When to Sell – Part Two

In my post titled Portrait of a Portfolio, I had talked about my conscious shift towards a higher frequency of trading since the start of this calendar year. A lot many informed voices were then pointing out to increasing choppiness and therefore the need to be nimble and hit the right spots in terms of stock selection. The standard ham was “India is a growth and domestic consumpition driven story – long term trajectory remains upwards – but there is a lot of pain in the international markets – higher volatility is expected – cannot predict what the market will do by end of 2010 but stock specific action will abound”. Since I personally agreed to this prognosis and also since a relatively high frequency style of trading/investing suits my personality, I applied this mantra not just to that Portfolio I talked about on 7Oct’10, but to the entire block of personal capital that I ‘play’ with.

A natural consequence of the rapid churing out of my positions is a sharp reduction in the average holding period of my trade positions. These days I have been holding my positions for an average of 45 – 60 days only! This is in stark contrast to the 500+ days positions I normally used to have prior to the crash of the previous year. So, as part of the ongoing effort to gather insights on the best method of selling out, I tried to look at the relation between the returns that I have earned and the time I have spent in nurturing my trades. I took all the 306 odd closed trades that I have on me since May’03 and tried to stack up the (weighted) average returns across the corresponding holding period in calendar days. The chart shown on the right is what came about. The picture in inset shows the same chart with the full range of the y-axis (representing % returns) – I could not resist blowing my trumpet on the 18 bagger investment of mine which I held on for a good 978 calendar days. It was not a black swan – though it is an outlier on the chart – there was logic and conviction backing that trade all the way. I really don’t know if it’s just poor me or even other market players are currently feeling that the age of finding such skyscrapers has passed us by. Anyways, the main body of the chart is squeezed into a narrower vertical range to bring out more detail on the other trades.

Some interesting observations and takeaways come about. I guess, some of these might be applicable to you as well since like it or not us amateurs seem to be cut from the same cloth:

  1. There is clearly no optimum holding period, but in the past 7 years or so the longer term holds win. They have the potential to compound much faster than the market. I spent a few minutes trying to isolate the high yielding tenures and checking if some logical pattern applies to the number of these days. Fibonacci Series? Nope. Prime (numbers) days? No. Numerologically significant days? Absolutely not! What is abundantly clear (at least to me) is that longer the hold, better off you will be provided you keep monitoring and assessing the position every now and then. Personally for me that is a challenge. See, when I started investing, a 3 year time horizon represented 11% of my lifetime! For someone like a WB, a 3 year hold represents 3.75% of his lifetime. The concept of time, patience and maturity is different. However, I cannot wait to grow old to hold for longer time periods and therefore compoung well and high. Who’ll have the inclination to purchase a Ferrowatch at age of 80! And as Adam Smith said, “In the long run we are dead”. Therefore, for me another takeaway from this data representation, though oblique, is that invest when young but think like an octogenarian. A smattering of maturity ahead of one’s chronological age might be the most important thing – apart from luck.
  2. Then there is the importance of stop losses. As I mentioned in some of the previous posts, for an average investor like me, with a full day/late evening job it is impossible to pour over balance sheets, interview managements (ha ha), overlay companies’ prospects in the context of larger economy and all that ‘bull’. I am also not the kind of guy who will read a research report from a brokerage house to invest. Not for me the kind of consensus building investing that some kind of people prefer – call up a hundred contacts from your phone’s address book and bounce an investing idea off them – and if most agree, then invest. My phone’s address book is quite impoverished anyways. So I guess what works for me is a ruthless culling off of losing positions – regardless of the long term, hidden value spiel. As long as the general trend of the local economy is expansive I am cool. This inbuilt bias in equity markets to rise tells me that while such an edgy response to volatility/corrections may not result in the most optimal of returns I think I will make enough to take care of the added burden that transaction costs and taxes place on such behaviour. That’s what I am thinking right now – but remain open to change my view as I “mature”.
  3. One last point regaring the sea of red at longer holding periods. This is my personal example of loss avoidance – of ego triumphing over prudence. Of imprudent youth putting false hopes of a turnaround. An example is the “Stupid Mining Company” trade of mine – when price falls, you just don’t care if it falls another 20% – 30% more, right? How does it matter? A loss is a loss. It was at a particular level once, it will surely climb back and beyond, right? Well, try plotting your own personal chart like the one above – then ask yourself these questions again. The fear of booking a loss is something I think I have hopefully gotten over now. And one should know when to call it a day. While my personal data may not be representative, the reds are concerntrated towards the right of the chart. That’s poor management of capital indeed! I guess what I am implying is that a dud can be spotted in a year or two – it does not require more than that (even if you are the oldest, most “mature” value junkie) to pull out one’s precious capital and put it to work elsewhere.

 

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When to Sell – Part One

I’ve been spending some time digging around in my trade journal and trying to understand this. Getting a handle of this very important aspect of investing is one of my birthday resolutions. This study and therefore these series of posts are a set of steps in that direction. I’ve entered into 337 sell transactions till date. The first time I ever booked a profit on a secondary market trade was way back in 05Oct’01 and the latest one was as near as 06Sep’10. To understand more about the when of my selling behaviour I looked at these 337 in conjunction with the market and it’s valuation. I also tried to plot my sales in along time to see if there were clusters of sales happening during particular time periods. I will bother (and write) about the other questions of why, how and what regarding my selling behaviour at a later stage.

For now, I constructed this chart which shows my selling activity during the period spanning Oct’01 to Sep’10. The small green histograms at the bottom show the distribution of my sell trades. Three clusters seem to emerge: Aug’04 to May’05; Jan’07 to Apr’07 and Aug’09 till date. I have started my investing career with a handicap – which might seem like a paradox given the upward ascent of the NIFTY since 2001. What I mean is that my investing thought process has been spawned during a whopper of a bull run. Nearly anything anyone touched during 2001-03 turned to gold. Midases were everywhere, hemlines were getting higher by the minute. Then after that 2008 and the early part of 2009 was such a humbling moment. And a great learning experience. I lost money on a few trades and the flurry of sales that you see during more recent times are my unwinding of those doomed trades as they recouped some of their lost ground. The wicked blue line represents the market – NIFTY in this case. The oscillating orange band represents the value of the market – trailing 12 month NIFTY P/E ratios. If one uses this lens to view the art of getting off the train, then it’s good to be a net seller when the NIFTY’s P/E is above 25. It pays to be a net buyer if the NIFTY P/E is below the first quartile (under or at 15). Currently the NIFTY P/E is around 24 so we are entering hilly terrain – best to tighten up our seat belts. I use the terms “net seller” and “net buyer” since even at exalted heights of market valuation one can find a few lonely bulls rampaging around and likewise the depths of market penury still throw up some bears lying in wait to maul you.

The idea is that statistics and data tell a story about your trading pattern. It is useful to step out of the frame once in a while and see things from a wider time perspective. I guess successful traders need to necessarily have oodles of experience behind them. The best minds in the business have lived through at least a couple of downturns and figured out their behavioural patterns and emotional compass. Also, when you see the picture in cinemascope, a few down months don’t seem all that frightening.

The wise ‘old’ men of investing mysteriously say – buy when you see value and sell when your asset gets expensive. but how the heck does one go about ‘seeing value’? We seem to know/have heard about things like fundamental analysis, discounted cash flows, industry compares, etc. Most of us however, do not have the time to do detailed down-to-the bone analysis of company financials. Some of us don’t even know how to go about doing it. I don’t think that such people should not participate in the markets or run scared of balance sheets and mathematics. I guess what is required for this set (I may fall in this realm) is to develop and consistently use common sensical heuristics with modest return expectations. One such rule is getting in and out depending on the movement of NIFTY P/E as compared to the two control limits as depicted in the chart. You may have a better method – gazing at tea leaves perhaps – whatever it is, I think the key is to stick to it. Economies and therfore the stock markets have a slight inbuilt bias towards expansion and growth. Therefore, the dice is loaded – but only if you stick to the same dice.

I don’t drink tea, BTW.

Stop Losses

Many investors err when they end up throwing good money after bad. The temptation to average the costs down has weighed down on most of us. The problem with this tactic is that it works only when you have studied the underlying asset very very thoroughly. Most of us do not do this. Most of us are not equipped to do this. Most of us do not have the time nor the patience to do this. The other mistake that many investors make is that they get into a position without having pre-decided their stop losses. Or ignoring the stop losses when confronted with a losing proposition.

Almost all of us would have had someone in our extended family or friend circle who might have been badly mauled by the markets and would have consequently vowed never to return. It’s not their trades or the risky nature of the markets that did them in. It’s their lack of discipline. So many times we hear the refrain that markets are too risky. Actually, the market is not risky at all – it is the behaviour of the investor that is risky. The market never induces you to buy. This weekend when I was in Bombay, my mother told me about the losses that my father had totted up during his investing misadventures. Luckily for us (my brother & I) he did not sell off his losses, he just ignored them. And these shares (most of them cyclicals) passed on to us after his demise. And wow! The cycle turned in 2002/03 and how! Imagine riding Steel Authority of India Limited from 6 to42 in a period of 18 months. That hooked me for life. Till the losses tested me.

It does not matter when you buy, it’s when you sell that’s most important. This post is one amongst the various efforts on my part to understand the full meaning of this sentence as per my 5Aug resolution. One can get out of a position making a profit or else leave the table with a loss. Stop losses are signposts that help you decide when to sell if your trade does not work out the way you intended it to be. There’s no emotion involved, just hard nosed, dispassionate, stoic discipline. Statistically, mostly men/boys invest – so much so that investing might seem like a male thing to do. But successful investing is really quite machinistic and dull. Stick to one trading system, do not flip in and out. Stick to your stop losses. Write down/visualise your goals for each position. Maintain a trading journal recording your behaviour and why you did what you did kind of thing. Boring. Please read this cool article which talks about the 5 uncommon rules of the really wealthy traders to get some sense of how boring trading can get! Putting money in a bank fixed deposit or better still a ULIP can be so exciting! You’d get all the time in the world to party.

Sometime back I saw the movie Kites. Kabir Bedi, a powerful casino owner plays the father of Nick Brown who tells this to his revenge driven son when the woman whom he was to marry elopes with Hrithik Roshan:

“The true gambler is the one who knows when to get up from the table”

The other anecdote that comes to mind is from a job interview that I had conducted for a senior position in my company some time back. The candidate was trading on the prop account of some agency and among other questions I had asked him about his trading style and attitude towards stop losses. The guy said that he had never ever violated his stops. The two people who reported in to him had busted their stops one time each. I don’t care if this was just for the effect but inspiration strikes from the most unlikely of places. I have read quite a few books on trading, psychology of trading but when I met this “pretending to be in control” guy I thought that if this chap can do it, why can’t I. I’ve respected my stops ever since – hopefully it will become a habit.

This is important since stop losses can protect you even if you suddenly get whiplashed by a sharp correction. In fact its quite cool since you will quickly be in cash and hopefully will be able to redeploy and make more than what the stops cost you. Which brings me to important question: What should the ideal stop loss be?

The quantum of stop loss depends on what you expect from your investments and who you are. If you trade in and out intra-day (the post is not meant to be read by such people anyways) then your stop loss levels will obviously be extremely tight. Maybe 1% – 2%? There’s a lot of material on discussion forums and websites which points out to 2% being a good rule of thumb. But I feel that if one trades for longer periods, across multiple settlement periods a level of 5% is good enough. The volatility in Indian stocks is high enough to justify a 5% stop loss level. This point is important since if you are an infrequent trader then there is a danger of getting whipsawed if you put too tight a stop. Putting too tight a stop is like writing an annuity cheque to your broker. Your choice of stop loss ideally should be predicated by:

  • your risk appetite
  • risk in each individual position
  • volatility of the position
  • the amount of capital locked into the position
  • market conditions – if you want to go long in a bearish market, it’s absolutely essential to impose tighter stops.
  • time frame for the trade (discussed above)
  • Bravado (best if this reason be read and forgotten)

 Mental stops do not work. Period. I have done some conditional formatting and alerts on my trading spreadsheet and the annoying things keep popping up reminding me to cut my losses and run. You could have your own custom system, more sophisticated than mine, but do not do it only in the mind. It’s easy to overrule one’s mind.

This piece is obvisouly written for people like me. Casual traders. Folks that have a day job and who can afford to look at stock prices only a couple of times a week when the market is on and perhaps 3 – 4 times a week at night while the market sleeps. Folks who want to flog their investible surplus for some alpha instead of letting it rot in bank deposits. The Anirudh Sethi Report, which incidentally became the first site to link to my website has a cool example of how stop losses can be used to make money a la big game shooting. The lesson is almost like a Zen Koan. In fact, Zen masters would make awesome traders.

Reliance Industries Limited

The biggest sloth in recent times has been the Reliance Industries (RIL) stock. As the market (i.e. the NIFTY) traipsed on from 4,800 to 5,500 in a matter of 3 months (~15%), I have been licking my chops (no, I do not work in the chop shop) and have been generally sporting a nice spring in my step. But now I do not know how long my sunny demeanour will last for I have just about picked up a biggish position in RIL and am squarely on the path of Mukesh Ambani. It’s a trading call, unlike the Godrej Industries investment of mine. I feel quite sanguine about the Godrej depoyment, but not so about the RIL punt. The former has careened up 22% (weighted average returns) in 2 months for me and I will surely add to the position should the stock correct in the future. There was news and informed criticism of the US Fed’s solving of its debt related problems by adding on more debt. It definitely means that they’ll have loads of cash sloshing around in their backyard which they will want to deploy in high alpha economies. So some of it will come to India and that may take our local market higher on from here. But since this is hot money and the investment managers need to keep booking profits, sure enough and soon enough the market should correct. Will give some more cash to Mr. Adi Godrej to manage when that happens.

But coming back to flirt with RIL, I have gone long the stock (cash) and have also bitten a bite of the 30Sep 1040 call. There is next to no liquidity (as of now) on the Sep call and maybe the informed, knowledgeable pundits will shake their heads – but I feel that I have a story. I almost never get my options right – the brokerage charges are also too high for my liking and moreover you need to A) be understanding of the math behind how option pricing works in reality and B) be nimble enough to strike (both in and out) at the right moment.

Earlier, I had briefly written about the drowsiness in the RIL counter here and have been keenly watching this oily worm every other night. As you can see from the chart, it has slithered down to 970. The Bollinger Bands and the RSI seem to be giving a buy signal unless the stock is stuck in a downward channel. Then it would be akin to catching a falling knife. These technical indicators work best when the underlying is smugly oscillating in an escalating envelope. Anyway, I have my grip on my stop losses. If one fears or loathes getting wet, then one should not venture into the sea. But remember, only deep sea fishing gives the largest catch. I also scoured the internet to see some reason behing this very sleepy state of this behemoth – at least on the bourses. there are a few things happening (as listed below) but I do not know if they matter much. You may be aware of the old chestnut about the market being a voting machine in the short term.

  1. They’ve started pimping their pumps. They are selling at same rates as that of the PSU oil retailers. I remember some of my trips around Bombay – the Reliance pumps were always closed. The price decontrol announcement by the Government seems to have opened up the nozzles at private oil vendors like RIL and Essar Oil (have a position there as well). BTW, one comes across a very interesting string of letters when we read about fuel retailing trade lingo – DODO COCO CODO (Dealer Owned Dealer Operated – Company Owned Company Operated and Company Owned Dealer Operated). Notice the absence of DOCO.
  2. Maybe the stock has been moribund due to the announcement of RIL’s acquisition of shale reserves in the US? Perhaps the markets did not like it?
  3. The company is going to raise some money by selling off some of its treasury stock. Is that why the stock has been tied down while the rest of the market was inching up?
  4. I think the real reason has been the orchestrated downgrading of RIL by some domestic and international brokerage houses towards the end of July based on the realisation that the KG Basin may not be able to pump out as much oil and gas as what was expected/communicated by RIL. So it’s like the force of gravity acting on a balloon. Things seem to have reached a state where the forces of buoyancy (market rising) and the forces of gravity (broker downgrades) have been counterbalacing each other. Any trade is now a bet on what gives.

My personal take is that RIL is too complicated a business to understand. I do not know how many brokerage houses themselves understand it’s business thoroughly. But the brokerage community lives by its own code – one of them being a shared recognition in the importance of belonging. There’s tremendous security if the whole bunch believes in, talks about and does the same thing. While you are not better off, but most importantly you are not worst off either. In fact there has been a book called Zachs method of investing whose central tenet is to make investing decisions based on a statistical analysis of brokerage ayes and nayes.

STOP LOSS. DONT THROW GOOD MONEY AFTER BADNot that I can claim to “undestand” the companies that I invest in. You really have to be a senior member of the insider team to know it all. But since the trajectory of the Indian market has been upwards during this past decade, it would take a terribly unlucky bloke to lose money on the markets – on a longer term basis. For me one thing is clear – most of the experts who I lend my eyes to are saying (in print) that there seem to be no signs of the market having topped out in the intermediate term. The logic therefore is that if the market needs to move up and reach it’s intermediate top (before the hot money decides to leave our shores), RIL needs to perform. Hope I get lucky on these punts. Stop losses are my pillows.

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