Summer 2010 The Mistake of not Buying Correctly

“Just when I was starting to feel good about the stock market….” The patience of investors is being tested yet again. Like aftershocks following an earthquake or the fear of another 9/11 on 9/12 or the fear of another bank collapse, these feelings are normal. I have written previously how “Investor Emotion,” the driver of stock prices, can play havoc with investor psyche, yet can also be successfully harnessed by investors.”

Emotion can be positive and drive stock prices up, or it can be negative and drive them down. This is evidenced by the anxiety over sovereign debt and the Gulf of Mexico oil spill despite generally good corporate earnings. I believe the secret to successful investing is to: 1. Identify great businesses; 2. invest in them when emotion has depressed their stock price; and 3. hang on through the volatility. Unfortunately, the ability to hang on during markets like these is sometimes eclipsed by fear. A common fear that an investor suffers during this stage of a market correction is buying a stock (let’s say near the market lows of last year or in the 2002 bear market), watching it rise as the market rebounded, and then watching its price go back down to where they bought it (or lower). This is sometimes referred to as “roundtripping”. Did he miss an opportunity to sell after the market rebounded? In this newsletter I will discuss what I believe is the cause of “roundtripping” and offer a solution.

“It’s easier to be critical than correct”

– Benjamin Disraeli

“I’m good at buying stocks I’m just not good at selling them.” This is an investor refrain that surfaces most often during stock market corrections or bear markets. It calls into question the soundness of your Investment Philosophy. By the way, it applies to many other types of investments as well. I would like to suggest however, that the real problem is the reverse; you are good at selling stocks but not as good at buying them. Let me explain.

To protect himself, an investor will sometimes employ what is known as a “stop-loss” order. A stop-loss order automatically sells a stock if its price falls to a certain level below the purchase price. The purpose is to minimize any loss. Yet why would an investor put in an order to automatically sell something at a loss. Could he be worried he made a buying mistake?

A stop-loss order is akin to telling your real estate agent, immediately after the purchase of your house, that if someone stops by tomorrow and offers $100,000 less for the house, sell it! Sometimes the excuse for a stop-loss order is to get an investor out of a stock in the event of a catastrophe. The false sense of security generated by a stop-loss order promotes investing in things the investor might otherwise avoid but for the feeling of this “safety net”.

“The difference between what we do and what we are capable of doing would suffice to solve most of the world’s problems”

– Mohandas Gandhi

Selling correctly is important and I have written previously about the four reasons to sell. However, investors are often too good at selling; in other words they sell too early. I would argue that much money is “left on the table” in the name of such selling delusions as “it’s reached my target price”; “it’s clearly overvalued now”; “I’ve already doubled my money”; “it’s now too big a percentage of my portfolio”; or “it never hurts to take a profit.” As an example, when Apple’s stock price went from $79/ share in 2007 to $179/share in 2007 all those aphorisms applied. When it went back to $79/share in 2009 an investor who had not sold complained about not being good at selling while those who did sell deluded themselves into thinking they had sold wisely. As of this writing, Apple stock is $260/share. The right move in the long run was not to sell and rather to buy more! By the way, with respect to Apple all the above aphorisms still apply. Those that sold at $179/share left money on the table and incurred taxes to boot.

“The old believe everything; the middle age suspect everything; the young know everything”

– Oscar Wilde

Finding a true gem of a company is rare and difficult. Holding onto it for a long time is also rare and difficult. Not selling too early takes tremendous discipline and patience, particularly when the stock is volatile due to events both within and outside a company’s control. Though I admit it is painful, the maximum downside on any stock is 100% (even less after taxes). Investors need big gainers to outweigh the mediocre holdings and the occasional and inevitable losers. What causes investors to hang on and not sell?

Let’s look at some specific scenarios. Long ago I noticed an interesting phenomenon with an employee’s ownership of his company’s stock. Notwithstanding the occasional (and quite rare as it turns out) 100% loss in value of such stocks as Bethlehem Steel or General Motors, many average employees, over their career at a single company build up substantial holdings of company stock. This, I believe, is the result of routine purchases, the effect of “dollar-cost averaging” (some months a $100 purchase buys 1 share and some months the same amount buys 4 shares), and an extreme amount of emotional patience with the ebb and flow of their company’s fortunes and the volatility of the stock.

Another way that an investor ends up with a substantial portfolio is if he inherits stocks that a parent, grandparent, or other benefactor had themselves held for a long time. Often emotion is part of the reason that the benefactor did not sell earlier. Either way, hanging on to the stock of a good “buy” is very profitable. It is interesting to look at the buying discipline of some great investors for tips to becoming a better buyer.

Perhaps the greatest growth stock investor who ever lived was Philip Fisher. Fisher’s philosophy about buying stated that “If the job has been done correctly when a common stock has been purchased, the time to sell is – almost never.” In this statement, Fisher showed that most of the work of investing revolved around making the correct buying decision. Warren Buffett also speaks about the importance of buying correctly. “Buy into a company because you want to own it permanently, not because you think the stock will go up”. Of course you want the stock to go up. Yet one can appreciate the idiocy of buying a lousy business simply because you think the stock will go up. That’s the definition of a trader or speculator (and possibly why stop loss orders were invented). Buffett says he knows of no one who has made and kept a significant amount of money trading stocks. Again, the emphasis is on getting the “buy” decision correct. It has been speculated that a very significant amount of the daily trading volume of stocks today is done by computerized trading programs. How can that be conceived as getting the “buy” decision correct?

My portfolios normally contain no more than 30-35 stocks. I consider each of those stocks as holding a coveted position in the portfolio. Adding a stock also usually necessitates making room for it by selling an existing stock that I previously thought was great enough to be bought in the first place. If I sell an existing portfolio holding, I may be admitting it was not as good to begin with – that I had made a mistake buying it.

Many mutual funds contain two hundred or more stocks. I have even seen mutual funds with as many as seven hundred stocks. In my opinion, that many holdings is a sign of indecision, lack of conviction, or maybe even a lack of in-depth research.

What does this say about index funds such as the S&P 500 with 500 stocks or the Russell 2000 or the Wilshire 5000? Fisher said he didn’t want to own a lot of good companies but rather a few outstanding ones. Can there be 5000 or even 500 outstanding gems? It has been said that the key to the success of the legendary value investor Benjamin Graham (teacher to Warren Buffett) may well have been his ability to say no to buying a stock. Often I have written that too many investors like portfolio churning because they mistakenly believe something is happening with respect to the management of their portfolio. Graham felt no compulsion to invest unless everything was in his favor. Using a baseball analogy, Warren Buffett said that unlike a baseball player, an investor can stand at the plate and wait forever for the perfect pitch. He can wait not only for a bargain, but for a particular one that he knows and understands to be a bargain. This patience often helps prevent an investor from buying simply because an investment is popular at the time and seems to be the right thing to do. Do you believe many of today’s gold investors understand the investment properties of gold or whether, at today’s price, gold is a good investment? Buying mistakes happen when an investor feels hurried, as in when he feels he is missing out on an investment everyone else seems to have discovered. Does AIG, Fannie Mae, or a condo in Florida ring a bell? Maybe the perceived safety net of stop-loss orders emboldens investors to swing at every pitch.

“If we are facing in the right direction, all we have to do is keep on walking”

– Buddhist Proverb

In summary, volatile markets are very draining. They test an investor’s patience and test the soundness of his Investment Philosophy, yet they also provide the opportunity to learn, and to upgrade the quality of the portfolio. If your Investment Philosophy is sound, and you concentrate your efforts on making correct buy decisions, you will be less likely to feel the need to sell out of fear. This should help your investment returns. In fact, a sound Investment Philosophy may even obviate the need for patience to some degree. If you “roundtripped” a stock, perhaps it’s because it was not a good purchase to begin with. If you truly believe it was a good purchase, then consider adding to it (unless you already have an appropriate amount) by selling something you already own that you believe has less potential. With approximately $2.8 trillion in money market funds earning near 0%, that’s a good place to start.

Thoughts for Investors is a quarterly newsletter written for clients since 1997 by this author. The purpose is two-fold. First, it is meant to help explain the investment philosophy that guides the author’s approach to portfolio management. Second, it is meant to remind readers of important behavioral skills that the author believes are necessary to help them become successful investors. The author welcomes comments and criticisms, especially if they can be shared for the betterment of all investors. Quotation is permitted with full attribution.