Report Card 2008 Part II - Why Trailing Stop Losses Matter

Report Card 2008
Part II: Why Trailing Stop Losses Matter
By Porter Stansberry

As I told you Friday, while I believe it's important to measure performance (and to demand good performance), I don't believe any given year's quantitative result is the only (or even the best) measure of quality.

Most of our publications produced negative average returns in 2008. Does that mean we did a bad job? Does that mean we're bad analysts and you're wasting your money reading our newsletters? Some folks undoubtedly think so.

Last year was the worst year for stocks since 1931. It was the third-worst annual performance of all time. Each major subgroup of the S&P 500 was down more than 20%. Stocks on average fell about 40%. The average mutual fund was down 40%. All our publications did much better than this. And as I showed you on Friday, we were among the few analysts anywhere to predict much of the carnage and get many of the big themes right: real estate, the investment banks, Fannie and Freddie, GM, Goldman, etc.

Our highlights weren't only on the short side, either. Only two Dow Jones Industrial Average components went up in 2008: Wal-Mart and McDonald's. Only one significant takeover went through last year: Budweiser. All three of these stocks have been long-time "strong buys" at Stansberry. I told my subscribers back in 2006 they could put up to 25% of their portfolio in Budweiser – the largest allocation I've ever recommended. I also reminded people to buy BUD when it was trading under $60 in October while the all-cash $70 InBev buyout was pending. Ferris pounded the table on Wal-Mart in late 2007. It was his top pick for 2008 at our Alliance conference. Likewise, McDonald's was one of Tom Dyson's first recommendations for The 12% Letter.

I understand you expect our recommendations to go up – whether the market goes up or not. And an analyst isn't going to get a good grade from me (an "A" or "B") unless he has a positive track record. But here's a question to ask yourself: Am I a better investor after reading S&A research? Looking at our work in 2008, I think there's no question we've given you excellent advice. We urged caution and told you where the trouble was coming from. We put you short the stocks that blew up and long the best stocks of 2008. And on average, our portfolios performed much better than the market.

One factor was critical to our group's outperformance: sell discipline. Most of our editors follow rigorous trailing stop losses, usually at 25%. I learned this technique from Steve Sjuggerud, who was among the first newsletter writers (if not the very first) to use the strategy in his letters, starting nearly 15 years ago. We get a large number of complaints from readers anytime we sell a stock – whether for a loss or a gain. Lots of people "fall in love" with their stocks and never want to sell.

If you fall into that trap, consider these numbers: The average loss on Steve's picks in True Wealth last year was 5.7%. Out of his 15 recommendations, four went up, nine went down, and two broke even. While still producing an average loss, Steve's average return was a loss anyone could live with compared to the market's average result (down 40%).

But without trailing stop losses, the damage would have been far worse. If Steve had held instead of following his stops, his average loss on the seven stocks he stopped out of would have been 29%, which would have dragged down his overall results considerably.

I have to give Steve a "C" for the year because he didn't produce a positive return. But I think he did a good job for readers by cutting his losses, recommending "virtual banks" (which produced good returns), not making any recommendation in July when the market wasn't safe, and picking lots of good companies after the market bottomed in November.

Tom Dyson's sell discipline also spared his 12% Letter readers massive losses. Says Tom:

Stop losses probably saved my career. They protected me from some substantial losses, especially on some picks I made in late 2007... The high-yield sector of the stock market was the epicenter of the great credit crunch of 2008. Many of the stocks in my universe were leveraged and employed financial engineering to goose payouts. Many of the stocks in my universe were in the real estate or lending businesses... or in bed with them. If there's one thing I did right this year, it was avoiding finance and real estate all year. But to no avail. Every stock I picked this year lost money...

Even so, Tom's average loss was only 9.9%. That's good enough to earn him a "C" for the year. Staying away from leveraged real estate and business development companies was smart, but there was nowhere to hide last year. Everything fell.

Tom says he learned one valuable lesson last year: "I am now very wary of structured products like REITs, MLPs, income trusts, closed-end funds, BDCs, etc. that use fancy structures to attract income investors. They almost always come with huge debts, complicated financial statements, and wizard accountants. You never quite know what is inside the black box..."

As you would expect, we experienced a negative average return in our S&A Oil Report. With the price of oil falling from near $150 to under $50, you might think we saw double-digit losses in oil stocks – but not from our oil analyst. Matt Badiali stopped out of nearly every recommendation this year and limited his average loss to 6%. No one ever wants to lose money, but minimizing losses during bear markets is absolutely critical to long-term results, and Matt did a great job of that this year.

First, he captured gains on picks made early in the year (Allis-Chalmers, Oilsands Quest) and then he hedged his portfolio with puts on the highly leveraged Peabody Energy – which soared. So even though he only gets a "C," I think he did a great job for our readers. (For comparison, look at T. Boone Pickens, who was running an energy-centric fund. He ended the year down 60%.)

Again highlighting the importance of risk management, our worst results of 2008 came from portfolios where we weren't using trailing stop losses, or where those trailing stops were set wide.

Our most disappointing result was in our new True Income letter. Based on December prices, the average bond recommended during 2008 fell 35%. But there's a big asterisk attached to these numbers.

Our bond analyst, Mike Williams, is the most experienced on our staff. He has literally been researching fixed-income investments for as long as I've been alive (he started in 1972), a
nd he's the only analyst at Stansberry to have earned his CFA designation. Mike is convinced these bonds will pay off at prices at or above their recommended prices – and most of them at par, which would result in significant capital gains.

It doesn't make sense to use trailing stop losses on bonds because bonds, unlike stocks, have a legal obligation to return 100% of their principal amounts to their owners. In the meantime, holders continue to be paid their coupons – which are substantial. Thus, we should recoup all of our losses (and more), as long as we're willing to hold to maturity. We're also collecting coupon payments while we wait.

Mike generally recommends bonds that mature in one to three years, so we should know pretty quickly whether this strategy works as well as it should or whether the losses on these bonds will hurt our principal.

In the meantime, though, the corporate-bond market has been in total panic since the collapse of Lehman Brothers. So... for now, we'll give Mike an "incomplete" grade for 2008. If you're interested in buying bonds (I believe you should be), make sure you check out his list. If Mike's analysis is correct, you should be able to make 25%-35% annually in his bonds – which is more money than you're likely to make in stocks. (Read more about Mike's strategy here.)

The worst result of the year in stocks – an average loss of 22% on 13 recommendations – came from Rob Fannon, who writes Phase 1, our early-stage technology letter. Rob's results included three picks down more than 50%, which reflects the wide stop losses he sets on his recommendations.

Because early-stage technology companies are incredibly volatile, it's difficult for Rob to set tighter stops. In good times, Rob can produce average results in excess of 100% a year. But in bad times, the losses will be severe – that's the nature of high-risk investing. Unfortunately, given these results, I have to award Rob an "F" for his 2008 campaign.

We've tried to improve our "hit" ratio in biotech investing by focusing on stocks that have received so-called "complete response" letters from the FDA. Dr. George Huang researches these situations in our S&A FDA Report. Frequently, a biotech company will see its stock fall more than 50% in only a few days after receiving such a letter. That creates a perfect opportunity for us to move in and buy at depressed prices.

George has done a fantastic job of trading in and out of these situations. In what was one of the worst years ever for biotech (along with everything else), George's 14 trading recommendations averaged a profit of 14%. Even more impressively, 10 of George's trades were still open as of the end of December. George earned an "A+" in 2008. There aren't many investors anywhere who produced better results, in any market.

To summarize... what was a horrible year in stocks – nearly the worst ever – was only a bump in the road for most of our portfolios. We only had two products with double-digit losses, and one of these was our bond letter, where we expect to recoup our losses at maturity. We also produced outstanding gains with Jeff Clark's S&A Short Report and George Huang's FDA Report.

Given the enormous crash in all of the world's equity markets, I am very proud of our results. I hope you've benefited materially from our work.

Warm regards,

Porter Stansberry
Baltimore, Maryland
February 2, 2009