Part 3 – Lesson 15

Overview


After all the hard work of researching a stock, building a financial model, and creating an investment write-up, it’s now time to execute your purchase.  And after your thesis plays out (correctly or incorrectly), there will come a time to execute a sale of that stock.  In this lesson, we will discuss some strategies around purchasing and selling your investments.

Purchasing a stock


When purchasing a stock, the most important consideration is position sizing.  When deciding on position sizing, you should consider the following:

  1. Maximum position size – Based on your risk tolerance, every investor should set an upper limit as to the largest position size they are willing to take within their portfolio. For some investors with high risk tolerance, they may be comfortable with a position size of 10% of the total portfolio or higher.  For others with more moderate risk tolerance, the max position size may be 3% or less.

  2. Conviction – After completing research on a company, you should determine your level of conviction that your investment thesis will be correct. Your conviction level may be very high if you’ve spent considerable time researching the company, if you have solid evidence/data that your thesis is correct, if your view is out of consensus, etc.  When you have high conviction in your thesis, you will want to size your bet close to your max position sizing.  If you have medium to low conviction in your thesis, you will want to size your position lower based on this conviction level.You can think of conviction in a similar manner to how you would bet in poker.  When you have a great hand and the odds are in your favor, you bet more aggressively, but when you are dealt a pretty good, but not great hand, you bet more conservatively.

  3. Current valuation and sentiment – Position sizing can also depend on the valuation and sentiment around the stock. Let’s assume you really like NFLX stock long-term, but other investors are also very bullish on NFLX and the valuation is very high.  Given the high valuation and already bullish investor sentiment, it may be prudent to size your position a bit lower, so you have capacity to buy more of the stock in case the valuation improves (stock goes down).Alternatively, if the valuation of a company is very low, you have a “margin of safety” in these situations since the low valuation provides the investor with downside support in the event your thesis is incorrect.  Given this downside support due to the low valuation, you may be more comfortable sizing your position higher.

  4. Timing to Catalyst – For long-term investors, this may not be a relevant factor for position sizing, but many funds with shorter-term investment horizons will size up their positions when the timing is closest to the catalyst that they believe will move the stock. For example, if most of the stock price move in NFLX is expected to occur on earnings day, some funds may choose to purchase the stock or size up the position just prior to earnings.

  5. Recent Stock Performance – When a stock has outperformed significantly relative to the market over a short timeframe, it can be prudent to put on a smaller position sizing and maintain capacity to buy more of the position. For example, let’s assume you like AMZN stock, but the stock has recently shot up 10% in the past week on no news vs. the S&P 500 that has been flat over the same time period.  Given the significant outperformance of AMZN in the past week, an investor may choose to put on a modest position size and wait for a better buying opportunity.With that said, if your investment thesis projects significant long-term upside, the near-term outperformance or underperformance of a stock relative to the market will not be material long-term.

The idea of leaving capacity to buy more of the stocks you like is referred to as “dry powder.”  When you like a stock but are in not in love the valuation or the stock has outperformed recently, there is no need to reach your max position size on day 1.  Instead, an investor can buy a portion of their target position size and leave some dry powder to buy more in case the stock moves lower.

What do you do when a stock goes down?


You will hear of many pundits that believe in creating “stop-losses” for their positions.  A stop-loss is a predetermined loss beyond which an investor will cut their losses and move on.  For example, some people may set a stop-loss at 10%, and if the stock goes down 10%, he or she will sell the stock and cut their losses.

However, stop-loss orders defy much of the logic behind long-term investing.  If you liked a company enough to buy it at $100, then, why would you not want to buy it at $90?  When the stock goes down absent any significant fundamental news, then, an investor in that company has been presented with a great opportunity to buy more at a cheaper valuation.  Instead of fretting about the losses incurred, investors should be excited about buying the same company at a cheaper price.

Buying more of a stock when it moves against you depends on two factors: 1) conviction and 2) current position size.  If an investor is already at max position size, there may not be any more room to buy more of the stock.  However, if the investor is not yet at max position size and the investor has high conviction that he/she is correct on the investment thesis, then, the investor should take advantage of the stock weakness to buy more.

However, if the stock goes down because earnings or cash flow estimates go down, then, this is not necessarily a signal to buy more of the stock.  For example, if Google’s earnings estimates go down 5% and the stock also goes down 5%, then, the valuation multiple is unchanged.  Although the stock has traded down, the valuation is no more  nor less than what it was the day before.  Instead, if earnings go down 5% and the stock goes down 10%, then, the valuation multiple has compressed, and this could be an opportunity to buy more at a cheaper valuation.

Here is a simple decision tree to help you decide what to do when a stock goes down:

  • Stock goes down due to earnings going down

    1. Calculate how much earnings/cash flow has declined
    2. If the stock has gone down by more than the earnings decline, then, the valuation has compressed
    3. Re-evaluate the investment thesis to make sure the thesis is not broken
    4. If the investment thesis is intact, then, re-evaluate the valuation and decide if the valuation is attractive enough to buy more
  • Stock goes down but not attributable to any company specific news

    1. Re-evaluate the investment thesis to make sure the thesis is not broken
    2. If the investment thesis is intact, then, re-evaluate the valuation and decide if the valuation is attractive enough to buy more

Remember: As long as you avoid the use of margin (borrowed funds), you will never have to be a forced seller of your investments and you will have staying power to survive downturns in your positions and the stock market.

One of the biggest mistakes new investors make is to sell stocks because the stock price is down.  An investor should not use the stock price movement as an indicator of whether to buy or sell a stock.  Instead, an investor should understand why the stock is going down and decide whether the stock price decline is warranted or not warranted.  If your long-term thesis is intact and the valuation is attractive, a lower stock price is often a great buying opportunity.  However, if the investment thesis has proved incorrect and/or the valuation is no longer attractive, then, it is time to move on.

When do you sell a stock?


An investor should sell a stock once:

1. The investment thesis has played out and there is limited future upside in the stock

    • Let’s assume you invested in Company A at $80 and believe the stock is worth $100. If the investment thesis plays out and the stock nears $100, an investor should re-evaluate the financial model and thesis to see how much future upside exists.
    • If cash flow for Company A is continuing to compound at 15-20% per year (for instance), there could be a good case to continue holding the stock and allowing the growth in cash flow to carry the stock price higher over time.
    • However, if future growth is limited and much of the easy gains have been made, then, an investor may be better served by recycling the capital into opportunities with more upside.

OR

2. The investment thesis is proven incorrect

    • To avoid making losses worse than they need to be, it is important for investors to remain intellectually honest and re-evaluate their investment thesis when certain events unfold differently relative to what they thought would happen.
    • For example, when a company puts up quarterly earnings that miss expectations, an investor should ask “was this quarter thesis-changing?” or “was this quarter just a bump in the road?”
    • Every company, no matter how strong the fundamentals appear, will invariably miss expectations for some of their quarterly reports. There is natural variability in every business, and nothing goes up in a straight line.  As long as a quarterly miss in numbers does not change the long-term thesis of the company, there is no rush to sell the stock.
    • There are instances in which a company dramatically shifts its strategy (such as through a large unexpected acquisition) or the industry health deteriorates rapidly or the need for reinvestment increases materially. These are examples of significant events that could dramatically alter the strength of the investment thesis.
    • When events like these occur and it is significant enough to break the investment thesis, it is time to sell the stock and move on.