The S&A Digest: Defending Max Value

Ian defends Max Value... No Tinkers... IPOs and second marriages... Another dividend grab to consider... Goldman says "buy" GM... Apple No. 3 in music sales...

 We didn't see any Tinkers.

We were looking for them: four or five old beat up campers, a near-dead horse tied up to a fence post on a road leading out of town, dirty kids, running around barefoot with their clothes falling to pieces around them. I wanted to stop in the camp, do a bit of shopping... maybe play a game of chance. Why would I want to go looking for trouble?

Traveling is so antiseptic these days. Every place you visit, no matter where you go in the world, has the same things on the shelves, the same food in the restaurants, even the same brand of coffee in the cafes. One of the only remaining true local experiences is rip-off artists. One of my most vivid memories of my first trip to China (in 1999) was getting "Shanghaied" by three local girls... they were wonderfully diplomatic while they emptied my wallet. I'd hoped to see how the Tinkers – Ireland's "traveling people," who are notorious hustlers – would do it.

But that was the only disappointment of our trip. Our group of eight fathers and sons spent a week in Northwest Ireland, playing seven flawless links golf courses. By consensus, our two favorite courses (in case you find yourself in Ireland with a golf bag) were the Sand Hills of Rosapenna in Donegal and Enniscrone in Sligo. But... my favorite course was the Donegal Golf Club... where I shot a 98, my low round of the trip. If you have any interest in playing golf in Ireland, make sure you read my friend Mike Palmer's book: Secrets of the Irish Links.

 Oh... one more thing... We did find a true slice of Ireland at the Harp Pub in Sligo. On Monday night, the locals come to play and listen to astoundingly good traditional music. When the band took a short break, two young ladies got up and sang such beautiful a cappella songs nobody wanted the band to come back on...

 We'd better move on to the drab and dull business of getting money...

 Ah... what's this... Goldman Sachs is telling investors to buy shares of General Motors (GM). Why on earth would an investor want to do so? Well, says Goldman, the United Auto Workers union may offer larger concessions than expected to the company. Shares gained 3.2% in morning trading.

 Goldman Sachs also will sell its 30.48% stake in South Korea's No. 2 cable operator, C&M, for close to $970 million. Macquarie and private-equity group MBK are said to be bidders for the stake, which Goldman acquired in 2004 for $151 million. Prediction: Goldman will make a lot more money on this cable investment (which it kept for itself and didn't recommend to its clients) than anyone is going to make buying shares of GM.

 To grab or not to grab... Corus Bankshares (Nasdaq: CORS) will pay a $1 special dividend on August 1 to shareholders of record July 18. The holding company will not borrow to make the $56 million payment. S&A Dividend Grabber subscribers will receive a recommendation next Monday.

 Yet another IPO... $20 billion European hedge fund GLG Partners will IPO on the New York Stock Exchange in order to help it expand and hire top managers. The group will also sell a 3% stake to the government of Dubai and private German bank Sal. Oppenheim.

 The number of IPOs declined in 2006 to 187, down from 345 in 2000. So far this year, 149 IPOs companies have gone public, according to Bloomberg. Feel free to draw your own conclusions.

 I'd like to commission a study of investors who buy IPOs. I'm willing to bet that they've been married more often than most people. Buying an IPO, like getting remarried, is proof that hope is more powerful than experience. Doesn't anyone wonder why the owners of a business would be so eager to sell that they'd willingly pay a 7% commission and agree to suffer expensive and onerous SEC rules (which even expose the senior management to criminal liability) just to get rid of it? I guess not.

 S&A Oil Report pick Eni (E) and Russian oil giant OAO Gazprom announced plans to build a pipeline from Russia to Bulgaria via the Black Sea. The pipeline, to be called "South Stream," will be 550 miles long and will distribute gas to northern and southern Europe. Sounds like a fantastic asset to own... but will Putin let Eni keep it once it has paid for it?

 Apple's iTunes became the No. 3 music retailer, jumping ahead of Amazon and Target. The company's 9.8% market share lags only Extreme Value pick Wal-Mart (WMT) with 15.8% and Best Buy with 13.8%, according to The NPD group. The firm counted every 12 tracks purchased online as an album sale, and did not count revenues.

 New highs: Schlumberger (SLB), Grey Wolf (GW), Westshore Terminals (WTE-UN.TO), Janus (JNS).

 And now... it's back to the "bag." How I missed your prose while I was in Ireland. I could only imagine your words as my tee shot sailed wide of the fairway ("you're a fraud"). And no subscriber commented when I three-putted – yet again – for a double bogey ("stop sending me those damn ads"). But... as I looked for yet another lost ball in waist-high rough... I thought I heard the wind whispering "I love the Digest... please don't stop writing."

I read them all, so please keep the comments coming: feedback@stansberryresearch.com.

 "I thought Jeff Clark gave a great explanation on why he asked his Short Report readers to ignore his 'stop order' on the HD Aug $40 calls. He only made one mistake. When he asked us to sell half yesterday to take some profits off the table (75%), I actually made 100% (in only 3 weeks!). Keep up the good work." – Paid-up subscriber Karl Folse

 "Dear Anonymous who paid some stranger's Extreme Value subscription: You're a cool cat. Thanks for reminding me there are nice people out there. Dan: It's up to you to make sure this act has a happy ending... "

– Paid-up subscriber DS

 "I have never invested anything in anything other than a work-sponsored 401K. Neither has my husband, that I am aware of. I recently subscribed to both the Penny Letter and True Wealth. I am reading with interest all the recommendations and watching them go up, but so far am too scared to actually do anything. Any advice for someone afraid to get out of the boat and take a walk on the water? I'm saving up for the Dividend Grabber. Maybe the idea of spending $1,000 along with potential for a quick return will do the trick. Also since I haven't worked in over 10 years, I don't feel like it's really 'my' money to invest and don't want to involve my husband, since I want to feel like I'm making my own contribution to the family income. How backwards is that? I think I need a psychologist rather than financial advice... Is it worthwhile to start with a couple hundred dollars in one thing? Maybe I can slowly work my way up. (I'll have to, since we don't have tens of thousands of dollars lying around). Maybe I'll start by actually opening an account with ScottTrade." – Paid-up subscriber Wendy Brownlee

Porter comment: My advice to all novice investors is to start with a very small amount of money, buy the safest investments you find attractive (instead of the ones with the biggest potential gains), and lower your expectations. The world's best investors average gains around 15% per year, on an unleveraged basis. If you're making 10%, you're doing pretty darn well. What you'll probably do though, is put far too much money in one or two investments that have "blue sky" potential and huge risks (that you do your best to ignore). Most people, it seems, have to blow up a time or two before they reset themselves to prudence. Remember: Opportunity is infinite. There will always be another great opportunity. Capital, on the other hand, is finite. You have to have chips to be in the game. So, when you start, play "tight." Don't take big risks.

 "Oh my God, I'm still laughing over Gary Gruen's letter and your response. I love it. Maybe you didn't realize that laughter increases one's life-span... by how much, I don't know, but this stuff is as good as it gets. Keep it coming."

– Paid-up subscriber R.J. Herman

 "Newly aboard... impressed with the stock referrals so far... PTR, BHP, PLC... all doing well for me. Thank you! I love traveling 'vicariously' through the world reading along with the ventures... happy travels. A rather novice question: when one has an opportunity to get on an IPO offering... what exactly is the procedure? [Through] brokerage or how is it handled?" – Paid-up subscriber Anne

Porter comment: Anne... see my note above about IPOs and second marriages.

 "I didn't see any reply to the crazy guy who thinks that Calgary is 200 miles from Vancouver, yet. Good luck sucker! 200 miles my rosy red butt! Once again, a little story for you: my wife is from Vancouver and we live in Calgary. It is exactly 997 km to her uncle's house in Coquitlam, and the Fairmont Hotel (which is downtown Vancouver) is about another 50 km. You do the miles/km conversion and try to come up with 200. Have fun cooking the books for that one!" – Paid-up subscriber Stephen

Porter comment: Two of my employees, Mike Cottet and Tom Dyson, are planning to ride bikes over the Canadian Rockies between Calgary and Vancouver on their way to the Agora Wealth Symposium. I don't know the exact route... but they have a 200-mile stretch picked out. Meanwhile, I've wagered that Tom Dyson will not make the trip without getting off of the bike at least once. We'll see what happens.

 "I'll give you another good way to sense a market top – and you have the statistics in-house to predict it. When subscriptions to your newsletters are pouring in, it may be time to get out. When nobody is renewing or taking out new subscriptions it's getting closer to time to buy. Based on these statistics... WHERE ARE WE NOW?" – Paid-up subscriber Howard C.

Porter comment: You're right about that... newsletter subscriptions are a leading contrary indicator. Judging from our numbers, I'd say we're near the top. But... I've been saying the same thing for three years.

 "I believe your service is only for the truly wealthy. Every time I look at your latest money investment, I need to sign up for another letter. I can't afford to sign up for one more letter. I would be ecstatic to receive 12.55% interest. I am going to be receiving $30,000 from my mother's estate in July. This is all the money my wife and I have. There are no vacations, no IRAs, no 401ks. Just tell me what can I do with this money to make it grow and not pay taxes on it." – Paid-up subscriber Dean Parsons

Porter comment: Dean... as you know, we can't provide you with any individual advice. That's not what we do. We provide independent research to investors, some of whom are wealthy and some of whom are professionals. However, we believe our letters are also extremely useful to anyone willing to read, learn, and think for themselves. I hope you fit into this category. Oh... one more thing... we stay in business through advertising. But, we only really make money from renewals and from satisfied customers. I hope you'll be patient with our advertising. And I know you'll find our research to be the best you can buy, at any price.

Defending Max Value

The Max Value strategy is a value-based trading system that I developed and write about in my free-to-alliance member's service called The Quant Trader. This system has produced unbelievable returns of 59.7% annualized over the last 30 years.

When I say "unbelievable" I mean truly impossible to believe. Today, I'm responding to an e-mail questioning the Max Value strategy.

Paid-up reader, Al Venosa wrote a long and thoughtful criticism of my Max Value trading strategy. Hopefully, the following responses will clear up these issues for both him and my other readers.

Mr. Venosa began by raising the question of drawdowns.

"Ian Davis has a great tendency to present lavish returns on his max value system without considering or even mentioning drawdowns."

I always consider drawdowns. In fact, it's one of my most important considerations when developing new strategies. Every time I write about my trading systems, I try to include the maximum drawdown, as well as some comments on the volatility of the system. Every time I've presented new research based on my Max Value system, I've listed the new max drawdown.

Some of the confusion might have come from the fact that in two issues I made recommendations based on my Max Value system and didn't mention drawdowns.

In these cases, I was recommending a specific trade, not describing a system, so I decided to stay away from the specifics of the strategy, so that I could delve more into the actual recommendation itself.

"It would be spectacular if one could make 59.7% compound annualized returns (CAR) every year since 1978, but that kind of compound return is unsustainable."

The Turtles (Richard Dennis' famous trainees) used a basic trading strategy which yielded 80% CAR for a decade, so obviously it is possible.

Even if the Max Value strategy performed half as well going forward as it did in the past would you be upset?

"With a 60% CAR, one could own all of the U.S., Dubai, and China within a few short years!"

Huh? I'm not sure how much it would take to "own" those countries, but even if you started with $1 million (and not $10,000), it would take 30 years before you had $1 trillion dollars, which would still be too small an amount to buy any of the countries you listed, assuming you could buy a country.

Besides, no one is going to pyramid their profits in that way... If you had $10 million would you really place it all on one trade?

"However, there are few investors or traders [who] could withstand 25, 30, or 40+% drawdowns while earning that huge return, which is likely what is happening. In fact, many traders cannot stomach 10% drawdowns."

I've listed maximum drawdowns numerous times. The strategies I've recommended had maximum drawdowns between 22% and 34%.

I think most investors can stomach more than a 10% drawdown. After all, you are a proponent of using a 25% trailing stop. This level of trailing stop would be meaningless without drawdowns of more than 25%.

"Has Ian tried incorporating the S&A philosophy of selling the index when a 25% drawdown occurs, then buying the next index at the end of the month?"

I have considered using trailing stops. However, for this particular strategy, they tend to seriously hurt your returns.

We are already buying undervalued sectors, and that's what's limiting our downside on any one trade.

Adding trailing stops just forces you to get out at the wrong time. (By the way, this is the philosophy S&A value guru Dan Ferris uses, and my numbers show it to be the right choice, at least for this particular value based trading system.)

As a side note, looking at the 10 cheapest sectors every month for the last 30 years yielded only four occurrences of getting stopped out using a 25% trailing stop. Sectors in general just don't fall that much in one month... especially undervalued sectors.

"I wonder what kind of return he would generate if he [used trailing stops]. I suspect his exposure would go way down, too."

The following table shows the return and drawdown of the Max Value strategy (where you buy one index and hold it for one month at a time), using various trailing stops. The 30% and above trailing-stops never trigger.

As you can see, using a 10% or greater trailing stop has no effect on drawdown, and a negative effect on returns. Using a smaller trailing stop reduces your drawdown but also quickly eats into your returns.

"There are many factors and variables that go into evaluating a trading system besides just profits. Maximum drawdown (MDD) is one, but others include the Ulcer Performance Index (UPI), the CAR/MDD, CAR/UPI, Sharp Index, Expectancy, etc., etc., just to name a few."

You're right, there are many ways to measure risk, and I'll look at other risk-measures if you're interested. However, before I recommend a strategy, I spend a lot of time analyzing the monthly and yearly returns. If they are too volatile, I won't recommend the strategy to my readers.

"C'mon, Ian, please show us an equity curve for just the last several years, so we can see how noisy it is. Showing a performance equity curve over a 30-year period on a log chart masks the drawdowns almost to the point of disappearance."

-See chart below. (By the way, a long timeline sure doesn't mask the drawdown in the buy and hold strategy.)

Equity Growth Using New Universe of Max-Value Indexes

Equity Growth Using New Universe of Max-Value Indexes

CONCLUSION

Two laws generally hold true about trading strategies. One is that the future performance of a system is never as good as its historic return. If you are planning on implementing a trading strategy, its historic return had better be phenomenal for its future return to be good. Luckily for us, this is the case with the Max Value strategy.

Another law of trading strategies is that if enough money is thrown at the strategy, it stops working. If hundreds of millions of dollars were used to trade this strategy, it would likely cease to work. You simply can't execute your trades in a timely manner, and the price you are going to get for shares will be too steep. This is why you will never be able to "own all of the U.S., Dubai, and China" from using this strategy.

I hope this clears up some questions about my Max Value strategy. (Note: Currently Quant Trader is only available to S&A Alliance members while it is in its development phase. Hopefully it will be available to anyone who wants it in the near future.)

Good investing,

Ian Davis

June 25, 2007

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