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.
Sincerely,
Paul Goodwin
Editor of Cabot China & Emerging Markets Report