The Diminishing Problem - Part 2 of 2

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This is the Second Part in a Blog Series of just the pair, and you can read Part 1 here:

http://wheeliedealer.weebly.com/blog/the-diminishing-problem-part-1-of-2

Averaging Down and what it means for The Diminishing Problem
As we have established, when you have a Stock in your Portfolio which is going ‘wrong’ and the Share Price is on the slide, it is a ‘Diminishing Problem’ in that as it drops the impact on your Overall Portfolio reduces.

Now the opposite effect is in play when you have a Good Stock which is going up - as it grows in Relative Size as a Proportion of your Portfolio, then the Positive Impact increases over time. These combined effects are extremely useful and another of the rare ‘Free Lunches’ that the Stockmarket gives us.

A line that is always trotted out by proponents of the use of Stoplosses is that a “50% drop needs a 100% rise to get you back to break-even” and of course this is mathematically correct IN ISOLATION. However, in the Real World (which is probably where the majority of us are !!), it doesn’t work like that because if you carefully ‘Average Down’ on your Stock, then the Maths changes entirely and as the Stock recovers, the beneficial impacts on your Portfolio progressively increase - and it can happen quite fast.

There are some simple reasons for this. Firstly when a Stock has a serious Problem, the ‘Fear’ gets to the fore and it normally turns out that the Stock gets very ‘Oversold’ and goes much lower than it really should in terms of its Fundamental Value. This is also brought about by the Momentum Effects whereby a Stock Price moves a lot more than it ‘should’ once there is either Downwards Momentum or Upwards Momentum - it tends to Overshoot. Because of this Overshoot, the rebound off the bottom can be really sharp and this tends to persist for quite some time. So you usually get plenty of chances to buy after the Bottom but still at a Price that gives you huge potential Upside.

For example, on Boohoo.com BOO I originally bought in with a small Position not long after IPO around 65p or so I think. Of course things then went very bad and I think at one point BOO was as low as 15p or something daft. Anyway, while the Company was troubled I held on to my Small Position and let things play out and after a while I realised that the Business was on the mend and the Share Price started to move up in confirmation of this improvement. I managed to buy a Load at 25p I think and then I bought more on the way up and I think I was buying around 44p and even a bit higher than that (‘Add to your Winners’) and of course it went much much higher than this and I still hold a load of BOO but I have Topsliced a lot as well - banking some lovely Profits.

Of course things don’t always work out and I really ballsed up on Stanley Gibbons SGI. The only thing that I did ok here was not to buy all that big a Position in the first place but I must have made nearly every other Mistake that is possible although I did not Average Down (so that was another thing I got right !!!). I am not going to beat myself up about it - I made lots of stupid errors and I must learn from it and move on - fortunately another benefit of Diversification is that you can get away with the odd one like this which is pretty much a 100% Loss.

However, the situation is very different if you think the Company could go Bust - for example, recently you could have been holding Carillion and if you had held to the bitter end, then yes it was a Diminishing Problem but you could have picked up that it was likely to go Bust and got out before the final denouement came and you would at least have protected a little bit of your Investment. Letting Problem Stocks run is only a realistic proposition if you think it is a Temporary Problem and it will recover. This can be speeded up with a judicious and careful bit of Averaging Down. 

I cannot stress this enough, it is essential to distinguish between a Temporary Problem for a Business from which it will most likely recover and a Permanent Problem where the Company very probably will go bust. You must get out of the latter as soon as you can once you realise the existential nature of the challenge.

My mate @conkers3 has written a superb and definitive Blog on the whole subject of Averaging Down which you can indulge in here - it is really good:

https://www.conkers3.com/averaging-down-the-investing-dilemma/

Deliberate Averaging Down
Quite often when I Average Down it is after a Stock has had problems of some sort or other and then I buy in once the Recovery is pretty much nailed on and the Stock is really quite ‘cheap’. So what has happened here is that I have bought into a Stock initially with my Fingers Crossed hoping for the best, but then something has gone wrong and the Stock has tanked.

However, sometimes Averaging Down is a more deliberate act. This is where you have a particular Stock that you really, really, really like for the Long Term but it has a very high and stretched Valuation and it makes you nervous to buy a lot. Examples of Stocks like this at the moment are things like Fevertree FEVR, Hargreaves Lansdowne HL., Hotel Chocolate HOTC etc. etc. When you get one like this, the trick is to buy a Stake in the Company and if it does well from when you bought (a lot of the time this happens) then your Position just grows anyway and you will be very happy, but sometimes the Stock drops back and when this happens you must take your time and Stalk your Prey and when you are ready you buy more you then Average Down.

Now it should be obvious with these Examples that using a Stoploss just makes no sense whatsoever - you have spent ages finding this superb Long Term Investment and yet it has a bit of a wiggle in the Price and you dump it. The contradiction between ‘Long Term Investment‘ and using Stoplosses must be pretty clear. 

If you use Stoplosses you are focusing on Price and acting as a Trader - that is fine, but please don’t pretend you are a Long Term Investor (you won‘t find Warren Buffett using Stoplosses).

In such cases you are using the drop in Price as a great opportunity to buy more of the Stock you really want to hold for many Years at a much lower Valuation - it is using Price Moves to your advantage as a deliberate act to build your Position, rather than letting them force you out of a Great Stock.

Momentum Effects
Stoplosses make sense for Short Term Traders because they can increase your exposure to Positive Momentum, but they reduce your exposure to Negative Momentum. It is very likely that a Person who uses Stoplosses will have a Portfolio which has more Stocks in an Uptrend than a Portfolio from someone who does not use Stoplosses. 

The big problem for those who don’t use Stoplosses arises from the concept of ‘Dead Money’ - you will have Stocks in your Portfolio which really aren’t doing much - but at least if they pay a Dividend of some sort then they are “washing their Face” while you wait for something to happen.

There are of course drawbacks from using Stoplosses and trying to ensure everything has Upwards Momentum. The obvious problem is that because of a Short Term fluctuation in the Share Price, you might get Stopped Out and therefore have Cash to recycle into another Stock - but there is no guarantee that you will buy a Stock that goes up. It is very possible to get Stopped Out on one Stock and then to put your Money into another, only to get Stopped Out again - that is infuriating, especially if we are talking about Stocks which you want to hold for the Long Term because you can see them being much larger Companies in a few years time (that sentence in itself must make you question the validity of using Stoplosses on Long Term Investments).

To an extent it is about Timeframe - if you were to give the Stock a little more room to wiggle about (and remember the ‘wiggliness’ of a Stock can vary from time to time and different Stocks have their own way of moving), then perhaps you would not get Stopped Out and the Stock would have time to move around just before it starts moving up nicely. 

I had this sort of thing on Entertainment One ETO - I was utterly convinced that it was cheap but I ended up holding it for probably 2 years where it just did pretty much nothing and was ‘Dead Money‘. Of course with Hindsight you can say “why did you hang on to it? You should have sold and bought something that was moving up” but that is classic Outcome Bias and when I was holding the Stock during those 2 Years I knew it would move up at some point when the value would come out but of course I thought it would happen a lot faster. In the event, ETO recently got its act together and it has made big gains in recent Months and I suspect there is a lot more to come. I still hold some that I bought at 80p so I am pretty relaxed about how things have played out with the irritating Piglet.

Of course it is swings and roundabouts - ETO didn’t happen anything like as fast as I would have liked but on the other hand, I made superb gains extremely fast on Water Intelligence WATR and yet again this is another aspect of the benefits of a Diversified Portfolio of Quality Stocks.

Another drawback of using Stoplosses and ending up with a Portfolio which contains a lot of Stocks in nice Uptrends, is that although this appears a very good thing, there is a big Risk that all of your Stocks are exposed to the same Factors - in other words, you probably hold all Growth Stocks. The problem here is that this probably works really well in a strong Bull Market but if conditions change, it could be very dangerous. I prefer to have a mix of Strategies or Factors in my Portfolio - again it is about Diversification. For instance, in my Portfolio I hold Growth Stocks, Income Stocks, Value Stocks, Defensives, Momentum Stocks, Collective Funds, etc. etc.

It really is Horses for Courses……

Some more Examples
I probably should have put this ‘section’ in earlier in the Blog Series (it would have fitted Part 1 better I suspect) but I did not recognise an example of why Stoplosses make little sense for Long Term Investments until last night when I was looking at my Portfolio to do my Daily Numbers as usual (I put these out on Twitter every night) and my eyes were drawn to my EU Supply EUSP Position.

(That reminds me, I haven’t done my Numbers tonight !!)

This is a miniscule Company with a Market Cap around £7.5m at the time of writing this and it is a Company which produces Software in an area I know very well from my last Role at Fujitsu before I ‘retired’. At the moment it is very early stage and they keep winning utterly tiny Contracts but of course it all adds up and the beauty of Software is that once you have a Customer you can sell them Upgrades and there is a large element of Recurring Charges with little corresponding Cost. I think this Business could do really well in coming years but it is not going to make me rich tomorrow and it could easily take 5 years or so to really get going.

So this for me is very much a Long Term Investment and it is High Risk as they are only just Profitable and are at the start of growing the Business. On this basis I know I have to hold for the future and the last thing I would want is to have an arbitrary 20% Stoploss or something because the Price is extremely choppy and at the moment I am probably down 25% on my Initial Investment but it moves very fast so all it takes is a little bit of News and it will jump up again. That is the nature of Tiny Companies in their early days.

I have controlled the Risk by only putting slightly less than 1% of my Portfolio into EUSP - so even if it goes really badly wrong I can only lose just less than 1%. If EUSP progresses in coming Years like I think it can, then I will have plenty of opportunities to buy more as the Business grows.

Another similar one is Accsys Technologies AXS which I have held for a few Years now. I am probably up about 40% on it or something but it has been a very up and down ride and had I used a Stoploss I would have sold out AT A LOSS ages ago. This just makes no sense. I bought it because I know the story really well because my Brother works for James Latham LTHM who are the Distributor for the Products that AXS makes and I have been aware of the usefulness and demand for the Products for a long time. When I bought the Shares I knew it was early stage and would need many Years to play out but I totally bought on that basis. The idea that I would sell because the Price wiggled around a bit is silly. Again I have controlled my Risk by only putting around 1% of my Portfolio into AXS and I might buy more in the future if the Business grows as I would like.

An example of a Stock I hold which has been a right pain in the posterior for a while but which I think is going to Recover very nicely is Telit TCM. Just this Week they put out a Trading Update and the key thing here is that the Net Debt position at the moment will be hugely transformed once they get the $105m for flogging off the Automotive Division and with more of a focus on Cash Generation and reducing ongoing Costs, TCM should be able to take advantage of a very buoyant Market for their Internet of Things (IoT) modules and this Market is expected to grow at a double-digit rate in coming Years. 

TCM has some Governance Issues which are a concern and anyone investing here needs to bear that in mind - ideally the CEO, Yosi Fait, would get kicked out but that looks unlikely although the changes in the Board might help keep him in line. There is also a lot TCM can do to lower Costs - they are unbelievably inefficient and hopefully after the troubles they have had there will be renewed focus on how they operate the Business with regards to things like Capitalising of Development Costs - which is fine if done in a properly managed fashion and not just as an Accounting Trick to boost Earnings. At the moment I do not want to Average Down here because of the ‘Yosi factor’ but if I get happier I will consider buying more. Because of it being an AIM Stock, I probably only have less than 2% in TCM.

Another one I am really annoyed about is Dart Group DTG. Years ago I had a position in DTG and it had run up very well and I had quite a nice Profit (40% or something) and I really liked the Company (I still do - what they have done with Jet2 is outstanding), but they put out a Profit Warning and the Shares dropped loads and I panicked and sold my Position, at just about Breakeven. Of course, after a few Months DTG put out some more News and it turns out everything was OK and the Shares then started taking off again - I couldn’t believe it !! Sadly I was so irked by the whole experience that I didn’t buy into DTG again and I have since seen the damn thing soar to fresh Highs and I would have made a huge amount of Dosh - it really grates with me to this day and the Lesson is clear - when you have a great, Quality, Business, hold on to the blessed thing !!

If I had a brain, I would have bought more once it was clear that the Problems were temporary and had been overcome.

Conclusion
Many Traders / Investors swear by Stoplosses and many (in fact, probably the vast majority) swear AT them. This Blog is not intended to say that Stoplosses are a bad idea - in fact, quite the opposite - for many People they are exactly what they need and I can totally understand why People use them and they can be beneficial in so many ways (I myself use them on Index Trades and on some High Risk Buys or Individual Stock Shorts).

Many People like myself have tried Stoplosses or at least considered them but have a psychological or even logical aversion to them and in a way I have written this Blog to make the point that if you do not use Stoplosses you can still make Money and do OK. I suspect that many People who use Stoplosses make better Returns than I do but having said that I would not be surprised if their Annual Returns do not beat mine hugely and I reckon an argument could be made that where Stoplosses add a few Percent of Annual Return to their Performance, it is other aspects such as a higher Trading Frequency, focus on Small Caps, fewer Stocks in the Portfolio and more of a focus on Upwards Momentum and Banking smaller Profits and moving on quickly are what really drives much of their Outperformance (you could say they take more Risk than I do……)

So don’t beat yourself up if you don’t use Stoplosses. As long as you do most other things ‘right’ then you will probably do well. The simple basic stuff like:

• Avoid AIM Trash Stocks (‘WheelieBin’).
• Buy Quality and stuff with strong Balance Sheets (low or no Debt) and paying some sort of Dividend.
• Run your Winners.
• Average Down only when a Stock is most definitely recovering.
• Re-invest Profits and Dividends.
• Hedge to reduce impact of Market Risk in Bad Times.
• Research your Stocks thoroughly.
• Understand Valuations and how to apply the relevant metrics.
• Have a Diversified Portfolio with no Stock making up too large a proportion of your Overall Pot.
• Use Leverage via Spreadbets carefully to boost Returns.
• Always think about Downside Risk and try to limit it by Position Sizing and Diversification and careful Stock Selection.
• Keep Trading Costs and Platform Costs etc. to a minimum.
• Add to Winners and TopChop where appropriate.
• Etc.

Above all, don’t beat yourself up if you don’t use Stoplosses - it is critical that you Invest / Trade in a way that matches your Personality and Risk Tolerance and you must feel ‘comfortable’ with how you do things or you are doomed to fail. It is daft tying to be a highly active and aggressive Trader if you are working 14 hours a day on a demanding responsible Job.

In terms of ‘The Diminishing Problem’, remember:

• A dodgy Stock becomes less of an issue as it falls - a Good Stock becomes of more benefit as it grows.
• When a Stock Falls your Risk reduces and when a Stock Rises, your Risk increases.

Regards, WD.


Related Blogs
You can find some scribbles about Stoplosses here:

http://wheeliedealer.weebly.com/blog/stoplosses-for-wimps

EUSP Buy Rationale:

http://wheeliedealer.weebly.com/blog/eu-supply-eusp-buy-rationale-part-2-of-2

AXS Buy Rationale:

http://wheeliedealer.weebly.com/blog/accsys-technologies-axs-buy-rationale

TCM Buy Rationale - I wrote this one back in October 2014 so a lot has changed but it might help you with Risks and stuff:

http://wheeliedealer.weebly.com/blog/telit-communications-tcm-buy-rationale