Disciplined Growth Strategy

Disciplined Growth Strategy

Though the following was written to advisory clients (a very few minor changes have been added to clarify the content for later readers who were not in the group of advisory clients being addressed), it contains concepts and information that should be both helpful and interesting. These clients were not traders. They were mostly retired and semi-retired individuals who sought greater than average growth in their portfolios. They did not want to learn the details about our investment strategies. Over time, we plan to discuss some of the details of high-performance investing. The following was posted here some time after we were no longer in the portfolio management business.

Introducing The Disciplined Growth Strategy

It is important to have an investment discipline. A discipline is a set of guiding principles and decision rules to be followed precisely because we do not really know what the market will do next. I’ve used this analogy before, but it bears repeating. The discipline is like the instruments used by a pilot when the weather turns bad. His instruments will tell him, even in a thick fog, whether the nose of the plane is up or down and whether it is turning left or right. Using those instruments, he can be sure he is flying straight and level, on course or off course. In other words, following the rules of our discipline will help us avoid a crash. We will not suffer much loss if the market plunges, but we will gain if the market surges.

If we buy at or near significant support (my “instruments” or charts tell me where regions of support exist), then our stop-losses can be placed much nearer our purchase price. If there are no clear levels of support, then Stops (our stop-loss calculating tool) will show us where we can place the stop so that it is just outside the maximum probable excursion of the stock (the probable excursion due to the “noise” or the normal non-significant and random behavior of the stock). Since it takes more than usual selling pressure to drive a stock below support or beyond a stock’s maximum probable excursion, we know that serious selling will be necessary to trigger our sell order. However, if our stop-loss is triggered, our loss will be relatively small. If it is not triggered, we will be in position to profit as the stock rises. The triggered stop-loss is the insurance premium we pay for protection while we participate in the market. We don’t always have to pay this premium, but sometimes we do. If we always make arrangements to protect ourselves just in case things get ugly, then we really have little to worry about besides when or where we will sell and how to make adjustments to our protection as the stock rises (Stops automatically generates this information). It is important to select only stocks that are near significant support. Every position should be taken with reference to a pre-defined stop-loss.

As you know, I have become extremely risk averse. We had a truly wonderful set of disciplines at one time. Both of these were value-based disciplines that had exceptionally good performance records. When your discipline can take $100,000 to nearly $1,000,000 while the market takes the same amount to just over $650,000, you have a very good discipline. Not only that, but we did it with utilities. The flaws in the discipline, if they can be called that, are that it was what I call mono-phasic, and that it was designed for a less volatile era. Historically, the market has gone through phases in which it alternately favored either value or growth investing as a means to portfolio growth. Mono-phasic disciplines designed around either investment style would generate decent results most of the time, even though one style of investing usually did slightly better than the other. The discipline was designed in such a way that an unusually prolonged period of bias toward growth would hurt performance. That is what happened. That is not all. The market was not only biased toward growth, but it was also biased against value. I cannot recall another period in market history when this has occurred. We also went through deregulation, which wreaked havoc with our utility discipline. As most of you will recall, those original models called for adjustments or “optimizations” on a quarterly basis. Thus, under-performing or overpriced stocks were automatically replaced each quarter. However, the new level of volatility in the market has rendered this approach unsatisfactory. A stock can decline precipitously between quarterly adjustments. At one time, this was rare, but now it is common.

The Disciplined Growth Strategy

For several years now, we have seen a very fickle and extremely volatile market. First, it trashed utilities when utilities were deregulated. We had been using a discipline that averaged 20% a year for about 15 years. With utility deregulation, the market panicked and dumped all utilities. Apparently, the assumption was that utilities were no longer “safe” investments. Actually, our recent measurements show that standard utilities (labeled as such in the utility sector of the S&P500) have less volatility than non-utility stocks and they pay much better dividends than most stocks. Also, many are returning to their “roots” as utilities. Therefore, they are indeed distinct from and less volatile than most common stocks.

The non-utility program we once used had averaged over 26% a year, but it stumbled when value stocks were “trashed” by the market (and the trashing lasted for over a year). Stocks that were undervalued just became more so. Portfolio managers who stuck to their disciplines (what we’re all supposed to do when the markets get rough) lost clients as well as money. Many managers fled value investing to go after growth stocks. Then the market slammed growth stocks, inflicting the Nasdaq with losses in excess of 60%. To summarize the last few years, we had the trashing of utilities, followed by the trashing of value stocks, followed by the trashing of growth and technology stocks. Finally, the market also “trashed” the analysts. At least, it turned the spotlight on various conflicts of interest regarding analysts and the nearly complete absence of “sell” recommendations before a severe bear market. Depending on the recommendations of analysts is not the path to making profitable investments. It hasn’t worked for the last few years, and it isn’t likely to work to an investor’s advantage in the future. In fact, it may be argued that this approach is more likely to feed investors to the sharks of the investment world. We capped this all off with the worst overall bear market in more than 40 years. The last four years have not been good to investors.

We believe that the stock market will maul any investor who does not have a well-defined strategy for dealing with its increased volatility and market “fickleness.” Many advisors and brokers say that they are disciplined investors. However, if a person cannot give a complete and precise articulation of his discipline, it’s probably because he does not really have one (even if he thinks he does). Simply saying that he or she buys stocks that are undervalued and sells them when they reach “fair value” is not describing much of a discipline. For example, I once read a Dean Witter mailer that said: “…Mid-Cap Dividend Growth Securities is managed with a disciplined approach that utilizes sophisticated investment screens designed to identify mid-cap companies deemed to offer an opportunity for solid growth.” It sounds like more is said than is actually the case. It says there is a discipline and that it is sophisticated, but little else. They look for companies likely to grow. Who doesn’t? The phrase “solid growth” sounds good but what does it mean? Is it better than “liquid growth?” All of this is hot air. Growth is growth, period. The question is, what discipline is used to obtain that growth while protecting assets, and how is that discipline executed?

Before I turned to full-time portfolio management, I spent almost all of my working time for three years developing, refining, and profitability-testing investment disciplines. As a result, I have tested more than 50,000 disciplines. That was my job and my main interest [I literally made it my full-time job for three years]. I gave these activities up in order to pursue a more active role in portfolio management. However, the increased convulsiveness of the market has caused me to revisit my old area of specialty. For over a year, now, I have been working on the development of a discipline (based on the findings of those three years of research) that is designed to thrive in a volatile market, and on how to structure it so that it can be implemented efficiently. In developing the discipline, the new levels of volatility and fickleness manifested by the market have been considered a given and “normal.” The first utility purchase under this “discipline in the making” was made on February 9, 2001 (while the system was still in its most rudimentary form), but we were kept in cash a few months longer in the non-utility portfolio. In June of last year, I began to pull the pieces of the discipline together into a much more cohesive whole. I called it the Limited Loss Discipline (but because the discipline is about more than simply limiting losses, I have changed its name to The Disciplined Growth Strategy). Since that time, the system has been greatly refined.

The system has muli-layered contingency algorithms, and possesses style-transcendent robustness. That is, it is not likely to be “trashed” by the next stylistic bias of the market. Also, a purpose incorporated in the design of the discipline is to protect portfolios against severe loss when a security or the market plunges (through the implementation of a rigorous stop-loss discipline).

Note to Web site visitors: We never implemented this “poly-phasic” discipline for clients. The “system” being introduced here (the Disciplined Growth Strategy) was the same one that Wendy Felt began using in her own portfolio at the time. Wendy’s experiences with the system over the following years, the returns it was capable of generating, and the inability of most our clients to adapt psychologically to the requirements of the disciplines involved, eventually led to our departure from the investment advisory business (see Q&A #10  for more information on this). The details of the system are proprietary. ~ Dr. Felt