a strange story involving the business cycle and being wrong

I once had a young colleague with lots of potential, whom I liked very much and who was an excellent securities analyst  …but who had only limited stock market success despite loads of potential.

Ass an apprentice portfolio manager, this person came to me with the idea of building a significant position in a company that made carpets.  The firm was well run, apparently had sustainable earnings growth momentum and was trading at a low price earnings multiple.   In this instance, I didn’t do my job as a supervisor well, more or less rubber-stamped the idea and okayed the purchase.

Soon after that (this was 1993), the Fed began to raise interest rates.  This is something I had been anticipating but–maybe because this wasn’t crucial to the structure of my own portfolio–was information I failed to bring to bear on the carpet company idea.  Higher interest rates slow down both residential and commercial construction, something which is bad for, among other things, sales of carpets.  Replacement demand slows down, too.

I went to my colleague, explained the situation–including the source of my mistake, and urged selling the stock.  We did, with a modest loss.  The issue ended up losing almost two-thirds of its value in subsequent months.

Now the weird part.

Eight years or so later, my colleague came into my office to rehash this trade–which I had long since forgotten.  The point was not to suggest that we buy the stock again–which would have been a fabulous idea, since business cycle conditions were finally very favorable.  Instead, it was to say that my colleague had in fact been 100% correct in recommending the stock all those years ago (apparently the stock has finally reached the point where its cumulative performance matched that of the S&P 500.

I didn’t know what to say.  This was somewhat akin to my aunt Agnes explaining that she was switching from natural gas to oil because the gas burner in the basement was really a malevolent space alien.

Why am I recalling this strange story–much less writing about it–now?

Two reasons:

–we’re coming very close to another period of Fed-induced interest rate hikes.  This is bad of early business cycle companies, including housing, commercial construction and related industries in the US, and

–it’s a life lesson about investing.  My former colleague had extreme difficulty in recognizing an analysis was wrong or that a stock, for whatever reason, wasn’t working.  But portfolio investors in the stock market are always acting on very imperfect information.  And economic conditions, both overall and in inter-firm competition, are changing all the time.  So having what one thinks is a better analysis than the other guy simply isn’t enough to ensure success.   Recognizing when things aren’t going well, stepping back to regroup and seeking out possible sources of mistakes are all crucial, too.  Denial may salve the ego, but it makes us poorer, not richer.


two types of orders: market and limit

As a professional, I always believed that the key to success was to have a sound strategy and good stock selection.  I’m still convinced this is true.

At the same time, good execution of my plan through competent trading–buying and selling the stocks in my portfolio–while a secondary objective, could add or subtract a percentage point from my overall performance during a year.  Given that the typical active portfolio manager underperforms the S&P 500 by around one percentage point yearly, good trading can be worth its weight in gold.  Having been blessed with good traders most of my career, and cursed with one horrible trader I couldn’t get rid of for about a year, believe me I know the difference between the two.

The main tool we as individuals have to control the trades we do is our choice between limit and market orders.

types of orders

market order is one where our instructions are to buy a certain amount of a stock at the market price, that is, the price at the time the human or computer that will transact for us receives the order.  Except in the most unusual circumstances–I can’t remember this ever happening with an order of mine–the transaction will always occur.  Sometimes, the price will differ a little from what we’ve seen on the screen a moment before entering the order, but in practical terms we’ll always buy/sell the stock.

limit order, on the other hand, is one where we specify the exact price where we want the transaction to happen.  That may or may not occur on a given day.  Limit orders take two main forms, day  and GTC (Good Til Cancelled).  GTC orders are, technically speaking, really not exactly what the name says.  They most often are tagged with a time limit, say, three or six months, after which they expire if not renewed. When entering an order online, a message will typically pop up giving an expiration date.

choosing one

As regular readers will know, I’m a growth stock investor.  For people like me, I believe firmly in the cliché that the more important decision is how we sell, not how we buy (more about this on Monday).


I tend to buy in two or three transactions.  I’ll almost always use a market order, for about a third of what I ultimately intend to own ,just to establish a new position.  I’ve found over the years that owning a small amount of a stock focuses my mind on it in a way that simply thinking about it, or having it in a paper portfolio, doesn’t. This also protects me a bit from the stock running away on the upside before I’ve finished buying.

My intention will be to buy the rest in one or two more transactions, hopefully at progressively lower prices.  If the market allows me, I’ll use limit orders to acquire the rest. I may decide, however, that I don’t have enough time to do so before others discover the stock.  If so, I’ll buy the rest at market.


If I change my mind about a stock, that is, if I realize that my favorable view is probably wrong, I’ll sell all I own at market–and relatively quickly.  On the other hand, if the stock has gone up a lot, and my sale is motivated by price, I’ll usually use limit orders.

For example, one of my sons and I own both own Tesla (TSLA), at his suggestion.  We decided to sell half of our holding at $260 (I’m thinking the rest should go at $275, but I haven’t broached the subject with him yet).  We placed a limit order about a week ago.  It hit yesterday.  (For what it’s worth, I think a large convertible bond offering is imminent and that, like last year, it will mark a near-term top in the stock.  And, of course, we can’t forget that this is a highly speculative, if intriguing, issue.)

More on Monday.



equity portfolio analysis to do now

Investors, even professionals, typically don’t want to look at their equity portfolios during a market downdraft.  It’s too ugly and too painful.  I’ve always thought, however, that if you can keep yourself from becoming too emotionally distraught from viewing what is after all a natural occurrence in equityland, you can get a lot of valuable insight into how the market will unfold as stocks inevitably turn up again.

Just from eyeballing charts–I’m too lazy to go back and do precise calculations–we had a particularly long and deep correction in 2011, two (maybe three, depending on how you count) in 2012, two 5%+ corrections in 2013–all before this one in 2014.

I’m pretty sure this correction has ended.  No one knows for sure until the downturn is clearly in the rear view mirror–and sometimes my native optimism gets the better of me.  I feel better  having made this disclaimer, even though there’s been enough if a reversal of form in stocks previously being pummeled (meaning most of my portfolio) to have me pretty well convinced

In any event, I think we should all do what I’m about to recommend, even if there does turn out to be another leg down.

First, two rules:

— Generally speaking, when the market declines value stocks go down less than the market; growth stocks go down more.  When the market begins to rise again after a correction, the pattern reverses itself.  We want to find stocks that are acting out of character–both good and bad.

–Often market leadership–meaning the industries/sectors that do the best–changes during/after a correction.  This change may simply validate ideas we already have  …or it may show us some economic development that we’d overlooked so far.  Either way we want to identify and ride new trends.

use a chart

For me, the simplest way to do this is graphically.  Set up a Google or Yahoo chart that will compare the performance of each stock in your portfolio with the S&P 500 from September 19th until now and look for anomalies.

Throw in some well-known names, stocks you think you might like but don’t own, volume leaders…to get a feel for what’s going on with names you don’t own.

The best case is a stock that has outperformed on the way down and which is rebounding more strongly than the market.

The worst is the opposite   …a stock that underperforms during the downturn and fails to bounce back during the rebound.  These are ones you especially want to detect and investigate.  In my book, you have to have very compelling reasons to hang on to a stock like this.  In my view, you don;t want a stock like this to be your largest position, no matter what reason you come up with.

Do this without having any expectations.  Just see what the numbers say.  Then you can begin to interpret.

Don’t make excuses in advance for stocks.  If a holding has, say, declined by a third during the correction and isn’t rebounding,  chances are that something is wrong.  Facebook (I don’t own it), on the other hand, did better than the market on the way down and continues to outperform.  Other social media stocks appear to be doing the same.

More tomorrow.



fixing mistakes: fast death vs. slow death

mistakes in general

One of the more important influences on my professional development was my immediate boss when I was running my first international portfolio.  I’ve written about her before.

–Her constant grillings on overnight Pacific stock prices pounded into my head the importance of observing daily price movements for the information they may contain.

–Her theory, or perhaps that of her British top-down mentor, that it takes three good stocks to offset the negative effects of a single clunker instilled in me how crucial it is to find and weed out mistakes as quickly as possible.

(An aside:  her idea was that a good stock could advance by 10% in a year, but that a bad stock would go down by a third before the average manager would smell the coffee.  I don’t think the numbers are necessarily accurate, but the sentiment is.)


fast death vs. slow death

Another of my boss’s favorite sayings–which has also become one of mine–is that “fast death is always preferable to slow death.”

What does it mean, you ask?

It has to do with fixing mistakes.

Suppose you have a large position in a mid-cap or small-cap stock  …one with low volume and/or a wide bid-asked spread.  You discover that business is not as good as you’d anticipated and the stock is likely to drop like a stone once more investors put two and two together.  What do you do?

Two choices:

–try to slowly trade your way out of the position, dribbling a little each day into the market (so that no one will notice you’re selling (as if you could keep this secret!).  That’s slow death.

–just shove the stock out the door, while others are still clueless.  Push the stock down 5%–10%, if need be–to unload most/all of it.  That’s fast death.  (This is the simplified version.  There’s technique involved in selling a large position, but that’s the general idea.)

Why is fast death preferable?

If the stock ends up 10% lower as your last shares get sold (and you’ve sold in equal amounts all the way down), your average price will be down 5%.  That’s not bad.

For one thing, you have the money to use to buy something else.

More important, if someone else discovers what you know and uses the fast death strategy, you’ll still have almost all your stock but the price will be 10% lower.  Even worse, the other guy will have used up a bunch of gullible buyers.  And his violent action will set alarm bells ringing that may cause any remaining potential buyers to change their minds.  Then you’re really in trouble.

People who choose slow death are delusional, in my view.  They don’t frame their situation using the fast death/slow death paradigm.  They want to pretend they haven’t made a mistake and that they therefore don’t need to act with any urgency in selling the bad stock.  In fact, they may think, maybe they don’t need to sell it at all.  They can consign it instead to the imaginary back room where bad stocks hide and can’t be seen (every portfolio has one).

why write about this?

It isn’t that we, as individual investors, encounter this every day.

What makes me think of this now is that bond investors are facing a similar situation in the overall bond market.  We know interest rates are starting to rise and that the upward movement has a very long way to go.  So losses are baked in the cake for anyone how continues to hold.  Why no fast death so far?