Investment Strategy

A common investor error to avoid (Part II of II)

The use of stop losses doesn’t make sense for the private value investor. But, as explained in part I, lots of people recommend stop losses as an essential tool in investment strategy. Part II will look at why they are wrong, specifically in the context of value investing.

I’ll start to explain this by way of a simple example.

Imagine a new office building that’s worth $100 million. Now imagine a group of investors get together and create a company to buy the building – let’s call it Tower Ltd. Then the investors divide the company shares between themselves according to how much they invested. We now have a simple company with a $100 million asset and $100 million of share capital.

Now let’s say the stock market crashes, perhaps because such-and-such foreign power decides to poke its nose into someone else business and start a war. It’s far away on the other side of the world, but it still causes foreign investors to panic and sell huge amounts of shares. Listed share prices property owning companies, similar to Tower Ltd also with no debt, fall by 20%.

However the shares of Tower Ltd aren’t listed on the stock exchange, so there’s no constantly changing share price to look at. But the investors are experts in the property market and know that the office building is still worth $100 million at current property market prices. So they also know that their shares are still collectively worth $100 million and there’s no reason to worry.

The next year the stock market recovers, and because some of the investors in Tower Ltd want to sell out a decision is taken to list all of the company shares on the stock market. 100 million shares are listed at a price of $1 each, giving the company a total market capitalisation of $100 million. This is the same as the office building value and therefore means the share price is the same as fair value of the underlying assets.

One day, a central banker is in a bad mood after taking a lot of criticism from politicians. To give them a scare, and to show them who’s the real boss, he surprises practically everyone by saying he’s decided to print a bit less money next year than most people expected. Global investors go into a panic, stock markets collapse.

The result is that the share price of Tower Ltd. falls by 20% to $0.80, giving the company a market capitalisation of $80 million. But the market value of its office building – in the physical property market not the electronic stock market – is still $100 million. Market prices per square metre, for similar buildings in the same area, haven’t budged a bit.

This means the market price of the shares is only 80% of their true value. Put another way, the market price-to-book ratio is 0.8 whereas the fair value price-to-book ratio is 1.0.

What should investors in Tower Ltd. stock to do at this point?

Should they automatically sell all their shares because the price has fallen 20% and triggered a 20% stop loss? Would you, if you knew the company was worth much more than the share price implied?

Or should you buy more shares because the fair value of Tower Ltd.’s net assets is considerably more than the market capitalisation of all the shares?

Obviously the logical answer is to buy more shares at a discount. The upside to fair value – the margin of safety – is 25% ($1.00 divided by $0.80 is 125%). Chances are, provided the prices of office buildings don’t fall sharply, that the share price will rise back up to fair value in future.

…advocates of stop losses would have told the investors to sell at the lower price, locking in a guaranteed loss of 20% on each share. This is despite no change to the underlying value of the company assets or the company itself.

But advocates of stop losses would have told the investors to sell at the lower price, locking in a guaranteed loss of 20% on each share. This is despite no change to the underlying value of the company assets or the company itself. To sell at that point would defy all logic. It would also lock in a loss and miss the possibility of a future price recovery.

This example uses a very simple company with a very simple asset – a building. In the past I’ve applied this approach to businesses that are similar to the fictional Tower Ltd. These are property owning businesses called Real Estate Investment Trusts (REITs).

REITs usually include a portion of debt financing as well as equity share capital, and they receive rental income from tenants which they pass on as cash dividends to investors. Plus they can own a wide range of different types of buildings. But otherwise they are much the same as Tower Ltd.

One REIT recommendation I made in August 2010, which owns prime offices and shopping malls in Singapore’s central business district, has made profits of 65% so far including capital gains of 35% and dividends of 30%, measured in US dollars. That’s equivalent to around 13% a year, with profit compounding.

That’s a great return from a business that owns such high quality assets. And it’s significantly beaten the MSCI Singapore index, whose price is up just 10% over the same period, measured in US dollar. Add total dividends of perhaps 10-12% over four years and that gives a total index return of around 20%, or about 4.5% a year taking account of compounding. The REIT has returned more three times that.

(I make investment recommendations in a service provided to wealthy families, mainly from North America and Europe. That’s an expensive service for dollar multi-millionaires. But in future OfWealth will be launching a low-priced investment service that will be accessible to everyone and full of new recommendations. If you would like to register to be notified when it’s launched then click here.)

So how did this REIT investment perform so well, especially against the local stock market?

The key is that it was recommended when the share price was well below the book value per share – in other words when the shares were selling for a big discount. That said, I calculate the share price still has around 11% upside to fair value, and in the meantime it has a dividend yield of over 5%.

Without the initial discount, and subsequent upwards move closer to fair value, I estimate the returns would have been much lower – around 7% a year. That would have come from dividend income and rising property prices. That’s still a decent return, but not exceptional.

By buying the shares when they were cheap the profits have been much higher than they would have been if bought when fully priced (or over priced). This is a clear example of how value investing really works as a way to boost investor profits.

The same principles apply when investing in other business sectors. Factories, brands, distribution networks, staff expertise and all the other things that make up the value of businesses don’t suddenly become devalued just because a share price falls. This is especially true if it falls due to a general market decline and not due to some specific company news.

Naturally, some companies do get into trouble sometimes, and the fair value of shares can fall (see here for a write up on a recent bankruptcy situation). For this reason not every value investment will work out as expected. But the built in margin of safety reduces the risk that the value falls below purchase price, and also boosts investor profits across a portfolio of value investments.

Of course, you should review any investment where the share price falls sharply. But what you mustn’t do is automatically sell it just because of a price fall. If the operating company is a stable and profitable business, and is still performing well, then chances are the price fall is a buying opportunity, not a reason to sell.

But permanent destruction of value is actually quite rare in solid businesses with a long track record.

On the other hand, if something has genuinely gone wrong, and it looks like it can’t be fixed, you may have to take a loss and move on to the next idea. But permanent destruction of value is actually quite rare in solid businesses with a long track record. Good businesses mostly just have temporary problems that can be fixed in a couple of years, or no major problems at all.

In the end, the name of the game in investing is to buy low and sell high. Using a stop loss strategy locks in a plan to sell low. This makes no sense to me.

If you want to be a successful private investor in stock markets, I strongly believe that the only strategy that will work is to patient investor with a medium to long term view. By that I mean you should expect to hold all investments for a minimum of three years and probably much longer.

Even better than that is to invest in stocks or index funds when prices are cheap, by being a value investor. The use of stop losses runs totally contrary to the principles of patience and buying value, and that, fellow OfWealthers, is why I recommend that you avoid them.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.