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Admitting defeat on a share is psychologically difficult, but history has shown that selling at the right time differentiates winners from losers in the investment world. But why is selling such a difficult decision for so many investors?
Hersh Shefrin and Meir Statman labelled this investment challenge the disposition effect. In a paper they produced in 1985 they stated their finding that people dislike losing significantly more than they enjoy winning. Thus investors have a far greater tendency to sell assets that have risen in value while holding on to assets that have dropped in value.
Humorously, Shefrin and Statman called it a “disposition” as shorthand for “the predisposition toward get-evenitis”. The disposition effect is one of the many biases investors must face — and overcome — when managing long-term, focused investment portfolios.
It is one of the most challenging because it forces an investor to confront the most basic of emotions — pride — while simultaneously asking us to overcome our built-in reluctance to embrace loss. In our experience the best way to find the strength to cut our losses when it is the best course of action is to put in place a robust and unemotional process of reviewing your investment thesis and selling when this changes.
The first step is to write down the investment rationale behind why you bought a share, and in what circumstances it would make most sense to sell. Documenting this allows you to revisit your original assumptions when the share price rises or falls, and use the information to inform your decision.
Keeping records of your original investment case is a simple disciplinary exercise that is likely to have positive implications for your investment portfolio down the line. For many investors it serves as a crucial reminder of when to let go of a losing position.
A typical trading approach looks something like the following. You take a number of active positions, sizing your exposure based on the risk and return you expect from each stock. Poorly defined limits mean you probably end up with more money allocated to risky shares, because you estimate the profit opportunity to be higher than it is realistic to expect.
Some trades work out and can be sold at a profit. But for many investors it is too difficult psychologically to lock in the loss so they hold on, hoping these securities will eventually rebound.
As tough as it is to do, the best advice is to ask yourself: “Am I holding on to this share because I want to make back the money I’ve lost? Or am I holding on because I believe a stock split will create further value?”
Investors who fall prey to these investment blind spots are likely to lose money on the stock market, or at best find that winning stocks compensate only partially for the negative performance of the losers.
We’ve found that the answer is to follow a process or built-in procedure of reviewing and selling when your original investment case (the reasons you bought the share) are shown to be incorrect. The benefits of having a process are clear in the following two examples of stocks we held over the past two years.
The first is Informa, a powerful marketing, business intelligence and in-person events platform business. Our original investment thesis consisted of a business growing its various revenue streams in excess of peers while increasing profitability, and in so doing garnering a higher multiple to earnings than its long-term average.
In February 2020. trade fairs and exhibitions generated almost two-thirds of Informa’s operating profit, but as the coronavirus outbreak began to gather pace Informa revealed that an increasing number of its shows were being postponed or cancelled. Its flagship health and nutrition show in the US — as well as a number of its important Chinese and Japanese trade fairs — were indefinitely put on hold.
We calculated that earnings per share could fall a material 30% in 2020, and 40%-50% in a bear-case scenario, with little visibility thereafter. When we revisited our original thesis we found it no longer held. Rather than giving in to the temptation to construct a new thesis (which in this case would be a recovery play — an entirely different investment case) we sold the share at about 600p. It is now trading at about 470p.
Heineken is another example of when we sold when the initial investment case changed. Heineken is a high quality consumer staple stock that we bought to participate in the growth of beer volumes in emerging markets (particularly Vietnam, Mexico and Africa), as well as the steady increase in operating margins from the mid-teens to 20% longer term.
This is a powerful algorithm that is not unfamiliar to long-term investors. The pandemic changed this. Initially we expected the effects of global lockdowns to be short term in nature, with minimal impact on Heineken’s long-term volumes (and investment case). However, as the pandemic deepened and movement and celebrations across key markets were curtailed, the investment case changed.
Currencies in key emerging markets dipped, and raw material costs experienced huge inflation. Employees were laid off and new debt was taken on. By December 2020 we took the call that the facts on the ground were too far removed from our initial investment case.
For both shares (Heineken and Informa), the subsequent performance vs the performance of our fund meant it was a good move to sell them.
Long term investors are often guilty of justifying critical events that have a profoundly negative impact on their stock’s investment case as simply “short term noise” — often a catchall for an investment case that has gone badly. The reluctance to accept losses prevents many of us from admitting the new reality to ourselves and making the right call, which is to sell. John Keynes’ famous quote is useful here: “When the facts change, I change my mind. What do you do?”
• Hundersmarck is with Flagship Asset Management.
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Published by Arena Holdings and distributed with the Financial Mail on the last Thursday of every month except December and January.