Published on October 27, 2020

Between 2012 and 2014 I had been researching small oil and gas companies throughout Africa, Latin America and the Middle East and had assembled a basket of stocks and bonds issued by low-cost producers in those regions.  Oil had started coming off the highs in the earlier part of 2014, but my analysis had shown that even under much lower oil prices, these companies were able to generate sufficient cash flow to pay an attractive return to the bonds or stocks owned.  Despite taking unrealized losses on the positions through the year, I had the conviction that they would turn around based on my analysis of the fundamentals. 

I was wrong.  By the middle of 2015, nothing in the basket fared better than a 50% loss and most stocks were down over 80% in the carnage of the oil market of 2014 and 2015.  Oil had collapsed, and no one wanted anything to do with it.  My analysis had also been off in some cases too, and while many of the companies’ underlying assets were still productive and profitable, and arguably cheap, that did not matter for prices.  

Have you ever had the same thing happen to you?   If you are a self-described value investor, probably.   For the avoidance of doubt, I am defining value investing as seeking investments where the market is discounting a security, as measured by various metrics or ratios, greater than either 1) general norms or 2) the investor’s own rules for valuation. An example would be buying a stock at a trailing P/E ratio of 5x because the stock has historically on average traded at 10x.   

Value investing can be a highly profitable strategy over long periods of time, but the dark side of the approach is “value traps”, or investments that keep declining in price, ie getting cheaper. 

In the subsequent years, I have turned to technical analysis to try and mitigate the same mistake and the general shortfalls of fundamental analysis.  As a result of this journey, I think value investors should incorporate a form of risk management that is independent of fundamental analysis.  I say this because the value approach can have several flaws:

  1. Your analysis can be wrong or cannot keep up with changes.  I am not saying to give up on fundamental analysis, but have the humility to think about fail-safes and the inevitability that you will be wrong for a significant portion of your ideas.
  2. If your risk management is solely dependent on fundamental analysis you will probably take more risk than you would otherwise.  The classical example of this is continuing to add to a position because your fundamental analysis shows the stock is only getting cheaper.
  3. Everyone else may be buying or selling the same security for reasons other than valuation over extended periods of time.   Examples would be ESG or passive investors.

Is every value investor now supposed to second guess everything more than they already do? No!  I am simply suggesting that value-oriented investors continue to analyze and select opportunities in the same way, but incorporate other tools in timing, position-sizing, entry levels, and exit criteria.  These latter elements are often called the risk management or money management elements of investing. 

Why Technical Analysis?

Technical analysis can be a great tool for supplementing risk management in value investing.  Technical analysis, or TA, is the use of securities’ price and volume history in an attempt to forecast future price movements.  The logic is that investors’ prior behaviors, where they bought or sold a stock, can provide clues about their future actions. TA can determine where a stock is likely to stop falling (support level), stop climbing (resistance levels), and, most importantly change trend.  Can you see how such insights might help a value investor and why some investors use these tools without caring about the fundamentals?

For example, your value-oriented analysis identifies a certain stock as sufficiently cheap to put in a portfolio.  Unless you have a high-conviction fundamental catalyst (earnings report, another announcement, etc.) how do you size and enter the position?  Aside from the trading catalysts above, value analysis provides no concrete recommendations for entry and many value investors believe the exit point is when a security reaches its intrinsic value.  On sizing, value investing provides no clues other than you should be more exposed to the positions that are cheapest. 

Technical analysis can help by providing clearer entry levels. If the example stock is in a downtrend, and TA defines a support level below current prices along with a potential change in trend, you can use that information to gauge an entry price.  

Likewise, TA can provide a reference to how high the stock can go based on prior support levels, Fibonacci retracements or other techniques.  How many value investors sell when a stock hits their target only to watch the stock go up much further.  Here is my personal favorite.  I thought I was a genius when I sold this one for a 2-bagger when the stock started to stretch past my own fundamentals-based target price. 

For background, Corticeira Amorim listed in Portugal is the world’s largest processor and manufacturer of cork products.  Portugal produces most of the global supply of raw cork, and between the 2008 financial crisis and later European debt crisis, people sold Portuguese assets and asked questions later.  

As the chart illustrates, by purely following my fundamental fundamentals analysis, I left a considerable amount of money on the table.  

TA can supplement your analysis to give you the confidence to let positions run intelligently beyond the possibilities of fundamental analysis.  After all, they say to let your winners run.

Lastly combining the two ideas above can also help with position sizing.  If TA can aid in determining potential upside and downside, it should help you size a position. All else being equal (and it’s not usually!), take bigger positions in those opportunities with a greater payout ratio (upside divided downside), constrained by the maximum loss you are willing to take on a position (more on this below).  

Types of Technical Analysis

Technical Analysis can be broken down into a few different disciplines.  TA enthusiasts, I am a relative newbie here so please pardon any miscategorizations. 

  • Dow Theory:  The first well-defined discipline of technical analysis, Dow Theory introduces the concept of major, intermediate and minor trends and rules for general market exposure based on the interaction of the industrial index with that of transportation. Dow Theory is a tool to determine the general direction of the market.  
  • Patterns:  Ever hear someone talk about a Head and Shoulders on financial news?  They weren’t talking about dandruff but a chart pattern often is seen at major market turning points.  Analysts have identified several chart and volume formations which have a high tendency of predicting a certain subsequent action.  Some signal reversals, others trend continuation.
  • Oscillators:  Using moving averages and other data smoothing techniques, Oscillators attempt to define turning points by signaling when a move may be too far in its current direction.  MACD and RSI are the two most common.  
  • Fibonacci:  Not so much a style, but the application of a particular set of ratios common in nature and in many stock charts.  The ratios can help guide investors on future support and resistance levels.  
  • Most people who use TA use a combination of items, and when multiple indicators provide the same insight, one can take more confidence in the conclusion. 

Risk Management

We’ve had a quick delve into TA and most importantly why value investors should consider them in their analysis.  But I also wanted to touch on general risk management.  The bottom line is that investors need some general risk management rules in place to protect them from themselves.  These rules may change over time as you learn but you need to have them.  Some rules and processes may include:

  • Maximum $ or % loss in a position:  Many value investors believe true value destruction or impairment rather than volatility is risk in investing.  After following this for most of my career, I now think that is only applicable to those managing long-term or illiquid portfolios.  For all other situations, having a pain point to, at a minimum, reevaluate or exit is critical.  Remember if you are down 50% in a position it requires a 100% return from the bottom to break even.  For active traders, as opposed to investors, they believe you shouldn’t lose more than 2% in any given trade.  For long-term investors with a good temperament, that figure can be larger but think about such a rule.  Maybe you can scale it slightly based on your level of conviction and/or asset class as outlined below.  
  • Initial position limits based on asset classes. Stocks are more volatile than bonds which are more volatile than FX.  Some stocks are more volatile than others.  Bear that in mind when you determine position size.
  • Journal:  Write down in some form why you are taking actions.  Your future self can learn from your inevitable mistakes and will thank you immensely.  
  • Checklist:  Have a checklist before taking actions concerning the items you are focusing on. It can help avoid repeating mistakes and dovetails nicely with journaling.
  • Keep some basic portfolio stats:  Aside from position and portfolio P&L, keep some statistics for your portfolio.  For your investments, how many are winners vs. losers both currently and historically?  What are the $ drawdowns you’ve had in the portfolio and how much did your winners make? 

Conclusion and Additional Resources

To summarize, value investing is a great way of identifying investments but has some risk management shortfalls.  TA is a great way to fill in the gaps and improve investors’ money management along with some basic risk management rules.  

For those unfamiliar with technical analysis and want to get started here are some of the books I have found useful:

Of the following two you probably only need to start with one as the topics covered are similar:

Technical Analysis and Stock Market Profits by Richard W. Schabacker

  • One of the first comprehensive books published on technical analysis back when TA required graph paper, ruler and pencil.   The book covers Dow Theory, major continuation and reversal patterns; and determining trend lines, support and resistance.  

Technical Analysis of Stock Trends by Robert D. Edwards and John Magee

  • Actually written by Schabacker’s brother-in-law, who took up the TA mantle after Schabacker died.   The book covers the same topics as Schabacker r but with more detail around the implications of patterns and devotes much more of the book to implementation and trading strategies.

Technical Analysis of The Financial Markets by John Murphy

  • A modern encyclopedia of TA, covering many of the materials in the earlier classics plus a summary of oscillators, moving averages, candlestick charting, among others.  Likely, however,  only an introduction for some techniques such as Elliott Wave Theory. Critically, it also provides checklists to help one understand and incorporate the analysis into one’s process.  

The Global Macro Edge by John Netto

  • I have included here for its coverage of risk management, but this book covers a lot more.  Netto is a trader, but I believe that a lot of the systems and processes he employs and describes in this book can be really important to long term investors.  In relation to risk management, his coverage of risk-reward and investing regimes is particularly useful.

Of the following two you probably only need to start with one as the topics covered are similar:

My Trading Bible by Mark Ritchie

  • An entertaining and quick read on risk management by a trading legend. Again, this book focuses on traders but with important risk management lessons for investors.  It boils down to discipline and respecting the process.  Ritchie highlights the importance of understanding the risk-return profile of your strategy and using the Ritchie (also known as the Kelly) rule to size positions.  Finally, he separates good strategy from good results and that even good strategies can have drawdowns.  As such, successful investing requires a bit of emotional fortitude.

What I Learned Losing A Million Dollars  by Jim Paul and Brendan Moynihan

  • This one covers the same topics as Ritchie but through specific anecdotes of learning the hard way.  

To your investing adventure,

The Castaway Capitalist

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