Investing is a tough business even for the pros. Here's a graph that will surprise no one.
The above chart represents the average 2016 return among the 70,000 investors who tracked their portfolios on the Openfolio social network. Their investments underperformed the S&P 500 by 7%!
It's unlikely Seeking Alpha investors fared much better. As a matter of fact, the estimated percentage of people who actually beat the market long term is virtually nil. Here's why.
At a very fundamental level, each investment represents a probability wave. The wave is made up of an infinite amount of variables. Each variable represents a probability wave with its own set of infinite variables and so on. Analyzing a winning stock is pure luck. That's the hidden reality of investing.
Success is a crap shoot. But that's not the worst part. The human condition is designed to minimize damage. Investors, by their very nature, will sell low to minimize the pain of a losing investment. That's why very active investors actually perform even worse. The best advice for most investors is to just dollar cost average using a low-cost index fund such as Vanguard. But, what fun would that be!
By allowing the fundamental physics of investing work for you, there are ways to actually beat the market. What if I told you you would never have to sell a stock at a loss again? Sounds pretty crazy, right? Well, the fact is you don't. I haven't sold a stock for a loss in years and probably never will again.
I maintain a large number of diversified investments in an actively managed portfolio. 34 stocks at the moment to be exact. When I start a position, I intend to hold it for life so the number of investments tends to increase over time. When an investment hits my target return, which I have arbitrarily set at 17.5%, I peel off a set amount and take realized profits. When the investment decreases by the same percentage, I buy more. Needless to say, volatility is my friend.
If a stock continues to increase in value, the position will naturally decline over time until it hits my minimum hold level. I will follow the investment until it ultimately takes a material dip (again, my 17.5% target), at which point, I repurchase the stock.
In simple terms, that's the approach. It takes advantage of probability waves by buying into the troughs and selling into the peaks. I believe in keeping it simple. One could try utilizing the Elliott Wave Theory and technical analysis to maximize the approach, but I'm not convinced of its predictability, and I have found complexity often leads to flawed judgment. Historical patterns can look orderly in hindsight but aren't always good predictors of the future. In probability analysis, it's the hidden variable you never see coming that gets you!
Cash And Taxes
The challenge with the approach is how to minimize the negative effects of cash and taxes, both of which will eat into returns over time and make it more difficult to achieve the ultimate goal of beating the market.
Cash is obviously a low earning asset. It's also the best asset to own in a declining market. The balancing act is to have enough cash on hand to always be in a position to take advantage of stock declines but not over-allocated during market rallies. My goal is to maintain around 30% cash during bull markets and no less than 10% during bear markets. Cash on hand can be actively managed by the number of stocks in the portfolio.
Taxes are a more challenging matter. Since I never sell at a loss, I have no losses to offset gains (good problem to have, right?). I always sell specific lots to take advantage of capital gains whenever possible. I also maintain a tax-deferred rollover account, which serves two purposes. The tax deferred account obviously is immune to the destructive nature of taxation from active investing. But it also is a sheltered asset. My advice to any young investor. Take advantage of tax deferred accounts to build wealth whenever you can. It will serve you well later in life.
Why Stock Picking Matters
When you're picking a stock you plan to hold for life, the right investment matters. Regardless of the approach, I consider myself a value oriented, situational investor. My goal is to select undervalued stock with strong potential for future growth. Once I open a position, the methodology determines future trades but it helps to believe in the company upfront. An investor should never forget he/she is buying a piece of a business not just a piece of paper (figuratively speaking) to be bought and sold.
In that regard, Edgar should be your best friend. 8-Ks, 10-Ks, and 10-Qs should be required reading. Management can say just about anything to entice investors (and usually does). However, there is accountability with SEC filings. Warnings aren't just boilerplate language as some investors believe. Disclosures are usually there for a reason and it typically involves around management's desire not to get sued or go to jail!
Here's a recent, high-profile example. I started following DryShips (NASDAQ:DRYS) out of curiosity. As is my normal practice, I started reading the filings. There was a history of opaque, insider transactions that appeared to destroy shareholder value, which looked interesting. But, before I could investigate those I came across the following:
Our Chairman and Chief Executive Officer, who may be deemed to beneficially own, directly or indirectly, 100% of our Series D Preferred Stock, has control over us.
On September 9, 2016, we entered into an agreement with Sifnos to convert $8.75 million of the outstanding amount under our then existing secured revolving credit facility to 29,166 shares of Series D Preferred Stock (3,500,000 shares before the 1-for-15 and 1-for-8 reverse stock splits). As of March 10, 2017, our Chairman Chief Executive Officer, Mr. George Economou, may be deemed to have beneficially owned, directly or indirectly, 100% of our Series D Preferred Stock. The shares of Series D Preferred Stock each carry 100,000 votes. As of March 10, 2017, there were 29,166 shares (3,500,000 shares before the 1-for-15 and 1-for-8 reverse stock splits) of Series D Preferred Stock outstanding. By his ownership of 100% of our Series D Preferred Stock, Mr. Economou has control over our actions. The interests of our Chairman and Chief Executive Officer may be different from your interests.
That should scare the bejesus out of any investor. And anyone who follows DryShips knows the impact of that simple fact, which was disclosed clearly in the 10-K. For a retail investor, alarm bells should have sounded immediately.
You don't need a degree in finance or be a finance professional to understand a 10-K. However, if you do want to become more proficient in interpreting the information and, if I could recommend only one book, it would be "The Intelligent Investor" by Benjamin Graham. I'm sure most have heard of the book or read it but you can never be overexposed to good advice, right? For those with an aptitude for numbers, you may want to follow up with Graham's earlier work, "Security Analysis".
Graham's work reminds me of the first great chess book I ever read, "Logical Chess Move by Move" by Irving Chernev. Once you read a book like that, you will forever be better for it.
Below is a snapshot of the portfolio.
The stocks highlighted in blue have reached the minimum hold position due to appreciation in stock price. In general, I would consider them fully valued at the moment. However, once they hit the buy target on the far right-hand column, I'll add to the position. The stocks highlighted in orange are most recent purchases. I consider them undervalued. Finally, the stocks highlighted in green are, for the most part, considered fully valued.
There are some exceptions. For example, I consider Intermap Technologies (OTCPK:ITMSF) undervalued (see "Intermap Technologies: A Case Study In Value Investing") but my disciplined approach requires that I follow a standardized methodology and not become over concentrated. After all, I could be dead wrong!
The first thing you will notice is that it's somewhat concentrated in healthcare. My goal is to maintain a diversified portfolio across the entire risk spectrum. However, healthcare and biotech, in particular, provides an extra level of volatility that generates added opportunity for realized gains. Of course, with the added volatility comes risk. The goal is not to minimize risk but to manage it.
I won't cover the entire 34 stocks in the portfolio here. However, I do try to include value-added, actionable recommendations whenever possible. One of the benefits of holding an investment for life is you develop an intimate knowledge of the company and its prospects for stock appreciation at any point in time.
With that said, my top pick at this point in time would have to be Depomed (NASDAQ:DEPO). Depomed is an activist investment opportunity that hasn't panned out as planned yet (see "Starboard's Activist Campaign Puts Depomed In Play"). But, as the saying goes, if you liked it then, you should love it now. And I do!
Mining For Profits
This system is not for everyone. It takes a strong stomach to stick with a losing stock, and some of your picks will invariably be losers. I like to think of it as mining for profits. Sometimes you have to dig deep to uncover value, but sooner or later, the market will overshoot to the downside. It always does. Some of my most profitable investments were losers early on.
There are many approaches to investing. The approach I've highlighted here has historically beaten the S&P 500. It's a systematic approach that requires discipline. But success can only be judged by time and measured by the relative size of one's brokerage account. I offer it here as an alternative approach to the typical scenario of buying stocks when they look attractive due to recent success and selling at a loss once the thesis is proven wrong. There is another way. You can never sell a losing stock again and profit for life!
Disclaimer: This article represents the opinion of the author, who is not a licensed financial advisor. The article is intended for informational and educational purposes only, and should not be construed as investment advice to any particular individual. Readers should perform their own due diligence before making any investment decisions.
Disclosure: I am/we are long DEPO, ITMSF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.