There are five pillars to our approach to investment success.
Number 1: Identify Major Investment Themes
In early 2003, we identified our favorable and unfavorable major investment themes for the next 10, 15, 20 years or so:
Favorable investment themes:
Gold and silver
Oil
Other commodities
Emerging markets
Unfavorable investment themes:
U.S. stocks (with certain exceptions)
U.S. bonds
U.S. real estate
Our favorable investment themes are the ones that were in primary bear trends for many years. As a result, they are the markets that are the most undervalued. On the other hand, our unfavorable investment themes are the ones that were in primary bull trends for years. They are the markets that are relatively overvalued.
Markets tend to go from relatively undervalued to relatively overvalued and vice versa. The process can take many years to complete. Concentrating on the big picture of our investment themes allows us to stay focused and not get distracted by counter-trend market corrections and noise emanating from Wall Street and the financial media.
Number 2: Asset Allocation
We allocate assets to emphasize favorable themes and de-emphasize unfavorable themes. For example, 10% of our overall portfolio is allocated to the ownership of gold and silver. We view that part of our portfolio as an insurance policy on a weakening U.S. dollar. We don’t expect that to change for at least several years.
The other 90% is allocated to profit when one of our favorable investment themes rise in price or when one of our unfavorable investment themes decline in price. As a result, we often have additional investments in gold and silver stocks and Exchange Traded Funds (ETFs) over and above our permanent 10% portfolio allocation.
Number 3: Let Profits Run And Cut Losses Short
A substantial percentage of our overall portfolio is allocated for the purchase of shares of stocks and ETFs. With this part of our portfolio we typically use trailing stop loss orders to allow our profits to run and to cut our losses short.
A trailing stop loss order is one in which the stop loss price is set below the market price. The trailing stop loss price moves incrementally with market price. This technique allows an investor to set a limit on the maximum loss without setting a limit on the maximum gain, and without requiring paying attention to the investment on an ongoing basis.
The stock selection in our portfolio are shares of companies that are either earning a high return on invested capital and are priced at a high earnings yield or shares of companies and ETFs representing one of our major investment themes.
Number 4: Position Sizing
We are firm believers in the fundamental truth that if you keep losses at a minimum, profits will take care of themselves. Therefore, we size our positions so that we rarely risk more than 2-3% of the equity in our stock portfolio on any one stock or ETF position.
The question that the average investor asks before making an investment is how much can I gain? That’s the wrong question. The right question is how much can I lose? We try to never forget asking the right question.
Number 5: Discipline
The typical investor is always searching for the “Holy Grail” investment strategy. There is no Holy Grail except for the discipline of the individual investor.
The best investment strategy in the world will have long periods of underperformance. Therefore, we realize that we must stay disciplined by staying the course when we are going through one of those periods.
Let me quote a passage from chapter 8 of Joel Greenblatt’s amazing book, “The Little Book That Beats The Market“:
Let’s take a look at the experience of a good friend of mine who happens to be the “smartest money manager I know.” Though he doesn’t automatically buy stocks that his computer-based formula spits out, he does follow a disciplined strategy of choosing companies to buy only from the list of companies his formula ranks the highest.
He used this strategy for 10 years at his previous investment firm, and nine years ago he set out to form his own money management firm using the same basic principles. Business wasn’t too good for the first three or four years, as the same strategy that had been so successful in the past drastically underperformed the returns of competing money management firms and the major market averages. Nevertheless, the “smartest money manager I know” strongly believed that his strategy still made tremendous sense in the long run and that he should continue following the same course as always. Unfortunately, his clients disagreed. The vast majority of them ran for the exits, pulling their money away in large numbers, most likely to give it to a manager who, unlike my friend, “knew what he was doing.”
As you guessed, they should have stuck around. The last five or six years have been so good for my friend and his strategy that now the investment record of his firm since its inception (once again, including those tough first few years) has trounced the returns of the major market averages over the comparable time frame. Today it stands among the top of only a small handful of firms with extraordinary investment records out of the thousands of investment firms on Wall Street. To prove that sometimes good things do come to those who wait, my friend’s firm now manages over $10 billion for hundreds of clients. Too bad that, in the face of several years of underperformance, most chose not to wait. Only four original clients remain [Joel Greenblatt is one of them].
The point of the story is that if a winning investment strategy always worked, everybody would follow it. And if everybody followed it, it would stop working. The reason that most people lose is that they lack the discipline to stay with a winning strategy while it goes through an inevitable period of underperformance. So, above all, we focus on being disciplined.
Larry Holmes
