Trading Warren Buffet's best stocks for greater returns..
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Everyone has no doubt heard of Warren Buffet, arguably the best investor in history, and no doubt less people will have heard of the equally credible Charlie Munger, both of which are chairmen of the company Berkshire Hathaway.
Berkshire Hathaway is an investment holding company which has achieved an average annual return of over 20% since 1964, which is considerably more than the S&P 500 with an average of 10.2% per year. To put this into perspective, we see here a chart showing the compounded returns from 1964 through to 2016.
Berkshire Hathaway managed an astonishing compounded return of over 1 million percent. Whereas the S&P returned 2300 percent over the same period.
An investment of 10,000 in Berkshire back in 1964 would have turned into 100 million 52 years later, whilst the same 10,000 in the S&P would have turned into 230,000.
The gains produced by Buffet and Munger were largely due to their value investing approach, investing into stocks which have good growth potential at a reasonable price and holding for the longer term.
We can see here the top 20 positions currently held in the portfolio, with Apple stock taking up a staggering 47.6% of its 330-billion-dollar portfolio value. As it stands, the company has 149 billion in cash.
Let’s bring the Berkshire stock price performance into more recent times, with this chart from the Motley Fool group. They title it “One of the greatest wealth creation engines in the history of capitalism”, a statement you could hardly argue against.
The only real negative you could possibly take from the chart are the periods of drawdown, although from a long-term investors perspective this is completely normal and should be expected. The drawdowns we see here are 52% in early 2000, 56% during the financial crash of 2008, 19% in 2015, and more recently, although not shown on the chart, the pandemic crash with a drawdown of 32%.
What if I told you that you could avoid these drawdowns significantly and improve the annualised returns?
The approach I’m about to show you does just that and has similar principles to the strategies I have shown on the channel previously.
In fact, the approach will reduce the maximum loss to just 6.8% whilst improving the annualised return from 20% to 35%, or for those looking to leverage their returns with the same buy and hold exposure, you could have achieved 280% annualised returns.
The approach is rather simple, yet people often frown upon simplicity and see complexity as the answer. Let’s take a look.
The approach is based on my dual mack dee strategy which uses the monthly mack dee to determine a trading window and the weekly mack dee to determine entry and exit points. In essence we are constantly following the trend direction from a macro and more recent perspective.
Using the Berkshire chart, we can see that In November 2020 the monthly mack dee turned positive, this created a trading window, at which point we then switch to the weekly mack dee to determine our entry and exit points.
When we look at the weekly chart, we can see that the mack dee is also positive at the point of the cross, we therefore enter a trade. Whilst in the trade we continue to ignore price action, we allow the mack dee, which is basically an average of price action, to continue its path. At some point the weekly mack dee will lose momentum and cross below the signal line, we see that cross in June 2021.
It is only at the cross of the weekly mack dee that we refer to the price action to consider a stop loss position, again on the weekly chart. We can see the long red candle which pushed the mack dee below the signal line, it is at this point we place a stop loss position, directly under the wick of that closing candle.
A few weeks pass without recovery until the price hits our stop loss and we sell the whole position.
This process continues, we look to ensure the monthly mack dee remains positive and wait for the weekly mack dee to cross back over the signal line. We see the cross here and once again make our purchase.
For this review we look back over the last 20 years, and here we can see the monthly price chart for Berkshire Hathaway. During this time, we had 9 trading windows, in other words the monthly mack dee was positive for 9 periods.
Throughout these 9 trading windows we saw the following returns, with the current window from November 2020 still open at 39.6%. Within each of these windows (dictated by the weekly mack dee) we made a total of 15 trades which equated to a compounded return of 225%, whilst being invested for 2338 days, or 6.4 years. This gave unleveraged annualised returns of just over 35%.
The key to this approach and others I share is that we not only avoid the declines, but we also avoid periods of stagnation, both are key to improving upon the all-important annualised returns.
The buy and hold investor would have all their capital locked up for the full 20 years, whilst experiencing all the drawdowns. The opportunity cost absorbed by the buy and hold investor is huge, whereas a trader applying this approach would have a spare 13.6 years to invest in other opportunities.
Next we get to the interesting part where we can really accelerate the returns, but first lets quickly summarise the comparison of buy and hold and the unleveraged dual mack dee approach for the past twenty years.
First we have buy and hold. This approach required the investor to buy shares in
Berkshire Hathaway and hold for the full twenty years, this gave a compounded annual return of 35.1%, a decent return but they would have endured numerous large drawdowns up to 56%.
The dual mack dee approach gave a comparable 35.2% annualised returns, with a considerably less drawdown of 6.8%.
Now we look at the more advanced approach which is dual mack dee and leverage.
The buy and hold investor would be wise not to use leverage, purely because they have no risk management, they allow for any drawdowns along the way. If for example this investor chose to use a leverage of 2 to 1, they would double the return to 70.2%, however they would also double the drawdown to 112%, meaning they would lose all their investment.
Our dual mack dee approach however incorporates risk management, keeping us out of major drawdowns. With this in mind, we could potentially use an 8 to 1 leverage ratio, meaning the maximum drawdown of 6.8% could be multiplied by 8 for a total drawdown of 54.4%, comparable to the buy and hold investor. We now also multiply the 35.2% return by 8, giving an annualised compounded return of 281%.
Can you see how by controlling the downside we can enhance the upside…
Now, I’m not advocating you use an 8 to1 leverage, but it emphasises what can be achieved.
Personally, I use no more than 16% of account equity on any position and no more than a 2.5 to 1 leverage ratio. Therefore in this example I would be willing to allow a drawdown of 17%, but expect an annualised return of 88%, again a huge improvement on the buy and hold approach.
The principle of limiting drawdown and staying with the trend is something I apply to all my strategies, but to really visualise the concept lets again look at the last 20 years of Berkshire Hathaway, and the trading windows identified by the monthly mack dee indicator.
We know the buy and hold investors encounter large drawdowns, and we know they lock their capital up for the full 20 years, but lets now see what our trading window looks like when we take out the 13.6 years of either declining or flatlining periods.
We are now left with a shorter inclining chart, of which within this window we are invested for 6.4 years, aligned to the weekly mack dee. Our cash is put to work only when the macro trends are increasing. The remaining 13.6 years was an opportunity cost which the buy and hold investor absorbed, we on the other hand could again put our money to work in other trending opportunities.
So lets recap the approach, not only do we have the best investors selecting the individual stocks which have shown to outperform, but by using the dual mack dee, we decide when to get in and when to get out, minimising drawdown and lack lustre periods, whilst being able to apply optimum money management to enhance returns.
Simple but a potentially huge wealth generator.
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