Price vs. Value - Think like an Owner - Part 2 of 2

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If you haven’t read Part 1 or you want a refresher, you can read find it here:

http://wheeliedealer.weebly.com/blog/price-vs-value-think-like-an-owner-part-1-of-2

Stoplosses
Oh gawd, not that topic again…..

I have been refining how I see Stoplosses and their usefulness (or not) and I have written a Blog Draft about this although I have not yet published it and it needs a lot more work. In terms of this current Blog where we are talking about Long Term Investing and Value as opposed to Price, I just see no place for using Stoplosses - in fact, I think they are a downright bad idea.

The whole ethos of what I do is to buy Shares of Quality Companies at an Entry Price which gives me a decent Upside Target and a large Margin of Safety. If the Price of the Share falls after I buy the Stock, then all the time the Potential Upside is INCREASING and the Margin of Safety is also getting better - so the idea of a Stoploss where you sell because the Price might be 15% lower, is plain silly - the Price for the Value you are getting has just dropped a lot !!

Note, I deliberately phrased a bit in the last paragraph as “If the Price of the Share falls after I buy the Stock” but I am referring here to just the normal waves and wobbles and meanders of the Price - the usual Market ‘Noise’ if you like. However, there are other situations which I see as quite different, and here a policy of Selling might very well be appropriate. What I mean here is when a Company comes out with a Profit Warning or similar (such as Fraud, Accounting Issues, Loss of Key Customer like Imagination Technologies IMG recently, etc.) - in this case you need to ascertain if you think the ‘problem’ is of a Temporary nature or if you run the Risk of Permanent Loss. 

Many people have a rule whereby they Sell on the first Profit Warning whatever else happens - in effect it is a Stoploss that is triggered by a Profit Warning and I have a lot of sympathy with this approach - particularly because you invested in the Business with the understanding that Trading was going well but you then discover later that there are problems and therefore the Investment Case has changed.

I tend to take things on a case-by-case basis. I had a Position in Safestyle SFE up until recently and they put out a Profit Warning and I dumped my Shares straightaway - this was quite a simple decision for me because I had held for a couple of years and was sat on a big Profit (80% plus) and the situation had now changed in that there might be more trouble ahead and also because the ‘Margin of Safety’ had fallen a lot and because my Upside Target would now need to be revised down a lot. Profit Warnings tend to come in multiples and you rarely get away with just the One - so that is a good reason to keep away from Stocks that are having problems. In addition, in the case of SFE, it is a very cyclical Stock and a fall away in trading could easily signal more problems of this ilk, rather than a one-off issue.

After writing that Paragraph in the First Draft of this Blog, SFE then came out and did a Second Profit Warning and the Shares got marmalised - so my Decision to dump them was unusually spot on !!

As I said on a Tweet recently - “Don’t go looking for Trouble, you can be assured that it is looking for you.” (Defo one of my better Tweets that one, but of course I can never get close to the quality of Tweets from The Donald).

I broke my own ‘Rules’ by buying Devro DVO after a Profit Warning - so that was very much me going looking for Trouble. Needless to say, just after I bought they did another Profit Warning and it started to look quite dicey - fortunately I did do one thing right and that was simply that I had only bought a small ‘Starter’ Position. Anyway, I rode things out for a bit and on the next Trading Update it was clear that they were making necessary changes to the Business and that the Recovery was in train - so I bought a lot more and I am now nicely in Profit on them and I expect there to be a fair bit more upside.

This very much shows another bugbear I have with Stoplosses and why I question their validity for a True Long Term Investor. Many of the biggest Profits I have made are on Stocks where I bought in first off and the Price fell lots and I was able to buy more at a really good Price. A classic example is Boohoo.com BOO - I bought a Starter Position at something like 65p and then it all went smelly but I bided my time and once I could see there was a Recovery taking place, I bought a load more at 25p then 36p I think and I have bought more on the way up too. BOO is now 228p.

I did a similar thing with Empresaria EMR and I find that such big falls in a Share Price can be an opportunity to buy more Stock in a Quality Business at an extremely low Price - as long as you are buying Quality Stocks and not the sort of Trash that belongs in the WheelieBin. For Quality Stocks, Averaging Down is a highly helpful technique - and I see this as far better than using Stoplosses which just kick you out of a Superb Quality Company because the Price wiggled around a bit.

I have also just done the same trick on Molins MLIN - I bought a small Stake in the Company a while back and then they had problems because the US FDA (Food and Drug Administration) failed to make the expected decision on Smoke Testing and MLIN’s labs were effectively pretty worthless. This caused a lot of turmoil and ousting of the Previous Management etc. but now there is a new Leadership Team and a new Strategy and MLIN can currently be bought at around its Cash Pile - this is crazy cheap and there is huge upside here I think. I recently bought a lot more as you can see on my ‘Trades’ page.

The idea of a ‘Permanent’ or ‘Temporary’ Loss is quite useful and there is a good example at the moment in the form of Galliford Try GFRD. This is one where there was a Profit Warning a few months back after some problems on Legacy Contracts, but despite the hit to Profits they have said the Dividend will be maintained - so they are currently yielding around 8% Dividend - and what people are missing is that when a Company has such issues with Contracts they nearly always put out all the Bad News in one big chunk - they are most likely to be ‘Kitchen Sinking’ - so it is unlikely we will see more similar problems. But of course there are people selling their GFRD Shares now - this makes no sense to me, it is more likely to be a time to Buy than a time to Sell.

Yet again, that paragraph above was written in an Early Draft of this Blog and since then GFRD has put out a Trading Update which shows that things are back on track. Blimey, another decent Decision I have made was to hang on !! (Note the Divvy Yield has dropped back from 8% now but it is still very high).

I do think Stoplosses have a value, but this is for more Speculative and Short Term Trader like uses and for High Risk Trades - and I think Stoplosses should always be in combination with extremely good Entries (the timing here is critical) and Stoplosses should be tight - if you are taking a 15% Loss or more I think that is far too much on a Quality Stock especially and quite often you are Selling when you should be BUYING. I would be far happier if a Stoploss was kicking in at around 6% or 7% or that sort of thing - i.e nice and tight - note this seems to be Robbie Burns’ (The Naked Trader) latest philosophy - Stoplosses should trigger fast and mean you take a very small hit.

Give Ideas time to play out - sometimes Value does not get reflected in the Share Price for a Long Time but I find that Patience usually Pays. It could be that if you need to use a Stoploss then you are taking on too much Risk or choosing Stocks badly. If you have done very thorough Analysis and have a Diversified Portfolio with appropriate Weightings with a nod to Risk/Volatility etc., then maybe Stoplosses are unnecessary. There is nothing wrong with Stoplosses as such, but they have a time and a place in my view and just blindly using them on every ‘Investment’ might be a mistake. For Trading it is entirely different - every Trade should have a Stoploss in this case (and most definitely a pre-determined and detailed ‘Trading Plan‘).

Think like the Owner
I have already touched on this but I want to add in a bit more. If you see yourself as a potential 100% Owner of a particular business, it is a good Mental Framework by which to make a judgement about whether or not you really want to be buying the Shares (or whether or not you SHOULD be buying the Shares). An easy way to illustrate this is by using the example of Petrofac PFC which has been caned in recent Months due to a Fraud Investigation which seems to involve the Company Directors. In such an example, would you want to be the Owner? Would you want to associate yourself with a Company that is being accused of Fraudulent Behaviour? Let’s be honest, it smells doesn’t it? Even without having any particular ethical stance on this kind of thing, I’m not sure many people would want to own this business with the potential for ongoing Court Cases and possible massive Fines and the Bankruptcy of the Company. Not for me thank you very much !!!

We could then look at a much more positive example - would you want to be the 100% Owner of BMW? I would. I don’t even need to explain that more but it makes the point that thinking about Stocks in this way is a really useful concept - and of course this is all part of the ‘Value’ of a business but has absolutely nothing to do with the Price you pay to get a Stake.

Another example is around Entertainment One ETO who are responsible for thrusting Peppa Pig upon the Parents of many a Toddler. In this case, the Value is pretty clear and you can easily put a number on it because they have had their Content Library valued at “more than $1.5bn”. At the time of writing this Blog, ETO Shares are at about 242p which gives a Market Cap of £1039m - with a £/$ rate of 1.305 this means ETO is priced at $1356m whereas the Library alone is worth more than $1500m. So in this example yet again Price and Value are 2 distinct and very different things.

There is an important link to Market ‘Noise’ here and Thinking like the Owner. As the Owner of the Company, why would you let Price swings and wiggles in the Market affect your attitude to the Company and whether or not you wanted to remain being the Owner? As Warren Buffett also says (or something like this anyway - you can look up the exact quote if you feel that way pedantically inclined):

“If the Stockmarket closed for the next 5 years I couldn’t give a toss” - it is his Stake in the Underlying Business that matters to WB, not the Price that the Market randomly attributes to its Stock on a second by second basis.

Thinking like The Owner also has another useful side in that it helps keep you out of Crappy, Junky, WheelieBin type Stocks - after all, who would want to own a Company that is going to lose money and cost you more and more every year with scant sign that it will ever make a Profit?

Long Term Investor as opposed to Short Term Trader
The kind of stuff I have written about in this Blog Series is key to being a Long Term Investor - if this is not the case and you rely on Price then you are not taking a Stake in a Business because you are behaving like the Owner but you are Trading or Speculating. 

These Blogs are not really a critique of either being an Investor or a Trader (or Speculator which is really another word for a Trader) - more I am suggesting a possibly useful Mental Framework for thinking about your Investments and being a Trader is perfectly honourable - Just don’t pretend you are a Long Term Investor when actually you are behaving and acting like a Trader.

This is particularly important because Traders need different Risk Management Techniques / Expectations / Time commitments / Mental Outlooks etc. to Long Term Investors.

‘Traders focus on Price, Investors focus on Value.’

Final Word
Another way to understand the difference between Value and Price is to think about how they change. On a Day to Day basis, the Value of a Company will alter very little - in reality, you could say that the Value of a Company on a given day is what someone would pay to take it over 100% - and absent a Bidding War and the special circumstances which persist once a Formal Takeover Bid is launched, the Value a Buyer would put on a Company would be fairly stable over time.

However, the Price of a Stock in the Market just varies constantly, by the second really (or more accurately, Fractions of a second). It is all quite mad - the Theory put forward by Economists would be along the lines that a Price today represents the myriad different ’Options’ on Future Values that People place on the Stock but it is all rather silly and more theoretical Bollox which WD Readers will know I am no fan of. I just hate this kind of Academic Theory nonsense which has zero practical use when it comes to our task of Buying and Selling Shares. 

And the Efficient Market Hypothesis (EMH) is more garbage - it is ridiculous to say “the Market is always right” when the truth is more like “the Market is always wrong” when it comes to Investing for the Long Term in Stocks. However, it might be appropriate for Short Term Traders.

Rather than seeing Price Falls as a bad thing and using Stoplosses which just kick us out of a great Stock, we may be better off seeing Price swings as an Opportunity to buy more Stock in a Quality Business at an advantageous Price.

Slightly off tangent but a related matter and relevant to the concept of thinking about Qualitative Aspects of a Business, is the idea that "The Past is History but the Future is what matters". What I am saying here is that the History of a Stock gives some level of confidence about the quality of the Management and its Track Record so far but to really make Money you need to be able to think ahead into the most likely Future and think about where the Business will likely be in 1 year, 2 years, 5 years, etc. I recently wrote a couple of Blogs about this which featured Utilitywise UTW in them.

OK, that’s it on this one, I hope you found the Series useful,

Cheers, WD.


Related Blogs:
Here are the Blogs about focusing on the Future:

http://wheeliedealer.weebly.com/blog/look-to-the-future-now-its-only-just-begun-with-special-guest-star-utw-part-1-of-2

http://wheeliedealer.weebly.com/blog/look-to-the-future-now-its-only-just-begun-with-special-guest-star-utw-part-2-of-2

Here is a Blog on Averaging Down:

http://wheeliedealer.weebly.com/blog/is-averaging-down-the-root-of-all-evil

These are about the differences between Investors and Traders:

http://wheeliedealer.weebly.com/blog/where-are-you-on-the-trader-investor-spectrum-part-1-of-2

http://wheeliedealer.weebly.com/blog/where-are-you-on-the-trader-investor-spectrum-part-2-of-2

This is Part 3 of my Blogs on ‘Cutting out Noise’ - it contains links at the bottom to the earlier Parts and some other Blogs which you might find interesting:

http://wheeliedealer.weebly.com/blog/enjoy-the-silence-cut-out-the-noise-part-3-of-3