In my last post yesterday, I posed a few investing problems that involved Method A and Method B portfolios. As you will recall, after twenty years, Method A ended up with significantly more in dollars than Method B. However, if one had a strategy to measure "rational value," Method B or portfolio B came out ahead. Now we need to drill down and try to better understand what is meant by "rational value."
To try to get at the concept of "rational value," think about appraising two houses in the same neighborhood. From the outside, both houses appear to be similar in value. If we examine them carefully we note that one has upgraded the bathrooms and kitchen. The furnace is new and the interior woodwork is in better condition. In other words, we have additional information that adds value to one house vs. the other. In a similar fashion, one can drill down into businesses and see particular value in one company vs. another company. One way to determine "rational value" is to calculate something called the Historical Value Ratio or HVR. This is a term coined by the writer of an investment book, "Take $tock." At a given time, every stock has a Price/Earnings ratio. For most stocks, the current P/E value dances around the ten-year average, generally staying within +/- 15% of the ten-year average. When the current P/E rises too much ahead of the ten-year average or HVR, we value the stock as over-bought or it is priced too high. If the current P/E is 85% of the HVR, then the stock is under-valued or we might say, has a strong "rational value." We want to take other factors into play, but you get the idea. If the price of a stock is depressed while the fundamentals are strong and a good business plan is in place, the company is said to have positive "rational value."
Now let me digress and tell you a story that happened a few years ago. Some of you have heard of NAIC or the National Association of Investors Corporation, now known as Better Investing. NAIC/BI is the organization that provides support to investment clubs. They are also strong proponents of investing in growth companies. I belonged to NAIC for many years when I was deeply involved in two investment clubs. During the roaring mid 1990s investments clubs were all the rage and growth stocks were performing extremely well. On a Forum supported by NAIC, a discussion began between the author of the Take $tock book and an index investor. The author of the book also published a software program by the same name. The debate between the index investor and the author and software developer focused on which method is superior, index investing or stock picking. The author of the book and software claimed that by following his program, one would double their money in five years. The index investor essentially said – Balderdash. To settle the debate I volunteered to put up $100,000 and invest it following a mechanical method laid out using the Take $tock software. Stocks were purchased and sold based on the calls from the Take $tock software. How to track the performance was a problem as we did not have any software to track an index. This was the beginning of the TLH spreadsheet as Jim Thomas from the Seattle area was interested in the index vs. stock picking debate. Jim coded the first edition of the spreadsheet and that is why we call it TLH, not HLT or something else. Bakul Lalla later made improvements in the TLH spreadsheet and I added more improvements. In addition to Jim creating the first version of TLH, a company called Bivio also developed a system for tracking the IRR of a portfolio and the IRR of different benchmarks. Now we had two methods for measuring performance and I also had Captool to track the IRR for the portfolio, but not an accurate index tracking method.
Getting back to the wager, known as the ICLWager, if the portfolio doubled in five years, I paid the software author $100 and if the portfolio did not double, he paid me $100. It was a win-win situation for me so long as the software program did not fall flat on its face. I was not too worried about that as I had been using the program for a few years and I had confidence in the logic behind the software. As you might expect, the portfolio did not double in five years so I collected $100. It is important to note that the software driven portfolio did outperform the VTSMX index by several percentage points. What no one knew was that I was also tracking another portfolio that was made up of a wide variety of ETFs and that index portfolio cleaned up over the VTSMX and the ICLWager Portfolio. The story does not end here, but I will keep the final chapter for another day as I want to tie it back to the Method A and Method B blog entry.
Photograph: Villeneuve, France