Investing Myths and Disjunction Fallacy

Here are the results from a twitter poll I ran yesterday.

gain loss quiz

It was a small sample size. Only 30 people. I assume most were financially literate.

I wonder what people thought when they saw the results, after answering the poll. Did they feel more or less sure of their answer? Did they feel validated or perhaps confident in their contrary position?

It seems most people believe that a 50 percent loss takes a 100 percent to make it whole again. That a 90 percent loss takes a massive 900 percent to offset it.

That my friends is bullshit. It is one of the most widely perpetuated myths in investing.

Investing is a parallel pursuit. A 50 percent loss in one investment is offset by a 50 percent gain in another investment of the same size. A 90% loss is made whole by a 90% gain.

the real gain loss picture

Yes if you loose 80% of your total portfolio you’ll need to make 400% to get back to scratch. While that concept is important, I consider focusing on outcomes for individual investments more crucial. I’ve always liked the saying, look after your pennies and the pounds will look after themselves.

There is no need to be terrified of losses. The upside is infinite the maximum downside is only 100 percent (ignoring leverage). I don’t wish to encourage you to be a bag holder and take big losses. My aim is simply to make you wonder why almost everyone is hell bent on convincing you that deepening losses require exponentially higher returns to offset.

Now for anyone thinking, but you didn’t say an investment I thought you were talking about a portfolio, let’s talk about disjunction fallacy.

In short disjunction fallacy is thinking that a member is more likely to be part of a subset rather than a member of the set which contains the subset. In the above poll, both 50% and 100% are subsets of it depends.

This is similar to the better known Linda effect or conjunction fallacy, when people guess that the odds of two events co-occurring is greater than either one occurring alone.

The return required to make you whole depends on whether you’re considering a portfolio or an investment and the position size of each investment.

Can retail investors outperform the market?

Lies, damn lies, and statistics” was popularised by Mark Twain to describe the persuasive power of numbers.

For many years I’ve replaced damn lies with facts. Lies, facts and statistics.

Facts, like statistics, can tell you whatever you want to believe. Many people believe the are looking at the truth through the lens of either statistics or facts, but they are often simply seeing what they wish to. They then use the “lies” to entrench their position.

Facts and statistics are often the trees stopping us from seeing forest.

I’m not implying it’s always best to focus on the forest, sometimes it’s the trees we need to look at. The important part part is to have the right focus for the circumstances, an open mind, and not to swallow statistics or facts without chewing.

Statistics tell us that retail investors woefully under-perform the market. Stats also highlight around 75% of fund managers lag the market. Many people concentrate on those dire figures and in the case of ETF and index funds heavily publicise them.

So why would a retail investor bother trying to outperform the market? Statistics say it is highly unlikely and individual investors are seriously out-gunned by institutions.

The answer is, invert those statistics.

Can retail investors outperform the market?

Market returns are the average of all participants. So if the vast majority of participants under-perform the market then a minority must be trouncing the market.

I occasionally communicate with one  of these market thrashing investors. Here are his returns to October 2014

retail-investor-market-beating-performance

Those are some awesome numbers. For some perspective on how good his performance is consider this. Over the last 5 years he would have turned $100,000 into almost $410,000 and over the last 3 years $100,000 would have grown to almost $290,000. Simply phenomenal.

Now let’s compare his returns to mine.

investor-x-returns-vs-fusion

While we both handily thrashed the market, I trail by a considerable distance. Even though my performance over 5 years appears pretty close to his, it’s not. Instead of growing to $410,000 over 5 years, I would have “only” grown it to $309,000. A few percentage points makes a huge difference.

Investor X wonders why I hold such a high cash balance, around 50 percent at the moment.

One comment I would have, is the fact that you have moved to around 50% cash. I also watch Geoff Wilson’s performance with his LICs WAM, WAX and WAA, and he also likes to keep between 30-50% cash. I have always thought he could do a lot better if he was prepared to be more fully invested. Yes, you are both in an excellent position to take advantage of the down turn we are now in, but I wonder at the cost of lost opportunity. I rarely have more than 2-3% in cash. If I sell something, it is because I have found what I judge will a better investment to move onto.

Investor X is right. My returns would be much closer to his over the last 5 years if I was 100 percent invested. While close to meaningless, we’ve also compared monthly volatility and my portfolio is more volatile. So why do I hold so much cash?

The simply answer is personality. While investor X was able to live with a 60 percent fall during the GFC, I could not. Our portfolio dropped around 20 percent during the 2008 market crash. I prefer to sacrifice some upside to ensure I can sleep well at night.

The other answer is buy fear sell greed. While many market pundits present facts and statistics showing that the market is under or over value, or  just right, I focus on the trees, the individual companies. I raised cash in September as companies I held became overvalued. I’ll redeploy capital when it’s easy to do so, when companies I want to buy are being sold by fearful investors.

Investor X is older and probably wiser than me. He clearly has better performance over the last 5 years. But what happens if we layer on our respective 60 and 20 percent drops?

It turns out if we started with a $100,000 prior to the GFC and our returns included both the falls and gains from above then investor X’s portfolio would now be worth $164,000 while mine would be $247,000. Naturally if we exclude the GFC drop, but our portfolios fell by similar amounts now, the figures would be the same, i.e. $164k and $247k.

I’m not saying this is what happened or will occur, but I hope it illustrates why I focus on the downside. If not then perhaps this graph of gains required to make you whole again will.

See the difference. While it only take a 25 percent gain to make up for a 20 percent loss, it takes a massive 150 percent increase to recover from a 60 percent drop. (See this post on the lies behind this accepted fact and how it can take exactly the same percentage gain to make up for a loss.)

I am so far off topic I should change the title, but hopefully through the many diversions you can see two retail investors thrashing the market in two different ways. While there are many wrong paths, there is no one right path to market outperformance. Each investor must fine the path that is right for them.

Some paths are easier to follow as they are clearly marked. Value, momentum and small caps are 3 paths that have provided strong tailwinds for up to 9 decades now.

A little meat

During September I sold, Analytica Limited (ASX:ALT) and Global Health Limited (ASX:GLH), and reduced M2 Group (ASX:MTU) and My Net Fone Limited (ASX:MNF).

While I say it’s the companies I focus on, that is simply part of the story. Market corrections are not fair to all comers. Some stocks get whacked 90 percent, some might only drop 10 percent and there will even be a few gainers.

In general stocks that are any of overvalued, speculative, small caps, without earnings or popular are hardest hit.

I continue to hold some stocks that are likely to get clobbered in a correction. Two companies that jump to mind are Somnomed Limited (ASX:SOM) and Nearmap Limited (ASX:NEA). I hold these and would look to buy on a correction as it is simply too difficult to ‘time’ individual growth stocks.

Disclosure: Long MTU, MNF, SOM and NEA.

Falling knives cut deep

Don’t try to catch a  falling knife.

Do you know the game mumblety peg? As kids we called it knives and loved playing it.

Alas the mollycoddled generations will never know the thrill and the fear of throwing knives at their own and each other’s feet.

Most versions of knives involved two players and a pocket knife. Our favourite version of the game was stretch.

The object of the game is to make the other player fall over from having to spread their legs too far apart. The players begin facing each other some distance apart with their own heels and toes touching, and take turns attempting to stick their knives in the ground outboard of the other player’s feet.

If the knife sticks, the other player must move their foot out to where the knife stuck while keeping the other foot in place, provided the distance between foot and knife is about twelve inches or less. Play continues until one player falls or is unable to make the required stretch.

The ‘traditional version was also fun.

Two opponents stand opposite one another with their feet shoulder-width apart. The first player then takes the knife and throws it to “stick” in the ground as near his own foot as possible. The second player then repeats the process. Whichever player “sticks” the knife closest to his own foot wins the game.

If a player “sticks” the knife in his own foot, he wins the game by default, although few players find this option appealing because of the possibility of bodily harm. The game combines not only precision in the knife-throwing, but also a good deal of bravado and proper assessment of one’s own skills.

There is nothing quite like the fear of a knife in your foot to sharpen one’s skill assessment.

Anyway that’s  enough of a stroll down memory lane.

Falling knives

The major appeal of trying to catch a falling knives is rooted in anchoring. Coca Cola Amatil was $15 last year, it must be a bargain at $9!

Coca-Cola Amatil falling knife

Last week I confessed to anchoring when selling. Unfortunately I still occasionally fall in to the trap of anchoring with falling knives. I have been closely watching Coca-Cola Amatil (ASX:CCL) since it’s precipitous fall in April. It appeared relatively cheap. Relatively that is compared to its past multiples.

Fortunately Peter Phan of Castlereagh Equity pointed out to me there are other large Australian companies priced similarly that have better growth profiles and less execution risk than Coca-Cola Amatil.

Falling knives present numerous dangers, most of which are as painful as a knife in the foot.

  1. They can and often do keep falling. Cutting deep as they fall.
  2. Even when they eventually land they often turn in to value traps, that is the stock doesn’t rebound to capture past glory.
  3. Those stocks that do eventually bounce often don’t provide a good compound annual growth return. CAGR is the key return long term investors should focus on. If it takes too long for the investment to “work out” then a good absolute return can become a poor CAGR.

Coca-Cola Amatil is a good, but not great example of a falling knife. It has decent underlying businesses and negligible chance of falling to zero.

Speaking of zero, a much better example of a falling knife is Xero (ASX:XRO). Xero is a classic falling knife. Since XRO began falling in March, every single person who has tried to catch this falling knife has been badly cut. And those cuts could get a lot worse.

With no earnings and well heeled incumbents successfully fighting back there is no sign of the floor for Xero’s falling knife.

Xero closed today at $18. And just in case you think I’m jumping on the beat it while it’s down bandwagon, I’ve been screaming watch out below since Xero was $42.

xero falling knife xro asx

Falling knives are worthy of a place on your watch list. If they fall hard enough for long enough then they can provide sensational opportunities, with limited downside and massive upside.

Hopefully my recent purchase of Maverick Drilling at $0.16 will be a case in point.

The trick is patience. Wait, wait, wait and then wait some more. Stocks can keep falling by yet another 20 percent over and over again. Take Xero for example, it’s closing in on its fourth 20 percent fall from its March high. From here it could easily fall 20 percent twice more in normal market conditions or even 5 more times if a bear market bites.

Here’s an old post on the footwear company Crocs that illustrates just how far falling knives can drop, $75 to $0.79.

Disclosure: Please seek expert advice before playing mumblety peg. I am not authorised to provide advice on knife throwing.
Long MAD. CCL is still on my watch list.

The death of the phone number and rise of OTT

Set in the not too distant future.

OMG! Can you believe our parents used to have just one phone number? One number that anyone could ‘ring’.

Worse yet, most of them had no idea who was ‘ringing’ them. So last millennial!  But wait…even crazier, when they were kids the entire family shared one phone and that was fixed to the wall! One phone shared between all of them, with one phone number and no idea who was calling! Far freaking out! 

Businesses also had one phone number. And our parents would wait for ages for someone to finally talk to them. They’d just wait there listening to hideous music!

What companies will thrive and which will slowly die? Or transform, like newspaper are now trying to and TV companies will tomorrow.

Kids of today are already two steps beyond the phone number. Their businesses will be too. A phone number will be as trivial an email address.

But that’s more than a decade away. So let’s dance while the funky music is playing white boy!

Saying that…

I sold the last of our Telstra the other day at $5.18. Now our telecom allocation of 16 percent is it’s lowest in years. It was 34 percent in April.

The new winner is…

Health Care now dominates our combined funds. 43 percent in one sector! Whoa, that’s extreme, but we’ve been here before a few times and so far so good. I’m sure of little in life, I generally leave that luxury (or is it laziness?) of thought to black and white thinkers. But I am sure of this, I will never be mistaken for an indexer.

Our weighting in the Heath Care and Telecommunication Services sectors combined is close to 60 percent, while those sectors make up a mere 8 percent of the Australian stock market.  sector allocation equities finance fund

It’s not Over The Top services

Before you start thinking I’m crazy, if you don’t already, I’m not selling down our telecommunications positions due to the rise of OTT services. I’m selling for a multitude of reasons.

  • Yesterday’s winners are tomorrow’s losers. Simple and seldom wrong.
  • The companies all offered less upside, with at least equivalent downside or worse risk return profile than our other companies. Better value else where.
  • We want to stay under 50 percent long at this late stage in the bull market, so selling is required.

Not much has changed with the Telstra story since August 2011 when I named Telstra as my number one ASX 20 pick for the long term.

Telstra Corporation Limited (ASX: TLS): Fantastic yield and one of Australia’s best brands. Telstra owns the leading wireless network and through the rental of their ducts to NBN will have the lowest cost fibre network. If Telstra continue improving customer service, their recent mobile and broadband subscriber gains will continue. Telstra is my number one ASX 20 pick for the long term as it provides excellent cash returns, limited downside and reasonable upside potential.

Not much, except the price. While Telstra’s subscriber gains did eventuate and its value has increased slightly, its price has increased significantly. So if you still don’t get why I sold Telstra, ask yourself this. What chance does Telstra have of providing the same market thrashing returns as it has over the last…like forever? IIRC Telstra’s total return has beaten the market over 8 years. With a total domination over the last two years. That’s a low probability bet.

My other top three picks weren’t shabby either. “Westpac Banking Corporation (ASX: WBC) Great yield and undervalued and M2 Telecommunications Group (ASX: MTU) Growth at a large discount.”

Heck. Let’s take a look.

My top 3 share market picks 2 years later

 

All three have thrashed the market. And if that chart was dividend adjusted my market outperformance would be even larger. An average total return on my top three picks of over 100 percent.

Yes I’m good investor, but you know what? I know I can get even better.

The Fusion Portfolio is highly concentrated

Portfolio Weighting
Top 4 54%
Top 7 76%
Top 10 88%

15 companies across our funds is a new high in concentration. And I’m reasonably sure all three top weighting stats are at all time high too.

The concentration is simply a result of pulling the weeds and watering the flowers.

Water the flowers and pull the weeds

The above photo is one of my cacti flowering. Such incredible plants.

Investing in biotech companies

Here’s what a clever guy said about investing in biotechnology companies.

After many years investing in Bio’s a few lessons that I learned have helped greatly in making money from them.

  • Charts have a place, but can’t predict those Black Swan announcements…like the data base ann…so relying on charts is very dangerous..
  • Very good deep research and experience count for a lot. That’s how the big killings are made in Bio’s.
  • BAD MANAGEMENT is the real killer, and the hardest to spot. The road to success in Aussie Bio’s is littered with wrecks from idiots sitting in CEO chairs and on Boards…
  • It [PBT] has very good management… A stable long term team who have skin in the game….
  • The successful outcome with PBT2 will make these guys Billionaires and Nobel Prize winners.. They have a very strong interest in success…
  • Management and Directors who have a lot to win or lose have much better outcomes….
  • There are enough companies that fit those rules to diversify and make a very lot of money here..
  • Finding time to do the of research is hard.

Good observations, except for calling the Prana database announcement a black swan. Most probably that was simply a clinical operations screw up. Mistakes happen all the time, so are common white swans, not black swans.

In short, dig deep, and focus on management’s ability and their skin in the game.

Here’s my last tweet on Prana  [old now] .

Prana Biotechnology ASX:PBT alert

I sold some of our Prana shares later that day at 71 cents. That trade was simple risk management. The trigger to sell Prana was the sudden deterioration of its risk reward  profile, fused with my euphoria meter peaking.

Risk management is one of the keys to long-term investment success.

I shoot for a win win strategy. Naturally I sometimes loss, occasionally badly, so here’s what I mean by win win.

  • I try to think of at least the two most probable outcomes. Then I decide what I’d have liked to have done in the event of those two outcomes occurring. That is, how would I fell like a winner in each event.
  • Then, multiply each outcome by the rough probability of the event occurring. Prior to gaining experience, a wild ass guess at the probabilities will help you think along the right lines. Always err on the conservative side.

I started writing this four weeks ago, and post it now after I  failed to implement my own rule on Psivida $PSDV.

Here’s a rough example using PSDV.

  • FDA reject 50% probability multiplied by $2 target if happens, plus FDA approve times $8 target, for a fair value of $5 [50%*($2+$8)]. At $5 PSDV had a 1:1 risk return ratio, $3 downside for $3 upside based on a binary event.

My own rules screamed trim the position. 30% would have left me felling like a winner in either event. I didn’t as I was not focused enough. Massive life change is so freaking distracting! I take a moment to think damn.

For those without a position in PSDV, now is a good time to tune in, as you may get a wonderful opportunity to buy, as I outlined back here.

Disclosusre: Long Prana and Psivida

The Motley Fool says sell Maverick

oil derrick and the statues kneeling before it

Has The Motley Fool called Maverick a Sell?

Investment forum Hot Copper has banned any mention of The Motley Fool on its Maverick Drilling & Exploration forum page due to the Australian investment newsletter’s reputed sell on Maverick.

Wasn’t it only a month ago that head honcho of The Motley Fool Australia Bruce Jackson said

“The addition was to my holding in a company that might be familiar to long-term readers of The Motley Fool — an oil producer called Maverick Drilling & Exploration (ASX: MAD).

It was just over a week ago when Motley Fool Share Advisor — our premium stock picking service — published an exclusive one-on-one interview with Maverick’s executive directors, Don Henrich and Brad Simmons.

This may give you a quick flavour of the interview, and as to why I added to my holding.  As a clue, it’s all about risk versus reward”

I have not seen the sell report and know little about it. But I’m happy to discuss it here. Please comment below.

Anyone know the key points of TMF’s sell call? Who wrote it? Was it part of Share Advisor? Or was this simply Bruce Jackson selling? Please share any details below in the comments. Or contact me via the form at the bottom of this page http://www.fusioninvesting.com/about/

Hot Copper has moderated an entire thread discussing the controversial sell call by The Motley Fool.

This post has been moderated on 21/05/13 13:00 (Copyright)
Comments: how many times do we need to address this issue ?? the organization you refer to is monitoring the thread and reporting copyright violations. Leave this subject alone altogether (entire thread moderated)

As this chart shows the sell call – if that is what it was – by TMF sent the shares in to a tailspin, down 17% on Tuesday and down another 6 percent this morning.

Maverick ASX MAD TMF sell

Then the brains at Macquarie Group woke up and realised they were over 2 years late in filing a Notice of ceasing to be a substantial holder. Compounding their idiocy by filing in the middle of a shit storm.

Update on foolish sell recommendation

Motley Fool recommended Motley Fool Share Advisor members still holding shares sell Maverick. The analysis was brief; Maverick is speculative and hasn’t delivered the results TMF had hoped for.

Here is a quote from TMF Share Advisor newsletter.

Since then, the company continues to drill new wells in the hope of drilling success that might turn what appear to be significant reserves into sizeable revenue and profits. As yet, those efforts haven’t delivered the material results we (and the company) had hoped for. Maverick remains at heart a speculative explorer that is hoping for commercial success from its new exploration wells.

As such, it doesn’t really have a place here at Motley Fool Share Advisor, reserved for our ‘best of the best’ stock ideas. We’re recommending Motley Fool Share Advisor members still holding shares sell Maverick Drilling and Exploration (ASX: MAD).

If that TMF sell recommendation caused the 25 percent sell-off then market participants are definitely irrational!

Long Maverick Drilling & Exploration. Longer now.

Step beyond margin of safety

Margin of safety is the much vaunted investment tool of value investors, and by value investors I mean all sensible long-term investors. Margin of safety is a great concept, but is it the best tool for investment selection, risk management and portfolio optimisation?

Michael Mauboussin argues it is in this excellent 2001 paper.

Investors should base the magnitude of their investments on the size of the margin of safety.

Mauboussin’s Ruminations on Risk is a brilliant paper. I mostly agree with him, but want to share an even better investment tool we can easily use.  But before we get to that, let’s play a game.

Game on

Imagine you have two investment options. Investment A has a margin of safety of 12 percent, while Investment B has a MoS of 8 percent. Which would you invest in?

Probably neither, right? So for the sake of the game imagine you must invest in either A or B.

I’m going to hazard a guess you opted for A. Its MoS is 50 percent greater than B and for some of you that return may even be above your hurdle rate.  Investment A is the logical choice if you use MoS as you primary investment selection tool.

Let’s keep exactly the same investments, but throw my preferred investment selection, risk management and portfolio optimisation tool into the mix. Let’s look at the return/risk profile of these investments.

risk/return ratio

The current price of both A and B is $5. Investment A has an 80 percent chance of being profitable, that is a 60 percent chance of 20 percent upside and a 20 percent probability of a juicy 60 percent profit. Conversely Investment B has a mere 20 percent of being 20% profitable.

Remember, I haven’t changed the game, the respective margins of safety for A & B are still 12 percent and 8 percent.

Are you still happy with your investment decision? As a reminder, A has a 12 percent MoS and an 80 percent chance of being profitable, whereas B has an 8 percent MoS and a mere 20 percent chance of profitability.

Think risk

If you’re still opting for A, then perhaps the following sentence which encapsulates my investment philosophy will help change your focus slightly. Focus on the downside, and the upside will take care of itself. (Hat tip to Mark Sellers.)

The downside for A is 60 percent, whereas B has a comparatively modest 20 percent potential loss. Hopefully, that changes your investment decision. For me, focusing on the risk rather than the return has led to better investment decisions, and I’m confident it will for you too.

Investment B is the better investment choice, despite having both a lower margin of safety and lower probability of profit. I know some of you won’t be convinced and may even believe the higher probability weighted MoS for A means that over time successive investments in A will result in higher overall returns.

The pain of asymmetry

We’ll you’d be right, except for the asymmetry of returns. For those not familiar with the asymmetry of returns, all it means is that identical percent gains and losses are not the same, e.g. it takes a 100 percent gain to make up for a 50 percent loss. Losses hurt more and not just psychologically.

This asymmetry results in B having the higher probable return after a number of iterations. For example if we start with $5 then after ten iterations B will have grown to $8.20 while A will only have grown to $6.10.

If you’re using a probability weighted margin of safety you’re already way ahead of most dart throwing investors, but it may be time to take another step on your investing journey. Adding the return/risk ratio to your tool kit helps you focus on the downside and will improve your risk management.

My hurdle rate is not a percent return, it’s a return/risk ratio of three. For every dollar risked I want a potential payoff of three dollars. Investment B meets that criterion, whereas A has return/risk ratio of 1:1. See what a huge difference the return/risk ratio makes? It’s like pulling back a veil to see the real picture.

As I said in this post, using a risk return framework forces me to consider multiple outcomes and to look forward. It provides a rationale mechanism to overcome the noise of fear and greed. Most importantly, it forces me to consider what could go wrong.

The return/risk ratio is also my portfolio optimisation tool of choice. The higher the ratio the larger my investment.   As I said 3:1 is my hurdle, I may invest a small portion of funds in companies meeting that hurdle, I start getting excited with ratios over five. I invest a lot when the ratio is over seven, as I did when I was pounding the table on Telstra in early 2011 – back when everyone else was calling Telstra a dog. Currently Telstra does not meet my hurdle rate, but as I’ve sold most of our holding and admit to being slightly addicted to its dividend, I continue to hold a small weighting.

Part Two – Putting the return/risk ratio into practice

Once you start regularly using the return/risk ratio it makes investment decisions easier.

What’s the probability and size of the downside? What’s the probability and size of the upside?

This same frame work should be used for both prospective and perhaps more importantly to current positions.  After all it’s only what you own that can hurt you. Saying that, I admit to not rigorously applying it existing holding, although I really should.

Imagine you’re a reasonably smart investor and followed my recommendations of investing in Integrated Research (ASX: IRI) at around $0.45. Hold on, I think I’ve written about this before. Yes here you go.

When I sold, Integrated Research was up 265 percent since my recommendation in the first edition of Motley Fool Share Advisor. IR was also up a market obliterating 300 percent since I’d recommended it as one of TMF Australia’s radar stocks.

Like me, you may have found IR was close to 3 times larger a position in your portfolio than originally intended. That’s a nice problem to have, but it is still an issue that requires thought. For example if you bought a 5 percent position, IR was now over 13 percent of your portfolio.

Above $1.30 IR was significantly overvalued. So why hold 3 times your normal position in an overvalued company? That would be stupid right? But hey if you see it differently please let me know in the comments below.

Here’s how someone summarised IR on Hot Copper:

However, it tells the story: 1st article when IRI had earnings of 4.5c, share price under 40 cents, dividend 4 cents, and cash. Relatively low risk.

Now, 2012 earning 5.4 cents, SP $1.20+, dividend 5 cents, still has cash.

Company obviously in a sound position, however value … ? One would have to say the “easy” money has been made.

I like that thinking. It’s simple, value focused and based on tangible information.

At the current price of $1.24 my analysis suggests a possible downside of $0.40. Yes, you should always work out the risk fist, remember focus on the risk and the return will take care of itself. So I only need to answer one question, is a $1.20 upside probable?

Can IR double in price from here? I see virtually no chance of that.

IR has grown revenues at 3.5 percent a year over the last five years, while earnings per share have grown at a miserly rate of 1 percent. The growth rate has been slightly higher over the shorter time-frames, but still nothing to get excited about.

While I respect the excellent management team and think Mark Brayan justly deserved the IT Executive of the year award for his excellent strategy and execution, there simply is no sound investment case that can be made for IR at the current price.

Mr Brayan sensibly diversified IR’s revenue stream due to the sword of Damocles hanging over the company – the huge risk in HP Non-stop infrastructure revenue collapsing. He has added a few more hairs to the sword, but make no mistake, software is a cyclical business and if, or more likely when, those infrastructure revenues go into terminal decline the slowing growth of unified communications and payments are unlikely to stop investors being cut.

Back to the point

Anyway, I’m getting away from the point of this article, which is that a return/risk framework is a superior investing tool than margin of safety. It conveys more information and focuses on both the risk and return, whereas margin of safety tends to focus the mind on returns. My returns have improved since adopting the return/risk ratio and my losses have shrunk. For me it is the ultimate risk management and portfolio optimisation tool.

Investing Myths: Gain Required to Make you Whole

Everyone knows Buffett’s rules number one and two, never loss money and don’t forget rule number one. They’re great rules and if we could apply more patience in our investing and weave in as many complementary rules like capital is scarce opportunities are plentiful then maybe we wouldn’t suffer many losses. My reality is that I incur losses and the same is probably true for you.

So how much profit does it take to recover from a loss? The following chart highlights conventional wisdom. The greater the loss the ever greater the gain required to make you whole again. For example a 10% loss only requires an 11%, a 50% loss requires a 100% gain and a 90% loss requires a massive 900% to make you whole again.

Scary stuff isn’t it? 10 baggers don’t come along very often.

As I said that is the conventional wisdom and one that is often used to promulgate stop losses and small position sizing opinions. I say the conventional wisdom is bollocks. It takes exactly the same percentage gain to make up for a loss. If you loss 10% it takes a 10% gain to make you whole. If you loss 90% it takes a 90% gain to make you whole.

Why conventional wisdom is wrong

Conventional wisdom is based on serial betting an entire stake. If you make serial bets (one after the other) of your entire stake then it does indeed take a 100% gain to make up for a 50% loss. Do you make serial bets of your entire stake? I doubt it. If like me you have a portfolio of stocks then you’re making parallel investments. If one investment losses 10% you are made whole by another similar sized investment gaining 10%. You never invest your entire stake in one stock, you spread your investment over many stocks.

Pull the weeds and water the flowers. Peter Lynch’s phrase was so good that Warren Buffett asked if he could use it in his annual report. While you may make a 100% loss on an initial investment, I know I have a few times, hopefully you’ll have headed Lynch’s advice and added to your winners. So your wins are magnified as they have more capital invested in them.

I’m not trying to encourage you forsake patience or forget the all important rule of never loss money, just realise that when viewed from the perspective of a portfolio some conventional wisdom is not so wise after all. Mental stop losses also make a lot sense in some cases and are almost essential for traders.

Long term investors, especially those investing in special situations, growth stocks or any other companies where major losses are a possibility should view their investments within the framework of a portfolio and cut their losers and let their winers run.

I’ll conclude with one of Peter Lynch’s 20 Golden Rules:

If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over the time you’re patient. You need to find few good stocks to make a lifetime of investing worthwhile.

If you want to read more then this post on position sizing is in a similar vein.

Unsolicited and Possibly Unwanted Advice

The following advice is offered with Matrix Composites & Engineering Limited (MCE) owners in mind, but it applies to all value investors who are holding on to fully valued companies.

I offer this unsolicited advice as I believe there are a number of new “value” investors who are sitting on substantial gains in MCE and my view is they should book those gains and move on.

  1. Is there a margin of safety at the current level? I think not, the only way to get see a decent MoS is to use a very low required rate of return and optimistic forecasts. The valuation to the right is from the excellent MyClime service. To get a decent MoS I had to use a ROE of 50% and required return of 11%.
  2. True value investors don’t forecast. Basing analysis on what analysts forecast is appropriate for growth investors not value investors. Analysts in general are over-optimistic in the long run.
  3. Surely you can find a better MoS else where. If not there is nothing wrong with holding cash, it gives a decent return plus the option of buying when bargains do appear.
  4. Who is buying at this level. MoMo (momentum) investors that’s who, there is no-one left to buy after them and they’ll head for the exists quicker than you.
  5. You never go broke taking a profit.
  6. Don’t fall in love with a position.
  7. If you don’t want to sell at least put in place a trailing stop.
  8. Mr Market is in a great mood at the moment and that means it is time to sell to him.

Put all the above together and I hope you conclude that taking your profit and looking for an investment with better margin of safety is the prudent path of value investing. I’d love to know if and why you disagree.

Disclosure: No position in MCE.

Valuable Insights from Ben Graham

ValueHuntr has generously posted a 96 page pdf compilation of 40 papers originally written by Benjamin Graham into an easy-to-read book format. If you’re interested in long term investing and value investing then ValueHuntr’s compilation is a real treat.
Here are a few excerpts I enjoyed.

[On Efficient Markets:] I deny emphatically that because the market has all the information it needs to establish a correct price the prices it actually registers are in fact correct. … Descartes summed up the matter more than three centuries ago, when he wrote in his “Discours de la Methode”: “Ce n’est pas assez d’avoir l’esprit bon, mais le principal est de l’appiquer bien.” In English: “It is not enough to have a good intelligence”—and I add, “enough information” — “the principal thing is to apply it well.” … any security analyst worth his salt should be able to make up an attractive portfolio out of this “universe.” [NYSE stocks]

[On Beta:] What bothers me is that authorities now equate the Beta idea with the concept of “risk”. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.

Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.

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