Systematic Relative Strength

This piece of investment “wisdom” is attributed to Bill Miller at Legg Mason Funds. There’s a grain of truth in it, and also a catch. The catch is covered nicely in a piece from Greg Speicher at Ideas for Intelligent Investing:

In a 2004 interview in The Motley Fool, Bruce Greenwald gives an example which drives home the importance of having the patience and discipline to average down in order to optimize performance. Greenwald talks about Paul Sonkin, who, at that time, had averaged about 25% after fees for the previous four and a half years.

Greenwald observed that Sonkin would often make additional purchases if a stock declined after he bought it. Greenwald looked at Sonkin’s trades and determined that, of the 25% return, fully 22% was from purchases made after the initial purchase. Greenwald also notes that he was looking at the performance of legendary value investor Walter Schloss who averaged 15.3% over five decades. It appeared that much of Schloss’s returns came from the same practice and then selling on the way up. As Bill Miller says, “Lowest average cost wins.”

Takeaways:

1. Follow-up purchases that lower the cost basis in a stock can have a powerful impact on returns.
2. Caution! This strategy only works if you have a strong valuation methodology so you can avoid expensive “value traps” and “falling knives.”
3. This approach requires having a certain self-mastery coupled with a proper orientation on how to think about market prices.

I put the caveat in bold. Even Bill Miller, who presumably does have a strong valuation methodology, has been hoisted on his own petard more than a few times, recently with Eastman Kodak.

The grain of truth is this: all other things being equal, it is better to buy on dips. By doing so, you are essentially doing the opposite of most retail investors, as measured by DALBAR, for example.

Buying dips is clearly a very risky idea if you are buying an individual stock—like Bill Miller, you could end up with a Kodak or equivalent. If you are a long-term investor in the market, however, it might not be so crazy if you are investing in a strategy. Think about it this way: by adding to a strategy on dips, you are letting market volatility work in your favor to reduce your average cost.

Let’s look at an example. I’ll illustrate the strategy with PDP, the Powershares DWA Technical Leaders Index. For a passive comparison, we’ll use SPY, the ubiquitous S&P 500 SPDR. PDP has been around since March 1, 2007, so we’ll use that as our start date. If you bought SPY at the close and held it, your passive return would be a negative 6.4%. It’s been a rough few years for the stock market! And it’s not that PDP was a whole lot better—buy and hold would result in a negative 2.4% return.

PDP has a couple of things going for it, however: 1) high relative strength has historically been a strong return factor, and 2) it’s pretty volatile. Let’s see if we can figure out a way to make volatility our friend.

Back in the 1990s, one of our senior portfolio managers, Harold Parker, published a paper on the NYSE high-low index that showed reversals at or below the 40% level were a pretty reasonable indication of a bottom. Not every signal is perfect (about 70% were accurate), and sometimes several reversals occur before a major bottom. Of course, you can’t know that ahead of time, so let’s just say that you bought more shares of PDP each time there was a reversal at or below the 40% area. That way any hindsight bias is removed.

You would have had 17 chances to buy on dips over the past 4 1/2 years. The first couple in 2007 were at higher prices because the market was still rising. The choppy markets in early 2008 created an additional five buying opportunities. Once the 2008 decline was in full force, there were five more chances to buy on dips not too far from what turned out to be the ultimate market low (ranging from 11/5/2008 to 4/16/2009). The swings throughout 2010 and 2011 have seen the NYSE high-low reverse up on five more occasions, including today.

If you had taken a nip on each of these occasions, your average price in PDP would be $20.68, versus a close yesterday of $23.17. Buying the dips has turned a negative return into a positive 12.0% return. (I’m assuming equal share amounts here; dollar-cost averaging would reduce your cost basis even further to $19.35 for a positive return of 19.7%.) Instead of lagging the benchmark by 6.5% annually—the DALBAR retail investor track record—you’re now running 3.9% ahead of the benchmark, primarily by consistently using volatility in your favor.

On any one occasion, you never know whether your purchase price will be somewhere near a low or if there is a greater decline ahead. You’re simply adding to the strategy on every dip, figuring that by reducing your average cost, you are increasing your odds of coming out ahead over time. There’s no guarantee that adding to a strategy on dips will work—there are no guarantees in the market, period. But by acting in a disciplined and consistent manner, you’ve certainly tilted the odds in your favor.

Click on chart to enlarge, and to see the buy points marked with arrows.

Source: Dorsey Wright Money Management; John Lewis

See www.powershares.com for more information on our three DWA Technical Leaders Index ETFs (PDP, PIE, PIZ).

Click here for disclosures. Past performance is no guarantee of future results.