Why Hedging Is Critical
Editor's note: You're a serious long-term investor. You only buy great businesses at good prices. Maybe you even follow good risk-management strategies like proper position sizing and trailing stop losses.
You're prepared for whatever comes next... Right? Not so fast...
In this week's final classic Digest – originally published in March – Porter explains why even experienced "buy and hold" investors should consider "hedging" their portfolios today...
Why Hedging Is Critical
Today... another unexpected twist...
In this week's Friday Digest, I'd like to share a letter I received from a subscriber. It's not flattering. But it made a big impact on me. Most publishers would rather light their hair on fire than advertise a subscriber who is canceling or unhappy. As you know, we take the opposite approach. We publish lots of unhappy feedback e-mails – sometimes even when they're incoherent. But this letter wasn't entertaining...
This subscriber is canceling for a good and thoughtful reason. He doesn't need us anymore. I think it's something you ought to think about carefully. You might agree with him.
I would like to cancel my subscription to Stansberry's Investment Advisory. I haven't been happy with the content and recommendations of SIA for some time now, and I feel that I will be better served by canceling this service. I feel like the service has lost focus on the types of long-term, Buffettesque-type picks that originally inspired Porter Stansberry.
I would also like to note that the Digest has been pretty stale lately. It used to be something I looked forward to read daily, but now it just skim through it. It's pretty much all... talk about gold and other macro opinions.
The everyday middle-class investor ought to focus his investing efforts on compounding wealth with equities rather than buying gold, which should be viewed as a store of wealth. Most people aren't wealthy enough to even consider gold as a viable asset class for their portfolio. Just my two cents. Not sure why there is so much focus on this subject rather than companies with durable advantages trading at favorable prices.
Perhaps I was spoiled by Porter for turning me on to these types of ideas.
I think P. Thompson is wrong on the facts. I'll show you why... but that's not the main thrust of my reply. I think something far more important is at stake.
P. Thompson thinks he knows all he needs to know about investing. Maybe he's right. Maybe he doesn't need anything but good businesses bought at fair prices. Maybe he doesn't need gold... or discussions about the macro risks we face... or reminders about position sizing... or recommendations on selling short.
Maybe not. But I suspect he does...
I think he's about to make a huge mistake. It's a mistake I hope you won't make too.
First, though... about the facts...
Over the last year, I've developed what I'm certain is the most important investment idea/strategy of my career. I call the idea "Magic Stocks." These ideas are the result of more than a decade of work on "Buffettesque" investing. We've explored exactly what creates the best kind of business for compounding wealth safely over the long term.
I've shared these ideas repeatedly in the Digest. If you haven't read my Magic Stock essays, I'd urge you to review them. (These were published in the Digest that P. Thompson says has gotten stale.)
We've also built an entire Magic Stock Monitor as part of our Stansberry Data service that's available to all lifetime subscribers of my newsletter. Every month, we update this screen that shows all of the stocks that qualify as "Magic Stocks."
In fact, this year we unveiled our latest version of the research. We added a small growth component to the formula to make sure we weren't including any "value traps" in our lists.
Adding this small, additional revenue growth hurdle to our other Magic Stock criteria (capital efficiency, great brands, high operating margins, and low volatility) produced even better results.
As you'll recall, we tested our original Magic Stock formula by creating model portfolios based on historical data and seeing what would have happened to investors who followed this approach from 2000 until now. In all, we created 34 separate model portfolios across the period, with durations ranging from one year to 15 years. This gave us a substantial body of data to judge what the actual outcomes would have been.
In that original analysis, the most stringent category – capital-efficient Magic Stocks with great brands – beat the S&P 500 across all periods by an average of 6.3 percentage points a year, with 34% less volatility than the overall market.
So how did adding a revenue growth element change our results? Here's what we wrote in Stansberry Data at the time:
Adding the new value-trap criterion... the portfolios beat the S&P 500 across all periods tested by an average of 7.5 percentage points a year, once again with 34% less volatility than the overall market. The average portfolio size decreased from five stocks to four stocks.
These results are outstanding. Instead of beating the S&P 500 by an average of 6.3 percentage points a year, they now beat it by 7.5 percentage points a year. The average return of these portfolios over all periods tested was 13.6% a year, compared with 6.1% for the S&P 500.
With an average annual return of 13.6%, a $100,000 investment would grow to $680,000 15 years later. The S&P 500's average annual return of 6.1% would only grow to around $250,000. Beating the S&P 500 by an additional 7.5 percentage points a year over 15 years would translate into an additional $430,000 in your pocket. And remember, these results are accomplished with far less volatility than the overall market.
In my newsletter, over the past 18 months, we've recommended 30 different equities, roughly half of which would qualify under a test for capital efficiency.
These were high-quality businesses like computer and electronics giant Apple, baby-formula maker Mead Johnson Nutrition, handbag label Coach, agricultural supplier Monsanto, soft-drink maker National Beverage, and glass manufacturer Corning.
No, these investments didn't work out great. Altogether, over the past 18 months, the average return from our long recommendations is flat. That's not a big surprise given the market's decline. But that doesn't mean we've stopped trying to add quality and excellence to our portfolio on the long side. In just the last three months we've recommended three more great capital-efficient investments: auctioneers Ritchie Bros., money-management firm Oaktree Capital, and high-end grocer Whole Foods Market.
I can't see where a subscriber would get the idea that we've abandoned our core strategy. We haven't. Not in any way. Not at all. In fact, the very opposite has occurred. We've refined our best ideas. We've added more coverage. And we've continued to recommend high-quality, long-term investments as some stocks have fallen into our buy range. So his criticism that our work has changed or that we've "lost focus" on finding great long-term investments is simply false.
On the other hand, we also know that during a bear market it is difficult to produce good results without hedging. That's why we have recommended 14 different short-sale positions, roughly one for every two long recommendations.
On average, these recommendations have done great. On an annualized basis, our short portfolio was up 15% from September 2014 to this past March. It's these recommendations – along with our gold and silver picks (see how much NovaGold is up over the past six months) – that will smooth out the volatility of your portfolio and help us achieve positive total returns, no matter what happens in the world around us.
But the main reason to hedge your portfolio isn't financial; it's emotional. And that's my main concern for P. Thompson and other investors like him who disregard our macro warnings and ignore our advice about hedging and other bear market strategies.
For real-life investors, the ability to continue to perform even in a bear market and the ability to reduce volatility is absolutely critical. Nobody wants to lose money. And almost no one can stand losing a lot of it – even temporarily.
But most people also ignore our advice about risk management (position sizing, trailing stop losses). As a result, there's no way they can stick with us. It's only a matter of time until they "blow up."
Likewise, most subscribers ignore our advice about hedging (short selling, holding precious metals, certain trading strategies). What most people do instead is exactly what P. Thompson describes: They find a strategy for buying stocks. They refuse to learn anything else. They don't allocate properly. They don't follow stop losses. And so when the market falls 10% or 15% (like I believe it will again this year, at least) they end up watching their portfolio completely disintegrate. They sell, right at the bottom.
And then, the kicker: They blame us. They tell everyone that following our advice cost them their savings. Meanwhile, they never followed our advice at all. Not even once.
Here's a tip. If you have more than 5% of your portfolio in any one stock (at the beginning of your investment)... if you don't know exactly what your exit strategy is going to be (if you don't know precisely when you will sell)... if you're not using TradeStops (or something similar) to monitor your portfolio... if you don't own any gold... and if you won't ever sell a stock short... then it's only a matter of time until you get clobbered.
It will happen. It's only a matter of time.
So please... take the time to learn how to become a successful investor. Learn how to manage your portfolio in good times and bad. Learn how to allocate appropriately. Learn how to hedge. You can learn how to make money in every market environment – and it's not even hard. Yes, learning to invest in capital-efficient, safe, Buffett-like companies is a great skill to have. It will help you generate fantastic, long-term capital gains and plenty of dividend income over time. That's a big part of being successful. But it won't protect you from watching your savings disintegrate in a bear market.
As I always tell you, there's no such thing as teaching, there's only learning. There's nothing I can do for you if you don't want to learn. On the other hand, there's so much I can do for you if you'll only try.
Finally... one more word about gold.
In an environment where two out of the three dominant central banks (the Japanese and the European) are openly pursuing negative-interest-rate policies and where the largest and most dominant central bank (the U.S.) is openly discussing the possibility of such policies... you should not blame us for focusing a large amount of our attention on macro issues and gold. You should thank us.
Do you have any idea how high the price of gold will go if all three major central banks institute negative interest rates? Where will you put your savings if keeping money in the bank actually costs you money every year? How will the global economy function if there's not a safe world reserve currency in which to store value and exchange trade receipts? Nobody knows. Nobody has any idea at all. And yet, that's the policy that's most likely coming.
Believe me... this is not the time to put your head in the sand and ignore the macro forces. We're approaching a major inflection point as the world's entire paper currency regime seems like it's falling apart.
Investors like P. Thompson have become convinced – after a seven-year bull market – that they have nothing to worry about. They believe "the water is safe." Or at least, they have come to believe that the macro forces don't matter enough to change their investment strategy.
It's certainly possible that he's right. It's possible we've reached the peak of policy madness and that interest rates, commodity prices, foreign currencies, high-yield bonds, and equity prices will all begin to act "normally." No one can predict the future.
But we can assign odds. And the odds are NOT in our favor. Far too much bad debt has been issued to students, subprime car buyers, foreign companies (whose countries have devalued their currencies), oil companies, and corrupt governments (like Brazil and China). We are in the early stages of an enormous debt default cycle – a cycle policy makers are desperate to stop, just like they did in 2009. We know their playbook: They will issue new debts and a vast amount of new currency. The result will be crashing currencies and huge market volatility.
And so... my fear is that subscribers like P. Thompson, having discovered our work and having enjoyed some success making safe investments, will now decide that they're long-term "buy and hold" investors. Describing their strategy in this way, they believe they have no reason to hedge their portfolios. After all, Buffett doesn't. And why buy gold? Buffett doesn't. Buying gold isn't investing at all, they rationalize.
Well, you ought to realize that three times in his career, Buffett saw the value of his Berkshire Hathaway holdings decline by more than 50%. And that's the portfolio of the best capital allocator the world has ever seen.
My hunch is that no matter how good of an investor you think you are... when you see your portfolio decline by 50%, 75%, or 80%, you're going to panic. You're going to sell. You're going to discover that you're not a buy-and-hold investor. You're just another buy-and-fold investor.
But remember: It doesn't have to be that way. You can learn to be successful in every market environment. It's not hard. You just have to try.
Regards,
Porter Stansberry
Editor's note: One of the best – and simplest – ways to hedge your portfolio is with Porter's "magic stock" recommendations. Last month, he made his first official recommendation. Learn more about "magic stocks" right here.