Kelly Letter Performance

The Kelly Letter’s Tier 1 value averaging strategy grows 3% per quarter, rain or shine.

Its Tier 2 Maximum Midcap strategy outpaced the market by a wide margin until the crash of 2008, when it fell back to the market’s growth level. That prompted me to change its approach to enable us to time it with charting techniques to protect gains against future sell-offs. More below.

Its Tier 3 individual trading positions have done well over the years, with 81 percent closed at a profit.

Some performance highlights:

Tier 3 trade selections from before 2009:

  • McAfee gained 30% in 17 months
  • Level Three gained 33% in 4 months
  • Panera gained 35% in 10 months
  • Deckers Outdoor gained 40% in 2 months
  • Grant Prideco gained 50% in 19 months
  • Ariba gained 60% in 5 months
  • Intel gained 64% in 10 months
  • Maxtor gained 65% in 5 months and
    60% in 3 months
  • Sun Microsystems gained 72% in 8 months,
    66% in 4 months, 5% in 1 month, and 3% in 2 weeks

Tier 3 main trades in 2009:

  • ZSL Silver -2x gained 15% in 2 weeks
  • DXO Oil 2x gained 18% in 1 month
  • Apple gained 32% in 10 months
  • FAS Financials 3x gained 33% in 3 weeks
  • BGZ Russell 1000 -3x gained 44% in 3 weeks
  • BGU Russell 1000 3x gained 54% in 2 weeks
  • Walt Disney gained 74% in 6 years

Tier 2 Maximum Midcap in recent years:

  • Maximum Midcap gained 60% in 2003
  • Maximum Midcap gained 29% in 2004
  • Maximum Midcap gained 19% in 2005
  • Maximum Midcap gained 10% in 2006
  • Maximum Midcap gained 6% in 2007
  • Maximum Midcap lost 68% in 2008 (prompting new downside protections)
  • Maximum Midcap gained 68% in 2009

Tier 3 buys in 2010 (no positions closed yet):

  • Transocean at $50 in June
  • Pfizer at $14 in July, our fourth buy

The letter’s Tier 2 Maximum Midcap strategy receives a lot of attention because it’s one of the permanent portfolios in The Neatest Little Guide to Stock Market Investing. It’s supposed to beat the Dow over time, and has, even including its old methodology that took such a hit in 2008. Starting in 2009, it offered the added benefit of timing to avoid future disasters like the credit crisis of 2008.

Here’s a chart of Tier 1’s value averaging strategy and Tier 2’s Maximum Midcap strategy against the Dow since Dec. 31, 2002 to Dec. 31, 2009:

Both value averaging and Maximum Midcap have beaten the Dow over time, but on wildly different trajectories. Let’s take a look at both, beginning with Max Midcap because it stands out so prominently on the chart.

Notice the power of Max Midcap (marked in yellow) when it’s firing on all cylinders, which is to say when the market is rising. It nearly tripled in five years before running into a threshing machine called the subprime mortgage crisis. Those adding more money along the way higher, as Kelly Letter subscribers did, made even more than the chart shows. Those were the days.

Then came 2008. It was the rappel drop down from the 2007 high to the 2008 low that inspired the introduction of charting to the 2010 edition of my book. My critics — of whom there are many, all blessed with much louder voices than those possessed by my admirers — cried that “Kelly was wrong!” after sitting frustrated during those several years when the strategy worked.

Was the strategy wrong, though, or just incomplete? I told myself that if I could find a way to lessen the impact of that drop from 2007 to 2008, and then participate in the resumption of performance to follow, I’d be in business. I embarked on a quest for better timing. The charting techniques I came up with for the 2010 edition are my best foot forward so far, and did indeed guide Maximum Midcap investors to good stepping-off points before the drop and good stepping-on points after.

I would like to point out, for my critics, that even the strategy in its original form is already back ahead of the Dow, and those who followed its advice to invest more money during the stomach-turning lows of 2008 and 2009 came out even better than the raw performance shown on the chart.

Now, to value averaging.

There are three performance tracking methods for the strategy plotted on the chart. The green bar tracks just the core account, which is the steady 3% quarterly growth achieved by buying and selling. The red bar tracks the core account plus the balance of the plan’s cash account, which ebbs and flows based on the quarterly buys and sells, and can go negative during long periods of weak prices like we saw in 2008-2009 when the plan demanded more buying power than the cash it previously kicked off. The blue bar tracks the core account plus cash flow to show the effect of buys and sells regardless of whether they were made with cash generated by the plan or new cash injected into the plan.

Notice that the core account’s green bar did, indeed, grow steadily all through the housing bubble rise and subsequent collapse. That’s as planned, and is a mathematical certainty. Still, it builds confidence to see its reliable presence on the chart.

The red core-plus-cash-account and blue core-plus-cash-flow bars illustrate what had to happen to make that steady quarterly growth possible in the core account. The reason the core account continued rising on its predetermined 3% quarterly growth pace is that new cash infusions propped it up when prices were cheaper. Look at 2008. The core account grew steadily as evidenced by the green bar being higher. New cash had to work hard to make that possible, however, as shown by both the red and blue bars being lower. The net profit, seen on the red bar by including the new cash needed to keep the plan on track, fell from 2007 to 2008 even as the core account grew on pace.

Eventually, though, the core-plus-cash-account and cash flow always win out. Why? Because those extra dollars invested during low-priced times like 2008 come out as fat profit when prices recover. Hence, in 2009, the red bar shot 47% higher and the blue bar shot 129% higher. The blue bar left everything else in the dust, proving yet again that the tortoise is a better bet than the hare.

The 7-year compound annual growth rate for each bar in the chart was as follows:

  •   3.1% Dow via DIA bought and held
  •   6.1% Maximum Midcap via UMPIX bought and held
  •   9.5% Value averaging core account plus cash account
  • 12.6% Value averaging core account only
  • 14.9% Value averaging core account plus cash flow

We should take a moment to appreciate that Maximum Midcap doubled the Dow’s performance even in its most basic form of just buying and holding. That improves when factoring in monthly buys in most environments and tactical sales in what appear to be dangerous environments.

Even more worthy of appreciation, however, is the outperformance of value averaging. Depending on how we track the strategy, its results were either three times, four times, or five times better than the performance of the Dow. That happened during a period that saw both a bubble-based bull market and a bubble-burst bear market, the two most extreme environments.

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