Many investors have compounded their losses by holding a share until they could ‘at least come out even’. They may not like the company as an investment anymore but they are loath to give up and admit defeat and crystalize a loss.
Not only is there a danger that the share will keep going down but there is often a large opportunity cost as the investor forgoes profits that might have been made through the reinvestment of the money that could be realised.
To hold on so that you do not have to tell anyone (including yourself) that you made a mistake and have made a loss is mere self-indulgence. Accept your mistake and move on.
Academics have produced reams of evidence showing that shareholders have a tendency to sell their winners too early and to stick with their losers too long.
This area of literature is referred to as the “disposition effect” which is short hand for “pre-disposition to get-evenitis” (Shefrin and Statman 1985)
Terrance Odean (1998) looked at 10,000 investor accounts at a brokerage and found that over an average year investors sell a higher proportion of their winners (15%) than their losers (10%). They held winning positions for 104 days, but held losing positions for 124 days.
This would be fine if the investment returns justified the behaviour. But when Odean observed the subsequent performance of the winning shares that had been sold, he found that they went on to out-perform the losing shares which had been held. He wrote:
“For winners that are sold, the average excess return over the following year is 3.4% more than it is for losers that are not sold. Investors who sell winners and hold losers because they expect the losers to outperform the winners in the future are, on average, mistaken.” (Odean 1998, Why are investors reluctant to realize their losses?)
What is the impact of this human tendency?
Odean had the following to say:
“Let us imagine that a hypothetical investor is choosing to sell one of two stocks. The first of these stocks behaves like the average realized winner in this data set and the other like the average paper loser. The investor wishes to sell $1,000 worth of stock after commissions and that happens to be what his position in each stock is currently worth. Suppose he is averse to realizing losses and so sells the winning stock. If his experience is similar to that of the average investor in this data set, his return on the sale will be 27.7%. Since the stock is currently worth $1000, its purchase price must have been $783, and his capital gain is $217. If he instead chooses to sell $1,000 worth of the losing stock, his return will be -39.3%, with a purchase price of $1,647, and a capital loss of $647. One year later the stock that he held will have, on average, a return 1% below the market; the winning stock that he sold will have, on average, a return 2.4% above the market.” (Odean 1998)
It helps if you have been investing for a while
It would seem that more sophisticated and experienced investors can dampen the disposition effect (e.g. Dhar & Zhu 2006, Da Costa et al 2013).
For example, Lei Feng and Mark Seasholes (2005) reckon “Sophisticated investors are 67% less prone to the disposition effect than the average investor………Trading experience on its own attenuates up to 72% of the disposition effect, but does not totally eliminate the behaviour…….. A combination of sophistication and trading experience eliminates the reluctance of in.....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Playing the in and out game: The great investors say they cannot predict short term price movements. Imagining that you can look at one of the shares in your portfolio and say that over the next six months I think it will go down and therefore I will sell it now and buy it back again in six months from now is foolish.
Equally foolish is the policy of looking for shares not yet in your portfolio that you estimate will rise over the next six months.
None of the great investors believe that they have sufficient knowledge to be able to say whether a particular share will be higher or lower six months hence.
And yet so many less experienced people think they know! What does that tell you about over-confidence untempered by long experience or by learning from the those with greater wisdom?
The long term holder will out-perform the short term holder.
Relying on these is ‘silly’. Our current state of knowledge of....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Should you automatically reject those companies that erred or worry about past share price trading ranges?
Rejecting companies that have made mistakes: Companies that are striving on a frontier, particularly a technological frontier, will experiment with projects; and many of these will fail. Technological pioneers must be permitted to endeavour, to go for the big breakthrough.
Look for a good average success to average failure ratio. If the firm is run by good managers bad performance will be transient.
Short-term focused investors have a habit of over-responding to earnings drops:
‘time and again the investment community’s immediate consensus is to downgrade the quality of the management. As a result, the immediate year’s lower earnings produce a lower than the historic price earnings ratio to magnify the effect of reduced earnings. The shares often reach truly bargain prices’. (Philip Fisher)
Judging a shar...To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
The commonplace concern is that you have too many eggs in one basket. But Philip Fisher, the intellectual leader of the growth investing school, was more concerned with the other extreme. This is the disadvantage of having eggs in so many baskets that a lot of the eggs do not end up in really attractive baskets.
Furthermore it becomes impossible to monitor all the eggs. Fisher was appalled that investors were persuaded to spread their funds between 25 or more shares, thinking that it is impossible for a person to keep track of so many companies in a satisfactory manner.
In reality the real problem for investors is finding enough outstanding investments, rather than choosing among too many. He dismissed those people who fill their portfolios with a very long list of securities as share punters unsure of themselves, rather than it being a sign of their brilliance.
The investor has to keep in touch with management teams directly or indirectly. He/she cannot do this when looking after holdings in dozens of companies. Over-diversification will lead to a worse performance than if the investor had owned shares in too few companies.
Having said this, an investor should always realise that some mistakes are going to be made and that he/she should have sufficient diversification so that an occasional mistake will not prove crippling.
However, beyond this point he/she should take extreme care to own not the most, but the best. In the field of share investing it is better to hold a few of the outstanding rather than a little bit of a great many.
Conventionally managed funds....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
It is not possible to rely on a simple comparison between price-earnings ratios, PERs. Consider two companies, firm A and firm B. Both companies’ earnings have been the same in recent years, and they are expected to double over the next four years. The PER of both companies is 20.
Similar companies in the same industry, but with no prospect of growth in earnings, are selling at ten times earnings.
Move on four years, and assume that investors still value shares with no growth prospect at a PER of ten.
Company A is expecting earnings to double over the subsequent four years as they did over the previous four years, so it will still be selling at a PER of 20 and its share price has doubled.
Company B on the other hand does not have any future growth potential, so it is now valued at ten times earnings because it is a no-growth company.
Despite its earnings doubling over the previous four years, its share price remains the same.
Investors must be prepared to pay a high PER for shares when confident that earnings will continue to grow over many years.
If a company has a proven policy of developing new sources of earning power, and if the industry it is in is one which is likely to continue to show substantial surges of growth, then its PER ratio in five or ten years time is likely to be as high compared to the average stock as it is now.
It is often the case that sha.....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
The movement of share prices is governed by appraisals made by the financial community, and is sometimes disconnected from what is actually happening in the company. It should never be forgotten that an assessment of value by an analyst in one of the brokerages is a subjective matter. It comes from that person interpreting what is going on rather than necessarily reflecting what is really going on in the real world about us.
Many analysts lack the skills or the time to accurately assess the facts and as a result their judgments are frequently faulty.
Thus an individual share price does not rise or fall at any particular moment in time in response to what is actually happening or will happen to that company. Rises or falls are caused by the current consensus of the financial community as to what is happening and will happen regardless of how far off this consensus may be from what is really occurring or will occur.
As a result of the difference between the financial community’s appraisal of a company and the actual underlying facts, shares may be priced considerably lower than the facts warrant for a long period.
Steers and herds
The markets tend to play ‘follow the leader’, where someone steers a whole herd of investors away from the track of rationality. Trends and styles dominate the financial market just as they do in the fashion industry.
The trendy investment is paraded to possible investors with all its positive attributes accentuated and irrational optimism pushes prices up and up.
Irrational pessimism t....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
True investors use the knowledge gained from financial analysis and Scuttlebutt to invest in companies which analysts disregard. Most share buyers tend to follow the crowd and invest in what is deemed by the professional analysts to be a good investment.
But real investors seek out companies that are unpopular, inaccurately appraised but intrinsically sound.
Zig, by putting faith in your research and sources of information, while the rest of the financial community zag, following each other like sheep.
This is where exceptional profits can be realised. And the risk of failure is relatively small if all your test requirements, including financial stability, are satisfied.
In yesterday’s newsletter we looked at the need for managers of your investee companies to be capable in two area, (1) day-to-day task efficiency, and (2) long-range planning. Today we look at the three other characteristics Philip Fisher required, (1) integrity, (2) outstanding labour and personal relationships, and (3) outstanding executive relationships.
Shareholders need to feel confident that their investment is in good hands; that the CEOs and management possess honesty and personal decency in their business dealings.
is only too easy for executives and management without integrity to benefit themselves at the expense of the owners of the company. If there are any doubts about the integrity of company management, then investors should take their cash elsewhere.
This is where Scuttlebutt can prove essential; how else can you find out about the character of the CEO and his/her team without speaking to them directly or obtaining the views of those who know them?
Bad news happens, and management with integrity does not try to conceal it. They have to be able to stand up in front of their shareholders, and inform them of adverse events, as well as favourable developments.
Warren Buffett gives a masterful example of honesty in the event of bad news in the Berkshire Hathaway Annual report for 1999: ‘The numbers on the facing page show just how poor our 1999 result was. We had the worst absolute performance of my tenure and compared to the S&P, the worst relative performance as well….Even Inspector Clouseau could find last year’s guilty party: your Chairman. My performance reminds me of the quarterback whose report showed four Fs and a D but who nonetheless had an understanding coach. ‘Son,’ he drawled, ‘I think you’re spending too much time on that one subject.’ My ‘one subject’ is capital allocation, and my grade for 1999 is most assuredly a D.’
Even the best-run companies with excellent prospects are prone to failures and setbacks. Unexpected difficulties, changes in demand and disappointing new products will occur sporadically, and should not deter the investor who is confident in the management team.
Any suspicion that management has covered up a setback or problem should be taken as a warning sign; management may not have a plan to solve the problem; it may be in a panic, or it may have the arrogant attitude that it need not bother to report such things to shareholders.
Dividend policy is another area where managerial competence and integrity is crucial. Bad management can hoard cash, far beyond what the business needs and therefore not in the best interests of shareholders.
Bad management may also divert cash into projects which offer poor returns for shareholders, but are good for their own position and salary.
Conversely, bad management may increase dividends needlessly and sacrifice good opportunities for reinvesting earnings in the company. Here they act like the farm manager.....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Fundamental to the success of any company, and therefore of great importance to investors, is the quality of its management and staff. The difference between the outstanding company and the average or mediocre company is the people running the organisation. Philip Fisher, the father of growth investing, identifies four different characteristics to define quality of these people:
Under business ability there are two different skills; first is the efficient day-to-day running of the company. Managers should be skilled at everyday tasks, and be constantly on the lookout for ways of improving efficiency in every part of the business.
There is no time for them to sit back and relax when everything seems to be going well.
They must also be prepared to accept that things do go wrong, and failures happen, especially if they are working at the leading edge of technology.
The good manager will not overly criticise those who fail, but be more concerned with finding a solution to the failure and moving on efficiently, accepting that failure is part of the process of advancement.
The company that is unwilling to take chances, and is satisfied with ticking along, will in the end become vulnerable to more daring competitors.
Secondly the management team must concern themselves with the long-range future; they need the talent to look ahead and ensure that the business is on track for significant future growth without taking undue risks.
Fisher says that many companies have managers that are either good at day-to-day matters, or at long range planning, but for real success, both are necessary.
Managers must be encouraged to continually challenge what is now being done. Pointing out that a way of doing things that worked well in the past is not sufficient justification for it to be maintained. The rigid company that is not constantly challenging itself will sooner or later find itself in decline.
Long-term prospects can be damaged by focusing on producing unduly high short-term profits because of the effect such a policy might have on customers and suppliers.
It is important that companies keep good relations with their customers and suppliers. Companies can, for example, refrain from being overly aggressive in obtaining the keenest terms from suppliers and squeezin ......To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Philip Fisher, founder of the growth investing school of thought, was aware of the importance of how a company’s management handles its financial affairs; only when this is done well and accurately is management in a strong position.
Those companies with above-average financial talent have several significant advantages:
Difficult to discover
It’s difficult for us investors to uncover inefficiency in these areas. As outsiders we cannot expect to obtain detailed figures, but by talking to customers, suppliers, employees etc. we can start to build a picture of competence over time.
Consistence in profit margins and savings
Fisher looked for companies with a consistent history of high profit margins, as these are likely (but not certain) to give an indication of future performance. Some companies have a high degree of pricing power by which they are able to maintain their profit margin.
At the same time, it is just a....To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
I'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk
investing is about making the right decisions, not many decisions.