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In this edition of the Alpha Letter, we cover:
Stocks & Portfolio Management: The curse of the individual investor
Options: How to spot momentum plays before they run
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Stocks & Portfolio Management
“You won’t beat the market.”
Almost every single day trader or investor who actively manages their own money has heard this at some point.
Today, I’m going to explain the curse of the individual investor and why most retail investors can’t beat the market consistently.
We all know the benefits of simply putting your money into index funds like SPY or QQQ. The money is diversified, so you won’t lose it all just because one or two companies or industries tank. You also don’t have to spend any time on it. Simply buy and forget about it for years.
The curse of the retail investor is this: To actively beat a market index like SPX, you need to do one of two things:
Understand the entire contents of SPX and underweight the bad companies and go overweight in the ones you like better. Mutual funds do this, but they have dozens of analysts to break down the 500 available companies.
Act more like a hedge fund and go after a much smaller number of plays that you have confidence in, without regard for having the “correct” diversification across industries.
The problem with the first option is obvious. As an individual investor, you likely only have the time and brain capacity to get extremely familiar with five to 20 companies. How would you possibly have a complex understanding of more than 500 companies?
The second option seems more feasible but brings up a paradox of the individual investor. You need to diversify to make sure one bad pick doesn’t completely tank your portfolio, but you’ll also likely only have a handful of great, high conviction ideas.
Ever seen someone make 50% in one day on a stock and say “man, I should have bought more”?
The reason they didn’t buy more is because it’s never a good idea to risk a large chunk of your portfolio on a volatile pick. Who knows — maybe your next “high conviction” pick won’t work out for whatever reason, and you could lose a huge chunk of capital if you decided to go all in.
So you can’t put all your eggs in one basket, but you may only have a handful of great baskets to put your money into.
As an individual investor, I might have three or four really great ideas per month. Should I put 25% of my portfolio into each one? If they’re risky plays that could either go +50 or -50%, probably not. Eventually, I’d suffer a big loss and would need two more correct calls to get back to even,
After using my four solid ideas, I may feel the need to jump into something with high potential returns to beat the index. But putting a large chunk of your portfolio into a play you feel just okay about is a horrible idea.
The best investors I know don’t play the game I described above. They have a long-term strategy — either they hold index funds, or have a concentrated portfolio that represents the entire market (for example, instead of holding 15 different healthcare companies, they pick the three; one with the largest market share, one with high growth potential, and one that pays a safe dividend).
Their long-term portfolio will do just about as well as the index. Where their “edge” comes is from playing those high conviction ideas, but only when they come across them.
Feeling like you need to make a play is a rookie mistake. The pros keep their money in index funds which can easily be converted to cash for when they see a play they like.
This way, you get the benefits of long-term investing, but allow yourself to take advantage of a short-term play when you see one.
Amateur investors try to catch every single trend. That’s why you see people chasing AMC or GameStop after they already popped 200%.
While some pros may have missed those ones, they have a certain wheelhouse that they’re always watching. For example, there are probably a few pros who know the retail space extremely well and saw the potential in GameStop at $5.
You shouldn’t be chasing every single part of the market for short-term plays. You need a sector or a strategy that you focus on. It could be software or it could be momentum plays. But you’ll never hit home runs if you’re not focused on watching for a very specific pitch.
I think this tweet sums it up best:
Over the last few weeks, we’ve discussed how you can often spot trends like AMC and Blackberry (BB) before the stock catches fire. This technique is known as watching the options flow.
I use the Options Matrix for this. They have a scanner call “Roaring Kitty Calls” which show us momentum stocks whose option contracts have unusually high activity.
Here’s what showed up in this scan as of close Thursday:
There are a couple things we want to look for. Number one, activity in out-of-the-money calls will usually give us the best shot at spotting the next runner. We also want to look for options that still have high open interest.
High volume means nothing if open interest is near zero - it shows us that a lot of the volume was actually people closing their positions.
One stock that shows up a lot here is First Solar (FSLR). It was up 4.67% Thursday, but activity in calls that are still out of the money were very high. Take the $90 call expiring next week, for example. Its volume was 4,814 Thursday and closed with an open interest of 3,145.
Another one that’s showing up a lot is Plug Power (PLUG). This is a hydrogen fuel cell company that’s generally tracked with renewable energy-powered car companies like Tesla and Lucid over the last few months.
New Top Idea
We recently published a new top idea (please see it here) for subscribers. The current price of this stock is $6.00/share and we think it will re-rate to $10-12/share over the next 12 months as there are a few catalysts on the horizon that the market is missing.
The company we wrote up is a small, micro-cap, met coal producer. If you have been following me on Twitter you might have seen that I have been vocal and also bullish on the met coal space.
Not only will there be a significant amount of steel produced (you will need a lot of met coal for this) but all of these miners are trading at depressed valuations of 3-5x EV/EBITDA.
I have been accumulating stock in one met coal producer that I think could double over the next 12 months as a new pricing contract is “re-struck” over the next couple months — effectively locking in higher prices for 2022. Not only will a new pricing structure provide massive operating leverage, but with the squeaky clean balance sheet this producer has, all of the cash flow will go directly to equity holders.
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Here is a list of our previous stock ideas and how they have done:
Idea one:Down 67% (we took out losses and moved on. A high risk high reward that didn’t work out)
Idea two: Up 337% (re-opening retail play)
Idea three:Up 93% (re-opening retail play)
Idea four: Up 120% (re-opening retail play)
Idea five:Down 2%. Still in play and highly bullish. Stock ran up a lot over the last month and we took profits. It fell back down and we are taking a second bite from this apple.
Idea six:Up 12%. Still very bullish and very long. A lot of great macroeconomic tailwinds driving this over the near-term that I am excited about.
Idea seven: Up 14%. Still bullish. A junior gold miner that is generating free cash flow and should do well during an inflationary period.
Idea eight: Up 13%. A movie theater play that is not AMC. Still bullish here with a lot of upside.