“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
It has been nearly a half century since Jack Bogle launched the first index fund available to individual investors, a revolution that took many years to gain traction. Today, trillions of dollars are managed using passive strategies that attempt to merely achieve the average return of a targeted index. An investment policy that was once seen as defeatist has been embraced by millions of investors. Even Warren Buffett has embraced indexing for the management of his wife’s portfolio following his death.
I have always believed that those who are most likely to dollar cost average into index funds over a long lifetime are the people who know the least about business and investing. Such people keep themselves occupied with their jobs and families and are much less likely to think that they are capable of selecting investments. Ego is less of a barrier when you know that you know nothing about business and investing!
For those of us who do try to pick individual stocks, it is important to have a long-term mentality but this is far easier said than done. This is especially true for value investors who buy companies at a discount to their assessment of intrinsic value. In cases where the stock advances to the investor’s intrinsic value estimate, a decision must be made to continue holding the stock, to lighten up, or to sell entirely.
I suspect that most value investors have experienced the agony of …
- Buying a cheap stock.
- Patiently holding the stock while it remains stubbornly unrecognized.
- Selling the stock when it finally hits estimated intrinsic value.
- Watching in dismay as the stock suddenly gets popular and rockets higher.
For those with a value mindset, it can be more difficult to keep holding a stock that appears to be richly valued than to adopt a stoic attitude holding an unloved stock below your cost basis for a long period of time. There is a tendency to fret more about a richly valued stock declining. Many long term winners have been lost in this manner.
One of my more popular articles in 2020 was My $2 Million Apple Mistake, a real life account of how I purchased 500 shares of Apple at $18 when it was statistically very cheap in the fall of 2000, only to sell the position in early 2001 at $20 for a $1,000 profit. At an intellectual level, I know that there was no possible way to know what the future would bring in early 2001. The iPod wasn’t even released yet!
But at an emotional level, what is now over $5 million in foregone gains stings!
As ridiculous as it sounds today, bankruptcy was not out of the question for Apple during the first few years after Steve Jobs returned to the company. But all I could have lost with my investment was $9,000. My potential gain was effectively infinite. This asymmetry in common stock investing is not considered often enough. Losing $9,000 in 2000 would have certainly stung since it represented nearly a fifth of what I was saving and investing each year, but it would have hardly been catastrophic.
What if I had adopted a strategy of just picking the best investment I could find every year and then doing absolutely nothing for at least ten years?
This would combine active stock picking with a passive hold strategy for at least a decade. In practice, what would have happened is that some selections would have worked out far better than others. But just having one massive winner, such as Apple, would have dominated my results. I would have been content to “admire the flowers” while just stoically allowing the weeds to wither away or even die.
Let’s take a closer look at the concept of “coffee can investing”, an approach that is very simple in theory but harder to implement in practice. After some background on the concept, I will present a proposed variation on the strategy inspired by a practice that both T. Rowe Price and Peter Cundill adopted during their successful careers.
Passively Active
In 1984, Robert G. Kirby published The Coffee Can Portfolio in The Journal of Portfolio Management. While admitting that in aggregate, professional money managers do not produce returns superior to an unmanaged portfolio, Kirby believed that it was possible for skilled active managers to produce superior returns if not hindered by high transaction costs. In order to achieve high returns, such managers had to think like investors with a multi-year time horizon. In other words, active stock selection had to be coupled with a passive buy-and-hold mentality once the selection was made.
How does the “Coffee Can” come into play here?
“The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.”
Back when investors received a physical certificate after buying stock, they would often place the certificate in a safe deposit box rather than a literal coffee can. When Warren Buffett started giving away his massive fortune in 2006, he literally went to his local bank to retrieve a certificate for 121,737 Class A shares of Berkshire Hathaway which he gave to a courier to transport to the transfer agent. That certificate, issued in 1979, was in a “coffee can” for 27 years.
How would Kirby’s coffee can approach work in practice?
“Take the example of constructing a new common stock portfolio of $100 million. The average, orthodox, professional money manager would build a portfolio of something like fifty $2 million commitments, each representing 2% of the fund. If that portfolio were then buried and forgotten for a while, several obvious conditions would apply. First, the most that could be lost in any one holding would be 2% of the fund. Second, the most that the portfolio could gain from any one holding would be unlimited.”
From an individual investor’s standpoint, it is more useful to think of funds being saved over many decades rather than as a lump sum being deployed all at once. One reason for the success of index funds is that a typical individual investor is putting money into the index every month for many decades, taking advantage of the general tendency of stocks to rise over time as well as periodic bear markets in which more stock can be purchased for a fixed monthly investment.
Kirby thought of the Coffee Can concept in the mid-1950s based on an experience with a client he had worked with for about ten years. During that period, Kirby’s firm would advise this client regarding stocks to buy and sell based on a conservative strategy focused on high quality companies. When the client’s husband suddenly died, Kirby’s firm was hired to manage the additional assets that his client inherited.
To Kirby’s surprise, the husband had “piggy backed” on his buy recommendations but had totally ignored the sell recommendations.
The client’s husband had invested about $5,000 in every purchase recommendation, put the stock certificate in his safe deposit box, and took no other actions. Upon his death, the man owned several small holdings worth under $2,000, several large holdings worth over $100,000, and one huge holding worth over $800,000 that exceeded the entire value of his widow’s portfolio!
By ignoring Kirby’s sell advice on several stocks, the man had suffered losses represented by the small positions worth under $2,000, but the impact of those small losses absolutely paled in comparison to the big winners which were only achieved by ignoring Kirby’s advice to sell. While Kirby’s client dutifully followed his advice, her husband only followed half of his advice and ended up far richer due to his passivity.
Did He Really Forget?
In the article, Robert Kirby writes that the man “would toss the certificate in his safe-deposit box and forget it” but I assume that he means this figuratively. Most people don’t just forget what they own. It is likely that this man simply had an unusual mindset when it came to investing and had the intestinal fortitude to see his portfolio become extremely “unbalanced”. The fact that a few positions came to dominate did not bother him at all. How many investors could adopt such a disciplined approach?
It is only natural to want to take some “chips” off the table when you have a big winner even if you continue to believe in the long-run success of an investment. This is even more true when a winner becomes dominant.
When I write about Apple being a “$5 million mistake”, this assumes that I would have held the stock for the past twenty-three years through all of the news cycles and fluctuations, as it grew to dominate my portfolio. However, I know that even if I had not sold in early 2001, there is no way I would have held the entire position until now.
But is this really an all-or-nothing proposition? Could there be a variation of the “Coffee Can” approach that would allow investors to benefit from big winners while also satisfying a natural tendency to want to take “chips” off the table? I think that there is one approach, but it seems unintuitive and even illogical at first glance.
A Rational Interlude
From a strictly rational perspective, investors should not focus on the cost basis of their investments with the exception of considering tax consequences, particularly when it comes to short term vs. long term gains. What one pays for a stock is obviously relevant at the time it is purchased, but what matters on an ongoing basis is the price of the stock relative to the investor’s current assessment of intrinsic value.
For example, if I purchase a stock today for $100 and it gets cut in half tomorrow due to a negative event, the fact that I paid $100 today has no rational bearing on whether I should hold it at $50 tomorrow. Assume that my assessment of intrinsic value was $150 when I bought the stock for $100. When the bad news comes out, I reassess my estimate of intrinsic value to $90. The fact that I paid $100 yesterday is not relevant when it comes to deciding whether to hold the stock. What matters is the level of confidence I have in the stock being worth $90 today relative to the $50 stock price.
The same logic applies to stocks that go up. If the stock that I purchase for $100 today is trading at $200 in one year, what matters is whether my assessment of intrinsic value a year from now is materially above the stock price. I should not anchor to my cost basis or my estimate of intrinsic value when I bought the stock. Intrinsic value is an estimate that must evolve over time. Cost basis is a historical artifact.
Selling Half After a Double
The approach that I am proposing is admittedly irrational when viewed from a strictly economic perspective, but I believe it could be rational when one considers human nature. Few active investors have the ability to operate in a completely rational manner because emotion always comes into play. Financial gains and losses are not seen as sterile figures on paper but as hopes and dreams fulfilled or lost.
When a stock rallies strongly, it is natural to worry about giving back your gains, and this is true for most investors even when the intrinsic value of the business has demonstrably increased. What if an investor decides that after a stock doubles in price, he will sell half of the position to recover his entire cost basis? If so, he might regard the remaining half of the position as “house money.”
For example, my position in Apple purchased on November 28, 2000 would have approximately doubled by September 8, 2004. What if I had sold 250 shares on September 8, 2004 and held the remaining 250 shares in a coffee can? Well, those 250 shares would have turned into 14,000 shares worth approximately $2.7 million today, plus I would have received substantial dividends over the years.
A similar exercise could be done with the shares of Costco that I owned all too briefly in 2003 and the much more substantial positions in Microsoft that I owned in the early 2010s. The only stock that I truly coffee canned during that timeframe was my longstanding ownership in Berkshire Hathaway which turned out well, but not nearly as spectacularly as the results that Apple and Microsoft would have delivered!
Of course, adopting the coffee can approach would have led to losses as well as winners, but would it matter? I have not gone through the “coffee can” exercise with all stocks I’ve owned over the years but it’s clear that the impact of the losses would have paled in comparison to the winners of a “sell half and let the rest ride” strategy.
This Isn’t An Original Idea
The concept of taking your cost basis out of a position by selling half after a double is not an original idea. I have seen this approach mentioned by investors many times in the past and some very successful investors apparently used it.
Peter Cundill is well-known in the investing community primarily because of Christopher Risso-Gill’s excellent book, There’s Always Something to Do, which I reviewed six years ago. The author was a director of the Cundill Value Fund for a decade and had access to Peter Cundill’s journals from 1963 to 2007. These journals contain a wealth of information about decisions made in real-time.
One of the experiences early in Cundill’s career involved buying Tiffany shares during the 1973-74 bear market. The company was selling for less than the fixed assets on its balance sheet including the flagship Fifth Avenue location in Manhattan. The brand was being given away for free, so Cundill eventually accumulated three percent of the stock at an average cost of $8 per share. The entire position was sold within a year at $19 per share, only to see Tiffany acquired by Avon Products soon after for $50!
Later in his career, Peter Cundill reflected on the problem of selling too soon:
“This is a recurring problem for most value investors — that tendency to buy and to sell too early. The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time. What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.”
The temptation to sell can be very strong. Cundill Value Fund board members debated the question of when to sell a position that rallies strongly and eventually they came to the conclusion that they would sell half of the position after a double:
“In the end the solution turned out to be something of a compromise: the fund would automatically sell half of any given position when it had doubled, in effect thereby writing down the cost of the remainder to zero with the fund manager then left with the full discretion as to when to sell the balance.”
In the case of the Cundill Value Fund, the remaining fifty percent was not put in a “coffee can”, but maintained at the discretion of the manager. However, the basic principle of taking the cost basis out of the position is the same.
Thomas Rowe Price Jr. was known as “The Sage of Baltimore” during his long and successful career. Price was a proponent of investing in growth stocks, “defined as a share in a business enterprise which has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each succeeding business cycle, and which gives indications of reaching new high earnings at the peaks of future business cycles.” Cornelius C. Bond’s biography of Price, which I reviewed in 2019, provides insight into his overall philosophy and track record.
Like Cundill, Price also adopted a variation of recovering the cost basis of a position that has appreciated significantly:
“Once a position is established, if a stock then moved to a significant premium over what it is deemed to be worth, he suggested that the stock be sold until the total cost of the stock position, plus capital gains taxes, is realized. The profit, he believed should be reinvested in long-term government bonds, or good-quality corporate bonds for safety and income. The profit represented by the shares left in the portfolio should be allowed to continue to grow in value until the company matures and is no longer considered to be a growth company. These shares effectively have no cost.”
Price’s version of the rule is slightly different because he suggests trimming a position after it becomes overvalued rather than when it doubles. However, the basic premise is the same. By recovering the cost of the position, plus capital gains taxes owed, the remainder is regarded as having “no cost” and can be left in the portfolio as long as it continues to be a growth company.
Epistemic Humility
As I stated earlier in this article as well as in my reviews of the biographies of Peter Cundill and T. Rowe Price, the concept of recovering the cost basis and letting the balance ride is not strictly rational and is essentially a form of mental accounting. The investor is purposely regarding the remaining position as “house money” even though there is a very real opportunity cost involved and the notion of “house money” is more closely associated with speculation and gambling rather than intelligent investing.
The benefit of the “Coffee Can” approach and its variants is that it implicitly acknowledges the limits of our knowledge and the difficulty of making intelligent decisions about the future prospects of high quality companies.
Recently, Aswath Damodaran wrote an article about NVIDIA, a stock that he initially purchased in 2018 on an intrinsic value basis but one that he now considers to be overvalued. At the end of the article, he made the following statement:
“I would be lying if I said that selling one of my biggest winners is easy, especially since there is a plausible pathway, albeit a low-probability one, that the company will be able to deliver solid returns, at current prices. I chose a path that splits the difference, selling half of my holdings and cashing in on my profits, and holding on to the other half, more for the optionality (that the company will find other new markets to enter in the next decade). The value purists can argue, with justification, that I am acting inconsistently, given my value philosophy, but I am pragmatist, not a purist, and this works for me. It does open up an interesting question of whether you should continue to hold a stock in your portfolio that you would not buy at today’s stock prices, and it is one that I will return to in a future post.”
Damodaran fully acknowledges that he is taking a pragmatic approach that is open to criticism from “value purists” who might scoff at his decision to hold a very expensive stock, but he is satisfied with retaining the optionality of the remaining position while cashing out his cost basis. He did not abandon his efforts to understand the company’s business or its valuation, going through a rigorous attempt to estimate its future prospects, but ultimately he exercised epistemic humility.
Conclusion
Hindsight bias can be pernicious because it is natural to focus on examples that prove whatever point we are trying to make while ignoring disconfirming evidence. Like all investors, there are decisions I would take back if I could make them again today as well as decisions that I am proud of and would happily make again.
The “Coffee Can” strategy is open to attack for being irrational on a strictly economic basis but I think that the concept has some merit. Admittedly, I did cherry pick a few examples from my own history where a variation of the “Coffee Can” method would have been desirable. But the power of this idea is that only a few examples over an investing lifetime are needed. Yes, the investor who coffee cans his picks will have many losers, but just a few big winners make the losers fade away to irrelevance.
The “Coffee Can” approach has the virtue of making investors think in terms of decades rather than months or years. Any company that you put into the can must have characteristics that at least open up the possibility of a long term multi-bagger. It is not enough for a company to be statistically cheap with the goal of taking profits when it reaches intrinsic value. The intrinsic value of the company must at least have the possibility of advancing materially over a long period of time.
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