was this exact concept that Warren Buffett referred to when he famously said, “Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down”.
If you must be early, make sure it is right. The key challenge is that ‘early’ and ‘wrong’ are often indistinguishable in the initial stages of a valuation-driven investment. An investor who is ‘early’ should increase their capital commitment as the probability-adjusted gain increases, much like a poker player should. However, if that investment is ‘wrong’, they should accept their losses and move on. This is what we tend to call value traps and are the nemesis of an auto-rebalancing policy.
At this point, it is worthwhile reminding that as a valuation-driven investor, you conform to the basic principle that you might be early to the party. After all, you are buying an investment today because it is cheap and no one else wants it, yet. By undertaking this exercise, there are no guarantees someone will want it next week, month or even year. Hence the reason value investors often emphasise the word patience.
Value Traps are Dangerous
As an example of a rebalancing policy gone wrong, many investors in the 1990’s never anticipated the progression of digital cameras, nor that Kodak would be left behind in that progression. By buying into Kodak in 1997, 1999 or 2001, they would have experienced a value trap first hand.
The problem is that Kodak was in structural decline, but very few understood that at the time, and a fixed rebalancing policy would have led investors to continually bid up this exposure only to find it halve, halve and halve again. In the case of Kodak, an auto-rebalancing policy would be a terrible idea.
What can an investor do to avoid value-traps? The process of identifying these value traps is beset with behavioural challenges and something every value investor can do better. They tend to cluster under the following situations:
Leveraged businesses that succumb to debt constraints. Every time the investment falls in price, the debt as a percentage of the investment rises. This can cause a perfectly good business to be a value trap based on a poor capital structure alone.
Business with poor cashflow management. Fundamental analysis should usually help an investor avoid such a circumstance, however if a Board decides to undertake a monumental capital expenditure program when they don’t have the cashflow to support it, they risk destroying the value of the business.
Situations undergoing structural change. This is the most common at an asset class level, which can evolve via comprehendible means, an ageing population or industry in structural decline, or via rapid disruption that is less probable, wiped out via technological advancements.
Of the major behavioural deficiencies we experience, the most important for value trap identification are likely to be the endowment effect and overconfidence. Specifically, investors tend to overvalue what they already have and this often skews their assessment of the resulting news flow. This is often due to over-confidence in the original buying decision and therefore less likely to change our assessment of fair value as it evolves. Said simply, we seek confirmatory evidence to support our view that something is cheap.
However, we must also be aware of the availability bias that tends to lead humans to extrapolate current trends. The more an asset price falls, the more likely we are to sell. Therefore, the worst situations occur when an impatient investor aggressively adds to a position in the early stages of a decline and then loses confidence at the lowest point, maximising the permanent loss of capital.
Said simply, the endowment effect can be damaging as we view fair value, while the availability bias causes us to ignore any fair value calculation. Both biases must be controlled if an investor wants to successfully and consistently identify value traps.
