Wall Street Jujutsu
How to apply the Japanese martial art principles to your investment regimen
Jujutsu is a Japanese martial art that teaches its students how to defeat an opponent by using the opponents energy and momentum against them. The same principles can be used by investors. Done correctly, those who analyze and invest in individual stocks can use price movements large funds create to their advantage.
Exchange Traded Funds (ETF’s) and mutual funds are baskets of stocks and/or bonds that give investors a broad exposure to an index, industry, sector, or even a specific investment strategy. With a small amount of money these funds provide investors diversity within hundreds of companies with one trade. This is how they are marketed to the public, and the marketing has been successful, as the ETF and mutual fund industry is enormous;18 trillion dollars in the US market alone. Investors worldwide are frequently shifting money in and out of these funds, and because of these dynamics, these funds can heavily affect the underlying stocks in which they invest.
EFT’s are becoming ever more popular, so let’s focus on how a stock ETF operates. The EFT will first establish its investment goal, then take in money from the public, and next will begin to buy the stocks it will hold. At this point, the whole ETF begins trading like an actual stock (matching buyers and sellers). For example, if you want to sell 100 shares of SPY, an EFT that indexes the S&P 500, and Joe at the same time wants to buy 100 shares of SPY, then the EFT would simply transfer your ETF shares to Joe. In short, you get Joe’s cash and he gets your ETF shares. In normal markets this works flawlessly, and there is no need for the ETF to buy or sell any of the underlying stocks on the actual stock exchange. But what happens when buy and sell orders are uneven? In an example of a market downturn, there is a possibility that you and Joe are both trying to sell SPY. For example purposes, imagine there are no buyers of SPY shares anywhere in the market. In this event, instead of swapping shares an Authorized Participant (“AP”) is forced to sell underlying stocks within the EFT to raise cash, and the AP must take whatever price the market gives them. This selling pressure is intensified when markets are in full blown turmoil. When downward volatility appears in the market many investors become fearful, and they sell their ETF position. The AP gets overweighted in sell orders and are forced to sell stocks to raise cash for redemptions. Other investors take notice of stocks moving down sharply, panic, and also ask for redemptions. The vicious cycle continues.
It is very important to understand that there is no discretion in which stocks to sell. Stocks of each company in the ETF will be treated the same no matter what their business prospects look like. Companies with superior business fundamentals will be sold at the same rate of those with inferior fundamentals. The good, bad, and ugly all get treated the same.
This is where the opportunity lies. Wall Street Jujutsu is using the price momentum large funds create to your advantage. Stock prices of very good companies will go too low, dislocate from their fundamental value, and the prepared investor can step in and buy great companies at very favorable prices.
Examples can be seen throughout history. The most recent example was created after the Brexit vote; when the UK passed a referendum to leave the EU. Many ETF investors hit the sell button expecting market turmoil, and many companies with little or no exposure to the UK lost 4% or more of market value the morning after the Brexit vote.
A more prolonged period of price dislocation happened between 1999-2003 as the Dot Com bubble and 9/11 ravaged the markets. Many businesses with decades of positive performance, pristine balance sheets, and strong earnings were watching their stocks plummet. McDonald’s was a prime example. McDonalds stock declined 45% from 1999-2003. As McDonalds stock price plummeted the actual business preformed quite well; sales increased each year and the company increased the dividend by 105%. As fund outflow orders continued during that period public sentiment began to determine stock values rather than true value. The public simply wanted completely out of the stock market at that time, and all stocks suffered, justified or not. McDonalds proved to be an incredible buying opportunity, rallying 138% in 3 years, for those who understood Wall Street Jujutsu.
Some may argue that all stocks were overvalued in 1999, and therefore deserved to fall. I would agree. The reverse happens when the public is euphoric about stocks. Large inflows go into funds, and that cash must be invested in stocks pushing stocks above fundamental values. It works both ways.
As ETF’s continue to attract large amounts of capital the dislocation of stock prices to their fundamental value will occur in the future. To take advantage you must do a few things. First, you much keep some cash on the sideline to take advantage of opportunity. Next, you need to have a deep understanding of the companies you follow. This includes understanding a company’s intrinsic value, how they make money, and which external factors affect their ability to make money. Understanding true value will enable you to develop deep conviction about a certain company at a certain price, and this conviction will give you the courage to buy when all the major funds are forced to sell.
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