Little Book of Bull's Eye Investing

1. Secular Bear Markets: Understanding the Long-Term Cycles

There have been seven secular bull markets and seven secular bear markets since 1800, if you identify them by peaks and troughs in stock prices.

Long-term market cycles. Secular bear markets can last anywhere from 8 to 20 years, with an average duration of about 17 years. During these periods, stock prices may be flat or falling, and valuations (P/E ratios) tend to contract. Understanding these cycles is crucial for investors to adjust their strategies accordingly.

Characteristics of bear markets:

• Average real return during secular bear markets: 0.3% per year
• Average real return during secular bull markets: 13.2% per year
• Cyclical bull and bear markets occur within these longer-term trends

Investors must recognize that we are currently in a secular bear market that began in 2000 and may continue for several more years. This understanding should inform investment decisions and expectations for returns.

2. The Disconnect Between Economic Growth and Stock Market Performance

From 1964 through 1981, while the stock market was piling up its 0.1 percent gain, gross domestic product (GDP) actually grew 374 percent.

GDP growth ≠ stock market growth. There is often a significant disconnect between economic growth and stock market performance. This counterintuitive relationship challenges the common belief that a growing economy always leads to rising stock prices.

Examples of disconnect:

• 1964-1981: GDP grew 374%, stock market gained 0.1%
• 1981-2000: GDP grew 197%, stock market rose 1,239%

Investors should not rely solely on economic indicators to predict stock market performance. Instead, focus on valuation metrics and long-term market cycles to make informed investment decisions.

3. Value Investing: The Key to Success in Bear Markets

Buying value means being patient if you are going to invest in stocks in a secular bear market.

Finding undervalued assets. Value investing involves identifying and purchasing stocks that are trading below their intrinsic value. This strategy is particularly effective during bear markets when many quality companies become undervalued.

Key principles of value investing:

• Focus on fundamentals: Analyze financial statements, earnings potential, and competitive advantages
• Margin of safety: Buy stocks at a significant discount to their intrinsic value
• Long-term perspective: Be patient and allow time for the market to recognize the true value of the stock

Value investors should look for companies with strong balance sheets, consistent cash flows, and sustainable competitive advantages. During bear markets, these opportunities become more abundant as market sentiment turns negative.

4. Investor Psychology: Overcoming Behavioral Biases

Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues.

Cognitive biases in investing. Investor psychology plays a significant role in market behavior and individual investment decisions. Understanding and overcoming these biases is crucial for successful investing, especially during bear markets.

Common behavioral biases:

• Recency bias: Giving too much weight to recent events
• Confirmation bias: Seeking information that confirms existing beliefs
• Herding: Following the crowd instead of independent analysis
• Loss aversion: Holding onto losing investments too long

To overcome these biases, investors should:

• Develop a disciplined investment process
• Regularly review and challenge their assumptions
• Seek diverse perspectives and contrarian viewpoints
• Focus on long-term goals rather than short-term market movements

5. Diversification: Beyond Traditional Stocks and Bonds

Bull's Eye Investing simply attempts to apply that same principle to the markets. In this book, I hope to give you an idea of the broad trends that I believe are at work now and will persist for the remainder of this decade.

Expanding the investment horizon. Traditional diversification across stocks and bonds may not be sufficient during secular bear markets. Investors should consider a broader range of asset classes and investment strategies to achieve true diversification and protect their portfolios.

Alternative investment options:

• Commodities: Gold, oil, agricultural products
• Real estate: REITs, direct property investments
• Absolute return strategies: Market-neutral funds, long-short equity
• International markets: Emerging market equities and bonds

By diversifying across a wider range of assets and strategies, investors can reduce overall portfolio risk and potentially enhance returns during challenging market conditions.

6. The Small Investor's Edge in Finding Value

As a small investor, you don't have the problem of too much money and too few good investments.

Flexibility in investment choices. Small investors have a significant advantage over large institutional investors when it comes to finding value in the market. They can invest in smaller, less liquid companies that are often overlooked by larger players.

Advantages for small investors:

• Ability to invest in micro-cap and small-cap stocks
• Greater flexibility to enter and exit positions
• Less pressure to stay fully invested at all times
• Opportunity to focus on a smaller number of high-conviction ideas

To capitalize on this advantage, small investors should:

• Conduct thorough research on potential investments
• Focus on companies with strong fundamentals and undervalued assets
• Be patient and willing to hold positions for the long term
• Leverage their ability to invest in niche markets and overlooked opportunities

7. Gold: A Hedge Against Economic Uncertainty

I divide gold into two piles: "insurance" gold and "investment" gold. I feel strongly about insurance gold. I think everyone should have some.

Gold as a portfolio stabilizer. Gold serves two primary purposes in an investment portfolio: as insurance against economic uncertainty and as a potential investment opportunity. Understanding these roles can help investors make informed decisions about gold allocation.

Considerations for gold investing:

• Insurance gold: Held as a hedge against economic crises or currency devaluation
• Investment gold: Potential for price appreciation during periods of inflation or economic instability
• Gold stocks: Offer leverage to gold prices but come with additional company-specific risks

Investors should consider allocating a portion of their portfolio to gold as a form of insurance, while also being aware of the potential investment opportunities in gold and gold-related assets during periods of economic uncertainty.

8. Commodities and Alternative Investments: Navigating New Opportunities

Do not attempt to trade futures on your own. I cannot make it any clearer than that. The odds are very high that you will lose money.

Professional management for complex markets. While commodities and alternative investments can offer diversification benefits and potential returns, they require specialized knowledge and expertise to navigate successfully.

Approaches to commodity and alternative investing:

• Managed funds: Professionally managed commodity trading advisors (CTAs) or hedge funds
• Exchange-traded funds (ETFs): Provide exposure to commodities or alternative strategies
• Mutual funds: Offer access to alternative investment strategies in a more regulated format

Investors should approach these markets with caution and consider professional management or well-researched fund options rather than attempting to trade directly in complex and volatile markets like futures.

9. Bond Investing: Adapting to a Changing Interest Rate Environment

Sadly, 45 percent of bond investors in a recent survey conducted by Schwab did not realize their bond fund could lose money if interest rates rose.

Interest rate sensitivity of bonds. Understanding the relationship between interest rates and bond prices is crucial for fixed-income investors, especially in a changing rate environment.

Strategies for bond investing in a low-yield environment:

• Ladder maturities: Stagger bond maturities to manage interest rate risk
• Focus on high-quality, individual bonds: Hold to maturity to avoid interim price fluctuations
• Consider international bonds: Explore opportunities in foreign markets with higher yields
• Be cautious with long-term bonds: Limit exposure to interest rate risk in a low-yield environment

Investors should be aware of the risks associated with bond funds in a rising rate environment and consider alternative fixed-income strategies to protect their portfolios.

10. The Importance of Absolute Returns in Bear Markets

In markets like those we face today, the essence of Bull's Eye Investing is to focus on absolute returns. Your benchmark is a money market fund. Success is measured by how much you make above Treasury bills.

Shift in investment focus. During secular bear markets, the traditional focus on relative returns (beating a benchmark) should be replaced with a focus on absolute returns (positive performance regardless of market conditions).

Strategies for achieving absolute returns:

• Tactical asset allocation: Actively adjust portfolio allocations based on market conditions
• Alternative investment strategies: Consider market-neutral or long-short approaches
• Focus on income-generating assets: Seek stable cash flows from dividends, interest, or rental income
• Capital preservation: Prioritize protecting capital during market downturns

By focusing on absolute returns, investors can better protect their wealth during challenging market conditions and potentially outperform traditional buy-and-hold strategies in secular bear markets.

Last updated: November 19, 2024