How To Get High Growth With Half The Risk

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Includes: AAPL, AMGN, AMZN, BST, CELG, GOOGL, HD, IEF, JPM, MA, MSFT, NFLX, PYPL, QLD, QQQ, QQQX, REGN, SHY, STK, TLT, V
by: Financially Free Investor
Summary

We mostly write on conservative and/or income-oriented strategies. However, this article focuses on strategies on how to invest for growth.

For most people, it is really difficult to recognize the next Apple or next Amazon in their early years of growth.

Our suggested approach is to invest in growth strategies that do not depend on your stock-picking abilities.

We discuss three such strategies.

A vast majority of our articles are based on conservative or income-oriented strategies mostly focused on retirees, near-retirees, or folks who are within 10-20 years of their retirement. This article is a bit of an outlier and focused on investing in fast-growing companies. However, rather than focusing on fast-growing companies or stocks, we recommend investing in growth strategies that could provide high gains during good times but limited downside during the tougher times.

The Wall Street runs on fear and greed. So, many investors, especially in their early years of investing, want to get rich quick. Sure, there is nothing wrong with that thought, and maybe that's how many people make their early mistakes, learn from those, and then go on to become successful investors.

Everyone wants to invest in the next Apple (AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) or Amazon (AMZN), especially in their early years of growth. They want to know the stocks that would turn into multi-baggers (return hundreds of percent) and could make them rich rather quickly, in years rather than decades. After all, we hear and read stories about how Apple could have returned a 40,000% gain from 1998-2018 if you were wise enough to invest in 1998. But that is not a realistic scenario. Most people could not imagine a scenario where its founder Steve Jobs would return and essentially turn the company upside down. Apple turned itself from a niche computer company into a highly successful consumer electronics juggernaut.

Of course, Apple is just one example. Take the case of Home Depot (HD). It is not even a tech, biotech, or some company that had the promise to change the world. It was simply a run-of-the-mill retail chain of home-improvement stores; however, its founders had a vision and skills on how to grow this company. Home Depot's growth since the '80s has been nothing less than spectacular. A $1,000 investment made in Home Depot in 1985 would be worth about one million dollars today (dividends reinvested). But, again, how many people had the wisdom to recognize the scale of potential back then.

Fortunately, You Don't Need To Be An Investment Wizard

For the reasons mentioned above, it is not realistically possible for most people to recognize the next Apple or Amazon in their nascent years, especially when they have little to none profit to show for. Sure, there are some exceptions.

However, we strongly believe that you don't need to have any such special abilities to earn solid gains from growth stocks. We will explain in a minute.

This article will explore the strategies and ways to capture the majority of growth in companies that are potentially going to be multi-baggers but avoiding the risks that come with such companies. However, we are looking for strategies that would not depend on our ability to pick multi-baggers but would rather depend upon the systematic and methodical ways to achieve the goals.

Invest In Growth Strategies Rather Than Growth Stocks

To avoid the pitfalls that come with trying to pick super stocks, we think it is much better and safer to invest in systematic growth strategies rather than growth stocks. We will run some back-testing on our strategies to show the potential. Of course, it is a good time to remind the readers the Wall Street adage "past performance is no guarantee of future returns."

Benefits of Investing in Systematic Strategies:

  • Investing in a well thought out strategy performs well and far better than having no strategy at all.
  • Most folks are not capable of taking good decisions in a crisis or panic situation. This is where a pre-determined strategy helps and will stop you from making bad decisions. Investing in a strategy can help take out the emotions out of trading decisions.
  • With the help of back-testing, it is possible to define the level of potential and risks with the strategy broadly. The investor is better able to assess the suitability and decide if the strategy fits well with their goals and risk tolerance.

In this article, we will lay out a few strategies with an aim to capture a large part of gains from the fast-growing companies. We will discuss three such strategies, including one with income.

  • A simple Rotation Strategy using Nasdaq 100 ETF or CEFs.
  • A modified version of Strategy 1, using QLD and TLT.
  • Volatility-Adjusted Growth (BTF) portfolio.

Strategy 1: A Rotation Strategy Using Nasdaq 100 Index ETFs or CEFs:

This is a simple strategy using two securities, Invesco QQQ Trust ETF (QQQ) and iShares 20+ Year Treasury Bond ETF (TLT). Every month, we will check their 3-month relative performance and invest in the security that performed better over the previous 3-month period. Here is the performance of this strategy in comparison with NASDAQ-100 (QQQ) from January 2003 to 2019.

Performance Chart - 1:

As you would notice, the strategy not only outperforms the QQQ (or NASDAQ-100 index) slightly, there is a big difference in the drawdown (from the peak to bottom) and the worst year's negative performance. Buying and holding QQQ on Jan. 1, 2003 until Feb. 2019 would have provided an annualized return of 13.64%. Not bad at all. However, you would have to tolerate the roller coaster ride of 2008/2009 with a drawdown of almost -50%. In contrast, using the above strategy, the annualized return would be slightly better at 14.39%, and the maximum drawdown would be only -17.7%. In fact, the year 2008 actually ending with positive gains for the QQQ-TLT strategy, instead of a huge loss in case of QQQ.

Modify the Above Strategy to Generate Income using QQQX:

If you need income on a consistent basis, instead of QQQ (which provides almost no income), you could choose one of the following Technology-based CEFs.

Symbol

Fund Name

Dividend Yield

QQQX

Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX)

7.68%

STK

Columbia Seligman Premium Technology Growth Fund (STK)

9.33%

BST

BlackRock Science and Technology (BST)

5.80%

Out of the three CEFs, only QQQX has a long enough history going back to January 2008, which incidentally covers the last recession. We will provide the back-testing results using the pair QQQX/TLT and compare with QQQ. By using QQQX, another advantage would be the consistent high income (current yield 7.68%), a majority of the times.

This strategy provided an annualized return of 15.48% since January 2008, compared to a 12.4% return from using QQQ. The big difference again was in the drawdowns. The strategy had a drawdown of only -20.6% compared to a whopping drawdown of -46% in case of QQQ.

Performance Chart - 2:

Strategy 2: Modified Rotation Strategy Using QLD and TLT

If you could tolerate a somewhat higher risk and deeper drawdowns but wish to generate higher returns as well, you can use this modified strategy. We will replace QQQ with PowerShares Ultra QQQ ETF (QLD). QLD seeks daily investment results that correspond (before fees and expenses) to two times (2x) the daily performance of the NASDAQ-100 Index. We will pair QLD with iShares 20+ Year Treasury Bond ETF (TLT). Rest of the strategy will remain the same as the first one. Every month, we will check the 3-month relative performance of the two securities and invest in the security that performed better over the previous 3-month period. Here is the performance of this strategy in comparison with the QQQ index from January 2007 to end of January 2019.

Performance Chart - 3:

QLD's history only lets us go back to Jan. 2007, but it does include the last recession period. You can observe that there is a huge boost in the overall returns, though there is larger max-drawdown compared to other strategies, but still less than half of what you would have to endure if you were invested in QQQ. We must caution that the strategy still had a maximum drawdown of 26%, and not everyone would have the tolerance for such a drawdown.

Strategy 3: Volatility-Adjusted Growth (BTF) Strategy:

Author's note: We use a similar version of this strategy in our subscription service "High Income DIY Portfolios" since 2017. The strategy delivered 31.6% gains in 2017, and 10.3% gains for 2018 versus 28.2% gain in 2017 and -3.8% loss in 2018 for NASDAQ Composite index.

In this strategy, every year, we select a set of 10-15 high growth stocks. The list of these stocks should be reviewed at least once a year and would possibly change from year to year. One way is to look for large-cap stocks that had a leading performance in the last six-month and last one year. The name "BTF" is derived from our current list, which includes stocks from Biotechnology, Technology, and Financial sectors. We also include three treasury funds, which are used as hedging during times of stress and when stocks are performing badly. The list includes:

Current list of stocks:

Apple Inc. (AAPL)

Amazon.com, Inc. (AMZN)

Netflix, Inc. (NFLX)

JPMorgan Chase & Co. (JPM)

Alphabet Inc. (GOOG) (GOOGL)

Microsoft Corporation (MSFT)

Mastercard Incorporated (MA)

Visa Inc. (V)

PayPal Holdings, Inc. (PYPL)

Amgen Inc.(AMGN)

Celgene Corporation (CELG)

Regeneron Pharmaceuticals, Inc. (REGN)

iShares 20+ Year Treasury Bond ETF (TLT)

iShares 7-10 Year Treasury Bond ETF (IEF)

iShares 1-3 Year Treasury Bond ETF (SHY)

At the end of each month, we would compare their volatility adjusted performance over a period of the previous three months. We will select the top three stocks which have had the best volatility-adjusted performance and invest for the next month. If none of the stocks performed better than the risk-free rate, we would invest in Treasuries or Cash. We repeat this process on a monthly basis.

There are two distinct benefits of using this strategy versus just investing in say these high-growth stocks in a buy-and-hold fashion:

  • The success of the strategy does not depend upon our ability to pick the best growth stocks. It would not penalize us if we picked up a few bad performing stocks on the way, because we are only investing in the top 3 stocks every month.
  • Second, by investing in Treasuries during any big corrections, or recessions, the strategy will reduce the overall volatility and provide protection from large drawdowns.

For back-testing, we excluded Visa and PayPal since they did not have long enough history to include 2008/2009 recession. Here is the back-tested performance of this portfolio since January 2007 versus the Nasdaq-100 Index ( QQQ).

Performance Chart - 4:

Conclusion:

Most of our work focuses on conservative DGI or Income strategies for folks who are nearing retirement or already retired. Our portfolios and strategies are focused on how to generate income safely and are designed to contain risks and large drawdowns using 'Rotation' strategies.

However, for younger folks, who may still have many years left before retirement, there is a place for growth stocks and growth strategies. Even for retirees or near-retirees, depending upon the individual's risk-tolerance, it may be desirable to invest a small portion of their investment capital in a growth strategy. A growth strategy can do wonders to your portfolio and bring some zing to your overall returns, however, will add to the risk as well. So, how much risk you can take and what would be the right balance will obviously depend on the individual investor's personal situation, risk tolerance.

It is easy to be lured into growth stocks during a booming market, but one has to remember the potential of huge drawdowns during a recession or big correction. No one wants to buy at the peak and then sell at the bottom, but unfortunately, many people just end up doing exactly that because they failed to understand the risks and assess their own temperament to risks and drawdowns. That's why it is very important to determine the right growth strategy that you would be able to live with during the good times and bad.

To provide some answers and ideas, we discussed three distinct growth strategies; none of them particularly depends on the ability to pick exceptional stocks. The first strategy also included a version which could generate a regular stream of income while providing the same or better growth than the QQQ index.

Last but not least, it is important for the individual investor to have realistic expectations and recognize the higher level of risks that come with any growth strategy. One should always analyze their personal situation and risk appetite before investing in any strategy.

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LYB, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, JPS, JPC, JRI, TLT. 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.