By Pieter Hundersmarck
Admitting defeat on a share is psychologically difficult – but history has shown that selling at the right time differentiates the winners from the 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, in which they found that people dislike losing significantly more than they enjoy winning. Thus investors have a much greater tendency to sell assets that have increased in value while holding onto 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 that investors must face – and overcome – when managing long-term focused investment portfolios. It is one of the most challenging because it forces investors to confront the most basic of emotions – pride –while simultaneously asking them 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.
Know what you own, and know why you own it
The first step to do 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 will then allow 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 significant 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 psychologically difficult to lock in the loss, and they hold on, hoping that these securities will eventually rebound.
As tough as it is to do, the best advice is to ask yourself: “Am I holding onto this share because I want to make back the money I’ve lost?”
Investors who fall prey to such investment blind spots are likely to lose money on the stock market, or at best find that their winning stocks compensate only slightly 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. Informa is 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.
As of February 2020, trade fairs and exhibitions generated almost two-thirds of Informa's operating profit. 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 between 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 into 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.
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.
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 massive 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 versus the performance of our Fund meant it was a very good move to sell them.
The bottom line
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?”
Pieter Hundersmarck is a fund manager at Flagship Asset Management.