If You Can Keep Your Wits About You…

“If you can keep your wits about you while all others are losing theirs” – Rudyard Kipling

Uncertainty is an inevitable part of investing and financial markets. When our money, our retirement or (especially for an investment manager) our reputations are at stake, how do we keep a clear head? What does it really mean to “keep your emotions out of your investing”?

What makes a decision “emotional”?

Imagine this scenario. Earnings results are released for a company that you hold in your portfolio and the results are terrible. The stock is down 7% in after-hours trading and you have a knot in your stomach knowing that you will be losing money the next day. Every possible response you could have to this situation could be considered an emotional reaction. If you sell the next day, you are panicking. If you buy more when the stock moves lower, you might be trying to avoid regret over a previous bad decision and clinging to hope that the stock will reverse. If you do nothing, you may be practicing serious avoidance. Maybe you should get honest with yourself and stop living in a fantasy world.

In reality, maybe you are doing some of these things or none of these things. However, rather than spending time trying to decipher whether an investing decision is emotional or not, I think there’s a better way.

Industries where you have special insight

If you are not (yet) an investment manager, some classic investing books recommend that you “buy what you know”—invest in an area where you might have particular insights that other investors might not. For example, it’s 2012, you work in retail and you see that Michael Kors handbags are so popular the store can’t keep them in stock. This might be a good starting point for an investment idea. But maybe your excitement is greater than the idea warrants because you “discovered” it. Is Michael Kors really worth consideration?

In psychology and behavioural economics, the endowment effect is the hypothesis that people ascribe more value to things merely because they own them. In this case, maybe you are placing a high value on your idea merely because you thought of it.

What’s the alternative?

Michael Kors might be a good investment, but I don’t want my “gut feel” about this company to affect my choices. I want my decisions to be guided by analysis and facts—facts about this enterprise that I’m about to (partially) own. I want to inform myself of all available facts and I also want to build risk control into my decisions—because I can’t know everything. I’m not thinking mainly about fraud or material facts that are being withheld (although this can also happen from time to time). I’m talking about the inevitable uncertainty that can come from disruptive technologies, unexpected drug trial or election results, natural disasters, business plans that don’t go as “planned”… the list goes on and on. If you have a concrete list of reasons for owning a stock in the first place, you can refer back to that list when something happens to that stock—good or bad. Your decision is then guided by the fundamentals and the reasons you originally made the purchase.

Risk Control

Under the category of “risk control”, I would mention two additional points. Diversification is paramount. You should never put too many eggs in one basket, as tempting as that may be, especially when an investment choice goes your way. It’s important to limit position size, which may involve trimming a successful position when it becomes too large a piece of your portfolio. This is a difficult but important risk-control measure.

Volatility is another important marker. When the price of one of my holdings starts to move or fluctuate dramatically, I take this as a yellow flag—caution is warranted, even when (or perhaps, especially when) the reason for the volatility is not apparent.

Here is an example from my own experience to illustrate what I’m describing:

Case Study

In 2014, I bought company XYZ for one of the portfolios I manage.

Here are some of the reasons I initially chose this investment:

XYZ is diversified by geography and by product and has limited genericization of their lineup. The CEO recently committed to a 5-year extension, and is expected to continue his growth-by-acquisition strategy.

In late 2015, I moved to an underweight in this name based on several factors. Some of the reasons I originally liked this company were still present, but other factors were impaired. I did not sell XYZ at its high, but I did manage to avoid a lot of the pain that eventually played out in this stock. Here was my reasoning in the fall of 2015:

I am neutralizing my position in XYZ and moving to an underweight in the name to manage risk. The negative sentiment will take a long time to play out. To this point, I believed that the holding satisfied my definition of quality, despite the high debt levels. I felt that the high levels of recurring and predictable cash flow justified those debt levels.

The other four characteristics I look for have also held up for the most part:

1. High margins due to the company’s low cost structure, low tax rate and low spending on Research & Development (R&D).

2. Low variability in earnings due to low patent cliff profile, supportive growth characteristics, diversified product offering, and a focus on non-government reimbursements.

3. Strong management— the CEO had a track record of success (at that point), although his aggressive strategy has come back to hurt them. The board also remains confident in the CEO, but I will re-evaluate my remaining holding if management is removed.

4. Growth at a Reasonable Price— this valuation aspect has been removed from the market price, as the company is worth a lot more if the majority of the allegations against XYZ are proven false.  Nevertheless, the growth aspect to the company has been impaired due to their inability to use debt or equity to make further acquisitions.

In early 2016, the removal of one of the initial reasons to buy (strong management) and the increase in risk around the position, caused me to eliminate the position entirely.

XYZ was eliminated from the portfolio from an already underweight position. Although the company’s assets are likely worth more than the sum of the company’s trading value, there are still too many unquantifiable risks currently facing XYZ to justify the holding. Moreover, XYZ announced its CEO is stepping down.

Next time: When a book about something else is really about investing

Craig Jerusalim, CFA

Craig Jerusalim, CFA

Portfolio Manager, Canadian Equities, CIBC Asset Management