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Author: Lammergeier40 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 63935  
Subject: What Gives You Your Edge? Date: 12/4/2002 6:53 AM
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I've been reading a lot of Jack Bogle lately (former Chairman of Vanguard), and I can't help but agree with his thesis that the average investor would be best served by following some pretty basic tenets: 1) employ sensible asset allocation (diversify within and among sectors), 2) don't try to time the market (i.e., use dollar-cost averaging), 3) invest for the long term, and 4) try to minimize frictional costs (e.g., commissions, MER's, taxes).

But I'm not a believer in efficient markets. In my view, markets at best tend towards efficiency, but with noise overwhelming signal at time frames of any less than several consecutive years: (http://www.efficientfrontier.com/ef/102/taleb.htm ). So I disregard recommendations 1-3, trusting that I can exploit the inefficiencies in the market and become one of the few who consistently generates market-beating returns. Hence, my plug for Bogle smacks of "do as I say, not as I do," because I all but ignore his recommendations, spending hundreds of hours a year trying to beat the market.

As does pretty much everybody who hangs out here on a regular basis, I'd imagine.

I think it's important to periodically step back and subject yourself to a critical evaluation. How long have you been doing this, and how well have you done, relative to an appropriate benchmark?

Since I started doing this for myself on Nov 2, 1998, I've had a 2.11-fold cumulative return, which works out to +20.1% on an annualized basis (that includes a 3-½ month break from June to Oct of this year while we were moving to the U.S.). That handily beats all the equity benchmarks I might want to consider (TSE300 +1.2%, S&P500 - 4.5%, DJIA +0.1%, NASDAQ -5.2%).

But even if you pass the benchmark test, there's another more difficult test you have to pass. You have to convince yourself (and others if you're a fund manager) that your success (if you had any) isn't just due to luck, but that you actually possessed skill. And this is somewhat an exercise in telling "just so" stories, but it requires a rational explanation of how and why you beat the market.

And in that vein, I offer the following 8 explanations of how and why I think I've been able to beat the market over the last 4 years.

1) Price Sensitivity

I'm extremely price conscious when I buy, and to a lesser degree when I sell. I'll only buy stocks when they're on sale, and even then I'll only buy with limit orders at several % below current market levels. This means I often don't get filled on a stock I'm interested in, but if I do get filled I get it at a very attractive price. I've only bought on an uptick once in the last 3 years (Nortel on Greenspan's surprise 50 bp Jan 2001 rate cut), and I'm still embarrassed both by my behavior and by the stock I bought, even though I ultimately made money on the transaction.

When selling (or selling short), I only sell on what might be described as major updrafts-large upward moves of 5% or more. Again, I use limit orders to try to get good fills at above market levels. After a few bad experiences with stop-losses, I never sell because something is falling (although I might take advantage of capital losses if I can offset taxable gains). I sell stocks because they're rising and have risen past my comfort zone. [Critique: Over the last 4 years, I have consistently sold too soon and would have benefited tremendously by holding out for higher prices].

Whether buying or selling, I ALWAYS move against the herd, even if it's only during a temporary "correction".

2) Use of Information

I agree with Marty Whitman's (Third Avenue Funds, Value Investing guru) adage that it's nearly impossible to have better information than the next investor, but it is possible to use available information more effectively.

As just one example, data on option grants are available in every company's annual report, but few investors go to the trouble to calculate the hidden costs of options. In the long term, knowing such information provides a competitive edge in understanding true profitability to shareholders.

3) Selling Short

Because the lion's share of equities are owned by pensions and mutual funds, and most such investment vehicles are prohibited from going short, I believe you gain an automatic advantage just by being willing and able to go short. Although I am not market-neutral (i.e., having equal dollar amounts of short and long investments), I do try to maintain long and short positions at all times, and this mitigates some of the broad market fluctuations that I can't begin to predict. No matter how under or overpriced the entire market may be, you can always find individual securities that are bucking the trend. Taking advantage of these opportunities has allowed me to make money in both up and down markets. I highly recommend Kate Stanley's "The Art of Short Selling".

4) Path Insensitivity

When I buy something because I think it's undervalued, or short it because I think it's overvalued, I'm very tolerant of positions that move against me initially (and even for extended periods). As Buffett and Munger would say, if you can't tolerate a stock dropping by 50% right after you buy it, you probably shouldn't be buying stocks. The important caveat here is "so long as your original analysis was correct." I bought MCIT/WorldCom earlier this year for $5.29 and bailed out for $2.67, but only after it became obvious that the numbers I based my cash-flow analysis on were fraudulent. But I'm still holding Schering Plough from a $31 purchase, even though it went as low as $16.

With short positions, because they're held on margin and losses can exceed 100%, you obviously have to modify this a bit. You would have been fundamentally right to short AMZN at $30 back in 1998, but you might not have survived a margin call long enough to be proven right. Margin investors are, by definition, path sensitive.

So are fund managers. A mutual fund that's losing money or underperforming its peers is going to see net redemptions, forcing additional sales, thus putting additional pressure on losing positions. Don't put yourself in a position where you have to sell because of market underperformance. If anything, you want to be in a position where you can buy because of market underperformance.

5) Time Insensitivity (a.k.a. Patience)

Value investing involves ferreting out hidden value that other investors fail to see. But failure to see something isn't going to be instantly rectified because of a rumour heard on the Street that Todd just bought something (maybe this would work if you were Buffett, but it doesn't always work even for him). Rather, the neglect that created value in the first place is likely to persist for a very long time (read "several years").

If I buy a security because I believe it is undervalued by 30%, I'm willing to wait 2 years or more for the market to see the value. But if the market sees the value later that day and the price soars 20%, I'm also willing to sell right away.

Mutual fund managers don't have endless time. A hot hand reputation will be lost in 2 years. You, on the other hand, have lots of time. Use it to your advantage, primarily by ignoring it.

6) Exploit Illiquidity

Traders would look at some of my current positions and exclaim "My God, it's thin as a ghost!" I own small-capital stocks that often go entire days without trading a single share. Or I'll watch the quote jump up or down by 10% and get all excited, only to realize that it's due to a single 200 share transaction on a $5 stock.

If you're dealing in positions of $3,000 to $20,000, you can exploit illiquidity by functioning as a market maker of last resort. Something like Liquidation World hardly moves at all on the NASDAQ (LIQWF). If the stock seems undervalued and it's also illiquid, put in a limit order to buy at well below the current bid. If someone who's price insensitive (i.e. a mutual fund) decides to dump 10,000 shares all at once, you could very easily get a golden fill at way below market value.

This often happens with illiquid preferred shares too. On the day the stock goes ex-dividend, there's almost always a big spike in volume as funds that were holding for a final dividend decide to dump their positions. And this spike in volume creates a bigger range in prices. You won't be able to get a good fill on a quarter million $, but you can often get a very nice fill on 400 shares. When a stock drops as much as $1.20 on the day after it pays a 50 cent dividend, that's an opportunity you can exploit.

But I've learned to be careful with illiquid limit orders, because your order to purchase 2000 shares at $3.06 can get partially filled, leaving you with only 100 shares at $3.06, along with a $29 commission. At 58 cents a share round-trip commission costs, you're unlikely to make any money on that deal. If something is really illiquid, I'll use one of two strategies to try to avoid this: 1) use an "all-or-none" specification on the order, or 2) break the order up into several smaller orders and stagger the bids (e.g. 700 @ 3.06, 700 @ 2.96, and 600 @ 2.86).

7) "Fade the Noise"

If you believe as I do, that most of what happens to share prices is just price-driven noise that has nothing to do with underlying value, you can do one of three things: ignore it, try to predict it, or try to fade it.

http://boards.fool.com/Message.asp?mid=17011355

For LTBH investors, ignoring it is probably the best strategy. If you embrace technical analysis, you're trying to predict its future path. I happen to think that's futile, but I'm more than willing to admit that what works for me might not work for you (good luck, unless I'm on the other side of the trade from you, which is highly likely). The strategy I adopt as a trader is to "fade the noise." Implied volatility, as measured by the VIX, represents "fear" on the part of put option buyers. I'm more than happy to sell fear when it seems excessive; likewise for hope. When things move too much in any direction, I'm willing to bet on a regression to the mean.

Remember, "the trend is your friend (until the end when it bends)". And it usually does, and that's where I want to be. Sometimes it doesn't bend though (WCOM), so you can't be putting too many investment eggs in any one basket.

Hope this is interesting. I'd invite feedback, both positive and negative. Remember, this is what works for me, and it matches my personality perfectly. What works for you will necessarily be different.

Todd


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