Five Steps to Timing the Market

Happy Thanksgiving from Porter & Co.! As a special holiday treat, we’re sending you Porter’s contrarian classic “Five Steps to Timing the Market,” first published in 2015 by our friends at Stansberry Research.

The Market Isn’t As “Efficient” As You Think…

As you relish the Thanksgiving holiday, spending time with friends and family, we’re sending you some enduring insights from Porter this Friday. We’ve decided to share Porter’s “Five Steps to Timing the Market,” contrarian and insightful lessons originally published in 2015 by our friends at Stansberry Research. We’ve condensed and updated the original piece a bit for this publication.

We hope you enjoy Porter’s simple but profound advice as you savor a leftover turkey-and-cranberry sandwich. Next Friday (December 1), we’ll be back to our regularly scheduled Big Secret issue, featuring a new investment recommendation – and published promptly at 4 pm.

I’ve made a lot of controversial claims in my career. People thought I was crazy in 2007 when I predicted the collapse of Fannie Mae, Freddie Mac, and General Motors – some of America’s most famous corporations. Then they all went bankrupt.

People thought I was crazy in late 2008 and early 2009 when I said the biggest mall owner in America and one of America’s biggest newspaper companies would go bust. Then those companies fell apart, just as I predicted.

People thought I was crazy when I said we’d see riots in the streets after the financial crisis… then the Occupy Wall Street movement erupted.

People thought I was crazy in 2012 when I predicted oil prices would go from $100 a barrel to less than $40. Then it happened.

But out of all the things I’ve said or written in my career, the thing that gets me in the most hot water is my view that you can and should time the market.

When I write “you,” I don’t mean some representative sample or some investor somewhere. No, I mean you… the person reading this essay… the person who is going to put his or her savings at risk when you invest in the stock or bond market. You.

Many people – even some smart ones – believe trying to time the market is a fool’s errand. They argue that the best you can do is simply plow your savings, year after year, into a mutual fund or index fund. These folks make a whole range of arguments and back them up with plenty of “facts.”

They’ll cite academic studies and average investor results. They will say, again and again, that “no one” can beat the market, so why should anyone try?

I disagree… completely.

Yes, You Can Beat the Market

Let’s start here. Let’s say they’re right. If the market is really efficient, it shouldn’t matter when you invest or what you buy. If that’s really the case, why not try to do better? As long as you’re investing in something, you should do alright, according to these folks. So what’s the harm in trying to beat the market?

Here’s another way to look at it… The efficient-market folks love to argue that it’s impossible for the average investor to beat the market because it’s impossible for most people to beat the average result.

At some point, it is a mathematical certainty that not everyone can beat the market. But just because something is true on average or across a population doesn’t necessarily mean it must be true for you.

For example, I might argue that on average everyone who marries will end up with a marginally attractive spouse of normal intelligence. Therefore, you’re probably wasting your time trying to find a beautiful and intelligent person to marry you.

In theory, that might be good advice. But was that your dating strategy? If you had dated anyone who would have you, would you have married the spouse you wanted?

In short… when it comes to a lot of important things in our lives, getting better-than-average results is a worthy goal.

Luckily for investors, beating the market isn’t nearly as hard as trying to date a supermodel.

I’m 100% convinced that anyone with normal intelligence and a modicum of emotional stability can beat the market. There are a few simple and logical reasons why…

The reasons come from Wall Street’s irrational focus on short-term “earnings” and most investors’ total lack of discipline.

In this week’s The Big Secret on Wall Street, I’m going to give you my five steps to timing the market. If you use my strategy, I guarantee you can double your average investment results over 10 years… or maybe even do much better.

But listen… there’s an entire army of people out there whose careers depend on you never doubting the idea that the markets are perfectly efficient and can’t be beat. If you speak to any of these millions of people in the financial-services industry about my ideas, they will tell you I’m a fool, a liar, or a fraud. So get ready for an argument. Listen carefully.

They Just Want Your Money

You’ll notice these folks won’t ever discuss the merits of my actual strategy.

You see, the financial industry can only survive and prosper if you’re willing to give it your assets to manage. The industry needs you to believe that it’s always a good time to put your money in the market. And it needs you to believe that you can’t do it yourself. That’s why when I write things that contradict that message, folks in or supported by the financial industry go bananas.

As far as who is right or wrong… listen to what the legendary newsletter writer, the late Richard Russell, said about market timing in his classic essay, “Rich Man, Poor Man”…

“In the investment world, the wealthy investor has one major advantage over the little guy, the stock market amateur, and the neophyte trader. The advantage that the wealthy investor enjoys is that he doesn’t need the markets… The wealthy investor doesn’t need the markets because he already has all the income he needs…

“The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the ‘give away’ table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

“And if no outstanding values are available, the wealthy investor waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn’t mind waiting months or even years for his next investment.

“But what about the little guy? This fellow always feels pressured to ‘make money.’ And in return, he’s always pressuring the market to ‘do something’ for him. But sadly, the market isn’t interested. When the little guy isn’t buying stocks offering 1% or 2% yields, he’s off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he’s spending 20 bucks a week on lottery tickets, or he’s ‘investing’ in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).

“And because the little guy is trying to force the market to do something for him, he’s a guaranteed loser. The little guy doesn’t understand values, so he constantly overpays… The little guy is the typical American, and he’s deeply in debt.”

Now… think about what Richard Russell said. Ask yourself, do you invest like the poor man or the rich man? How much do you know about the value of what you’ve bought? How long did you wait for the right opportunity to buy it? How long are you willing to wait for your result – in a year, in three years, in 10 years

The poor man can’t even imagine a 10-year investment return. Nothing he buys lasts that long. Of course, if you want to get rich in stocks, almost everything you buy should last that long. It’s the compound returns that will make you rich – not the quick trades.

Listen to what Warren Buffett says… Buffett argues that all the value investors he knows – those who broadly follow the tenets of Benjamin Graham and David Dodd, authors of the value-investing bible Security Analysis – have beaten the market by a wide margin.

Now a Word From Warren Buffett

This isn’t an accident or a coin flip. These value investors all used the same principles to guide their choices. Their picks were not random or lucky. They involved all different types of securities and strategies. The only common theme was an intense focus on understanding the value of each security purchased.

As Buffett wrote in his 1984 essay, “The Superinvestors of Graham-and-Doddsville”…

“The common intellectual theme of the investors from Graham-and-Doddsville is this: They search for discrepancies between the value of a business and the price of small pieces of that business in the market.

“I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.

“I have seen no trend toward value investing in the decades that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

The first step in our guide to beating the market is based on the ideas of Russell and Buffett…

Step 1: Always Buy at a Good Price

Before you buy a stock or bond (or anything else), ask yourself, “What’s the intrinsic value of what I’m buying?” Always make sure you’re buying at a good price.

There are lots of ways to estimate intrinsic value. And as with the value of a house, there isn’t one right answer.

If I asked you to estimate the value of your home, you could give me a range based on similar sales in your area. You could tell me the replacement cost based on what a lot of land nearby would cost and the construction costs. You could give me the tax basis. And I could look up what the insurance company estimates your house is worth. 

The point is, people of normal intelligence can figure out what something is really worth. When it comes to publicly traded stocks, plenty of information is available to help you do the same.

When we look at stocks, we generally assign them an intrinsic value that’s based on cash flow (how much cash the company can generate) for operating companies or a “take out” price for asset-development stocks.

In general, public companies fall into one of these two categories. They’re either operating businesses (which are designed to make annual profits) or asset-development businesses (which may have many years of losses as they build out something like a gold mine, oilfield, or new drug).

Simple rules of thumb?

  • Be patient and wait for the stock to pull back so that it’s cheap relative to the free cash flow (“FCF”) the company produces. Never buy a stock when its FCF yield is below its five-year average. (FCF yield is FCF divided by market cap. You can think of it like dividend yield. The higher the FCF yield, the cheaper the stock.)
  • Never pay more than about 10 times the maximum annual FCF for operating companies.
  • Never pay more than half of the appraised value of an asset-development company.

Step 2: Become a Connoisseur of Value

The next part of our strategy to “time” the market is even easier. There isn’t really any math involved: Become a connoisseur of value.

Look around the world. What are other investors running away from? Is there a safe way to invest? Is it extremely cheap? Does this opportunity seem like one of the greatest deals you’ve ever seen?

That’s how you become a connoisseur of value. Be patient. And wait for the “dinner bell” to ring.

Step 3: Allocate to Value

The next step in our guide to beating the market is even easier. Learn to make big commitments only when other investors are clearly panicking, stocks are cheap, and extremely safe investments are available.

This is what most people mean when they refer to market “timing.” This is what I mean when I say “allocate to value.” Two quick examples…

First, in the fall of 2008, investors were clearly panicking. Warren Buffett wrote a letter to the New York Times explaining why it was time to buy stocks hand over fist – and was criticized on CNBC for doing so! If there has ever been a better contrarian indicator, I’ve never seen it.

Meanwhile, you could have bought shares of iconic beer maker Anheuser-Busch (BUD) for around $50 for several weeks in October and November in 2008. At the time, global brewer InBev had an all-cash deal in place to buy the stock for $70 per share. I told my Stansberry’s Investment Advisory subscribers that the situation was so safe, they should put 25% of their assets into the shares.

It was the easiest and safest way to make a lot of money that I’d ever seen. Even if the deal fell through (and it couldn’t – it was an all-cash deal at a reasonable price)… the stock was worth far more than $50 a share. In my view, there was zero downside and an almost certain $15 to $20 profit in just a few days.

Second, a few months later – in February 2009 – shares of renowned jeweler Tiffany (TIF) were trading for less than $25. The company has large inventories of gold and precious stones. Subtracting the value of its inventory from its debt load and dividing by the shares outstanding revealed a liquidation value of around $24 per share.

In short, you could have bought Tiffany – one of the premier luxury brands in the world – for the value of its inventory. That means, you could have gotten the real estate, the brand, and all the future profits for free.

It’s at times like that when you must be willing to make large commitments.

Fine, you might say. But what should I do, just hold cash for years or decades, waiting for a perfect situation? Stocks were only as cheap as they were in 2009 three or four times over the last 100 years.

No, I don’t argue that you should stay 100% in cash until stocks crash. That is probably the biggest misunderstanding most investors have about our advice. We never advocate selling everything. We didn’t sell everything in 2008, even though we knew the mortgage associations Fannie Mae and Freddie Mac were going to zero and that Wall Street was going to collapse.

We never believe that we can predict the future accurately. Instead, we want to build a portfolio that will thrive over time, no matter what happens.

If you remain dedicated to only buying stocks at a discount from their intrinsic value… if you become a connoisseur of value… and if you only make large investments when other investors are panicking, you should find it easy to keep a cash reserve.

But how many stocks should you own? What’s reasonably diversified? I recommend never owning more stocks than you can completely understand and follow.

A good test is this: Can you explain the stocks in your portfolio and why you bought them (the elevator pitch) to a friend? If you can’t, then you don’t know your investments well enough to own them or you’re trying to follow too many.

Another good test for your portfolio is to make sure that there’s not a single position that could cost you more than 5% of the value of your overall portfolio. Don’t end up with so few large positions that a catastrophe in one stock wipes out all your other gains for the year.

Step 4: Maximize Your Returns, Tax-Free

The next part of our strategy to always beat the market is: Do everything you can to avoid the damage from fees and taxes, to maximize your long-term, compound returns.

Whenever possible, keep assets in vehicles that allow you to compound investments tax-free. Minimize trading and fees, which enrich your broker, not you. Look for companies whose management is well-known for doing tax-efficient deals and rewarding shareholders in tax-efficient ways. And always reinvest your dividends – either in the same companies or in new ones that offer better value.

Step 5: Know When to Cut Your Losses

And finally… Regardless of your goals, losing too much of your money when you’re just getting started in investing is a surefire way to ruin your financial future.

That’s why you also need to use exit strategies.

A good investor knows losses are part of the game. If the losses are small, they don’t matter.

A bad investor sees every loss as a failure. But small losses aren’t failures. They are victories – victories against big losses. And big losses have to be avoided at all costs. Nobody can survive a big loss.

If there’s only one secret you must learn, it’s the golden rule of trading: Cut your losers, and let your winners ride. If you refuse to do these two things, you will never be successful as an investor.

When you’ve made a mistake, admit it quickly and move on. When you get everything right, treasure it. Hold on as long as possible.

An exit strategy is a plan for how and when you will sell your investment. If you stick to your exit strategy, it can serve as a near-foolproof way to methodically cut your losses and let your winners ride. If you follow this rule, you have the best chance of outperforming the markets. If you don’t, you could lose big.

There are two main types of exit strategies we advocate: a hard-stop loss and a trailing-stop loss. Stop losses are when you pick a price at which to sell your investment no matter what. It takes the emotion out of the sell decision.

A hard-stop loss is a set price at which you sell your investment to protect against a falling market. It’s designed to minimize your losses. Say you buy Stock X for $30 per share. You place a hard stop at $27. That means if the stock falls sharply at any point after your purchase, you’ll cap your losses at 10%. You won’t be tempted to cling on, hoping the stock will turn around, only to see it plummet farther.

A trailing-stop loss is more flexible than a hard stop. It’s designed more to protect your gains than cap your losses (although it does both). When a stock’s price increases, the trailing stop rises along with it.

Let’s take that Stock X example again. This time, when you buy the stock at $30 per share, you immediately set a trailing stop loss of 25% – or $22.50 per share. That means that if the stock falls from your purchase point, you’ll minimize your loss to just 25%.

Instead, shares climb to $40. Unlike with a hard stop, your trailing stop follows the share price higher. Your new stop is $30 (25% below $40). Even if Stock X shares fall 25%, you’ll still be breakeven on your investment. If shares continue to climb to $50, your trailing stop will continue to climb, as well… to $37.50. And you’ll be assured a 25% gain.

Most brokers give you the option to enter your stops “into the market” using stop-loss orders or trailing-stop orders.

But keep in mind… entering your stop price into the market also leaves you vulnerable. Investors or brokers who see your stop can manipulate the share price to push you out of the position.

The safest thing to do is track your stops privately. You can do this with a simple Excel spreadsheet or with a service like TradeStops.

Studies show that most investors perform terribly when managing their own assets. That doesn’t mean that you can’t do well. It does mean that the odds are stacked against you. So make a note of this list. Start living by it.

  1. Never buy a stock whose intrinsic value you can’t estimate reliably.
  2. Become a connoisseur of value. Follow the cheapest, most hated segments of the market carefully. Wait and watch for moments of extreme pessimism.
  3. Allocate to value: Wait to make major investments when other investors are panicking and truly safe, outstanding opportunities abound.
  4. Do everything you can to avoid fees and taxes. 5. Know when to cut your losses – by using hard stops and trailing stops.
  5. Know when to cut your losses – by using hard stops and trailing stops.

Porter & Co.
Stevenson, MD

P.S. If you’d like to learn more about the Porter & Co. team, you can get acquainted with us here. You can follow me (Porter) here: @porterstansb.