Dennis Gartman’s first rule of trading: A commentary

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.

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The successful DIY investor

 

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.