The Trend Is Not Your Friend… Portfolio Rule Seven says:
Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
Rarely is a stock a better idea after it has risen 20%, thus, sell some off in case of mean reversion. When a stock falls 20%, it is usually a better idea, but to make sure, a review should be done to make sure that nothing has been missed. Since instituting this rule, I have only had two bad failures over the last 13 years. One was a painful loss on a mortgage REIT, Deerfield Triarc, and the other was Scottish Re.
But still I resist trends. Human opinion is fickle, and most of the time, there is overreaction. As a guard, on the downside, I review new purchases to make sure I am not catching a falling knife.
Much of it comes down to time horizons — my average holding period is three years. If the asset has enough of a margin of safety, the management team will take action to fix the problems. That is why I analyze management, their use of cash, and margin of safety. A stock may seem like a lottery ticket in the short run, but in the long run it is a share in a business, so understanding that business better than most is an edge. How big that edge is, is open to question, but it is an edge.
Another reason I resist trends is that industry pricing cycles tend to reverse every three years or so, offering opportunities to firms that possess a margin of safety in industries that are not in terminal decline, like most newspapers, bricks-and-mortar bookstores, record stores, video rental stores, etc. (The internet changes almost everything.)
The second last reason why I resist trends is practical — experience. Most of my best purchases have suffered some form of setback while holding them — were they bad stocks? No, time and chance happen to all, but a good management team can bounce back. It offers me an opportunity to add to my position. I made a great deal of money buying fundamentally strong insurers and other companies during the crisis, sometimes with double weights.
The last reason is an odd one — the tax code. Short-term gains are disfavored, and also cannot be used for charitable giving.
So why not take a longer view? I can tell you what you would need to do:
- Focus on margin of safety (debt, competitive boundaries, etc.)
- Analyze how management uses free cash (acquisitions, dividends, capital investments, buybacks)
- Analyze industry pricing trends, at least implicitly.
- Look at the accounting to see if it is likely to be fair (there are a few tests)
- Look for cheap valuations, which may have ugly charts. People have to be at least a little scared.
That takes effort. I am by no means the best at it, but I do reasonably well. I avoid large losses without having any sort of automatic “sell trigger.” Most of my initial losses bounce back, to a high degree.
With that, I wish you well. Have a great Thanksgiving!
By David Merkel, CFA of Aleph Blog
