From the April 18, 2004 Break Out Report

The Rich Get Richer
by Marco den Ouden 

In this article from 2005 I explore the idea of marrying the concept of buying stocks hitting new highs with a partial buy and hold strategy. In 2006 I actually launched a Rich Get Richer Portfolio in my paid subscription newsletter, The Break Out Report and it did so well that I have now incorporated it into my Model Portfolio.

Over the last couple of year’s I’ve noticed an anomaly in our Model Portfolio. It seems that we do just as well and sometimes better with a simple buy and hold strategy than with our active trading approach. On top of that, we have on occasion sold off a strong stock because it has hit a stop loss, only to buy it back later when it regained strength. The sell-off and buy-back sometimes works to our advantage but usually works against us as we end up buying back fewer shares at a higher price.

As noted in our book review (The Scuttlebutt on Philip Fisher, also in the April 18, 2004 issue), such investment masters as Warren Buffett and Philip Fisher do not think one should sell a well-chosen stock hastily. And we pride ourselves on careful selection of stocks we think have strong and sustainable upwards potential.

Terrance Odean and Brad Barber, two professors in the Graduate School of Management at the University of California at Davis, reported in a 1999 study that most investors over-trade their accounts to their detriment. Women, in fact, make better investors because they are less prone to cut and run on a good stock. In the brokerage trade, promoting the over-trading of an account is called churning and is illegal.

In short, we’re caught between the proverbial rock and a hard place. On the one hand we like the elegance and simplicity of the buy and hold strategy. On the other, the devastating bear market of 2000-2002 speaks to the value of having an exit strategy. Bernard Baruch, the wealthy financier, is quoted as saying that "Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he has been wrong."

I’m also fascinated by an insight of William O’Neill’s in his How to Make Money in Stocks. He observed that stocks making new highs tend to go higher while stocks making new lows tend to go lower. Recently, after compiling my monthly Top 500 Stocks on the TSX report, I wondered whether this even applied to stocks with outrageous advances. What would happen, I wondered, if one were to actually invest in just the Top Ten stocks on the TSX each month? I haven’t done a thorough study to back-test it, but I did take a look at the Top Ten for the first three months of 2004.

The results were interesting if inconclusive. The Top Ten Stocks on the TSX on Dec. 31, 2003 and their value a month later were as shown below.

As you can see, half of the Top Ten at the end of the year gained in the following month and half declined. Conjuchem, which was up 1215% for the year gained another 67.49% in January. Cedara Software had a similar gain. On average the stocks were up 7.59%. The subsequent months weren’t as spectacular. February saw four stocks up and six down for an average gain of 2.20%. March saw the Top Ten at the end of February drop an average of 1.95% with four up and six down.

But these stocks are a mish-mash and many are speculative. If one used a narrower field, specifically a field of quality stocks with growing revenues and earnings, the chances are that the results would be improved. Maybe a field of about fifty, like my Watched List!

I’ve been doing quarterly reviews of my Watched List like the one in this issue for two years.  So I had a handy resource to back-test a new strategy aimed at investing in quality growth stocks while reducing excessive trading. The strategy is this:

What if, I thought, we invested in the Top Ten performing stocks in our Watched List at the end of each quarter. If the stock continued to be in the Top Ten at the end of the quarter, we’d let it ride for another quarter. If not, we’d sell it and use the proceeds towards buying the new entries to the Top Ten.  The results were nothing short of amazing.

You’ll recall that our Model Portfolio returned 24.78% in 2002, beating the TSX which declined 14.0% by a wide margin. In 2003 we did even better with a return of 35.66%. At the end of 2003 we were up 69.28% and at the end of the first quarter of 2004, we were up 8.21% for the year and 83.18% since inception. (Note: Our Model Portfolio, launched on Jan. 11, 2002, is up 244.80% as of March 9, 2007)

Employing our test strategy, which I call the “Rich Get Richer” strategy, I back-tested over the same time frame starting with the best performing stocks on our Watched List for 2001.  I divided $10,000 equally between the ten stocks, recording them as bought at the closing price on the last day of 2001. Checking out our quarterly review for the first quarter of 2002, I held on to the stocks that continued in the Top Ten and sold off the rest, trading the proceeds into the remaining Top Ten stocks. I continued the procedure throughout the year – just four trades a year.

At the end of 2002, our portfolio was up 71.63%, far outstripping the return of 24.78% we got actively trading. Continuing through 2003, we ended up ahead 155.50% on December 31, 2003, far outstripping the aggregate return of 69.28% for our actively traded portfolio. But was this just a carry-over from the spectacular gains of 2002? We tested a second portfolio launched on Dec. 31, 2002. Same deal - $10,000 evenly divided between the Top Ten stocks on our Watched List for the fourth quarter of 2002. At the end of 2003 the portfolio was up 55.70%, considerably ahead of the 35.66% achieved with active trading.

What about downside? The returns quarter by quarter were as shown below:

As you can see, there was only one negative quarter – a minor drop of 1.35%. We were vastly aided by our initial quarter return of 45.00% which is not typical.  But quarterly returns in the teens were not uncommon with four of nine quarters.  The maximum draw down for any of our stocks in any quarter was 18.38%. And the maximum number of negative performing stocks was six – in the month we had a loss.

Also of interest is the maximum number of quarters a stock continued in the Top Ten. This record was tied by Bennett Environmental and Repadre Capital. Each was in the Top Ten for four consecutive quarters. Both also were in the Top Ten five times. Calian Technology and Home Capital Group each appeared three consecutive times and a total of four. Peyto Exploration was in the Top Ten two consecutive times twice for a total of four. And McGraw Hill Ryerson made the Top Ten two consecutive times and three in all.

Why did we get these results? First, we have a limited Watched List consisting of stocks screened for  growth. Secondly, the O’Neill observation that stocks hitting new highs tend to go higher is in play. Thirdly, we are cutting down on excessive trading by cutting more slack and using a three month buy and hold approach.  We should still employ stops for safety, but maybe a very loose stop of 20% or 25% off an interim high is adequate.  We’ll continue to explore these statistics in future issues. (Note: In practice in our current Model Portfolio, I have done away with stops entirely, only selling off stocks and replacing them after each quarterly review. This creates a relatively low maintenance stock portfolio.)

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