Often readers' questions go to the heart one's investing style. One such question this week has made me think about why I often sell some but not all of a position. The reader asked why I had sold part of my positions in Societe Generale (OTC:SCGLY) and Credit Agricole (OTC:CRARY) when they still were trading substantially below book value and the eurozone looked less risky today than it did when I made the recommendation back in March. See my post on the current state of the U.S. stock market.
Whether the eurozone looks less risky today than it did in March is a matter of opinion. In my opinion, although the eurozone has made some structural progress, the macro risks remain significant.
The Medium Term
When I recommended SCGLY, CRARY and Deutsche (DB), I said specifically that I was looking at medium-term investments, not long-term ones. I was fairly confident that the eurozone would muddle through the next six months or so; I was not so confident that its leaders would find solutions for the long term. Six months, my medium term, was up in September and the prices of SCGLY and CRARY were substantially higher (30-40%) than my basis, so although I was enjoying a holiday in rural France, I decided to reduce my risk and take some gains. I sold approximately two-thirds of my positions in those stocks. I decided not to sell DB because, although I had a small loss, I do not see DB as quite as risky a play as the two French banks, and I think DB is likely to make progress over the next six months. I did not sell the entire SCGLY and CRARY positions because I think they still have the potential for significant gains in the next six months, but I am watching them and the situation in Europe very carefully. These stocks are trading not so much on their merits as on the macro situation in Europe, and I might sell the remaining positions any day.
Leaving Money on the Table
These sell and hold decisions reflect an investment style that I have tried to apply fairly consistently over the last 10 years or so. It is a style that has resulted in good returns relative to the S&P 500 in most years, but it also is a style that, on many occasions, has left money on the table. And right now, my style is certain to leave money on the table if QE3 continues to cause the market to go up.
Evaluating Bad News
"Cut your losses but let your winners run," is one of the common adages of Wall Street. Indeed, cutting losses is one of the most difficult things that an investor should do. But what kinds of triggers should an investor use? As an example, here is a quote from Investopedia:
"Have reasons to sell a stock.
An investor generally has quite a few reasons why he or she bought a stock, but typically no set boundaries for when to sell it. Don't let this happen to you. Set reasons to sell stocks, and sell them when these things occur. The reason could be as simple as: 'Sell if bad news is released about corporate developments or a price target'."
In my opinion, this is not the best advice if you really are investor who should invest in individual stocks. It is not the best advice because the bad news or the reduced price target often provides an investment opportunity. Yes indeed, bad news or an adverse report from an analyst requires you to do some work, but if you are worthy of being an investor in individual stocks, you should welcome this opportunity to do the work necessary to decide for yourself. If, for example, a quarterly report was out of line with expectations, you not only should read the report; you also should listen to management's conference call with analysts and review your reasons for buying the stock in the first place. Were there reasons for the bad reported numbers that might make you take advantage of the drop in the stock price to buy more? Or, on the other hand, were the reasons such as to make you feel that, more likely than not, you made a bad decision to invest in the first place or that things have changed for the worse? Go back and review the process you went through before making the investment. Does your investment thesis still apply?
If your original investment thesis still applies, then buy more; do not sell. This is not a question of "averaging down" or "trying to catch a falling knife"; it is a question of taking advantage of an opportunity that has come your way because you work hard. Have I sometimes made mistakes in this review process? You bet I have. But on many more occasions I have been correct and been rewarded.
Let's take the case of SCGLY and CRARY. They are foreign banks, and therefore it is difficult to apply the precise procedure that I would apply to a small-cap stock investment. But when I saw the two stocks going down, I had two immediate reactions: One, my goodness, I just recommended these stocks and maybe a few people bought in part because of my recommendations; I feel terrible. Two, should I sell, hold or buy more? I reread the basic disclosure documents of the two banks to see whether anything had changed. I found some things that I had missed earlier, but they were not enough to change my assessment. The stocks were going down because of worries about European banks in general, and I had been following the ECB's actions carefully and writing about them here on Seeking Alpha, so I had anticipated the process that the ECB was going through and I already believed, although he had not yet used the words, that Mario Draghi would do whatever it takes, within a reasonable interpretation of the ECB's mandate. That is what I said back in November 2011 when I reported on Mr. Draghi's first press conference:
The ECB cannot solve the euro's basic problems. But the ECB's vigorous action to 'do whatever it takes' could buy enough time for the political process to make fundamental changes in a less heated atmosphere.
So I bought more SCGLY and CRARY, which reduced my basis and, when the stocks turned upward, made it much easier to take a significant profit.
I had gone through similar processes in the last year with Bio-Reference Laboratories (BRLI) and what is now Catamaran Corp. (CTRX) but then was SXC Health Solutions Corp. In the case of BRLI, the stock dropped precipitously after an analyst reported that management had made statements that, in effect, insulted the company's customers. After investigation, I decided that the issue was not likely to damage the company's future, so I bought more of its stock at the new lower price. I now wish I had been even more aggressive in buying then, but that is not my investing style. I recognized then and now that I could have been wrong; therefore my bet was fairly modest. The stock has come back and gone up significantly. One of the side benefits of my investigation is that I listened carefully to the company's CEO on conference calls and have more confidence in my investment.
SXC Health's stock dropped after a competitor made an acquisition that made it appear more likely that the competitor would be able to take one of SXC's top customers. After investigation, it appeared that SXC had a 5-year contract with the customer, so no loss of revenue was immanent. The company still was sound, with good growth prospects and almost five years to plan for the possible loss of business. I bought more stock in that case as well, and the stock has performed well, recovering all of its loss and continuing upward.
On other occasions my review has suggested that I made a mistake in the first place and I have sold the position. That has occurred sufficiently often that sometimes I take a small position in a stock in order to make me focus on it carefully for a period of time before buying a full position.
Taking Gains to Reduce Risk
The corollary to my stories about making good choices to invest more after a stock has gone down is that I also take gains as a stock goes up, frequently taking the gain on the new purchase when it has reached 25-30% if it does so in a brief period. In my view, annualized gains of 50-100% are to be prized. I am not such a great stock picker that they happen every day. Therefore I have left money on the table, at today's prices, on BRLI and CTRX, as well as better known companies such Apple (AAPL) and Under Armour (UA) where my gains, in percentage terms, have been substantial.
I do not mind leaving money on the table this way. I retain some of the stock because I have not changed my mind about the company, but the size of my investment has gone up and I take the general view that nothing grows to the sky. I still hold SCGLY, CRARY, BRLI, CTRX, AAPL and UA, but on paper I would have made more money on them had I never sold any.
Taking Account of the Macro Situation
That brings me to QE3. My general investment allocation is heavily skewed toward equities.
On occasion, I have been over 80% in equities. But that is when the market is down, such as late 2002 and early 2009. Now the market is up. Is it up too high? Seeking Alpha readers probably read five commentaries a week on each side. I tend to think the market has got ahead of its fundamentals. In keeping with my willingness to leave some money on the table if I am wrong, I have reduced my percentage in equities and increased my percentage in cash, even though cash earns nothing. If stocks drop by 20%, as I believe is possible over the next year, then my cash will be well positioned to earn well in the next upward cycle.
QE3 may well pump up equities for a time. But as I said, I do not believe that anything grows to the sky uninterrupted. If there is a significant interruption, I want to be able to take advantage of it rather than wringing my hands. In the meantime, although I may leave some potential gains on the table, I still have enough in equities - something like 45%, down gradually from 90% in March 2009 - that I will prosper if the market continues to go up. Taking profits along the way and pruning stocks where I think I have made a mistake have allowed me to make that transition from 90% to 45% invested in equities without too much pain.
Buy Low, Sell High
The idea, as I said in my first article on the Buy-Low Sell-High portfolio back in January, is to buy low and sell high. We take some risks in the process of attempting to do that. We try not to take foolish risks and we try to reduce risk when possible while maintaining the opportunity to make money.
Total Return is the Benchmark
One of the corollaries of this kind of investing is that it always is concerned with total return. Income for its own sake is not relevant. We use cash from the portfolio to pay a proportion of our living expenses. But it is just cash. Whether it came from interest, dividends or the sale of securities is of interest only for tax purposes.