Conviction: An Investing Virtue Or A Fatal Flaw?

by: Dan Stringer

Summary

Conviction can often be a crucial component to earning outsized investment returns, most notably in small cap investing.

However, it can also become a dangerous attribute if it begins to cloud judgement.

The key is to know yourself as an investor and balance the two sides of conviction.

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The concept of conviction in investing is a commonly held virtue, especially in the small cap investing world which is where I spend the majority of my investment dollars.

If we look at the meaning of conviction, Merriam-Webster gives the following simple definition:

  • law : the act of proving that a person is guilty of a crime in a court of law

  • : a strong belief or opinion

  • : the feeling of being sure that what you believe or say is true

In the investing world, we commonly associate conviction with the latter two definitions. We develop our thesis, based on many different criteria: cash flows, EV/EBITDA multiples, capital structure, macro trends, secular trends, or whatever makes the case compelling for you. If the price is right, we then take our stake (or half stake, depending on your method of entry) and hold through thick and thin.

In higher volume, large capitalized companies, conviction is less a factor. With high levels of HFT buying, day trading and index funds that are simply buying allocations, this doesn't require a lot of conviction; individuals may have it, but it is not a core requirement for many of the price drivers behind these stocks. In the current market especially, the waves of volatility, both up and down, conviction is definitely at a premium.

In the small cap space, conviction has a greater impact. These securities are often uncovered by analysts, resulting in lower volume and larger bid/ask spreads. This can result, especially in the under $1 crowd, in significant movements either way in the price paid for the security. If you establish a position in these types of companies, it is highly likely you will see large swings in price, even if there is no underlying news flow or material change in your thesis. This is where conviction becomes key.

In Chris Mayer's 100 Baggers book, he details several great case studies on securities that end up returning 100x your investment. The long and short of it is, there is no real magic formula; however, he does note that in some cases, on the way to returning 100x, you will suffer some significant drawdowns on the way, upwards of 30% at times. If this type of drawdown would have shaken the investor out, the eventual return would have been missed. Below I show the chart for the MTY Food Group (OTC:MTYFF) that Mayer used in his books which clearly show several instances where maintaining conviction has paid off:

MTY Chart

MTY data by YCharts

Sometimes maintaining conviction is clear cut. This is most notable in event-driven investing. An example I have recommended of this is Morien Resources (OTC:APMCF), that I most recently detailed here. Being a security priced in the $0.20 range, it can fluctuate up to 20% day-to-day. However, the underlying thesis in this case, is that despite a very tough coal/commodity market, the local dynamics of the Donkin coal mine underpinning the royalties Morien will earn is still intact. I can handle these price swings as that is what I have signed up for.

This could also be the case with an operating company. If we look at another example I have looked at, TIO Networks (OTC:TNCGF), we see two points below:

TNC Chart

TNC data by YCharts

I originally wrote about TIO Networks here shortly after they announced a very lucrative business combination. The stock has obviously performed well from that point, but so has the company which I reviewed after the run up in a PRO article here. It has not done as well since then.

However, to reach this return, I needed to maintain conviction; several times the stock has run up only to pull back each time; the current pullback is almost 25% from its high. However, nothing has changed with the company; in fact, things have gotten brighter; this is just the vagaries of a small cap stock.

Maintaining conviction in small caps is key; one of the large premises in small caps is the high upside optionality that they provide, either through binary events (such as Morien) or through exponential growth (like TIO Networks). Investing here requires the ability to get those 10x (or if you are lucky 100x) returns as you will likely have more than your share of losers; this downside risk is what is (hopefully) missing in large cap investment strategies. In Tio's case, if I had sold at the first sign of weakness, I would likely have made a decent gain but would be well below my current return or any future return; instead, I have a double in place while continuing to participate in any upside.

The Dark Side of Conviction

There can be another side to conviction; this occurs when you become "convicted" by your beliefs (pun clearly intended). This can occur by following the same pattern as above: you do your homework, identify your thesis and take your stake. The difference is that it works against you, sometimes right away. Your thesis may still be in act but the market, for whatever reason, may disagree with you. I have two examples where this happened to me. The first is a small energy company, Anderson Energy (OTCPK:AXLFF). It had accumulated some very good assets but had over-levered itself. Even before oil prices went down, they were well on their way to monetizing itself and getting out of the danger zone. My thesis was that they were great deal makers, the major shareholder had a strong history in the industry and that they would be able to get out of this - a classic turnaround. Let's see how this played out:

AXL Chart

AXL data by YCharts

Early in 2014, it seemed like it would work out; however, as oil prices kept slipping, so did Anderson. I had conviction that management would be able to get out of it as they were still producing decent cash flow and were deal making; however, they ran out of time. The market clearly had recognized this early than I did; I was able to avoid the full loss here by selling out in July but, because of my conviction, I held on even when I knew better because I wanted to "get my money back" "oil can't get THIS bad," and "the insiders won't let this happen". These are all things you can trick yourself into and write off to maintaining "conviction" to your idea. Maybe it will still turn around but I have my doubts after they issued over 8 Billion shares to settle its convertible debt! With better risk controls, I could have certainly reduced my loss; likewise, if I could let go of my conviction to this idea, the same could have happened.

My last example is Amaya (NASDAQ:AYA), an online gaming company. After receiving a very unfavorable litigation result in Kentucky, the company suffered a massive sell-off. I bought it as I had assumed this was a one-time event as the company was very cheaply valued, was achieving scale with terrific margins and good brands. However, instead of bouncing back, it continued to drift down. I had set a 25% trailing stop loss and it hit at that time:

AYA Chart

AYA data by YCharts

Now, nothing had really changed. I still believed it was a one-time event and Amaya still had good financial performance; however, the market disagreed with my thesis. However, as we saw above with Anderson, I have had trouble maintaining too much conviction; as a result, I have used stop losses to help mitigate this risk. Let's see if this helped when we look at where it is today:

AYA Chart

AYA data by YCharts

By letting go of my conviction, I have been able to avoid further losses in Amaya (though at times it looked the opposite). I didn't enjoy taking a loss (especially in that short a time period - about two months) but my thesis was working against me.

So What Should You Do Now That I Have Argued Both Sides?

Unfortunately, since we cannot yet see the future, this depends on who you are as an investor. For myself, my fatal flaw was the inability to accept that I could be wrong on an investment thesis and I hated taking losses. Was it arrogance, a lack of humility or immaturity? Probably yes. This caused me to maintain conviction at ALL times. So for me, I instituted risk controls, notably utilizing stop losses to prevent me from taking catastrophic losses. Sometimes this will mean I miss out on rebounds, but I adhere to the "there is plenty of fish in the sea" approach to investment ideas. Even on the stop loss front, it is not a one size fits all solution. In a recent piece on DATAWIND (OTC:DWDZF), I put a strict stop loss in; but in the TIO Networks examples I have a wide 35% loss in place. The consistent theme is that my risk is defined and I have a way out so that my conviction doesn't turn into a flaw. Even then, I continue to be human and will make mistakes; however, these tricks have helped me make less.

Maybe you are too quick to sell, either to take immediate profits or to avoid even the smallest losses. In small cap investing, this just won't pay off; just look at the MTY chart above and if you had sold in 2002 or 2006, you would have lost substantial future gains, even after some nice gains at the time.

The key is to know yourself as an investor. While this is not really data-driven, the area of behavioral finance can be a great field to get into as it helps to correlate your own cognitive processes with your investment style. There are many ways to be a profitable investor but you need to find the one that fits you. I would suggest, if you are into podcasts, to listen to Michael Covel's Trend Following. Despite the title, he goes beyond that niche to interview many types of traders, investors and behavioral finance thought leaders. The works of Daniel Kahneman is also illuminating. This will help you to flush out the type of investor you are and whether you need to try to maintain conviction or to avoid being "convicted" by your beliefs (last pun, I promise).

For continued discussion, please don't hesitate to comment below; I learn from your feedback.

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Disclosure: I am/we are long APMCF, DWDZF, TNCGF.

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.