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11/6/2006 12:13:55 PM In my inbox... Another Brick in the Wall: How to swing at stocks only inside your strike zone … Dylan Jovine Tipster. n. Informal. One who gives or sells tips or information, as to bettors or speculators. In my line of work I meet a lot of tipsters. Not the kind who “sell” them but the kind who love nothing more then to “give” them away. You know the type I’m talking about: the friend or family member who always has that penny stock that is one announcement away from sending the shares from .50 cents to $10. A few years ago, one of those tips circulated among my circle of friends. What was most dangerous about this tip though was that the tipster had credibility in the field he was talking about: he was a network engineer who heard that a no-name penny stock was on the verge of getting a big contract with Cisco. As is often the case the Cisco rumor was false. 90 days later the stock was selling for 25% of the price it was on the day the tip was shared. Naturally, the tipster never mentioned the stock ever again (people who share information to gain approval rarely do). The reason I bring this up is because I think that one of the most important things you can do as an investor is to swing only at pitches that are inside your strike zone. Baseball and Investing: the art of taking high percentage shots … Ted Williams, the greatest hitter ever to play baseball (and last Major League Baseball player to bat .400 in a season), once shared the secret to his unmatched success: “I break the strike zone into little boxes and only swing at the pitches inside those boxes.” What lesson Ted Williams recognized is a principle which must be learned by anyone who wants to make money investing: invest only in companies that are inside your own strike zone and which will give you the best chance for hitting the ball and making money. My definition of the perfect “plain vanilla” investment opportunity which would be right inside my “strike zone” has the following qualifications: Consumer interaction business (consumer products, retail etc.) One, two or three focused product company (easy to understand financial statements) Operating history through several economic cycles Veteran management Return on Capital > 20% Capital Spending < 15% of cash flow Debt to Equity Ratio < 25% Pricing Power High Barriers/cost for competitors to enter the industry (reflected in a high return on capital) Moody market creating irrational price depression The Importance of a Well Defined Strike Zone A well-defined strike zone means that you know exactly what types of investment opportunities to look for and you only invest when you see one. Well-Defined Strike Zone: Low risk, high percentage outcome When you’re operating at this level, investing becomes a game of patience. You simply wait around until you find the right pitch (stock) and swing the bat (invest) only when you’re comfortable. As you can see below, a poorly-defined strike zone means that you are swinging all over the plate. Poorly-Defined Strike Zone: High risk, low percentage outcome When you’re operating at this level, you swing at any pitch that comes across your plate. This includes investing money based on rumors, tips, research reports and anything else you can find. Generally, this is an indication of someone who hasn’t spent the time to understand what the conditions need to be in order to qualify as a successful investment. The Investment Newsletter Paradox But, as is often the case with human nature, it isn’t always black or white. Let me explain ... I don’t think it would be an exaggeration to say that when I find a company which matches all of the characteristics defined above, the odds are so stacked in my favor, I make money 90% of the time. But even a casual glance at the FAS model portfolio would show you that I’m right less then 90% of the time. How can this be possible? The simple answer is that I’m human and I make mistakes as well. For example, when I first started writing Fallen Angel Stocks, I felt pressure to deal with the expectations some of our members had for “action.” Thus, I made some recommendations outside my “perfect” strike zone just to satisfy a segment of my readership. Think about that for a moment: after all of my many years of investing I had developed a system that worked perfectly for me on an intellectual, mental and emotional (yes, emotional) level. But yet I remember thinking to myself “who would pay $229/year for a service that only recommends 4 stocks each year?” So what did I do? I went against my own experience and began to recommend more and more stocks to my members in an effort to satisfy their desire to trade. (I call this the “newsletter paradox.” The paradox is being that newsletter editors are not like brokers: we don’t get commissions to recommend stocks. As a result there should be no pressure for quantity of trades. However, many of us succumb to recommending more trades just to satisfy requests from customers. The irony being that we, the “experts,” are succumbing to pressure to mostly inexperienced investors who are looking to us for guidance!). Here was the final tally: 93% of the stocks I recommended inside my perfect strike zone were winners; 60% of the stocks I recommended outside of my perfect strike zone were winners. The ironic thing is that some of our biggest winners were stocks I recommended outside my perfect strike zone. Two trades even showed profits of 233% and 150%. But the reality is that my overall performance was better when I swung at stocks only inside my strike zone. Furthermore, by swinging at stocks outside of my strike zone I took greater risk in my recommendations. Thus, not only does our batting average go down, but our risk-adjusted rate of return is far lower then it would be otherwise. The Best Trade if Often No Trade At All! In June, the full editorial team here at Tycoon got together and talked about what it was that we were trying to accomplish as a firm. Chris, Teeka, Wayne, Jason and I talked about what it was that made us so different from the rest of our competitors. We first realized that at this stage of our experience, the most harm that could be done to us investing is from our own hands. For example, I knew that I had a good system for picking stocks, but yet I still succumbed to pressure to increase the quantity of my recommendations. Who could I blame for such a silly decision other then myself; specifically my desire for “approval” from FAS members. Secondly, we realized that what truly made us special or unique in the investment newsletter industry in relation to our competition was our direct Wall Street experience. If anybody should know when to trade and when not to trade it should be us! That’s when we formally adopted the “let the chips fall where they may” policy. It stated that we would only recommend trades when were inside our strike zone. If we kept fewer long-term members as a result of that decision, so be it. At least we would know we would be honoring our hard-earned experience. The result? Today, each editor here only recommendations trades when they fall into our strike zone. That often means that on any given week one of our editors may make the “recommendation of patience.” Of course, any experienced investor would automatically realize the value inherent in such a “recommendation.” But it’s the inexperienced customers who, if they can manage to transcend their inexperience and stay long enough, benefit the most. (There is ZERO doubt in my mind that ANY customer of ANY newsletter we have will walk away with a much stronger investing framework by virtue of doing business with any of us.) At this point, I’d go as far as to say it’s probably been the one small decision that has separated us most from the rank and file competition. I can’t tell you how many times a customer of ours has told us about a competing service that had plenty of exciting recommendations when the customer first signed up. But statistically, it’s virtually impossible to make money with too many trades. That’s why these services so often conveniently “forget” bad trades they recommended. None of our editors ever conveniently “forgets” a trade because of the work that was put into it beforehand. Plus, after putting in that kind of work we like to study what went wrong if a trade goes against us so that we can improve and learn from it. How to Define Your Own “Strike Zone” But how do you define your own strike zone? First, take a moment to think of the 10 most important things you look for before you buy a stock. If you’re a trader, perhaps the list includes heavy volume price breakouts, increasing quarterly earnings, low institutional ownership, strong sector strength and so on. If you’re a long-term business investor, the list may look similar to mine. Either way just write down what’s important to you and DO NOT MAKE A TRADE UNTIL TRADES APPEAR THAT FIT INTO YOUR CRITERIA. The result is that you’ll begin saying “NO” to 99% of all investment opportunities that come your way. Instead, you’ll just wait for ones that fit into your strike zone. But if you spend the time to focus on developing a good process first the by-product of a good process will be a good outcome (i.e. you’ll make tons of money). In the short-term it may not be pretty but every investor who has made serious money knows that in the long-term it’s what works. And the best part is it’ll keep you from swinging in the dirt. Have a Great Weekend, Please let us know what you think about Dylan's article. Rate his article here » Dylan Jovine Chief Investment Officer Fallen Angel Stocks |
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