Warren Buffett, Meet Jesse Livermore

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Do stocks always seem to fall after you buy them?

Do you buy cheap stocks only to sit back and see them get much cheaper?

Or, after selling a stock because it is ‘expensive’, does it continue to rise in a seemingly deliberate attempt to spite and humiliate you?

Well, this is the topic of my Facebook chat with Kris Sayce today. Hit the screenshot below and have a listen. And remember to ‘like’ it:

 


 

In today’s Daily Reckoning I’m going to offer you a solution to these woes. I’m going to explain why so many people seem to make these ‘mistakes’. Don’t worry, I’ve made them too. It’s what led me to this solution.

But first, a quick comment on the latest from China. Just what is going on in the Middle Kingdom? Are the Mandarins starting to lose it?

Yesterday wasn’t a good one for the central planners. Credit data for the month of July showed that nearly 900 billion yuan in new loans went to ‘non-bank financial institutions’. This is money that effectively went to prop up the stock market.

The data from Reuters is even worse:

China has enlisted $800 billion worth of public and private money to prop up its wobbly stock markets, a Reuters analysis shows, but the impact of the unprecedented government-orchestrated rescue has so far been modest.

Public statements, media reports and market data reveal that Beijing unleashed 5 trillion yuan (515 billion pounds) in funds – equivalent to nearly 10 percent of China’s GDP in 2014 and greater than the 4 trillion yuan it committed in response to the global financial crisis – to calm a savage share sell-off.’

Hang on…let’s get this straight. China just blew 10% of its GDP to prop up the stock market!? If true, this is crazy. No wonder money is flying out of the country.

And then at the same time, China devalued its currency, the yuan, against the US dollar. While the devaluation was ‘only’ 2%, that’s large in currency terms and the biggest move in the yuan against the greenback since 1994.

I’ve warned about this happening. The US dollar is in a bull market and it’s dragging the yuan along with it. That makes China’s exports less competitive and with the economy struggling, it doesn’t need a strong currency.

The market reaction was negative. Aussie stocks started strong yesterday but then turned down as news of the devaluation hit. Asian markets fell too and the selling continued in Europe and the US overnight. Clearly there is concern about the state of the Chinese economy and an official devaluation hints that China’s leaders might be worried too.

But as far as I can tell, this was bound to happen. China’s trying to manage a bust after going through a boom. It doesn’t make sense that its currency should rise. Its strength is purely a result of the peg to the dollar. So it makes sense to loosen that peg a little, no?

China said the adjustment was a ‘one-off’. Which means it probably isn’t. If it is a sign of things to come, it could accelerate capital flows from China and lead to a tightening of domestic monetary policy. This in turn would slow the economy further. That’s not a good sequence of events.

Is this the ‘treadmill to hell’ that Jim Chanos said China was on? Whatever it is, the risks are clearly increasing for China. Its managers really need to tweak their economic knobs carefully.

This is all part of the big picture volatility unfolding in the world due to a busted up monetary system. It’s not going to change folks. In fact, it’s only going to get worse.

Which brings me back to the topic: how do you invest sensibly and prudently in such an environment? I used to think that ‘value investing’ was the answer. I studied Warren Buffet and learned to focus on things like return on equity and book values. His valuation methodology is different to what most people think or understand, but it’s brilliant.

But I’m no Buffett. No one is. There’s no point trying to emulate a genius. You have to find your own way. I also worked out that Buffett’s success has much to do with random chance, a fact that he too has acknowledged in the past.

He started investing during America’s golden economic age. An already powerhouse economy gained the ‘exorbitant privilege’ of issuing the world’s reserve currency. This was an effective tax on the rest of the world, a tax capitalised into US stock values, all of which Buffett owned.

That’s why Buffett is so gushing in his praise for the US economy. There’s none like it in terms of scope and diversity. But there is also no other that gets a free kick like the US does.

Buffett’s genius is in having the patience and the stock picking skills to sit back and let the magic of compounding work. Few of us have such a luxury.

Also, Aussie companies don’t have the same scope for growth as US companies. You can’t just sit back and own an Aussie stock for 10 or 20 years and let the growth take care of itself. Our economy is too small, too narrow, and too cyclical.

I found myself buying stocks that I thought were cheap…only to see them fall by another 30% or so. Value investors think this is great, and that you should buy more! But I found that ‘averaging down’ was the fatal flaw in value investing.

I also found the ‘Buffett’ value approach hit and miss. Some stocks went on to do very well, and some stocks turned out to be duds…their high returns on equity a short term mirage.

There had to be a better way, I thought. A way of continuing to invest sensibly by ‘buying low’, but also protecting myself against common mistakes.

Then I read Reminiscences of a Stock Operator. Written by Edwin Lefevre, it’s a book about the experiences of Jesse Livermore. Livermore was a Wall Street trader in the early 1900s. You think markets are volatile now! Back then there were no central banks to assuage investors at the first sign of trouble.

Livermore didn’t care about value. He cared about ‘the tape’. If stocks ‘acted well’, he bought them. If they continued to ‘act well’, he bought more. A stock ‘acted well’ if it went up. Simple as that.

What Livermore was really saying was that he invested with the trend. If a stock was going down, he got out.

After absorbing Livermore’s lessons (and having discussions with our own ‘Quant Trader’ Jason McIntosh), I began to realise further how flawed value investing is. Buying low is fine, but it’s not fine to buy lower, and lower…until you run out of cash or conviction.

A strict adherence to values doesn’t take human emotion into account. A stock may look like good value, but if the trend is down and sentiment is negative, why stand in the way? Why not be patient, wait for the trend to exhaust itself on the downside and buy on the way back up?

It sounds so simple that I can’t believe it took me so long to work it out.

But I promise you, if you go back and look at every stock you lost money on, it will be because you bought into a downtrend or you didn’t get out when the trend turned from bullish to bearish.

I know I’m no Buffett. And I’m not a trader in the sense that Livermore was. But by combining the lessons from these two disparate approaches, you can become a much better investor. Tomorrow, I’ll show you how…

Regards,

Greg Canavan+,

For The Daily Reckoning, Australia

Join The Daily Reckoning on Google+

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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