Lessons From A Market Great: Nicholas Darvas

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Includes: AAXN, AMZN, GOOS, KHC, SBGL, SPY, TAP
by: Taylor Dart

Summary

In this article, I will discuss a few timeless principles from Nicholas Darvas.

Nicholas Darvas ran his account up from less than $100,000 to more than $2 million in a span of less than four years.

Darvas' system is a successful case study that buying high is a much quicker way to get rich than buying low.

While most investors have likely heard of Paul Tudor Jones, George Soros and Richard Dennis, one of the pioneers of momentum trading was a lesser known individual by the name of Nicholas Darvas. Darvas began trading in the 1950's and managed to parlay his initial stake of less than $100,000 into over $2 million in less than a four-year span. His success stemmed from his ability to do what most traders and investors cannot bear to do: buying stocks once they had reached new all-time highs. Darvas' story and his ability to consistently take profits from the market with ease is a successful case study on what it pays to be the minority in the market. Most investors love to buy low with the hopes of selling high. Darvas has no problem paying the highest price ever for a stock; his main concern is that it's going in the right direction when he gets on board: up.

Darvas' Start On Wall Street

Nicholas Darvas' story of getting rich on Wall Street is less conventional than others, as was his line of work. Darvas was a dancer and toured the world with his dancing team. His introduction into the stock market came when he was paid in stock by a Toronto night club he had planned to perform for. Darvas was given 8,000 shares in a stock called Brilund by the Smith Brothers at a price of $0.50 cents. By a massive stroke of beginner's luck, he sold the stock shortly after for a price of $1.90 for a profit of nearly $10,000 (after fees). He was now entranced by the stock market and was determined to find a way to continue in what looked to be a successful operation. The below passage was how he decided to continue with his journey in the stock market.

"I knew absolutely nothing about the stock market. I was not even aware for instance that there was one in New York. All I had heard about was Canadian stocks, particularly mining shares. As they had been very good to me, obviously the smart thing to do was to stay with them. But how to start? How to find what stocks to buy? You couldn't pick them out with a pin. You must have information. That was my major problem. I asked everybody I met if they had any stock market information. Working in nightclubs I meet rich people, rich people must know. So I asked them. The question was always on my lips "Do you know a good stock"? I listened eagerly to what they had to say, and religiously bought their tips. I was the perfect pattern of the optimist. Clueless, small operator who plunges in and out of the market. I bought stock in companies in names I could not pronounce, what they did and where they came from, I had no idea. All I knew was what the last head waiter at the last nightclub I had performed in had told me was good. I completely ignored the fact that I was holding a lot of stock which was standing well below the price I had paid for it, and looked like it was staying there. It was a period of wild, foolish gambling. I followed hunches. I went by god-send names. Rumors of uranium finds, oil strikes, anything anyone told me."

(Source: "How I made $2,000,000 In The Stock Market" by Nicholas Darvas)

A look at a couple of his trades during this period are below:

Old & Smoky Gas And Oils

Bought at $0.19 cents, Sold at $0.10 cents

Quebec Smelting & Refining

Bought at $0.22 cents, Sold at $0.14 cents

Most of us, whether we'll readily admit or not, had a similar start in the market. We looked for tips, we watched for "inside" information, and listened to rumors, all in the hopes of getting a head-start on the average investor. Similar to how this plays out for most investors, Darvas suffered a similar fate. His stint on the Canadian Market ended up being short-lived, after quickly realizing that Brilund was beginner's luck and he had no clue what he was doing. Fortunately for Darvas, a two-year dancing tour that had him traveling the Eastern hemisphere would be the solution to all of his problems.

(Source: CartoonStock.com)

Isolate Yourself - Ignore The Opinions Of Others

Darvas' two-year tour of the world with his dancing act turned out to be a blessing in disguise for his trading career. Darvas instructed his brokers to send him a daily telegram of the high, low and closing prices of all of the stocks he owned, as well as those he was interested in. To save time and money, Darvas had assembled a code where only the first letter of the stock would be sent as well as the high, low and closing prices following it. It would look as follows:

L: $50.95 $50.15 $50.40

The telegram would lay out for Darvas the symbol of the stock (shown by a single letter), as well as the high, low and close which followed after. At first, this proved to be a problem for Darvas as the mysterious cables that came in each day were bothering the post-office employees. Their thinking was that Darvas must be a spy or a secret agent, and he was confronted on several occasions to explain what the purpose was for these daily telegrams he was receiving. After careful reasoning with the post-office, they finally got off his back, and he was able to continue with his operation.

The massive benefit of these cables was that Darvas could not possibly get any phone calls or hear of any contradictory rumors from Wall Street being situated halfway across the world. He was completely isolated from all of the day-to-day noise from Wall Street and was able to zero in on the stocks of his interest with zero outside forces to cloud his thinking. There was no more herd mentality, no more taking hot stock tips from acquaintances, and no more opinions to potentially sway his judgment.

In a world that is dominated by social media today, it is not as simple as flying to Kolkata like Darvas did and completely blocked himself out of any news. Having said that, what we listen to and what media outlets you choose to fill your day with is strictly our choice. Darvas' decision to separate himself from Wall Street would be equivalent to us turning off CNBC, staying off of Twitter, and barring ourselves from ever listening to ZeroHedge or analysts preaching about daily and weekly news events. It also means avoiding checking the futures market every thirty minutes after the market close, as this has little bearing on our day to day dealings in the stock market.

(Source: The Market Oracle)

As I have explained several times to new traders I have taught and worked with: there is zero point in ever watching the overnight futures. As a trader, it's imperative to focus on what we can control, not focus on things that are entirely out of our control. If our job is to look at 2000 stocks each night and find the best two stocks that purchase the following day, what value does watching the futures tick by tick have for us? The answer is absolutely none. A market that is falling in the overnight futures will likely cloud our thoughts, give us a bias on stocks we should be looking for, and maybe even cause us to not put in our orders the next day out of fear. If traders have learned anything from futures in the past two years, they would know that futures have no bearing on where the market is headed the next day. During the 2016 Election night, the market was off by nearly 5% or 100 points on the S&P-500 (NYSEARCA:SPY) but managed to close up more than 1% the following day - a swing of almost 6% from the overnight lows.

(Source: TC2000.com)

When it comes to CNBC and the doom & gloomers, they are just as detrimental to our daily trading. There is always some negative news being trotted out that will affect our day to day trading, and there is zero value in allowing ourselves to be subject to any of this. On the flip side of things, you couldn't find a single piece of bad news in January of this year, and all we heard about was how tax cuts were likely to fuel the market another 10-15% higher. The herd is almost always wrong when it matters most, and this is why detaching ourselves from the herd is necessary for long-term success. During April all we heard about was how the market was likely to make new lows, and it was a time to be on the defensive. At the same time, Canada Goose Holdings (NYSE:GOOS) was trying to emerge from a multi-week base and was tapping on previous all-time highs. By being concerned about what the market was doing, many traders would not have bothered looking for long ideas and would have been too paralyzed among all the apocalyptic predictions to put in orders to purchase the stock. Despite the S&P-500 only being 7% higher than April levels, Canada Goose Holdings is up 70%. As Darvas explains in his own words below:

"I was influenced by nothing but the price of my stocks. I could not heard what they said, but I could see what they did.

(Source: "How I Made $2,000,000 In The Stock Market" by Nicholas Darvas)

Buying Strength - Lorillard

One of the first stocks Darvas traded in his quest towards $2 million in profits during the 1950's was Lorillard. The company made filter-tip cigarettes under the Kent and Old Gold brands. Despite the general indices being tangled up in a bear market in 1957 and down sharply for the year, Lorilla had nearly doubled during the same period. This unusual strength in the stock amidst pronounced market weakness was a sign that something special might be going on in this name. This inkling by Darvas turned out to be entirely right. While the market gained 40% over the ensuing fifteen months, Lorillard stock shot up from $27.00 to a high of $89.00 and more than tripled in value.

Conventional wisdom would tell you to buy the stock down the most in a bear market as it has the most room to regain once the market comes back in favor. This "buy low" mentality could not be further from the truth if one is looking to achieve superior returns. The best way to own the strongest stocks is to buy the strongest stocks. Those traders/investors that are unwilling to buy "expensive" stocks are missing out on a world of opportunity as typically the real gems are not found on the sale rack. Just like it's unlikely you're going to find a Burberry scarf at Goodwill, you'll have just as much trouble finding the next big leader in the 52-week lows list.

Darvas ended up selling the stock at just over $57.00 per share for more than a 100% profit in less than 9 months.

Let's see if the same holds true today:

Axon Enterprises (NASDAQ:AAXN) hit the 52-week high list at the same time the market was near its February lows after enduring a more than 10% correction. Amazon (AMZN) did the same only one week later.

Axon Enterprises has returned 155% since it made that new 52-week high, Amazon has returned 21%.

Meanwhile, Sibanye Gold (SBGL), Molson Coors (TAP), and Kraft Heinz (KHC) all made new 52-week lows immediately following the February correction. Sibanye Gold is down 44% since, Molson Coors is down 13% since, and Kraft Heinz is down 13% since.

Is this really a coincidence or is it possible that Darvas was onto something and the same principles still hold true today?

Know The Market You're In

One of my favorite analogies ever written by a market timer is by Darvas below which I have shown below. A trader/investor can have the greatest and most sound system in the world, but ultimately they need to be able to differentiate between what type of market they are in. Conventional wisdom would tell you that you should study the market to get cues about what type of market you are currently in. While I would agree with this and I do the same, I use a bottom-up approach to determine the health of the market by looking at stocks. By the time the market has moved clearly into bear market territory, the average stock you're holding is already going to be down by 30%.

"After a few weeks of being without a single share, I decided to take a closer, clinical look at the situation. To understand it clearly, I made a comparison between the two markets. The bull market I saw as a sunny summer camp filled with powerful athletes, but I had to remember that some stocks were stronger than others. The bear market, the summer camp had changed to a hospital. The great majority of stocks were sick, but some were more sick than others. When the break came almost all of the stocks had been hurt or fractured. It was now a question of estimating how sick the stocks were, and how long their sickness would last. I reasoned that if a stock has fallen from $100 to $40, it will almost certainly not climb back up to the same high again for a long, long time. It was like an athlete with a badly injured leg, who would need a long period of recuperation before he could run and jump again as before.

(Source: "How I Made $2,000,000 In The Stock Market" by Nicholas Darvas)

Darvas' wisdom above explains that based on his careful study of individual stocks, he was able to distinguish the damage that had been done, and had actually sidestepped the whole bear market. His stops on long positions continued to get hit, his new entries in long positions were showing dismal success, and it made little sense to continue purchasing stocks if he was seeing no reinforcing stimulus. This is yet another benefit of buying on strength and not buying dips. Due to the fact that Darvas was looking for new all-time highs to buy stocks, there was absolutely zero reason for him to commit any money to a bear market. This is because there are not going to be any real number of stocks hitting new all-time highs while the market is busy tumbling like it was in 1957.

While it is a great asset to be able to see signs that signal where the market might be going by studying solely the market, it is a great deal more helpful to get the tip-off from stocks alone. By the time the market is more than 10% off of its lows, many of the leaders are already up by 50% - 100%. The average investor that waits for the market to give him clues that it's time to redeploy more capital is going to miss all of the strongest names as they'll be getting the memo weeks late. The key point Darvas drills home here is to pay attention to the character of your stocks, not just the character of the general indices.

Darvas made a fortune by buying stocks that most felt were too expensive, completely detaching himself from Wall Street, and by staying true to one system and trading it religiously. I have done the same in my trading as I have not watched a minute of CNBC in the past three years, have made a concerted effort not to check overnight futures, and do not let doom & gloomers affect my everyday decision making. Less is more in the market, and it's best to keep it simple. Watch your stocks closely for changes of character, keep a watchful eye on the market during trading hours and tune out all of the unnecessary noise. All that's needed to make money is conference calls, price charts, and earnings history. The great traders of the 50's, 60's, 70's, and 80's did just fine without CNBC, ZeroHedge, and Twitter; I think we can too.

Disclosure: I am/we are long GOOS, AAXN, AMZN, UPRO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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