晨星投资课程 26.The Fat-Pitch Strategy 

405-The Fat-Pitch Strategy

Course 405:
  The Fat-Pitch Strategy
  
  In baseball, a batter who watches three pitches go past just inside the strike
  zone will be called out by the umpire. Also, as many baseball fans know, the
  strike zone from one umpire to the next can be a different size. Baseball
  players thus often have an incentive to swing at pitches they would rather
  not, out of fear of being called out.
  
  Many investors, especially professional money managers, think about investing
  like it's a baseball game. Because they aim to beat the indexes they are being
  scored against, professional money managers feel a lot of pressure to get base
  hits, doubles, triples, and home runs in order to earn their keep. Out of fear
  of being "called out," they might swing at pitches that may be just inside the
  strike zone, even though they may prefer to watch those pitches go by. In
  other words, investors often forget their valuation discipline and think about
  investing like it's a baseball game--three called strikes and you're out. So
  they swing away.
  
  But what if the rules of baseball were different? What if a batter could watch
  any number of pitches go by, waiting for the perfect "fat pitch" to come along
  before swinging? Baseball will never adopt this rule, of course--games would
  last too long and pitchers would bemoan their escalating eras. But as an
  investor, you can (and should) play by these rules.
  
  You can significantly raise your investment batting average by waiting for the
  pitcher--Mr. Market--to throw you a nice fat pitch right down the middle of
  the strike zone. Unless the market throws a pitch that you're very confident
  in swinging at, you can stand by and watch strike after strike be thrown
  without worrying about being called out, because, unlike in baseball, there is
  no penalty for being patient in investing. With the market pitching, you can
  let as many curveballs, knuckleballs, and sliders go by as you like until you
  see the one you want to hit.
  
  The fat-pitch strategy that we have developed here at Morningstar has five
  parts:
  
  
  1. Look for Wide-Moat Companies.
  
  As we've described in previous lessons, companies with wide economic moats
  reside in profitable industries and have long-term structural advantages
  versus competitors. These companies are fat pitches with predictable earnings,
  returns on capital higher than the cost of capital, and long-term staying
  power.
  
  The beauty of a wide-moat company is that the odds are pretty high that the
  actual intrinsic value of the firm will increase over time, leading to higher
  shareholder value. In other words, time is on your side with these companies.
  By contrast, companies with no economic moat generally destroy shareholder
  value over time--when you buy a no-moat company, you're making a speculative
  bet that the stock will bounce up just long enough for you to sell it. That's
  a very tough game to play, and generally only seasoned pros should attempt it.
  
  We recommend maintaining a watch list of wide-moat companies that you
  consistently monitor for any opportunities. You can input and manage your
  watch list using Morningstar.com's Portfolio Manager. Premium subscribers can
  also use Morningstar.com as a resource to see which companies we think have
  wide moats. (If you are not a Premium Member, sign up for a free trial.) Once
  you've compiled a list of wide-moat stocks, you can set up alerts that will
  inform you when certain events occur, such as when a stock's price drops below
  the price at which you'd consider buying it.
  
  
  2. Always Have a Margin of Safety.
  
  Instead of buying a stock based on what everyone else is doing, buy a stock
  only when it's selling at a decent margin of safety to your estimate of its
  fair value. Don't even think about the overall direction of the stock market,
  because that's impossible to predict with any consistency. By doing this,
  you'll need to exercise a lot of discipline and wrestle with the fear of
  missing out on a market rally. Patience is indeed a virtue when using this
  approach because oftentimes it may take many months, or longer, before a
  fat-pitch opportunity presents itself.
  
  Although you may feel at times that the market is running away from you, and a
  fat pitch may never come around, rest assured that there will be opportunities
  in the future, and you'll be poised to swing away. Think only about individual
  wide-moat companies; if you find one where the price is irrationally low
  relative to its long-term intrinsic value, consider buying it. If not, hold
  off for a fatter pitch.
  
  Obviously, to determine whether a particular stock is trading with a
  sufficient margin of safety, you must have some sort of an estimate of what
  you think the stock is worth. The lessons in this Investing Classroom series
  have given you enough information that you should start to be able to place a
  value on a stock. We encourage you to practice this repeatedly to hone your
  valuation skills.
  
  Also, you must determine how much of a margin of safety you'll require before
  buying a stock. If the firm is not very risky, you could be content with a
  15%-20% discount to its fair value. If the firm is riskier than average, you
  may demand a 30%-40% discount. Ultimately, it's your decision.
  
  The beauty of fat-pitch investing is that it has two built-in factors that
  help offset the risk that your fair value estimate is wrong. First, by
  requiring a margin of safety, you've given yourself some "error cushion," just
  in case your estimate was too high. Second, by purchasing wide-moat companies,
  chances are high that the firm will increase in value over time. Thus, even if
  your estimates were way off, the firm--and its stock price--will likely
  appreciate in value, eventually catching up to your fair value estimate. In
  effect, by buying wide-moat companies, you have another margin of safety built
  into your investment.
  
  
  3. Don't Be Afraid to Hold Cash.
  
  Holding cash is like holding an option--the option to take advantage of
  volatility in the market. The value of this option rises when market
  volatility rises. Thus, when the volatile stock market provides you an
  opportunity to buy wide-moat companies at bargain prices, you'll be ready with
  cash in hand to take advantage of the irrationality.
  
  Many market participants often neglect this important aspect of investing and
  stay fully invested at all times. For instance, many professionals getting
  paid to invest other people's money feel they are actually required to stay
  fully invested even if there's a lack of fat-pitch opportunities. Thus, when
  the market drops, they often can't do anything but watch (or worse, sell out
  near the bottom).
  
  Being fully invested at all times goes hand-in-hand with the professional's
  focus on relative returns--beating an index. For example, if the market drops
  by 10% in a year, but the fictional Relative Return Fund dropped only by 8%,
  Relative Return's manager has provided value because the fund had a better
  return relative to the market. However, had you invested in this fund, you'd
  still be 8% poorer, not exactly anything to cheer about.
  
  We argue that individual investors should care more about absolute returns
  (how much money did you make) and less about relative returns (did you beat a
  benchmark). So if the market isn't throwing you fat pitches, just hold on to
  your cash and wait until it does, because fat-pitch investments are much more
  likely to provide strong absolute returns over time.
  
  
  4. Don't Be Afraid to Hold Relatively Few Stocks.
  
  There are very few good ideas in any given year--Warren Buffett has said he's
  happy to have even one. For the rest of us (i.e., those without the need to
  invest several billion dollars to make a difference in their portfolios),
  there may be five or six good ideas a year. In any event, if you feel the need
  to hold more than 20 stocks, you probably aren't using the fat-pitch
  approach--more than likely you're speculating and trying to diversify away the
  risks of your speculations by holding lots of different names. Remember, it
  takes great patience to be a fat-pitch investor, but when opportunities
  present themselves (nice fat pitches right down the middle), you should buy
  boldly (swing away).
  
  We caution you, however, that it's risky to hold a concentrated portfolio (few
  positions) unless you do three things:
  
  1. Buy only wide-moat companies, which will increase in intrinsic value over
  time.

  2. Buy them only at a significant discount to fair value (a margin of safety).

  3. Have a time horizon of at least three years on each pick you make. It may
  take this long (or longer) for the market to recognize the value of a company.
  
  If you aren't willing to follow these three rules on each and every stock you
  buy, then you probably need more diversification in your portfolio. (We'll
  talk much more about portfolio construction in Lesson 501.)
  
  
  5. Don't Trade Very Often.
  
  If you're using the fat-pitch approach, you won't need to trade very often
  because you'll hold only wide-moat companies. By definition, a wide-moat
  company has long-term advantages and creates shareholder value year-in and
  year-out. Because a wide-moat firm creates value each year, its fair value
  tends to increase over time. These are the only types of stocks in which a
  buy-and-hold strategy works well, because the odds are in your favor that the
  actual underlying value will continue increasing over time. As we mentioned
  earlier, when you buy a company with no moat, you are making a bet that it
  will bounce up just long enough for you to sell it.
  
  Think of it this way: Investing is nothing more than a game of probabilities.
  No matter how diligent you are, your fair value estimate for a stock will
  never be exactly right. It's really just an estimate of what a stock is worth
  under the most likely scenario for future earnings growth and profitability.
  Thus, there's always less than a 100% probability that you'll be right about a
  stock pick. Given that the odds are below 100%, there's little point in
  trading from one stock to another frequently; your odds of being "right" on
  the new pick are probably only a little higher than the odds of being wrong on
  the current pick.
  
  Add to this the costs of trading--including taxes, bid-ask spreads, and
  commissions--and the odds of generating higher returns by trading frequently
  are worse than simply buying great stocks at good prices and holding them for
  three years or more.
  
  
  The Bottom Line
  
  By following the fat-pitch approach to stock investing, we think you can
  tremendously improve your odds of investment success. Although it requires
  plenty of discipline and patience, you should be able to earn strong returns
  over the long term by buying only those stocks that present a nice fat-pitch
  opportunity.