February 19, 2014

Last weekend, I had to answer a question: < I have read all your posts, but I am a little unclear about the following where you said: " It does show the value of accumulating shares of a rising stock and letting the market pay for it. " >.

My answer might be of interest to some. I thought the easiest way to answer this question was to illustrate the point with a few charts.

The first graph shows a total financing case (one of many feasible scenarios). From an initial investment, one waits for a sufficient price increase to acquire additional shares; after each $50 rise, 1,000 shares are bought at the then prevailing price.

The formula used was presented in my paper: Jensen Modified Sharpe, starting on page 28 (see Fig. 8 for cash requirements). One could choose other price increments and use the same formula to determine at what price no additional capital will be needed to sustain the strategy, as well as how much capital will be required to do the job.

The chart below is an example based on Berkshire Hathaway stock. It was chosen because it is one of the few stocks that had the age factor and had not split or issued dividends since inception making all the calculations simple from start to finish. Nonetheless, the same principles would apply to any long-term portfolio outlook. Berkshire is not the only stock to have survived a long time or outperformed the market; it is also highly correlated to general market conditions as it follows the same path as a market index.

If you intend to stay in the market for 30+ years, you might as well look for stocks that can last that long! You think a stock won't survive, don't wait till it goes under, get out on any kind of doubt, there are plenty more out there that can prosper.

Berkshire Scenario

Berkshire Scenario

(click to enlarge)

As the graph above shows, in the beginning, you won't see much of a difference with a Buy & Hold scenario, but as prices rise with time, the difference will be phenomenal, as illustrated in the following chart, which shows the strategy's output up to September 2011 (it is higher today, price has gone up $50,000 per share since then (about 40%) resulting in an additional 290B in portfolio value):

Berkshire Long-Term Scenario

Berkshire Portfolio

(click to enlarge) 

All shares purchased after the initial positions were paid for using the accumulating profits. In the Berkshire case, no additional capital was required (the purpose was to show a simple long-term scenario). It's not the only scenario one could use; the equation controls what one does over time and thereby presets all future trades. It becomes more what are the parameters you might prefer to use corresponding to your own acceptable trading methods. The point is that you let the market (using generated profits) pay for additional stock purchases over the long-term horizon. You require the stock price to go up sufficiently to generate enough profits to cover the next purchase.

Each time you purchased additional shares, it was because "all" your previous positions were already profitable. Each position contributes its part to the total. Your whole accumulating stock inventory is profiting as each additional price level is reached. At any time, you could quit and be ahead of the game. The chart shows that the later, the better.

The above chart makes the point that this long-term endeavor is worthwhile. And yet, there are few trading rules, none related to what the market does, but to what you do based on the positive price action. The price did not go up, and you did not purchase additional shares. Note that if the selected stock did not go up long-term, it was not that great a trading stock either. It does suggest that one should look at the market from a long-term perspective. One could elect to trade on his/her own long-term objectives as an alternative or complement to simply trading short-term. I think as you develop your own strategy, you will start to notice that the same long-term criteria Mr. Buffett uses in his stock selection process will also apply to you.

The above scenario has been improved by adding a trading component to the mix and using smaller price differentials. You should note from the above graph that as prices rise, a greater and greater portion of the portfolio is cash equivalent and remains unused. You could retrieve some of the available cash for your own use as you go along or use it to trade over the accumulative process. There is much to learn from the above two graphs. There are many trading scenarios and variations on the theme that can be designed to suit one's needs.

I think this kind of trading strategy could change the way we look at things. It provides a long-term plan, knowing from the start that you are going to win and most probably win big. I see it as about the same bet as Mr. Buffett made: a bet on America.

The improved approach has also been illustrated in detail in the following presentation.

There are many ways to trade, however when you look at the long-term picture, you find that few short-term strategies survive. Adding a long-term perspective to your trading plan could help you reach the finish line with a much higher portfolio value than you think.

Created... February 19, 2014,    © Guy R. Fleury. All rights reserved.