averaging down

My trading objective: To increase net worth as a function of book value

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Yesterday we attended a seminar with Jason Ayers of Optionsource.net on how to create cash flow using options.  He spoke a little about his trading and how his company has taken their holdings to 50% cash before this recent downturn and how they plan to buy back in at reduced rates.  Sometimes I regret not being a better trader and having such superb market timing.  Kudos to Jason!  If you have an opportunity to learn from this guy, it’s really worthwhile, for he’s an excellent speaker and knows his stuff.

I have a different trading strategy.  If you ask me if my portfolio is up or down, I’d have to admit that my “net worth” based on market capitalization is down 7% since February peak.  Ouch!  But what if my goal is not to increase my net worth in market capitalization–but instead to increase it in book value?  Book value is itself not an indicator of the market value of a company, which is really about the profitability of that company in the years to come, but of the total assets (cash, real estate, lands, equipment, inventory) minus liabilities.  Book value is much more stable than market capitalization because it points to the value of the company as a company:  i.e., if another company were to buy out your company you would expect that company to pay book value plus a premium based upon the future profitability of the company:  you will only sell if you think that the premium–i.e., the cash in hand today is more valuable to you, for whatever reason, than your own ability to extract profits from the company in the future.  If the potential buyer offers less than book value then either there is something terribly wrong with your company (Nortel) or you just simply show them the door.  Why would you sell your company at less than book value?  You would only do that if you were insolvent and were forced to sell.

I like junior oil companies and I discovered a means to de-risk them–pay attention to the book value.  This requires looking at the quarterly reports because it changes regularly–as the oil companies use cash to develop their lands.  If the reported book value is higher than the market capitalization, then you are buying the assets of that company at a discount while obtaining its future profits for nothing.

As a strategy, buying junior oil and gas companies at below book value has worked for me with Midway Energy, Crocotta Energy, Prospex (just bought out by Paramount) and Great Plains Exploration (bought out by Avenex).  These were the first junior oil companies that I bought and their share prices are now all well above what I paid despite the recent weakness in junior oils.  Each one was originally purchased below book value.

So while I am down 7% in terms of net worth as a function of market capitalization, as a result of averaging down on junior oil companies, I now own more book value than ever before.  So I consider myself to be doing well despite the current market.

Jeet kune do investing I: the case of Canadian junior oil and gas

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I have great admiration for Beating the Index.  The website provides very valuable analysis of the Canadian junior oil and gas sector, the major plays (esp. Bakken and Cardium), and the macro issue of why the price of oil will likely rise in the long term investment horizon.  In addition, Mich, the website’s sole proprietor, reveals to us a part of his self-managed portfolio, what moves he makes as he beats the index.  His style is his own, adapted to suit his particular portfolio.  For example, because he is using leverage, he has to cash in on his winners–sometimes he also drops losers and holdings which remain  static.  In one post, his commentors on his blog praise him for being willing to take losses and move on, saying that this is the mark of great trader.

But then one has to wonder, if an analyst has done his due diligence and decided that a company is a good buy, and then the market decides to dump the stock, whether that stock just became a better deal.  So in my trading, I very rarely dump losers, though I have sometimes done so to realize a tax loss or to implement a change of strategy.  Rather, I’ve averaged down on losers, and most of the time it works, as I shared in a post critiquing Dennis Gartman’s first rule of trading, “Never, under any circumstance add to a losing position…. ever!”  Gartman says to add to winning positions rather than to losing positions.  Generally speaking, I ride the winners, but I don’t often add to my positions.  Gartman’s rigid style seems to be flawed, and his own HAG fund is still going nowhere.

Now Keith Schaeffer, one of the leading independent analysts of the Canadian junior and intermediate oil sector, provides a compelling argument why it is better to add to the companies with momentum:

When it comes to the junior and intermediate North American oil and gas plays, I want to buy expensive stocks. I rarely buy cheap stocks. That sounds counter-intuitive, but it makes sense.

When a company trades at a high valuation it can raise money with less dilution, and can use its stock as currency to take over other companies. They can grow more quickly and more efficiently than companies with low valuations.

“Dilution” is one of the terms that junior oil and gas investors seem to fear.  Indeed, share price usually seems to drop after a public offering.  Crocotta Energy’s recent share offering is a great example:

CTA share price fell on Feb 3 after announcing a $25 million bought deal

One day on an airplane on the way to Barbados, I met A. Zoic, an experienced entrepreneur, who explained “dilution” to me:  He said, “The number of shares are increased, but the size of the company also increases.  So you have smaller percentage of the whole, but the company is much larger.” Zoic’s words came back to me, the inexperienced investor, time and time again as I watched Midway Energy, my largest holding, take on more and more new shares; and Zoic’s advice helped me over the last couple of years to understand that when a junior oil raises money in a public offering that that is a really good thing because it increases the overall size of the company.  This has the added benefit of increasing the average volume of shares traded which in turn makes all shares more liquid.  A great CEO with an established reputation, like Midway Energy’s Scott Ratushny, has been able to raise the investment dollars to create the momentum that makes a good value into a great investment.

In the end, the best strategy for trading junior and intermediate oil and gas is neither the value nor the momentum strategy alone.  Rather, in my view, the two strategies should be implemented together in an artful Jeet Kune Do of  (1) Momentum–buy winners:  I keep adding to my position of CPG; (2) Averaging down seeking value:  I kept buying MEL (when it was still TFL) as it plummeted in price; (3) Buy and hold:  I watched MEL go from 0.39, my lowest price, to $5.19 (and am still holding).   Junior oils are too volatile to cut losses early, and I’ve found for the last four years as a junior oil investor, that my overall gains far outweigh my losses.

What works depends as much on the investor, his liquidity, credit limit, available margin, size of portfolio, as it does on the style of investing.  I rarely cut my losses.  I don’t see that ability as the mark of good investor.  The mark of good investor is perhaps better described as an even keel temperament to do the right thing without allowing the market to determine his next trade for him.  According to the legendary martial artist, Bruce Lee, the best style is no style–consider how these words fit investing:

Too much horsing around with unrealistic stances and classic forms and rituals is just too artificial and mechanical, and doesn’t really prepare the student for actual combat. A guy could get clobbered while getting into this classical mess. Classical methods like these, which I consider a form of paralysis, only solidify and constrain what was once fluid. Their practitioners are merely blindly rehearsing routines and stunts that will lead nowhere.

I believe that the only way to teach anyone proper self-defence is to approach each individual personally. Each one of us is different and each one of us should be taught the correct form. By correct form I mean the most useful techniques the person is inclined toward. Find his ability and then develop these techniques. I don’t think it is important whether a side kick is performed with the heel higher than the toes, as long as the fundamental principle is not violated. Most classical martial arts training is a mere imitative repetition – a product – and individuality is lost.

When one has reached maturity in the art, one will have a formless form. It is like ice dissolving in water. When one has no form, one can be all forms; when one has no style, he can fit in with any style.

“I never recommend a trade”, Mark D. Wolfinger

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Mark D. Wolfinger is an experienced options trader who kindly offers his expertise to others.  His blog, Options for Rookies, has excellent advice about buying and selling options, including information on doing spreads like condors and collars–strategies I don’t use because I am a seller of put options.

Recently, he has made the following comment on his blog about recommending trades, which applies not just to options but also to all trading:

As you know, I NEVER recommend a trade. That violates one of my core beliefs:

When someone sells a trade recommendation, the advice seller probably believes the trade will be profitable. However, ultimate profitability is not only dependent on the trade chose, but also depends on how it is managed. That salesman may be able to turn a profit, but that does not mean that you would. Your pain threshold is lower and there would be many instances in which you exit with a loss and he holds and earns a profit.

He claims a profit for his followers and all you see is a loss. Do you understand why that happens?

Each trader has his/her own comfort zone, trading goals and the ability to withstand a loss. Each would exit the trade at a different time. Each is at a specific point in life – perhaps raising a young family or retired. Perhaps wealthy or struggling. No one who understands trading would suggest the same trade to every person. Yet, that’s what these gurus do.

The post in which these lines are found is called, “Risk Management for the Small Trader” in which he recommends that options trader have a minimum of $10,000 trading cash and preferably twice that amount because the newbie with $5000 or less will have just enough cash to enter positions but insufficient cash to manage them well.

His advice about the management of trades applies also to stocks.  If new traders, who enter a stock with the hope that it goes up quickly, sell  it when it goes down 15%, they will likely lose that cash forever.  If they average down, and I believe in such a strategy, then they will be much less likely to lose money as a trader–even the black swan event of the market drop of 2008-2009 could have been overcome with a strategy of averaging down on losing positions.  But alas, if you have only a limited amount of cash, then that strategy won’t work, because you shoot your wad in the first instance, and there’s nothing left with which to average down.

Dennis Gartman’s first rule of trading: A commentary

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Dennis Gartman’s first rule of trading:  “Never, under any circumstance add to a losing position…. ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!”

Horizens AlphaPro Gartman Fund (source TD Waterhouse)

Dennis Gartman is a colorful media figure who apparently has a trading business on the side.  Fabrice Taylor, in an article in the Globe & Mail, “Dennis Gartman needs less talk, more action“, points out that for all of Gartman’s media presence, he doesn’t do all that well as a fund manager.  The Horizens AlphaPro Gartman Fund (HAG.to) closed at $9.00 yesterday.  Fabrice Taylor, critical that Gartman’s fund was still at only $9.12, wrote almost a year ago (Nov. 30, 2009):

But the market is up 30 per cent since the fund launched. What’s up with that? Mr. Gartman didn’t get back to me, but the people at Horizons AlphaPro tell me the fund is intended to be market neutral, meaning it won’t move with the market. Why? Because it’s long and short, and supposedly constructed in such a way that the market’s performance has no net effect on the returns. The only thing that does have an effect, in theory, is the manager’s skill. It may be early days, but Mr. Gartman’s performance has been found wanting.

He’s expected to return between 6 and 12 per cent regardless of the market. Eight months in, he’s nowhere near that. …

Nearly a year later, he’s still nowhere near that point.  I thus view Gartman with a great deal of skepticism, particularly because he shorted Berkshire Hathaway, calling Warren Buffet an “idiot” on account of his (Buffet’s) buy and hold strategy.  Gartman explains his first rule:

Averaging down into a losing trade is the only thing that will assuredly take you out of the investment business. This is what took LTCM out. This is what took Barings Brothers out; this is what took Sumitomo Copper out, and this is what takes most losing investors out. The only thing that can happen to you when you average down into a long position (or up into a short position) is that your net worth must decline. Oh, it may turn around eventually and your decision to average down may be proven fortuitous, but for every example of fortune shining we can give an example of fortune turning bleak and deadly.

By contrast, if you buy a stock or a commodity or a currency at progressively higher prices, the only thing that can happen to your net worth is that it shall rise. Eventually, all prices tumble. Eventually, the last position you buy, at progressively higher prices, shall prove to be a loser, and it is at that point that you will have to exit your position. However, as long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly.

With all due respect, I doubt that averaging down is what killed those companies.  Usually what destroys investment companies is unwise use of leverage.  In my view, the goal of business is to be in business tomorrow.  So I don’t tend to use leverage for momentum stocks but for income stocks.  That way, short of a dividend cut, I will always be able to pay the interest and I won’t have to go bankrupt.  In addition, it is probably unwise to depend on the margin in your account to cover the leverage.  More credit (such as a HELOC) has to be laying in wait to cover a margin call, if God forbid, the market drops to that point.

Averaging down vs. Gartman

So Gartman says never to average down.  Never buy more of stock when it goes down–the market is telling you that you are right when you buy stocks on the rise.  Yet my experience teaches me that this is wrong.  Consider the following positions that I averaged down on during the last two years since the beginning of the crisis:  Western Gold Fields (WGI.to, now NGD) up 252.33%; Crescent Point (CPG.to) up 37.28%, plus 7% dividend; NAL Oil and Gas (NAE.un.to) up 16% plus 8.6% dividend; Barrick Gold (ABX) up 45%; Midway Energy (MEL.to, formerly TFL) up 294%; Great Plain Exploration (GPX.to) up 30%.  Some of my picks are still weak, but nothing is losing me any substantial capital.  Overall, the current positions in the portfolio are up over 62.3% above my book value.  By Gartman’s rule, I should pick my own style of trading over his, since his fund is still in a net zero position over the same period.

Why does averaging down work for me?  Here are some rules for averaging down:

(1) It is not a good idea to average down on stock that is in trouble. I did not average down on BP.  Nor Nortel.  Nor would I have averaged down on BreX or Enron. I sold my Enbridge (ENB.to) after the first oil pipeline spill (though that turned out to be wrong); I dropped Centerra Gold (CG.to) after the coup in Kyrgyz Republic (also wrong).  And I am thankful that the dot.com stocks collapsed before I began trading, but I doubt seriously I would have been caught in that mania.

(2) Begin with an appreciation of the value of a company. Perhaps it is an income stock like CPG.to or NAE.un.to.  Perhaps a junior oil company with a good team of proven oil men (like MEL.to).  I like commodities because my hunch is that fiat money will diminish in value while commodities will retain their value.  So I like trading gold mining stocks.  I now begin by easing into a long position or selling a put option to reduce the cost of entry.

(3) Understand that the market is not only sometimes wrong but often wrong.  Gartman’s point that a trader should let the market tell him whether he is right must be refined.  The market may be right over the long haul but in the short run, it is usually over buying or over selling.  The dictum of Buffet is better, “Be fearful when others are greedy and greedy when others are fearful”.  This is clearly saying a contrary message to Gartman’s first rule of trading.  The reason Buffet’s advice works is that, as  he learned from Benjamin Graham the author of The Intelligent Investor, publicly traded companies have two values:  (i) the value that the market places on it; (ii) the value it has based upon an evaluation of its balance sheets and its potential earnings going forward.  This second value, which is the most overlooked during periods of market insanity, represents the worth of the company if it were to be bought in a private sale.

(4) Pay attention to book value. Book value (a.k.a., shareholder’s equity) is an very important consideration.  Graham recommends that a defensive investor never buy stocks that are selling at a price to book of more than 1 1/2 times. He also taught that buying a company at a  price to book ratio of 1.0 means that the buyer is getting the company for nothing, for the buyer pays only for the shareholders’ equity, at a one to one value, but pays nothing whatsoever for the company’s future profits.  During the 2008 market crash, many stocks were selling at below shareholders’ equity.  An averaging down strategy makes it possible to take advantage of such deals.  But paying attention to book value saves the investor from sinkholes like the dot.com companies which often had negative book values.

(5) Maintain sufficient cash or credit to be able to average down.  When I first started trading I would shoot my wad and then there would be nothing left with which to average down.

(6) It is permitted to “average back up”; i.e., to take profits from the stocks as they come back up, especially when it helps to reduce leverage.

The successful DIY investor

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Would you have bought this stock in January 2009? If yes, you too could become a DIY investor

Both Preet Banerjee at the Globe and Mail (see also his Lap of the blog) and Jonathan Chevreau at the National Post have written recent articles recommending that DIY investors use financial advisers.  I chose to step out completely on my own a few years ago, moving all our assets from full brokerage accounts to DIY discount brokerage accounts–the transfer fees were all paid by the receiving firm as a incentive to move our assets.  That was February, 2007.  Since that time, our retirement accounts are up a total of 154%.  I have also done well in our TFSA’s (up 40%) as well as our non-registered accounts.  Thus, I am not in the least tempted to follow their advice because I am confident that I can do well without a financial adviser.

I have learned through experience and here are some things that make DIY investor successful:

(1) Financial education:  I’ve learned through reading as much as I can from blogs and internet Newspapers including the Financial Post and Global and Mail financial page.  I’ve a limited number of books.  Benjamin Graham, The Intelligent Investor and Neill Ferguson, The Ascent of Money.  This is time consuming work, and those who don’t have the desire or the time to do it, should probably stick with index funds or a full-service financial adviser.  I’ve also occasional taken advantage of seminars or webinars to increase my knowledge–but these can be expensive so I am careful about them.

(2) Control of cash flow and leverage:  It is important to understand and control cash flow.  For example, it is probably a bad idea to buy a momentum stock using leverage.  You can never tell whether it is going to go up or down and the hold period may be much longer than expected.  By the time it goes up, the return may be greatly diminished by the interest paid.  However, it is much safer to use leverage to buy a dividend stock–as it can cover or exceed the interest rate during the entire period that it is held.

(3) Accurate tracking of results:  I keep track of such things as total net worth, total net sales of stocks, total value of stock portfolio and its net gain or loss, total debt to equity ratio, and the total amount invested in each sector (e.g., oil & gas, mining, food, banks, cash-GIC-bonds).  This makes it possible to know whether my strategies are effective or losing money and it helps me to manage risk.

(4) Specialization.  I can’t know everything about every sector.  So I invest most heavily in the oil and gas sector and am becoming more comfortable with how to evaluate the risk of buying into an energy company.  I do rely on published reports by professional analysts (at TD Waterhouse and Scotia Capital).

(5) Familiarity with different trading and investing strategies.  I use the following strategies:  Averaging down, selling of cash covered puts, and value investing–particularly the attempt to buy companies close to book value, a.k.a. shareholder’s equity.

(6) Control of emotions.  The best investors are probably not always geniuses; it is probably incorrect to say that the reason Warren Buffet succeeds is because he is smarter than everyone else.  Rather, it is his ability to control fear and greed.  He can bring himself to buy when everyone else is selling and to sit on cash while everyone else is buying.  A DIY investor must be cool and collected and must be able to buy into market when all the numbers are red and sell in a market where all the numbers are green.  My most successful move was averaging down on a company whose book value per share was $3.40 but its market price had dropped to a tenth of that: that was Trafalgar Energy (now MEL).   One day it fell so low that I called their office in Calgary and the investor relations guy said that they were still generating positive cash flow.  So I overcame my utter fear of loss and bought thousands of shares that day and the next.  It turns out that it may have been the trade of a lifetime.