10 Rules that Helped me Outperform 90% of Hedge Funds for the Last 6 Years.
I have been researching and investing in public companies for the last 14 years. During that time I have learned lessons that have enabled me to consecutively outperform the S&P 500, NASDAQ and Dow Jones by a wide margin. The tactics outlined below are not bulletproof, but they have been effective at generating outsized portfolio returns during periods of boom, while also preserving those returns during significant pullbacks and corrections. What I love most about researching and investing in securities is that it’s an ever evolving game whereby past experience and forward thinking analysis can help predict, but not guarantee, better returns in the future.
In an effort to legitimize the following I am open sourcing my recent public sector investment returns from as far back as I have records: EOY 2016–2023 YTD. It is important to note that my investment returns were not designed to outperform risky and speculative investments. Instead, my goal was to compete with traditional investments in mutual funds and ETFs, while minimizing the portfolio’s downside risks.
When reviewing my results a key element is to see how my portfolio performed during corrections, pullbacks and minor recessions.
Personal Portfolio Returns 2017–2021 - 246.71%
NASDAQ Returns 2017–2021 - 161.13%
Dow Jones Returns 2017–2021 - 78.38%
S&P 500 Returns 2017–2021 - 101.52%
Personal Portfolio Annualized Returns of the Last 3 Years — 59%
Annualized NASDAQ Returns Over the Last 3 Years - 26%
Annualized Dow Jones Returns Over the Last 3 Years - 24%
Annualized S&P 500 Returns Over the Last 3 Years - 33%
My Performance Against the S&P and NASDAQ in 2017 and 2018
My Performance Against NASDAQ in 2017
My Performance Against S&P 500 in 2017
My Performance Against the NASDAQ in 2018
My Performance Against S&P 500 in 2018
My Performance Against the S&P, NASDAQ and Dow Jones Industrial Average 2019, 2020, 2021, 2022
My 2023 YTD Performance Against the S&P, NASDAQ and Dow Jones Industrial
I cite the above information only to add legitimacy to the following rules that I will now expand on. I have spent the last 6 years deploying the below tactics and rules and they have proven — with a disciplined approach — to be highly effective at generating alpha.
Here they are:
1.Don’t Hold More Than 15 Positions in Your Portfolio at Any Given Time
Less is more. You should always try to own no more than 15 stocks at any given time. This allows you to more effectively track the companies in your portfolio. Owning less than 15 companies in your portfolio will make you prioritize the companies that are most important to you, which is a good thing. I personally choose 15 as my number because there are 11 Sectors in the stock market and having 15 positions enables me to have diversification, proper weighting, and room to weight certain sectors heavier than others, while also preventing me from spreading too thin.
The best analogy to help explain this discipline is to imagine that you are packing a bag for an important trip. You do not know when you’ll be home next and you have limited space in your bag. Knowing your bag has a finite carrying capacity, you will only pack the essentials and likely avoid packing speculative items that you may not need on your journey. The same philosophy of carrying capacity applies to this method of portfolio management. By limiting your portfolio of stocks to 15 companies you are focusing your portfolio on assets that are less speculative, and which to you instinctively, will have the highest chance of success.
The only exception I have made to this discipline was in March of 2020 when I went on a buying spree during the peak of the COVID-19 pandemic. Too many asset classes were grossly undervalued especially among the energy, consumer discretionary, and information technology sectors. Recessions or corrections greater than 15–20% provide great opportunities for portfolio expansion and are the only times that I buy and hold more than 15 companies at one time. In layman’s terms, limit the number of positions in your portfolio to an amount that you can comfortably track weekly. In the event of a major pullback consider disregarding this discipline and buy value when it presents itself.
2. Passive Investing is Better than Active Investing Most of the time
If you spend hours looking at your portfolio and are worrying about its daily fluctuations all the time that is a problem. When I started investing in 2008 I was focused on short term movements and securities that had substantial volatility. The strategy of tracking daily movements caused much heartache and rarely generated significant alpha for me. By 2012, a number of forays into complex options strategies and a series of volatile investments helped me redefine my relationship with investing. Everyone is different, but I have found that longterm investing is not only more effective for me personally, but also more lucrative. Nowadays, I only make a handful of simple, but methodical trades a quarter.
3.How to think about Dollar Cost Averaging
Traditional passive investors use a method called Dollar Cost Averaging. Dollar Cost Averaging (DCA) is a great way to balance your portfolio’s performance over the longterm and is ideal because it helps reduce the impact of market volatility both positive and negative. The chart below illustrates the outcome of DCA for someone who invests $15.00 / day consistently over an extended period of time.
Example of Dollar Cost Averaging
Though using DCA is a good passive strategy, my personal preference to get optimal returns is different. Rather than implementing DCA, I prefer to keep 10% of my portfolio in dividend paying utilities and or cash (i.e. my reserves) and wait for market contractions between 6–10% to start buying and building onto positions. A good strategy is to slowly build onto your positions as the market continues to contract further. One approach is to start building your positions for every additional basis point the S&P 500 loses below 6–10%. If applied correctly you will be rewarded over the longterm by this strategy.
What happens if you have deployed your 10% reserves and the broader markets continue contracting due to a recession and or depression?
If the (6–10%) market contraction develops into a correction and or recession leveraging can become your ally. A recession is perhaps one of the few occasions when strategically acquiring securities on margin and buying aggressively can be advantageous. During recessions certain securities become oversold and interest rates are traditionally lowered by the Federal Reserve. That being said, I personally avoid leveraging more than 20% of my portfolio’s entire value unless I am hedging to protect my gains. You should only leverage when and if broad based indexes such as the S&P 500 are already more than 25% below their peak and you should avoid leveraging more than 20% of your portfolio’s value at any given time. Leverage can also be valuable in that you can use it to deduct the interest expense to offset tax liabilities associated with dividend income, while gaining strategically from longterm upswings. However, leveraging too much and or haphazardly can be terminal and you may not be able to “play out your hand” if you don’t deploy leverage methodically.
In Summary, buy on market weakness, deleverage and have a reserve ready when the market is reaching new highs.
4. Portfolio Weighting can be More Important Than Being an Incredible Stock Picker
Too often people hyper focus on picking and investing in as many “great” stocks as possible. However, if your portfolio is not weighted correctly one bad stock can cause your entire portfolio of great stocks to underperform. This is why I think portfolio weighting is often an under appreciated component to successful investing.
One example of proper portfolio weighting happened to me while I was in Iceland in October of 2018. I was lost somewhere in the Western Fjords of Iceland while the NASDAQ flirted with correction territory and was down -9.20%. The bulk of my portfolio was being impacted with one exception. I owned shares of a small semiconductor company Electro Scientific Industries, Inc. (ESIO) that I had weighted more heavily in my portfolio. ESIO was an overlooked semiconductor business based out of Portland, Oregon. At the time, ESIO was trading at a 4 P/E ratio — industry average at the time was a ≈ 25 P/E ratio. ESIO also had significant insider buying and the company’s balance sheet maintained a healthy 2:1 assets to liabilities ratio. ESIO represented a company with great fundamentals, which to me could also be an ideal acquisition or buyout target. When I arrived in a small fishing village and checked my portfolio I had discovered that ESIO had just been acquired and my portfolio was spared an entire market correction.
The takeaway from the ESIO investment was that one company — weighted correctly in my portfolio — not only protected me from a minor correction, but allowed my portfolio to rip higher when markets rebounded shortly thereafter.
5. Be Patient and wait as long as you need to for a great opportunity, but when an opportunity presents itself strike and strike hard.
Imagine you are on a hunt. However, on this particular hunt you have unlimited resources and time. As you trek through the metaphorical forest you encounter countless animals. Due to limited space you can only bring one animal back to your tribe. You also have to ensure the animal you hunt is of the highest quality and does not carry any diseases. Your tribe is the portfolio, you are the hunter and the animal is the company that has shares you want to acquire. The point of this esoteric metaphor is to train yourself to be disciplined and patient in your due diligence.
One example is Marathon Petroleum (NYSE: MPC) a company I had been tracking since 2015. I watched MPC for 5 years before making an investment in it. When I did make an investment in Marathon Petroleum on 3/16/2020 I purchased shares for $21.00 each. In less than 3 years Marathon Petroleum grew to over $150.00/share and I netted a quick 623% gain + 3 years of healthy dividends.
The point of the MPC story is to take your time and wait. If you are patient you will eventually find a great investment opportunity and when it enters your crosshairs you will be able to strike from a position of strength. When you find a great company at the right price you will know when to pull the trigger. When you do decide to pull the trigger do so decisively and aggressively.
6. Some of The Best Investments Are Obvious
In 2011, people believed Apple had maxed out growth and would soon be crippled by Samsung. Apple shares had traded down to a 10x earnings despite Apple maintaining strong YOY growth and billions in cash residing on the company’s balance sheet. While everyone was prognosticating the demise of Apple, I was aggressively building a position and using this as an opportunity to buy shares. I had waited years to buy Apple at a quality price and finally I found it. The iPhone was the dominant smartphone in North America with great software and hardware that was deeply embedded in peoples everyday lives.
Buying a company like Apple is not a sexy investment and it certainly doesn’t make anyone sound any smarter at cocktail parties, but it was still an obviously undervalued company. The point here is that sometimes the smartest investments are the obvious ones. I can’t reiterate how many times I have seen people create the most elaborate and magnificently sophisticated trading strategies only to have their portfolios crater over the long run.
7. How To Use Leverage To Drive Gains
Traditionally I am not a fan of leverage or trading on margin/debt with my brokerage. However, there are times when strategically using leverage can be immensely advantageous:
- How to Use Leverage To Create a Hedge — If you have substantial returns with a specific investment and you believe the investment will continue to grow in the longterm, but you expect near term headwinds (such as a bad set of quarters or a near term sector-wide headwind) it can be strategic to use leverage to deploy a hedge. Hedges can be executed in several ways, but the easiest is to open a short position for the same number of shares in a stock you own. Opening a short position can help you offset market fluctuations and protect your prized gains. This is especially tactical if you want to lock in your gains at a lower tax rate (i.e., Longterm capital gains vs. short term capital gains). I typically open hedges on margin because I don’t want to allocate real capital from potentially great investments to protect returns on existing investments.
- How to Use Leverage During a Market Pullback — During a recession and or major market pullback companies reach bargain bin prices and interest rates typically get lowered. Using leverage is opportune during these liquidity events, because debt is cheap and 2–4 year returns can substantially outpace the interest on your debt and or the cost of capital. As an example, you purchase a quality positive cashflow company at $100.00 / share during a major market pullback. Your cost to purchase the company’s stock using debt is 5% / year (i.e. $5.00). In 1 year the stock rebounds with the broader market to $150.00. You netted $45.00 / Share and pay your brokerage ≈$5.00 in margin fees. Your return on this investment is 45% and your gains were obtained through the usage of the house’s money.
7. Cut your Losers and Let your Winners Run
The old adage, “Cut your Losers and Let your Winners Run” dates back to a time long before the iconic trader Jesse Livermoore shot himself in the coat room of the Sherry-Netherland Hotel and the essence of the statement still rings true. There have been several instance where I sold winning companies way too soon and held onto terrible companies in hopes of a recovery that never came.
One of my biggest regrets was Advanced Micro Devices (NASDAQ: AMD). I had first opened a position on AMD in 2015 at around $6.36 per share. by 2016 my position had rocketed to around $11.00 per share and I exited with some healthy gains. Now AMD trades around $100.00 / per share. I would have made 1472% return had I held onto even just a portion of my equity position.
If you are investing in growth stocks it’s important to have a disciplined approach and thesis. Just blindly holding a stock can be a brutal formula to guarantee exceptional losses. In the case of AMD I clearly underestimated the explosive growth of CPU’s and Graphic Cards. I sold the position because I had established a predetermined value on the underlying company. The point being if you do let your winners run, make sure you are adjusting your strategy, thesis, and plan as you do to maximize returns.
8. Analyze Your Portfolio For Dislocations
People often become hyper focused on one or two companies / investments in their portfolios. When reviewing the securities you own it is important to look at how your broader portfolio is performing against the overall market i.e., S&P, NASDAQ and DJIA. If broader markets are up 2% and your portfolio is down -2% it is important you learn what factors are contributing to your portfolio’s dislocation. Identifying dislocations quickly is critical to improving your portfolio strategy. If your portfolio is completely dislocated from the market in a negative way some questions to ask yourself are the following:
- Are you overly invested in sectors that are past their cyclical prime? Alternatively, have you invested in certain sectors too early or before they gain their momentum? It is never bad to be investing early, but to be building a position in a sector that is at the end of bullish cycle can be detrimental.
- Are you invested in certain companies that keep weighing down your portfolio? If so, why are you keeping these companies? Do you have a good reason to remain invested and or has it simply become a case study in Sunk Cost Theory?
- How volatile is your portfolio? Are you seeing your portfolio jump 6% when the broader markets go up 1%? Conversely are you seeing your portfolio contract -6% when your portfolio contracts -1%?
Everyone has different levels of pain tolerance, but don’t mistake volatility for a great portfolio. The integrity of your portfolio is measured by both how it performs during upward and downward swings. Identifying dislocations and understanding what is driving them will help apply discipline to your investment thesis. Always challenge your original thesis. People change, companies change, stock prices change, and so should your thesis and perspective.
7. Never Buy When the Market is Finding A New High
A quick way to expose your portfolio to underperformance is to build positions in companies or the broader market when they are reaching new highs. Always wait for the metaphorical “dust to settle” in a bull market. Periods of lower volatility or market contraction offer great buying opportunities.
8. Before Buying Any Stock
Be sure to examine the quarterly and annual Income Statements and Balance Sheets of the company for the last 3–5 years. If you haven’t studied a company’s financials intimately don’t buy the stock. Always know your numbers! They will guide you and act as your baseline when the going gets tough, which it always will. If you haven’t examined a stock’s financials you shouldn’t be buying it.
Once you understand a company’s financials it is important you establish a set of valuation guidelines for yourself. The purpose of individual valuation guidelines is to allow you to establish a baseline value for the companies you are buying into. The logic here is to view buying shares of a company as you would any other purchase or transaction in your daily life. When you walk into a grocery store if someone were to try and sell you a single orange for $1,000.00 you would probably refuse. This is because you know that an orange is worth less. The only exception is if you believed that the orange would offer you something that would be worth $1,000.00. Perhaps a chance at immortality? If so, you would likely still want to analyze the purchase before doing so. The same philosophy applies to any stock. If you don’t have a core set of principles to help you define what the baseline value of a company should be to you — how do you know if it is overvalued and or when you should sell it? Before buying any company you should always attempt to write down, notate, and also date what you believe the value of the company should be and why. These notes and entries will help you ensure that you don’t lose your sense of gravity.
Obviously there are always exceptions to these metrics based on growth rates and the company being analyzed, but some company metrics I like to see before initiating a position are the following:
For a Non Growth Related Security:
P/E Ratio — 15 or less
2:1 Assets to Liabilities Ratio (excluding Goodwill as an asset)
Positive EBITDA and Net Income
Consistent Pattern of Quarterly Beats
5–10% YOY Growth and strong pricing power
For a Tech Related Security:
P/E Ratio — 30 or less
2:1 Assets to Liabilities Ratio (excluding Goodwill as an asset)
Positive EBITDA and Net Income
At least 15% YOY revenue growth
Consistent Pattern of Quarterly Beats
10.Don’t Let Yourself Get Emotional. Always Be Optimistic when Markets are down and a Skeptic when Markets are up.
Behavioral Economists Daniel Kahneman and Amos Tversky discovered the phenomenon known as “loss aversion,” which highlighted a key disparity in peoples reaction to fluctuations in their financial disposition. The two behavioral economists discovered that when a person loses 50% of their net worth they were likely to get twice as emotionally upset compared to when their net worth increased by the same 50%. The outcome of the “loss aversion” phenomenon as it relates to market psychology is that people are inherently more impulsive decision makers during market downturns. This is an immutable law of human biology and as such herein lies the easiest opportunity for alpha.
At the peak of the COVID-19 crisis I was buying every oversold company I could find when a friend cautiously asked me, “What if the market fully collapses? What will you do then?” To which I replied, “If the market fully collapses we may have bigger problems than worrying about stocks and money.”
The point of this last anecdote is to highlight the futility of worrying about money and not letting those anxieties impact effective and logical decision making. Money will always come and go, but our family, friends, health and the experiences we have will be what endures. So when the going gets tough and you see your assets rising and falling just remember that none of it really exists.
If you have read this far thank you for doing so. I hope that some aspect of my experiences will help you build and create value for yourself and those around you. Happy hunting.
Author Bio— In 2019 I sold my company Solace Technologies for $16.25m to (NYSE: TPB). I have started and invested in a number of other private companies. Currently, some of my favorite private sector investments include: Charge Fuze, ActionResponder, Carro and Fazit.
Currently, I am the Chief of Strategy at Turning Point Brands (NYSE: TPB) where we are focusing on building a world class CPG business for tomorrow’s brands.
I also co-founded the Advertising, Market Research and Branding Agency DPGW in 2013, which has worked with companies ranging from startups to fortune 500 companies on brand development, advertising and market research.
To learn more or to reach out to me directly visit www.lorenzodeplano.com and subscribe.
Disclaimer — Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above are purely subjective and reflect the opinions of the author only. The author is not a licensed securities dealer, broker or US investment adviser or investment bank. Invest at your own risk.
