Strategic Outlook 2010 Part II

[Edge7]

I have just finished reading this thread with much interest as the strategy I have been using this year in the share market is very similar to that used by Intrinsic Value's. It's an approach that I think works well in sideways/falling markets.

I start with my estimate of intrinsic value for what I consider to be the best quality stocks. I have been trading some of those stocks that have fallen in price and present a big margin of safety. I have been buying in times of high volatility and sell into market strength (low volatility).

It's been a good way for me to generate some additional capital and more importantly cash flow with the high dividend yields this strategy has been producing while preserving my capital. For me, it is all about minimising risk while creating some upside. I liked the analogy about being like an insurance company in that way.

For me, I think this strategy will come to an end sometime in the next few months as I am concerned about being caught on the wrong side of a market fall. If I am, at least it will be in a good quality stock/s bought with a large discount to my estimate of intrinsic value. At this point my strategy will change.

If/when the market falls, I won't consider my change in strategy as 'speculation' but more a pragmatic conviction of the situation.

 

[contrary]

This is very interesting, I guess if you are interested in individual stocks, you are thinking of the dividends you are foregoing by going into cash. The alternate viewpoint is that you may be able to buy 10 or 20% more of the stock and the related dividend with your cash later.

I came by this article today and the comments are fantastic to read.

http://seekingalpha.com/article/315...012-100-cash-the-only-way-to-play-this-market

Basically, the comments in particular lay out the various arguments for and against scaling, investment position, cash position and dividend investing in a bear market. The scaling strategy you outline is utilised by some people, particularly for stocks you feel are deep value/very below IV.

However, scaling does not get you away from the underlying issue which to me appears to be: is there a role for a substantial cash component at any time in your portfolio, is it not easier/ less complex and possibly more profitable to just raise more cash or reduce your exposure when the risk:reward ratio is more than 3:1 ie. you deem there to be a high probability of a substantial (10-20%) decline compared to the potential gain in the index (when your individual stock dividend returning stock's price would also be affected). When you use this with your emphasis on individual stocks the result would be to sell when there is a high probability of a decline and to buy the stocks later at lower values rather than frontrunning the declines with scaling, where there must be at least some slippage.

I have been thinking about this and whether my strategy would have been resiliant to previous bear markets such as in the 1970's or 1930's and how resiliant it might be to the current market. I am not by any means a perma bear, and rapidly went from cash to 100% equities in about may 2009 and had been in 100% equities until this year. The current situation alarms me and I have been raising cash again and am now 100% in cash in my discretionary investments and super. Unlike you I invest wholly in index ETF's so I admire your interest in individual stocks. You obviously have more knowledge than I do of valuing individual stocks. It is always interesting to look at alternate viewpoints adn investment strategies.

 

[Intrinsic_Value]

I came by this article today and the comments are fantastic to read.

http://seekingalpha.com/article/315...012-100-cash-the-only-way-to-play-this-market

.

Interesting article.
Some commentary:
Discussion about 'average investors'. Average investors tend to underperform for the sole reason that they are over exposed to an asset class when that asset class is expensive and under exposed when it is cheap. Why? because when its expensive it tends to be going up in 'price', people look at 'price' and make investment (as oppossed to trading) decisions on the movement of that price. ie Mr average buys when something is expensive and its price is going up further (by the time they notice the investment, it will be expensive because of previous years of appreciating price, ie a bull market that has been in existence for a while)

Safety over yield, is talking about owning debt instruments, not other asset classes. Totally agree, with debt instruments, its very important to chase quality not yld, the GFC occurred because people where buying crap mortgage backed securities to chase that bit of extra yld.

Interest commentary about GOLD. Notice the different commentary regarding Gold as a store of value compared to consumer goods, and Gold as an investment compared to income generating assets.

However i strongly disagree with his suggestion to short gold. In a bull market (which gold is in), one does not short. One is either very long, long or neutral. If you dont like gold, stand on the sidelines, dont short into a bullish market.

Disagree about Mr Average should be in just cash at the moment. By the time Mr Average figures out when will be a good time to invest, he will have missed the boat, and more importantly be stuck with low yielding investment (cash).

Mr Average should have a balanced portfolio of cash and equities. Equity exposure should be limited to good quality boring, dividend paying companies.

All this commentary is from a US point of view, not for Australians (for starters our bank deposit rates are much higher, and second the quality of our equity market is lower)

 

[Aaron_C]

Mr Average should have a balanced portfolio of cash and equities. Equity exposure should be limited to good quality boring, dividend paying companies.

2011 was the year for small caps who don't even pay one iota of dividends. The big dividend paying ones just sank like a stone.

 

[Intrinsic_Value]

2011 was the year for small caps who don't even pay one iota of dividends. The big dividend paying ones just sank like a stone.

I think big dividend paying quality stocks did ok during 2011 (ie didnt drop like a stone), but you are right from memory small caps did much better.

But this was a generic comment, if you were giving an opinion to Mr Average who just wants to concentrate on his family and day job and have some side investments would you suggest a portfolio focus on small caps??

As for the 'safe' alternative being bank deposits, zero % interest doesnt provide much upside, 10 year bonds at less than 2%.

 

[contrary]

"However i strongly disagree with his suggestion to short gold."

I don't think he is advocating shorting gold at this level, but it is interesting to think of that possibility in the future. Many people have gotten into the gold boat and when everyone is eventually in...


"Disagree about Mr Average should be in just cash at the moment."

Yes, I agree, it is not a good strategy for Mr. average. Too complex, they would need to be comfortable and capable of both switching in and out of cash at the right time. But I like looking at how it applies to me. If as you say in a secular bull market (like gold currently), one should be either very long, long or neutral - THEN in a secular bear market one should have a bias towards cash as the neutral position. In a secular bull market the default position whould be long equities but in a secular bear market, arguably the default position should be cash and preservation of capital. I don't think people have got used to that yet or the change in position sizing/scaling and bias that should happen if you have decided that the market is indeed a secular bear.

The last 2 years and particulary the period after March 2009, although very good maybe misleading. If we follow a more classic bear market from here then the bounce will not be nearly as satisfying and much more prolonged.

I also agree with his point that people will be more psychologically able to switch to equities (risk) if they are already in cash in a significant decline. Most people appear to switch to cash near the bottom and are not comfortable to switch back to risk until most of the return is gone ie. they tend (for very understandable psychological reasons) to crystalise losses and miss out on gains in cyclical bull swings in a secular bear. This does not matter so much in a secular bull market but is very capital destroying in a secular bear market.

"Mr Average should have a balanced portfolio of cash and equities."
Yes, this applies to the last 20 years and particularly to the period 1980-2007, but does it apply now? There is always a period when one asset class outperforms. Equities have had their day in the sun, now bonds have, one wonders whether cash will have it's day also at some stage. Also IV, why have you not included bonds? Mr. Average may perform very poorly if this is a period like 1970's, paticularly if one includes bonds.

"Equity exposure should be limited to good quality boring, dividend paying companies."
Interestingly he argues that dividend growth stocks are overvalued currently in the US due to the demographic bias towards this in retirement. Not in bubble territory but overvalued and this may correct at some stage. At the very least it makes the margin of safety less.

"All this commentary is from a US point of view, not for Australians (for starters our bank deposit rates are much higher, and second the quality of our equity market is lower)"

IV, this would be a stronger case for being in cash in Australia, all other things being equal. As real interest rates are not negative, you get some real return from cash (but not necessarily after tax). One of the reasons the US market may have been more resiliant recently than the Australian market is that people in the US percieve that they have no other place to park their investments other than reaching for yield or dividends. Which is what the Fed wanted. But this does not weaken the case for cash if we are indeed in a bear market in equities.

I agree with him that people have been brainwashed into thinking that being in cash is a huge risk and income foregone. That only applies if the market is about to shoot up significantly. Cash obviously is not a good asset class to be in long term (ie 2 years plus) but I think it has it's place for risk management and I am comfortable being in this setting for 6-12 months. Although I might be wrong about this and lose a significant amount of gain, I have thought it through and it appears it is the best avenue for me at the current time. This might not be the case for someone else as their circumstances and psychological makeup may be quite different.

I appreciate your thoughts. This is a very interesting topic and of relevance for ones own personal investments and one's close family members. I have found it particularly interesting in the case of my parents who had a strong desire to switch to cash near the bottom during the last downturn and I remember quite a long conversation with them about this.

 

[Intrinsic_Value]

If as you say in a secular bull market (like gold currently), one should be either very long, long or neutral - THEN in a secular bear market one should have a bias towards cash as the neutral position. In a secular bull market the default position whould be long equities but in a secular bear market, arguably the default position should be cash and preservation of capital. I don't think people have got used to that yet or the change in position sizing/scaling and bias that should happen if you have decided that the market is indeed a secular bear.

Yes this is a very very good point, in a secular bear market the bias should be towards cash as the neutral position. With the tide running against me this year, i tried to focus on individual stocks that i believed were still representing value against share price. The problem has been that over the course of the year, many of those stocks have seen a subsequent decline in intrinsic value (as time progressed).

I am implementing one of Gartman's trading rules that i believe apply to investing as well as trading:
Do more of that which is working, do less of that which isn't.

I am tightening the screws on my investment selection criteria.

"Mr Average should have a balanced portfolio of cash and equities."
Yes, this applies to the last 20 years and particularly to the period 1980-2007, but does it apply now? There is always a period when one asset class outperforms. Equities have had their day in the sun, now bonds have, one wonders whether cash will have it's day also at some stage. Also IV, why have you not included bonds? Mr. Average may perform very poorly if this is a period like 1970's, paticularly if one includes bonds.

Yes it applies just as much now as it applied to the last 20 years, but with one key difference. In times past Mr Average was massively overweight equities, as they thought the asset class could only go up. Now Mr Average is at risk of going 100% to cash. Another extreme. Why do people have to operate at the extremes of either end?

IV, this would be a stronger case for being in cash in Australia, all other things being equal. As real interest rates are not negative, you get some real return from cash (but not necessarily after tax). One of the reasons the US market may have been more resiliant recently than the Australian market is that people in the US percieve that they have no other place to park their investments other than reaching for yield or dividends. Which is what the Fed wanted. But this does not weaken the case for cash if we are indeed in a bear market in equities.

Totally agree, there is definately a stronger case for Australians having a higher weighting of cash in their overall portfolio than their US counterparts. 5-6% risk free for australian vs 0-2% for Americans. If i was Mr Average in Australia i would definately be keeping a decent cash buffer at this time.

 

[Intrinsic_Value]

Is there an update for 2012 then

There is now, and this is strategic, not operational.

The AU$. Our economy is not structured to handle such a high exchange rate.
I am developing several game strategies for myself with this structural issue in mind, but essentially whilst our AU$ is at such elevated levels, it represents a clear and significant structural issue to investing in Australia.