I have often been guilty of holding onto our losing stocks for too long, of being patient when I should have been more decisive. Between the two evils of being too patient or not patient enough, it’s better to err on the side of patience. However, our performance over the years would likely have been better if we had been quicker to sell stocks of failing companies.
I recently engaged in a reflective exercise regarding all the stocks we hold in our portfolio. Are there stocks we are too patient with, that we should sell? And if so, how do we identify them? What are the questions we should ask ourselves to help identify them? Here are those questions:
1. Is the initial purchase scenario compromised?
For each stock we buy in our portfolios, we establish an initial purchase scenario based on a few lines that identify the main reasons for our purchase.
Here is such a scenario for a stock we recently acquired:
(September 2024 - $127.50) Growing and less cyclical sector (affordable luxury). High entry barriers: expertise, brands, long-term agreements, global and exclusive distribution network. Strong balance sheet. Few fixed assets. Both founders hold 44% of the shares and remain active. It is difficult for brands to bring operations in-house. Excellent track record. Reasonable valuation at 22 times expected earnings. Deserves a premium compared to the market.
Over time, this scenario may lose its relevance. Having written this scenario allows us to revisit it regularly to ensure its validity. It is also possible that over time we realize we were wrong in our initial scenario. Even with thorough research to analyze a company, mistakes can be made, and our scenario may not hold up over time.
2. Has the risk increased too much?
Many factors can increase the risk of a business model or company. Perhaps the most obvious is a major acquisition, which can involve significant integration risk and a significant increase in the company’s balance sheet. However, there are other risks such as a strategic change, the launch of a new service or product, or a change in leadership, among others.
3. Has the company delivered financial results over several years?
If revenues and earnings per share have not grown, or have only shown minimal growth, for at least five years, it is legitimate to ask questions. In some cases, minimal growth may be justified. For example, the pandemic may have had a significant impact on the company’s results; in such a situation, it may be preferable to measure growth from 2019, before the pandemic began.
4. Has the stock performed poorly for at least five years?
In the long term, stock markets rarely misjudge a company’s evaluation. If the stock has not shown significant performance over many years, it is likely that there is an error in the company’s evaluation.
5. Are there better alternatives to replace an underperforming stock?
Sometimes, the stock we are considering selling remains attractive in the long term. However, it may be wise to sell it if we are convinced that we have found another much more interesting stock.
Philippe Le Blanc, CFA, MBA
Chief Investment Officer at COTE 100
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