PE Ratio Valuation Metric

A Simple Three-Step Process To Combat This Investing Mistake

Editor’s note: In today’s essay, we’re sharing more timeless advice from our friend and Empire Financial Research founder Whitney Tilson. Today, Whitney tackles one of the biggest mistakes you can make – and shares three simple steps to help you overcome it.

Q1 hedge fund letters, conference, scoops etc

PE Ratio Valuation Metric

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When you buy a stock, one of two things will inevitably happen…

It will go up. Or it will go down.

In the beginning, it’s really that simple. You buy a stock with just two possible outcomes.

But the truth is, things can get complicated really fast. And as that happens, it often leads to one of the biggest mistakes an investor can make… letting your emotions get in the way.

When you let your emotions take over, you often rush into decisions that you’ll regret later… That’s the case no matter which way a stock is moving.

One common and costly mistake is selling a big winner too early.

As I explained yesterday, that happened to me with video-streaming giant Netflix (Nasdaq; ticker: NFLX)…

On the day Netflix’s stock bottomed in October 2012, I pitched it to a crowd of 500 at my Value Investing Congress and then went on national television on CNBC. I said Netflix was going to be this decade’s Amazon (Nasdaq; ticker: AMZN), a stock that had risen 20 times in the previous 10 years. And as it turns out, my analysis was spot on…

Over the next two years, the stock rose sevenfold as Netflix’s streaming business grew. But as the stock kept moving higher, I made a terrible mistake… I started to let my emotions take over.

After the stock doubled, I sold half my shares. And when it doubled again, I sold some more. As the stock was doubling a third time, I exited the position altogether.

My analysis revealed that Netflix was trading at a 90 percent discount to its intrinsic value – in other words, a “10-cent dollar.” So as the story played out even better than I could have hoped for, why was I selling it after it doubled? It was still a “20-cent dollar.”

I thought I was conservatively managing risk and didn’t want to be greedy. But I had it backward… To build a successful long-term track record, you must be greedy when the opportunity arises. Finding a monster stock like Netflix only happens maybe once a decade – or even once in a lifetime. So it’s critical that you make the maximum amount of money on such moonshots.

I should’ve made more than US$100 million on Netflix for myself and my investors. Instead, I made less than US$10 million. Of course, that’s not terrible… But it was a costly mistake.

It’s equally important to harness your emotions when a stock is running against you…

Take SodaStream, for example. Its machines help you turn regular tap water into sparking water with the touch of a button.

I knew SodaStream had a great business model. The company sells something that people use over and over. And the carbon dioxide bottles in its machines need to be replaced regularly. So SodaStream made something like an 80 percent profit margin doing so.

But the company had botched its marketing in the U.S. and was also relocating its main factory in Israel, so its sales and earnings were down. I patiently waited until the stock had been cut in half and bought a small position in 2014.

It turns out that I was much too early. The company continued to struggle and the stock kept drifting lower and lower… for nearly two years!

Making the right decision in these situations is critical. Had I stumbled into a “value trap” that would never turn around – in which case I needed to sell? Or was the company still strong, with fixable problems – in which case I should buy more?

It was very painful losing so much money for so long. Emotionally, I wanted to sell and never think about this terrible investment again.

But I was able to set aside my emotions and focus my analysis on the fundamentals, which remained strong. I added to my position all the way to the bottom – and was well rewarded.

In early 2016, SodaStream’s stock took off as I expected…

By the time I closed my funds in late 2017, it was up five times. And then PepsiCo (Nasdaq; ticker: PEP) bought the company last year for 12 times the price only two years earlier.

It can be challenging to figure out whether a stock is just hitting a few speedbumps (like SodaStream) or if it’s doomed for good (like old-school film company Kodak). But by following a simple three-step process, I realized that I should hold on to SodaStream…

First, assume the market is right and you’re wrong.

You must begin with this mindset because it helps overcome the natural bias we all have to not want to admit a mistake.

You must respect the market. The hard truth is that most of the time it’s right… and you’re wrong. My experience with SodaStream is the exception, not the rule.

Then, you must figure out what you’ve missed and actively seek out disconfirming information.

Redo your work… But don’t just rehash what you already did. That won’t lead to any new conclusions. Instead, you must ask – and honestly and correctly answer – a series of key questions.

Have you made a research error? Are you possibly missing anything? Have you openly and carefully considered contrary arguments? Have you invented new reasons to own the stock (so-called “thesis drift”)?

Many smart investors lost a lot of money owning film company Kodak’s stock in the decade before it filed for bankruptcy in January 2012. It wasn’t an unreasonable investment initially… The company had one of the strongest brands in the world, it generated robust cash flows, and its stock traded at a low multiple of earnings. Sure, digital photography was a threat to Kodak’s film business, but it seemed far off – and the company was making investments to compete in this space.

For most investors who lost money with Kodak, the mistake wasn’t so much the initial purchase. Rather, it was failing to recognize that the film industry was rapidly being obliterated and that Kodak was getting no traction in the digital arena. So its profits were destined to disappear.

The key is to tune out the noise and think clearly and rationally. Focus on the fundamentals… If the company’s earnings rebound, its stock will as well.

Lastly, to make the right decision, you must pretend like you don’t already own the stock.

It’s so hard to make the right decision about a stock you’ve lost money on. The emotions are so powerful!

On one hand, you’re probably telling yourself that if you liked it at the price you bought it, you should like it more now that it’s cheaper. That may be true – but it could also be a value trap. No matter what, you must resist the temptation to double down again and again to try to make back your losses. Remember the old saying… “You don’t have to make it back the same way you lost it.”

On the other hand, your emotions are likely telling you to sell, so that you don’t have to suffer any more pain and never have to think about this terrible stock ever again.

There’s also a powerful feeling of wanting to wait until it gets back to the price you bought it before selling.

You must resist all of these feelings! Emotions are deadly when it comes to investing…

I’ve found that it helps my thinking to pretend like I don’t own the stock. I ask myself, “If I were 100 percent in cash today and building a portfolio from scratch, would I own this stock? And if so, what size of a position would I have?”

Doing nothing may be the best option, but you also must have the courage to admit a mistake and get out – or know that you haven’t made a mistake and buy more.

If a stock is going against you, follow this simple three-step process. And if you wouldn’t buy the stock if you were starting a portfolio from scratch, then you should sell it immediately.

Regards,

Whitney Tilson


Editor’s note: On April 17, at 8 p.m. Eastern time, Whitney will join Stansberry Research founder Porter Stansberry for a special investing event. He’ll reveal the secret to his investing success… and announce the biggest prediction of his career. Folks who tune in will even get the name and ticker of the company he calls the “No. 1 retirement stock in America”… just for showing up. Sign up for this free event right here.

Article by Stansberry Pacific


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