Introduction Over the long term, shares have historically produced the highest average annual returns out of all the mainstream Australian asset classes. The average annual return from Australian shares over the last 50 years was 12.2% [note=1]Vanguard Investments Australian Limited, Realistic expectations for share market returns, 2005, p 1.[/note]. Thus, we conclude that shares should form an integral component of all investors’ wealth creation strategies. Broadly speaking, there are two ways to invest in the share market, either direct investment or indirectly through a managed fund or similar managed investment. Of course one may utilise a combination of direct and indirect investing in shares to achieve the desired exposure to the market. We’ll cover some of the basic share market techniques and strategies before investigating how Dollar Cost Trading works and compares to other methodologies.
Sharemarket Basics Sharemarket Basics Direct Investment With direct investment in the share market, the investor personally manages his or her share portfolio and is responsible for all investment decisions, including: which companies to invest in and how to source up-to-date and impartial research; what level of exposure is acceptable to each industry/business sector; when to buy and sell, and in what quantities; appropriate capital management; and administrative record keeping for analysis and tax purposes. Generally, a direct investor’s main costs will be brokerage payable to the share broker who executes share trades on the investor’s behalf. However, even that cost need not be substantial: there are many on-line discount brokers who will execute trades in real-time for flat fee or very nominal value based commissions. These brokers typically don’t add any value in the way of professional advice, but instead usually offer access to research data which you must access and interpret yourself. Of course, an investor may incur additional costs such as maintaining a computer and internet connection, and in purchasing information services and computerised trading tools in the hope of enhancing their returns. Indirect Investment Many investors gain their share market exposure by investing with professional managers in either unit trusts or through individually managed accounts – generally referred to as “managed investment funds”, or as is more common, simply “managed funds”. The fund manager takes on responsibility for investing and managing your money as per the goal of the fund, and aims to provide returns in the form or income and/or capital growth. Whilst the underlying structure of the various managed investment facilities can differ, one common feature they share is that the fund manager will charge the investor a fee to invest and manage the investor’s money. Fees There’s nothing intrinsically wrong with fund managers charging a fee for their services – just like your plumber or dentist. If your fund manager, through exercise of the investment skills of its staff have made you better returns than the market average they deserve to be paid for that service – just like the plumber who unblocks your drain. However, the problem with almost all fund managers, and thus the funds management industry as a whole, is that managers will charge their clients a fee irrespective of whether the investment return is better or worse than average. My personal philosophy is that a fund manager should only make money when the manager has made money for their client by beating the market average. If your funds don’t outperform the agreed upon performance metric, your fund manager shouldn’t get paid – otherwise they are getting paid for adding no value! You wouldn’t pay the plumber who turned up and then incompetently failed to fix a simple blockage – I believe the same should apply to funds management. Direct investment can be seen to remove one (or more) layers of fees which should – in theory – enhance returns. On the other hand, direct investment, particularly when one takes an active approach rather than a passive approach (a distinction discussed further below) can be quite time consuming and requires constant administration. Realistically, many investors lack the necessary skill or time to successfully invest directly on an ongoing basis. Alternatively, indirect investing through a managed fund frees up an investors time because the investment management decisions have been outsourced to the fund manager. In addition, the tedious administrative tasks will be done by the manager who will produce concise performance statements which you can usually pass on as-is to your accountant at tax time. The downside of course is that all this work by the fund manager typically isn’t done for free. In summary, both direct and indirect methods of investing in the share market can be equally valid provided the underlying investment strategy used can consistently produce good returns for the investor, with direct investing generally the cheaper option, at the expense of requiring more personal skill, effort and time from the investor.
Investment Styles Investment Styles A comprehensive discussion of all the past and present share investment theories and strategies would fill an entire library of books. Every field of study from astrology to technical analysis has been called upon at one time or another in an effort to make money on the share market. However, in explaining Dollar Cost Trading to you what I’d like to do is divide the universe of investment styles into a couple of broad categories. In this way we will place DCT in context and go some way towards explaining its uniquely logical theoretical basis. Active vs Passive Investment Strategies The first distinction to draw is between active and passive share investment strategies. Where an investor frequently buys and sells shares to generate a profit from those sales, the investor is an active investor. This approach is commonly referred to as share trading or often just trading. In contrast, if one merely buys and holds shares for their long term growth and dividend generation and rarely buys and sells then the investor is a passive investor. Dollar Cost Trading, as the name suggests, is an active investment approach. Efficient Markets As an aside here, academics have spent many years debating whether or not the share market is an efficient market and the extent of that efficiency. The relevance of that debate here is merely to note that to my mind, the answer lies in actual observation of what share prices do on a daily basis. Certainly some of the observed volatility may be justified by valid re-evaluations of the intrinsic value of a business following good or bad news or results. However, I believe it is mostly “noise” generated by illogical and ill-disciplined investors (both at the personal and institutional level), who are often swayed by a mercurial media. Ultimately it is irrelevant whether you believe that volatility is due to the inefficient dissemination of price sensitive information, or prefer the view that the market is efficient but people regularly get their valuations wrong. The observed fact is that prices fluctuate and well prepared investors can take advantage of this fact to generate extra returns over and above the performance of the underlying shares. Reactive vs Predictive The vast majority of investment styles, in particular the various forms of technical analysis, are predictive in nature. That is, they look at a range of factors and calculations in an effort to predict what the future price of a share will be to decide whether it is worth buying that share today at the current market price. In contrast, DCT is a reactive trading system. The distinction is subtle, yet powerful. A predictive system attempts to engage in a form of “fortune-telling” whereas DCT as a reactive system merely seeks to react to actual changes in price and volume as they occur. It is well known that I do not believe anyone can foretell the future. I defy anyone to produce independently verifiable evidence that anyone can consistently and reliably predict the future. Consequently, to my mind any investment system which at its heart depends upon the impossibility of divining the future is fundamentally flawed. Regardless of the apparent discipline and logic of the analysis process which attaches to any predictive system, the process must fail because it is built on an unsound foundation. Contrarian vs Consensus Investing Another broad categorisation of investment styles is to distinguish between contrarian and consensus investing. Consensus investing relies on following the market, watching for trends and trying to pick the sentiment of other traders and take advantage of the movements they cause. In contrast, contrarian investing is the share market equivalent of “buying straw hats in winter”. When a share becomes unpopular and loses investor support its price will fall because more people are selling than buying. The contrarian investor sees this as the perfect time to buy (assuming that the company is still a fundamentally sound business). Contrarian investors essentially do the opposite to what consensus investors would do – while a consensus investor will attempt to “jump on” to an upswing and “bail out” of a downswing, a contrarian investor will take profits as the shares go up, and increase holdings as the share price falls. An added bonus of buying when everyone else is selling is that it makes it easier to fill large trades. Dollar Cost Trading vs Dollar Cost Averaging What a difference one word can make! Dollar Cost Averaging (DCA) is a share investing technique which involves investing a set amount of money, often monthly, to purchase a particular share or managed fund, regardless of the price at the time of purchase. The theory behind dollar cost averaging is that one cannot time the market and thus investors should merely buy in a robotic fashion so that, hopefully, the weighted average purchase price is lower than the average price at the end of the process. Typically, dollar cost averaging is utilised as a “savings” technique – and from this point of view, it does have a useful place – especially when investors need some extra help to be disciplined enough to invest regularly. However, at best, dollar cost averaging provides “average” results – as its very name suggests! An active fund manager, carefully timing their trades, buying low and selling high, should be able to produce much better than “average” returns. Example To illustrate, let’s say one has $600 per month to invest in a share. In the first month the share price is $6 so 100 shares are purchased. In month two the price has dropped to $4 so you are able to buy 150 shares that month. The average cost of the 250 shares is thus $4.80 (i.e. $1,200 ÷ 250 shares) but the average of $6 per share and $4 per share is $5 (i.e. (6 + 4) ÷ 2). In contrast, under a DCT approach it is more likely that the investor would wait until month two when the price drop generated a buy signal and then take the $1,200 available and buy 300 shares at $4 per share. Let’s consider then what happens if the share stages a recover and returns to its $6 previous level. For the DCA investor they have 250 shares currently worth $1,500. Thus, they’re sitting on an unrealised gross profit of $300. In contrast the Dollar Cost Trader’s 300 shares are now worth $1,800. Thus DCT has yielded a potential profit of $600 – twice that of the averaging approach.
DCT in Action – NavTraDE DCT in Action – NavTraDE The only organisation utilising Dollar Cost Trading as described in this article is NavraInvest Limited, a boutique funds manager which launched two Australian share funds in 2003. NavraInvest own the NavTraDE system – a trading system based around DCT, and they use the fundamental principles of DCT, but within a very strict framework that has been developed over many years of testing and refinement. Conceptually what the Dollar Cost Trading investment approach provides is the means by which to convert a high share price into cash and a low share price into value, by managing the investor’s cash flow, and identifying buy and sell signals and appropriate volumes for each trade. There are two investment principles which form the foundation of the NavTraDE system: High quality blue chip shares represent good investment potential. Active, objective and quantitative investment management provides the flexibility to take advantage of fluctuating share prices. Contributing factors to DCT’s operation Before exploring those two investment principles in detail, it is useful to consider some of the factors which impact upon and support the operation of the Dollar Cost Trading methodology. Unpredictability – No investor can consistently predict future share prices. The Dollar Cost Trading approach rejects prediction but is premised on the general belief that quality blue chip shares will over time demonstrate reasonable growth (see further below). Chaos – Share prices overreact quickly to major events. The extent to which share prices are driven by short term swings in sentiment in response to chaotic events is amazing, even for quality blue chip shares. Rapid falls in price represent opportunities to buy shares, and rapid rises in price represent opportunities to sell and take profits. Volatility – Share prices vary much more than the net tangible asset backing of the underlying companies. Whilst the price of a share will change on a daily basis, the value of the underlying business will generally change much more gradually. The price of large companies can vary enormously. Often the share price falls below the estimated net asset backing of the company and this can represent an investment opportunity provided that the company’s fundamentals are sound. Increasing value – This is not being predictive, merely recognising that over the long term the share market continually rises in value. Despite returns from the Australian share market in individual years ranging from -8.6% to 54% [note=2]Ibid, at p 3.[/note] over the last 50 years, as noted at the outset, the average annual return over that 50 year period has been in excess of 12%. Step 1 – Share selection Because the DCT methodology involves buying increasing volumes of shares as the price falls more dramatically, it is absolutely essential to carefully analyse the shares you intend to trade to make certain they are financially robust. Otherwise you risk following a share price buying it right into oblivion! Let me stress again, you should only consider Dollar Cost Trading shares which have passed through a rigorous filtering process to ensure so far as you are able that each company on your target list cannot technically become insolvent. NavraInvest utilises a series of “filters” to separate out those stocks within the ASX200 index which are not suitable investments to apply the DCT methodology to. Necessarily the share selection process will involve a mixture of objective and subjective judgments about the financial robustness and prospects of potential investee companies. However, whilst a company remains “approved” the mechanics of trading its shares become purely objective. Briefly, the filters are as follows: An overall “health check” of the company. My experience is that this first filter halves the potential investee companies leaving approximately 100 companies to face the subsequent testing process. Examination of the company’s outlook. Reasons companies will drop out at this stage are sometimes related to the outlook for their industry rather than the company specifically. Minimum market capitalisation of $1.1 billion. One reason for this is to ensure a deep and liquid market for the company’s shares. Without this the full potential for the DCT method may not be realised if buy or sell volumes could not be fully filled. Another factor is that generally larger companies attract more media and analyst attention than smaller companies. Paradoxically this increased scrutiny has the effect of increasing the volatility rather than smoothing it out. It’s a case of more information and opinion failing to lead to sounder judgments. Financial robustness. This is a measure of the company’s ability to withstand challenges such as interest rate rises and entry of new competitors etc. Sector diversification. No more than 15-20% of your portfolio companies should be in the same industry sector. The reason for this is not so much to spread your risk but rather a recognition that different sectors will tend to outperform or under perform in a cyclical fashion. For example, resources stocks are currently performing strongly, but had a period of less than stellar performance prior to that. Number of companies. Finally the portfolio is constructed from between 20-25 stocks. Any less than around 12 shares arguably leaves you unacceptably exposed to company specific risk. Equally, any more than 20-25 stocks will not significantly reduce the risk. In addition to this regular filtering process, NavraInvest monitors and reviews its portfolio on a daily basis. If for any reason a company ceases to meet any of the above criteria, the share is exited immediately, even if that means realising a loss. I cannot stress strongly enough the importance of a thorough and rigorous share selection process before Dollar Cost Trading a share. Step 2 – Trading the shares Volatility is the key. The more volatile a share, the greater the opportunity presented to realise extra value through those price fluctuations. Dollar Cost Trading, as embodied in the NavTraDE system employed by NavraInvest places particular emphasis on recent share price movements and trading volumes to identify trading signals. Typically a buy signal will be generated when a share price is falling and a sell signal generated when a share price is rising. The timing of the signal and the transaction volume indicated (i.e. how many shares to buy) will depend on a variety of factors taken into account by the proprietary algorithms which form the basis of the NavTraDE method. Dollar Cost Trading involves buying when investor sentiment has pushed the share price below its equilibrium price and frequently locking-in gains by selling once the situation has corrected itself. Conversely, DCT also involves selling when investor sentiment has pushed the share price above its equilibrium price. The concept of equilibrium price simply means the price where both the volatility and volume of trades in a share by others have returned to a normal level for that share as determined by the NavTraDE system. The objective is to maximise returns from share price volatility in addition to the return that might be expected from the underlying blue chip shares over the longer term. One of the key aspects of DCT is its ability to generate returns independent of the performance of the underlying share. The diagrams set out below provide examples of where this extra value was actually found for three different stocks in circumstances of a rising, steady and falling share price. The contrast of DCT with dollar cost averaging noted above is useful to recall in the context of equilibrium price. DCT involves buying only when prices are below the equilibrium price and selling when they are above the equilibrium price, whereas dollar cost averaging will buy shares at any price. Flexibility to be fully in or out of the market Another feature to note with DCT is that it is possible in a rapidly and consistently rising market to sell all your holdings and be entirely out of the market. Equally, in a falling market an investor may experience sufficient buy signals and volumes be fully invested. In my experience periods of both 100% cash and 100% investment are very rare and when they occur quite brief. The reason is that in all market conditions there is typically some level of volatility which will trigger buy or sell signals. Fees NavraInvest is unique within the funds management industry in their approach to fees: they only charge fees if they perform! The basic goal of their funds is to provide performance significantly above the ASX200 index (for the Blue Chip Australian Funds). Indeed, if they fail to perform better than this index, they will not charge any fees at all. Most other fund managers will charge a fee regardless of their performance (or lack thereof), but NavraInvest are so confident in their ability to perform that they are willing to commit to maximising the returns of investors by only charging for out performance. Case study – Leighton Holdings Attached to this article is a chart showing the actual Dollar Cost Trading data from the NavTraDE system for construction company Leighton Holdings (ASX Code: LEI) over a period in which Leighton experienced a sharp share plunge due to cost overruns on its Spencer Street railway station development and recovered over the course of the year. You will see that the graphs show: the period up to the share price drop; the one month period after the price drop; and the period up to the end of that year. The accompanying table of data includes each day’s price, every buy and sell and the profit accumulation. These figures are net of brokerage, which is set out in the last column. What I hope this case study will demonstrate to you is that the Dollar Cost Trading system can make money irrespective of whether prices rise, fall or merely trend sideways.
The importance of income; Summary The importance of income – where DCT fits within your strategy Investors usually invest for a combination of growth and income. Generally, income is required by investors to meet their living expenses and to service the costs associated with their investments, particularly where the investor has borrowed to acquire those assets. One of the key points to note is that in my experience DCT produces remarkably consistent income distributions because they are realised as a result of the overall volatility of all the shares in the portfolio. As the attached case study demonstrates, DCT works in all market conditions. Thus a Dollar Cost Traded blue chip share portfolio, with its regular and high income distributions is the perfect investment to offset a portfolio of negatively geared investment properties. The distributions from the share fund can be utilised to service the interest costs on the property loans and to otherwise provide a cash buffer for contingencies. Other obvious benefits are that utilising a share fund together with property gives a spread of asset classes and the shares are liquid i.e. they can be converted into cash in 3 business days or in the case of managed funds, generally within one week. Summary In this article we’ve covered quite a bit of ground to place the Dollar Cost Trading approach in context and describe its unique features. We began by observing that Australian shares deserve a place within your asset portfolio because of they have provided very good returns over the long term. Looking forward, whilst the future is always uncertain, there is nothing to suggest that this general outcome is likely to change. We then discussed the pros and cons of investing directly in shares against investing indirectly through a manager fund or other managed process. Either method is valid. The choice will depend largely upon whether you have the time, skills and inclination to go it alone or would prefer to perhaps focus on other areas such as your day job and/or direct property investing, whilst outsourcing share investing to a professional fund manager. The choice is not an all or nothing one – you can quite happily do both. For example, you might invest in blue chips through a Dollar Cost Trading fund manager such as NavraInvest but also invest directly in international, mid-cap or small company shares which currently fall outside the Navra Funds’ investing universe. Next we considered different broad investing styles and concluded that DCT is an active, reactive and contrarian investment style. Also, the similar sounding but vastly different dollar cost averaging technique was distinguished from DCT and found wanting. We then got to the heart of DCT by outlining how it works in practice (as implemented by NavraInvest through its managed funds) by considering: some of the broad market factors which contribute to DCT’s success; the rigorous filtering process which is the essential first step in DCT; a general description of how the proprietary NavTraDE quantitative DCT system generates buy and sell instructions for the fund manager to execute; and looked at a case study which demonstrated the versatility of the DCT method in different market conditions. Finally, we briefly touched on the role which Dollar Cost Trading can play within your overall investment portfolio as a strong and reliable generator of income to offset other investment holding costs and living expenses. The Navra Blue Chip Australian Retail and Wholesale Share Funds Whilst this article will have given you a high level overview of what DCT is and how you can make it work for you, the reality is that it has taken me more than 20 years to develop and refine the NavTraDE system, which forms the core of the active trading component of the Dollar Cost Trading approach. Whilst investors can certainly apply many of the concepts discussed in this article to their own trading, many will lack the share-specific skills, time and inclination to set out on the investment journey I began over 20 years to perfect DCT (and which is still continuing). With that in mind, at the request of - and to meet the needs of - my clients, I developed the Navra Blue Chip Share Funds, run using the NavTraDE Dollar Cost Trading system into which my clients could invest. After raising some seed capital from my clients we formed NavraInvest Limited as a funds management company in November 2002. During the months than followed NavraInvest applied for an Australian Financial Services Licence (AFSL) from the Australian Securities and Investments Commission. Key staff were recruited, service providers appointed and the whole operating structure established to operate a modern professional funds management company. On 17 April 2003, NavraInvest’s AFSL was granted, and on 28 April 2003 our first two funds were launched, catering for retail and wholesale clients. I trust you’ll indulge the references to NavraInvest and the Navra Blue Chip Funds throughout this article. Apart from being extremely proud of the Funds’ performance record they are inextricably linked to the concept of Dollar Cost Trading because NavraInvest is the only Fund Manager in the world which operates DCT under the NavTraDE system. Full performance details for the funds are available on NavraInvest’s website as are product disclosure statements for each Fund which you must read before considering an investment in the relevant Fund. See also Discussion about this article Shares and Managed Funds articles Shares and Managed Funds discussion forum NavraInvest Managed Funds discussion forum Investing Book reviews Glossary of Investing Terms
