Little Causes; Big Effects, The 80–20 Rule
Simple Stock Picking and Simple Selling
Chemical & Mining Co. of Chile (SQM)
There was a commonly held rule in my family, developed (and likely borrowed) from somewhere in the deep past, that you could do 90% of the job of moving stuff from one house to another in 10% of the time. But it would take 90% of the time to get rid of the other 10%.
And it’s true. Once you get the furniture, appliances and books into the U-Haul, it seems that you’re almost ready to shove off. But getting all the miscellaneous trash and treasures from the depths of the kitchen cabinets, the basement, the shelves in your closet and, worst of all, the attic, seems to go on forever.
Interestingly, the world seems to be filled with this kind of disproportion in time and effort. In fact it seems that there is a universal principle that the distribution of everything is uneven.
Take, for instance, my old favorite from my statistics class, the Pareto Principle, a proposition stating that 80% of the effect in any set of circumstances is always produced by 20% of the cause. [Note: I suspect that the Pareto Principle is the real origin of my family’s 90–10 rule about moving, with a few adjustments for dramatic effect.]
The Pareto Principle was named after Vilfredo Pareto, an Italian economist who noted in 1906 that 80% of all the land in Italy was owned by just 20% of the population. When Pareto began looking at land ownership in other countries, he found that the results were almost exactly the same. (He also found that it applied to the production of peas in his garden, but I don’t want to make him sound like a crank.)
This principle was picked up by analysts in other fields, and they all found similar 80–20 distributions. It was found, for instance, that 80% of any country’s population lives in 20% of the country’s cities; that 80% of the area burned in forest fires came from 20% of the fires, etc. The rule applies to the size of meteorites, the size of casualty losses in many types of insurance, and, most interesting to me, the standardized price returns on individual stocks.
The mathematics that have been used to make sense of the Pareto 80–20 Principle make my head spin. (If you Google “The Double Pareto-Lognormal Distribution—A New Parametric Model for Size Distributions,” you’ll see what I mean.) But I think there are a couple of very commonsensical, very important conclusions from taking The Principle seriously in growth investing.
First, the 80–20 rule tells me that picking growth stocks is not really that complicated, although you can make it complicated if you want to. The biggest improvement to your stock selection will come from relatively little effort. If you have been buying stocks based solely on their story (a very common occurrence, believe me), you will get the biggest improvement from a simple review of revenue, earnings and margin trends for the last few years, then taking an educated look at the stock’s chart. Finally, you can check the major trend of the market and you’re good to go.
You can locate tons more material on any given stock by just rooting around on Yahoo Finance or using your online broker. You can check out the company’s competition, corporate debt, cash reserves, research budget, qualifications of the C-level officers and data-mine the annual report all you want. But you won’t ever achieve certainty about the stock’s likelihood of making you money.
It’s pretty much the same situation as with your own personal health. You can spend days and weeks reading health websites about how to live longer and better. But ultimately you will get the most out of just a few common pieces of advice. Once you get past “Stop smoking, lose a little weight, get some exercise and a bit more sleep, don’t drive like a maniac and try to keep a positive attitude,” you’ve probably hit your 80% improvement mark. And obsessing about your chromium levels or getting your colon cleansed are probably well down the road of diminishing returns.
Second, if you remember that 80% of your total return for any given year will be attributable to just 20% of your stocks, you may take the task of selling your losers more seriously. Because the 80–20 rule also applies to your losses. We all know that a big loss in a stock has dire consequences for your portfolio. It draws down your capital and you need a much bigger gain in the stock to recover it. And the larger the loss, the harder it is to make it up.
Cabot’s loss-limit disciplines direct you to sell any stock that is down 20% from your buy price at the close of a trading session. That’s a maximum loss during a period when the markets are healthy. When markets are in a downtrend, you should reduce your exposure (curtail buying and hold cash) and lower your loss limit to a maximum of 15%. And we will often take losses of 10% or even less because the stock isn’t acting well.
If you can reduce your loss totals, 80% of which are produced by just 20% of your portfolio, you can make huge strides toward winning big for the year.
I’m always interested in the insights that a few simple statistics can produce. But when statistical rules begin to affect my wallet, I’m absolutely fascinated. I hope this has been informative for you, as well.
My stock pick today, Chemical & Mining Company of Chile (SQM) is a bit of a sleeping giant, but I think there are signs that it may be waking up.
Chemical and Mining Company of Chile (CMCC for short, although its Spanish name is Sociedad Quimica y Minera de Chile) owns enormous mineral reserves in Chile’s Atacama salt flat, the second-largest salt flat in the world. The minerals include nitrates that are sold as specialty fertilizers whose micronutrients make them suitable for premium crops; this segment yielded 34% of 2011 revenues. Potassium contributed 26% and iodine kicked in 21%.
But the resource that keeps the buzz going about CMCC is lithium. The growing popularity of lithium batteries (think iPad and Toyota Prius) is just the headline application for this light metal. Other uses include metallurgy, pharmaceuticals, lubricants and manufacturing.
CMCC has been growing strongly, with 27% revenue growth in 2010 and 17% in 2011. Q1 results featured a 36% jump in earnings on a 10% gain in revenue.
SQM doubled from the middle of 2010 to the middle of 2011, but has traded sideways in a tightening range ever since. The chart shows a stock that has made a strong run in June and July, soaring from 51 to around 60. And the increased volume indicates that some significant accumulation is going on.
The ideal trigger will occur if SQM trades under resistance at 60 for a few weeks, building support while investors wait for Q2 results, which will likely be out sometime near the end of August. If quarterly results are good, buying the breakout above 60 could be a good move.
Editor of Cabot China & Emerging Markets Report