A Little-Known Strategy for Great Returns - The 5 Minute WrapUp by Equitymaster
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A Little-Known Strategy for Great Returns

Jan 30, 2016
In this issue:
» Japan's yet another unconventional monetary policy
» Revision in key macro numbers
» Round up of global markets
» ...and more!
0.00
Rahul Shah, Co-Head of Research

I am a sucker for winning strategies with great flexibility. I want to be able to move from one discipline to another with the same great results. Today, I will share with you one such strategy that I'm particularly fond of but does not get the attention it deserves.

Napolean Bonaparte, arguably the greatest military general of all time, did not believe victory came from dare devilry or having a better plan than the enemy. Rather, the greatest general is he who makes the fewest mistakes. You don't need bravado or out-of-the box thinking. Simply limit your mistakes and the glory will be yours.

From football to tennis to baseball, successful coaches know this all too well. They don't preach swagger or inventiveness. Their job is to drill the importance of committing fewer errors than the rival. After all, at the highest level, the difference in skills isn't all that wide, so it's usually the team that commits the least mistakes that wins.

Does this principle apply to stocks as well? Does the strategy of beating the market in bad times instead of trying to outperform in good times work well in the long term?

In a recent letter to shareholders, Warren Buffett wrote:

  • I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong.

We all know Buffett's one-point agenda is to beat the markets over the long term. But here Buffett is saying he isn't trying to do that by beating the markets in good times. Instead, his focus is on beating the indices when they have a down year or a year of only moderate returns.

A little bit of math will show you why this is a smart strategy. Imagine the index is having a good year. It's up 25%. But your portfolio is up only 20%. How much more you will have to gain to match the index's returns? The answer is 4.2%.

Now, imagine the index is down 25% for the year. But because your strategy is to lose less than the index during bad times, you are down only 20%. How much will the index have to rise to match your portfolio? The answer is 6.7%.

Same numbers on the upside as well as the downside - yet the laggard in a down year has to cover more ground to catch up. Smart investors like Buffett exploit this anomaly.

All this is fine, but how do you ensure your portfolio loses less than the index during bad times? Well, we know of a process that works really well. And its track record going back many years is outstanding.

The logic is simple. If your aim is to lose less than the broader market, you have to buy companies with strong fundamentals at valuations that incorporate a sufficient margin of safety. You must also have a large portion of your portfolio in cash when the index looks expensive from a valuation perspective.

Subscribers to our Microcap Millionaires service know this strategy well. In fact, they will soon celebrate two years of this strategy beating the index by huge margins.

I think the strategy works because it looks to minimise three of the biggest risks in investing: market risk, valuation risk, and poor fundamentals. Once we minimise these risks, the portfolio has a strong chance of outperforming the index during bad times and doing a decent job in good times.

Does this strategy make sense to you from a long-term perspective? Let us know your comments or share your views in the Equitymaster Club.


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2.30 Chart of the day

The Central Statistics Office (CSO) scaled down GDP numbers for the past two years. For FY15, the estimates have been lowered to 7.2% from 7.3%. For FY14, the numbers have been revised to 6.6% from 6.9% earlier. The revision in FY15 estimates is largely due to muted growth from the agricultural sector (down 0.2% versus provisional estimate of a 0.2% growth). Other sectors that didn't perform as expected were manufacturing, trade & transport and financial services.

Today's chart of the day gives an indication of the provisional estimates versus the revised estimates for FY15 by the CSO.

Downward revision in key Sectors

M&Q - Mining & quarrying; Mfg. - Manufacturing; EGWUS - Electricity, gas, water supply & other utility services; Constr. - construction; PADS - Public administration, defence and other services

As per the Hindu Business Line, the CSO will release the GDP data for 3QFY16 as well as advance growth estimates for the current fiscal year on February 8 i.e. a week from now. It also added that the low GDP growth could make things more difficult for the government to keep the fiscal deficit in check. In fact fiscal deficit is another number that has made headlines today. For the first nine months of the year, it has already touched 88% of the full year target.

Commenting on this, RBI Governor Raghuram Rajan has cautioned the government to not give in to the pressure to boost growth. His key concern is that of hurting the debt dynamics, as any deviation from the fiscal target could up the bond yields.

Well...while our knowledge of all things macro is limited, it does seem that the road ahead is not as rosy as thought out to be. As long as things are well balanced, India should continue to chug along just fine.

3.30

If we were to ask Bill Bonner his views on Japan's negative interest rates, pat would come the reply - Zombie Economy. And we can hardly disagree with this. After all, the Bank of Japan has decided to do something that literally turns conventional economics on its head. Banks in Japan would now penalize you for keeping savings with them.

Now economic doldrums in Japan have lingered, for years. Its leaders have tried a number of tricks to revive the economy. Everything from increasing government spending to flooding the financial system with cash have been tried. But with little success. With the global economy looking increasingly fragile, Japan is now taking a more aggressive step by cutting interest rates below zero.

Being an economy with aged population, Japan has more savers than borrowers. That explains the poor rate of consumption and low demand for credit. The cheap credit too has failed in helping the economy move out of recession. And it is rather unlikely that penalizing savers will be the answer to Japan's economic distress.

In fact, Bill Bonner, who was here last week for the Equitymaster Conference, sounded a very cautious note precisely for these kind of insane policies that central banks around the world have been adopting. In case you have missed the event and would like to know more about his big picture views, you can get online access to the video recordings of the Equitymaster Conference 2016.

4.15

Global markets continued their rally this week. Sentiment received a huge boost when the Bank of Japan announced a surprise decision to implement Negative Interest Rate Policy (NIRP). Markets around the world were up on the hopes that central banks would maintain accommodative monetary policy. The US Fed, as expected, maintained the status quo at their meeting this week.

The market in Brazil was the top gainer. The Dow Jones Industrial Average was up by about 3.7%. In Europe, the European central bank (ECB) president stated that further stimulus measures could be on the cards. The British FTSE, the German DAX, and the French CAC indices were up 3.3%, 0.7%, and 2.1% respectively for the week. However, stock markets in China remained under pressure as investors continue to exit the country.

Back home, Indian Indices also gained in line with global peers. However, the up move has been muted compared to the global rally. The BSE Sensex was up 1.8% for the week.

Performance during the week ended 29th January, 2016

4.55 Weekend investment mantra

"The first rule is not to lose. The second rule is not to forget the first rule" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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