A couple of weeks ago, we looked at the thorny issue of when to sell stocks, looking at the use of stop-losses and focusing on the telltale signs suggested by Bill O'Neill that a growth stock may be getting toppy. As should have been obvious, this approach suits a growth-focused investor like O'Neill who's looking for rapid breakout, momentum stocks and wants to bail out of non-performing turkeys as quickly as possible. It's less clearly applicable in the case of value investing, where one is deliberately investing in companies that are ignored or misunderstood by Mr Market with a long-term view about the underlying intrinsic value and using a Margin of Safety. To illustrate this contrast, Warren Buffett hardly ever sells - indeed, his philosophy is that a lower price makes a stock cheaper and a better buy, although admittedly he's mainly dealing with entire companies, rather than parcels of shares.
A View from Philip Fisher
Although himself more a growth investor, Philip Fisher has laid out a more useful set of selling guidelines for value folk in chapter six of his book, quot;Common Stocks and Uncommon Profitsquot;. He argued that there were three general conditions which suggest that a stock should be sold:
- The investor has made an error in his/her assessment of the company.
- The company has deteriorated in some way and no longer meets the purchase.
- The investor finds a better company which promises higher long term results after factoring in capital gains.
One thing that seems to be missing from this list is when the company's stock price reaches intrinsic value (although that could be part of point 3). Interestingly, gut feelings or worries about a potential market decline are not reasons to sell in Fisher’s eyes - and rightly so, given the inherent difficulties of market timing. He explains:
“When a bear market has come, I have not seen one time in ten when the investor actually got back into the same shares before they had gone up above his selling price.”
Should value investors use stop-losses?
This is a very interesting question for value investors. As blogger TurnAround Contrarian notes, stop-losses are something of a taboo subject among value investors:
quot;The reason being EGO... Value investors including myself spend hundreds of hours researching a company. I like to think my work, which includes digging deep behind the numbers, gives me a good perspective to place a fair market value on a company. My due diligence includes not only financial analysis but also an exhaustive amount of work speaking to competitors, customers, ex employees and analyzing the psychological profile of the management teamquot;.
Value investors tend to take the view that this work means that they don't need the protections of stop-losses -there's no need to worry what the market does because: i) they understand what they are buying, iii) prefer companies with low leverage (lowering the risk of bankruptcy), and iii) they want to take advantage of volatility, not chase momentum.
While it's certainly true that the whole premise of value investing is that the market often drives the price of unloved stocks absurdly low before recovery begins, it may still be sensible to have some rules - or semi-automated procedure - for recognising losses because...
You won't always be right
While we all hope that the market will come to recognise what a bargain our latest investment was, there are two distinctly unpleasant alternatives. It may be that you've bought in far too early and from a return perspective, any future realisation of value will be far too distant to justify tying up your capital that long. Alternatively, you may got it wrong altogether and the stock may simply be a value trap - a company that appears cheap because of a large price fall, but which is actually still expensive relative to intrinsic value because of a fundamental change in their business prospects. Again from TurnAround Contrarian:
quot;How many value investors purchased the home builders after they had fallen 50%. Only to watch them fall another 80% in many instances. Having operated turnarounds, I know how quickly industry dynamics can change and how those changes can quickly impact pricing, cost structures and a companies competitive position in the marketplace. An investor needs to realize cash flows can decline very fastquot;.
With that in mind, it's worth considering implementing two selling-related rules in your investing:
1) Stop-Time, not Stop-Loss?
An alternative to selling merely because the price has dropped is to consider a specific time-limit for loss-makers. Ben Graham suggested selling either after a price rise of 50%, once the market capitalization matched the net asset value, or at the end of 2 years.
Sticking to a similar quot;stop-timequot; may be useful in automatically taking you out of dodgy investments. The specific time-frame of 2 years is of course somewhat arbitary but the idea is that too short a time period may not be enough time for management to turn a company around, whereas allowing more than, say, three years is likely to cut your compound returns to unacceptably low levels.
2) Always Write down Your Investment Thesis
It's well worth writing down at the time of purchase the specific thesis that underlies the investment and any metrics for tracking this. This allow you to monitor how future events have impacted that thesis objectively, without getting caught up by hindsight bias or issues of loyalty/saving face. One approach - advocated here by Greg Woodhams - is that, should the thesis be (materially) compromised, the holding should be sold immediately and one should avoid allowing new reasons to justify retaining the position.
Recognising Failure is Hard
Selling out at a loss is not easy - this is both due to the well-documented tendency/bias of quot;loss aversionquot; and because loyalty and a desire to save face can get in the way emotionally. You may feel compelled to stick with the company you've come to know and love (only rats jump ship etc), even when the rational thing is to walk away. For that reason, although a stop loss may not suit your investment style, it's still worth establishing some other clear guidelines / procedures for disposing of your investments before it's too late.
Further Reading around the Web
- Some thoughts on when to fold them
- Value investing, stop losses and truth
- Whitney Tilson Shareholder Letter
- Value Investors: Stopping the Losses