When Investment Strategies Work But Not all The Time

When Investment Strategies Work But Not all The Time

One of the constants in investing is that investment theories are disbelieved, prosper, bloom, overshoot,  die, and repeat.  So is the only constant change?  That’s not my view.

There are valid theories on investing, and they work on average.  If you pursue them consistently, you will do well.  If you pursue them after failure, you can do better still.

How many times have you seen articles on investing entitled “The Death of ____.” (fill in the blank)  Strategies trend.  There is an underlying kernel of validity; it makes economic sense, and has worked in the past.  But any strategy can be overplayed, even my favorite strategy, value investing.  My style of valueinvesting tries to adjust for that, but it is not perfect there.  (And to tell the truth, September has been a bad month for me, though 2013 has been a very good year.)

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So what are valid strategies?

  • Value
  • Price Momentum
  • Long-term mean reversion
  • Insider Buying
  • Neglect (Low volume relative to market cap)
  • Accounting Quality (Net Operating Accruals)
  • Low Equity Price Volatility (which isn’t working now, because it became too popular)
  • Shrinking Assets
  • Shrinking Shares (Buybacks)
  • High Gross Margins as a Fraction of Assets (“Quality,” a quantitative measure of moats.)

This list is not exhaustive, but it is what I use.  The main idea here is to be aware of what is out of fashion, and to be ready to invest when that which drives a strategy to be out of fashion stops getting worse.

So, don’t lose confidence in winning strategies.  Rather, trade out of winning strategies when they are too good, and revisit them when you see the “The Death of ____” articles, or things like them.  This can apply to sectors and industries as well.  Be willing to pick over industries that have underperformed, and buy strong companies that can survive the downturn.  As I have said before, failures occur in weak industries, and after they do, the remaining companies gain pricing power, and thus you invest in survivors.

Value investing is emotionally hard.  You have to be willing to take short-term pain in the interests of long-term gain, if there is a sufficient margin of safety.  No strategy works every month or year.  Returns from valid strategies are most often lumpy.  The markets are almost always lumpy.

Prepare yourself for volatility.  It is the norm of the market.  Focus on what you can control — margin of safety.  By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up.  Most people who give up do so at a time where stock investments are about to turn.  It’s one of those informal indicators to me, when I hear people giving up on an asset class.  It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year.  Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.

By David Merkel, CFA of Aleph Blog

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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.
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