This article is about how, and why, I focus on the medium-term, rather than the short or the long-term when investing in stocks.
Medium-term investing has several advantages over both short, and long-term investing.
Medium-term investing is more attuned to the business and credit cycles than long-term investing.
Medium-term investing makes it easier to buy stocks when the prices are low and to avoid buying stocks when the prices are high.
Medium-term investing makes it easier to face up to one's mistakes and learn from them than long-term investing does.
My investing approach is fairly unique. It also underpins virtually everything I write about on Seeking Alpha. The combination of those two facts means that many times readers aren't aware of the philosophical foundations that are working behind the scenes of the ideas I write about. This can sometimes lead to misunderstandings. Usually, those misunderstandings get hashed out in the comments section, but I think having a readymade explanation of what I'm trying to accomplish will be useful as well. Additionally, writing out one's philosophical assumptions and basic investment strategy is a good practice in and of itself because it can serve to clarify and sharpen exactly what it is one is trying to accomplish while investing.
My basic approach to investing involves trying to find certain areas where I am well suited to get better than average performance. The first step in doing this is to define "average performance". I usually define average performance as the total return of the S&P 500 index. (I would also be open to using a total stock market index, but it's a little easier to use the S&P 500 because more people use it and because the data is more easily accessible.) For those investors who are retired and who are investing for income, I would use a different definition of average performance, but I am going to set that discussion off to the side for now and save it for a future article. For now, we're focusing on those investors who are still in the accumulation phase of investing (like me).
I know, as an investor, that there is good evidence that I can put all of my money in an S&P 500 index fund that charges low fees (SPY) (VOO), and expect to have a reasonable annual return over the long-term of around 6-7%. So, the question I ask myself is: "How can I do a little better than that?"
I think there are five main ways I can do a little better. I can choose alternative indexes that have a history of performing better than the S&P 500 over the long-term. I can assess the business cycle better and behave accordingly. I can avoid below-average companies and/or management. I can avoid owning high-priced stocks. And I can buy low priced stocks. My view is that if I can do even a little better than average in those five areas, then I can consistently and significantly outperform the market while taking less risk. Four out of those five ways involve investing over the medium-term, and that's why I focus the vast majority of my efforts trying to determine where a stock or ETF might be 3-5 years in the future.
Tilting Indexes In My Favor
The idea behind tilting indexes in my favor is that there are some indexes that have a long history of outperforming the market. Seeking Alpha contributor Ploutos has written extensively and convincingly about these factor tilts, which include Dividend Growth, Equal Weighting, Small-Cap, Value, and Low-Volatility. Collectively they have outperformed the S&P 500 index on average 4% per year. Even if we only achieved half of that historic outperformance, and expected 2% per year, by investing in these indexes instead of the S&P 500, we could boost our 6-7% annual return up to 8-9%. Over the short-term, this is a little better than average, but over the long-term, compounded, this is exceptional outperformance.
What this means for me is that instead of my 'default' position being the SPY or the VOO, my default investing position should be in an ETF that represents one of the factor tilts Ploutos describes. And if I had to choose only one, it would be the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP). According to Ploutos's research, the underlying index has outperformed the S&P 500 by 3.7% over the long-term. I don't see any reason to think that outperformance couldn't continue into the future. Even after one deducts expenses, it has still outperformed the S&P 500 by about 50% over the past 20 years or so. That means if one had built a nest egg of 1 million dollars using just an S&P 500 index fund, then they could have had a nest egg of 1.5 million by using the RSP instead.
The way I think about this is that unless I have a good reason to think I can outperform, then my default investment should be the RSP (or similar ETF). I call it a default position because it can be trumped if I can find better opportunities in the market-place using medium-term investing. If that happens, I will invest in those opportunities instead, but if I can't find anything, then it makes sense to simply default to the wisdom of the market instead and to try to get that 8-10% annual long-term return. In this sense, I suppose I'm 1/5 long-term investor, as long as one recognizes that medium-term investing always gets priority when I find something better available.
Accessing Market Cycles
The fact is, many investors don't pay much attention to market cycles when it comes to their investment strategy. This opens up an opportunity for those who do pay attention and can roughly identify where we are at any given time in the cycle. I've noticed two distinct groups of investors and two potential mistakes they may be making with regard to these cycles. The first group, mainly retail investors, are either ignorant of the cycles or disregard them as completely unimportant or too unpredictable to be useful. The second group, mainly professional investors or traders, attempt to get too precise in their cyclical predictions and make bets that are too time sensitive. Then, if their timing is off, they lose money or underperform the market. I think there is room for a third option and that is where I try to position myself.
My view is that if I can simply get close to knowing where we are in the market cycle, and if I position my portfolio a little better I might be able to do a bit better than average. And, that if I can avoid making time-dependent investments, then I can have more margin for error in my cycle assessment. I break the market cycle down into four stages of Transition, Early, Middle, and Late.
I want to keep this really basic and just sketch out roughly what I'm talking about with regard to market cycles. Given that we increasingly have a credit-driven economy, using the Fed Funds Rate is a good way to hopefully illustrate my basic point that having a rough idea of where we are in the market cycle is not impossible. I'm going to begin by describing some of the periods we've gone through the past twenty years beginning with transition periods.
Transition periods are generally characterized by a rapidly falling Fed Funds Rate. We see this happening from ~mid-2000 to 2002, and from mid-2007 to 2009. During these periods the market and the general economy are in decline and contraction. These are reasonably easy periods to identify while they are happening, but the problem is that they can be very rapid declines and it can be very hard to predict at what point the declines and contractions will stop. My approach to dealing with these transition periods is two-fold. The first is to get more defensive with regard to my 'default' position before we get to a transition period. This involves rotating out of an ETF like RSP and into what I consider to be more defensive ETFs like PowerShares S&P 500 Low Volatility ETF (SPLV) and the Vanguard Utilities ETF (VPU). (At least this time around these look more defensive. Next cycle, something else might look better.) The goal here is for the defensive positions to fall a little bit less than the 'default' ETF. Ideally, my goal is for the defensive position to fall 20% less than the default position. So, if RSP or SPY falls 25%, then I would like my defensive ETFs to only fall 20% during the same time period. If the transition period lasts a couple years, then perhaps we are talking about outperformance of 2.5% per year over this specific time period. Again, this doesn't seem like a lot, but it adds up over time and compounds. Also notice that this is a medium-term strategy. It's not claiming that the market will go up or down over the course of a few months, but rather it is generally trying to adjust for what might happen over the course of 2-3 years. It doesn't have to be exactly right in order to have a high percentage chance of modest outperformance. It just has to get close.
The early-stage of the market cycle generally has low yet stable interest rates while the market makes a V-shaped bottom. We saw this from ~2002-2004 and ~2009-2011. This is a great time to buy high-quality stocks at low prices. Ploutos has shown that value tilted ETFs tend to outperform during these periods, and rotating from defense into value could be an opportunity to increase one's performance by another couple percentage points.
The middle-stage is characterized by economic growth, a market where prices have mostly recovered from the downturn, and, eventually, rising interest rates. This is a period where the market is mostly near equilibrium and things are going as they should. Usually, the middle-stage lasts the longest of all the stages, ~2004-2006, and 2012-2017, I consider middle-stage, and 2018 might end up middle-stage as well, we'll see.
The late-stage is characterized by interest rates that have been rising for the previous 2-3 years, the stock market at all-time highs, high credit balances, and strong economic growth. Previous late stages would have been from ~1999-2000, and 2007-2008. I think we are in or approaching late stage now, and that the current question is how long we have until the market falls and we enter the next transition period. It's virtually impossible to know this, but if I assume that I'm early by a year on my assessment and that the late-stage lasts two years, then I feel very comfortable looking out three years and assuming a downturn will occur. That is why it was this year I started writing about how far stocks might fall if we were to have a downturn within three years. It's not that I'm trying to 'time the market', it's just that we are in a stage of the economic cycle where it is reasonable to consider a downturn over the medium-term, and the medium-term, unlike the short-term, is somewhat predictable.
Essentially, taking into account where we are in the market cycle is medium-term investing. It rejects the idea of many long-term investors that we can know nothing about economic and market cycles. And it recognizes that the argument "we can't know what the market will do one day, or one month, or even one year from now" is a straw-man. Warren Buffett might not know whether bitcoin investors will mostly lose money over the next day, or month, or year, but that probability shifts dramatically when go out 3-5 years. He can say more about that medium-term time period, and it doesn't have to be that bitcoin will go to zero, it might just be that the odds of bitcoin being valued less than it is now are very high in 3-5 years. As investors, we don't have to be any more precise than that in order to do better than average.
Buying Stocks at Low Prices
The above strategy is good for someone who always wants to be fully invested and who doesn't want to own individual stocks. Personally, however, I think that on occasion the market temporarily misprices stocks over the short-term (0-2 years) and that I can take advantage of those mispricings if I am willing to invest over the medium-term (~2-5 years). I am not one that thinks the market usually misprices stocks beyond the medium-term. For this reason, my default will be an index of some kind as discussed above, but whenever I find a company that is good quality and under-priced that has a high probability of returning to a previously established price that is much higher, then I rotate out of the default ETFs and into the individual stocks until the stocks are trading back near fair value at which point the strategy is to rotate back to the 'default' ETFs.
These investments are generally weighted in the 1-4% range. It is not uncommon that one these investments can return 100% in less than two years. So each one has the potential to add 1-2% to the overall portfolio value in any given year. Again, this isn't a gigantic impact, and there will be some losers mixed there as well, but over time this can add up.
Buying stocks at low prices is a generally accepted goal among investors, what is more controversial is selling the stocks when they reach fair value. This is where investing for the medium-term differentiates itself from typical long-term investing. I assume that I can't forecast a company's earnings beyond 5 years. That means I need to find a different way to value a stock than attempting to calculate all its future earnings. I typically use two methods. The first is to find a previously established market price that 1) did not occur during a bubble and 2) that the stock has a high probability of returning to over the medium-term. I assume that any price higher than a previously established market price is higher than fair-value.
For example: On April 1st, 2016 I published the article "Cyclical Strategy Says Buy FMC ", and on August 3rd, 2017 I published the article "FMC Corp. - A Successful Cyclical Investing Case Study" at which point I took profits.
The reason I sold FMC was that it going into uncharted territory price-wise:
Its previous all-time high was in the spring of 2014, just over $80 per share. I sold when the price moved beyond that in August of 2017. Does that mean the stock was over-valued then? No, it does not. It just means that the stock wasn't clearly undervalued anymore, and I only want to hold individual stocks that I think are priced too low. If they are priced fairly, then I might as well own an index fund, all other things being equal.
That is my (simplified) method of valuing cyclical stocks. For other stocks that are less cyclical, I use a basic, long-term p/e multiple, or price/book, or whatever is the standard for that particular stock. I don't necessarily use that ratio to determine when to buy the stock (I have less traditional methods for doing that), but it is a good indicator of when a less cyclical stock has reached fair value. Let's take Apple (AAPL) for example.
On July 1st, 2013 I bought some Apple shares for my daughter's account because the price was low. Apple had fallen nearly 40% from its previous high.
It was one of the rare occasions where a large-cap stock was truly on sale relative to the rest of the market and relative to itself. The question then was when to sell the stock. Apple has only occasionally traded at its average 10-year p/e ratio over the past five years. Using my normal rules, I would have sold Apple somewhere around when it was trading at that average p/e ratio of 15.8. Let's take a look on F.A.S.T.Graphs so we can see what I'm talking about:
Okay, when the black line touches the blue line that is when Apple was trading close to its normal 10-year p/e multiple. One year after I purchased Apple near its lows in 2013, it was trading back near its normal p/e ratio, and it would have been reasonable to sell the stock at that point in time (the gain would have been around 70% in one year's time). I didn't, though. Mostly because I wasn't paying attention, but even though Apple was trading at fair value, it was still trading at a value price relative to the rest of the market (more on that in a moment). Instead of selling, I ended up buying more Apple at $109 per share in 2015, this time for my son's account, and I haven't sold either position, even though, as you can see, currently Apple overvalued a bit and needs to drop about 10% to bring it back to its historic p/e ratio.
Part of the reason I haven't sold the positions is probably just plain laziness on my part. I imagine that if Apple becomes 20% overvalued I probably will sell. But the other part of the reason is that relative to the rest of the market, which, if the Shiller P/E Ratio is used as a guide, probably needs to fall 50% to get to its historical P/E ratio, then Apple being 10% overvalued makes it a relative value.
The main point here is that in order to keep holding a stock, I need to be able to make the case that it is priced low. Preferably I base that judgment on the history of the stock itself, and perhaps sometimes, in rare cases like Apple, I base that judgment on the price and earnings relative to the rest of the market. I can't imagine ever holding a stock that was not priced low compared to both its own historical metrics and compared to the wider market as well. I have no commitment to holding Apple stock forever, and if the price rose high enough, I would sell it even if the business was still growing and looking good.
Avoiding High Priced Stocks
It should be obvious by now that if I rarely hold individual stocks at what I consider to be fair value, that I'm not going to hold stocks that appear overvalued, or that rely on long-term projected earnings growth in order to justify a current price that is historically higher than normal. The trickier part about this has to do with my 'default' ETF positions. There are occasions, like now, where nearly the whole market is overvalued based on historical metrics. Using my writings on SA as a guide, I only have 10% of the portfolio in individual stocks I think are good values still. If we include those stocks that I think are good relative values (Berkshire Hathaway (BRK.B) and Apple), then perhaps 16% of the portfolio is in individual stocks that I don't consider to be overvalued relative to the wider market.
Following what I have written so far in this article, that means 84% would be allocated toward defensive ETFs (SPLV and VPU are the two I've been writing about in my articles.). But I've never made the case that SPLV and VPU aren't overvalued themselves. Certainly, SPLV is, and probably VPU is too a bit. Do I really want 84% of my portfolio in ETFs I think are overvalued?
The obvious answer is "no", but the more difficult problem is that I don't know how long the market could stay expensive. And since I'm usually looking for low priced stocks and not fairly valued stocks, it might take even longer than normal for me to find places to invest. Ultimately, I have decided to simply split the difference, and defer to the market on the first 50% of the portfolio that I can't find individual stocks to invest in, but after that, whatever money I can't find a place to invest in underpriced stocks, I have decided to hold in cash.
Going back to our market cycle estimates, the portfolio breakdown might look something like this for each phase of the cycle:
Transition stage if it happened today: 50% defensive ETFs/16% individual stocks/34% cash equivalent.
Early Stage: 100% individual stocks
Middle Stage: 1-50% ETFs (like RSP)/50-99% individual stocks
Late Stage: 50% defensive ETFs/1-50% individual stocks/ 1-50% cash (cash is whatever isn't in individual stocks)
The idea behind this isn't to try to precisely time the market. If that were the case we would be 84% cash and 16% individual stocks. The goal is to do a little bit better than the market when it gets really overvalued and there doesn't appear to be very many values around. By holding some cash, in this case 34% worth, it should allow us to avoid really high priced stocks at least to some degree, without making a huge bet on the market. If someone would have been three years ahead and started holding cash in mid-2004, they still would have had an opportunity to buy the market at lower prices in 2008 and 2009.
Same goes for if someone was 3 years ahead in 1997:
And while the 1997 example doesn't appear to be all that great, one needs to keep in mind that cash was earning a lot more money during this time period. You could have made around 4% on your cash per year over this period.
At any rate, holding some cash when I judge the market to be over-valued is how I try to avoid holding stocks when they are priced too high. I also don't buy individual stocks unless they are at least 30% off their highs. The combination of those two strategies should keep me from buying the most overpriced stocks.
Avoiding below-average companies and management
If you haven't noticed, I care a lot about price. That is because, over the medium-term, price is ultimately how we measure things. There is no fall-back position about how great the company is, and how over the long-term the company is destined to convince Mr. Market of their worth. Nope, after five years, Mr. Market is the judge, jury, and executioner for me. But that doesn't mean that the businesses and management don't matter.
They matter a lot. I just tend to examine them from the opposite direction than most investors. Once you start looking at companies that have been around for over 25 years, you find good companies and good management are quite common. It's easy to find above average companies and even easier to find great companies. Those companies stand out. Good prices are what is hard to find most of the time.
Once we start looking at companies with cheap prices, we find far fewer great companies with great management and far more below-average companies or below average management. If I can find an average company with average management trading at below average prices, I'm perfectly fine making an investment over the medium-term. You don't have to have a company with genius management and an impenetrable moat if you are only attempting to forecast out 5 years into the future. If you are planning to "hold forever" you darn well better have both. However, I do agree with Buffett on the basic premise that you should only buy a company's stock if you wouldn't mind owning it even if the stock market closed for a while. The way I see it, the stock market could close for up to 5 years on any or all of these investments and I would be perfectly fine so long as I have avoided below-average businesses or below-average management because those are the stocks that don't rebound over the medium-term.
Before I wrap things up, I want to mention one more reason I invest for the medium-term that I did not cover above, but that I think is at least equally important. Medium-term investing allows you to learn from your mistakes more quickly than long-term investing. Even if one used 10 years as a basic starting point for their research instead of 20 or 30 years, I will know whether I have made a mistake with absolute certainty twice as soon as someone who waits 10 years before they declare an underperforming investment an error. This allows me to carefully analyze my process for mistakes so that it can be improved. The more reps one gets, the better they should become if they learn from their mistakes, and using a medium-term horizon helps with that.
Ultimately, medium-term investing has a lot of advantages over both short and long-term investing. (I didn't write as much about the advantages over short-term investing because people write about those all the time and this article is already very long.) In my view, other than having the potential to be completely passive and to be more tax friendly, long-term investing has no advantages over medium-term investing. Additionally, if one uses the same type of index as a default that a long-term investor would, and invests in tax-sheltered accounts, then long-term investing offers no real advantage over medium-term investing if one assumes the medium-term investor has slightly above average skill and temperament, combined with some free time.
That said, this article isn't intended to tell other investors how they should be investing. It is mostly to explain to my occasional critics why I invest for the medium-term, and also to show that we have more choices than choosing between short-term trading and long-term investing. Medium-term investing is a choice, too.
Disclosure: I am/we are long AAPL, BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This article is about how, and why, I focus on the medium-term, rather than the short or the long-term when investing in stocks.
Medium-term investing has several advantages over […]