After a recent article I wrote disparaging index investing (here), I received a number of private messages asking “then how do we do it?” Some were genuinely seeking a way out of the index fund morass, some were saying, nicely, “OK, smart guy, but what works any better?” Let me answer by excerpting something I wrote in the February issue of Investor’s Edge ®:
Our investing discipline rests upon three steps:
(1) re-balancing as appropriate to be more in the market when it is rising and less in when it is declining;
(2) determining the best asset classes and sectors within those asset classes to maximize potential gains; and
(3) selecting those companies’ stocks we believe are most undervalued and offer the highest appreciation potential within our favored asset classes and sectors.
This is the strategy we use to attempt to consistently maximize our returns, and one that has historically beaten a “buy and hold” philosophy as well as day-trading / over-trading. Let’s dispense with these two extremes by turn:
Warren Buffett says his favorite holding period is forever. Well, heck, that would be my favorite holding period, too! If only we could buy stocks that never went down, even in a secular bear market, of course we’d like to hold forever. It requires only one decision, then we let the miracle of compounding make us rich, right? Um, not exactly. It is seductive in its simplicity, but it doesn't really happen that way...
What is disingenuous about the comment, for most investors besides Mr. Buffett, is that the rest of us don’t have 80% of our earnings (closer to 100% lately) coming from 100% privately-held cash cows. By owning so many privately held firms, Berkshire Hathaway (BRK.A and the now much more widely available BRK.B) doesn’t have to worry when the value of their publicly-held securities plummet, as long as the private parts of the company still reel in the cash flow. And the publicly-held stocks are corporately-held -- so it doesn’t matter if it takes 10 or 50 years to come back.
But we as individuals may not have the 10 years or more it takes to get whole again. (BRK’s biggest holding, Coca-Cola (NYSE:KO), was 55 in 2000 and is 54 today. Its 2nd-biggest holding, American Express (NYSE:AXP), was 50 in 2000 and is 39 today. #3 Wells Fargo (NYSE:WFC) was 20 ten years ago and is 28 today. Etc.) If you want to buy-and-hold, I hope you’re getting lots of dividends because even legendary investor Warren Buffett has earned just under 0% over the last ten years on his let’s-just-hold-it-forever portfolio.
At least the buy-and-hold extreme has a certain charm, a “don’t-we-wish” quality that those with a vested interest in keeping your money with them all the time (like brokers, hedge funds, mutual funds, et al) will sonorously intone is the only safe way for an individual to invest.
(What they mean, of course, is leave all your money with them all the time so they can trade it willy-nilly -- Goldman Sachs’ SEC filing for 2009 shows they made more than $100 million day-trading, closing out their positions by the end of the day, on 131 separate days in 2009! They only lost money day-trading on 19 days, and then never approaching $100 million.)
Those who believe they can duplicate Goldman’s success at day-trading, however, have an infinite capacity for self-delusion. Have inside information? A Cray super-computer? An office a half-block from the exchanges’ servers? Can you execute trades in milliseconds? I’ve been involved in the market as an investor and an insider for 40 years and I have yet to see a day-trader make money for more than one lucky bull market cycle. And in lucky bull market cycles, chimpanzees could buy and hold or throw daily darts and make money. Genius is a rising market.
If your propensity is to disagree based upon the propaganda you’ve been fed by Wall Street, you need look no further than the documented results in these pages since we began our Model Portfolios, with timely re-balancing, 11 years ago. We just had the worst two-year run we’ve ever had. Ever. And still, over those 11 years, we beat buy-and-hold, “the market” and, with all the gyrations of up Dow 400 one day, down 600 the next, no doubt the day-traders, were whipsawed mercilessly.
The risk we take in re-balancing, of course, is getting the time we choose to re-balance wrong. I claim no infallibility; just good fortune or good instincts (conscious and subconscious analysis of past history and current events) over that time. Let’s take a look at the past two years where, even with our -- my -- lousy re-balancing choices, we are still ahead of the market.
This is a critical analysis because it clearly shows that you can be wrong on your entry and exit points by some number of weeks or even months, but by taking the proper action -- even "too early" or "too late" relative to the absolute optimal entry point, still do better than you would have by “buy-and-pray” or “trade-and-lose.”
If you began the year 2008 with $1000 in an S&P 500 index fund, you would have lost 38.5% -- $385 -- by the end of the year, leaving you with $615. But let’s say you are a devotee of buy-and-pray and you hung in there, not the least bit swayed when the market plunged and your portfolio fell apace. By the end of 2009, you would have enjoyed a whopping 23.5% gain on your remaining $615, sort of vindicating your decision to hold through thick and thin. Add 23.5% to your $615, and you have $760. At year-end 2009, you were only down $240 after 2 years, having lost “only” about one-quarter of your net worth.
I was way off in my re-balancing timing in 2008 and 2009. I predicted the decline in 2007, then stayed far too long at the fair in 2008, hit the exact week to get back in March 2009 (SA article here), left too early and, horror of horrors, went short in the summer via inverse ETFs. As a result of that in-retrospect-terrible decision, I had my Thead handed to me. Those results may not be typical, but the frequency is: major re-balancing to meet market, external event and sentiment expectations typically happens about twice a year. I’m usually 2 for 4 or 3 for 4; over this 2-year period, I was just 1-for-4. Abysmal. And yet…
Because we re-balanced in 2007 and 2008 to get subscribers into a good chunk of cash, we were only down 18.7% in 2008. (Only is relative – the S&P 500 was down 38.5% in 2008 and makes no apology for it. At least we have the humanity to be embarrassed by our staying too long at the fair and the humility to try to do better.)
Even after failing to reduce our equity position to $0 in early 2008, and under-performing the great rebound in the S&P 500 by 23.5% to just 5.4%, still -- every $1000 invested the way we recommended in our Model Portfolios left you with $857 versus $760 if you bought-and-held. Our awful decision to exit too early in 2009 and go short for 12 weeks of gut-wrenching wrong-way Corrigan was partially made up with our out-performance in the 2nd and 4th quarter, but we were up just 5.4% for the year, leaving subscribers at the end of those two years with $857. That means we still beat buy-and-hold by $97 for every $1000 invested – making just 4 re-balancing decisions in 2 years to do it, only 1 of which was spot-on. (to be continued)
In Part II, I’ll contrast buy-and-hold with an example of better re-balancing decisions and suggest reasons why people typically hunker down with what they have rather than re-balance their portfolios.
In the meantime, if you’d like to act upon these thoughts, it takes nothing more than reducing your current equity exposure. You don’t have to sell everything, but how about selling 50-70% of the issues that you are uncomfortable with at their present valuation levels? How about replacing them by increasing your exposure to some good income-producing firms like Penn Virginia (NYSE:PVR), Natural Resource Partners (NYSE:NRP), Atlantic Power (OTC:ATLIF), Bell Canada (NYSE:BCE), New Zealand Telecom (NZT), and Nuveen Senior Income Fund (NYSE:NSL). Do your research on these dividend standouts and see if you agree they are excellent holdings for uncertain times.
Author's Disclosure: We and / or clients for whom these investments are appropriate, are long BCE, NRP, PVR, MMP, ATLIF.PK. NZT, and NSL– while maintaining a sizeable cash cushion.
The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.
Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – for example, our Investors Edge ® Growth and Value Portfolio beat the S&P 500 for 10 years running but did not do so for 2009. We plan to be back on track on 2010 but then, “past performance is no guarantee of future results”!
It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.