Buy-and-hold champion sells everything

Derek Foster promotes himself as "Canada's youngest retiree" - a regular guy who punched out of the work force at 34 by investing in blue-chip stocks and living off the dividends.

His seductively simple approach to riding out turbulent markets by focusing on dividends, not day-to-day market gyrations, resonated with tens of thousands of Canadians who bought his bestselling books such as Stop Working, Here's How You Can! and The Lazy Investor.

So it may come as a shock to his loyal fans that Mr. Foster - the same guy who advised readers to hold good stocks "forever" and to "buy more shares" if there's a market crash - recently did something out of character: He dumped virtually all of his holdings.

When one of the most fervent advocates of buy and hold investing bails out is it a sign that the bear market is about to get a lot worse? Or is it the ultimate contrarian indicator, signalling that markets have reached the point of maximum pessimism and are poised for a rebound?

We reached Mr. Foster at his home near Ottawa and asked him to explain why he liquidated his portfolio last month. We also asked him to address the apparent contradiction between what he's doing now and what his books - which have generated more than $200,000 in profit for the now 39-year-old - advise investors to do.

You recently sold all of your holdings. Why?

A: I don't consider myself to be a panicky investor. I've been through a couple of typical bear markets, the typical 20- or 30-per-cent declines ... but I just started researching it more and more and I just think that this is not a garden variety bear market. I think this is almost like a paradigm shift. We've lived in North America, more so in the States, in a fictitious economy to some extent because people ... were living way beyond their means. And I think this crash is an inflection point. So going forward I don't see the economy growing as robustly as it has because I think we've been living on borrowed money.

But the market has been pretty much cut in half, so it's discounting a lot of what you are saying. What makes you think there is still more downside?

A: Looking at history, traditionally, what's the bottom? There are a few different indicators. One of the things I looked at is, for example, the yield on the Dow. Typically the market peaks when the yield hits about 3 per cent ... Historically once the yield gets above 6 per cent it's a good time to buy. We're only at 4 per cent right now. But that's a moving target because even venerable firms such as GE and Bank of America and Citigroup have been cutting their dividends. So even if all the dividends remained the same going forward basically you still need the market to fall 33 per cent until you hit that 6 per cent [yield].

Do you follow any other indicators?

A: Another thing people use is the market capitalization to total GDP. ... Right now, it's between 70 and 80 per cent, but if you look at history usually it gets down to about 50 per cent before there's a market bottom, so again that points to another 30 per cent or so decline. The one other statistic I was looking at is just the general P/E ratio. On the S&P 500 it's around 11 right now or 10.5 ... at market bottoms it usually has single-digit P/E ratios, which points to more downside.

Aren't you worried about missing the rebound?

A: I could be wrong. But if I'm wrong, I don't think the markets are going to head back to the glory days anyhow, so the risk in being wrong is not that big. I don't see the market suddenly booming.

Your first book, Stop Working, preached the buy and hold, dividend-investing philosophy. Selling all your stocks is a repudiation of that. So will you stop selling that book?

A: Absolutely not. Because I think this is a temporary thing. ... My total goal in this is to absolutely get back into stocks, but I want to get back into stocks when the yields are up and it's going to be a wonderful time to buy, when all the excesses have been wrung out of the system.

Do you ever worry that, now that you, the guy who preached buy and hold, now that you've sold that maybe that's a contrary indicator?

A: It might be. Who knows? I've just looked at history and I've analyzed this quite a bit over the last few months, and I don't think so. But I mean, yeah, part of me wants to get back into the market, which is why I'm selling options again.

Your options strategy had a rocky start because you sold puts on companies like Bank of America, Pfizer and others that plunged in price. What makes you think the strategy will work any better now?

A: You have to put it into perspective. You can't just say the options strategy was rocky and compare it to if I'd put my money in a GIC. Because the options strategy was a replacement for money that I was planning to use to buy stocks. And the money I lost through options was much, much less ... That's the nature of investing, you're going to make mistakes some time.

Do you ever worry that you've made a big mistake by getting out now?

A: I'm sure that's always a possibility, but then if I'd stayed in maybe that would have been big mistake, too.

Still playing the market

Although he's dumped his stocks, Mr. Foster is still playing the market with options. Specifically, he's been selling "puts" - contracts that give the buyer the right to sell their shares to him at a predetermined price by a specified date.

Options are complex instruments, but the rationale is straightforward: In exchange for selling the put - a form of insurance for the buyer, who wants to limit his or her downside risk - Mr. Foster collects a "premium". And it's those premiums that have replaced the dividend income in his portfolio.

In his latest book, Money for Nothing and your Stocks for Free!, he argues that selling puts is a "win-win" because one of two things can happen: Either the shares stay above the strike price and he simply pockets the premium, or the stock falls below the strike price and he is forced to buy the shares. That's why he sells puts only on companies he would want to own anyway.

The problem is, if share prices plunge, the seller of the put may be forced to buy the stock at above-market prices or close out his position at a loss. Indeed, many of Mr. Foster's puts came back to bite him when the market collapsed last fall.

That's why experts advise investors to be wary of selling options.

"I think it's a terrible strategy. I think retail investors should not play with options, that's the bottom line," says Norbert Schlenker, president of Libra Investment Management in Salt Spring Island, B.C.

Quotes

From Stop Working, Here's How You Can!, self-published in 2005 by Derek Foster.

"Once you've bought the perfect company, never sell it."

"You have to be committed to the stocks you buy. It's like a marriage - 'till death do us part' situation."

"The performance of the stock market does not affect the dividends companies pay."

"With these types of investments, even if the market crashes you keep collecting cash regularly. And you NEVER sell them."

"Remember selling stocks, like divorce, comes at a high cost."