03/07/2013 The Marshmallow Style of Investing

How much money do you want to make?

Do you need 6% returns compounded for life?  Heck, hold an ETF like SPY, IWM, or RSP and call it a day.  It will fluctuate from year to year, but if your time frame is in decades and you aren’t greedy, that’s your ticket.

How about 15%?

Well… is that before or after taxes?

Let’s put this in perspective, using some ETFs as surrogates:

	Base Return	Decay Rate	Short Tax	Long Tax
SPY	8.43%	N/A	4.74%	6.42%
SPY*2	16.86%	N/A	9.47%	12.85%
SSO	8.74%	8.11%	4.91%	6.66%
SPY*3	25.29%	N/A	14.21%	19.27%
SPXL	1.41%	23.88%	0.79%	1.07%

 

This is a weird table, but bear with me.

SPY is an ETF that tracks the S&P 500 index.  The 8.43% annual returns are what it averages since it began in the 1990s.  SPY*2 and SPY*3 are simply 2 and 3 times the return rate of SPY.  The ONLY WAY to get 15% or better returns, after taxes, is to TRIPLE the return rate of the S&P500 index – year after year after year.

SSO is an ETF that tries to double the returns of SPY.  SPXL tries to triple the returns of SPY.  If you only hold it during the day, it works okay.  If you hold it overnight you get the leveraged decay effect.  (I got the decay rates by measuring the difference between actual SSO and SPXL returns against SPY*2 and SPY*3).

There are a number of reasons for that decay rate, such as leverage costs embedded into the ETF.  But the biggest reason is simple math.  If you have 1000 dollars and lose 10% you have 900.  If you gain 10% you have 990.  If you TRIPLE those moves, you have 1000 to 700 on the first move, but only 910 in the end.

The difference between 990 and 910 is a result of leverage decay.

So, SSO, which is supposed to double SPY, instead runs about dead even (with twice the risk).  SPXL, which is supposed to triple SPY, gets left in the dust with 1.41% annual returns.  If you pay short term capital gains taxes you end up with 0.79% for your troubles.

So much for leverage.

What about market timing?

Best overview of the subject is a book called Technical Analysis.

Thick book.  Great read.  Disappointing revelation: pretty much all the ways to time the market stopped working about ten years ago when all of these methods were fed into high frequency trading algorithms that are now self-adapting (i.e. evolving) faster than human nature can keep up.

It CAN be done, but it’s EXTREMELY difficult and requires a high degree of sophistication.

But don’t some people get rich in the market?

Yes they do.  But here’s another disturbing thing: some of it is luck.  The concentration of wealth follows a power law.

A simpler example is to picture “trades” like the flip of a coin.  Heads I win and tails I lose – but I win FROM YOU or lose TO YOU.  Take a thousand people and pair them off.  After one flip you have 500 winners.  Two flips you have 250.  Another flip 125.

Keep flipping a few more times and only a handful have all the money.

Now, most of us don’t lose ALL our money on a single trade, but we do a LOT of trades and it accumulates fast.

Although the losers aren’t entirely out of the game, they can only stake what they have left from the loss.  Enough losses and they will never make it to the wealthy group, no matter how many times they win afterward.

So, you STILL want to beat the market?  You CAN do it, but the VAST MAJORITY of our coin flippers have nothing left and only a few are wealthy.

How about cheating?  Will that help?  Get a good inside stock tip and you’re set, right?  First, you have the problem of getting arrested for cheating.  But what’s even worse is that many of these cheaters get convicted EVEN THOUGH THEY LOST MONEY cheating!

(remember him?)

Ever get a stock tip email?  Gosh I love those…

Basically those stock tips are from people who own a stock with such small liquidity that a little buzz will give them enough room to pop out with a profit, while you’re stuck with a stock that you cannot sell to anyone at any price, and so you sit on it till doomsday – which eventually comes while you watch a train wreck play out over a couple of years.

You’ll see the stock pop up 100% and then… fall 100%.

What about trading the news?

Too late.  There’s a robot that does it faster than you:

 

As I said in the previous post – the ones who win the game are the ones who aren’t playing.  Investing in BUSINESSES is a BUSINESS venture.  If you try to gamble you’ll get wiped out by the power law.  If you try to cheat you’ll get wiped out by the legal law.  And if you try to leverage you’ll get wiped out by your in-laws.

Relax – you can beat the market, but only if you don’t play the MARKET.  There are thousands of stocks out there.  Each one is its own market.

Let’s compare two stocks:

AAPL (Apple Computer) and BRCD (Brocade Communications).

Although BRCD doesn’t have the greatest chart in the world, it’s been beating the pants off of AAPL since June of 2012.

Going on price alone, a person invested in BRCD would be a lot happier than his neighbor who’s grumbling about AAPL.

Not only that, but earnings per share has been growing since last quarter in BRCD (20), but falling in AAPL (-0.41). 

The daily and weekly moneyflow have been crushing AAPL, and kind to BRCD.

Looking at just price, moneyflow, and earnings growth, BRCD should be the one to ride.

But we aren’t looking to RIDE a stock.  We are looking to INVEST in a company.

Let’s examine those earnings.  3 quarters ago AAPL was at 12.3 and BRCD at 0.06.  That’s a HUGE difference.  No wonder BRCD’s earnings have been “growing”.  They’ve been growing from dirt.  For the past 10 years AAPL’s earnings have grown (58.5) while BRCD’s have fallen (-0.5).

Sure the next quarter’s earnings growth “forecast” is negative for AAPL (-8.51) and positive for BRCD (33.33), but forecasts are just people extrapolating the present into the future – and humans are notoriously bad at doing that.  In fact, we’re SO bad at it that I actually TARGET stocks with negative forecasts.

For the past 5 years, Book Value has grown better in AAPL (47.5) than in BRCD (13.5).  5 year Cash Flow has favored AAPL as well: 61 to 11. 5 year sales growth has favored AAPL: 39.5 to 12.

AAPL has a better operating margin: 35.5 to 21.2.

AAPL pays a dividend (10.6) and BRCD doesn’t (0).  If you consider that dividends are taxed at LONG TERM capital gains, we want to invest in as many dividend stocks as possible.

Now – I picked those two since I’m not planning to be long OR short either one in the near future.  This is a completely disinterested view of AAPL against another stock.  And if these were the ONLY two stocks in the universe I’d go to AAPL and not BRCD.

Heck, if I were to get a job in either one, I’d feel more secure in AAPL than BRCD.  Wouldn’t you?

So, AAPL is “out of favor” right now.  Heck, the stock price could drop like a rock.  Even the fundamentals could turn ugly.

But the ODDS are more in favor of AAPL than BRCD.  If you were to invest in ten companies like AAPL or ten like BRCD, you’d more than likely be better off with the AAPL type fundamentals than the BRCD type technical traits and forecasts.

The reason is actually rather mundane.  People think short term and give recent information more value than long term information.  And the odds are that BRCD will continue to do better than AAPL in the SHORT TERM.  1 to 5 weeks, BRCD will probably win.  1 to 5 months BRCD will possibly win.  1 to 5 years, AAPL will much more likely win.

People are generally right about good and bad news – but they are horrid at QUANTIFYING it.  They almost always overshoot. And that’s what we should look for.

Find something that looks better long term than short term, and you’ll find value.

Find something that looks better short term than long term, and you won’t.

This is the “marshmallow” style of investing; eat one now or get two later:

 

Tim