Friday, February 13, 2009

A tough short term for a long-term strategy

Sent by Sumit Aggarwal-
To win in this market, you really needed to have taken short positions or have switched to cash. I didn't, so I've been hit hard.
No new trades.
Choose your adjective: painful, unprecedented, gut-wrenching, historic -- any or all of them apply to the six months covered by this round of Strategy Lab. What started as a shaky market has turned into one of worst we've seen in our lifetimes, and I ended up faring much worse than I have in any of my past Strategy Lab performances. As of Tuesday's close, the major indices were down in the 30% to 40% range since the start of the contest, while my portfolio was down more than 40%.
For a long-only, fully invested manager like myself,

this was a particularly nightmarish market. With investors readjusting to a financial world that now lacks the massive, profit-generating overleveraging of the past, prices of just about every category of stocks -- and just about every category of assets -- have been driven downward. The result: To win in this market, you really needed to have taken short positions or have switched to cash. I didn't, so I've been hit hard.
I don't regret my decisions, however; I believe -- and copious data shows -- that most who try to time the market fail, and that sticking to a long-term strategy is an essential part of succeeding over the long run, even if it means dealing with the stomach-churning down periods. And over the long haul, the Guru Strategy models I used for this competition all remain ahead of the market, some by almost 100 percentage points (the Benjamin Graham model, for example, is up 81% since July 2003 vs. the S&P 500's 17% return).
I give a lot of credit to my counterparts in this competition. While we come from different strategic perspectives, I've enjoyed listening to all of their takes on the market and investing in general, and the fact that the top players limited losses -- or even posted gains -- in one of the worst six-month periods ever deserves congratulations.
While my portfolio was hit hard, I have no plans to change my strategy. It's not a matter of being stubborn. I just believe it is prudent to continue to act on two centuries of data that show stocks are the best choice for long-term investors, rather than on a few (albeit very trying) months. Stock market history is littered with supposedly "landscape-altering" short-term changes that later gave way to long-term patterns -- the advent of the Internet, 9/11, etc. -- and I believe that will again be the case with the credit crisis. In fact, given the recent declines, I am as high on stocks for the long run as I've ever been.
Since this is my final entry, I'd like to leave you by quickly touching on what I believe are important tenets of successful long-term investing. These are principles that I've learned during my years of studying Wall Street's greatest minds, and through my own practical experiences in implementing their strategies. I go into greater detail on these "Six Guiding Guru Investment Principles" in my new book

Principle 1: Combining strategies to minimize risk and maximize returns The strategies I've developed are based on the approaches of some of the most successful investors in history. Each is thus a well-rounded approach that looks at stocks from a variety of angles, meaning that they all focus on stocks that are fundamentally strong. But by using multiple strategies, I've been able to both increase my returns and limit risk (this most recent period notwithstanding).
Two ways to do this: You can build a portfolio that picks a number of stocks using multiple strategies that perform differently in different types of markets, which should essentially act as a hedge to smooth returns; or, you can focus on stocks that get multi-Guru Strategy approval. If, for example, a stock gets approval from both my James O'Shaughnessy-based value model and my Peter Lynch fast-grower model, I know it is strong on a number of different levels. Over the long run, such stocks gain ground far more often than not.
Principle 2: Stick to the numbers -- or the market will stick it to you
Just about everyone thinks they're clever enough or experienced enough to outsmart the market. But several studies (many of which I detail in my book) show that as forecasters, most humans flat-out stink -- even those supposed experts.
Studies also show that statistical or actuarial models are much better at predicting the future than we emotional humans are. By sticking to the numbers -- i.e., using proven quantitative approaches that measure a stock's fundamentals -- you remove emotion from the equation and put the odds in your favor.
Principle 3: Stay disciplined over the long haul
There simply is no strategy that will always succeed (see: Madoff, Bernie). In fact, every guru I've followed -- from Warren Buffett to Peter Lynch to Benjamin Graham -- has gone through rough years.
But one similarity these diverse strategists shared was that they stuck with their approaches through thick and thin. When others bailed, they were thus there to pick up great bargains. That's a big part of why they fared so well coming out of downturns.

Principle 4: Diversify, but you can't beat the market by owning it
Everyone knows that diversification is generally a good thing. You can invest in a company that has the strongest fundamentals and balance sheet imaginable, and tomorrow something unpredictable -- an earthquake swallows its headquarters, it's revealed that its CEO has embezzled billions and fled the country -- could happen that leaves you with nothing. At the same time, however, over-diversification presents its own problems. Mutual funds that own 500 stocks are inevitably going to come pretty close to mirroring the broader market's returns.
To beat the market, you need to own enough stocks to diversify away systematic risk, but few enough that you're not simply going to track the broader market. One study I examine in my book found that diversification benefits are limited once you own 50 or so stocks, and I've found that you can beat the market over the long haul with focused, fundamental-driven portfolios of 10 or 20 stocks.
Principle 5: Size- and style-focused systems only limit investment possibilities
"Style-box" investing has become quite popular over the years, and many funds focus specifically on one segment of the market -- small-cap growth, mid-cap value, etc. That's great for big institutions that are required to hold so much of each category. But for individual investors, it simply limits your returns.
Every category goes out of style for periods of time; if your strategy is finding that the best opportunities are in mid-cap growth at a particular point in time, why limit how many of those stocks you can buy? A good value is a good value, regardless of what category it comes from
Principle 6: You don't have to hold stocks for the long term to be a long-term investor
A lot of people think long-term, buy-and-hold investing means that you buy a stock and hold on to it for years and years and years, if not forever. But that can lead to trouble. For example, say your strategy calls for you to buy stocks with long-term EPS growth of 20%, less debt than annual earnings, and a return on equity of 30%. If you buy a stock that meets those criteria, and then it takes on tons of debt, its earnings growth drops, and its ROE declines, should you keep holding it? I don't think so. You buy stocks because they have qualities that make them good candidates to rise; if those qualities disappear, so too does that potential for the stock to rise.
By selling stocks that no longer meet your criteria and replacing them with stocks that do, you ensure that you always have the most fundamentally strong stocks in your portfolio. And history shows that those are the stocks that are most likely to gain ground over the long haul. You can thus be a long-term stock investor even if the specific stocks you hold turn over every month, quarter, or year.
So there you have it. Following these six principles won't guarantee that you'll beat the market every month or every year; nothing can do that. But over the long-term, I've found these tenets to be invaluable in managing a portfolio, and I think my models' long-term track records back up that notion.
As trying as the past six months have been, I've enjoyed this round of Strategy Lab, and I hope my columns have offered some perspective and insights that can be of value to you. I'd like to thank all of my readers and the folks at Strategy Lab, and I wish you all the best of luck in your future investing endeavors.

by-John Reese

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