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Wednesday, May 2, 2007

Rule No. 1

Recently, a number of stock market blogs and websites (e.g. Malaysia Finance, nexttrade, tradesignum weekly CI analysis) have advised their readers to exercise greater caution in May (or short to intermediate term). It may be timely to remind the readers here of Rule No. 1. What do I mean by Rule No. 1?

1. A clearly, very important investing principle. "Rule No 1: Never lose money. Rule No 2: Never forget Rule No 1". (Buffett).

2. It is not necessarily a single activity, but more often, a collection of activities that are continually practiced and designed to reduce the odds of losing money on the entire cash+stock account, whilst maximizing the odds of making money.

3. It doesn't mean never lose a single cent. No one can guarantee that in the stock market. But it does mean to focus on the right decision and activities that has a higher reward/risk ratio, and to avoid those with lower reward/risk ratio. We may not be able to control the end result, but certainly, we can control our investing decisions and activities.

4. Prevention is better than cure. It is better to sit on cash, than to make a hasty buy that results in a 50% loss, which then requires a 100% return in order to break even. The odds of making a loss is much too easy, whereas the odds of finding 100% gains are much harder.

5. Watch your stock%/cash% allocation. As a general rule, avoid leveraging, unless you are 100% sure (and not 100% "hope") of your investment. Graham suggests 50/50 (50% in stocks, 50% in cash/fixed income) in the Intelligent Investor. Personally, I think it's not so simple, and would depend on the individual circumstances (e.g. whether he is still in savings mode, or has retired, his risk tolerance, etc.). Find the balance that is suitable for you. (for me, it is now around 60%-65% stocks, as a result of LITRAK). Imagine the worst (e.g. a 10%-20%+ market correction), and ask whether you are still comfortable with your stock/cash allocation. If not, consider reducing the stock% down to your sleeping point.

6. Select stocks carefully. Whatever your criteria for selecting stocks (whether you are a value investor, trader, speculator, etc.), re-evaluate your criteria to make sure that you are selecting stocks that offers the best reward/risk ratio. If it doesn't meet your criteria, do nothing.

7. Always insist on a sufficient margin of safety. Even better, invests in stocks with higher potential upside, and limited downside.

8. Be patient and wait for the "fat pitch". Buffett always say "When there is nothing to do, do nothing". The "fat pitch" applies to both buying and selling.

9. Review existing stocks carefully. Especially for your more "speculative stocks" (e.g. stocks that appears to offer "easy money" in the past, but might not have fully met your full selection criteria). Especially for warrants and other highly leveraged instruments.

10. If unsure, take some profits to reduce your average cost, unless you are confident that stock still has higher potential upside and limited downside. This is a favorite method of mine where in cases where the stock has run up quite a lot (beyond my initial expectations), and at the high price, my certainty of further upside has reduced significantly, but might still meet my requirements. At that point, I would sell some to bring my average cost down to a level where I can sleep comfortably. Typically, it is at a level where it is just slightly below the 52 week low price, but sometimes, even lower, making my original cost to become nil. But as a class, I stay invested in equity 100% of the time (with around 50%-70% equity allocation), because I believe that we are in a long-term bull run.

11. Sell completely stocks that you have the least confidence. Consider rotating into stocks with highest confidence. For me, I have been reducing my more speculative (but small) holdings, and swap them over to LITRAK over the past 2-3 weeks (taking the opportunity to advertise LITRAK whilst the price is still around 3.6x :-) ).

12. For traders, never play without a stop loss. Ideally, the stop loss should be a trailing stop loss that gets higher ("trailing the rising price"), but just slightly below support levels. The legendary Nicolas Darvas is a stickler for stop loss, and refused to invest when the NYSE took away the stop loss facility for one of his stocks. For Bursa, unfortunately, there is no stop loss facility yet, so, one must constantly keep an eye on the screen. For HLEbroking players, beware that sometimes, there is a delay in the prices. As Soros would say: "Survive first, make profit later". For investors who are sitting on a paper loss and the business fundamentals appear to be changing for the worse, cut your loss immediately to avoid further bleeding.

13. Don't over-trade. If one were to practice Graham's investment approach using 10 stocks, it would be prudent to limit a single stock investment to be no more than say 15%-20% of the entire stock portfolio. For warrants, it may also prudent to reduce that by the gearing factor. E.g. if the gearing is 3 times, and the limit is 20%, then, the maximum purchase might be 20%/3 = 6.7%. Whilst this reduces the downside risk, it also reduces the upside gain, since the pure Graham's approach does not promise returns that are substantially more than the index. Naturally, if a stock like LITRAK (where I have the highest confidence) is included in the 10 stocks, I would not hesitate to make it say 5 times larger than the average value stock (or as much as I can get at a reasonable price). This is just one possible approach of course, and detailed discussion on "position sizing" is beyond the scope of this short article.

14. Should the stock market crash / correct significantly, be prepared to act quickly and decisively. The best bargains are usually found at the bottom of a crash / correction, just after the major panic selling ends and the market starts to pick up again. If unsure, spread out the buying to test the market, value investors included. E.g. if you intend to buy $50,000, you might want to spread out the buying into say 5 lots of $10k each, depending on the price action. Similarly, if one is unsure where the top of the bull market is, spread out the selling to test the market.

14. Focus on protecting the total cash+stock account, not protecting individual securities. My goal in investing is more on maximizing my total account value, rather than having 100% success record in 100% of the stocks that I invest. So, I have no qualms shedding stocks that I believe will continue to head south at a small loss, into stocks that I believe will head north.

15. In essence, one controls the overall portfolio risk at all times. This is not something one only does only in May, but something a prudent investor/trader/speculator would do throughout the year.

16. I am a strong believer that when ones controls one's investment risks rationally, one will not get a bad investment result over the long term. Naturally, I don't expect to cover all the forms of risk controls in stock investing. The above are just some of the ones I've used in the past, that I can remember on top of my head at the time of writing. It's possible I might have missed others. Hopefully, this list is sufficiently useful. If you are not sure, better to be safe than sorry and seek the advice of someone whose judgement you respect and has a good investment track record. If it could be rewritten better, don't hesitate to let me know.

As usual, comments welcomed. Use your own judgement, and invest at your own risk.


peisheah said...

I'm impressed that your views resonate with Graham & Buffett's ideas to such an extent. However I'm looking to divest my holdings in the share market in this month of May. Might be coming back in October but most probably in low beta stocks like YTL Power or Litrak (depending on the values offered at that time).

Seng said...

Hi peisheah

Thanks for your kind comments.

In the case of LITRAK, my reasons for buying is I believe it is mispriced, and I believe the mispricing will not last until October. Its Q1/07 results are expected to come out at the end of May. As this is the first quarter results, it will incorporate for the first time, the financial effects of the 1 Jan toll hike. There is absolutely no doubt in my mind that LITRAK will post stellar earnings results. My expectation is that once LITRAK's good results are confirmed, the market will remove much of the mispricing, that by October, it will be mostly gone. In fact, you can already see that happening over the last few weeks. LITRAK's share price has already risen (from $2.6x at the bottom, to $3.8x today), even though there is no news during that period. Current price looks expensive, but I am expecting LITRAK's results to at least double (and more) the average result prior to the Jan 1 toll hike.

You might have noticed that I have not mentioned "low Beta" above, nor in my blog article on LITRAK. Beta is calculated using historical stock price & historical market indices, which I feel is not really relevant to LITRAK's profitability and valuation. My decision on LITRAK is certainly not based on Beta. But in a long-run bull market, in theory, one can make quite a lot of money buying a representative sample of high Beta stocks, although I have not practiced this method of investing. But what one doesn't want to do is to hold high Beta stocks at the top of the market, as the fall (or reversal from bull to bear) could cause a totally different result than expected.


JB119 said...

Hi Seng, when do you think Litrak's 1Q result will be announced? 3rd week? 4th week? Thanks.

Seng said...

Hi jb119,

I haven't seen an official date (and if anyone else has seen it, do let me know), but based on past experience, I'm half-expecting it to be around 24 (Thu) -28 May (Mon), i.e. towards the end of the month. It may be better to check Bursa current announcements every night by Financial Results.