Recently I had the opportunity to review an investor’s portfolio. This was valued in excess of £1m. The allocation of the funds was entrusted to a well known brokerage. I was asked for my opinion on the performance and allocation of the fund.
A review of the portfolio showed there were significant holdings in resource stocks - oil, mining and gas, that had been held for a while.
Part of the problem is that typically, these brokers tend to rely upon their own analysts for stock ‘picks’. And, these picks are based on some form of fundamental or ‘value’ analysis.
Anyone with reasonable eyesight would be able to see that, on a basic long term chart, stocks in those particular sectors have generally been in a significant downtrend for a while – reflecting the drop in the underlying commodities.
Below are some of the charts (on a weekly timeframe) of some of those stocks held, plus the chart of the one decent performing stock that kept the losses in the portfolio to a minimum.
The problem with using some from of fundamental analysis is that, when calculating ‘value’, as price drops, those stocks may look to become even better value. The difficulty is knowing when price has finished dropping, as what may look good value now, may look even better value in 6 months or a years’ time.
Last year, I spoke to a trader who had entrusted the running of his long-term investment portfolio to his broker, and he ended up with a significant holding in Tesco. Even worse, as price fell, the broker suggested increasing the holding, as price was becoming even better ‘value’. You can guess what happened next – Tesco announced their major accounting error which caused a cratering in their stock price. This caused the investor a significant loss in the value of his portfolio. But prior to that announcement, price had already been trending downwards.
As we have seen in the past, even stocks with the strongest fundamentals can get caught in a major market downtrend – in 2008, Apple fell over $100.
People seem to forget an undeniable truth about stock speculation:
You can only ever make a profit on an investment if price moves up after you have bought in;
If price moves against you after entering, you will only ever make a loss - regardless of how appealing the fundamentals may look.
Fundamentals can be a catalyst behind the price moves, but ultimately you may well not have the relevant information to hand. Trading statements or earnings reports either give historical information or predict future information – which may or may not come true. And, if you subscribe to Paul Tudor-Jones’ theory, more often than not, “price precedes news”.
I'm also reminded of Richard Donchian's comments in this regard. Although he refers to traders, it equally applies to investors:
"It doesn't matter if you're trading stocks or soybeans. trading is trading, and the name of the game is increasing your wealth. A traders job description is stunningly simple: Don't lose money. This is of utmost importance to new traders, who are often told do your research. This is good advice, but should be considered carefully. Research alone won't ensure a profit, and at the end of the day, your main goal should be to make money, not to get an A in How to Read a Balance Sheet."
I would suggest it is far better for an investor to look to potential holdings based on fundamentals, but to then 'time' his entries and exits on some basic, long-term, price trend analysis.
A while back I spent an enjoyable morning with an trader who works at a major investment house, with hundreds of millions of Assets Under Management. His knowledge of trend following was substantial.
Anyway, he advised that, after quite a period of discussion, their team implemented a technical analysis element to their stock selection criteria – in other words, a very basic trend following filter. And they had started to see a marked improvement in performance - not so much in terms of the profitable holding doing any better, but by cutting the non-performing or losing holdings.
People who have read the story of Nicolas Darvas will know he identified attractive stocks based on fundamentals, but then only bought (and sold) his holdings based on price movements and his ‘box’ theory. In essence, this is no different. And what worked for Nicolas Darvas in the 1960’s can still work now.
What can you learn from all this as an individual trader or investor?
Well, you need to remember that there are four possible monetary outcomes on each individual position you take:
- Large win;
- Small win;
- Small loss;
- Major loss.
If you can eliminate the last of those scenarios, then you are well ahead of the game.