Value Investing, Stop Losses and The Truth

I recently read Whitney Tilson’s letter to shareholders (found here) where he discussed having a drawdown (loss) of 20%. His letter explained that large drawdowns were part of the process to achieving long-term investment success. I don’t manage a fund but I do invest my own capital. The concept of money management and limiting losses is a taboo subject among value investors. The reason being EGO. Value investors including myself spend hundreds of hours researching a company. I like to think my work, which includes digging deep behind the numbers, gives me a good perspective to place a fair market value on a company. My due diligence includes not only financial analysis but also an exhaustive amount of work speaking to competitors, customers, ex employees and analyzing the psychological profile of the management team. This research is critical since all I do is turnaround investing and look for stocks that will turn into 5 baggers. With large returns comes large risks. However, despite wanting large returns, I do not like or want large drawdowns. I incorporate both technical and sentiment analysis to help me identify when a stock has bottomed. In most cases I have been pretty successful picking bottoms. It takes patience and is like watching paint dry in some respects. However, when I am early I can be very early. Since I take concentrated positions being early is not pleasant. This is the hard part for value investors. You have spent months analyzing a company and placed your savings down to take advantage of what you consider a fabulous price. Then the stock is down 10% then 20% then 30% then 40% what does one do. Does an investor have a strict rule where he cuts losses based on an individual security or on the entire portfolio? Many value investors pride themselves on buying companies with great balance sheets or discounts to working capital. They believe it allows them to buy more as the share price falls. It will come back they say. However, has that investor considered the concept of value traps? How many value investors purchased the homebuilders after they had fallen 50%. Only to watch them fall another 80% in many instances. Having operated turnarounds, I know how quickly industry dynamics can change and how those changes can quickly impact pricing, cost structures and a companies competitive position in the marketplace. An investor needs to realize cash flows can decline very fast. Value investing is buying shares in companies that are experiencing problems one way or another. You can never underestimate the problems a company can experience when its industry turns down.
The next issue for Value investors is their comparison to Buffet and his philosophy that a lower price makes it’s cheaper and a better buy. I understand the theory but an investor has to understand their temperament and capital position. When you manage other people’s money they don’t care about value they care about cold hard cash. Whitney may love his positions but his investors are not happy. They may realize that china is slowing, we are in a balance sheet recession and those circumstances may create numerous value traps. Buffet can hold his positions because his capital comes from an insurance company. Mr.Tilson’s investors may not be so patient. His 20% loss may not allow him to stay through the cycle. He is in the horns of a dilemma.
I have been very bearish on the equity markets for the last four years but am beginning to warm up to equities as prices fall and valuations become attractive. I have begun to invest in 3 highly selected shipping stocks that have the balance sheet and working capital availability to survive the shipping depression and turn into 3 and 5 bagger returns. Many shipping companies are going into chapter 11. I am investing in what many consider a precarious time. I believe I am right. However, I am in drawdown now on the positions as they have fallen. I am in the horns of a dilemma. My ego says to keep buying more as it goes down. However, the markets are bigger and stronger than any one of us. Over the past 20 years I have seen brilliant investors wiped out and taken out of the money management business because they did not want to take losses. I suggest everyone read a passage in the book, ‘Inside the house of money,” page 202 which is a profile of Yra Harris. He speaks of this concept of being right but at the wrong time. Many people in the money management world are super smart having Harvard MBAs and CFA certificates etc. However, they you and me are not bigger than the markets. I am super bullish on my three shipping equities but it looks like I am early. I want to live to fight another day, so I am putting my ego on the shelf and ring fencing any further losses. I will have a stop and reenter plan. I will cut the position size but have a reentry plan to get back to a full position. I look forward to hearing from other value investors and there strategy for dealing with losses. It is the most important and least discussed topic among investors