Stop trying to avoid book losses
Professional and retail investors alike often stress the importance of “cutting losers and underperformers fast”. In essence, the rationale behind selling out stock positions that have been laggards in a portfolio is twofold:
- The first percentage points in book losses have the largest impact in absolute terms. For instance, if you have USD 5’000 invested in a dividend paying stock of a business which is facing some operational problems, forcing the company to cut its dividend, many disappointed shareholders will dump their investments. Well, let’s assume the stock falls by 20 %, that shareholding position would have lost USD 1’000 in book value. If then in the following month the stock falls for another 20 %, that additional book loss accounts for USD 800 which is the smaller amount in absolute terms compared to the USD 1’000 book loss that occured in the first 20 % stock price drop. So yes, the first losses hit you the most.
- The second point is a reasonable one as well. Having money in underperforming businesses leads to huge opportunity costs. After all, an investor could have invested into other stocks that could have fared much better. That opportunity costs compound over time.
These two arguments are absolutely correct, plainly obvious, and logical. But in practice, it’s almost impossible to effectively apply that mantra to “sell out loser fast”. In fact, it’s quite often to the detriment of the long-term development of a stock portfolio performance. Selling stock positions is a tricky one.
Let’s just take a very simple example as an illustration: Microsoft.
That stock chart clearly shows it all. You cannot predict stock price movements and furthermore, they don’t always go in tandem with the business performance. Warren Buffet is right: over the long haul, a stock market is a weighing machine, in the short term it is a popularity contest. But the long term can mean 15 to 20 years.
From 1999 to 2011, Microsoft’s stock was a clear underperformer. But make no mistake: even in that time period, Microsoft was one of the strongest and most dominant technology companies in the world. Licensing its software and operating systems were already money-printing back then. Yes, today Microsoft is so much stronger, clearly more profitable and more diversified, and at the same time incredibly specialized. Just take for instance its competitive edge in cloud computing through Microsoft Azure.
Interestingly, from 1999 to 2011, earnings per share (EPS) have been growing, and yet, the stock has been out of favor. But here’s the key: long-term-oriented investors should look at the fundamentals. Microsoft managed to increase its EPS almost every year since its existence. That’s an incredible track record for a giant of the size of Microsoft.
So what we clearly learn from the case study of Microsoft: even stocks of wonderful businesses can underperform markets even for a decade and longer. Investing requires a whole lot of patience. Following the mantra of “cutting underperformers fast” means throwing out high-quality positions instead of giving them the time they require to adapt, recover, and thrive.
One point to be made is the following: even when a stock underperforms, that does not necessarily mean that you are invested in a “loser business”. Again, it’s tremendously important to look at the business fundamentals. If cash flow generation is intact and the economic moat still persists, there is a realistic chance that the company remains a strong compounding machine.
And always bear in mind: it’s sheer impossible to avoid the first couple of percentage book losses. We as investors cannot know what happens to businesses beforehand, we just wouldn’t be fast enough to react in order to avoid book losses or to avoid that book gains evaporate.
I mean, could investors have known that the social media giant Facebook would face a severe backslash from its customers in May 2020 putting the company under pressure from large players like The Coca Cola Company or Unilever? Facebook’s stock price plummeted, almost 10 % in a short time, and at that time it looked as far more pressure on the share could follow.
Just to be clear: Facebook is the undisputed social media giant leader, a cash machine that just has started. Everyone knows that Facebook is so much more than a social network. With properties such as Facebook Messenger, Instagram, and WhatsApp it provides people with an ecosystem. Facebook that’s networking, messaging, photo, style, promotion, etc. and it does not stop there. With its service Facebook Shop, the group has become a player in e-commerce. Facebook’s balance sheet is pristine with a cash balance in the tens of billions of dollars, it’s an incredibly profitable business but still, in May 2020, due to some backslash, investors reacted quite abruptly and many sold out their Facebook positions back then.
Some Investors might have thought for themselves: I made a nice profit on my Facebook position so far. I have been holding these stocks for some years now. Why risking my book gains? After all, never can anyone be blamed for locking in some gains?
Well, just looking at the multi-year stock chart of Facebook it becomes crystal clear that selling out such a position in the past would have been a huge mistake.
So, always think twice before throwing out pieces of businesses that have been growing in the past like crazy and still have catalysts for growth. Rebalancing a portfolio can be incredibly risky.
Time works in favour of wonderful businesses
What do Microsoft, Apple, Alphabet, Facebook, Amazon, NVIDIA, etc. all have in common? Well, they all have unique market dominance in their segments, incredibly strong financials, and the benefit of economies of scale and network effects.
You can find that kind of wonderful business of course in other sectors too.
Just look at PepsiCo, which through its 120 years of history has always been able to compete against The Coca-Cola Company. PepsiCo had to try new things, it had to innovate and diversify and in the process it became the world’s largest snack producer and a major player in the breakfast sector, challenging Kellog and General Mills. Today, PepsiCo’s revenues and market value are even top Coca-Cola’s.
But make no mistake, The Coca-Cola Company – even older than PepsiCo – has a unique market position as well, it is the undisputed beverage leader and has slowly but surely been adapting to changing consumer preferences.
Once a business has built its economic moat, established a global footprint, and is committed to keeping its competitive edge, most of the time, these companies remain compounding machines. To think that their best days are far from over clearly neglects business reality and corporate history. Yes, one day every company will go down. But think of that: a diversified stock portfolio invested in high-quality businesses inherently contains tens if not hundreds of winners. Let them multiply. Don’t cut their wings. Let them fly from All-Time High to All-Time High.
Now, let’s have a look at another wonderful company that would not be nearly as successful without the existence of another fantastic business called Amazon. I am talking here about Shopify. That business is THE PRIMARY BENEFICIARY of huge pressure Amazon puts on many small and medium-sized businesses around the world.
For years, Shopify’s stock price has been on a raging huge bull run. Many might think that its shares have become overvalued. Well, let’s look at the business model. Shopify Inc. is a Canadian e-commerce business that delivers the tech infrastructure and services including payments, marketing, shipping, and customer engagement tools to simplify the process of running an online store for small merchants (retailers with less than 500 employees).
Shopify’s is incredibly scalable and capital-light. The incremental cost for every client (business) they gain is disproportionally lower resulting in a disproportionally positive effect on the bottom line.
Now, knowing that there is a huge secular trend towards digitalization going on and knowing that this pendulum is pushed by dominant businesses like Amazon, is there any doubt that Shopify will continue to be a huge beneficiary?
Shopify reached break-even late in 2020 amid huge customer gains due to the COVID-19 lockdowns. For 2021 investors can expect at least USD 40 EPS, that company is set to grow its bottom line by 50 % for years to come.
Now, with a stock price of around USD 1’600, we are talking about a Price Earning Ratio (PE-Ratio) of around 40. Yes, the stock price has been running up like crazy, but so did the business fundamentals.
- super growth companies
- with a durable economic moat
- nearly no debt
- a capital light and amazingly scalable business model
do you know with a PE-Ratio of around 40?
And things are getting better for such wonderful companies. These will give your stock portfolio the drive it needs.
So, it is wise to keep stocks of businesses like Estee Lauder, LVMH, L’Oreal, Alphabet, Amazon, etc. Keep that kind of business through thick and thin. It is likely that these stocks – as a group – will keep rewarding their shareholders handsomely.
You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.