The Pyramiders Mindset
A New Leader in the Aerospace Boom
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I’m not a huge gambler, but in my younger days I used to go to a casino three or four times a year. Craps was probably my favorite game, partly because of the action, and partly because everyone’s basically on the same “team” against the house. But Blackjack was a close second, both to play and to watch others.
I have a very close friend who also works in the financial world who’s a higher roller than I am, and I swear that he (and his Dad, for that matter) were born under some casino-shaped lucky star. Sure, he takes a haircut every now and then, but when he loses, the losses are usually relatively small. When he wins, he walks away with big money. It’s crazy.
Now, I’m not going to sit here and write about some secret Blackjack strategy or anything like that. My friend is anything but a card counter and just follows basic strategy, which was developed decades ago, along with (of course) a little gut feel here or there. Nothing fancy or unusual.
But after watching him play dozens of times, I realized he does do something far different than most players at the table. He manages his bet in a unique way.
My friend will sit down at the high roller table (he especially likes when he’s the only one at the table so the dealer works quickly) and plops down $100. (For this example it could just as well be $10 or $25; the dollar figures aren’t as important as the procedure.)
Now let’s say he wins the hand, what does he do? Well, most people take the $100 of winnings and put it in their side pile ... and there’s nothing wrong with that. But my buddy pushes his bet—not only will he take the $100 he wins and add it to his next bet, he’ll put another $100 on the table, making his total bet $300 on the second hand.
It sounds aggressive, but if he loses that second hand, he’s out a total of $200 ... the same as if he had simply lost two hands in a row, which isn’t a huge deal. Conversely, if he wins, all of a sudden he has something going—he has a total of $600, of which $400 is profit. At that point, he might push his bet just a little further (say, raising it to $400), or he might not. But he will take some chips off the table and start “paying himself,” so to speak.
Exact numbers aside, the point here is that my friend is unafraid to lose his small, initial profits—that first $100, or even a bit more on the second hand. Instead, he’s looking to use those initial winnings as leverage; to build a bigger bet so that he has a shot at making big money. His goal is to win six or seven hands in a row. Just one streak like that, using this technique, can make his night.
It’s not unusual to see him bet $500 or $600 on any one hand, but if he has that much money on the line, it means he’s on a roll, he’s taken some chips off the table and he’s playing with the casino’s money.
Now, as I said above, I’m not trying to convince you that my friend has some sort of magic system to beat the odds. Nope! He knows full well that the luck swings both ways, and hitting the casino is simply entertainment (and, partly, competition) for my buddy.
That said, it struck me after talking with him a few days ago (when he was recounting yet another solid win at the tables) that his system is a lot like that of investors who practice pyramiding—i.e., systematically averaging up in stocks.
Most investors—like most gamblers—are very protective of their profits. Thus, if they buy a stock and it immediately rises a few percent, they rush to raise their stop-loss. Some even take some or all of their stake off the table. Jesse Livermore said it best: An investor must “reverse what you might call his natural impulses. Instead of hoping, he must fear; instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.”
That’s exactly what people who pyramid in stocks (buy more on the way up ... generally in smaller amounts) try to do. They effectively re-invest their small initial profits back into the stock, giving them a larger position size, which could pay off big if the stock keeps doing well. In other words, they push their bet at the start of the trade.
If done properly, a “pyramider” will never increase his risk of loss on a trade beyond what he started with. Looking at the math, if his initial risk (the initial stop-loss level, minus the cost, times the shares owned) was $700, he’ll never buy so much more that his risk of loss rises above that figure.
The main risk of the system is what happens if you get off to a nice initial start but then lose right after—as mentioned above, if my friend loses his second hand, he’ll be out $200. The person who simply pocketed the initial win would be at breakeven (win $100, but then lose it on the next hand). It’s the same when averaging up in a stock—if you buy at 50, buy more at 54, and then the stock tanks, you’ll probably end up losing money. But the person who doesn’t pyramid might be at breakeven or even sneak out with a small profit.
Of course, the question then is: Does the downside of losing profits (or taking small losses) on small winners outweigh the extra profits you get by averaging up into a big winner? I think the answer is no—over the long-term, investing is a game of outliers, and if you can make the most of your winners, you’ll end up with more money.
I talked for a few minutes last August at the Cabot Investors Conference about pyramiding techniques, and I made sure to mention that it’s very mentally challenging to follow it. While your risk of loss is always kept in check, the risk to your pride—when you see a few small winners reverse into losers—can wear on you. Simply put, the system is geared more toward moderate and bigger winners, so if you go a while without getting one (say, in a choppy market environment), it stinks. But most of the best investors in history have done some sort of averaging up scheme on the initial portion of the move, which tells you there’s validity to it.
I’m not pounding the table on the idea; you have to make sure you’re up for the challenge. And right now, after a year-long move in stocks and with some signs of distribution creeping in, it probably pays to be light on your feet. But it’s something to consider experimenting with, especially if you have the mindset to ride winners.
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As for the current market environment, my viewpoint hasn’t changed much during the last few weeks. Overall, the major indexes are still in firm uptrends, and the broad market is in generally good shape; most stocks and sectors are moving from the lower left side of their charts to the upper right side.
On the flip side, growth stocks continue to lag, with big investors looking for either defensive-type names, or what I’m calling “dependable growth” names—stocks that have steady outlooks and reasonable valuations (and maybe a dividend and share buyback program, too). It’s not bad that those names are leading, but it’s a clue that institutions’ risk tolerance has diminished.
Moreover, near-term sentiment remains elevated—various objective measures (as well as many subjective ones) tell me that there are a lot of weaker hands in the market. Again, that’s not a death knell, but it’s contributing to what I see as a positive-but-not-powerful kind of advance. Long-term sentiment, which I wrote about recently, remains subdued. (The fact that bubbles have been mentioned recently by both Barron’s (on its latest cover) and Carl Icahn is a sign few investors are thinking bullishly long-term.)
Mixing together all that evidence, I’m sticking with a “lean bullish” stance—some new buying is fine, but so is holding a chunk of cash. And it’s important to pick your spots on the buy side—waiting for good entry points, going with stocks that have shown great buying during the past month and firms that have a high probability of strong growth going ahead. It also helps if the stocks aren’t on most radar screens.
One name I like, which I’ve mentioned in both Cabot Top Ten Trader and Cabot Market Letter of late, is Spirit AeroSystems (SPR), a leading supplier in the aerospace industry, which is booming as the new-jet delivery cycle roars ahead. Here’s what I wrote about the firm in Top Ten Trader two weeks ago:
“Aerospace stocks remain one of the groups that has barely noticed the market’s wobbles; with the new jet delivery cycle well underway, the big dogs in the industry (Boeing) and all the major suppliers, like Spirit AeroSystems, are sure to benefit during the next two or three years. What institutional investors like is that there’s little competition here—most firms dominate their area in the industry. And Spirit certainly fills that bill; it’s the largest aerostructure supplier (think fuselages, propulsion and wing systems, etc.) to both Boeing and Airbus; its products go into every Boeing commercial jet, including 70% of the content for the 737 and it’s the largest suppler to the new 787. What’s held the company back in recent years isn’t demand but cost overruns; management has been sub-par. But the top brass (including a new CFO) has finally gotten a hold on their expenses and earnings are expected to explode in the quarters ahead. In fact, the third-quarter report crushed estimates (77 cents per share vs. 60 expected), and the company ended September with a jaw-dropping backlog of $38 billion. Earnings are expected to reach $2.66 per share next year, but we think that could prove very conservative if the top brass finally pulls the right levers.”
The stock battled with long-time resistance around 26, but after pausing for nearly three months, it just gapped up to new highs after earnings at the end of October, and stretched into the low 30s following Boeing’s big weekend of bookings. The buying power has been excellent, though the stock is extended to the upside.
There are two ways to go about buying SPR. You could buy a half-sized position around here and look to add more shares on the way up. Or you could be patient, and look for a dip of a point or two during a market shakeout before starting a full-sized position. A drop below 27 would look abnormal at this point, but long-term, I think shares can ride the aerospace boom for many quarters to come.
If you would like to receive further updates on SPR as well as additional momentum stocks that I select each week for Cabot Top Ten Trader, click here.
Working to make you a better investor,
Chief Analyst of Cabot Market Letter and Cabot Top Ten Trader