Buisiness card
David Fried
May 26, 2008 
 
Buyback Strategy version 1.2 -- new and improved!

Dear clients and friends,

 

Photo 2 At first glance, the two statements above might appear to be a contradiction. Maybe if it ain't broke, don't fix it, but that doesn't mean we can't or shouldn't adapt and adjust along the way?

 

The economic events of the past six months have caused many of us to reexamine our businesses to see how we can do things better, faster, cheaper etc. Most business people have been busy for a few months redoubling their normal efforts to deliver more value to their customers and clients. The current climate demands it.

 

My investment/asset management business is no different. As the weeks unfolded last fall and dismal financial news stacked up, I wondered if or how I could have foreseen the problem, how my Buyback Strategy should adapt to deal with it, and what I might do differently to position my clients to be in the best spot for the future. None of us has a crystal ball, but how could I adapt to the changing financial climate to emerge as the strongest?       

 

Here's an example of what drove me: Last October in the middle of the financial meltdown, we were forced to sell JANUS FUNDS (JNS) when the company announced that it would suspend its stock buyback program due to business conditions. We sold Janus at that point at $8.55 a share (JNS ultimately bottomed at $3.73!). We had made an initial purchase of Janus on 11/2/2005 at $17.86 a share, so the sale at $8.55 produced a loss of 52%. However, it gets worse. Just about a year earlier, on 11/6/2007, JNS closed at $36.80, which was a little more than double our investment. Seasoned investors know it is not possible to consistently buy at the exact high and sell at the exact low. Nonetheless, selling a stock that had doubled for a loss of over 50% is unacceptable, even for an investment strategy with our superior track record.

 

It is my job to stick to my investment strategy and not be emotional about buying and selling stocks. Even so, this particular trade made me sick. There had to be way I could adjust the discipline without "fixing it" and possibly breaking it. In November I set out to figure out how I could avoid losing large profits that had been achieved. In short, while recognizing that one never can consistently buy at a bottom and then turn around to sell at a top, I wanted to find out how -- and if -- it would be possible to sell nearer to a high.

Before I go on to describe some of the process and results, I will answer the question that most of you are probably asking at this point: Why now? The answer is that the Buyback Strategy has worked remarkably well over an extended period of time.* Perhaps, in a sense, we were a victim of our own success, our investment system had worked so well for so long that we trusted it even in a disrupted environment. For example, as of the end of 2007, our Buyback Strategy® had aggregate gains from inception (1/1/98) of about 198%, almost 4 times the 52% gain for the S&P 500 for the same time frame! In 2008 we were down about 11% vs. a 22% decline for the S&P at the end of September.  2008 was unfolding in textbook fashion for our strategy. We typically gain about 10% more than the market during up times and decline about 65% of what the market decline is in down markets. Therefore it makes no sense to try and time the market on a wholesale basis as there is a 65% reward for being correct and a 110% penalty for being wrong. In other words, I would have to be correct two out of three times on market calls just to break even! That is a sucker's bet and a bet I did not want to take at that point.
 
What ensued in the financial markets -- a total credit and liquidity freeze -- was not predictable. Worse, the consequence that this particular scenario had on portfolios was counterintuitive. One would expect that investors would hold onto quality companies with good prospects, and investors would sell the stock of speculative companies. Unfortunately, as the markets went down, stock in speculative companies had become, in many cases, next to worthless. The result was that investors who were leveraged and had to raise funds had no choice but to sell the quality companies as there was at least a liquid market to sell into, albeit at distressed prices. The result was a decline of about 40% in our managed accountsfor the October-November time frame!
 
We concluded that the strategy "ain't broke," as two months (no matter how awful) in an 11+ year history does not qualify as "broke." Additionally, the strategy has resumed working as it did before the meltdown as our managed have out gained the S&P 500 by about 10% since the end of November.*
       


Before I go on to describe some of the process and results, I will answer the question that most of you are probably asking at this point: Why now? The answer is that the Buyback Strategy has worked remarkably well over an extended period of time.* Perhaps, in a sense, we were a victim of our own success, our investment system had worked so well for so long that we trusted it even in a disrupted environment. For example, as of the end of 2007, our Buyback Strategy® had aggregate gains from inception (1/1/98) of about 198%, almost 4 times the 52% gain for the S&P 500 for the same time frame!* In 2008 we were down about 11% vs. a 22% decline for the S&P; at the end of September. 2008 was unfolding in textbook fashion for our strategy. We typically gain about 10% more than the market during up times and decline about 65% of what the market decline is in down markets. Therefore it makes no sense to try and time the market on a wholesale basis as there is a 65% reward for being correct and a 110% penalty for being wrong. In other words, I would have to be correct two out of three times on market calls just to break even! That is a sucker's bet.
 
What ensued in the financial markets -- a total credit and liquidity freeze -- was not predictable. Worse, the consequence that this particular scenario had on portfolios was counterintuitive. One would expect that investors would hold onto quality companies with good prospects, and investors would sell the stock of speculative companies. Unfortunately, as the markets went down, stock in speculative companies had become, in many cases, next to worthless. The result was that investors who were leveraged and had to raise funds had no choice but to sell the quality companies as there was at least a liquid market to sell into, albeit at distressed prices. The result was a decline of about 40% in our managed accountsfor the October-November time frame!
 
We concluded that the strategy "ain't broke," as two months (no matter how awful) in an 11+ year history does not qualify as "broke." Additionally, the strategy has resumed working as it did before the meltdown as our managed have out gained the S&P 500 by about 10% since the end of November.*

 
Up until this point, we had held onto a stock until the share repurchases waned and we continue that practice as it has served us well. Yet at the same time it was apparent that we want to capture more of the potential gains available to our investors. In short, we chose to take last year's lemons and make lemonade, by adapting. We started by analyzing all the trades we had made since 2001. We found that our average trade netted a profit of about 5.7% (this during a period of negative returns for the market) and was held about 270 days. We began to experiment with stop-loss points to see if that would add or detract from results, and determine what should be those stop-loss points. We found that a stop-loss of 20% below the purchase price raised the average gain per trade to about 6.5%, an increase of about 15%. Using this as an additional sell trigger in the case of Janus Funds, we would have netted a loss of 20% ($14.28) instead of the 52% loss that was realized. Improved, but still unacceptable for a stock that had doubled.
 
We then set out to see what would improve that part of the equation. The trick in doing this was to find a stop-loss percentage that would not be so tight as to lead us to sell stocks that would wind up to be big winners, and not be so loose as to give up too much of the gains. Through experimenting and statistical analysis, we discovered that a trailing stop-loss of 25% that was raised as a stock went up did the trick.
 
Referring back to the Janus example, again we would have sold at $27.60, a 54% gain (and a hold period of about 2 years instead of 4 years) instead of a 52% loss. Using this additional method, our average gain per trade went up to about 7.5%, a 31% increase over the original 5.7%. More importantly, these stop-loss rules further shortened the hold time to an average of about 140 days. The shortened holding period is also important because it allows for more trades and therefore more profit to be made. 
 
So we have adapted our strategy, and it will make us -- and you -- stronger. We continue to search for other ways to adjust the buy and sell parameters that add value. We have indeed found additional methods, but the description of them gets arcane and statistical and would be very difficult to describe in this format.  
Our adjusted selling discipline does not change the basic strategy -- being invested in a portfolio of companies that repurchase their stock -- remains unchanged.   
 
"The difference between genius and stupidity is that genius has its limits."
--Albert Einstein
 
While hindsight is always 20/20, the stupidity engaged in by many of our banks and lending institutions was unlimited, and would still be ongoing had the system not crashed. We hope this won't happen again for a long time. Unfortunately, we know it will happen again eventually and when it does, our new stop loss limits and more finely tuned discipline should help limit damage a great deal. In the meantime we expect our returns to be enhanced compared to what they would have been without the adjustments.*
 
One final note: You may have noticed there has been more trading than usual in your account. This will continue for awhile as we reposition the portfolio to reflect the changes
 
Thank you for your continued support, confidence and trust. As always, please call any time you would like. We are here for you at 310-459-9196. You can be assured that we will continue to ply our craft and to look for additional ways to enhance our strategy.
 
David Fried
Fried Asset Management, Inc.
 
*Past results are not a guarantee of future performance.