Preston Pysh  1:16  

We’re thrilled to have you here, Richard. On today’s show, we really want to talk about the current market trends and momentum trends that you’re seeing as profitable. But before we go into that, let’s start off by talking about what you suggested last time here on the show. I just want to refresh people’s memories. 

You were here last summer in August of 2018. During that time, you were excited about small cap stocks and energy stocks. And since that time, we’ve had a lot of volatility in the market. I’m just kind of curious how that’s performed for you.

Richard Smith  1:50  

I think it illustrates pretty well my approach to investing overall, especially with energy stocks in particular. At the time that we last met in mid-August, XOE, the energy sector ETF was at about $71. It made a high six weeks after that at about $77. And then, along with the market, everything else in the market in October of 2018 started a pretty steep decline and turned red in my system at about $66. 

I got stopped out with about $5, about an 8% correction on that stock. Energy stocks went down as low as $54 in December. So getting stopped out at $66 was pretty good in my book. It just turned green again in my system in early March. It was at about $64 to $65 a share. I was able to get back in about six months later at about the same price that my system has stopped.

I think it was a really good response. I also think it’s really interesting and important for the listeners to know that whenever you follow a momentum strategy, or whenever you do see a draw down, you might be thinking, “Why should I be using a system like this in the first place?” 

Stig Brodersen  3:00  

The value does not only come from picking the winners. It also comes from cutting the losers, instead of just like holding on, praying and hoping for the best. 

Richard Smith  3:09  

I think a lot of the value comes from psychology. You could look at this and say, “Oh, well, hey, you stopped out at $65 in November, and then you just got back in at $65 six months later. Why even bother getting stopped out?” 

If you would have had to live through that whole 20% drawdown to $54, that might have been the point where you panicked and threw in the towel at the low. That’s what used to happen to me as an investor. I would often wonder, “How does the market know exactly when I throw in the towel and then turn around and go back up?” 

I just needed a system for myself where I could make sure that I was on board. It could be some good long term trends. I don’t have to worry too much about getting out at the top or buying at the bottom.

Perfect, and thank you for also summarizing the conceptual framework. We know you pay very close attention to what billionaires are investing in, including Warren Buffett. Now, based on your research, what are the billionaires buying right now? What did you find interesting in the momentum perspective?

I think the last time we talked to billionaires, we were pretty heavily into consumer discretionary stocks. That has continued to be the case. They’re still about my system. It seems to be about 22% of the capital. That is what the billionaires that I follow allocated to consumer discretionary stocks. 

The one that I was just looking at, Stig is Dollar General. That good moment. Their new high’s around $120 a share right now. It has been in the news as well. In general, I’d say the billionaires are still focused on consumer discretionary stocks, financials, industrials, and also information technology. Dollar General is one stock that a few of the billionaires that I’m tracking are particularly interested in.

Preston Pysh  4:52  

Richard, it’s really interesting to see how you’re tracking all of these allocations across all these key influencers in the space. When you invest in stocks that are similar to their picks, are you digging into their 10Ks and 10Qs? Is it more simplified based simply on your momentum indicators?

Richard Smith  5:09  

Oh, absolutely. What I’m doing is essentially a form of what’s called “factor investing.” It is kind of pioneered by Cliff Asness of Advanced Quantitative Research. Some of the well known factors include value, volatility, and momentum. Cliff Asness was kind of the pioneer of momentum as a factor. 

He convinced his PhD advisor at the University of Chicago, Eugene Fama of the efficient market hypothesis. It says that momentum was indeed a factor in the markets that could generate above average returns or good alpha. 

I use the billionaires essentially to get my value factor. I’m not going to be the guy who spends my life reading financial statements, reading quarterly reports, and etc. I want a good filter for value in my decision making.

I’d say, “Hey, these are great value investors. Let me take their universe of ideas.” I will incorporate value as a factor in my investing strategy by making sure that I’m working from a base of ideas that great value investors have already vetted for me. 

I’m a busy guy. I’m running businesses. I’ve got three kids. I can’t be studying the markets 24/7. I want to check in maybe once a week. That’s a key part of my strategy to make sure that I’m following the base of ideas of great investors with great track records.

Stig Brodersen  6:27  

I’m sure you’re looking into back testing some of this. What do the results tell you?

Richard Smith  6:31  

I do a lot of back testing. Over the years, I’ve found some kind of surprising what people might find counterintuitive results. I’m just taking the billionaires as a group of investment ideas. One thing that I found surprising is that oftentimes, it’s better to get into a stock that a billionaire has brought about six months after it got into the stock. 

A lot of people, the billionaire, filings come out to 13Fs, and think, “Oh my God, Buffett bought this stock, I better get in, or it might be too late because he bought it six weeks ago.” But it doesn’t work that way at all. That’s what I found. 

Some of the best results that I found is to follow investment ideas of billionaires where there’s no good momentum. They’re kind of in the red. And then wait for that momentum to really kick in, and get on board some of the longer term trends after the billionaires have bought.

Preston Pysh  7:25  

Richard, I’m just curious, are you waiting for certain billionaires, such as Warren Buffett who has a higher weighting than some other billionaire, or are you just looking at the 13Fs and just kind of give everybody an equal weight?

Richard Smith  7:38  

It turns out that I don’t really have a lot of preference for one billionaire over another. I just want to know that I’m working from a solid base of investment ideas from the world’s greatest investors. After that, I try to keep my personal opinions out of my investing as much as possible. 

Warren Buffett is the North Star of investing for a lot of people. But overall, I haven’t found that Warren Buffett’s ideas plus momentum are necessarily better than say, David Einhorn’s ideas plus momentum. I try to keep personal opinion out of it as much as possible. Again, just make sure I’m working off of a good base of great ideas from great investors. And then, I let my systems do the heavy lifting for me from there.

There’s so much noise in the financial media. I think one of the most prevalent theories that we hear and that we also covered on the show is that commodities will perform really well in 2019. I don’t know if you agree with this thesis, but you might be able to provide some context to whether or not you agree with this or not. And in any case, which commodity do you think will perform best?

I’m not seeing the momentum across commodities that I really would want to see before I get a lot of conviction about the upside opportunity for commodities. Some of the best investors I know are very bullish on commodities. I don’t like to second guess great investors’ theses. But so far, I’m not seeing a lot of indication across the commodities world that the momentum is there yet. 

Looking at the Bloomberg Commodity Index, for example, I still see a solid downtrend drawing a trend line between the highs from 2008 down to today. That downtrend is still intact. Overall, I’m mildly bullish on gold. Although, I’ve been bullish for a while. We’ve seen pretty good run ups in gold. 

I see some risks in April for gold. I’m pretty bullish on oil too. After the big fall, there’s still a lot of upside sentiment. But overall, I don’t share the same extreme bullishness that some other investors in the commodity space do right now. 

Preston Pysh  9:46  

Richard, so you’re an expert in volatility and in understanding what normal looks like in the price movement of various stocks. That’s something that we haven’t talked too much about on the show. We talked about a little bit but not a lot is the VIX. Can you explain how you look at the VIX, and why it might be important today?

Richard Smith  10:03  

Well, the VIX is tracking the implied volatility. There’s historical volatility, meaning how volatile stocks have been in the past. And then there’s implied volatility, which means what investors are anticipating the volatility to be in the pretty near future. You take the prices of options that are selling, or being traded between investors. The prices of those options imply a certain expectation of volatility in the future. 

The VIX is what I call an “anticipatory indicator.” It’s kind of anticipating what volatility is likely to be in the future. It’s a measure of how people are betting about the future volatility. That’s about 30 days out approximately. I love looking at volatility as an indicator. I like to look at historical volatility going back about three years on the S&P 500. Right now it’s about 10%. 

That means that over the next 12 to 18 months, I need to be okay with the S&P flopping around, up or down by about 10%. That’s different from what the VIX is. The VIX is telling me how much volatility I should expect based on how people are betting on options over the next 30 days. 

The VIX is a powerful indicator. I don’t use it a whole lot myself, except maybe as a short term kind of sentiment indicator. But I am very interested in volatility as a factor in my investing, in terms of how I anticipate and how much noise I need to be okay with in an investment over the next 12 to 18 months.

Let’s continue talking a bit more about volatility. We would really like to talk about options. We haven’t really been talking too much about options here on the show. Before we dig more into it and talk more about volatility and the impact of options, perhaps you could explain the basic principles of options theory first.

Options are what are called, “derivatives.” The basic idea of “put” in call option. You own, let’s say, a stock like Apple. It’s trading at $170 a share. A call option would allow you to buy Apple at a certain strike price, at a certain time in the future. Let’s say you bought a $200 call option that expires in December of 2019 on Apple. 

That’ll give you the right to buy Apple at $200 a share, anytime before December of 2019. If Apple goes up to $300, you can buy it from a person who sold you that call option at $200 a share anytime before December of 2019. That would obviously be a very profitable purchase of a call option. You could buy that call option for an inexpensive price right now. It could be relative to a $300 resulting price at the end of December. 

On the flip side, in a put option, if you think that stocks are going to fall, you can buy a put option. It will allow you to sell a stock at a certain strike price for a certain period of time. 

Options are very powerful. They have a lot of leverage. They can really add a lot of diversity to your investment strategy. But that leverage can cut both ways. You have to be very careful with options as part of your investment strategy.

Preston Pysh  13:18  

Richard, real quick. One of the reasons we wanted to talk about options is because you include a momentum component in this option strategy. Can you talk to us about that a little bit?

Richard Smith  13:27  

I had to come up with an option strategy that used a little bit more of a long term approach to options investing. I like to use options where I have good upside momentum. And then what I found, Stig is that it is about 8 to 10 months out. An 8 to 10-month expiration date from when you buy the option is kind of the best target expiration period that I’ve found using my indicator. 

A good example, Stig of my approach to options investing at this point is Dollar General. It is a stock that we were talking about earlier that several billionaires are interested in. It was corrected along with a lot of the rest of the market in December, but only fell into the yellow zone in my system. 

Now the yellow zone means that you’ve fallen a little bit more than halfway from the recent high down to what I call the “red zone.” In Dollar General that was about 18% below its high. That’s where the red zone would start in my system. 

Now, Dollar General fell about 15%, so it hasn’t turned red. It was in the yellow zone. But then it started going back up and it turned green again. It went from yellow to green. That’s a great indicator of more upside momentum and a good stock like Dollar General. 

At that point in time, when it turned from yellow to green and that momentum reasserted itself, I’d be looking for a call option in Dollar General. That would be around October of 2019. Buy a call option on Dollar General at about the strike price that it was trading for at that time. It was about $106 a share. 

Use the leverage of options to make a conservative but high odds bet . You don’t have to invest a lot of money. But today, Dollar General is already up at about $120 a share. That would be quite a profitable trade at this point.

It’s a little different approach than what a lot of people do with options. Again, I’m trying to use momentum. Take advantage of longer term trends. That’s kind of the option strategy that I’ve evolved. 

Stig Brodersen  15:25  

I guess of all the questions that we have prepared for you today here Richard, I was most excited about this one. We recently did a podcast episode about billionaire Stanley Druckenmiller. He’s a famous hedge fund manager. He’s probably best known for speculating with George Soros against the British pound. He was literally breaking the Bank of England for $1 billion. 

One thing that surprised me a little when we covered him was what he said in December 2018. He found the price signals much harder to read. He mentioned 6 to 7 years. It’s all because of algorithm trading. Do you encounter some of the same challenges when you are reading the price signals?

Richard Smith  16:08  

I’d say yes and no. On the one hand, yes, there has been some whipsaw, especially over the last 12 months. The V-shaped bottom that we saw going into December with those big falls were basically all the losses that have been recouped by now. Those are tough situations for anybody to follow, especially if you’re using a momentum strategy. 

I haven’t found a lot of disruption in those opportunities in the markets. There are always different sectors of the markets, such as different market capitalization levels, commodities versus stocks. I think there’s always opportunities in the market. I think you just have to find the ones that are still working well today. 

I think a lot of the algorithmic traders are more focused on shorter term investing. That’s partly why I kind of shy away from shorter term, even swing trading investing. That’s because there’s so many people in that space. There’s so much computing power in that space. I don’t think I can really compete with a part time investor. 

That’s why I like to focus on a little bit of the middle part of a trend. I haven’t seen a whole lot of disruption in my indicators, or that kind of time horizon. You might get excited about short term moves. But given their lifestyles and what they’re trying to accomplish in the markets, capturing that big chunk in the middle, I find it to be a more effective long term strategy.

Preston Pysh  17:29  

Richard, when you say, “Catch the middle,” are you talking about a year to 3 years? What do you mean by that?

Richard Smith  17:34  

Let’s take the S&P 500 coming out of the 2009 bottom just as an example. I think it famously bottomed at like 666 in around March of 2009. Now, it didn’t turn green in my system until the S&P 500 was above 900. Though it already rose about 40% by the time it turned green, it didn’t turn red again until about 2017. That’s a 7-year run of capturing the gains of almost 100% in the S&P 500 from about 2010 through 2017.

Those are the kinds of trends I’m looking to capture. I want to stay out of the big drawdowns because they’re too psychologically painful for me. I want to get on board long term trends with good momentum. If you can get on something where you’ve come in out of a strong bottom like we had in 2009 with the S&P 500, ride that up. Those are the sweet spots that I’m really trying to capture.

I think it’s a nice segue to the next question, which is about the price signals. You already talked about the time horizon – the short term, medium term, and long term. Do you see different price signals that are easy or harder to read, say if you go from an asset class, like gold, energy, stocks, or treasuries? Is it something harder to read than others?

I don’t. I’m willing to consider investments in different asset classes as long as I can count on those 12 to 16-month trends. I have found overall that sometimes if an asset class has very low volatility like treasury bonds, for example. There won’t be enough momentum to really help me get on board those long term trends. 

And conversely, if very high volatility asset classes like Junior Gold Mining Stocks or speculative biotech stocks, those can sometimes be very hard to read, as well as their trends. There’s just too much volatility. Too much uncertainty for most investors to put up with.

All of my work is really informed by behavioral finance and behavioral psychology. Let me just mention while I’m on this topic a fantastic book that I came across recently called, “The Behavioral Investor” by Dr. Daniel Crosby. 

He’s actually a clinical psychologist, who ended up going into finance about 20 years ago. He has been working in the finance space using his clinical psychology background to help in this case, mostly professional investors like RIAs understand investor psychology better. 

He’s written a very accessible book for the lay investor to really understand the psychology of investing and where we get tripped up by our own psychology. I can’t recommend this book highly enough. It’s a fantastic kind of compilation of all the different mistakes we make as investors, along with some concrete advice about how to rethink your investing strategy so that you don’t get tripped up by the common pitfalls that have been tripping up investors for frankly, thousands of years. 

Everybody needs to really understand investor psychology. A lot of my work is informed by how I help a broad swath of successful people become successful investors by basically getting out of their own way. That’s been an inspiration to me. 

I think this book, “The Behavioral Investor” by Daniel Crosby is the best resource that I’ve come across at this point to really understand the impact of psychology on decision making and investing.

Preston Pysh  21:04  

Richard, I love the book recommendation for people listening. We’ll be sure to have a link to that in our show notes so that you can quickly find that after listening to the show. So before we wrap things up here, I just want to personally thank you for always making time to come on our show. 

I’m a huge fan of what you do. It’s really funny because Stig and I are always using your platform to help our argument when we’re talking about value investing. That might sound strange for a lot of people. 

But in value investing, the big mistake in my personal opinion is that people sometimes catch falling knives, or they have to deal with the pain of a value pick for a year, or a year and a half before it finally bottoms and then starts coming back to what they find its value to be. That’s because they’re doing a lot of fundamental analysis. They’re looking at the financials and things like that. 

But with your platform, it helped me a lot. I know it has helped Stig a lot, too. We’re finding these value picks, and then we’re confirming with momentum indicators. I know from our Mastermind discussions, there are many times where I’ll find something that looks great from a fundamental standpoint. I’m looking at the financials. I think I’m going to get a really fat yield out of it. But then, I see that the momentum indicators are still red. 

And so, I hold off on that pick until that changes, or that transitions. I just want to give you an opportunity to tell people about your platform because we just get so much value out of it. Can you talk to our audience, or just tell our audience a little bit more about Tradesmith?

Richard Smith  22:33  

I appreciate that a lot, guys. It’s very interesting to me that you, as value investors, appreciate the kind of extra layers that my products bring to your investing. I think as value investors, you’ve probably experienced what’s called the value trap, right? A stock looks valuable, but it just keeps going down.

And again, it all goes back to psychology. How do you make sure that you’re making investments that are in your psychological tolerances. That’s where momentum can be a huge help to value investors, and help supplement value investments with great timing. That’s what my work basically does. 

I’ve talked about my green, yellow and red zone. I just call that the stock state indicator. We’ve got indicators. We help people decide how much to invest. We got an incredible tool called “the risk rebalancing” that can take a whole portfolio of stocks in an amount of money. It can tell you how much money to put in each one of those so that you’re taking equal risk based on volatility across all those investments. It’s a really powerful tool.

Fantastic, Richard. I would also like to give a quick hand off. There’s a completely free report on harnessing market volatility to discover great new stock ideas. You can download that for free as well. That is at tradesmithideas.com/tip. 

Stig Brodersen  23:49  

We’ll make sure to link to tradesmithideas.com/tip in the show notes. Richard, thank you so much for coming on the show. We hope we can bring you on again.

Richard Smith  23:59  

Thank you, guys. It’s great to talk to you as always. I can come back absolutely anytime. Just give me a call.

Stig Brodersen  24:04  

That was all Preston and I have for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro  24:11  

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