Kill Your Losers

As investors, we spend most of our time trying to find winning stocks. But finding winning stocks is only part of the recipe for success.

What’s crucial is how much we make when we’re right, and how much we lose when we’re wrong.

I recently looked at my own track record and noticed that I make a profit on approximately 50% of the stocks I buy. I am a full-time portfolio manager who speaks with management teams, conducts site visits and channel checks, and performs detailed financial modelling. Yet, my odds of buying winning stocks are actually no better than a coin flip.

Let that sink in.

The key to my process is that I make it up by hitting it out of the park on a handful of stocks. In the Rivemont MicroCap Fund, only 6 or 7 of the 125+ stocks we have owned over the last 8 years accounted for most of the profits. I call these my homerun investments.

While analyzing winners is fun, paying attention to the losers can be even more instructive. A key component of profitable investing is to minimize losses when we’re wrong.

My two worst investments each lost as much as some of my 6 or 7 best ideas individually made.

Avoiding these two losers would have been like finding an additional homerun stock on my P&L.

These two losers declined by over 70% from their peak before I completely got out. I had plenty of opportunities to limit the damage and cut them out sooner, but I didn’t.

There are plenty of well-documented biases that make it challenging to accept a loss: anchoring to your purchase price, loss aversion, sunk-cost fallacy, regret minimization, overconfidence, etc.

Ultimately, I think the challenge comes down to this: it’s mentally and emotionally hard.

It means admitting you’ve made a bad decision.

It means living with the potential regret that the stock rebounds after you’ve sold.

It means hurting your ego if you’ve discussed it with your friends or online.

Most people frame selling as a performance decision (‘I made a bad decision and lost money’). The key is to reframe selling as a means of freeing your mind.

We have all had this losing position in our portfolios that takes up way too much of our time and attention. It makes us anxious. We just hope that the business turns around or that the stock rebounds so we can sell.

You know exactly which position that is in your portfolio currently, don’t you?

These types of losing positions don’t just hurt the P&L, they also crowd out better decisions. They drain us emotionally and consume mental bandwidth we could use to research new, better ideas to add to the portfolio.

When you find yourself in a losing situation, you basically have two choices: sell the position or buy more.

Holding is typically a mistake. Either the stock declined for a good reason (which should lead you to sell) or for no reason (which should entice you to buy more).

Being an assassin means killing your losers as soon as your thesis breaks. I picked up this concept from an excellent book called The Art of Execution.

As I said in the introduction, I am wrong on 50% of the stocks I buy. The mistake is not being wrong, it’s staying wrong when you know it.

In a losing situation, amateur behaviour is often to trim a little bit and wait to see what happens. ‘Just one more quarter,’ you think. (Did that ever work?)

In contrast, the best investors tend to be decisive and to act fast.

They also tend to exit entirely when they lose conviction, not in stages over several months.

One of the most important things I do before buying a stock is to summarize why I’m buying it. I’m not talking about a 20-page write-up, but a few sentences outlining the key reasons why I think it’s a great opportunity and the results I expect the company to deliver.

When you don’t perform this kind of exercise, you run the risk of constantly reframing your thesis to justify holding the stock even if the situation deteriorates. This is one of the biggest pitfalls.

What often compounds the problem is that management teams will readily provide all the reasons to hold on to a broken thesis.

‘We expect results to improve in the second half of the year.’

‘We’ve experienced delays in converting our sales pipeline, but it’s the strongest it’s ever been.’

‘X hasn’t worked, but we believe doing Y instead will result in meaningful growth.’

Don’t buy into management narratives when you can objectively tell the company has been underperforming.

The key to avoiding getting sucked into management narratives is to identify the thesis breakers at the outset.

Every time I buy a new stock, I write down a summary of my investment thesis (2-3 key points) and identify events that would trigger a sell review.

Each company is different, but it can be things like:

• If revenue growth slows down to less than X% year-over-year

• If the company doesn’t announce X number of orders or new clients by this date

• If a key executive leaves the company (assuming your thesis heavily relies on management’s track record)

• Etc.

You want to be as explicit as possible (‘if this specific thing happens by this date, I’m going to consider selling’)

When one of your thesis breakers materializes, nothing forces you to sell. But reminding yourself of why you bought in the first place and what has broken your thesis can help you avoid the psychological trap of holding on for the wrong reasons.

This is probably the area where I’ve struggled the most historically.

By the time it’s clear your investment thesis is broken, the stock has probably already declined (and it might be hard to sell too, if it’s a microcap with limited liquidity).

The typical reflex is to fall back on valuation and conclude that it’s probably fine to hold because the stock is now cheaper.

Wrong.

Valuation shouldn’t matter that much if the thesis is wrong.

Cheap stocks can get a lot cheaper, especially when fundamentals deteriorate. It’s a fallacy to assume that a cheap stock is safe. It isn’t.

Yes, sometimes a cheap stock will experience a rebound. Perhaps you could have waited a few extra weeks or months to optimize your exit.

The problem is when the stock doesn’t rebound and actually goes down another 30% or 50% from the point where you knew you should have sold. It’s probably not worth it to wait for a 5% or 10% rebound to exit when you consider how much a big loser could hurt your portfolio.

In essence, don’t let a small mistake become a big mistake.

Your capital doesn’t care whether you make it back in this specific stock or another one.

Be an assassin.

Kill the loser, then redeploy into your next winner.

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Disclaimer

This publication is for informational purposes only. Nothing produced under the Stocks & Stones brand should be construed as investment advice or recommendations. Mathieu Martin, the author, is employed as a Portfolio Manager with Rivemont Investments. This publication only represents Mathieu Martin’s own opinions and not those of Rivemont. Rivemont doesn’t guarantee the accuracy of any metrics shared in this article. Always do your own research and consult a professional before making investment decisions.