“99% of the people buy right, but only 5% sell right”

This quote came from a grizzled old trading veteran who has long since passed.  In the early 1990’s I travelled to Austin, Texas on three different occasions to sit by this trader’s side and soaked in the wisdom of his 50 plus years of trading.  There are wonderful old quotes, sayings or stories in the investment business that have a bit of truism in them.

My old friend loved to tell me a story of the “Oracle of Montgomery”, as in Alabama.  The Oracle was the most successful trader in the region and was sought out by many for his trading knowledge.  One day a young man sought out the Oracle in the men’s washroom at a local hotel and asked him his secret of success.  The Oracle looked at the young man sternly and agreed to divulge his trading secrets.  The Oracle laid out price charts on the washroom floor, that were daily price charts of wheat, corn, and other commodities.  He took a gold chain from around his neck, which had attached a crystal orb.  The Oracle held the chain in his right hand and passed it over each chart.  He told the young man if the orb moved counter-clockwise over any of the laid out charts on the floor this would be his buy signal.  The young man looked intently as the Oracle’s hand went from chart to chart.  Having finished, the Oracle began packing up his stuff and placed the chain around his neck.  As he was leaving and almost through the bathroom door, he looked back at the young man and said, oh yes, if my trading position declines 5% I’m out of the position – no ifs, ands or buts.

There is so much wisdom in this parable that I didn’t mind my trader friend telling me this story three times with equal enthusiasm and energy.

So if a sell strategy is so important, why aren’t more investors focused on this?  The simple answer, from my personal experience and watching the experience of many other investors is selling an investment for gain or loss requires discipline.  Discipline is very hard for the majority of the population in any endeavor let alone investing or trading stocks.  The other aspect of selling involves a part of your brain we know little about.  It’s part of your brain pejoratively called “the lizard brain” or the amygdala.  This part of our brain was great for our ancestors to survive on the Serengeti however ill equipped for handling financial markets.  The flight-fright, adrenaline-dopamine response of the amygdala can have ruinous financial results of anyone participating in the financial markets.

Do you want a sell strategy?  Use our EBV lines!

A Review of our EBV Lines

Model price charts calculate Economic Book Values (EBV) zones or channels through mathematical analysis of the balance sheet to quantify support and resistance levels.  The advantage EBV lines has over other quantitative models is that it is not dependent upon empirical relationships, relationships which inevitably break down as the economic and financial environment changes.  Rather, it is built upon structural equations, equations that do not change over time or across companies.  These equations are part of a theory of how economic activity is related to the structure of an entity and how the economic process creates value.

Model price charts present this analysis in a graphical format, which integrates our quantitative research with the stock price.  The intent of this visual presentation is to assist in the analysis of securities without burdening the investor with numerical overload.  In this format, investors can quickly and efficiently assess their securities or screen for new ideas in a timely manner.

To briefly summarize this product, Model Price calculates fundamental trading channels which individual companies trade within.  Stock price movements are constrained by these channels, hitting resistance at the top to the zone and support at the bottom.  It is no wonder that the concept of “reversion to mean” is popular as it is a natural consequence of prices reacting to their channel limits.  The problem with blindly applying such concepts as reversion to mean is that the mean can change and what had worked historically no longer does.  In our framework, a company can change channels, rising to a higher channel on improving fundamentals, or falling to a lower channel on deteriorating fundamentals.  In fact, when a company does breech these channel limits, it is a powerful market indicator.

Two Case Studies

I have picked two long-term charts of two separate companies for you to review.  These two companies have had extraordinary market moves, however they were constantly giving sell signals to those who were willing to listen.

Research In Motion (RIMM)

Here is the long-term Model Price chart on RIMM.  RIMM went from $150 a share in mid 2008 down to a low of $6.22 a share just in the last few weeks.  I’m sure there are investors who have been holding RIMM since mid 2008, and have suffered losses as a result.  Did investors need to suffer such losses?

Research In Motion with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

On this long-term chart I have indicated sell signals, by a negative transit through an EBV zone or channel.  RIMM went from EBV+9 to under EBV-3, with each transit telling investors that something was wrong fundamentally with the valuation of RIMM.  I count 14 different sell signals given to investors.  Remember these transits are about the fundamentals NOT technical analysis, which sometimes our model price charts are confused with.

The second item I like to point out is our model price line.  Remember our model price line, is using analysts’ earnings estimates as an input to determine our model price or our definition of fair market value.  Notice RIMM as the stock was climbing from EBV+6 to EBV+9, between 2006 to mid 2008, far in excess of our model price calculation.  Probably indicating mean estimates were too conservative as the stock was climbing.  Also notice conversely, as RIMM was transiting down through our EBV zones, especially since the first quarter of 2011 as analysts’ seemed late in lowering their earnings estimates compared to the stock price.  We see this phenomenon quite often, as analysts’ do seem to follow each other as a group.  In these situations EBV transits are more meaningful then model price.

Crocs Inc. (CROX)

CROX was a high flyer until the end of 2007, before it started its’ long descend.  Here is the long-term model price chart.

Crocs Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

As I have pointed out there are 12 different sell signals on CROX, which occurred in 2008.  Also notice our model price calculation, perhaps too conservative in terms of median analysts estimates on the away up, and over optimistic on the way down.

The reason why I select CROX is look what happened once CROX went below EBV-3.  Notice how the EBV lines down trend in 2008, this signifies management wrote of something from its’ balance sheet.  Once the write-offs occurred CROX transited back up through EBV-3, which we call “Coming out of the Blue”.  The investment returns from EBV-3 to EBV+5 are almost 600% or a “6 bagger”.  Not bad.  This is why I highlight stocks coming out of the blue or a positive transit through EBV-3.

Use EBV lines as your sell strategy

If you have observed this business for any length of time, you will notice everybody talks or recommends buying strategies.  Nobody talks about sell strategies.  Or as the Oracle of Montgomery will tell you the buy strategy doesn’t matter, it’s the sell strategy that matters.  Selling is hard.  Unfortunately from my experience investors, traders do not employ a sell strategy, or worse hang on to the position in hopes of a turnaround or disinclined to realize a loss.  EBV lines are fundamental, in that they are derived from the company’s balance sheet, and as we overlay the company’s price series, information is being communicated to those who are listening and major losses can be avoided.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s