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.

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.

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.

Have you ever been heard how insider sales are meaningless while insiders buying can only mean one thing? The story goes that the only reason insiders buy is they expect the share price to increase while sales can be for a variety of reasons, e.g. a new house, kids college, taxes etc etc. That makes intuitive sense and I’ve often seen that story repeated, especially when an investor in nervous about insider sales.

Well it turns out that the reverse is true. Academic studies in America and Australia show that their are limited abnormal returns gained after insiders buy, yet insiders do sidestep abnormal negative returns with their sales. Further investors can also on average earn abnormal returns by following suit when the insider sales are publicly disclosed. Keep in mind we’re talking averages here. So please don’t go selling your shares the next an insider in one of your companies unloads a few shares. Though perhaps it is worth keeping this in mind the next time you see large insider sales. It may be a good trigger to dig deeper and ponder whether that company is the best place for your funds.

The following graphs are based on a study by Uylangco, Easton and Faff (2010). They concluded “imitators may earn small abnormal returns by imitating directors, especially with respect to sales.”

The pile of documents on my desk was out of control, so it was time for a throw out. Here’s a few of the investing and financial gems I’m throwing out, but want to keep links to.

Lessons and Ideas from Benjamin Graham by Jason Zweig. Here are even more of Zweig’s articles on Benjamin Graham.

Baupost Group’s Seth Klarman “IT’S A GREAT TIME TO BE A VALUE INVESTOR. THE COMPETITION SEEMS TO HAVE GONE AWAY.” excerpted from our March 17, 2009 edition of Outstanding Investor Digest, OID.com

A pile of GMO quarterly letters and other articles.  via GMO.com Especially The Last Hurrah and Seven Lean Years and Reinvesting When Terrified.

Simple Maths for Safe Doubles by Seth Jayson at TMF

The New Yorker – Anatomy of a Meltdown

Investment Outlooks by Bill Gross and other archives at PIMCO.

Be Nice to the Countries That Lend You Money Atlantic Magazine.

The following article comes from one of the best discussion board posts I’ve read. The post is republished below with the permission of the author. This enriching and entraining article exemplifies a style of fusion investing, the fusion of business momentum and value. I hope you enjoy reading and thinking about this article as much as I did. It’s a fantastic example of looking at things from a new angle.

What did we do right in 2009?

One year of good return may be just a result of high tide lifting all boats or simply mean-reversion from a terrible year. Nevertheless, my biggest take-away from 2009 was a subtle but important change to my investment philosophy – I have changed my focus from “good and cheap” to “better and cheap”. I care more about change in fundamentals – I prefer a bad company that is getting better over a good company with no change in story. This new philosophy has led to solid stock picking, which generally out-performed the market with what I believe to be lower risk (“permanent loss of capital”). Equally important, this new framework gives me better guidelines to size my bets, especially betting heavily in situations where both the story is getting better and stock is cheap.

When I started investing a few years ago, I was firmly in the value investing school – concepts like “intrinsic value” and “Mr. Market”, coined by Ben Graham and popularized by Warren Buffett, clicked for me instantly. I spent time studying company fundamentals, coming up with an estimate of the intrinsic value, and trying to buy at a cheap or discounted price. In short, I was trying to buy “good and cheap”, and results were satisfactory.

However, I have come to realize the quality of the company and absolute discount to intrinsic value are not everything – one has also to consider the time and factors it takes for the discount to narrow, which typically depend on the business cycle. Thus my new approach comes down to balancing between value and momentum. Value refers to the price paid for the business. Momentum, not to be confused with price momentum in quant and technical analysis, refers to business momentum, i.e. how well the business is doing. Improving momentum can come in the form of higher margin, accelerating topline growth, or improving ROIC. With the exception of select great companies in their growth phase, most companies’ stock price and business momentum move in cycles/curves similar to sine waves with peaks and troughs.

These two curves are closely related – when business momentum is good, stock price tends to go up, and vice versa. However, there is often a lag between the two curves, and depending on the part of the cycle, stock price will react to the change in business momentum very differently. I believe this is the crux of investing – how you identify which part of the cycle the company is in, which drivers to watch for and which valuation metrics to use. For example, earning revision is a powerful factor but completely useless at business peaks and troughs. P/E may be a good valuation metric in general, but unadjusted for margins, it is useless or even dangerous at extremes. [I stopped highlighting here as it's all so good the entire article should be highlighted!]

For example, assume a retailer’s intrinsic value is $20, and buying at $15 may give an expected return of 33%. However, the same $15 price may correspond to two points on the momentum curve – one where the curve is turning up (story getting better) and the other where the curve is trending down. In the former case, you will probably get to $20 in 6-12 months. In the latter case, you may have to wait 18-24 months before the retailer corrects excess inventory and produces positive SSS (curve turning up again) to reach the $20 intrinsic value.

There are two obvious problems with buying at the latter point. First, time adjusted return is obviously inferior. Second, the stock price may first plunge to $6 before recovering. While a pure value investor may think a lower price makes it a better buy (even more margin of safety), reality is that an adverse price movement will slowly but surely inject doubt into my mind. Have I made a mistake? Is this a value trap? Very seldom does stock price move down without some deterioration of business fundamentals and some changes to the initial investment thesis. So unless one has an iron stomach (I don’t), it is very tough to keep calm during the price downdraft and continue to average down. There is an even bigger issue – if you are prepared to average down, chances are that you will not buy a full position initially, and inevitably you will end up establishing similar-sized partial positions for all new ideas. Yet some of those ideas will have good business momentum and they are your surer bets, so you lose potential profits in positions that actually have the best risk/time adjusted return.

So doesn’t quant investing capture “better and cheap”, as preached by the noted quant investor Cliff Asness? Yes and no. I believe there are two problems with quant investing. First, it mistakes cause with effect – price momentum is the result of business momentum, and while the two will resemble each other at certain part of the cycle, they will diverge significantly at critical turning points. Second, the effectiveness of various factors differs significantly from industry to industry as well as at different parts of the business cycle. Quite simply, quant investors lack the domain knowledge of each industry and use the same factors or same weightings across sectors during different points of the cycle.

For example, quant investors will universally use factors such as earning revision, revenue/EPS surprise/breadth to capture business momentum. While this does a satisfactory job overall, it will not capture key drivers for each industry, which often cannot be retrieved from standardized financial statements, such as inventory/store for retailers, or asset inflows for asset managers. Often changes in these key drivers will long precede actual changes in earnings, so generalized quant investing could easily miss the turn. As another example, six months ago, both KIRK and ARO got the highest rating in our internal quant system, yet the two retailers could not be more different in terms of where they were in the business and margin cycle, and the subsequent divergence in stock performance illustrated the flaw in the quant investing approach.

I certainly do not want to leave the impression that other investing approaches are inferior. Indeed, there are many ways to achieve success in investing, and everyone needs to find approaches to fit his or her own traits. I believe I have found mine by balancing between value and momentum. Put simply, I aim to invest in situations where fundamentals are about to turn or have turned while valuation is reasonable. I am certainly not reinventing wheels here, as this is the approach advocated by both Peter Lynch (“catching the turn”) and Warren Buffett (“What we really like to see in situations is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it”).

Well, this approach may sound good on paper, but how many of these “perfect” situations exist, given how efficient market is with so many hungry and smart investors poring over every corner of the market? I believe these opportunities happen more often than one may think, especially if one can invest in small-cap or micro-cap land. For example, I monitor about 50 names closely in the retail industry (which I shamelessly consider to be my circle of competence). This year alone, I identified 4 separate names that fit the criteria. They respectively returned 50%, 70%, 100% and 900%.

One may counter that retail stocks have done very well in general this year and question whether throwing darts randomly would have generated similar if not better results. I would argue that much of the return (especially the out-sized ones) was hope-based, and rational investors could not have predicted those returns ex-ante with any confidence to place a big bet, as some of those names could easily turn out to be zeros. Yet in all four names I identified, I was reasonably certain of the business momentum and earning surprise, and could accordingly place out-sized bets (10%+), with confidence that even if it did not play out according to plan, I would suffer very small losses due to valuation. While hindsight is 20/20, I could also identify at least two retail names annually over the last few years that fit my “better and cheap” criteria. So they definitely occur, and one just needs to have the patience and courage to bet big when they do come along, usually when market is bad. Those situations can occur in large-cap stocks as well, such as FDX throughout this year. FDX had over $20B market cap, was followed by 25 analysts, yet the stock was at trough EV/sales, even though earnings had bottomed and was poised to recover through cost cuts and market share gains. Earning estimates have moved up 60% in 6 months and stock went up over 150%.

As with anything in investing, there are also drawbacks to my approach. One is depth vs. width – I need to be able to identify and evaluate key drivers for the companies and industries, and this takes significant amount of time. The rarity of these “perfect” situations forces me to turn over a lot of rocks. To date, I am reasonably comfortable with retail industry, and to a much lesser degree with software, asset managers and transport industries. I may soon reach (if not already) a point where I can not physically monitor more names. The other problem is scalability – most of my top ideas are in small to micro-cap land, so it is questionable whether my approach can really handle more than say $50-100M of assets. But that will be a nice problem to have, and I suspect I will just have to make the trade-off between absolute performance and AUM.

Concentrate to accumulate, diversify to protect.
When you diversify do it via a broad index or specific individuals, who through careful analysis you judge to be extremely competent and capable of significantly* outperforming the index.

Remember that indices are not static beasts, they are actively managed funds of the leading companies. Failing or at least flailing companies are cut from the list while successful and growing companies are added. That’s a difficult investment strategy to best, especially when actively managed fund’s fees are going to be meaningfully higher.

• Concentration means 2-20 positions. Small business people can put all their eggs in one basket, the rest of would be foolish to do so.
• Significantly is greater than 3%. As you’ll loose around 1% in fees compared to an index fund or ETF and you want at least 2% return for taking the individual risk.

Index Funds and ETFs in Australia

There are two main choices, though others do exist:

1. Vanguard Index Australian Shares Fund charges a management fee of 0.75% p.a. for the first $50,000, then 0.50% p.a. for the next $50,000 and 0.35% p.a. for the balance over $100,000. There is also a spread of .2% on purchase and .1% on withdrawal.
2. State Street Spiders ETFs on the top 50 or top 200. Management costs are 0.286% and there will be the bid/ask spread.

Index funds and ETFs are the most suitable choice for investors who do not have the time or interest for investing, but desire exposure to a particular asset. I wrote more about investing in Australia here and its related posts.

I’m still working on reducing the number of US equities we hold. I forget the peak, maybe 46. We’re down to 30 now, with three more on the chopping block followed by five more waiting a final thumbs up or down. Pfizer is our largest position.

My son has embraced his creative powers, this image is from his Gorillaz Demon Days concept series. He drew a picture for each song on the CD.