By Mario Mainelli
This is another in our series of articles exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.
The “buy low, sell high” trading strategy is one that is often thoughtlessly used by investors. The concept is intuitive – if I buy something at a low price and sell something at a higher price, I make a profit. Since few investors are opposed to making a profit, the strategy must be a good one. Dever argues that a simple “buy and hold” strategy will outperform the “buy low, sell high” in almost any case. He also stresses the fact that he is not in support of the buy and hold, but in this case, it is the lesser of two evils.
The author cites an example which compares the performance of these two strategies using the S&P 500. The buy low, sell high strategy is executed in such a way that the investor purchases the S&P 500 after a 10% drop and sells following a 20% increase from that purchase price. I’ve included a chart from the book, which summarizes the comparison over a 29 year period.
Two points are important here. The first is the staggering difference in annualized return. The buy and hold almost doubles the buy low sell high! The reason for this is that the buy low, sell high strategy limits the upside potential by selling out while stocks are on an upward trend. This will cause the investor to lose potential gains in a bull market – gains they would have received with a buy and hold strategy. Additionally, a purely buy and hold strategy limits the investor's potential to profit on the downtrend as well. Though we won't get into the advantages of short-selling here, a prior article in the series examined how regular investors can benefit from the strategy.
The second problem is the negligible difference in “maximum drawdown.” Let’s take a step back and define the term “drawdown.” Expressed as a percentage, a drawdown occurs when there is a drop from the peak price. A drop to $5 from a peak of $10 would be a 50% drawdown. A maximum drawdown is the largest drawdown that occurred before the previous peak price is exceeded. Maximum drawdown basically represents downside risk. Contrary to popular belief, the buy low, sell high strategy doesn’t limit your downside as one may think. Investors may buy in at a low price; however what often happens is the price rises from there, but not enough (ie. the 20%) required to sell out of the position. The stock then proceeds to fall even further. We like to call this less popular technique the “buy low and watch the stock, well as your profits, plummet” strategy.
To ensure that the example above was not an outlier, Dever also conducted the experiment with many different parameters. He tested the same strategy looking at every 5% buy point during selloffs of between 5% and 30%, and then exited those trades following gains of between 5% and 30%, producing 36 possible combinations. The results all showed that buy low, sell high has considerably lower expected returns than the buy and hold, while barely providing better downside protection. The buy and hold certainly wins this risk/return duel.
If the buy low, sell high strategy is inferior, then why do so many investors use it? The author explains that this is a “feel good” method of trading. Buying a stock at a low price then selling it shortly after at a higher price feels good because it allows the investor to lock in the profit. Locking in a profit will make the investor feel safe and smart. Investors fail to see the inefficiencies in this style of investing. It would be like driving 10 minutes past one coffee shop to get a half-priced coffee at another. Saving money on the coffee makes you feel good, but you may fail to consider the extra cost of gasoline required to get there (not to mention the opportunity cost of the extra time you spent driving). For a further in-depth look at behavioural finance, please see the article 4 Ways to Use Behavioural Finance to Pick Better Stocks.
While I am largely in agreement with the author’s arguments, I do still have a squabble. I agree that the buy and hold strategy is inefficient for most investors, but I also do think it can be used effectively by experienced technical analysts. Anybody familiar with investor psychology may be familiar with the Elliot Wave theory. The theory states that investor sentiment changes between optimistic and pessimistic in predictable patterns. There are two main types of waves: impulsive and corrective. Impulsive waves are composed of five sub-waves that tend to move in the same direction as the larger trend. Corrective waves, conversely, moves against the larger trend and are composed of three sub-waves. The terminology may sound a little confusing, but what this is really saying is that you can make a profit using the buy low, sell high technique by timing the market patterns. An example below should make this clearer.
Amazon (AMZN), the large and ever-popular multinational e-commerce company, was priced at 163.56 on October 18, 2010 and increased to 186.5 by February 18, 2011. In between, there were many waves of increases and decreases in price. An investor using a buy and hold approach could have purchased 100 shares of Amazon on October 18 for $16,356, held it for four months and sold the shares at a value of $18,650, and earned a profit of $2,294 (or 14%). On the contrary, a savvy technical analyst could have used a buy low, sell high as follows to make a cool profit of $6,010, or 36.7%:
Obviously, very few investors can predict the patterns of a stock with enough accuracy to buy in at all of the lows and sell at all of the highs. To predict such stock patterns, technical analysts use many mathematically rigorous techniques – techniques which I will spare you both because I am no expert and because it will drive this article further away from its purpose. They also have to consider macroeconomic factors that could affect the stock’s price. There are superb technical analysts out there that can profit handsomely from this technique. Nevertheless, I would agree that it is probably useless to a vast majority of investors – those who aren’t technical analysis experts and those who don’t have crystal balls.
In the action section for this chapter, the author describes a portfolio strategy called CAN SLIM, which was created by William O’Neil, founder of Investor’s Business Daily. While it may sound like low-carb diet, the CAN SLIM is actually an effective stock screening technique, which I will break down below:
C=Current Quarterly Earnings per Share – Ensure there is positive growth in the current quarter vs. the equivalent quarter last year.
A=Annual Earnings Increases – Ensure yearly growth is increasing. One way to do this is as follows: the growth in Q3 2011 from Q3 2010 must be greater than the growth in Q3 2010 from Q3 2009
N=New Products/New Management – This can often create a buzz for the stock and result in a large increase in price.
S=Small Cap plus Volume Demand – Ensure there is not an excessive float. Dever describes picking stocks that have less than 25 million outstanding shares.
L=Leader or Laggard – Try to find stocks that are undervalued that have similar characteristics to the industry leaders
I=Institutional Sponsorship – Stocks with a higher percentage of Institutional Investors will typically be more liquid and less risky.
M=Market Direction – Examine the overall trend of the stock market.
My favorite aspect of the CAN SLIM is that it places a lot of significance on growth stocks that are somewhat undervalued. The first two parts (the C and the A) focus on the growth of the stock, while the fifth part (the L) focuses on ensuring the stock has not yet hit its full stride. I’ve created a stock screen below that includes my favourite aspects of the CAN SLIM strategy.
Note: EPS=Earnings Per Share; MRQ=Most Recent Quarter; TTM=Trailing Twelve Months; Cont. =Continuing.
The first filter looks at the most recent quarter vs. the same quarter one year ago and the second filter looks at the trailing twelve month EPS vs. the trailing twelve month EPS of a year ago. The minimum growth for these two filters is 10% for each. I’ve also included a filter for income growth of continuing operations for both the one and five year periods. This is to ensure that the company’s income is coming from sustainable activities, rather than extraordinary events.
I’ve set the five year filter at a minimum of 10% and the one year filter at a minimum of 5%. The reason for the lower filter on the one year is to allow some leeway for recent market turmoil. The fifth filter ensures that there are no more than 25 million shares outstanding, which captures the small cap feature mentioned by the author. The sixth filter ensures that each company’s common stock has a minimum of 50% Institutional ownership, providing greater liquidity and lower risk. The last filter makes certain that the stock’s current price is not different from its price one year ago by more than 10% in either direction. This ensures that the stock has neither hit its stride, nor has it dropped significantly.
The first stock, the specialty paper producer Schweiser-Mauduit (SWM), was chosen because of its rapid growth in income from continuing operations. They have impressively increased their income from continuing operations from 6.8 million in 2006 to 71.4 million in 2010. Holly Energy Partners LP (HEP) was also chosen because of its rapid five year growth in income from continuing operations. They have plans to continue their expansion as proven by their $88.6 million purchase of an extra storage facility, which is estimated to increase earnings by at least $27.2 million annually (per 2010 annual report). American States Water Company (AWR), a utilities operations company, was chosen mainly because its most recent EPS vs. Qtr 1 Yr. Ago of 43.02 is significantly higher than the industry average of 26.63, meaning it has relatively outperformed. Lastly, Chemed Corporation (CHE), a medical care provider, was chosen for its combination of growth and low risk (beta is only .28).
The stock screen I have created is a great start, but further in-depth analysis on each stock would be required before any position is undertaken. I think the CAN SLIM strategy is a great tool for portfolio analysis; if used, it should be modified to suit your needs as an investor. I would recommend adding some diversification through various asset classes; I discuss diversification in further detail in a recent article called How to Remove Familiarity Bias from your Portfolio. You can always try out this strategy using a paper money account and track its result to see how it fares. For those naysayers that are still skeptical about an active approach to investing, a prior article in the series showed how common indexes used by investors are not created to generate returns but instead by arbitrary rules.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.