SIF Folio: Lessons from my biggest losers

Hi Roland (and to all the others who add to this great thread)

I think BH1991 (post 15) makes an extremely coherent point with his comparison to the insurance industry.

One excellent rule I learned from reading Mark Minervini was his uncompromising stance to managing risk, first and foremost. Above and beyond picking stocks, using metrics to identify good stocks or picking when to enter a trade.

His rule was so incredibly simple I could not believe I had not thought of it myself.

Quite simply, if a trade/investment is going against you, then slice by 50%. If it continues to slide, exit 100%. A refinement to this, if the trade is clearly going against you on first falling (or the market signals are going red), exit 100%.

Now, I realise this is biased towards a trading mind-set rather than an investing mind-set which favours looking for good metrics within a stock. But, this rule has been a fantastic bonus to my investing behaviours (and peace of mind).

I also realise this goes against your hands-off approach but you could adopt a variant, whereby at buy time you note at what negative percentage you might slice by 50% (say -10 to -15% from purchase price). Then exit 100% at say -20 to 25%. If first drop is below -15% then exit 100% at first hit.

I appreciate this might not align with your approach, but what it does offer in line with your approach is that it allows you to stay in a holding after an initial falling, to then see out that holding to your full nine months. With a benefit that the stock might rise again (as your 6 month holding vs 9 months holding analysis suggested to you happens, when you did that quite a few months ago). If the stock does not rise but does not hit the exit 100% level, then although you have taken a loss initially it is lower (in absolute terms) than if you had run the full holding for your nine months assessment.

Many thanks for your continual write ups I read them avidly and always learn from them and the others who are attracted to contribute to your threads.

Regards
Howard

Interesting article as always Roland!

In my opinion, if you want to avoid big losses, the simplest and most effective way of doing this is to apply a stop loss. In your case, that’s 20%. I don’t disagree with tweaking your risk selection criteria to avoid low probability investments, but losses are an inherent part of investing and need to be actively managed.

I work in the motor insurance industry and can draw similarities between insurance portfolio management and stock portfolio management. Insurance companies design risk selection criteria, which aim to mitigate the frequency and severity of losses (claims). Although insurance companies will tweak their criteria if they see an emerging trend (e.g. theft of keyless entry vehicles using relay amplifiers), they still can’t avoid the inevitable large loss.

You see, insurance companies recognise that a large loss can occur at any time, with any vehicle/driver they insure. Everybody has the capacity to cause serious injury whilst driving. It doesn’t matter if you have the most sophisticated insurance pricing model, you will incur losses. It’s simply the cost of doing business.

The stock market is no different. Every stock has the potential to drop 20% or more, regardless of its industry group, operating margin or P/E ratio. Therefore, the investor needs to recognise this and apply prudent risk management when such events occur.

My worry here is that you will apply more filters to your stock screen, move into different industry groups or stocks, incur the inevitable 20%+ losses and start the whole process again. This is the trap most investors fall into. They believe applying more filters to your screen will solve the problem when in fact, its risk management.

Your current stock screen contains all the factors which increase the probability of finding winning investments (quality, growth, value & momentum). However, even when all the stars align, you will still have losing investments. Unlike insurers, you can cap those losses at whatever level you choose, in order to stay profitable and that's the great thing about the stock market!.

Would you consider applying a stop loss? Interested to hear your thoughts.

I also got caught on Bilby (LON:BILB) by not selling out at the first warning (which I usually do), being lulled into a false sense of security by the institutional buying of the founder shares (another red flag). So, like you, here I am trying to asses if this is the bottom on a stock with the potential to grow.
The elephant in the room - which we should not have had to guess at - is just how large and damaging is the MoD litigation? I am decided to hold not least because of the recent installation of David Bullen as the new CEO. We shareholders may not be getting any insight into the litigation, but I assume that Bullen will have dug deep into this before deciding to take on the job, and presumably concluding that the problems are not fatal. But I am also all too aware that a "new CEO kitchen-sinking" may be on the cards here. Our pain may not be over yet and it has to be asked - do I want any more?

I think you have identified the right lessons. With a systematic high level approach like the SIF portfolio I would avoid construction / large contract businesses entirely. While the valuation multiples often look superfically cheap, they actually tend to be wildly overvalued given the execution and competition risks and cyclicality. The base rate return for investing in this sort of business must be terrible I imagine (like small-cap resource stocks). Unless you have a specific insight from more detailed research it makes sense to avoid...

Could you amend your rules so that you would exit a stock if a profit/trading warning occurred? That way, if you held a stock that lost 20% of its value but the rest of the market, or at least sector, fell a similar amount then you would still hold but if there was a company specific trading warning then you would sell? That would certainly have stemmed losses in Bilby (LON:BILB) - I lost about 35% investing in this catastrophe, but at least I sold at around 71p.

I can't make any informed view on international stocks... but do the same rules applied to a UK SIF approach also work for international markets without tweaking?

I agree with other suggestions to avoid companies with a low margin... though I can't decide what that should be.

I would not select companies that have an operating margin under 5%, that would cut out some of the losers. Also I would avoid Israeli based companies, too many seem to go wrong. Go-Ahead (LON:GOG) was a timing issue, if you had held on you would be in profit now. I'm not keen on this holding for a certain time, think you could be more flexible on selling if things have changed.

Roland deserves a 5 star recommendation for :
1. publicly declaring his losses
2 facing up to his mistakes honestly and objectively .

Few stock commentators have the internal resilience to do either.

I think he is a bit too harsh on himself. Once a share has collapsed it is all too easy to job backwards and say it fell because of X when many other influences both good and bad muddied the company's situation at the time the
purchase was made.

I think that successful investment means taking a measure of risk and inevitably and occasionally the risk results in a loss. A portfolio that only has gains is arguably not taking enough risk.

As an experienced Bank Manager once told me: a Bank Manager who has no bad debts is probably not lending enough (or is very good at covering up).

Further all companies including the best have occasional dark periods (check Warren Buffett's last annual results) .The question devolves to the long-term fundamentals for the industry and the product/service and in sum the willingness to withstand the showers and wait for the inevitable sun (apologies for the metaphor).

Avoid outliers: My rules specify a maximum P/E ratio of 30 and a minimum of 5.

Here's food for thought. If we look at the quantiles for P/E we get:

So the choices of 5 and 30 are not balanced. You might consider a slightly higher lower bound of maybe 9 or 10. Although it seems like a small difference it could trim out another 15% or so of "difficult" stocks.

I suspect that most people would prefer to skew their P/E selection towards the low side to avoid overpaying of course. But in terms of performance over the next year, higher P/E tends to perform better.

Galliford Try (LON:GFRD) another good example of what you preach today Roland