There are a lot of different thoughts on how to create a position trading strategies . Some use seasonality or catalysts events to develop their strategies. Others used a long term contrarian momentum play to develop their strategies.
As defined by Investopedia, a position trader is a stock trader who holds a position for the long term (from months or years). So there is not right way or wrong way to build a position trading strategy as long as it is built to take advantage of longer term trends.
When it comes to deciding on how to build a position trading strategy, I would follow a couple of names. The first would be Warren Buffett. If there is anybody you could emulate when it comes to position trading this would be the person. The second person would be Phil Town. He wrote the book Rule #1 Investing and Payback Time (which would be a good read if you are interested in learning more about a different position trading strategy).
First let’s start with building a position trading strategy based on what has been published on Warren Buffett’s investment strategy.
Let’s start with the main investment tenets we can all agree on.
- Buy companies with a moat. Some type of industry or company advantage.
- Look for companies that have demographic trends in their favor over the long term.
- Buy companies with a margin of error.
- Find companies with honest management.
- Try to create cash flow. In my opinion this is the center of his whole investment philosophy. Cash flow can help you build your positions over time.
There have been
There have been several books written about his investment strategy and I know there are many more thoughts or ideas about how he chooses his investments. This is a good start to developing a position trading strategy.
Rule Based Position Trading Strategies
So let’s look at how to put this all together in a rule based system. First, we need to turn each of the investment tenets into a rule.
1. Buy companies with a moat. Some type of industry or company advantage.
Most value managers look at ROIC (return on investment capital) or ROE (return on equity) to give them a view of the companies pricing power or “Moat”. We will use ROIC in our position trading strategy.
2. Look for companies that have demographic trends in their favor over the long term.
How do you identify long term demographic trends? First, just look around and think about how the world will look in 5, 10 or 20 years. This is a very subjective exercise but it is important to the strategy because you need to believe in the long term prospects of the companies you select so you can add to them when the news and media are saying not to.
Here are two easy ones to start with: Baby Boomers, Technology Innovations
- Baby Boomers – the US is getting older. This is not a secret. So how can we position ourselves to take advantage of this long term trend
- Technology Innovation – this is a very broad trend and it can be broken down into several themes. Social Media, Online Retailing, Robotics, Smart Everything (phones, televisions, cars, etc.)
3. Buy companies with a margin of error.
How do we measure if we are buying the company at a good price? There are several ways to look at this but I think it is best to keep it simple. Look at projected cash flow and growth of cash flow and discount it based on an assumed discount rate to come up with a present value.
The easiest way to do this is to take an average of what analysts think the growth rate of earnings will be over the next 3 to 5 years. Take that growth rate and the current earning and growth them for 10 years. No company grows earning in a straight line and that is why we have to apply a margin of error.
Multiply that earnings number by an average P/E multiple and discount it by the average 10 year treasury yield. From there you can apply a discount of 25% or more depending on what type of margin of error you need based on the history of the earnings per share volatility.
4. Find companies with honest management.
This is probably the hardest one of these investment tenets to put into a rule. So we will make it a homework assignment we have to complete before we make an initial investment or any additional investment in the company. Review company filings to see if there are any news items that would lead you to believe there is an issue with the management of the company.
5. Try to create cash flow. In my opinion this is the center of his whole investment philosophy. Cash flow can help you build your positions over time.
Cash flow can come in two different forms
- Dividends that the company pays out (cash flow you can use)
- Free cash flow generated by the company (cash flow the company can use)
Once you have built your rules and filtered out a list of potential companies to buy then you need to create a strategy for initiating the position, adding to the position and selling the position. Basically you need a position sizing model. No matter how convinced you are of the company’s value you need to have a stop loss protection. Remember there are a lot of other very informed investors trading in the stock market and if your thesis is wrong you have to have a rule to cut your losses.
1. Initiate a half position after you are comfortable you have a margin of error built in. Using a stop loss of 25% to decide on the appropriate size of the total position.
2. Build the position on market pullbacks.
3. Trail the stop to your adjusted cost basis every time you add to the position.
4. Sell if it breaks your stop. I have found that if your 25% stop is hit there is something going on in the company that you have not accounted for or did not anticipate.
5. Sell half once you are up 100%. Now you are playing with the houses money and you can let it run without worrying about it. Continue to use your stop to make sure something has not changed.
6. Create cash flow to continue to build your positions. This could come from the dividends paid out or from you saving additional money to add to this strategy. As far as this strategy goes, this is probably one of the most important pieces for it to be successful.
What Will Work for You?
Remember not every strategy is right for every person. There are a few things you need to ask yourself before you enter this type of strategy. First, do you like to dig into company financials or look at larger demographic trends? Second, do you need a lot or moderate trading to keep you interested? Third, do you don’t want to wait months even years for your investment to become profitable? If you answered no to any of these questions this type of strategy may not be for you.
If this type of strategy works for you and you want to learn more here are some resources you may be interested in reviewing. The first is GuruFocus. This website follows what the investment gurus like Warren Buffet are buying. It even has a screener which screens for companies that would fit Warren Buffet’s criteria. It also has one of the best financial statement tools available from any website. Another resource would be to read a book about Warren Buffet, Snowball.
Finally, never go all in when you begin developing a new position trading strategy. You need to begin small and get a feel for the strategy and drawdowns. You want to make sure you are comfortable with risks and it fits your trading psychology.