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The Curse Of A Bull Market

“Vishal, since the market is up so much over the past two years, I’m looking for cheap stocks and sectors that have been left behind, even if they are average businesses,” a value investor friend Ravi told me this as we met for lunch last weekend. “Why?” I asked. “Because it’s almost impossible to find value among good quality companies…your so-called moat businesses. And I am a true-blue value investor you see.” “Oh no,” I told Ravi. “That is a dangerous thing to do.” I understood what Ravi was hoping to do. It also sounded logical i.e., to identify and buy stocks that remain cheap in a market where most businesses are quoting at high valuations. But sensible investing doesn’t work that way. “There is a big difference between ‘cheapness’ and ‘value’, Ravi.” “Why do you say that, Vishal?” “Think about stocks from the real estate and infrastructure sector as an example,” I said. “Since March of 2009, which was the bottom of last major stock market crash, shares of companies like DLF, Suzlon, GMR Infra, and JP Associates are down between 13% and 61%. Note that I am talking about these returns from the bottom of 2009, when almost everything was cheap . And we all know what has happened to these stocks from the peak of January 2008. These are down anywhere between 90% and 96%. “Now compare these with a few high quality businesses (as in 2008) like Asian Paints, Pidilite, and Titan. If you had owned them at the peak of January 2008 (note again, at the peak), and you held on to them till today, you would have earned CAGR of between 19% and 29%. “And we all know what has happened to these stocks from the bottom of March 2009. These are up anywhere between CAGR of 42% and 50%. “In short, if you had bought bad businesses in March 2009 when they were cheap , you would have been sitting on losses even six years later. On the other hand, if you had bought or held high quality businesses when then were seemingly expensive in January 2008, you would have still made big gains over the years.” “So are you advising me to buy high quality businesses, even if they are expensively valued?” Ravi broke his silence. “No, not at all Ravi. Far from that! Consider what Warren Buffett has said so often: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. “And why? Well, here is Buffett again: Time is the friend of the wonderful company, the enemy of the mediocre. “The message is simple, Ravi. Avoid the mistake of buying ordinary companies just because they are trading cheap and you have nothing to buy among high-quality businesses. “Patience, as I understand, is required not just after you buy a stock, but also before you buy it. “Look Ravi, what we have seen over the past two years has been an amazing bull run in stocks. If a stock did not rise in this run up, you must investigate why it has been so. Maybe something is wrong with the business. Maybe it is cheap now for a reason.” Ravi was listening carefully, and so I continued. “Most people, like I used to do earlier, think that it’s safer to buy a cheap stock – one that didn’t participate in the big run. They think that there’s some safety there. They think that it can’t fall as much as the ones that ran up, simply because it doesn’t have as far to fall. But having been an investor in the markets for almost 12 years now, and seeing others investors who have done really well over the years, I know this isn’t how it works. Buying the previous underperformers that are trading cheap doesn’t provide you any protection against market crash, or a potential for reasonable return in the future. “Some stocks that did not participate in the past run up may do well in the future, but it’s because their underlying businesses do well and not because these stocks were cheap at the start of their turnaround. “Once the market has run up like it has, the temptation is to look for deals among ordinary companies. Resist that temptation, Ravi. Trust me, it doesn’t work. “Learning this lesson was hard for me. I hurt myself a few times looking for cheap stocks after bull runs before I got it. But it doesn’t have to be hard lesson for learn for you. Now you know it. Don’t let yourself get burned by cheap stocks, too. Focus on business quality and then wait for the right valuations for them, even if you have to wait for some time. “But how long should I wait Vishal?” Ravi asked. Well, wait till you find high quality stocks worthy of buying, Ravi. As Charlie Munger says: It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that. “It’s the curse of the bull market that leads people to give up on their sound investment philosophy and become impatient (especially because ‘others’ are making money fast). But take my word – this stuff doesn’t work in investing. It has never worked. “Beware this curse of a bull market that makes you forget the risk of losing money, and leads you to assume that making money in stocks is easy. “And with that, let’s begin our lunch,” I told Ravi, “I am very hungry, so let’s talk of good food now and not investing.”

November Update – ETFReplay.com Portfolio

The ETFReplay.com Portfolio holdings have been updated for November 2015. I previously detailed here and here how an investor can use ETFReplay.com to screen for best-performing ETFs based on momentum and volatility. The portfolio begins with a static basket of 14 ETFs. These 14 ETFs are ranked by 6-month total returns (weighted 40%), 3-month total returns (weighted 30%), and 3-month price volatility (weighted 30%). The top 4 are purchased at the beginning of each month. When a holding drops out of the top 5 ETFs, it will be sold and replaced with the next highest ranked ETF. The 14 ETFs are listed below: Symbol Name RWX SPDR DJ International Real Estate PCY PowerShares Emerging Markets Bond WIP SPDR Int’l Govt. Infl.-Protect. Bond EFA iShares MSCI EAFE HYG iShares iBoxx High-Yield Corp. Bond EEM iShares MSCI Emerging Markets LQD iShares iBoxx Invest.-Grade Bond VNQ Vanguard MSCI U.S. REIT TIP iShares Barclays TIPS VTI Vanguard MSCI Total U.S. Stock Market DBC PowerShares DB Commodity Index GLD SPDR Gold Shares TLT iShares Barclays Long-Term Treasury SHY iShares Barclays 1-3 Year Treasury Bond Fund In addition, ETFs must be ranked above the cash-like ETF (NYSEARCA: SHY ) in order to be included in the portfolio, similar to the absolute momentum strategy I profiled here . This modification could help reduce drawdowns during periods of high volatility and/or negative market conditions (see 2008-2009), but it could also reduce total returns by allocating to cash in lieu of an asset class. The cash filter is in effect this month, the same as the previous four months. SHY is the highest rated ETF in the 6/3/3 system. Therefore, it will continue to be the sole holding in the portfolio. The top 5 ranked ETFs based on the 6/3/3 system as of 10/30/15 are below: 6mo/3mo/3mo SHY Barclays Low Duration Treasury (2-year) PCY PowerShares Emerging Markets Bond LQD iShares iBoxx Invest.-Grade Bond VNQ Vanguard MSCI U.S. REIT TLT iShares Barclays Long-Term Treasury In 2014, I introduced a pure momentum system, which ranks the same basket of 14 ETFs based solely on 6-month price momentum. There is no cash filter in the pure momentum system, volatility ranking, or requirement to limit turnover – the top 4 ETFs based on price momentum are purchased each month. The portfolio and rankings are posted on the same spreadsheet as the 6/3/3 strategy. The top 4 six-month momentum ETFs are below: 6-month Momentum VNQ Vanguard MSCI U.S. REIT TLT iShares Barclays Long-Term Treasury SHY Barclays Low Duration Treasury (2-year) PCY PowerShares Emerging Markets Bond TIP, a holding for 2 months, will be sold for a loss of -.56%. LQD, a holding for 1 month, will be sold for a gain of .28%. The proceeds will be used to purchase VNQ and TLT. The updated holdings for the pure momentum portfolio are below: Position Shares Purchase Price Purchase Date PCY 85 27.65 8/31/2015 SHY 29 84.86 7/31/2015 VNQ 30 79.89 10/30/2015 TLT 19 122.74 10/30/2015 Disclosure: None.

To Diversify Or Not To Diversify?

Summary Investment risk – or probability of losing money – can’t be measured precisely (outside of casinos and some other narrowly defined domains). It’s impossible to predict how a stock will perform in the future; sometimes the safest-looking stocks turn out to be the riskiest. Which is why it’s never wise to put all of your eggs in one basket… if the basket is dropped, all is lost. Diversification is a more robust approach, because it allows you to make (small) mistakes without destroying your portfolio. When one asks me how I can best describe my experiences of nearly forty years at sea, I merely say, uneventful. I have never been in any accident of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked, nor was I ever in any predicament that threatened to end in disaster of any sort. The above quote comes from a 1907 interview with Captain E. J. Smith. Five years later, he was captain of the Titanic when it hit an iceberg and sank. More than 1,500 people, including him, went down with the ship. The Titanic disaster illustrates perfectly the dangers of inferring the future from the past. Just because something hasn’t happened before doesn’t mean it’s impossible. It sounds almost too obvious, but it’s a common mistake made in the world of finance. Consider the story of the infamous hedge fund Long-Term Capital Management (LTCM). Like the Titanic, LTCM was supposed to be “unsinkable.” It was run by a so-called “dream team” of Wall Street professionals, academics, and two Nobel Prize winners, all of whom – like Captain Smith – had impeccable track records. But then in 1998, after only four years in operation, the excessively leveraged LTCM collapsed like a house of cards. This time, the iceberg was Russia defaulting on its debt – something LTCM’s risk models, which relied on limited historical data and phony bell curve-style statistics, never saw coming. Unfortunately, LTCM wouldn’t be the last to make this mistake. This same over-reliance on flawed risk models later led to the 2008 financial crisis, resulting in the demise of many major financial institutions, most notably Lehman Brothers. These disasters have taught us that financial markets aren’t a casino with simple bets; real-world risks are more complex and can’t be measured precisely. Historical data never fully reflects all of the possible events that could take place (recall Captain Smith who “never sunk before”). Moreover, statistical risk-measuring tools are largely useless, particularly when dealing with rare events (i.e., black swans). The best way around this risk measurement problem is to simply ignore it, and focus on the consequences instead. For example, I don’t know the odds of an earthquake in Tokyo, but I can easily imagine how a heavily populated city like that might be affected by one. Similarly, it’s easy to tell that a highly leveraged bank is doomed should a crisis occur, but predicting when and how severe that crisis will be is a fool’s game. In short, it’s much easier to understand if something is harmed by shocks – hence fragile – than try to forecast harmful events. This whole notion of fragility has important implications in portfolio management, particularly when it comes to deciding how many stocks to hold. There are two schools of thought on this. One suggests that we should spread our eggs across many baskets. The other says that it’s better to put all your eggs in just one basket and then watch it carefully. So, who’s right? The school advocating broad diversification is, because it makes your portfolio less fragile to bad bets. The critics, however, claim that diversification is a recipe for mediocre returns. You don’t get on the Forbes Richest List by diversifying, they argue, but by concentrating your bets on few stocks. It’s true. You probably won’t become a billionaire by holding a well-diversified portfolio. But the reverse is also true – those on the “Fools Gone Broke List” also concentrated their bets, and paid a big price for it. Ignoring these losers is financial suicide. The point is, concentrated investing is like playing the lottery – you could get lucky and win big, but it’s far more likely that you’ll lose. Diversification, on the other hand, is insurance against the extreme unpredictability of any one stock. It makes your overall portfolio more robust, preventing one or two losers from ravaging your wealth. So, how many stocks do you need to be sufficiently diversified? A simple way to approach this question is to ask yourself: What’s the most I can afford to lose if one of my stocks goes bankrupt? For the typical investor, it’s about 5% – the equivalent of owning 20 stocks in equal proportions. Now, let’s view this from another angle. Owning just 10 stocks eliminates 51% of portfolio volatility (i.e., diversifiable risk). Adding 10 more stocks eliminates an additional 5% of the volatility. Increasing the number of stocks to 30 eliminates only an additional 2% of the volatility. And that’s where the good news stops, as further increases in the number of holdings don’t produce much additional volatility reduction. In short, it’s possible to derive most of the benefits of diversification with a portfolio consisting of 20 to 30 stocks (assuming they’re diversified across industries, geographies, and market capitalizations). Contrary to what the critics often claim, adequate diversification doesn’t require 100-plus stocks in a portfolio. The Benefits of Diversification Note: Portfolios are equally weighted. Volatility is calculated as the annualized standard deviation of historical stock price returns. Source: A North Investments, Elton and Gruber Study The central idea of this article is that investment risk (or the probability of losing money) can’t be measured precisely. It’s impossible to predict how a stock will perform in the future. Even the safest-looking stocks can surprise you. Remember Enron? Before it became a symbol of corporate fraud and corruption, Enron was widely regarded as one of the most innovative, fastest-growing, and best managed companies in the world. It was the “darling of Wall Street,” a stock you could “buy and hold for a lifetime.” It was rated a “buy” or “strong buy” by most analysts. Thousands of investors put their life savings into the stock, thinking it was a “sure thing.” Most would never see their money again. Enron is the perfect example of why you should never put all of your eggs in one basket. If the basket is dropped, all is lost. Diversification, on the other hand, allows you to make (small) mistakes without destroying your portfolio. It’s a more robust investment approach. Some call it “protection against ignorance,” and they’re absolutely right. We’re all ignorant; some of us just don’t realize it yet.