Trading surgery

My investing strategy has two stages. The first is to identify a watchlist of the highest quality businesses I can find. This takes advantage of the ‘big idea’ underpinning my strategy – that I can identify high quality businesses that are likely to be materially undervalued when their long term growth is properly accounted for. The second stage is to trade the businesses on the watchlist based on their current momentum, valuation and news flow.

In practice, it’s been the first stage rather than the second which has delivered most of the returns. This is demonstrated by the strong relative performance of my benchmark buy and hold portfolio, which simply holds all of the shares on my watchlist for the long term. My approach to the second stage is less clearly defined and has evolved over time as I have experimented with different approaches. If I want to improve my results, I think this is what I need to focus on.

The first question is why have a second stage at all. The most simple implementation of my ‘big idea’ would be to just buy and hold the highest quality businesses I can find. This is what most ‘quality’ investors seem to do. Why not just focus on trying to identify the very highest quality rather than faffing around trying to overlay a trading strategy? I have some concern that part of the motivation may be a desire for excessive engagement and an inability to sit on my hands. However, the bottom line is that I believe a simple trading overlay should add value if implemented well. While it hasn’t added much value as yet, I’m not giving up yet. I will continue experiment carefully and try to learn from my mistakes.

If I am going to trade actively, I think the secret is finding the right balance between rules and discretion. Rules are important to control the unhelpful impulses that lead to systematic mistakes. However, allowing myself to exercise judgment, taking account of any important nuances that arise from case to case, is important too. My aim is to get this balance right while ensuring that I can continue to develop and improve over time.

When to trade

An investing strategy needs to tell you what to trade and when to trade. The latter is where I think rules are particularly important. Investors face a constant barrage of temptations to take action when none is needed. Rules about when you can trade provide some much needed discipline to stop over trading and limit impulsive errors in judgment.

I am happy with my simple system of periodic rotation (first discussed here), under which I currently make one trade (swapping one share for another) once a fortnight. It is straightforward to adhere to and provides clear discipline against over-trading. I also like that this approach keeps me fully invested and forces me to directly consider the qualities of different investments relative to one another. Other trading rules, such as stop losses, are more about managing the risk from individual investments in isolation and I think are more suited to a more short term trading mentality.

However, the frequency of my trades needs recalibration. Trading once a fortnight out of a portfolio of 25 shares implies an average holding period of one year. I now think this seems too short. It has resulted in me becoming overly sensitive to short term price movements and incurring excessive trading costs. Following momentum too closely is particularly problematic as it results in buying on the highs and selling on the lows.

There are two ways to remedy this. One approach is to have a longer interval between trades – say once a month rather than once a fortnight. The other is to instead hold more positions (but still trade every fortnight) so each position ends up being traded less frequently. For example, by continuing to trade once a fortnight but holding twice as many positions, each position would be traded about once every two years on average rather than once a year.

It hasn’t been easy to decide which way to go. It seems to partly about how much discretion to apply when picking shares. On one hand, having fewer, more concentrated positions increases the potential for stock picking prowess to add value. Having a longer interval should mean that a stronger rationale can develop for the trades I do make. Fewer trades means more thought can go into each one and may make it easier to review past decisions and learn from them. On the other hand, holding more positions and trading more frequently could be a better way to exploit a more systematic edge more confidently. It might take more of the emotional sting out the game and would reduce my fear of missing out of the many decent opportunities on my watchlist.

It’s a close call but overall I think trading a smaller portfolio less frequently is the better approach. While I am fond of the idea of running a larger portfolio with a highly systematic approach, I think there is potential for greater outperformance in relying on more careful judgment over a smaller number of decisions. Perhaps I might change this in the future once my portfolio is larger and starting to become unwieldy, but for now I’m going to keep it more concentrated. This means that starting with my last trade earlier this month, I’m going to be trading once a month rather than once a fortnight.

What to trade

What to trade is a much more complex decision. The objective is straightforward – to continually optimise my overall portfolio’s likely return and exposure to risk, taking account of developments from month to month. By and large this means selling the investment in my portfolio with the worse prospects and replacing it with the candidate from my watchlist with the best prospects, though ensuring diversification also plays a role. Deciding which shares have better prospects over this time horizon is the challenge, as the outcomes are highly uncertain. I try to approach this in a probabilistic way by comparing investments according to characteristics which I believe are important predictors of return.

Selection criteria

The characteristics I look at when deciding what to trade are quality, value, momentum and news flow. Investing in high quality is the cornerstone of my strategy and is already largely captured by the first stage of my strategy, where I decide what to include in my watchlist. However, while everything on the watchlist is high quality, some shares are higher quality than others, so I want to put some weight on quality at the second stage too.

The original inspiration for the other selection characteristics primarily comes from empirical research into ‘factors’. ‘Momentum’ and ‘value’ are factors that have been shown statistically to have tended to result in outperformance in the past. The most obvious explanation for their existence is that they result from systematic behavioural errors made by investors as a whole. However, I think it’s important not to take too much comfort from these statistical findings. There is no guarantee that what has worked in the past will work in the future. The behaviour of market participants is constantly evolving. To be confident in relying on factors it helps to have some understanding of why they might work and to tailor your reliance on them appropriately. Unfortunately there are no bright lines here. In my view this is as much about judgment as it is about empirics.


For some investors valuation analysis is the be-all and end-all. This is far from a crazy idea. In principle you can bake all the fundamentals in to the valuation assessment, also taking account of ‘quality’ by adjusting your valuation assessment accordingly. However, in practice this is very difficult. What is particularly difficult is to judge how to value uncertain cashflows occurring a long way in the future. In practice what tends to happen is that investors implicitly bake in conservative assumptions of mean reversion after a certain period of time. For example, they might assume that after 10 years growth of all investments reverts to a common growth rate, or they might apply a common discount rate across investments that doesn’t sufficiently account for differences in relative risk. Trying to accurately account for these points is extremely challenging, as it is highly speculative and indeterminate. The primary thesis behind my strategy (and several other quality investors) is that it is better to just focus directly on quality rather than valuation. Quality tends to be systematically undervalued as other investors implicitly tend to take too short term a perspective when considering valuation.

Of course, ‘value’ as a factor is not the same as valuation analysis. With its focus on various types of valuation multiple (like PE ratios, price-to-cash flow, price-to-book etc.) value factors have an explicitly short term focus as they typically do not account for growth at all. In practice, this means that ‘value’ is really about the ‘short term’ valuation – implicitly baking in a sort of worst case scenario for further growth. This penalises those businesses with better long term growth prospects.

I’ve always been quite skeptical about the behavioural basis for the value factor. What is it about investments with lower valuation multiples that would make investors more likely to undervalue them? The standard hypothesis is that this exploits a tendency for investors to over extrapolate short term trends or mindlessly ‘herd’ after the latest hype, causing prices to mean-revert afterwards. No doubt this sometimes happens, though my impression is that most of this occurs at an overall market level, driving panics and bubbles. Using value as a factor is about comparing a shares relative to one another. In this context my impression is that most the time investors are overly influenced by short term relative valuations. It is notable that the value factor hasn’t worked consistently for some time and that the times when it has worked have coincided with big market crashes. I wonder how much of the reason for the empirical support for the value factor’s outperformance is simply because the information needed to assess valuations was harder to find in the past?

When I look at value I make some assumptions about growth over the next five to ten years, bringing my assessment somewhere closer to a fully fledged valuation analysis than a simple multiple, but without a lot of the complexity (or the pretense that it is in any way accurate). This makes my value assessments more about the ‘medium term’ valuation. All else equal, I prefer to invest in situations where the share price is more obviously justified by the medium term valuation as well as the long term quality. Sometimes there are situations where you get this double whammy – a business in which you have especially high long term conviction also appears clearly undervalued on a medium term basis. There may be a specific reason why I think the market has got it totally wrong. However, more often than not, all else is not equal and I have to judge how to trade off a better medium term valuation against worse long term quality. Intuitively it feels like the better play is to put more weight on the latter, in line with my broader strategy, if in doubt. This means that most of the time I want to put relatively less weight on value compared to other factors when deciding what to buy. However, there are circumstances when the valuation is either so compelling or so demanding that it seems foolish to disregard entirely.

The other way in which value is useful is as a factor for proxying the risk from a change in market sentiment or market conditions. If the market’s appetite for risk or long term growth falls, then highly valued, high quality investments will be hit proportionately harder. This means I want some diversification over investments with different medium term valuations. Given my focus on high quality this typically means in practice that I worry about having sufficient exposure to business with lower valuations. I can also use this as a more moderate approach to market timing than selling out and going to cash, ie by incrementally increasing my exposure to lower valuations when conditions become more bubble-like, as is the case now.


To me the basis for buying shares with momentum has always seemed more compelling than the basis for buying what looks superficially cheap. Not only is there strong empirical support for momentum’s outperformance, but I find the behavioural explanations intuitive and credible. I’ve often experienced the strong feeling of having missed the boat when contemplating an investment that has already done well, compounded by the fear of buying at the top and becoming the biggest fool in town (or the converse false sense of reassurance that if I buy on a low then at least I’m not as foolish as those who bought before me). One of my earliest reflections on investing was that it seemed more contrarian (and so likely more profitable) to bet against these instincts rather than to follow the buy-low sell-high orthodoxy. I’ve wrote more about the underlying reasons for momentum in one of my earliest posts.

Over time, I’ve come to appreciate that there may be more to momentum than these simple behavioural explanations. In the short term illiquidity plays a major role, by making it take longer for large institutional investors to respond to news without affecting the price. This means that share prices often drift upwards for some time after positive news. Illiquidity can also cause share prices to consolidate at a certain level, as a large seller may be forced to take their time waiting for buyers to ‘come to market’ when offloading their position if they don’t want the share price to collapse.

More importantly, ‘long term’ momentum results from the fact that over the long term all businesses have to compete with one another for the attention and scarce resources of their customers. The process of competition allows the best businesses to use their advantages to eat the lunch of their more mediocre rivals and invest in further reinforcing their advantages. Over time the returns necessarily accrue to the few most successful businesses, while the rest fall by the wayside. The market’s short-sightedness in failing to anticipate this is what drives the famous fat-tailed distribution of returns, as I explained in this post. This empirical result pretty much directly implies that long term momentum should predict outperformance – those businesses possessing the competitive advantages enabling them to achieve higher returns in the past are more likely to achieve higher returns in the future.

I think these are all compelling reasons to incorporate momentum into my investing strategy. However, implementing this well is not trivial. Get the sensitivity a bit wrong and instead of following momentum, you can end up being ‘whipsawed’ by short term price volatility, buying on the highs and selling on the lows. I have suffered from this in the past.

One way to deal with this is to explicitly ignore the volatility over the most recent time period when measuring momentum and focus solely on the long / medium term momentum effect. For example, you ignore the last three months and measure the price increase over the previous nine. A more qualitative approach is to simply observe the long term price chart. If you zoom out and ignore the most recent volatility, to what extent has the price been trending upwards over the long term?

An alternative, more short term, way to trade momentum is to try to identify points of inflection, where the share price is likely to make a big move, potentially in either direction. The most intuitive explanation for the existence of these points of inflection is illiquidity (though the other behavioural biases described above likely play a role too). As noted above illiquidity can result in the price consolidating at a certain level for a period of time, eg as a large seller waits for buyers to ‘come to market’ (or vice versa). Once this has worked itself through, it becomes clear whether demand exceeds supply (or vice versa) at that price, other buyers (or sellers) pile in and the share price starts to trend upwards (or downwards). Sometimes a catalyst, such as a results statement, is what resolves the situation.

If you can identify these points of inflection, then you should be able to exploit them by using a ‘money management’ strategy that sells quickly if the price starts to fall but holds for longer if it rises. By doing this it is possible to have a highly profitable strategy that is ‘correct’ less than 50% of the time. This approach is not contingent on whether the price rises or falls, simply that if it does start to rise then it is likely to continue. However, it obviously is contingent on being able to identify these points of inflection. There are various methods to this captured by technical analysis (ie looking at charts), eg looking for ‘breakouts’ above points where the price has previously met resistance and consolidating, or bounces off points where the price has previously found support.

These two approaches are quite distinct from one another. While both superficially appear to be ways of exploiting momentum, they are really exploiting somewhat different market inefficiencies that occur over different time periods. I think one of the issues with my current trading may be that I’ve confounded these ideas, combining them without thinking too carefully about how I was doing this. I discuss my updated approach below.

News flow

I see positive news flow, like a recent ‘ahead of expectations’ trading announcement, as complementary to momentum. Momentum can be driven both by the under-reaction to positive news and by a self-reinforcing over-reaction to the momentum itself, as other investors pile on to the trade. By taking account of the recent news flow, I make it more likely that I’m capturing shares where momentum is indicating that the share has under-reacted to recent positive developments and so is more likely to be undervalued.

Rules vs discretion

It’s one thing to identify selection criteria, it’s quite another to implement them effectively in a coherent framework for making trading decisions. Since deciding what to buy involves weighing up several qualitative factors against each other, I think there is a lot to be gained from having some flexibility. Human intuition and pattern recognition can be incredibly powerful if applied wisely and trained over time. As I discussed in this post, rules aren’t there just to directly restrain you from making silly mistakes. They also help to frame your perspective. It’s as much about retraining unconscious impulses to align with what actually delivers success, as it is about resisting and supplanting them with conscious thought.

Up to now I have tended towards trading as methodically as possible. I’ve experimented with a few approaches, such as using a simple scoring system to rank the shares on my watchlist or trading purely based on momentum. I have allowed myself a bit of discretion in making the final call out of the top suggestions thrown off by the system and in implementing the scoring, but by and large I’ve tried to keep things as mechanical as possible in a bid to keep unhelpful impulses under control. However, now I’ve been following my strategy for a few years I feel my instincts are better trained. I think it’s time to take off some of the stabilisers and give myself more flexibility.

Updating the trading strategy

My main idea to give myself more flexibility is to allow myself to freely choose between several different types of trade, rather than try to awkwardly shoehorn all my ideas above into a single approach. I’ve already started doing this to some extent but incorporating it more explicitly into my strategy should help bring more clarity to my thinking. Hopefully this will allow me to more confidently rely on my intuition while preserving a degree of discipline. Running multiple types of trade also has the benefit of helping with diversification and allowing me to adapt to market conditions, though only to some extent as I’m still limited to my overall strategy of only buying the high quality shares on my watchlist.

I have three types of trade in mind:

  • Default approach: these trades broadly follow my current approach of attempting to weigh up the factors described above (quality, value, momentum and news flow).
  • Value trades: these trades are primarily motivated by an attractive valuation, regardless of momentum.
  • Breakout trades: these are shorter term trades aiming to exploit the points of inflection I describe above.

The overall idea is for me to actively monitor my watchlist for opportunities to make any of these types of trade. Most of my trades will still follow my current ‘default’ approach – the main update is that I’m going to think about the other two types in a more clearly distinct way. Below I describe the specific approach to each type of trade.

Default trades

These trades follow my current approach of trying to weigh up the quality, valuation, momentum and news flow and pick the trade where the overall balance looks most promising. Currently I use a ranking system (included in my watchlist spreadsheet) to help me do this. The spreadsheet draws my attention to the more promising prospects, which I look at a bit deeper before deciding where to pull the trigger. In the same way it also helps me decide what to sell.

I’m sticking with this approach for most of my trades but tweaking how I look at momentum in line with the thinking outlined above. My current scoring system involves looking at the chart and making a combined qualitative judgment based on both whether there is an uptrend and on whether the price is ‘breaking out’. I’m changing this to focusing just on the strength of the medium term uptrend, while trying to ignore the short term price volatility. I think this is more in line with the time horizon for most of my trades. I’m also tweaking the weighting in this system for my main strategy to tilt it more towards shares with better quality and stronger momentum over shares with cheaper valuations in a way that I feel better aligns with my broader thinking on the relative importance of the different factors. I think it may work better to deal with more value-oriented trades with a separate approach that ignores momentum entirely…

Value trades

Value trades are essentially about ‘buying the dip’. Most of the time I prefer not to put much weight on my assessment of valuation, but there are some exceptional situations where I have high conviction that I’m getting a great deal in spite of momentum being weak. For example, there may be a ‘clumsy’ forced seller in a particularly illiquid share, or a situation where the market has clearly overreacted to some apparently unfavourable news that shouldn’t actually hurt the investment case much. In addition, it can often make sense to buy the shares that have been punished the most by a market correction. A big price drop in a market correction can sometimes be an opportunity to buy the highest quality obvious long term winners that look overvalued much of the time (the ‘Amazons’ etc.).

Value trades are easy to screen for, through the simple valuation assessments I already use for scoring in my spreadsheet or by looking at what shares have fallen the most from their highs. However, they require more conviction that what I’m buying is genuinely a bargain and that this is going to be recognised by the market before too long. A relatively cheap valuation typically isn’t sufficient in itself to make me want to buy. I want to invest in situations where I also have particularly high conviction in the long term quality and am confident in the near term prospects too. I don’t want to be caught out by buying in situations where are share price fall correctly anticipates a profit warning, or where a recovery is drawn out over several years.

Value trades fit in neatly within my system of monthly trades. The precise timing of when to buy doesn’t matter so much. I have no expectation of being able to call the bottom. My previous experience is that patience is key. It’s important to restrain the impulse to jump in quickly. The point of capitulation at the low typically takes longer to reach than you expect and it’s better to err on the side of being too late than too early. Catching a falling knife can really test your resolve and buying on the way back up minimises your opportunity cost.

Breakout trades

As I described above the rationale behind breakout trades is to take advantage of the tendency for prices to head off in one direction after a point of inflection. The way they work relies heavily on money management ie by selling quickly if price goes down but allowing more profit if successful. This approach inherently implies a short time horizon and the use of stop losses. I think them properly implies that I would need to make additional trades on top of my normal monthly rotation. This makes breakout trades a bit of an awkward fit with the rest of my approach. On top of that many of the shares breaking out to new highs would be likely to be picked up by my default strategy anyway, so it often it seems that it would make more sense to treat the breakout as icing on the cake within my default approach.

Given they don’t really fit with the rest of my strategy, it’s questionable why I need to include breakout trades as an option. I don’t intend to do them often. The potential benefit I see is that they have the potential to deliver returns over a much shorter time period and so can compound much more profitably over time. I intend to use this approach sparingly as a way of turning over my portfolio more quickly and delivering greater returns when market conditions are particularly favourable.

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