Ownership Impact

I have been amazed by the impact that ownership has on my thinking. Often I place a price on a security and am unwilling to pay more than this price. Yet, if I have the opportunity to purchase the security at my price and it rises in value on the following day, I am unwilling to sell it. This spread between my willingness to purchase and my willingness to sell is my Ownership Impact.

This Ownership Impact is the basis for a framework to "buy low and sell high." In essence, I am willing to be forced to become an owner if the price is lower than a specified amount and am forced to leave my ownership if the price is above a specified amount. However, this Ownership Impact is somewhat irrational in that if I buy something for $10 and am only willing to sell for $20, why wouldn't $11 be appropriate for new money added? After all, everything I own, am I not essentially repurchasing everyday (assuming frictional costs are negligible).

I discovered a recent article that discussed how deeply hard-wired these behaviors might be. Some researchers at Johns Hopkins focused on how our preferences for something deepen because we chose them. They brought 10- to 20-month-old babies into a lab and gave them a choice of objects to play with - two equally bright and colorful soft blocks. They set each block far apart, so the babies had to crawl to one or the other.

After the baby chose one of the toys, the researchers took it away and came back with a new option. The baby could then pick from the toy he or she didn't play with the first time, or a brand new toy. The baby reliably chose to play with the new object rather than the one they had previously not chosen, as if saying, "Hmm, I didn't choose that object last time, I guess I didn't like it very much." That is the core phenomenon.

It appears that this dynamic is working in reverse to drive my Ownership Impact - that once I have chosen something it is endowed with value. Conversely, once I have not chosen something, I develop an aversion to it. Such lurking biases are important to identify and overcome if good choices are to result.

You Can Only Sell It Once

I heard the phrase "you can only sell it once" from an astute real estate investor. I did not see this wisdom as applicable to the stock market because Mr. Market offers pricing everyday on every security. However, since that time, I have come to see it as partially applicable.

Most businesses are simply businesses. With an adequate amount of capital, these businesses could be replicated. Yet there are some businesses where no amount of capital can replace them. These businesses could be termed "irreplaceables" or franchises. My real estate friend's outlook is applicable to these companies because such franchises accrue value at a return on capital higher than the growth rate of their environment. "Buy, don't sell" could be the subtitle on these companies.

Examples from the past were brands like Coca-Cola or Hershey's. In today's world, the creativity and changing tastes of millennials has made these brands less irreplaceable. More of these irreplaceables are now in the tech world. The sheer scale of  Mastercard's reach or Facebook's address book makes them franchises. More importantly for the appropriate sale of such companies is the identification of a movement to being a replaceable from being an irreplaceable, as occurred to the Washington Post on the advent of the internet.

Financial Ratios: Signposts not Goalposts

Financial ratios are important to the investor and I group them into two categories: operating ratios and market ratios. The former address the operating characteristics of the business, such as "net profit margin." This takes the "net profits" (addressed in a prior post) and divides it by revenues. These ratios are important to understanding the business models itself. 

Market ratios, on the other hand, reveal the general assessment of the value of the business. There are several, but the most attended is the "P/E ratio," which means Price to Earnings. Like any measure, simplification has occurred and is important. Any time a "P/E" is discussed, an investor should ask does this mean Price to last year's Earnings or Price to Trailing Twelve Months Earnings or Price to next year's Earnings. I have seen all of these used almost interchangeably. 

As companies continue to creatively account for and present their results, the investor needs to use these ratios as a passageway to gaining greater qualitative understanding. For years, the "value" investor was simply focused on such ratios as a means of identifying a "margin of safety." In a world of change accelerating by globalization, the internet and cheap capital, such ratios may be misleading if they are not specifically connected to underlying qualities.