This is yet another Blog that I have had conceptually parked in the WheelieBrain for perhaps even as much as a few Years but I never seemed to get around to writing it until now. It is without doubt part of the infamous ‘Stoploss Debate’ and funnily enough a couple of Weeks ago I innocently put out a Tweet saying that I had decided to write a Draft on this very subject over the coming Weekend and simply by sending out that Tweet I then sparked off a massive discussion on Twitter about whether or not to use Stoplosses and we even got a Poll going where something like 58% or so did not use them (bear in mind this was a Self-Selecting Poll though and most of my Followers are probably more at the ‘Investor‘ end of things than the ‘Trader‘ end).
Anyway, Stoplosses are the subject of many more debates to come I am sure and no doubt I will be writing in my Blogs about them for many Years to come and I have already indulged in this subject area many a time in previous Blogs and I will include some Links at the bottom of Part 2 to some of those earlier scribblings.
For the purposes of this Blog the idea of ‘The Diminishing Problem’ (in other words your ’Problem’ is getting increasingly smaller) I see as an important and little addressed element of the Stoploss discussions and I want to just focus on the particular subject in hand and not move too much onto the wider topic (I am not sure my Emotional Wellbeing could withstand the onslaught of yet more Stoploss discussions - if anything, I think it would be less contentious to talk about Brexit !!)
I was just heading off to the Kitchen to put the Kettle on and create the essential Brew which I tend to find helps my Blog writing immensely, when I did an about face and headed back to my Keyboard cos it hit me that the idea of ‘The Diminishing Problem’ is in fact almost never discussed at all. In all my Years of Investing I think I have only ever seen it mentioned once and that was probably on a Bulletin Board a long time ago - it might even have been someone writing on Paul Scott’s Comments bit on Stockopedia - but clearly the guy was very switched on and yet no one picked up on it.
I really like writing Blogs on unusual but highly relevant Subject areas and ideas - I am sure Readers like this sort of stuff as well because we can find the usual ‘Run of the Mill’ subjects discussed all over the Financial Writing available on the InterWeb and we all like something a bit different !! Hopefully this kind of thing can get you thinking and there is huge value in mulling over such subjects and relating them to how you do things and adapting how I do things to help your own Investing if you see some useful aspects.
I better get that Mug of Tea……(you never know, Guy Martin might have taken to reading about Stocks and you won’t ever see him without a Brew in hand - I wouldn‘t want to disappoint him as he is clearly ‘Hard as Nails‘ !!).
Setting the Scene
Readers who often read my Blogs and stuff (note how I sneakily avoided the use of the ‘Regular’ word there, thus dodging the need to mention All Bran), will have no doubt seen my seemingly never ending battle with the concept of Stoplosses and in essence my current standing is that I don’t see them as helpful for Long Term Investing but there are occasions, particularly with High Risk Trades and Index Trades (where I now use them all the time), when they are useful and I think a Flexible and Pragmatic Approach to their use is probably the way to go.
One of my reasons for not likely Stoplosses on Long Term Investments is because of the concept of ‘The Diminishing Problem’ and hopefully after reading these Blogs, Readers will see what I am getting at.
When thinking about Returns and Performance, I am not particularly interested in how my Individual Stocks do. I am Old enough and Ugly enough (no comment you lot !!!) to know that across my Portfolio of for example 40 Stocks in my ‘Normal’ ISA, some will do extremely well, some will be diabolically bad and the vast majority will probably be ‘middling’ and just about do OK. However, what matters to me and where my focus is on is the Performance on 31st December each Year of my Overall Portfolio of Stocks. How I get to that Portfolio Result is unimportant in terms of the Individual Stocks. What is really crucial for me is that I achieve a Reasonable Return (I target 10% a Year Compounded and in practice I get around 12%) and I want to do very little ‘work’ in getting there with a low level of Trading Activity (and therefore the associated Costs of Trading and probably more crucially, the Hassle involved).
Keep that in your Mind - it is the Performance of the Portfolio that is important and paramount.
Right, the way The Diminishing Problem works is that when a Stock you hold drops in Price, the Value of that Position in Monetary Terms falls with it (obviously - this is not difficult stuff…….yet). Actually, there is more to that as I will come on to in a bit - so in effect The Diminishing Problem affects you in 2 ways - one is sort of at a Stock Level and one is at a Portfolio Level.
Let’s do it at the Stock Level first which is what I was starting on just now. Imagine you have a Stock and the Price drops on a given Day. The Diminishing Problem effect means that if the Stock drops again on the Next Day, then the proportion to which it hits the Value of your Portfolio is reduced from the Day before (another way of looking at this is that after the Initial Fall, your Risk has been lowered - in much the same way that when a Stock rises, your Risk increases. This is obvious really - if you have a smaller Position then you have lower Risk in terms of how much Money you have now got at Risk). If it then drops for a third Day, then the impact of that Fall will be even smaller in terms of your overall Portfolio.
Let’s do an Example Exercise:
Imagine you have a Portfolio worth £50,000 with one of the Stocks having a Position valued at £5000.
Now let’s say there is a Profit Warning and the Stock falls by 30% - this means your Stock Value is now £3500 and you have suffered a Monetary Hit of £1500, so your Portfolio has suffered by 3% from this Hit (ignore the other Stocks you hold for now - in practice they might have collectively fallen and made the Hit to your Portfolio worse or they might have collectively gone up and offset some of the damage and there are loads of variations on this).
To keep it better for comparison, let’s say on the Next Day that the Stock drops 30% again (blimey, this one really is bad - I thought we were supposed to be buying ’Quality Stocks’ !!!). This time the Hit to your Individual Position is £1050 and your Position is now worth £2450 but the Hit to your Overall Portfolio is now 2.2% - so you should be able to see how the Problem is Diminishing (note, for this Calculation I actually reduced the Value of the Portfolio to £48,500 which assumes the Other Stocks in the Portfolio did nothing which is fine for this Theoretical Example but of course it would be different in the Real World).
Let’s do one more just to fully illustrate the Diminishing Problem effect - let’s say the Stock falls 30% again on Day 3 (“flippin’ ‘eck Wheelie, where did you find this Total Turkey?”), this time the Hit to the Position is £735 and the Hit to the Overall Portfolio is 1.5% - so again this shows the Problem is reducing.
Now I have kept the Falls at a constant 30% because I thought it would illustrate the Concept well and it turns out that I was right because it is very apparent exactly how the Effect plays out. Of course in reality, things would be very different and I would expect a Stock that falls 30% on Day 1 might even rise a bit on Day 2 and Day 3 then drop back again perhaps. Or it could keep falling on Day 2 and Day 3 but the falls would be a lot smaller. You can muck around with the Numbers yourself but the Principle of The Diminishing Problem is 100% spot on.
Now I mentioned earlier that there is another angle to this. We might be able to discern this best from considering the Example we just talked about. In that case, the Overall Value of the Portfolio kept dropping as the Individual Position fell in Price, but in reality over a period of time, the most likely scenario is that the Value of the Portfolio actually increases (Stockmarkets in general tend to rise maybe 6% or 7% a Year or so on average so even if you are a total numpty by Investing in Quality Stocks you should at least do pretty much similar to the Overall Market - so your Portfolio should increase in Value over time) - so this means that ‘The Diminishing Problem’ as it impacts your Overall Portfolio as a Problem Stock misbehaves is even more of an effect.
Let’s do this in a very simplistic Example:
Again let’s say your Stock is worth £5000 and your Portfolio is worth £50,000. If you get a Profit Warning and your Stock falls 30% that is an impact of £1500 which hits your Overall Portfolio by 3%.
Now let’s say time has moved on and your Portfolio has now grown to £70,000. In this case, if you have a Position that is worth £5000 and it takes a Hit of 30% which is £1500, the impact on the Overall Portfolio is only 2.1% (OK, I have done that Example extremely simplistically but my Concept is spot on - create your own Examples if you want to play around with this).
What this all means is that if you hang on to a Stock that is going through a Difficult Period, then if it keeps falling (and it probably will because Downwards Momentum Effects are quite powerful and often overshoot) then it will have Less and Less impact on your Portfolio - and for me this is one of the reasons why I am pretty relaxed about not using Stoplosses on my Long Term Investments and this is especially the case if the Stock concerned is really quite a High Quality Business that is well established and just going through a Temporary Problem - and if it pays a Dividend then it in effect ‘Washes its Face’ while I wait.
There is yet another angle to this - just recently I had a ‘Problem Stock’ in Esure ESUR where it had not put out a bad Trading Update or anything but the Stock just kept falling and falling and falling (in fact, I mentioned it in a Weekend Blog and lots of times on Twitter because it struck me it had got very Oversold and there could be upside). As it turned out, there was a Takeover Bid and it jumped up 32% on the Day of the Bid and before this it had started to rise. If I had used a Stoploss, I would be pretty frustrated now.
And now another slight variation on this. Some time ago I bought into Quantum Pharma QP. mainly because it looked like a very defensive and reliable sort of Business and it had some potential upside from getting Unlicensed Medicines through the Approval Process and this would widen their appeal as they became Licensed. However, things certainly didn’t go as I would have liked and it got quite messy for some time but eventually Clinigen CLIN did a Takeover Bid where QP. Shares were converted into CLIN Shares so now I hold a load of the latter. It is perhaps a rather unusual one as most Takeovers are Cash or something but in this case it has got me into CLIN and I am quite happy about this because it seems a pretty well run Business and it probably has a lot more Growth potential than QP. did - and still I have exposure to the good bits of QP. At some point I might buy more CLIN but for now I am getting to learn the Business and quite happy with how it has been rising of late and the Deals that they have announced recently.
I think there is an important principle here that if you buy fundamentally solid and decent Businesses that have proper Revenue Streams and which can reliably and consistently sell stuff then from time to time you will get problems but these kinds of Quality Stocks nearly always Recover and you can Average Down to speed up that Recovery in your Investment (more in Part 2 !!) and of course you are quite likely to get a Takeover if it really is a Good Business because Competitors and Value-Seeking entities like Private Equity Firms will no doubt be looking at them.
Something struck me the other day with regards to the difficult period Neil Woodford has been going through with his Funds suffering several high-profile problems with several of his Stocks. Anyway, what struck me was that a couple of his ‘Failures’ were actually recovering pretty well - one is Pearson PSON which has had a good run lately and the other is International Personal Finance IPF (I‘m pretty sure he holds this after it was spun out of Provident Financial PFG which he most definitely holds - that one has yet to recover much).
It is a particularly difficult situation for Fund Managers (especially ones like Neil Woodford who probably has one of the biggest Funds there is in terms of Monetary Value where he is forced to take Big Positions in many Companies simply so he can invest all of the Money sent to him by Private Investors), because they cannot just quickly Sell their Stake and at best they can only trim a bit over time to try and reduce a Problem as the Stock falls - but even then if the Market really gets wind that they are Selling then this can hit the Price of the Stock even more and inflict more pain on the Fund Manager’s Portfolio. So largely they have little choice but to ride such problems out and perhaps they can do some Averaging Down once it starts to recover (but at that point a big Fund faces the problem of being unable to buy enough Stock to make it meaningful).
However, on the more ‘Junky’ stuff that Woody has bought into in the Biotech and Speculative End of things, if something goes wrong then there is probably no chance of recovery for those and these are without doubt things you should NEVER Average Down on.
I had written a pretty full Draft of this Blog and thought it was almost complete when my mate Leon (@Leon305633591) asked me an unrelated question about Galliford Try GFRD and it struck me with regards to yet another aspect to this overall subject.
In this case, GFRD the Housebuilder and Construction Company hit upon problems with a Major Road Contract which meant that more Cost was going to impact them. Following on from this they did a Rights Issue to ‘beef up’ their Balance Sheet (many Construction Companies have obligations to have a lot of Cash to ensure Financial Security built into Customer Contracts and it might have been related to this - I can’t remember the exact circumstances but that is not the issue here anyway) and as a consequence I got the chance to buy more Shares at 568p and tonight on Wednesday 29th August 2018 they are trading at 981p so although I am probably down on my Position overall, the Rights Shares have done really well and of course I have been picking up the Dividends. I am very happy to hold GFRD and expect the Shares to recover a lot more in time and while I wait I am picking up something like 8% Dividend - that is juicy.
There is another consideration with regards to Rights Issues which often happen on Big Companies that are going through temporary challenges and their Share Prices have got very beaten up. I tend to find that once they have got the Rights Issue away, the Shares in the vast majority of cases start to recover and do very well. Even if you do not hold Shares in a particular Company that is doing a Rights Issue, it might be worth thinking about buying some Shares in the Market after the Rights Issue has gone through.
If you are already a Shareholder, a Rights Issue is like a heavily discounted way to ‘Average Down’ - I will be writing more about Averaging Down in Part 2. Obviously such Averaging Down will mean that when the Recovery in the Share Price takes hold it won’t take so long for your Position to get back to Breakeven and hopefully into Profit if you are patient.
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