Continuing our series of posts aimed at helping you all achieve financial enlightenment, I wanted to focus today on what you actually already hold as investments. Most of the advice we see around us is about what to buy and when to buy it. However, equally important - if not more important - is what happens after you have invested. After all, your hard-earned money is now on the line! You must have all figured out by now that I am a firm believer in long term investing based on detailed fundamental analysis. But however good your initial analysis, life, as we all know, doesn’t always go according to plan. It’s so important therefore to perform a regular and disciplined reassessment of the companies you’ve invested in - looking at things with ‘Fresh Eyes’ as I like to say. Learning to do this objective periodic reassessment is actually a key skill in maximising your returns.
Now let’s take a practical example below.
What if I showed you these recent results from a company in my personal portfolio?
All looks incredible, doesn’t it? All the more incredible if I told you these were just half year results! You’d be intrigued and ready to know more, perhaps even already thinking of quickly buying the shares. Revenues and profits look to be on an absolute tear. Just by looking at these figures, we can guess that the company must really be onto something and worth investigating. But some of you (most of you?) might then rightly say, ‘sounds great, but what’s the price’ i.e. you are thinking that even though the underlying growth looks great, the shares may have gone up too far already….
Then I show you this chart… (spoiler alert in case you are trying to guess the company from my clues above!)………
I’d bet you’re not so keen now! It’s gone up so much already. Over 80x times this year to be exact. Ok, so obviously, I’m using this very extreme example for dramatic effect - almost never seen before speed of share price rise (probably only really possible in these crazy Covid times).
Novacyt, a small Anglo/French clinical diagnostics company was in the right place at the right time and management were smart enough to see the business potential of Covid already in January, long before others jumped on the bandwagon, giving them a sizeable first-mover advantage in developing Covid tests. Over the course of 2020, they’ve been a real beneficiary of the bonanza of new money directed at fighting Covid - the biggest global economic threat we’ve seen for decades. This example also highlights a truism: there are always winners, even in the most negative situations…
Potential upside is more dependent on business prospects than anything else
What I want you all to note: all the way up that chart, be it six months ago or even three months ago, people could have thought to themselves ‘what a shame, I’ve missed it, no point investing now‘. But their psychological dislike of the fact that they weren’t ‘buying at the bottom’ would have been an expensive mistake. Really the key valuation metric is earnings prospects and in this never before seen scenario, the earnings prospects kept rising.
Hindsight is 20/20 and, in this case, we now know that Covid beneficiaries continued to rake in the cash in an unprecedented way, quicker and larger than early expectations with obvious implications for the share price. In this case, the prospects of the business just kept getting better and better, and the risks were decreasing as the company passed every hurdle, so an unbiased and unblinkered review of the situation would have helped you stay invested.
My point with this simple example is to show you what I feel is one of the biggest factors in successful investing: the ability to look at your existing investments with ‘fresh eyes’. What I mean by this, is having a completely unemotional review of the situation in the light of how events have unfolded since you invested. Having as little bias as possible regarding what has happened in the past (and importantly how you feel about that) is so useful.
Keep asking - what would I do now today?
So, when I was managing large investment funds, every month or three months (depending on the underlying investment mandate of the particular fund), I’d get my team to sit in a room with a piece of paper on each stock we held. This piece of paper would be an up-to-date assessment of the risk/reward situation: key catalysts to value creation and key risks too. I didn’t want to see the company names or charts as I was really trying to think afresh what would I do today if I came across a business with this particular risk/reward ratio and valuation profile.
It’s really irrelevant actually why and when you bought initially and at what price. During the period you have held the shares, the business dynamics may have changed so that risks have increased. Maybe a new risk emerged on the horizon that you hadn’t thought about? - e.g. I hadn’t thought about film distributors delaying blockbuster release dates as Covid fears dragged on, absolutely extinguishing all hopes of early recovery from cinema openings for poor Cineworld.
Don’t hope against hope
Of course once you know how the company stands today, there’s the possibility to add the extra layer of analysis by considering the price today in light of this positive/negative change to the underlying picture. But that, as I’ve explained in previous posts, is only important in the context of what we are paying for. Only when we know how the company is positioned in risk/reward terms today, are we in the right position to look at prices and say that’s still an attractive investment proposition and cheap or alternatively, “no way!”, it’s far too expensive/risky and therefore unattractive.
So, in this simple mental exercise, these are the sort of questions to ask yourself:
• Are there any risks now that I hadn’t thought about when I invested?
Covid would be a good example here. if something significant which is new and unexpected has happened since you invested, then it’s important to reassess the business’ prospects in the light of this massive change to fundamentals
• Looking at the key risks I identified when I invested, have these risks now increased? or decreased?
The world is uncertain and things that are likely to happen often don’t and vice versa. So, it’s important to reassess where the company stands now. We are obviously less keen to stay invested if risks to the business prospects have materially increased. We shouldn’t just hope against hope if the odds are now more against us.
• Looking at the share price catalysts/value creation opportunities I was looking at when I invested, have these become more or less certain?
We invested for upside based on a number of ‘catalysts’ to value creation, are those drivers still likely or have prospects worsened in the industry or for the company in question. Could be that changes to regulations, competitive environment, political or economic backdrop have dimmed the company’s prospects.
• Are there brand-new opportunities for value creation that I hadn’t thought about?
One company I’ve invested in is super excited about selling their healthcare data to wearable fitness providers. This was definitely not on my radar when I invested. The prospects of the core business are excellent, but this new avenue obviously enhances share price prospects.
• Are earnings expectations now higher?
As we discussed in a previous post, shares are mostly valued on the prospects for earnings. Counterintuitively therefore, the shares may have got cheaper despite any rise in the share price if earnings prospects have risen more. If earnings are rising faster than expected (look at upgrades) or perhaps the sector is becoming more attractive given the picture painted by recent economic data, then earnings estimates are becoming more certain in the minds of investors (investors pay up for certainty).
But it’s time-consuming and actually quite difficult to ignore your biases
At Pynk we really believe in educating yourself and understanding investments and this requires consistent effort and ongoing learning. A regular review of your portfolio may require time you don’t feel you have, but it’s definitely time well spent and an important skill for Pynksters to develop.
The real downside with this approach to your investments is that it may increase your dealing/switching costs, especially if you’re not confident about stripping out the ‘noise’, i.e. factors that aren’t really that important. I am obviously a strong proponent of long term investing but I would argue that having a process that identifies potential investment losses in a proactive way is worth the cost.
It’s really hard not to be emotional about what’s happened. If you’ve lost money, it’s difficult to cut your losses because somehow they don’t feel real if you don’t sell and you still have a glimmer of hope - like a gambler that has lost at the roulette wheel - the temptation is to continue to hope against hope despite all the evidence that things can improve, however unlikely that may be. Equally, it’s so tempting to bank your profits as soon as things start to go well. This ability to be objective irrespective of the past is probably developed over time and is a work in progress for most of us.
Behavioural finance is a fascinating and too little understood area. Razvan, from our investment committee will be writing something with more detail on this subject for you guys. I urge you to read It!
I believe that by taking the time to regularly review each of your holdings in this way you really cut your risk of losses and are more likely to enjoy more of the upside potential. It prevents you from ignoring a negative change in fundamentals and also helps you avoid missing more upside by selling too quickly when prospects are improving.
We should always strive therefore to undertake a fresh assessment of each equity investment without the emotional noise of how much money we have made or lost. Successful investing is about not only understanding the businesses you buy, but also about being disciplined in revisiting with fresh eyes and as little emotion as possible the company’s ever evolving situation.
Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.