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Sunday, 3 June 2018

Buying low, selling high (Dogs Strategy, Part 3)

Buy low, sell high 

In previous posts I discussed the Dogs of the World strategy, and then mean reversion

To implement and take advantage of mean reversion, you must be able to, as the saying' goes 'buy low, sell high '('BL-SH'). 

Like many such catchy investment principles, it's simple but not easy. 

Firstly, note I said buy low and sell high.

To maximise your returns using this approach, you must be able to do both. Let’s break this down.

The market dogs strategy requires that you dispense with being a 'buy and hold' investor - you are simply an investor.

A corollary of this is that you also need to dispel yourself of the belief in the 'long term'. 

And finally, it is, to some extent, possible to time the market.

You’ll hear many financial people mention Buffett, buy, and long term in the same sentence.

But those who think Buffett is not a market timer are not quite right - he purchases most stock when markets crash or correct, after all. Market timing! 

In other words, the economy has business cycles and there is no reason that your investment strategy can't cycle as well. 

Buffett adopted this approach from his mentor Ben Graham, who also spoke of the advantages of buying stocks when the overall market is low.

Formula for profit

John Templeton was another great investor had a formula for determining how much money you should have in the market given its overall price level. 

So, the first aspect of BL-SH is to consider the level of the relevant market overall. 

As Ben Stein points out in his excellent book Yes, You Can Time The Market:

'People come to accept the notion that the price of the market was irrelevant, when price was so ruthlessly applied elsewhere'. 

Many advisors will tell you about individual company valuation and company fundamentals.

Now, I am not saying that individual company valuations are not important.

But what I am saying is that you can greatly enhance your returns when the whole market is cheap.

Take a look at the following:

Source: Meb Faber

Now tell me buying low is 'risky'! For individual companies, perhaps, but for sectors and countries, not so much. 

My post regarding mean reversion should hopefully get you thinking.

This post gets you to action that principle on both counts - buying low and selling high.

The reason why is that if you simply and patiently wait for cheap markets, then you raise the probability of success. 

If that table above doesn’t get you thinking about buying low, then probably nothing will (in which case stick to buy and hold with diversified products - and there's nothing wrong with that!). 

Being a 'long-term' investor?

Valuation - many financial folks tell you not to 'time the market' or derivations of this theme.

The fact is that, on average, you'll be better off selling after a good return and looking for the next bargain. 

This way your money will compound faster - if you can pull it off.  

I have spent more words so far on buying low rather than selling.

Why? As Charlie Munger, Buffett’s long-time business partner said, 'a stock well bought is half sold'. 

Using the market dogs strategy, only if we are still under water do we hold and I’ll explain that in my upcoming blog post on rebalancing and asset allocation. 

So when do you sell and what is a good return? Well, have a look at the chart below.  

Note how after 12 months, that the returns often begin to decline. So take profits and avoid the cardinal sin of many investors - getting greedy.

So, how do we buy low, sell high?

1. Look for markets/sectors/styles that are out of favour. You can buy product that reflect indices of a whole country and sectors via ETFs (or individual companies if you must and that’s your bent). 

A cheap market usually implies that individual companies within the asset class are cheap. 

Note that does not mean you can buy any old company, but usually large systemic type companies with modest debt levels are a good place to start. 

2. Remember there are two parts to this equation - so sell after 12 months when the tax implications are positive and then repeat the 'buy low' process again. 

Remember profits are not realised until you sell.

3. Mean reversion should be at the forefront of your mind, so you need to not get psyched out if the stock falls further.

I’ll deal with asset allocation and rebalancing in the next two posts on this strategy.