Why ‘The Trend Is Not Your Friend’ And You Should Focus On Valuation

The Trend Is Not Your Friend… Portfolio Rule Seven says:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Rarely is a stock a better idea after it has risen 20%, thus, sell some off in case of mean reversion.  When a stock falls 20%, it is usually a better idea, but to make sure, a review should be done to make sure that nothing has been missed.  Since instituting this rule, I have only had two bad failures over the last 13 years.  One was a painful loss on a mortgage REIT, Deerfield Triarc, and the other was Scottish Re.

But still I resist trends.  Human opinion is fickle, and most of the time, there is overreaction.  As a guard, on the downside, I review new purchases to make sure I am not catching a falling knife.

Much of it comes down to time horizons — my average holding period is three years.  If the asset has enough of a margin of safety, the management team will take action to fix the problems.  That is why I analyze management, their use of cash, and margin of safety.  A stock may seem like a lottery ticket in the short run, but in the long run it is a share in a business, so understanding that business better than most is an edge.  How big that edge is, is open to question, but it is an edge.

Why 'The Trend Is Not Your Friend' And You Should Focus On Valuation

Another reason I resist trends is that industry pricing cycles tend to reverse every three years or so, offering opportunities to firms that possess a margin of safety in industries that are not in terminal decline, like most newspapers, bricks-and-mortar bookstores, record stores, video rental stores, etc.  (The internet changes almost everything.)

The second last reason why I resist trends is practical — experience.  Most of my best purchases have suffered some form of setback while holding them — were they bad stocks?  No, time and chance happen to all, but a good management team can bounce back.  It offers me an opportunity to add to my position.  I made a great deal of money buying fundamentally strong insurers and other companies during the crisis, sometimes with double weights.

The last reason is an odd one — the tax code.  Short-term gains are disfavored, and also cannot be used for charitable giving.

So why not take a longer view?  I can tell you what you would need to do:

  • Focus on margin of safety (debt, competitive boundaries, etc.)
  • Analyze how management uses free cash (acquisitions, dividends, capital investments, buybacks)
  • Analyze industry pricing trends, at least implicitly.
  • Look at the accounting to see if it is likely to be fair (there are a few tests)
  • Look for cheap valuations, which may have ugly charts.  People have to be at least a little scared.

That takes effort.  I am by no means the best at it, but I do reasonably well.  I avoid large losses without having any sort of automatic “sell trigger.”  Most of my initial losses bounce back, to a high degree.

With that, I wish you well.  Have a great Thanksgiving!

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.