Our Most Controversial Strategy
Editor's note: Despite what you may read in finance books, the stock market is NOT efficient.
In today's Friday Digest – which originally ran in June 2014 – Porter explains why... and shares the simple ways you can use this to your advantage...
Our Most Controversial Strategy
Out of all of the things I've said or written in my career, the thing that gets me in the most "hot water" is my view that you can and should time the market. When I write "you," I don't mean some representative sample or some investor somewhere. No, I mean you... the person reading this e-mail... the person who subscribed to my newsletter... the person who is going to put his savings at risk when he invests in the stock or bond market. You.
A lot of people – even some smart ones – believe trying to time the market is a fool's errand. They argue that the best you can do is simply plow your savings, year after year, into a mutual fund or index fund. These folks make a whole range of arguments and back them up with plenty of "facts."
They'll cite academic studies and average investor results. They will say, again and again, that "no one" can beat the market, so why should anyone try?
I disagree... completely.
Let's start here. Let's say they're right. If the market is really efficient, then it shouldn't matter when you invest or what you buy. If that's really the case, then why not try to do better? As long as you're investing in something, you should do alright, according to these folks. So what's the harm in trying to beat the market?
And here's another way to look at it. The efficient-market folks love to argue that it's impossible for the average investor to beat the market because it's impossible for most people to beat the average result. At some point, it is a mathematical certainty that not everyone can beat the market. But just because something is "true" on average or across a population doesn't necessarily mean it must be true for you.
For example, I might argue that, on average, everyone who marries will end up with a marginally attractive spouse of normal intelligence. Therefore, you're probably wasting your time trying to find a beautiful and intelligent person to marry. In theory, that might be good advice. But was that your dating strategy? If you had dated anybody that would have you, would you have married the spouse you wanted?
In short... when it comes to a lot of important things in our lives, getting better-than-average results is a worthy goal. Luckily for investors, I don't believe beating the market is nearly as hard as trying to date a supermodel. I'm 100% convinced that anyone with normal intelligence and a modicum of emotional stability can do it. There are a few simple and logical reasons why...
The reasons come from Wall Street's irrational focus on short-term "earnings" and most investors' total lack of discipline. In today's Digest, I'm going to give you my five keys to timing the market. If you use my strategy, I guarantee you can double your average investment results over 10 years... or maybe even do a lot better.
But listen... there's an entire army of people out there whose careers depend on you never doubting the idea that the markets are perfectly efficient and you can't beat them. If you speak to any of these millions of people in the financial-services industry about my ideas, they will tell you I'm a fool, liar, or fraud. So get ready for an argument. Listen carefully. You'll notice these folks won't ever discuss the merits of my actual strategy.
You see, the financial industry can only survive and prosper if you're willing to give it your assets to manage. The industry needs you to believe that it's always a good time to put your money in the market. And it needs you to believe that you can't do it yourself. That's why folks in or supported by the financial industry go bananas when I write things like today's essay.
As far as who is right and wrong... listen to what the first and wisest newsletter writer, Richard Russell, says about market timing:
In the investment world, the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that he doesn't need the markets... The wealthy investor doesn't need the markets because he already has all the income he needs...
The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the "give away" table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.
And if no outstanding values are available, the wealthy investor waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn't mind waiting months or even years for his next investment.
But what about the little guy? This fellow always feels pressured to "make money." And in return, he's always pressuring the market to "do something" for him. But sadly, the market isn't interested. When the little guy isn't buying stocks offering 1% or 2% yields, he's off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he's spending 20 bucks a week on lottery tickets, or he's "investing" in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).
And because the little guy is trying to force the market to do something for him, he's a guaranteed loser. The little guy doesn't understand values, so he constantly overpays... The little guy is the typical American, and he's deeply in debt.
– Richard Russell, Rich Man, Poor Man
Now... think about what Richard Russell said. Ask yourself, do you invest like the poor man or the rich man? How much do you know about the value of what you've bought? How long did you wait for the right opportunity to buy it? What's your downside? What are you expecting as your result? In a year? In three years? In five years? In 10 years?
The poor man can't even imagine a 10-year investment return. Nothing he buys lasts that long. Of course, if you want to get rich in stocks, almost everything you buy should last that long. It's the compound returns that will make you rich, not the quick trades.
What does Warren Buffett, perhaps the greatest investor ever, say? Is the market so perfectly efficient that knowledgeable and patient investors have no opportunity to earn excess returns? Buffett argues that all the value investors he knows – those who broadly followed the tenets of Ben Graham and David Dodd, authors of the value-investing bible Security Analysis – have beaten the market by a wide margin.
This isn't an accident or a coin flip. These investors all used the same principles to guide their choices. Their picks were not random or lucky. They involved all different types of securities and strategies. The only common theme was an intense focus on understanding the value of each security purchased.
The common intellectual theme of the investors from Graham-and-Doddsville is this: They search for discrepancies between the value of a business and the price of small pieces of that business in the market.
I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.
I have seen no trend toward value investing in the 35 years that I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It's likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.
– Warren Buffett, The Superinvestors of Graham-and-Doddsville; 1984.
Step 1 in our guide to beating the market is based on the ideas of the men above. Before you buy a stock or bond (or anything else), ask yourself, "What's the intrinsic value of what I'm buying? And how does that intrinsic value compare with what I'm going to have to pay for it?" Always make sure you're buying at a good price.
There are lots of ways to estimate intrinsic value. And as with the value of a house, there's no single right answer. If I asked you to estimate the value of your home, you could give me a range based on similar sales in your area. You could tell me "replacement cost" based on what a lot nearby would cost and the construction costs. You could give me the tax basis. And I could look up what the insurance company estimates your house is worth (that's usually the most accurate).
The point is, people of normal intelligence can figure out what something is really worth. When it comes to publicly traded stocks, plenty of information is available to help you do the same.
When we look at stocks, we generally assign them an intrinsic value that's based on cash flow (how much cash this company can generate), for operating companies, or a "take-out" price, for asset-development stocks. In general, public companies fall into one of these two categories. They're either operating businesses (which are designed to make annual profits) or asset-development businesses (which may have many years of losses as they build out something like a gold mine, oilfield, or new drug).
Simple rules of thumb? Never pay more than about 10 times the maximum annual free cash flow for operating companies. Never pay more than half of the appraised value of an asset-development company.
Step 2 of our strategy to "time" the market is even easier. There's not really any math involved: Become a connoisseur of value. Look around the world. What are other investors running away from? Is there a safe way to invest? Is it extremely cheap? Does this opportunity seem like one of the greatest deals you've ever seen?
The key is to focus on the areas of the market where value abounds. And then... be patient and wait for the "dinner bell" to ring.
Step 3 in our guide to beating the market is even easier. Learn to make big commitments only when other investors are clearly panicking, stocks are cheap, and extremely safe investments are available. This is what most people mean when they say market "timing." This is what I mean when I say "allocate to value." Two quick examples...
First, in the fall of 2008, investors were clearly panicking. Warren Buffett even wrote a letter to the New York Times explaining why it was time to buy stocks hand over fist – and was criticized on CNBC for doing so! If there has ever been a better contrarian indicator, I've never seen it.
Meanwhile, you could have bought shares of iconic beer maker Anheuser-Busch (BUD) – a stock I first recommended in 2006 – for around $50 for several weeks in October and November. At the time, global brewer InBev had an all-cash deal in place to buy the stock for $70 per share. I told investors the situation was so safe, they should put 25% of their assets into the shares.
It was the easiest and safest way to make a lot of money that I'd ever seen. Even if the deal fell through (and it couldn't; it was an all-cash deal at a reasonable price)... the stock was worth far more than $50 a share. In my view, there was zero downside, and an almost certain $15-$20 profit in just a few days.
A few months later – in February 2009 – shares of renowned jeweler Tiffany were trading for less than $25. The company has large inventories of gold and precious stones. Subtracting the value of its inventory from its debt load and dividing by the shares outstanding, gave you a liquidation value of around $24 per share. In short, you could buy Tiffany – one of the premier luxury brands in the world – for the value of its current inventory. That means, you could have gotten the real estate, the brand, and all the future profits for free. Again, I remember the specifics of the trade because I wrote about this situation to subscribers. It's at times like these when you must be willing to make large commitments.
Fine, you might say. But what should I do, just hold cash for years or decades, waiting for a perfect situation? Stocks were only as cheap as they were in 2009 three or four times over the last 100 years.
No, I don't argue that you should stay 100% in cash until stocks crash. That is probably the biggest misunderstanding most investors have about our advice. We never advocate selling everything. We didn't sell everything in 2008, even though we knew the mortgage associations Fannie Mae and Freddie Mac were going to zero and that Wall Street was going to collapse.
And we haven't recommended selling everything now, even though we have grave concerns about the stability of the global monetary system.
We never believe that we can predict the future accurately. Instead, we want to build a portfolio that will thrive over time, no matter what happens. Today, we see that stocks are no longer great values. It's harder for us to find good opportunities. And so, we've told subscribers, begin to build cash. When you sell something, sock away the profits until better opportunities emerge. When do you sell? Well, that depends. But, no matter what, follow your trailing stop losses. And that leads us to...
Step 4: Stay reasonably diversified, use trailing-stop losses, and always maintain a large cash reserve. Here, we part ways with most value investors. A lot of good value investors (including Extreme Value editor Dan Ferris) refuse to use trailing-stop losses. Instead, they hope to sell when stocks become too expensive. But in our experience, it's nearly impossible for most investors to know when to sell. Therefore, we want to focus on buying at the right time. Then we simply admit that we're not going to sell at the optimal point. We just can't predict how high stocks will go. And we want to capture as much of that upside as possible. Using trailing stops allows us to do this.
Also, it's important to never give your stockbroker your stop-loss points. And never, ever base your stops on intraday prices. If you put your stops in the market (which is what happens when you give them to your broker)... events like a flash-crash can wipe you out.
If you remain dedicated to only buying stocks at a discount from their intrinsic value... if you become a connoisseur of value... and if you only make large investments when other investors are panicking, then you should actually find that it's easy to keep a cash reserve.
But how many stocks should you own? What's reasonably diversified? I recommend never owning more stocks than you can completely understand and follow. A good test is: can you explain the stocks in your portfolio and why you bought them (the elevator pitch) to a friend without using notes or looking at your portfolio? If you can't, then you don't know your investments well enough to own them or you're trying to follow too many. You're not going to be able to find more than a handful of extraordinary investments at any given time. Why own anything that's not extraordinary?
Another good test for your portfolio is to make sure that there's not a single position that could cost you more than 5% of the value of your overall portfolio. Don't end up with so few large positions that a catastrophe in one stock wipes out all of your other gains for the year.
What's the last of part of our strategy (Step 5) to always beating the market? Do everything you can to avoid the damage from fees and taxes, to maximize your long-term, compound returns. Whenever possible, keep your assets in vehicles that allow you to compound your investments tax-free. Minimize trading and fees, which enrich your broker, not you. Look for companies whose management is well-known for doing tax-efficient deals and rewarding shareholders in tax-efficient ways. And always reinvest your dividends – either in the same companies or in new ones that offer better value.
Studies show that most investors perform terribly when managing their own assets. That doesn't mean that you can't do well. It does mean that the odds are stacked against you. So print out this list. Start living by it.
Never buy a stock whose intrinsic value you can't estimate reliably – and always get a big discount when you buy.
Become a connoisseur of value. Follow the cheapest, most hated segments of the market carefully. Wait and watch for moments of maximum pessimism.
Allocate to value: Wait to make major investments when other investors are panicking, when truly safe and outstanding opportunities abound.
Use good money-management techniques. Follow position-sizing guidelines and trailing-stop losses. Never own more positions than you can carefully follow. Always keep a large cash reserve.
Do everything you can to avoid fees and taxes. Simply avoiding a 2% annual fee against your asset base (by not using money managers) is the No. 1 surest way to outperform your peers.
Regards,
Porter Stansberry