STOP DON’T FORGET THE RULES EPISODE 2

STOP DON’T FORGET THE RULES EPISODE 2

October’s blog looked at the two most important investment rules these being “Never Lose Money” and “Never forget Rule Number 1”. Well we talked about Rules 1A and 2 at least. This month we look at Rule 1B which is about the use of stop losses in a long term share portfolio.

October of course was an appropriate month to start a discussion about managing the downside risk with shares given that October is statistically the worst month of the year for shares. As Mark Twain said about October “This is one of the peculiarly dangerous months to speculate in stocks in. The others are July, January, September, April, November, May, March, June, December, August and February”. And of course Mark Twain hadn’t seen the Octobers in 1929, 1978, 1979, 1987, 2008 ( October was the worst month in the stockmarket chaos of that year) which were a real hoot for share investors or the sharp short lived (so far) correction in share markets a few weeks ago.  Now that I have cheered you up a reminder that we invest in shares of course because the long term returns of share investing do justify the risks.

Just to recap when we talk about not losing money we are, in practice, talking about reducing the chances of permanent losses of capital as much as is realistically possible. Rule 1A means restricting share investing to companies that appear to represent a green lights situation (see the September blog “Is Cash Trash?” at www.lifestylefstas.com.au). If we do this it is likely that a higher proportion of share investments are likely to be successful than would otherwise be the case. Investing in shares is essentially a probabilities exercise.

In a long term share portfolio Rule 1B is to mitigate losses from those stocks that do ultimately disappoint by using stop losses on original capital invested. A stop loss is essentially selling a stock if the share price falls to a predetermined price level. The stop is set when the stock is bought. By way of example if we buy that notorious company Should Never Have Bought The Darn Stock Ltd (SNHBTIDS or SNH for short) at $1.00 and the stop loss level is set at 20% below the purchase price then if SNH trades below $0.80 consideration should be given to selling.in order to preserve capital by keeping the loss to an acceptable level. Better to keep a loss at relatively modest levels than risk a much higher loss if business deteriorates badly for a particular company. Just look at the longer term share price performance for Telstra and Qantas in the previous blog. A good recent example of how far share prices can fall when business goes pear shaped for a company is the mining services sector where there are almost as many casualties as on the Somme in 1916. Many stocks in this sector have fallen in price by more than 70% from their highs. Never assume that because the share price has fallen that the price cannot go sharply lower if the company is not performing as a business.

The mathematical logic of restricting losses with stop losses is compelling. In practice if we are using a 20% stop let us assume that the average loss from any stock sold under this strategy is 25% because if the stop is triggered (the share price closes below the stop loss level) it may well be that the price will be lower again the next day when the shares are actually sold. Anyway if the stop strategy is consistently applied you only have to have one stock in your portfolio that increases in value by 25% or more for every stock sold at a loss to, ignoring dividends, preserve your share portfolio capital. Over time successful businesses tend to increase in value by more and sometimes by much more than 25%. If we use green lights investing the ratio of successful investments to unsuccessful investments should be well ahead of one in two. If you can eventually score a ten bagger (a stock that over time increases in value ten times or more) then you only have to have one successful share in every 40 share investments to break even. Even Blind Freddy can do better than that. Ten baggers are of course not common but do exist. Some current examples of ten baggers where the investor has held the stock for long enough are Commonwealth Bank, CSL, Ramsay Health Care and Woolworths.

Looking at it another way if your share strategy is to aim for a portfolio with 15 or 20 stocks and you are prepared to sell on stops when you invest in a new share you are only risking 1.7% (100% divided by 15 divided by 4 or 25%) of your share portfolio capital. With 20 stocks you are only risking 1.25% of capital. If only half of your investment or superannuation portfolio is invested in shares then the capital at risk is halved from these levels. Share investing is all about managing risk. If a share is being bought in instalments (i.e. half now and half if the share price increases 15% and the company is still a green lights investing proposition) then the stop is set 40% below the entry price while only one instalment has been bought because this is still risking only 1.7% (15 stocks) or 1.25% (20 stocks) of your share portfolio capital. Once both instalments have been purchased then the stop is set at 20% below the average entry price.

We can argue the toss over whether 20% or some other level like 10% or 30% should be used. We cannot say 20% is right and the other levels wrong. If however the stop is set too close to your entry price you will find yourself getting stopped out of shares quite often simply because of the usual share price fluctuations. If you set the level too far below your entry price you may as well not have a stop loss strategy. I used to use 10% and found that it at times resulted in shares being unnecessarily sold but now recommend 20% as a better balance between preserving capital and avoiding unnecessary selling. The main objective of using stops is to avoid significant long term losses that offset the returns from successful share investments.

Selling on stops (or at any other time for that matter) is not necessarily emotionally easy and can be a much harder decision than a buying decision which is focused on the potential for a share even if the risks are acknowledged.  After all with buying it’s a blue sky decision. Selling on a stop means turning a paper loss into a cold hard reality even if the loss is relatively modest. There is always the hope (as opposed to a reasonable expectation) that something will happen to turn things around. And sometimes of course something does happen but frequently it either doesn’t or there is opportunity cost i.e. holding on to a non performing share (with maybe significantly reduced or even no dividends) for a number of years waiting for a recovery while other more attractive investment opportunities are missed. The question should always be do I have the best chance of recovering my loss (realised or unrealized) in this particular share that is no longer performing or in another share where the prospects are brighter.

Where it can become difficult is where a stop is triggered and the company appears to be performing as a business. In the Miss Clavel Theory blog we talked about how there is always information about a company that is known and information that is not known. It could be the price fall is because business for the company has started to deteriorate. It can be particularly difficult when there has been a recent update for the company that indicates business is going fine and the share has fallen in price because of general downward moves in the overall market or in the particular sector that the company is in. In this situation (and assuming that apart from the price fall the company continues to appear to be a green lights investing situation) one needs to ask whether selling on an automatic rule like a stop makes sense. It wont in some situations. Although stops should generally only be ignored where a company is being bought in instalments and only the first instalment has been bought. After all only half of the planned investment is at risk.

So occasionally a judgment call can and should be made not to sell on a stop however the more and more experienced I get the more I take the view that there should only be occasional exceptions. In 2008 during the global financial crisis stops were being triggered where the company’s business appeared to be fine and the decision to ignore the stops was made too often. As it eventuated selling on stops in 2008 would have been a magnificent strategy and provided some downside protection to share portfolio values at that time. If selling on a stop proves unnecessary the company can always be repurchased. While this may result in additional brokerage mitigation of losses is likely to more than offset this over time. Clearly capital gains tax is not an issue when selling on stops.

The main thing that can go wrong (and will sooner or later) is that a share is sold and you then experience a technical phenomenon called post divestiture flourish. This is where you sell a stock and the share price takes off and upwards like a scalded cat with the result that selling was unnecessary and you don’t get the opportunity to buy back into the company at a price anywhere near where you sold. Still there is no methodology for share investment that will produce the right result each and every single time.

Where the use of stops can be particularly powerful is that it allows you to invest in shares that have a higher than average risk but also have the potential for higher than average returns. Green lights investing is not about avoiding (but is about managing) risk. If there is a reasonable expectation of higher than average returns then, notwithstanding that there is an increased possibility of the investment not being successful, then it is green lights investing provided the expected return is sufficient to compensate for the risk. If we look at an idealised life cycle for a business (it is never this easy or obvious in practice) it may go as follows. There is an embryonic stage where a company starts a new business. At this stage an investment would be totally speculative. It may then be that the business starts gaining some traction. Sales start increasing and the company approaches breakeven or starts making a profit. It may then start to shape up as a business with significant longer term potential. The chances of things going wrong at this stage are of course still higher than they are for a company which is well established and been in business for many years. The share price has probably increased from when investing in the business was totally speculative. The business becomes further established. If investment is made at this stage the risks are clearly lower than they were before. The price however is likely to be higher (to reflect the increased certainty) which means the return potential is also lower than it was. And if the company continues to successfully develop its business it may go all the way to being a major company. At this stage the risks (and the potential returns) have reduced in comparison to what they were at an earlier stage in the development of the business. Most of the large businesses on the stockmarket were once upon a time smaller businesses.

If an investor is prepared to sell on stops then higher risk higher return stocks can be considered (provided the share appears to be a green lights situation) because the amount of capital risked will still only be 1.7% (15 stock portfolio) or 1.25% (20 stock portfolio) of your share capital notwithstanding the potential for higher returns. It is not totally a free lunch though because if you do invest in higher risk higher reward green lights stocks you can expect to experience a stop loss more frequently than if you do not invest in these types of shares. Share prices for these stocks also tend to be more volatile increasing the risks of post divestiture flourish. Unless an investor is committed to using a stop loss strategy then higher risk higher return shares should be avoided no matter how attractive the risk reward relationship may be. Now every investor is going to have a different attitude and tolerance to losses even if any losses are kept to modest levels. You need to decide for yourself whether or not you want to invest in higher risk higher return green lights stocks and if so, what proportion of your share portfolio.

Well this blog has gone on for long enough so it is now stopped out in order to preserve the writer’s time and your time and patience.

Regards

Curtis