Value Investing? Don't Quibble Over Nickles
I got a great value investing question from one of our members that I wanted to share with the rest of you.
You Are Not Paying the Quoted Price When Value Investing
If you've been trading for a while then you know that the quoted price of a deep value stock is not necessarily the price that the stock is being sold at. There are inevitably two prices: the buy price and the ask price. The gap between those two prices constitute a price spread.
The reason for this has to do with liquidity -- essentially the ability of the seller to sell when he or she wants to sell -- by finding a willing buyer or by using a middleman to hand the stock off to when it's not wanted. While the inner-workings of the financial markets is a bit beyond the scope of this value investing article and not something that investors really have to worry about to make great returns in net net stocks, the fact is that the spread is there and that it's decreasing your overall returns by a hair.
Usually the spread is fairly thin. On mega cap stocks you can find spreads of only a couple pennies. Where it gets more meaningful, though, is in low volume stocks or stocks of small cap companies. Here, the price that an investor thinks he or she is buying at and the actual price the trade is settled at can be vastly different. In some cases it can erode your margin of safety quite a bit.
To combat this I use limit orders when value investing. When placing a limit buy order I'm essentially telling my broker that I'm not willing to pay more than X amount for the shares so stick to that price or lower and try to get them for me.
Can We Turn Protection Into Value Investing Profit?
An obvious question can then be asked: If it makes sense to protect yourself from paying a much higher price than what is quoted when value investing, does it also make sense to skim half a percentage point from the price above or below where the stock is trading? For example, does it make sense to offer $1.99 for a $2 stock, and sell a $4 stock at $4.02? Similarly, does it make sense to wait on a very well priced net net stock to see it get cheaper before buying?
It might seem obvious that this little trick is a good way to boost your returns. If you can successfully do this on an ongoing basis when value investing then you would boost your returns by 1% which, in time and over a large number of holdings, would add up. There is a major problem with this, though.
The Lynch Experiment
Peter Lynch, an investment legend, once wrote that it doesn't make sense to quibble over a nickel. Let's run this advice as part or a value investing thought experiment.
Suppose that you are able to actually skim a 1/2% off of buy and sell transactions. The question that needs to be asked is: would you be able to do this on every trade?
If you were able to do this on every trade then the upside is an additional percentage point of return on the stocks that you hold. This tiny bit extra would add to your compound returns and you would see a more valuable portfolio than you otherwise would in the future if you hadn't been skimming. On the other hand, if you aren't able to do it every time you want to buy or sell then you risk missing a low buy price as the stock rises above its additional level, or a high sell price as the stock sinks below fair value.
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To me, it doesn't seem likely that an investor would be able to skim on every transaction he or she makes when value investing -- the risk of not being able to pull this off actually seems quite high. Ultimately that risk means forfeiting a large amount of potential profit.
On the buy side, an investor might see the stock price advance all the way up to the point where it reflect's the company's net current assets and be out thousands in potential profits just because he wanted to save a 1/2%. An investor would be out a large chunk of money even if the stock rose only a handful or percent higher.
On the sell side, perhaps the investor has to wait longer to realize a return or never sees those price levels again. In either case, missing that potential profit would completely wipe away any gain the investor could have made by skimming. And, it would only have to happen once during your value investing career.
Missing opportunities like that is much too common to make the net return of skimming profitable when value investing. Of course, your portfolio will show greater returns because you initiate the practice of skimming but the net effect would turn overwhelmingly negative if you took into account the profits you could have made if you just bought at the price offered.
Here's My Advice For Your Value Investing Career
As deep value investors, we have the chance to buy current value stocks at deep discounts to intrinsic value by taking advantage of the fear, greed, or ignorance of other people. If you want to boost your portfolio returns then there are much better ways to do it than by demanding the last cent from desperate sellers.
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