ALEXANDRIA, VA (Oct. 30, 1998) -- Over the last week, Dale and I have been taking a look at some execution-related portfolio management issues, but we have yet to specifically outline the costs associated with trading -- the kind of costs that high turnover portfolios endure. I'd like to visit that issue today, and I'd also like to take a brief look at shorting stocks -- just to provide some guidance for a reader's sojourn through these Boring parts.
With respect to trading costs, there is much more than the direct outlay of cash for brokerage commissions that needs to be considered. As Aswath Damodaran has outlined in his book Valuation, which examines active trading, there are actually three ingredients that go into the trading costs. All these costs taken together, along with commissions, make up the total trading cost of a particular investment strategy (this is before any tax considerations):
(1) The first is the spread between the price at which you can buy an asset (the dealer's ask price, or the lowest price at which the dealer is willing to sell) and the price at which you can sell the same asset at the same point in time (the dealer's bid price, or the highest price the dealer is willing to buy).
(2) The second is the price impact that an investor can create by trading on an asset -- pushing the price up when buying the asset, and pushing it down while selling (this is also called "slippage" when purchasing).
(3) The third cost is the opportunity cost associated with "waiting to trade." Waiting can cost profits both on trades that are made and on trades that would have been profitable if made instantaneously but which became unprofitable as a result of the waiting (work done by Jack Treynor).
Even portfolios that don't thrive on active management can suffer from the verities associated with transaction costs. An oft-cited example is the difference in returns between the fund that Value Line had run and the paper portfolio that Value Line had used to compute the returns that its recommendations had made. Between 1979 and 1991 the paper portfolio had an annual return of 26.2%, compared with the Value Line fund, which had a return of 16.1%. The disparity was due to subscribers getting into positions before the fund, and, of course, trading costs. Fortunately, our philosophy of extremely low turnover will steer us away from a lot of these concerns. However, we will announce our intention to buy or sell before we actually conduct any transaction.
We have written about shorting stocks ad nauseam in this forum -- and even debated its merits and pitfalls. In the Boring Portfolio we will actively look for opportunities to short stocks, even though it requires a skill set that is somewhat outside of our articulated area of specialization. Employing a fairly rigorous analytical framework for checking out companies often allows us to conclude a stock is trading well above its intrinsic value. However, using this reason alone as justification for taking a short position is not always financially fattening.
Though we like to state that the market recognizes business success in the long run, it seems that positive markets also like to cling to overvalued companies until investors actually get clubbed over the head with a deteriorating bottom line. Louis Corrigan writes in a recent duel about some of these issues, including the short-term instability that investors in these positions must often endure: "Again, the reason shorting differs from going long is that your broker can force you to cover your position when you least want to, either because of a short squeeze or because a stock has moved so much against you that you don't have enough equity left in your account." For those unfamiliar with some of the terms here, check out Louis's piece on short squeezes.
In the realm of the ideal -- hoping that reality will conform to our expectations in the Boring Port -- we can short to create a float that will allow us to buy more of a company that we already like. The superior economics of such a transaction are clear. We'll take a look at this issue again next week. Until then, have a great weekend.
Stock Change Bid ANDW + 5/8 16.38 CGO +1 34.50 BGP + 5/8 25.38 CSL +1 5/8 38.63 CSCO + 5/16 63.00 FCH + 1/8 23.56 PNR - 1/8 37.63 TBY --- 7.06
Day Month Year History BORING +1.65% 6.90% -8.53% 15.10% S&P: +1.18% 8.03% 13.22% 76.75% NASDAQ: +0.81% 4.58% 12.80% 70.17% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 63.00 162.99% 2/28/96 400 Borders Gr 11.26 25.38 125.43% 3/5/97 150 Atlas Air 23.06 34.50 49.62% 8/13/96 200 Carlisle C 26.32 38.63 46.72% 4/14/98 100 Pentair 43.74 37.63 -13.99% 5/20/98 400 TCBY Enter 10.05 7.06 -29.69% 1/21/98 200 Andrew Cor 26.09 16.38 -37.24% 11/6/97 200 FelCor Sui 37.59 23.56 -37.32% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 14175.00 $8785.01 2/28/96 400 Borders Gr 4502.49 10150.00 $5647.51 8/13/96 200 Carlisle C 5264.99 7725.00 $2460.01 3/5/97 150 Atlas Air 3458.74 5175.00 $1716.26 4/14/98 100 Pentair 4374.25 3762.50 -$611.75 5/20/98 400 TCBY Enter 4018.00 2825.00 -$1193.00 1/21/98 200 Andrew Cor 5218.00 3275.00 -$1943.00 11/6/97 200 FelCor Sui 7518.00 4712.50 -$2805.50 CASH $5750.59 TOTAL $57550.59