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