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There's a huge difference between a Successful Investor and Billy Bagholder. One simple, huge difference.
Knowing when to sell.
"Pffft. Thanks for that GENIUS, why didn't I think of it before?"
I know how it reads. Just buy at the bottom and sell at the top, duh!
But it's a great framework to start with (and nobody said simple meant easy).
First thing to do is set aside price altogether. If we're looking at 'selling the top' there are more important things than an arbitrary number created by the output of millions of decisions and transactions.
By the time the top is in, that number we call price is essentially meaningless.
Price is subservient to market conditions.
Pay attention to the cycles
I've been re-reading Howard Marks recently. His work on cycles is second to none.
The following is from Mastering the Market Cycle.
It should sound familiar. 👇
The idea of “growth stocks” began to be popularized in the early 1960s, based on the goal of participating in the rapidly growing profits of companies benefiting from advances in technology, marketing and management techniques.
It gathered steam, and by 1968, when I had a summer job in the investment research department of First National City Bank (the predecessor of Citibank), the Nifty Fifty stocks—the fastest growing and best—had appreciated so much that the bank trust departments that did most of the investing in those days generally lost interest in all other stocks.
Everyone wanted a piece of Xerox, IBM, Kodak, Polaroid, Merck, Lilly, Hewlett-Packard, Texas Instruments, Coca-Cola and Avon.
These companies were considered to be so great that nothing bad could ever happen to them.
And it was accepted dictum that it absolutely didn’t matter what price you paid. If it was a little too high, no matter: the companies’ fast-rising earnings would soon grow into it.
The ever-repeating cycle of price doesn't matter, I just want to be involved! always ends with FOMO buying at the top.
Now you might look at some of those Nifty names and think... So what? Hold them long enough and at least some of them will work out in the end. The winners will pay for the losers, it'll be fine.
And, over a long enough time horizon, you'd likely be right. Many of the 'Nifty-Fifty' companies are still household names now, over 50 years later 👇
American Express, American Home Products, American Hospital Supply Corporation, AMP Inc., Anheuser-Busch, Avon Products, Baxter International, Black & Decker, Bristol-Myers, Burroughs Corporation, Chesebrough-Ponds, The Coca-Cola Company, Digital Equipment Corporation, Dow Chemical, Eastman Kodak, Eli Lilly and Company, Emery Air Freight, First National City Bank, General Electric, Gillette, Halliburton, Heublein, IBM, International Flavors and Fragrances, International Telephone and Telegraph, JCPenney, Johnson & Johnson, Louisiana Land & Exploration, Lubrizol, Minnesota Mining and Manufacturing (3M), McDonald's, Merck & Co., MGIC Investment Corporation, PepsiCo, Pfizer, Philip Morris Cos., Polaroid, Procter & Gamble, Revlon, Schering Plough, Joseph Schlitz Brewing Company, Schlumberger, Sears, Roebuck and Company, Simplicity Pattern, Squibb, S.S. Kresge, Texas Instruments, Upjohn, The Walt Disney Company, Walmart, Xerox
But should you just HODL your way through and hope for the best? Fortune favours the brave! Tally ho!
At best, that could be classified as (be nice) errrm... sub-optimal.
Why suffer through the drawdown if the mania is so obvious? 👇
The stocks were often described as "one-decision", as they were viewed as extremely stable, even over long periods of time.
The most common characteristic by the constituents were solid earnings growth for which these stocks were assigned extraordinary high price–earnings ratios.
Trading at fifty times earnings or higher was common, far above the long-term market average of about 15 to 20. Professor Jeremy Siegel analyzed the Nifty Fifty era in his book Stocks for the Long Run, and determined companies that routinely sold for P/E ratios above 50 consistently performed worse than the broader market (as measured by the S&P 500) in the next 25 years, with only a few exceptions.
Twenty five years of underperfomance. You want to sit through that?
Of course there were exceptions, but are those the kind of odds you want to be backing?
Especially if those stocks are down 80 or 90% from the price you paid AND underperforming the broader market?
Here's a historical chart of Eli Lily 👇
After posting a high of $2.10 in 1973, it was down only for the next four years until the stock finally posted a low at 77c in 1977. Followed by eight years of infuriating sideways action, until in 1985, the price finally matched that 1973 peak and marched higher.
Twelve long years when that capital could've been put to work elsewhere, generating and compounding returns instead of stagnating and being devalued by inflation (which was rampant throughout that whole period) 👇
The purchasing power of a 1972 dollar devalued to 5 cents by the end of those twelve years. Even though the nominal breakeven price is $2.10, the real breakeven price is far, far higher.
Adjusting For Quality
There's a massive difference between HODLing tech titans like these and HODLing a stock like Peloton. Nothing's guaranteed, but the moats these companies have: their ability to earn, innovate, acquire, invest, and grow, are world's apart from cash-burners like Peloton.
That doesn't mean these companies are immune to the broader macro environment, the impact of interest rates, or the many other factors that can impact their business.
But if you buy a company like Peloton because everyone's locked down but they still want to 'socialise' and exercise...
And then, within six months, the stock price trebles, while the P/E ratio hits 97 just as the vaccines are being mobilised and lockdowns are lifted, why would you hold on to that stock?
What needs to be true for the company to grow into that valuation?
How likely is it?
How deep is the economic moat around an iPad on a bike?
Anyone trying to pick stocks without a good idea of what 'peak valuation' might look like is going to have their work cut out 👇
Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent -70%+ decline from their peak value.
For Technology, Biotech and Metals & Mining, the numbers were considerably higher.
Summing up, buy and hold can be a solid strategy if you're buying something like a passive index fund.
But if you want to manage your own portfolio, think ruthlessly about the different cycles, peaks and troughs in interest rates, credit conditions, and risk sentiment, and what active management truly means.
Don't be a Billy Bagholder.
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Two Things That Make You Go Hmmmm
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