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Gold, Speculation and Gambler's Ruin

A "concentrated portfolio" approach to Gold Mining stocks...

PORTFOLIO manager at Wolverton Securities, Rodney Stevens believes investors speculating in precious metals must be disciplined to avoid gambler's ruin. While "disciplined speculation" may seem like a contradiction, it is key to Stevens' approach. 

Through both technical analysis and fundamental analysis, and a careful read of intermediate trends, Stevens has developed a concentrated portfolio of precious metal companies held both long and short. In this interview with The Gold Report, he shares where the sweet spot in the mining space is and advises how to limit portfolio risk. 

The Gold Report: Rodney, in July 2007, StarMine rated you a top analyst for the metals and mining space based on stock recommendations and market analysis that generated a return of about 8% over the industry benchmark. The metals and mining space has changed a lot since 2007. What are some key ways your approach has changed in the five years since that rating?

Rodney Stevens: Since being an analyst at Salman Partners, my strategy has developed into a more disciplined approach to speculating, which now includes the use of technical analysis in security analysis overall and short selling. The disciplined approach involves having a concentrated portfolio of securities both long and short in conjunction with progressive stop-losses. 

The concentrated portfolio, while adhering to progressive stop-losses, helps control company-specific risks. Being both long and short provides a natural hedge to protect the gains from extraordinary market risk such as a market collapse—collapses when stop-losses are breached. This disciplined approach allows us not to fall into gambler's ruin even though we still are looking for stocks with great potential.

TGR: What do you look for in stocks to short?

Rodney Stevens: We look primarily for ideally topping formations, so we can benefit from the downward trend when it begins. The ideal shorting scenario is picking a company that goes bankrupt. That may be rare, but we also look for certain catalysts that may be divergent from what management is saying. 

TGR: What would a chart look like on a stock that you would consider shorting?

Rodney Stevens: There' s a classic head-and-shoulders formation that looks like a head with two shoulders on the top of a chart, which breaks through a neckline. In general, you're looking at topping formations, downward trends and even some consolidation formations. A right angle triangle of the descending formation could lead to a continued drop in share price. We look for cues for timing, but then also look for the fundamentals to get an idea of how much downside there might be and for catalysts.

TGR: What's your typical weighting of shorts to longs?

Rodney Stevens: It depends on the degree of bullishness. We could be 50/50, 80/20, 20/80, depending on where we think we are in the intermediate trend. Right now we're about 80% bullish on gold and silver stocks. 

We are interested in capturing as many intermediate trends on the upside and the downside. The problem with the intermediate trend, however, is often there is little notice as to when the trend changes direction. 

Despite being 80% bullish, there's still a risk that the intermediate trend can drop, so we want to be partially hedged, perhaps having a 20% allocation of stocks that we are shorting. Then if the intermediate trend halts and goes down sharply, we'd be cutting our longs short through stop-losses, but allowing our shorts to ride, which could make up for some of the loss from the unexpected change in trend. 

Of course, we also look for stocks with homerun potential and are happy to ride out the gains as long as we don't get stopped out of our positions.

TGR: Is it fair to say that the intermediate trends are where you really make your money?

Rodney Stevens: We look at the intermediate trends because if we could capture a fair share of these intermediate trends, we might be able to do better than just playing the long-term trend alone. We use Dow Theory to put the long-term Primary Trend into perspective. The tools we use to identify the intermediate trends are other technical indicators, such as important reversal patterns, trend lines, trend channels and support, and resistance levels. All those help assess the intermediate trend. We really make money on our stock picks, but we have to gear our portfolio in the general direction of the market.

TGR: Please explain what Dow Theory is.

Rodney Stevens: Dow Theory was originally developed by Charles Dow to gauge the overall health of the global economy. It is based on technical analysis. It identifies a bull market and bear market depending on if one sees higher highs, or lower lows in the Averages. It uses the Dow Jones Industrial Average and the Dow Jones Transportation Average. If both averages are confirming that we are in a bull market by higher highs, then we can be confident that we're still in a bull market. If the indexes contradict each other, then we may be heading for a bear market and the onset of lower lows in the Averages.

TGR: What is it currently indicating?

Rodney Stevens: Basically Dow Theory is saying that we are still in a bull market but with the caveat that it might be turning. There's been a divergence between the Dow and the Transport Average; we may be on the cusp of a change in direction over the long term from a bull market to a bear market. That tells us to be a little more cautious. There are no time limits as to when the Transports and the Dow have to confirm each other. 

TGR: You recently launched a weekly newsletter called The Disciplined Speculator, and the investment strategy says, "The portfolio is speculative, suitable for those investors who can afford the substantial risk associated with seeking capital growth through trading a concentrated portfolio of speculative securities. Volatility of 50% or greater may be experienced." What's your read on investor appetite for that type of risk right now?

Rodney Stevens: It may sound somewhat contradictory to be a "disciplined speculator." I would argue that being disciplined is the most important thing about speculating so that it doesn't lead to gambler's ruin. For example, if the average stop-loss were 10% on a rolling 10-stock portfolio, one would have to get stopped out of many losing trades in a row before losing 50% of one's principal.

We only note the extreme volatility because we don't want people to believe that our disciplined approach is not speculative. It is designed so that investors shouldn't fall into gambler's ruin, but it is speculative. 

Investors should always have an appetite for some level of risk, the degree of which should depend on personal circumstances. For example, investors who rely on their investments primarily for income, then only a small portion of their portfolio should be allocated to this type of strategy.

TGR: A lot of what you do involves the junior resource space. Are these typically good stocks to be long on?

Rodney Stevens: It depends on the market. If we're in a bear market, resource juniors are the worst, and when we are in a bull market uptrend, they can be the best. We look for stocks that are volatile enough that they make trading worthwhile, but hold them both long and short. For the smaller-cap issues that are below $5/share, we might only venture into that category when we're in a bullish trend. Right now we're in a bullish trend; we feel that there is sufficient liquidity and the tides are going in our favor so that we can venture into this market. 

TGR: Given the current intermediate trend and the long-term trend, what's the sweet spot in the junior mining space? Is it the precious metals explorers, the precious metals development stories, or are the junior producers the place to be at the moment?

Rodney Stevens: The sweet spot is new high-grade gold discoveries or near-term production opportunities in the mining space, but only when the market is in a bullish trend. These opportunities are some of the riskiest, so it's also good to round out your portfolio with some established producers with good growth prospects. Another reason to add the larger-cap stocks is for liquidity because you want to be able to reverse your position if necessary.

TGR: Are you generally more bullish right now on silver than gold?

Rodney Stevens: It's hard to actually time the performance of gold and silver over an intermediate trend. They tend to track each other. Without trying to be too cute on timing, I'm weighted toward silver but I think they will both rally nicely and outperform the general market.

TGR: What's your advice to investors playing this space?

Rodney Stevens: Investors face some tough decisions in this market. If we are toward the end of a long-term bull market, then investors can be completely out of the market because buy-and-hold may be over. Another thing investors could do is to trust someone to actively manage their money if they can't do so for themselves. They have to take a wise, disciplined approach and it is a little more dangerous market to be in. My newsletter gives advice on avoiding a single stock commitment that could wipe an investor out, avoiding being frozen in a market that has turned against the investor and also informing the investor on how to take profits while limiting losses. Learning how to maneuver through the risks that there are in the market would be a first step.

TGR: Is there one thing that made you more disciplined as an investor?

Rodney Stevens: It's been the losses that I've sustained. I'm known for some good stock picks. I do look for great opportunities, but I have had a tendency to be a less disciplined gambler. I've learned from hard knocks of the risks that are involved to develop a belief in this more disciplined approach. 

The typical gambler's ruin, which we try to avoid, is if investors are taking a 40–50% risk in any commitment, it doesn't take many wrong calls before the capital is wiped out. In our disciplined speculator approach, we're limiting risk to a more reasonable level so that investors have ample time to turn it around and make good calls.

TGR: Thanks for your insights, Rodney.

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