The Learning Curve And Surprises

The complexity of the market is sufficient to confuse anyone. A complex portfolio management process is not going to overcome that. You don't get to manage the market, but you do get to control your portfolio. Simplicity, transparency, and low activity levels should be the backbone of your management process. Only a simple, transparent process can be tracked and adjusted over time. One way to simplify your system is to eliminate large swaths of the investment world from study. In truth, if you hope to be able to make effective investment decisions you have to ignore almost all of the available information on the market. The first job of a portfolio management system is to reject all of the information, and investment ideas you don't have to pay attention to. Works for me (14.5% 2002 - Oct. 2017).

In my first article, I noted that my chief investment activity was paying attention to the market and daily news. [Yup, we have a contradiction here.] Justification: I enjoy doing that, always have. I feel it keeps me grounded and the reading often suggests investment ideas - which, of course, I quickly reject. Look at it all, focus on a bit.

I am a stock picker, and rather proud to be able to say that. I am not a buy and hold guy, nor a day trader. I buy a stock assuming that it will continue to show the strength that it has already demonstrated. Typically, I hold a stock for about three years, though I have one item, a mutual fund, which I have held continuously since 2002 and I most recently sold a stock which I held for only 31 days. Currently, I have 16 items in my portfolio. That is 'the bit' which I feel comfortable focusing on.

What is my stock picking record then? I am embarrassed to admit that my winning record is about 50%. My portfolio tracker reveals that I have traded in about 120 stocks over the years; half were winners and half losers. I also track several other model portfolios to allow for easy comparisons. The most important of these is the portfolio made up of all my stocks sold. I not only know how well these stocks did when I held them, but how they performed after I sold. My picking record is not impressive, but a closer look turns up a few surprises. My five best all-time winners have gained $800,000 and my five worst all-time stock picks lost $60,000. Clearly, my frequency of correctness is not nearly as important as the sizing of my positions. The figures show I have let winning stocks run, and even added to their positions, while I have been quick to cut losers before they could do much damage.

The figures reveal another surprise; 45% of my lifetime profits still reside within my portfolio as unrealized gains. I love that the untaxed portion of these profits continue to work on my behalf. The fellow who claimed you could never lose money taking a profit did not understand the costs of a missed opportunity, nor our tax laws.

Reviewing long-term data has an important calming effect and encourages me to hold my positions during market volatility. The figures above show that selling is absolutely critical to good portfolio performance. I always consider selling when facing negative surprises, but volatility is not a surprise. I may sell a good performing stock when it appears to be drifting negatively away from its expected performance. With a particular stock it can be very difficult to tell if you are dealing with volatility, a cyclical variance, drift, or actual deterioration. The future is murky.

Recent headlines caught my attention. “Japan’s Nikkei stock index logged its longest winning streak in more than half a century” and “Japan’s main stock index rose to its highest level in almost 21 years”. I held the iShares Japan Fundamental Fund (CJP) (purchased in late 2012 and liquidated in early in 2014). Trading in Japan's index was pretty heady stuff for a Canadian equities investor in 2012. During my brief holding period [less than two years] my annualized gain was over 80%. My initial purchase was prompted by an article by Larry Macdonald, an investment writer I have come to trust. His enthusiasm and common sense encouraged me to step outside my comfort zone. Digging into the headlines shows I missed out on a healthy total gain of 45% since I sold all shares in March of 2014. However, additional calculations reveal that my total portfolio has advanced 60% in that time.

Selling in 2014 was a good move.

Lesson: Headlines, (or any current news) must be put in perspective to determine its actual significance. Despite the striking headline, I am much better off for having sold my Japanese holdings three-and-a half-years ago. Only consistent record-keeping saved me from a moment of regret and perhaps an error of comprehension. Additionally, because I was out of my comfort zone and lacked confidence, it is extremely unlikely that I would have held the index fund long enough to realize that 45% gain.

For comparison I turn to Norbord, a stock I also first purchased in 2012. This is my favourite type of holding, a Canadian company with a long history, strong management, and a large international exposure. My timing (luck) was exquisite and in a short 8 months I liquidated my total position and made a 75% profit. I continued following the stock and as it fell below my previous selling price, I became convinced that it was again a good buy. Things did not go particularly well. At the end of two years, buying on the dips, I had accumulated the exact number of shares I had previously sold at a profit. By April 2015 I had all my shares back but had lost 30% of my original profit. The difference was that I was much more comfortable with Norbord than I had ever been with the Japanese index. I was quite prepared to wait for good management to exert its positive influence. I also understood that Norbord was a cyclical stock stretching its high and low spikes out over a very long time frame. This month (Oct. 2017) I completed selling 90% of those shares. My new holding period had stretched out over four years but eventually managed to almost exactly duplicate the gains of my original position. As a result, Norbord earned a 33% annual gain during the five years I held it. I have kept a small 1% position in my portfolio for educational reasons. Experience is an excellent teacher and holding a small position is an effective way to sharpen your skills.

Lesson: A well defined selection process and transparent management system will minimize anxiety, discourage selling, and promote long-term gains. I would add that you should be very clear about why you are selling. Get the reason into your investing diary. If the stock you sold goes on to seriously outperform, your notes should provide consolation, or lead you to modify your process.

A comment here on performance is in order, specifically what you personally are going to consider acceptable performance. In the beginning I was ready to accept performance which approached what the TSX and SPX did. I still regularly compare to those indexes. Short-term differences are useful for identifying how my portfolio's emphasis differs from the main markets. Over the long-term, I have been able to exceed 14%, even when limiting choices to Canadian products. My benchmark has become 14%. If I can't reasonably expect a stock to perform at that level I will not pick it. If a stock in my portfolio falls below that, I want to have solid reasons for keeping it. An all equities portfolio offers the best chance of profit and is high risk only over the short term.¹

For investors who want to set up a more balanced portfolio, including bonds, cash, etc., your benchmark will necessarily be lower than mine. Since I can tolerate high risk, I choose an equities-only portfolio and select only those companies which generate cash. I basically ignore all the information about bonds, interest rate projections, and gold. I also avoid commodities, reasoning that good management doesn't have sufficient impact on stock prices and that their cycles are too long for my comfort. My chosen investing universe will be smaller, simpler, and likely more profitable than yours.

Until the third article then: a couple more tidbits and a diary entry to assist you in refining and sticking to your process.

Achieving Superior Returns

To achieve superior returns, you have to do something most people are not willing to do. If it were easy, everyone would do it, and the profits would be small. Ivanhoff says, "The only way to make big money is to be right about something about which almost everyone else is wrong." I would add that, in the case of picking stocks, you not only have to be right when others are wrong, but they have to later discover that you are right. Otherwise, your investment remains static, even though you are on the side of right.

Undiscovered Value

Purchasing undervalued stocks is a key winning strategy. However, it is not reasonable to expect that the value will be discovered by others immediately following your own purchase. Time will reveal whether your evaluation is correct.

Diary Entry Jan. 20, 2017

The trend continues. I am down 3.1% year-to-date while the TSX is up 1.7% and the SPX up 2.5%. This is very disappointing and a reflection of last year, though not yet as severe. Should I be doing something different? It certainly feels like I should, but it is quite silly to wish that my portfolio performed more like the TSX. [I could easily buy the index.] Had that been the case since first establishing my portfolio in 2002, my lifetime earnings would be cut in half. Therefore, it becomes a question of timing. When should I shift strategies? When should I move into cash? The recent study referenced below, shows the answer to be, “Never, in response to market turmoil.”

A great study by the London Business School, academics Elroy Dimson, Paul Marsh and Mike Staunton showed in 2013 that market timing using valuation did not work.

The academics tested a strategy, in 20 countries, that sold stocks and went into cash every time price-to-dividend multiples went clearly above their historic mean at the time, and re-entered when they had become cheap. In every single country, this strategy fared worse than simply buying and holding stocks.²

Diary Update Oct. 31, 2017

I am up 16.9% year-to-date while the TSX is up 4.8% and the SPX is up 15%. Stay the course works! It is just very difficult to do.

Suggested Reading:

Ten Tips For Successful Long-Term Investing, in Canadian MoneySaver, October 2017 page 23. (Especially #6, but all are correct.)

Don Mackenzie, Retired teacher (1998), Landlord (1993-2017). Set up investment portfolio in 2002; lifetime gains 14.5%/yr. to Dec. 2017. Resides in St. Catharines, Ontario. Email: succinctscribe@gmail.com

1. Kalos in Canadian MoneySaver Oct. 2017 page 19.
2. Time In The Market — Not Market Timing — Is The Secret To Investment Success. by Jill Schlesinger.