Forget About Good Deals

There a few investors who can buy stocks, or other financial assets, on sale and succeed over the long haul. The winners are household names, the value kings. Warren Buffett and Charlie Munger, Joel Greenblatt, Seth Klarman, David Tepper, and maybe a few others.

Interestingly, many of these famous value investors have actually strayed a bit from their true value roots. Buffett and Munger are now better described as "quality" investors, choosing factors like growing free cash flow, low debt, and profitability over price. This has evolved into the famous line "great companies at fair prices".

On the other hand, Klarman and Tepper run hedge funds using a lot of derivatives and leverage and are noted for being contrarians--a very different strategy from value investing as most amateur investors know it.

Value Investing

While it's certainly extremely difficult, I'm not suggesting that it is impossible to be a profitable value investor. There are clearly people out there who do well in value investing, scouring the markets for deals based on factors like Price/Book, Price/Earnings, Price/Free Cash Flow, and Enterprise Value/EBIT ratios.

The challenge is that you, the amateur investor, must be firmly rational in all your investment decisions in a systematic manner. At the same time, you must believe the entire market is irrational in its pricing of those same investment positions. That takes cojones.

Aside from the contrarian nature of value investing, there is also a massive built-in problem: the "Value Trap". A stock that is falling in price can look like a better and better buy based on value metrics right up to the point where it's essentially worthless. To protect yourself, a successful value investor needs to know exactly when to buy, how much to buy, and, maybe more importantly, when to cut your losses.

Broad-based value investing, in the form of buying the lower valued chunks of broad markets, seems to be failing in many ways. Over the past ten years, traditional, passive value funds have under-performed the whole U.S. stock market by more than 1.3% per year. Over that ten years, that translates to a cumulative investment growth of 136% versus just 106% for value. It's too soon to say if passive value is dead, or if its a temporary blip, or anything else in particular.

Every strategy has periods of out-performance and under-performance, but the widely believed value premium is certainly not a given. Even Jack Bogle, a noted proponent of passive investing, has suggested that historical analysis demonstrating a value premium is flawed. The suggestion is the value premium is actually a case of cherry-picking a good time for value investing, but over long time periods passive value will perform equal to or less than the broad market.

Trend Investing

This is why I choose trend investing instead, using leverage and a range of markets. Although buying something that appears to be on sale appeals to the frugality in me, I would rather buy something that is going up in price. I am content to following the collective rational and irrational players in the markets who slog it out every day determining the price of everything.

If the participants of a liquid market are bidding the price of a particular stock higher and higher, there's something going on under the surface. A company might be producing highly profitable products that are selling faster and faster, a company may have cut costs to increase profitability, maybe there's a takeover coming that hasn't been announced yet.

If the market is bidding down a currency, maybe the country is in economic trouble. Perhaps interest rates in the country are too high and the market is betting that rates will fall. Maybe the country is intentionally devaluing to try boost exports as part of their economic policy.

The same logic applies to interest rates. Interest rates are a great measure of risk and perceived risk. In general, the more financially responsible a borrower is, the better their rates will be. If national debt rates are going down, chances are the country is doing well, the government is going down a more fiscally responsible path, there might be a positive trade balance meaning foreign currency is pouring into the local economy.

On the other hand, if interest rates are going up, lets say on corporate debt, it might be a good signal to sell. Rates on corporate debt often begin to rise when the markets believe a company is getting into some kind of trouble. Maybe they have too much debt on their books, it could be an issue of declining market prospects in that company's sector, sometimes sales and profitability are an issue. Other times the market believes the assets held by the corporation might not be worth as much as the company has stated in the past.

It is difficult and maybe even impossible to decipher the exact reasons why price is going one way or another. However, it's easy to decipher the price itself. The price is published every day, every hour, every minute, every second and it tends to trend.

Where Valuation Comes Into Play

Just because I invest based on the market price and the trends in those prices doesn't mean I believe the price is correct relative to fundamentals. More often than not, I ignore fundamentals. To me, fundamentals and valuation come a distant second to the trend of the price alone.

No matter how cheap an asset is, I will not buy it because it is cheap. The asset only comes into consideration if the price is moving up and has entered an up-trend. I understand that means I don't buy at the cheapest price possible, but that's precisely my goal.

I would rather have the market as a whole identify a bottom and turn around a price than try finding that bottom myself only to miss over and over.

For me, cheapness, or valuation, are only important when cash is limited and I have to decide between two or more investments that are in a price up-trend. In this situation, I will go with the cheaper asset provided other factors are more or less equal.

For example, lets say I have 10% of my portfolio in cash that can be allocated to investments. There are two markets that I am following which have recently entered an uptrend. I can only buy one of those two assets, which one should I choose? Well, this is where valuation comes into play. If Market A is in the 99th percentile of its historical valuation and Market B is at the 60th percentile of its historical valuation, I will choose Market B.

Sure, Market A might go completely crazy and hit the moon. But a reasonable person making disciplined bets would have to agree that Market B has more room to run before the price gets into unprecedented territory. On a balance of probabilities, Market B is the better market to invest in.

Always buy into an up-trend and ignore value unless resources are limited while opportunities are plentiful.

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Risk Management for Speculators & Trend Investors

Risk management is the absolute key to success for speculators and trend investors. If you can limit your losses and downsides, the upside will take care of itself.

Here are a number of rules to help you reduce risk in your trend investing portfolio.

1. Divide your total portfolio equity into equal sized portions.

Ten portions is good to begin with and you can expand to twenty equal portions as your portfolio equity grows and you gain access to more markets. Unless you are managing millions, there is no point into dividing your portfolio further. Keeping your portfolio equity portioned will help with setting risk levels and stop losses for each position later. It is also a good way to help you determine the number of markets you should monitor and trade.

 

2. Only put up to one portion of your portfolio to work in any one asset.

By limiting your bet size on any one asset, you are ensuring your portfolio stays manageable from a risk perspective and properly diversified for broad return potential. You never know which markets are going to make you your profits, so don't bet the ranch on just one or two assets. Cash, or short-term bonds, are a default holding so nearly your entire portfolio may be in cash if markets are not trending.

 

Example Assets Only

3. Trade diverse markets that provide returns which are independent of each other.

Trading only stocks and bonds will not provide you with a broad range of returns. Instead, monitor a range of uncorrelated and liquid assets: stock indices, currencies, precious metals, real estate, and bonds. If your account is larger and you have access to futures markets, include energy, grains, and industrial metals.

A lot of these assets can be traded with ETFs, but be careful to pick the right ones. You want liquidity and reasonable costs.

 

4. Determine the size of each position, including leverage, based on volatility.

Leveraging up your position can help increase returns on each position, but it also increases your chances of hitting a stop loss quicker than you need to. This can increase your whipsaw costs. Use Average True Range or Standard Deviation to measure the volatility of an asset. The asset's stop loss price should be a low multiple of ATR or SD.

Your stop loss price will help you determine an appropriate size for each position once leverage is factored in. Based on this formula, a highly volatile asset might be purchased with no leverage, or maybe less than a full position. Many assets can be leveraged up 2x to 5x or maybe more.

 

5. Never risk more than 2% of your current portfolio equity on any one asset.

Regardless of the size of the position and the amount of leverage used, the maximum loss of any trade should never be more than 2% of your portfolio equity. Newer and more cautious investors should start with a 1% maximum risk per trade. In dollar terms, if your portfolio equity is worth $100,000, your maximum equity loss on any of your positions should not be greater than $2,000. Limiting losses is the key to long-term success.

Source: Flickr - DoD News

6. Enter a Stop Limit Order on every trade set at your maximum risk.

To ensure your emotions don't get in the way of your trading, always place a stop limit order on every position. The stop price should be set at or near your maximum risk. Assuming you are risking 2% equity per position on a $100,000 portfolio, your stop price will never allow your total equity loss on any position to exceed $2,000. Move your stop loss up as your position becomes profitable, but never move your stop loss down.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.