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Sunday, 27 May 2018

Diamond Dogs (with apologies to David Bowie)

Market dogs

I'm mostly known as a 'real estate guy', but I do invest in the share markets - mainly via index funds - and a few people have asked me to write a bit more about the 'Dogs of the World' approach to investing.

The concept of Dogs of the World isn't new, and the idea of buying what's unloved is almost as old as the hills. The 'dogs of the Dow' strategy was popularised in 1991, for example, which focused on buying the 10 stocks with the highest dividend yields.

And Dogs of the World certainly isn't cool right now. But that's actually the entire point. Dogs of the World is about doing precisely what's not trendy, which is one of the reasons why it's so darned difficult to do.

But buying investments when they are cheap and the markets are having conniptions does have one wondrous and proven benefit: it works!

This is not my area of expertise, by any means. I'm too young to have seen it all before, for one thing. Rather, I was schooled in the mechanics of Dogs of the World by my coach Steve Moriarty of Macro2Micro (email me if you'd like to learn more).

When Steve first introduced me to this idea I'll admit I was sceptical, as I am of most such things, but he's been using this strategy for more than 15 years now and seeing returns of 15 to 20 per cent per annum.

I back-tested the numbers - it works, and smarter people than I have concluded the same thing. Let's take a quick introductory look, and I'll revisit the subject in future posts. 

Buying a dollar for 50 cents

One way to outperform the stock markets over the decades has been to find and then invest in wonderful businesses. Another key element has been having the wisdom and patience to wait until those enterprises are cheap before buying in meaningful volumes. 

Alas, most people don't have the ability to analyse companies very well, and certainly not as adroitly as the great value investors. In fact, to be brutally honest, most people are hopeless at analysing company financials in any meaningful way.

But that doesn't mean that you can't aim to buy investments when they are cheap, and Moriarty has explained to me how individuals can apply similar principles in a less risky manner. 

Market dogs in action

The basic principle of the market dogs strategy is to invest in the most unloved companies, or sectors, or asset classes, or countries.

For example, can you remember how bad everything was in the energy sector through 2014 and 2015 as the oil price collapsed? Refer to the green boxes in the graphic below. Summarily, it was pretty morose.

Indeed, it was the end of the world according to some of the usual suspects - some of whom somehow still manage to sneak their way onto my Twitter feed, despite being muted half a dozen years ago! - posting up their analysis after the event to explain why the oil price was a bubble (worse than useless, but thanks anyway!).

Energy was the worst performing sector of the market for two years consecutively as investors rushed for the exits (click to enlarge the images).


Source: Novel Investor

The market dogs principle holds that you would then buy the unloved sector of the preceding years, and sure enough in 2016 the energy sector delivered the strongest sectoral performance in the S&P 500 market at +27.4 per cent.

Of course, our simple brains are not wired to work in this way at all. Instead, it feels much safer to do what everyone else is doing.

Despite my inherent snark, I might be doing the social media Armageddonists a disservice. They may, after all, serve one very useful purpose: when they've become alerted to a market crunch and start telling you that the 'smart money' is now short or selling, this might well prove to be a signal that the worst has now passed - a contra-indicator in real time, if you will. Exhibit A from one of the said usual suspects:

In a similar vein, when all those truckloads of books came out in 2009 explaining after the event how the subprime crisis and subsequent great crash of 2008 happened, that was an optimum time to be buying stocks, certain classes of real name it. Returns from the US stock market since Q1 2009 have been spectacular, and so too have the returns from some residential real estate, commercial real estate, and an array of other assets that were on sale.

Of course, in many respects it was also the hardest time to be buying, with the end of the world apparently nigh. But the Dogs of the World strategy cares not about the prevailing sentiment, it merely compels you to buy when markets are cheap and on sale.

Trend not always your friend

So, what's become hip today? At the moment everyone seems to be talking about technology or IT stocks (refer back to the orange squares in the sector performance graphic above) which have delivered positive returns every calendar year since crashing spectacularly in 2008, as they are periodically wont to do. 

Buy and hold investors generally don't like this kind of volatility; yet this same volatility can be the best friend of the market dogs investor. When people and sentiment are pessimistic about a volatile industry then the price falls can be very sharp, but mean reversion then eventually delivers positive returns. 

All around the world

You can apply similar principles to investing in the stock markets of other countries, or at least exchange traded funds (ETFs) which fulfil that job for you. 

For example, take a look at Ireland's stock market returns (turquoise boxes in the graphic below) which suffered a sharp 20 per cent correction in 2007, then followed by a catastrophic crash in 2008, dropping by more than 70 per cent in that calendar year alone.

You'd have needed a little patience in this instance, but buying markets when they are so remarkably cheap can deliver outstanding returns, simply through reversion to the mean (from 2011 until 2018 in this case). 

Source: Novel Investor

And to take a look momentarily at the local Ireland stock market index (ISEQ) graphically. Wowsers.

Source: ISEQ

Of course, you probably aren't going to move to Ireland and buy shares in the local index in a local currency. But there are two beautiful things about investing today.

Firstly, you can easily buy ETFs (through, for example, iShares) that do the job for you. And secondly, there is so much data available, that you can readily back-test any investment strategy.

Dogs of the World can be as simple or as complex as you choose to make it. Poring endlessly over inflation rates, currency swings, and relative dividend yields can become very confusing, and you can receive contradictory signals.

But the fundamental principle of buying low and selling high can be elegantly simple - using this strategy you may need to invest only once per year - although in my opinion it would only form a part of a sensible portfolio, rather than being the core of it. 

Emerging markets crack (Turkish delight)

In investing there is a risk hierachy, and as a general rule investing in a sector of the market or the index of a country is less risky than investing in an individual company.

Take a look back at the international stock market returns graphic and you will see the biggest challenge facing the Dogs of the World strategy right now. And that is that most assets are expensive today in this era of low interest rates, with 2017 delivering positive returns across most almost all countries, and most sectors. 

However, rates are now tightening in the US, and the US remains a major influence on global stock market valuations. And there are already some signs of cracks in some emerging markets.

An investment in a Turkey iShares ETF (TUR) has been a shocker since 2008 - even with all of the dividends invested a notional $100,000 invested would find you with 20 per cent less today than you started out with. Not so much Turkish delight there,

But that's kind of the point. With the ETF product now showing a P/E ratio of under 8.5, the entire country is practically on sale. 

Actions, not words

Of course, I'm not saying that you should be getting ready to buy Turkish equities in 2019. After all, I don't know anything about your personal tax position, money management skills, or your tolerance for risk. 

For one thing, the outlook can always get worse before it gets better, and by its very nature the Dogs of the World strategy is mentally very challenging to put into practice. In short, you have to develop the ability to hold your nose and buy anyway, and markets can always become even cheaper so asset allocation is vital here too. 

When markets are at their most unloved the media headlines will be hollering in their most acute tones, as they presumably are about Turkey right now.

More than that, imagine for a moment that on 28 May in 2012 you'd told your friends and family you'd decided to buy $100,000 of shares in Irish equities because the market had crashed and it had become very cheap. 

They'd quite possibly have thought that you'd lost your mind. Yet roll forward to May 28 this year and including the dividends reinvested your $100,000 is worth more than $¼ million, ready to be rolled into the next big opportunity. 

At the moment, the trendy thing seems to be talking about shares in companies like Netflix (NASDAQ: NFLX) - or 'Debtflix' if you prefer - a tech stock that has gone parabolic, and has just risen to yet another all-time high. 

With a P/E ratio of somewhere way north of 220 in the past week and a market cap of well over US$150 billion Netflix is now valued at more than Disney! Even just based on the movies, merchandise, and general exposure in my household alone, I can see that this is some seriously irrational pricing.

Last year, some people were prepared to pay close to $400 for a single share in Tesla (NASDAQ: TSLA). It's not a fashionable thing to point out by any means, but even today the market is still valuing Tesla - a loss-making company that's burning through cash like there's no tomorrow - at about US$50 billion, which is another idiosyncratic state of affairs.

I can't predict the future, but mean reversion is a powerful leveller, and it's not hard to imagine that ending painfully when the tide goes out. 

Dogs of the World is about doing the opposite of that. Which means buying investments when they are cheap and letting mean reversion do the heavy lifting for you, instead of trying to pick up pennies in front of Tesla- or Netflix-shaped steamrollers.

It's a proven and profitable strategy, and I'll add some further details and ideas in future posts. But I warn you in advance, your friends will think you're barking mad!