I read an interesting piece in the Shareholder Letter of Weitz Funds annual report (31 March 2007) by Wally Weitz couple of days back. You can find it here.
He was writing about the subprime mortgage meltdown. I quote:
As fears deepen and the possibility of a temporary, but severe, hit to Countrywide’s earnings looms, we have chosen to hold our position. Our rationale is that we do not know that it will go much lower, and we strongly believe that it should sell at much higher levels in the future. The alternative is to sell our position now with the hope of avoiding some temporary markdowns but risk missing our chance to repurchase the position before the stock recovers. Stocks have a way of bottoming long before the bad news is over and the good news appears. We sold some Berkshire Hathaway A shares in the 1970’s at $510 per share for some short-term reason, and with the stock now at $109,800 per share we’re beginning to think we are not going to get it back for $510.
So he knows well ahead of time that there would likely be a hit to CFC’s earnings, deepening fears, and possibility of a price drop. However, he had chosen to hold on due to the risk that he cannot get back in in time. Gurufocus reports Wally owning close to 11.2 million shares of Countrywide (average daily trading volume over the past 3 months is around 12 mil).
Well, what happened with my portfolio was, I suppose, a result of reading too much stuff from value fund managers =) Basically, I held on to my stocks, and when the crunch came, my portfolio that is heavily skewed to housing-related stocks, tanked like crazy 🙂 That’s mistake #1. Mistake #2 is that I’ve bought so much of those stock earlier on, I had no more spare capital to average down. So that got me thinking (nothing beats losing a lot of money to make you think), should I have done differently?
Getting Out Before The Drop
And the answer is Yes! As a small investor, if you know the price will crash, just get out, sell EVERYTHING! You don’t have to worry about not being able to get back in in time as you can get in and out quickly. And if you’re a fund manager managing a large position, perhaps you should sell out a portion that you know you can get in / out fairly quickly. For example, instead of not selling anything (like Wally above), may be sell 2 million shares? at least that would help limit the loss somewhat.
Getting In During/After The Drop
Now how should you get back in. My big mistake was that I kept buying more as it went down, very soon I’m out of capital – too much too quickly. What happened was I was buying more with each ~4% drop. With a 25% drop you will be out of capital in no time. I need to stagger the buying. I’m thinking in this way:
- Wait for the price to stabilise before buying.
- If the price is stable for a period of about 10 trading days, then buy a small portion.
- If the price remains stable for another 10 days, buy another small portion, so on and so forth.
- If the price drops further (after prior stabilising), let it be stable for 10 days at the lower level before buying a “bigger” small portion. Repeat the general process.
- If the price goes up, don’t be too eager to go all out thinking that you will miss the boat. Forgoing potential gains is fine for the sake of not increasing your potential loss (i.e. the decline may not be over yet). Depending on your read of the situation at that time, decide whether you want to go in more.
[As a side calculation: if for every drop in the price level to the next stable level, you double your “small portion”. For a 3-stock portfolio (max 1/3 each), assuming a 3-month decline, 6 stable price levels, the initial “small portion” should be 0.5% of total capital.]
What about about for large fund managers? I think the rules of buying in during/after the drop is the same for both institutional and individual investors. In both cases, unless you have a steady inflow of capital from some other source (at a significant size compared to total portfolio value), you need to keep a reserve of cash to average down.
Are there any rules for buying in when there are no drops? Actually I think for value investing, most of the time the buying happens in distress situations. Without a distress situation, you might be more confident to initiate with a larger position.
Value Investing and Portfolio Management
I think such money management / portfolio management stuff above is a neglected part in the teachings of value investing.
All the value investing literature out there talks more about selecting companies with good business, management, price. I’ve not seen any value investment piece that talks about actually when to enter into the position, how large a position to enter with, what’s the accumulation process, basically how to buy? Similarly, selling presents various challenges. For example, I saw an interview where Mohnish Pabrai said that he had previously rode a company all the way up to the peak at the dot-com boom, and sold it then. On hindsight, he said he should have sold it when it reached its fair value. I remember reading somewhere that Wally Weitz would sell a stock if its trading at too high a value. Even for selling, do you just sell everything off at one shot at fair value? or stagger your selling? or put a “stop-loss order” once it has reached fair value and keep raising the level of your “stop-loss order” as it goes up? basically again, how to sell?
While this money management / portfolio management part may not be as important as the first part on how to pick stocks, its impact on overall portfolio performance is very significant indeed. If the first part pertains to capital preservation and some gain, money management / portfolio management pertains to making the big gains.