Catching bottoms

I recently came across an article titled “Ten Rules For Catching A Bottom“.

Market timing is hard enough that no one can do it consistently but the rewards of success are high enough that it piques interest. Besides, the question “when should I buy?” is on the mind of every investor/trader simply because it affects outcomes.

Of the rules themselves:

  • My experience agrees with rules 3 (wait for a higher low) and 4 (wait for a longer term moving average to stabilize).
  • Rule 7 (keep your trades small) is vital, and I wrote about this in a recent post.
  • Rule 10 (step in slowly) is dangerous if one doesn’t understand how it affects rule 7. If you keep investing 1% of your portfolio repeatedly into a stock that keeps dropping and eventually goes to zero, you could lose 5-10% of your portfolio.
  • Rule 6 about using stop losses is not very useful if one follows rule 7 to keep trades small. In my experience, Rule 6 (use stop losses) can hurt outcomes. I would sell only if new information says that the stock isn’t worth holding; otherwise, I would hold. I’ll explain this with an example. Here are three stocks that were in the news last year, and the gurus who owned them:
  1. Valeant (VRX): Ackman
  2. Sun Edison (SUNE): Einhorn
  3. Horsehead (ZINC): Pabrai

Of these, VRX bottomed and then nearly doubled, but Ackman sold near the bottom. The other two (SUNE and ZINC) went to zero. If these hedge fund managers, with their extensive resources, could not predict survival, it is fair to say that most individuals cannot accurately predict outcomes either. A stop loss gives up a potentially large gain from a rebound for a small but certain avoidance of loss. If an investor wishes to avoid losses, bottom fishing isn’t the place to be to begin with, but once in the game with a tiny bet (e.g. 1%, all trades inclusive), getting out of the game with 0.2% remaining may not be a good idea.

DISCLAIMER: I own VRX stock. In the past, I have owned SUNE and ZINC stocks. The information on this forum is provided without any express or implied warranty of any kind. This information does NOT constitute financial or investment advice. The information is general in nature, and is not specific to the reader. YOU SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON THIS FORUM WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A PROFESSIONAL BROKER OR COMPETENT FINANCIAL ADVISOR.

Warren Buffett vs. the bond king

I came across two news items today. In one, Warren Buffett said that US stocks are not expensive. In the other, Jeff Gundlach trashed the S&P500 (deprecating passive investing in  general) and suggested buying emerging markets instead. On the surface the opinions seem to be at odds, but the two gurus are providing pieces of a jigsaw that makes sense if we find and put together the missing pieces.

Buffett was responding to a question on the overvaluation of US stocks as measured by the “Market Cap to GDP ratio” and the “Cyclically Adjusted PE ratio”. His answer was that ratios are informative without being absolute. Further to Buffett’s point, early signs of a recession are conspicuously absent. Buffett no doubt sees this through the reports Berkshire Hathaway receives. Granted this could change quickly, but for now the economy is doing well. Buffett prefers stocks because their expected return is much higher than that of treasuries. Two points struck me as essential to complete the picture, yet not clearly stated:

  1. Buffett is a stock picker. I’m not surprised he is finding good value in US stocks, because there are enough companies whose stocks are cheap in relation to their future cash generation potential. However, the US stock market also has plenty of companies that will do far worse (many will go bankrupt) than treasuries. Investing in a stock market index may not be a good idea because one ends up buying the good and the bad.
  2. Which is what Gundlach (google “bond king”) was saying at the SOHN conference: Investing in a stock market index (such as the S&P500) is a bad idea. His point is that stock pickers (like Warren Buffett) will do much better than a market index. But he is also implicitly saying something else: that we are not constrained to invest inside the US alone. It’s not “do we invest in US stocks or US treasuries?”. There’s an entire universe of securities that we have access to. Gundlach sees good returns – even without stock picking – in emerging markets.

It would be fair to say that those with the talent for picking stocks globally will do quite well.

Buffett’s journey – a case study

My previous blog post was on the importance of saving in the early part of life. Saving early gives investments the time they need to grow. Now, I use the example of a well-known billionaire – Warren Buffett – to emphasize a few key points.

As of the end of 2015, Buffett’s wealth was estimated at somewhere between $60 and $70 billion. Is Buffett’s example a realistic one to use for the average person? It is. Not in the “everybody can be a billionaire” sense, which is obviously not true. Buffett however, was not born into exceptional wealth, nor did he become a billionaire overnight. He became focused on amassing wealth at an early age, did jobs and earned money for offering his investment skill as a service to others. He was uncommonly frugal, as described in his various biographies. As his earnings grew, so did his savings. At some point, the compounding of his wealth outgrew any salary or fees he would earn. My guess is that his investment return was already more than his salary/fees when he was in his 30s. Buffett is 85 now, and the wealth we see today is the result of over half-a-century of compounding at a rate faster than the US stock market’s. His is an extraordinarily executed example of the wealth growth trajectory I described in my earlier post. Persons who can emulate the things he did right even to a limited extent can find financial prosperity.

Here are a few data points on the growth of his wealth (quoted verbatim from the wikipedia page describing Warren Buffett):

  1. By 1950, at 20, Buffett had made and saved $9,800.
  2. In 1956, … Buffett’s personal savings were over $174,000.
  3. By age thirty-five, he was worth $7 million. – from “Buffett-The making of an American Capitalist” by Roger Lowenstein.
  4. Buffett became a paper billionaire when Berkshire Hathaway began selling class A shares on May 29, 1990.
  5. On August 14, 2014, the price of Berkshire Hathaway’s shares hit US$200,000 a share for the first time. While Buffett had given away much of his stock to charities by this time, he still held 321,000 shares worth US$64.2 billion.

Buffett’s net worth vs. his age is plotted below:

Buffett's net worth over time

And here’s the rate at which his net worth grew over different periods.

Age Rate of growth of net worth
20-26 62%
26-35 51%
35-60 22%
60-84 19%

It is easy to see that Buffett’s wealth grew much more rapidly in his early years. There are two main reasons for this:

  1. When he was young, his wealth was growing from two sources. One was the money he saved from the salary/fees he earned, and the other was his investments. Later on, his savings became insignificant, and the growth of his wealth was due to investments alone.
  2. A skilled investor like Buffett can achieve higher investment return when he is investing only a small amount of money. When investing tens of billions of dollars, one is forced to invest in a lot of different things. The business Buffett likes best might return 50%/yr but the size of such business opportunities is usually small – in the millions, not billions. Buffett commented in an interview: “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” Regardless of whether Buffett can actually achieve 50%, the inverse relationship between investment size and investment return is logical.

My main point here is that early life is a great time to multiply one’s net worth. Even without Buffett’s investment acumen, today a frugal person with a healthy salary can save five figures each year and quickly achieve a net worth of $100,000 in 5-10 years, at which point investment returns start to matter. Buffett went from $9,800 to $174,000 in the six years between age 20 and 26. That was a lot of money in 1956. Today, a person earning $60,000/yr, and saving $18,000 (which happens to be the annual contribution limit for a 401K) can go from $0 to $72,000 in six years by just saving. Saving $18,000 out of a $60,000 salary isn’t easy, but it’s doable. Investing like Buffett is a lot harder.

Now imagine that the saver, with $72,000 saved, decided to invest in the US stock market (S&P500) for the next fifty years, and achieved not Buffett-like returns, but merely stock market returns. Based on the data here, the index was priced at 44.15 in 1956 (when Buffett was 26) and priced at 1278.73 in 2006 fifty years later. If our saver achieved the same growth as the index has done in the past, then the $72,000 would grow into a little over 2 million. The saver wouldn’t be a billionaire – not even close – but I’ve assumed that the saver saved nothing past the first five years, and I’ve also not taken dividends paid by the S&P500 into account. This saver would be one very prosperous retiree by doing two simple things: saving early and staying invested.

Stories of people who earned little but saved, invested, and retired rich are numerous. But in all fairness, I make it sound easy. While the path outlined is real, it is hard to follow because of human nature. I will talk about pitfalls of investing another day.