Small caps is an area of the market that I am very personally attracted to right now. It’s an overlooked sector of the market and it’s really a unique section of the market that we have an opportunity to dig into ourselves and to invest in that a lot of the bigger institutional players can’t really maneuver in that small cap space. So small caps is one area of the market that I’m really excited about.

Preston Pysh  4:01  

Richard, when you say small cap investing, how do you recommend people step into that type of investment? Do they buy individual companies or buy ETFs? Give us an idea what you’re talking about here.

Richard Smith  4:14  

The retail investor has an opportunity to really look into individual small cap stocks. Of course, there are ETFs. There are ways to invest in small caps broadly. I think finding a good source of small cap ideas and then applying some of the strategies that we’ll probably be talking about today, like momentum and volatility, to individual small cap ideas is where I’m personally very interested in myself.

Stig Brodersen  4:45  

Could you be a bit more specific in terms of, perhaps even like put some numbers on, like so what is the strong price momentum? By your definition, what should we be looking for?

Richard Smith  4:56  

I came up with a proprietary momentum indicator a few years ago. It’s a moving average type of indicator and it tends to be a little longer moving average, but it is unique for each asset that I apply it to. It’s not just a 200-day moving average. It’s not just a 50-day moving average. 

We actually look for the moving average that has the best bounces off of trend, okay? When that kind of price falls down, hits the trend line and bounces back up. That’s what I’m really looking for. I want to see strong bounces off of the trend.

I actually will analyze, quantitatively, a range of moving averages for every different asset in our database and look for the moving average that has the strongest bounce off of trend. Those tend to be a little longer, say between 100 and 300 days, and that is also overtrading is one of the biggest reasons that individual investors tend to underperform the markets. 

It’s so easy to just click a button and make a trade today and we always have this urge to do stuff and to fix things. Jesse Livermore, I think who said the investor that can be right and sit tight is going to be more successful. 

Stig Brodersen  6:22  

Let’s talk more about those different ranges. For most people who would then go into stock investing, before they discover value investing, which is really like the foundation of where Preston and me are coming from. Most people would go into trading. They start looking at those moving averages and suddenly, candlestick charts and whatnot…It suddenly becomes a bit more complicated. 

They are looking at should it be like 10 days? Some people would say that or 20 days. Then Richard, you come here on the show, and you’re talking about 200-days moving average, and you’re talking about a longer whole period. Could you talk to us [about] some of the advantages and disadvantages there are to those two approaches, just like the extremes if you want to put it like that in training?

Richard Smith  7:07  

Yeah. Just taking a step back for a minute, I am a big believer in a moving average strategy. The main reason is because it’s an improvement over the behavioral biases that all investors bring to investing, right? 

We think we can go into the markets and make shots from the hip decisions about what to do and that somehow we’re smarter than the markets. It’s not true, right? You have to get run over by the markets a few times before you go, “Man, that just doesn’t work and I don’t want to do that again.” 

I then think what a moving average strategy does, as at its most basic level, is it lets us behave better in the markets more consistently, right? Behaving consistently following a system is going to put you in the minority of market participants. That’s how I see it and I think that is so important. It reflects back to sort of my personal journey and to getting where I am today. 

I started by advocating a 25% trailing stop strategy. It’s a mechanical strategy for individual investors: sell when the stock falls 25% from its high, don’t sell if it hasn’t. And I was just amazed how when I would apply that to portfolios, newsletter portfolios, individual investor portfolios. I would almost always see improved performance. 

What I eventually figured out is why because of an insidious bias that we bring to every investment decision we make. Two Nobel prizes have basically been awarded for this in economics. Now, the first to Daniel Kahneman and then Richard Thaler. 

We are risk-seeking when we’re losing, so we want to take more risk when we’re underwater. We want to put more money into these positions we want to double down, try to get back to breakeven. However, we are risk-averse when it comes to our winners, right? So we get up 50% or 100%, and we start to feel like, “Oh my god, I better take those profits off the table before I lose them.” 

That is an incredible bias that seeps into every investment decision that most individual investors make, not just individuals but professionals too. So a simple strategy like a 25% trailing stop strategy reverses that. It makes you risk-averse with your losers and risk-seeking with your winners. 

Those are the kinds of things that I’ve come up again, personally, as an investor, that I think these quantitative strategies, even like a simple trailing stop strategy or a simple moving average strategy have alpha for individual investors, because of the behavioral biases that we bring to the market. 

Preston Pysh  9:50  

Richard, a common theme that we see with all the people that we study on this show is that these great investors try to match their investing strategy with their personality. Some people are like more of a month-to-month, or they’re looking at a six-month window. Then you have other great investors like Buffett and Munger that are looking literally to own a business forever. We’re curious about your personality and why you implemented this kind of investing approach.

Richard Smith  10:19  

Well, I’m a mathematician by training so I’m attracted to quantitative strategies, right? I’m running a business. I have three kids that are still in school. I don’t have time to be watching the markets on a day-to-day basis. I believe that watching prices flicker during the day is bad for your wealth and bad for your health, unless you’re a day trader. 

I think that the best way to do that is to focus on a little longer time horizon than most people are focused on. I think there’s this kind of push to the shorter term time frames because it’s more exciting. You can stoke more greed and fear, and the media can really grab your attention on a constant basis. I want to tune all that out. 

A lot of my work is about figuring out how much noise you have to put up with in order to be in the markets, and then make sure that you’re ignoring that noise. Then noticing kind of when it’s not noise when it has moved beyond just noise, right? My goal then is to tune out as much noise as possible, but have my ear open for when it’s signal and not noise.

Stig Brodersen  11:30  

I absolutely love that you say that. It kind of reminds me when we were talking to Guy Spier. He was talking about how one of the most valuable personal traits is really to stay sane. It’s not about doing all those amazing stuff. It’s actually more about not doing all the stupid stuff.

Richard Smith  11:46  

Totally agree, man. I totally agree. Let me take one step back and just share another sector of the market that I’m excited about personally, and that’s the energy sector. I see a lot of strong momentum in the energy sector right now.

Energy for me is something that is kind of particularly interesting. It’s been beaten down for years. It’s really just starting to show positive momentum now. I think the energy sector is a very exciting area of the market right now.

Stig Brodersen  12:16  

When you talk about going into the energy sector, are you then looking at the price momentum of the various stocks? Or are you more looking at, for instance, something like the oil price that has really been soaring? Then saying, well, that’s the underlying factor anyway?

Richard Smith  12:30  

In the case of energy, I’m looking at both. Oil has had positive momentum now for at least a year, probably 18 months. That’s a trend that I’ve been all over since the beginning. It’s an area of the market that I really get excited about, in part because I used to be oil. It used to be my total nemesis when it came to investing and speculating. 

It was because oil was a lot more volatile than I realized, right? I have this indicator that I call the volatility quotient or the VQ. Oil is typically like 30% on average. You don’t think for a massive commodity like oil that it can swing around 30% in a year just because of noise in the market, right? But it does. 

Once I understood how volatile oil was and that it wasn’t something that you could basically kind of short term trade, that really helped me out in terms of being able to understand the oil markets better. 

Oil has been on a nice uptrend and has had good momentum for 18 months. That has started to transfer into energy stocks itself. So XLE, I look at the SPRD sector ETFs to kind of understand the sectors of what’s going on in the markets. 

XLE has great momentum right now and I think if you drill down into XLE, you will find the individual stocks that are in the XLE. 

Stig Brodersen  13:57  

Very interesting pick.

Let’s talk about momentum investing in a potential bear market. I think to a lot of investors out there, they might think it’s kind of odd. I would be speaking to a momentum investor about a bear market, but you brought up like when we saw the drop of 10%, or whatever it was back in February… What is your indicator, can you tell about what happened back then? I’m sure that’s something that was on your radar. Was there also ever a point where you would simply start shorting or just like not long in that period?

Richard Smith  14:31  

I do still have a concern about the kind of large caps and industrials in the US stock market right now. My momentum indicators told me that the S&P 500 and the Dow fell more than they should have fallen just, based on normal noise in the market. I use volatility to define noise here. 

So I’ve been kind of very cautious about large caps for a while. Obviously, the bottom didn’t fall out of the market, and the S&P 500 actually hasn’t made new highs yet, but it’s getting close. However, I still saw strong momentum in the NASDAQ 100 and in the mid caps and the small caps of the market. So I really didn’t see the market breaking down as a whole. 

YI think momentum is starting to return to the market overall in spite of what we’ve seen for the past week with some prices falling. I’m not a big believer in shorting myself. It’s not that I’m not a big believer in it, I’m just not that comfortable with it personally.

To me, going to cash is my form of shorting right. I will look for indicators when I see the market starting to fall apart across all market capitalizations, all sectors. I will be looking to go to cash and basically going to cash is my form of shorting the markets.

Stig Brodersen  15:54  

Let’s talk about volatility. Whenever you read up on stock investing, there was all these write-ups about volatility and the importance of not having too much volatility. I’m always referring here to value investing, which is really like the core here of most of our listeners, because they’ve been brought up with volatility and to some extent is good. 

Volatility means that you as a value investor, by doing fundamental analysis, go in to say, “It’s undervalued, I can buy. If it’s overvalued, I can sell,” especially if it’s out in the extreme. So for you, is volatility good or bad? How do you optimize your portfolio accordingly to volatility?

Richard Smith  16:39  

Yeah, great question. I think this is a really interesting area for investors to be looking at. I kind of stumbled upon volatility as a way to help me in my investment decision making, because I started out with trailing stops.

Initially, my interest in volatility was to find the optimal trailing stop that I could use on any stock. I was using 25% trailing stops as a strategy and I was like, “Well, it doesn’t make sense to use a 25% trailing stop on all stocks.” I’m investing in a small cap energy company or I’m investing in Walmart, Johnson and Johnson, those are totally different stocks. 

I then used volatility and I came up with this volatility quotient that I call it, that was an optimal trailing stop loss strategy to use on any stock. However, when I saw that number for each of the stocks in my database, it started to change the way I thought about my investments and changed the way my subscribers thought about the investment. So just to see Johnson and Johnson and Walmart, 12% a small cap energy stock, 50%, it was like, “Whoa, what does that mean?”

That was very interesting to see those numbers and go, “That stock has a 50% volatility quotient, 50% VQ. Maybe I shouldn’t put half of my portfolio into it.” Again, we tend to want to put more money into the stocks that we’re most excited about. The stocks that we are most excited about are the ones that have great stories. 

The reason they have great stories is in part because there’s a lot of speculative fervor around the opportunity. You can really spin a good story when you basically don’t know what’s going to happen. 

I then found this measure of volatility quotient to really help me understand how much noise or how much uncertainty I had to put up with for the stock, if I wanted to be invested in it. It became something bigger than an optimal trailing stop strategy for me. It was like, “Man, that’s 50%. Do I really want to be in a stock that’s essentially got that much uncertainty or that much noise?”

What I found in my back testing is that if I allocated my capital… So I was putting the same amount of money into the taking the same amount of risk on each opportunity based on volatility, that automatically helped me to put more money into the less volatile opportunities. I also like to say just the right amount of money into the more volatile opportunities and more speculative opportunities. 

A big part of that, for me, is about being able to sleep at night. So I love the idea of swinging for the fences on some small cap speculative opportunities, but you have to put the right amount of money into it, so that you can still sleep at night, and so that you can be in that stock for the long run to actually capitalize on the opportunity that’s really there. 

Just as a simple illustrative example, if I may: a stock with a 50% volatility quotient, if you want to risk $1,000 on that stock, you can put $2,000 into that stock. If that $2,000 investment falls 50%, you’re down. 1000 bucks, right? 

On the other hand, if you have a stock like Walmart, or Johnson and Johnson, that’s a 10% volatility quotient stock, you can put $10,000 into that stock. If that $10,000 investment falls 10%, you’re down $1,000. This is a much more advanced strategy for the individual investor. 

I think most of us have considered before that it’s not necessarily a mechanical strategy as I see it, but it’s a great place to start to consider how are you deciding about how much to invest in different opportunities.

Kind of my focus on volatility, I will say one more thing, which I’ve found, you know… You mentioned kind of volatility going up being a good thing. I think that can be a good thing. 

Recently, I’ve been exploring something that I call kinetic volatility or kinetic VQ. It basically means like when a stock has gotten above its historic average volatility that can be a really interesting sign when you have positive momentum combined with a kind of extra volatility. 

If you can start a positive uptrend with good momentum, and you’ve got this kind of extra volatility or extra noise or worry that you can measure in the stock, that extra worry can really fuel a new uptrend that can be more enduring than typical uptrend. So that’s an area that I’ve been personally exploring and having seen some pretty compelling evidence that it’s a cool strategy.

Stig Brodersen  21:36  

Yeah, that sounds very interesting and a very different approach to volatility than I heard from other people who are trading the market.

Preston Pysh  21:46  

So, Richard. Stig and I want to ask you about a certain investor. His name is Bill Miller. For people who are not familiar with Bill Miller, he was the former Chief Investment Officer at Legg Mason. He managed something like $60 billion or something while he was there. He now runs his own fund. It’s called Miller Value Partners. 

The reason we want to talk to you about Bill Miller is when we had him on our show, Stig and I were both very surprised to find out that Bill disclosed to us that he always follows up a value investing approach by looking at the momentum trends of the price action as well. We want to ask you then, are you the inverse Bill Miller, meaning you’re starting with this momentum approach, but then do you go back and look at the fundamentals before you conduct the purchase?

Richard Smith  22:37  

First of all, Mr. Miller is full of surprises. *inaudible* and price action and yet everybody thought he was just a deep value investor, so kudos to Mr. Miller for looking into all the things that might really work.

On the value side, for me, I think I just don’t really have the stomach to be a deep value investor myself, but I do value fundamentals. But I really looked at other people to make sure that I’m having elements of value in my investing strategy. 

We are both interested in billionaires so one of my strategies is to sort of limit the universe of stock ideas that I’m choosing from, to the universe of what the world’s greatest investors are choosing from, right? If you take you know, 10 or 20 of the world’s greatest investors, and you just kind of aggregate what they’re invested in, you can come up with a list of a couple hundred stocks, 200 or 300 stocks. 

In my mind, those stocks have been vetted for value by the world’s greatest investors. So I would like to take that universe of opportunities that have a value bias to them, and then apply my own kind of quantitative strategies to that smaller basket of ideas. 

Personally, when I’ve tried to do value investing, I’ve gotten caught in the value trap, more times than I care to admit and written a stock down to just unacceptable losses.

Stig Brodersen  24:21  

Haven’t we all tried that, Richard?

Richard Smith  24:24  

And then I just don’t have the 10 and 20-year time horizon patience of a Warren Buffett. I think my attention span is a little better than maybe the average millennial. I’m more Generation X myself. I think we’ve been having a deteriorating attention span now through the generations. 

Anyway, my sweet spot is holding a stock for 18 months to maybe 5 or 6 years max. That’s what works for me. I think that’s an interesting kind of time range for a lot of people in the world today that are interested in investing but aren’t necessarily going to be Warren Buffett.

Stig Brodersen  25:08  

Now, I’m really going to apologize, Richard, because I’m putting you on the spot here again. We talked about this interview back and forth and then we settled on today for various reasons. This is coincidentally 15th of August, just the day when the 13F filings have been released, which is basically if you are and as I mentioned the *inaudible* has managed more than $100 million, then you will need to disclose that once a quarter. 

The market opened 33 minutes ago so I’m really putting you on the spot here but have you seen anything like pop up for this 13F round or for the previous one that’s really just very interesting, both in terms of value and in terms of price momentum?

Richard Smith  25:55  

The data is still very fresh, Stig. I haven’t done a deep-dive on it but I ultimately intend to do. 

The one easy one here for me is the fact that Warren Buffett is buying more Apple. I think that is a really great lesson for individual investors to hear because you see, Apple is at all time highs. It just passed the trillion-dollar market cap. Buffett continues to buy it. 

I think so many of us who get involved in the markets succumb to the very unfortunate idea that, “Oh, it’s at all-time highs, I can’t buy it here.” So seeing Buffett continue to pile into Apple, it just crushes that mindset that you can’t buy at new highs. Look at what he’s been doing. He’s been accumulating it for a couple of years now. Then, brush through a trillion-dollar market cap and he’s still buying it. I think that’s a great lesson for individual investors that we can take from investors like Buffett. 

I also have done a little bit of analysis on the kind of what the billionaires are doing overall, sector wise. I have a little bit of data on that so far, it looks like they’ve kind of backed out of the consumer discretionary sector a little bit. That was one that I had talked about back in February. They kind of cut their position there by about 15% or so. They really increased their position in industrials, in energy, and in materials. 

So those were smaller parts of their portfolios overall, but the biggest increases that I’m seeing are in industrials, which is interesting because the industrials have been so beaten down especially the Dow and energy as well, which is a sector that I’m pretty excited about right now.

Stig Brodersen  27:46  

I’m really curious about your response here to the next question. We’ve been talking about Warren Buffett quite a few times here, and this episode is four years in the making here of TIP. He is really someone we should follow, so we always look forward to him disclosing what Berkshire Hathaway is buying 4 times a year. 

When you follow the financial markets, you can also observe that we are not the only people who are following what Buffett is doing. It’s very common that the stocks that he would load up on, they would go up in price quickly. 

How do you as a trader… I don’t know if the time horizon then, because it largely happens within the day, if that’s too short a period for you… But, how do you factor that into your decisions that you would have these four times a year then you almost know before the market opens that there’s a good chance that they might go up in price?

Richard Smith  28:44  

I would ignore that and what I found is that digging into the 13F data, the information that you can get has value 6 months, 12 months, 18 months out from when the events take place in the industrial portfolios. Even think about the 13F data that’s coming out yesterday or in the last couple of days. 

Like I said earlier, my, one of my favorite approaches is to kind of narrow down my stock selection universe to a couple hundred, 200 or 300 different ideas. I just don’t think it’s that useful to look at what’s happening 48 hours after this data is released, I think looking three to six months out, from looking back at what happened in the 1Q data is actually…There’s still a lot of alpha in there and it’s not where most people are looking. 

Most people are looking at, “Oh, my God. They just released the data. What’s happening?” So it’s hard to find alpha, when you’re looking in the same place as everybody else.

Stig Brodersen  29:48  

That’s a good point.

Preston Pysh  29:52  

Richard, you absolutely come to the table with just a wealth of experience and knowledge and I’m sure during that period of time, you have made plenty of mistakes along the way. I’m excited to hear your response to this question. If you could go back in time and give yourself any piece of advice for trading or momentum strategies or what have you, what would you tell yourself?

Richard Smith  30:18  

Don’t sell your winners. The gentleman that I learned about trailing stops from is Dr. Steve Sjuggerud. He publishes a great newsletter called True Wealth. He has a great track record. 

I was studying the 25% trailing stop strategy and I went back and looked at his performance when I applied a mechanical 25% trailing stop strategy exit strategy to his recommendations. I found that it significantly improved his performance and was like, “Well, how could that be? I know he uses a 25% trailing stop strategy.” 

It was because he wasn’t using the trailing stop strategy to stay in his winners, right? So, because [of] that bias that I mentioned that we are risk-averse when we get profits, and we start to want to pull those profits off the table, sticking with your winners and experiencing what I call irrational profits instead of irrational losses… You know that saying that the markets can stay irrational longer than we can stay solvent, right? 

Well, let that market irrationality work for you. Okay, like let your profits defy your wildest expectations, instead of letting your losses defy your wildest expectations. You get some 10 or 20 baggers in your portfolio, instead of 80-90% losers in your portfolio. 

So being able to really stick with what’s working like Buffett and Apple, and buying more of Apple, that is probably the single biggest change in my own behavior as an investor that I think has made me a more successful investor today than when I got started 20 years ago.

Preston Pysh  32:00  

Well, Richard, thank you so much for coming on the show. We just truly value your input. I’ve been personally using trade stops for quite some time now. I can honestly say that I don’t execute any buy or sell of any stock without first checking the momentum metrics that I find on your platform. So it’s really an honor for me and Stig, I know he also uses the platform, to have these conversations with you. Thanks for making time for us and coming on the show. 

Before we go, Richard, I’m sure people listening to this might be interested in learning more about you and your TradeStops platform. Give them a hand off where they can learn more about you.

Richard Smith  32:38  

We have a special page set up for your listeners at tradestops.com/TIP. So anyone who’s listening to this podcast can go to tradestops.com/TIP and learn a little bit more about how our tools can apply to the type of investing that you guys like to talk about. You also get a special offer for your subscribers.

Preston Pysh  33:03  

Awesome stuff. Richard, thanks again for joining us. We really appreciate your time.

Richard Smith  33:08  

Hey guys, I love spending time with people who are serious about helping individual investors.

Stig Brodersen  33:14  

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

Outro  33:22  

Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. 

This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP Network. Written permission must be granted before syndication or rebroadcasting.