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Sunday, July 21, 2013

 

As Promised, My Trading System

Though we have previously revealed all of the elements of the Redwave trading system, they have never appeared all in one post.  So we promised to do that to save interested readers a laborious search through the Musings archives.  Here goes, with apologies to readers who have no interest in things financial.

First, a few general comments about what the system is designed to do, what it is not, and why it works for me, until it stops.  After years of investing with decent but unspectacular results, I looked back and considered where and why I had underperformed, and how I could have made my successes more profitable.  Studying the matter, I came to some important conclusions.

The sell decision is by far the hardest.  How do you know when to take profits?  When do you give up a losing position, as opposed to waiting to break even?  Should tax considerations dictate sell decisions?  I determined to find a way to take the emotion out of the sell decision.

In building a position, should you average down when your new purchase turns lower?  How do you know when a stock is hopeless?  I determined that if the reason for buying a stock is still valid, then averaging down makes sense.  If not, the whole position should be sold.  And if a stock falls below $1 a share, the market is telling you not to throw good money after bad.

Should you try to time the market?  How can you tell when a market or a stock is overbought or oversold? More to the point, the trouble with most systems, and especially a failing of technical analysis, is that it gets you in too high and out too low.  We all say that we want to buy low and sell high, but the vast majority of investors do the opposite.  The secret must be to set up buy - sell triggers that tend to get you in low and out high, and then to execute trades according to those triggers, and doing it without emotion and without exception.  The system is designed to tend to buy low and sell high.  In doing that, it tends to get us in early and out early.

So let's be clear.  My system is not about market timing, though some trades seem well-timed.  Fundamentally, I don't believe the market can be timed.  The system is very much about asset allocation.  Prices dictate trades, we let trades come to us.  We never try to force trades.  We have rules and we live by them.  We take what the market gives us.  However, this does not mean that everyone using my system can expect the same results.  There are variables, and the most notable one is stock selection.           

Executing the system starts with building a buy/hold list.  It's called buy /hold because in theory, anything you are willing to hold, you should be willing to buy.  This is where stock selection enters the picture.  For me, compiling this list comes from all my sources: reading (WSJ and Forbes), my full service broker, other financial experts, etc.  I am always adding stocks to the list, and occasionally removing them.  Removal causes me to sell the whole position.  Accumulating positions in the selected stocks, is done gradually.  I tend to buy in 100 share lots or whatever round number approximates at least a $2,000 transaction.  So, I would buy 200 shares of a stock priced between 10 and 20, 100 shares between 20 and 80 (20 and 40 for zero buys), and 50 shares of anything higher than that.  Sales are done the same way, except when the whole position is liquidated.  Why?  Because we can't time the stock, we want to have multiple points of entry and exit.  We will tend to buy more shares at lower prices.  Cramer calls this "buying lightly on the way down" because he thinks he can time the market.  The principle is the same but my formula lets the math do the work.

So I had to select the stocks on my buy/hold list and continue to review them.  I had to choose the cash allocation that's right for me, given my age and the other factors in our financial situation.  I chose 20%.  That is subject to change as we get older.  Finally, I had to choose a discount broker, because if you are going to build a position slowly, and sell it piece meal, you need to have access to very low commissions.  And I do.

But I still use a full service broker as well.  Why?  Because I get very good recommendations from him, and because if something happens to me, he can take over to make sure my wife and daughter still benefit from this portfolio as they should.  So we pay retail commissions on some trades, but our average commission is low enough.

So how is the formula executed?  First how often do I trade?  I determined to trade twice every two weeks for the first 500,000 of assets under management, adding another trade for each additional 500,000.  So as the portfolio gets bigger I trade a little more.  But Wall St. is never going to get rich off me.  A day trader I am not.  I still think of myself as a buy and hold investor, but it's so important to have a sell discipline and to take some profits before they all evaporate.  When it's a trading day, I determine the cash position.  If it's less than 20%, I'll put in a sell order; if it's more than 20%, I put in a buy order.  If it's a sell, I simply look for my common stock position that's the biggest in terms of market value (shares I own times price), and sell a 100 shares (or 50 if the stock is over 80, or 20 if it's over 100).  I don't question the formula.  I may hate selling that stock, but I do it anyway and don't look back.  In any event, I'm never selling the whole position. 

If it's a buy situation, I alternate the criteria.  First would be a "value buy."  In that case I look for the stock with the lowest market value in my portfolio where the debt to equity ratio is less than .70 and the price to book value is less than 2.  If the price to book is a little over 2, and the sum of that ratio and the debt to equity ratio is less than 2.5, that also qualifies.  The next buy will be a "zero buy" meaning, I ignore the ratios,  and just find the stock that has the lowest market value in my portfolio (meaning number of shares I own times price) and buy that as long as it is trading above 1.  In any case, whether it's a sell, a value buy or a zero buy, any stock that has been the subject of my last three trades is ineligible.  That keeps me from trading the same stock over and over.  Every third buy is a preferred stock, except every third preferred wil be either the GLD or TIP ETF, which I consider a necessary inflation hedge.  I alternate those too.  Once either GLD or TIP gets to be 4% of my portfolio, I will stop buying them, and I will sell them instead if they ever exceed 5% of the portfolio.

So that's a real conservative approach in my opinion, and I am gradually building in some income, suitable for a 60 something, while maintaining a very healthy exposure to stocks.  The formula is overridden when there is a takeover of course, or when a preferred matures, or if I dump the entire position of a stock when I remove it from the buy/hold list.  But the point is, there is plenty of room for me to exercise discretion in building the buy/hold list and setting the allocations, but after that, i am on automatic pilot.  And the tendencies are very healthy.  When markets rise, as now, I do a lot of selling.  When they go in the crapper, as in 2008, I do a lot of buying, when most people didn't have the stomach for it.  I didn't either, but I stuck to the formula and profited as a result.  I am going to stick with it until it stops working.  It may not be suitable for anyone else, but for me it works.

Most people don't have the time or interest to do this and they shouldn't be in individual stocks.  They should be in funds.  Personally, I don't like funds.  Funds are tax inefficient, and fund managers make the same mistakes individual investors make.  But for most people, that's the way to go.

Next post, we will get back to music, politics, sports, etc.  I promise to catch up promptly.
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It took us quite a while to put this post together, so there have been quite a few transactions in the meantime.  On June 27, we bought 100 shares of Newmont Gold (NEM), a value buy when gold was in the crapper,  at 27.64.  On 6/28, we sold 100 shares of Graham (GHM) from the IRA at 29.39 after a nice run.  We paid 23.48 on 2/9/11.  On 7/1, we sold 200 IDT at 18.78, booking a loss even as the stock moved higher.  We paid 27.08 on 4/15/11 and 28.70 on 4/29/11.  On 7/3, we sold 300 USA Trucking (USAK) at 6.68, booking another loss.  We paid 10.08 for 200 on 6/27/11 and 7.81 for 100 on 8/25/11.  On 7/5, we bought 100 shares of BRLI at 29.74, a zero buy.  Then on 7/8, we sold 100 more shares of Graham Corp from the IRA (GHM), this time for 32.42.  We paid 22.92 on 2/23/11.   On 7/9, we sold 100 shares of AAON at 23.76.  We paid 6.47 on a split adjusted basis on 9/25/06.  Sometimes, you have to be patient .  On 7/12, we sold 100 shares of FLIR Systems (FLIR) for 28.96.  We paid 29.28 on 10/26/09.  Also on 7/12, we sold 200 shares of Newpark Resources (NR) at 12.03.  Newpark is one of our great Tulane portfolio stocks.  We paid 2.62 on 11/30/09.  On 7/15, we sold 600 shares of Sirius XM Radio (SIRI) at 3.75.  We paid 1.34 on 9/2/08.  On 7/17/09, we bought 20 TIP at 113.08.  Finally, on 7/19, we sold 50 shares of Dover Corp (DOV).  We got 84.04 versus a purchase price of 35.51 on 3/22/01.  This is an example of a stock where it pains me to sell, since I have been a fan of Dover for such a long time, but we simply don't ignore the system.  

Comments:
Thank you for sharing this. Would be keen to know more about what makes a stock worthy of your buy/hold list. Are there other features beyond Debt to Equity <0.7and Price to Book <2.0 that you can share?
 
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