Case study: The Importance of Loss Avoidance
This is Part 2 of A Portfolio For Mom, which explores the portfolio we're building for one of our most important clients. The series outlines our investment philosophy, centered on loss avoidance, while hopefully educating our client through a variety of case studies and stock research
We'll introduce the philosophy, present case studies, and discuss potential stock candidates. With the help of the Seeking Alpha community, we hope to improve her investment returns.
In this edition we'll present a Case Study that supports our investment philosophy, specifically the importance of loss avoidance. Hopefully it helps Mom "buy-in" to our investment discipline.
The Importance of Loss Avoidance
Loss avoidance is one of the most boring concepts in the investment industry..
Despite Warren Buffett's famous instructions (Rule #1: Never Lose Money. Rule #2: Never Forget Rule #1), you rarely hear investment professionals talk about loss avoidance. Its boring-ness rarely grabs our attention or sells advertising so few newspapers, TV shows or research articles talk about it. After all it is far more entertaining to listen to a portfolio manager talk about why you should buy this great stock or hot sector than hear about downside protection.
However, it is perhaps the most under-appreciated idea in investment management. Loss avoidance is critical to building wealth over time.
Remember David Einhorn's quote from Part 1:
"The trick is to avoid losers. Losers are terrible because it takes a success to offset them just to get back to even. We strive to preserve capital on each investment. It does not always work out that way, but that is the goal"
As mentioned, we aim to achieve the same.
The Math on Losses
In March of 2014, Crescent Point was a $40 stock. Oil was around $100 a barrel and the company paid a generous dividend. Flash forward two years and it is an $18 stock, oil is around $40 a barrel and the dividend has been slashed.
At the same time, Pizza Pizza was trading at $13.80. As a result of worries about the Canadian economy, the stock hasn't done much. However, Pizza Pizza still increased their dividend (6% yield) and grew sales despite the slowdown in the Canadian economy.
So even though we may not have made any money in Pizza Pizza, we've collected a good dividend and own a part of a business that makes more money today than two years ago. Most importantly, we've thus far avoided a significant capital loss.
In order to break-even on Crescent Point, the stock must now more than double in price. In addition, investors have likely experienced significant mental anguish as a result in addition to a meaningful loss of capital. We believe this creates some serious behavioral challenges, especially with respect to patience.
Here is the price change required to break-even on both stocks (excluding dividends):
Note: a 5-year time period yields a similar result
Pizza vs. Oil
Our investment philosophy deliberately avoids commodity investments. Not because we don't like them but because we want to find situations where the odds are more in our favor.
Commodity companies are very difficult to predict. Not only is the price they sell their product at extremely volatile, it has proven very difficult for CEOs to manage this type of volatility to the benefit of shareholders.
In contrast, we believe the odds are more in our favor with respect to pizza consumption and pizza prices. For example, in 25 years we still expect the world will be eating lot's of pizza but I'm less confident that gasoline will be fueling our cars. Further, the price of pizza is far more stable than oil. While we, as owners of Pizza Pizza, still need them to operate the business well, the stability of the pizza industry gives us a good head-start when trying to avoid losses.
Investors now require some heroic returns from Crescent Point or must find another double in order to break-even. Is it possible? Absolutely. It's even exciting and attention-grabbing to point out how such a great company is in such a great position after the fall in oil. Crescent Point could very well be a great investment.
However, these "actionable ideas" (i.e. temptations) have no place in our portfolio. They are just not part of our discipline.
A simple, boring industry like pizza offers, in our view, an opportunity to sleep well at night. With Pizza Pizza, investors receive an attractive dividend while owning a good-quality company with a history of steady growth. The dividend looks safe and the stock should generate decent returns regardless of what happens to the oil industry. Not a guarantee but we think the odds of avoiding a loss are better with pizza than with oil.
You'll see this same theme when we begin introducing the stock candidates for the portfolio in Part 3.
What do you think about loss avoidance? Is it a consideration when you invest on behalf of your clients or for yourself? What else could we add to help Mom?
Disclosure: I am/we are long PZRIF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.