Hi KTP,
Nice to see you back. I've been busy too but thought I would pop in. Especially nice to see you responding so well in this thread, I love people who have a clear thought process, who know themselves well, yet remain open to commentary.
As per usual though, I'm going to ask a couple of thought provoking questions for you and give you my thoughts (This is still based on the idea that while you like the idea of a hard exit, you don't know how to implement - if you've changed that the below might be pointless)...here we go...
Thanks Sir O.
Can we know everything? Of course not. No matter how diligent our analysis of a stock may be, (whether technical or fundamental) we frequently operate in an environment of imperfect or incomplete information. I run several systems across differing time periods. I'm also a weird person because I use both Technical and Fundamental analysis, having no preference for either style...They both have their place. For some of my systems, FA has more weight, some TA. All my systems however employ mechanisms to limit downside risk. The reason being that it produces a statistically better result over the longer term. To me a stop loss is a mechanism to determine when the imperfect or incomplete information is going to adversely impact my investment...IE a measure of financial risk within my strategy of investment.
You asked above why use a known criteria for an unknown event. My answer (not necessarily yours) is because the third dimension of financial risk, (the extent) is unknowable. The "event" may cause a small retracement in the share price, or may be the initiating event that snowballs into complete destruction. Only with hindsight can we know the answer to this question.
I agree it is only with hindsight that we will know which ones continue falling and which ones will bounce back.
But what are the odds? I will ramble on...
Out of 10, or 100, good, financially sound companies - how many continue going down and how many recover? My analysis/experience/reading tells me that selling after a big drop in these kind of companies is not the best strategy.
Furthermore, "good" companies experiencing large drops are very often (but far from always) the very best investment opportunities. Again, I feel experienced human judgement is required rather than an automatic decision.
Another argument is about risk - is the company that dropped in price more volatile and therefore more risky, or is it less risky because it is cheaper?
I agree that selling on substantial decline will further mitigate risk - but I think it will end up being the wrong decision more often than not. For the type of companies I invest in, anyway.
A lot of FA is based on finding companies that are priced below value. In many cases, this means you look at companies that have had a fall in price. This results in a situation where for the same kind of company:
- If I already own it, than I sell.
- If I don't own it, Buy!
Let's go back to CAB. I bought it 2009 for my super at $6.20. It has recently fallen down to under $4, for reasons we all know. Now, I agree with "the market" that the company is worth less now than a year ago. It has deteriorated. Should I sell? But despite deterioration in value, I still think there's plenty there now that the price has fallen.
If I sold at $4 or under because it's gone down, when do I allow myself to buy back in? Do I time the market?
What do I do with companies like LYL, where I expect them to have a bad year in 2014. I bought them because they were cheap enough, I did not try to time the low point. If they go on to have a bad 2014, just as I expect, and the share price drops even further, do I sell? My underlying assumptions have not changed, everything is going as I expect, what to do?
I am curious of what your previous FA experience tells you. How often did you get out and the price has gone back up? Was it a worthwhile percentage play in your case?
I think a lot of the auto sell comes from background of timing the market. Sell, wait till it goes up, buy again. I have nothing against that approach, but I have long ways to go before I am competent in anything like that. So what are the benefits of it for me, who makes no attempt to time the market?
Let me give you an example of what I am talking about (based on Fundamentals). I purchased Babcock and Brown at IPO. Purchasing at IPO there is no TA to be done. The stock (at listing) had all those characteristics that you have identified. Low/no debt, significant ownership by management, excellent ROC and simple to understand (similar model as Macquarie Bank). I managed to get my hands on 2,000 B&B IPO shares at $5.00 (a relatively small position size within that system, and purchased another 1,500 shares on the first day of listing at $8.27) (over 60% increase from IPO price).
I held the stock for 12 months before conducting any significant analysis beyond looking at the price. I eventually sold the stock at $28 and some change (from memory I think it got comfortably over $30). At this stage B&B was still being compared to Macquarie Bank and analysts were still talking it up. Whilst I appreciate that you don't have all the information (see what I did there?) Why do you think I sold it?
I will have to disagree with you on one bit - simple to understand. I looked back on my notes for it and I have just one sentence against it - "I don't understand this business well enough". But that's for me, it's not the kind of company I usually invest in, so other may find it easy to understand.
But that places me in a good position for your experiment because I've done no research on them and can therefore try to guess why you sold:
- got too expensive based on FA analysis
- too many people talking it up, etc.
- fundamentals changed.
Am I close? Or was there a large dip in the price?
* * * * *
I've seen you repeatedly state that you will use diversification as a method to reduce risk in your investing activities. Fair enough, diversification will reduce certain types of risk. Specific stock risk in particular is mitigated (not eliminated) by diversification. What about market risk? Market risk is something that impacts the entire market, for example, Interest rates. A stop loss mechanism is a way of mitigating (not eliminating) an event that can impact your entire portfolio. If it's your intention to carry positions for long periods of time in your system or strategy, you will be impacted by Market Risk...how do you intend to recognize and/or mitigate this risk?
That's all for now, I have more but time-poor.
Cheers
Sir O
That's a good point, short/medium term, I am not really protected against market risk. Some protection I do have:
- generally long term holding
- 2+ years to enter the market.
- safety margin on my investments. Due to the price I am willing to pay for my investments, I tend to buy less when the market is high and hold less in stock. I am also a lot more likely to sell as some of my stocks will trigger my sell price.
I will expand further on my sell strategy, as I've realised it may sound like I don't have one. I have clear rules about when I will sell, and I do so on a regular basis. I've posted the following sell criteria in my first post, almost directly from Phil Fisher:
1. When I made a mistake.
2. When circumstances changed.
3. When there's a better investment.
4. In some special cases, when performance objective was complete. Will mainly apply to less than stellar companies trading below NTA.
and I've recently added:
5. 3 years performance rule.
6. I should add a new one yet again, based on my experience with IRI a few months back. Sell whenever something gets "Stock of the Month/Year" award.
1 & 2 -fairly self explanatory. I regularly revisit my investments to see if my reasons for buying are still valid. If they changed, either due to new events or finding a flaw in my reasoning, I sell. But first, I consider the investment merit of it in light of new evidence, and whether I would have liked to buy into this now if I didn't already hold.
4. Special situations - won't happen often, so let's move on.
5. enough said.
3. This is key. It's a small point, but has a lot to it. One important thing to remember is that all my investments need to also be compared to a cash account. When the price gets high, I will sell, even if there's no other equity investment to put it in.
I've mentioned this before, for me, buying a share is not a yes/no decision. It is a comparison. What do I compare on?:
1. Price. I do a valuation of the company based on what I think is most likely scenario.
2. Risk.
3. Long term potential.
4. Certainty of earnings or competition moat.
I try and keep these things separate, eg. I don't price risk in my valuation. I can then look at all companies which prices are below my required margin of safety. I know that my price estimates, like anyone else's are probably way off, so whether a company if 50% under value, or 70%, does not make a big difference to me. I assume they are priced about the same.
I can then compare these companies on the other 3 factors. Again the key to the comparison is that Cash account is an option I compare against, as it has all 4 factors locked in.
Which means I will sell when the price gets above my value. The company with more risk and less potential and earnings certainty will be sold at a less of a premium than one with low risk, higher potential, etc.
To reach the selling trigger, either the price has to go up, or the value to come down. But I disagree, that under this methodology, sell trigger can be reached by price going down
I fully understand everyone's arguments about stop losses and their benefits. My point is that not all risks have to be mitigated. It's a decision that's based on personal circumstances. And sound logic, hopefully. There's risks which you may decide are worth bearing, for more reward. But one must understand exactly what's at risk. Do I?