HTCH Principle 1

“There’s no luck to professional portfolio investing.  It is a craft, involving thousands of decisions a year.  You can no more pile up a superlative record by luck or accident than you can win a chess tournament by luck or accident.”   -John Train in The Money Masters¹

At Adams Financial Concepts, we have managed to achieve superior performance for our clients over the long term. We do not believe in averages. When your head is in the oven and feet on a block of ice, your average temperature is normal. The economy and the markets are not average. They deliver multiple shocks like pandemics, great recessions, and high inflation. We want our clients to maintain or improve their quality of life, all of their life. We feel it may be more important now if inflation picks up steam as it did in the 1970s. We believe the probability of that happening is better than 50-50. The 5% or so performance achieved by most financial planners and financial advisors² will probably fall short of keeping up with longer-term inflation.

Our strategy is based on three principles.  The first principle is to search for equities that have twice the upside return compared to the downside risk. Here is an example that shows the principle:

Buy one share of three different stocks each with twice the upside as downside risk. If each stock costs $10, that would mean this:  upside to $20; downside to $5.

Beginning Portfolio:

A                           $10

B                           $10

C                           $10

Portfolio              $30

If only one stock works out, and two fail:

A                           $  5

B                           $  5

C                           $20

Portfolio              $30

Conventional wisdom on Wall Street says, if you want to make money, you must be right 66% of the time. This shows if you are right 50% of the time, you can make some money.

In 1992 I purchased Hutchinson Technologies stock for clients. The purchase price was between $9 and $11 per share. For the next 4 years the price of the stock fluctuated from $9 to $11. The revenues and net income continued to increase. The chart of the stock price looked like the EKG of a dead person. It just bounced between $9 and $11. The fundamentals continued to improve, but the stock did not move. The stock market (S&P 500) increased from 403 to 651 (up 61%) during those four years. Then beginning in late June 1996, the stock surged from $9 to $29 in early August. From an average price of $10 to $29, that was a compounded annual return of 32% versus 13% for the S&P 500. The stock tripled while the S&P 500 was up 61%.

On the other side, I added 3-D Systems to client accounts. Also purchased for an average of $10 I also held for four years. Unlike Hutchinson Technologies, 3-D systems fundamentals changed during those four years. Each time it happened I evaluated the changes and held the stock. I did at least until the third time and at that time I sold the stock for around $8 per share.

Although the times the stocks were held, the time and value illustrate the first principle concept. One worked and one failed. Thinking of principle 1 with one stock that worked and two failed I can get that with one share of Hutchinson and two in 3 D Systems: $10 in Hutchinson Technology and $20 in 3 D systems. One went to $29 and the other to $8. The illustration shows $30 invested and $45 when sold.

This illustration shows how Principle One does work.

We believe this principle works in conservative, as well as moderate and aggressive portfolios. Seeking stocks that could double or fall 50% is not aggressive. Consider some bluest of blue-chip stocks and their highs and lows over the last 52 weeks.

These are all Dow Jones stocks. The column in the center shows the price as which each of those stocks would have had twice the upside and downside in the past 12 months. It is not just aggressive stocks that have that property. It is every stock – aggressive, moderate, and conservative.

It’s just math.

For the table above the 2X – 1X price was figured by looking backward at what the stocks had done. The issue is looking forward to the next five years.

Hutchinson Technology illustrates another aspect of stocks I like. It was the low price for four years. It allowed clients to add to the positions at the low price. They could add for four years at the lower price. Most people would have been happier to see the stock zoom from $10 to $25 right after they bought it. They would have been happy to add to the position at $25.

In the case of the first person adding $10,000 a year to the position, they would have added 1,000 shares for four years. At the end of four years the value would be $116,000 when the stock was $29. For the second person who added $10,000, they would have had only 2,600 shares (1,000 at $10 and 400 shares at $25 for three years). Instead of $116,000 they would have $75,400.

Yes, it can be very discouraging to see the stocks hang down for some time, but there is an advantage. Even when no additional cash is added to the portfolio as some stocks go up there will be a rebalance sometimes to the stocks whose price has not increased but the fundamentals have gotten better.

It takes patience. I held Hutchinson Technology year after year. The markets were increasing, and Hutchinson Technology’s price was not moving at all. I sometimes wonder how many people gave up in those three years and moved to another stock. They missed the big move.

Conventional wisdom on Wall Street says, if you want to make money, you must be right 66% of the time. This shows if you are right just over 33% of the time, you can make some money.  Being right half the time can deliver superior results. Of course, I have to say that past performance is no guarantee of future results.

Principle one has worked over the years, and I believe it will continue to produce superior returns in conservative, moderate and aggressive accounts.

Notes

1. The Money Masters by John Train, 1980: Revealed the unique investment styles that have made Buffett, Templeton, Price, Fisher, and Lynch each whom delivered results that distinguished them from the crowd.
2. The 5% is based on the Cerulli Study for 2010 and 2011. It is also based on the SEI study for 2015, 2016, 2017, and 2018. It is also based on the Think Advisor Magazine study for 2021.