The Case Against Target Prices

sell-side analysts

The Case Against Target Prices by David Merkel, CFA of Aleph Blog

I know that much of the money management business sets target prices for buying and selling, particularly value managers, and sell-side analysts.  I don’t set target prices.  Why?

Think of what a target price means.  It says that at a certain price you are willing to exchange securities for cash (sell), or vice-versa (buy).  The trade-off between an individual security and cash is difficult to calculate.  Even if you have a really good dividend discount model, the target prices are very sensitive to model inputs.  I think the question of whether I would rather have cash or an individual stock or bond is a difficult question.

Analysts ratings 1 Target Prices

Target Prices

So why don’t we focus on easier questions?  It is simpler to rank stocks versus other stocks at least in broad, and bonds versus bonds.  I am not saying that you have to optimize.  You can’t be exact in ranking the desirability of stocks or bonds, but if we can’t identify a group of stocks outside the portfolio that are better than a group of stocks inside the portfolio, there is not much sense in trading.  Same for bonds.

With bonds, the tradeoff is more obvious, because you can consult yield relationships, and make all of the adjustments necessary to decide whether a trade is a good one or not.  Even then, there had better be a good yield advantage after all adjustments, or the trad will not make sense.  As an example, back in the first half of 2002, I engaged in a wide number of trades that gave up some absolute yield, but improved the portfolio’s credit quality dramatically at a time when credit spreads were narrow.  Though overall yield went down, the portfolio was in better shape.  This was the opposite of what we did after 9/11 — buy distressed bonds while spreads were very wide, accepting more credit risks when it paid to do so.

Thus, most of my portfolio management is not so much “Aim for the best.”  I’m not sure I can do that.  “Aim for something better than what I currently have” is achievable.  In cases where I can find no clear improvements, sitting on my hands it the best strategy.  After all, time is on the side of a portfolio representing great relative value.

This is not to denigrate those that are better than me, like Seth Klarman.  He has a strong sense of when he would rather hold cash versus taking any risk, and so he manages value in an absolute sense, even giving back money to clients when  he doesn’t have anything to do with it.

I’m still finding some attractive assets to buy, though not many.  Later this month, I will do my formal quarterly reshaping of the portfolio, where I will trade away a few stocks I like less for those I like more.  And if I can’t find any that I like more, I don’t have to do anything, because if I’ve got a really good group of stocks, doing nothing may be the best idea of all.

PS — If you want more, some of the details are in Portfolio Rule Eight.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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