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You Just Bought A Stock - Now What?

April 24, 2014 | About:
The Science of Hitting

The Science of Hitting

228 followers
You just bought a stock. After months of research and thought, you’ve found a security trading at a discount to intrinsic value; your brain, while anticipating the potential future gains that will result from the investment, is reacting similarly to a cocaine addict anticipating their next high. Eventually, the euphoria subsides; Mr. Market doesn’t care that you’re now the proud owner of 50 shares of Coca-Cola (KO). It’s time to play the waiting game. What is an investor to do?

Inverting the question can point us in the right direction: what shouldn’t we do to remain sane, to remain focused on what really matters? Most investors, who realize that they only had the opportunity to make that investment in the first place because markets are inefficient at times, will suddenly turn to Mr. Market for the answers. Suddenly, the stock price is all knowing, and delivers important clues about the validity of your thesis on a daily – or even hourly – basis. It’s such a perverse line of logic – and yet it is utterly unavoidable for many people. They simply cannot refuse to hear from Mr. Market – and they are inclined to believe that he knows what he’s talking about.

At the same time, consistently referencing to a slow moving number undoubtedly causes some type of anchoring (or at least it has for me in my experience); the move from $30 to $38 suddenly seems astronomical after watching a stock trade between $28 and $32 for six months – even though it’s a relatively small change with a multi-year view. I’ve found it very hard to get comfortable with a stock’s new valuation after it has been range bound for a long period of time; that type of thinking can take control of your investment process if you don’t eliminate it quickly. This is increasingly difficult to do in the age of ubiquitous computing: stock prices are always just a click away, on your desktop and in your pocket. I don’t have an easy answer for dealing with this – but I do know that failure to do so will undoubtedly be detrimental to your results over time.

Rather than focus on the stock price, certainly it would make more sense to turn our focus to the underlying results of the business; how would one go about doing that?

Not surprisingly, we now have a new set of problems to address: we only get an update on the underlying business every few months (conference calls / quarterly results, investor events, etc); we are left waiting for long periods of time without any clear indication of how things are going. Even worse, when an update finally comes, we must decide whether what’s being reported is noise, or the emergence of new problems at the company; doing so is easier said than done.

What's the answer? I’m not sure there’s a perfect solution, but here’s what I’ve come up with.

First off, to go back to the first point momentarily, the stock price is not the answer; if you cannot keep yourself from anchoring to the stock price or becoming dependent upon Mr. Market’s opinion, you’re in big trouble.

If Weight Watchers (WTW), which I discussed recently, shot up to $30 over the next month (and assuming it was then sold), only to file for bankruptcy in eighteen months, would you consider that a successful investment? Some would argue that the 50% gain means it was; if you question that conclusion, then I think you can understand why the stock price alone - or even realized results on a one off basis – can be a shaky ground on which to judge investment success.

Once we eliminate the stock price, we’re left with the results for the underlying business. Unfortunately, what happens in any ninety day period may not be representative of what will come in the ensuing years. The idea that a single quarter can change an investment thesis that was built upon the results for the previous 10+ years seems a bit shortsighted in my mind.

Thus, we’re left with looking at longer periods. Personally, I only start to get comfortable after I have a year or more of data; if you’re not the type of market participant that is comfortable holding a position for years at a time (“investing”, as it’s called), then I’m not really sure how you can address this problem while focusing on the fundamentals of the business in question.

The other thing I think you can do to monitor your original thesis is to set expectations at the outset. On this front, I think we can learn a lot from Warren Buffett (Trades, Portfolio)’s (BRK.B) investment in IBM; here’s what he said on CNBC when he disclosed the position (bold for emphasis):

I don't think there's any company that's—that I can think of, big company, that's done a better job of laying out where they're going to go and then having gone there. They have laid out a road map, and I should have paid more attention to it five years ago [when they laid out] where they were going to go in the five years ending in 2010. Now they've laid out another road map for 2015. They've done an incredible job. First, Lou Gerstner, when he came in, he saved the company from bankruptcy. I read his book a second time, actually, after I read the annual report. You know, "Who Said Elephants Can't Dance?" I read it when it first came out and then I went back and reread it. And then we went around to all of our companies to see how their IT departments functioned and why they made the decisions they made. And I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things.”

Warren’s clearly focused on two things: (1) the sustainability of the moat, and (2) what that means in terms of per share intrinsic value in the coming years (with management’s markers as laid out in the five year plan as guidance). In IBM’s case, management had set a reasonably long term target, and then went out and performed as promised. The way that I would judge them going forward is (1) against their own expectations, which in a perfect world would be largely tied to their compensation, and (2) as it relates to the maintenance or widening of the moat.

This is one area where I think management is key: if you can trust the individuals at the top of the company to provide reasonable forward estimates with a high degree of certainty (which requires an industry / market position where doing so is even possible), the inherent volatility of the equity markets is likely to create plenty of buying opportunities over time. I think this trust must be earned; it comes from reading previous conference calls or annual shareholder letters, and benchmarking prior statements against subsequent results - and a CEO that writes or says a lot without delivering anything of substance or sliding past the tough conversations is worthless in my book.

This may seem like an unsatisfying conclusion, but I think the answer is that the action required after the purchase is largely an extension of the research you completed beforehand; if you read through the first quarterly or annual filing after buying the stock and find a lot of surprises, that’s not a good sign.

More than anything, I think what’s needed after a purchase is patience; as I’ve discussed on here before, I personally set predetermined holding periods for myself that I would only consider breaking in the rarest of circumstances (so rare that I’ve never done it since I started the practice). For myself, that’s a blunt tool with an effective outcome – I can’t buy anything that I would hate to own at a 25% premium to the buy price (those type of movements are bound to happen every now and again, like in 2013), and I can’t buy anything where the next few quarters has the potential of scaring me away. If I’m worried that might happen, I’ve effectively barred myself from buying the stock.

I think I’ve become more focused on the long term since I’ve made that transition, which allows me to key in on the factors discussed above. I focus on the sustainability of the moat and the prospects of the business in the coming years / decades more than the trailing or future P/E, and have started to realize that the idea that all businesses should trade at some arbitrary premium or discount to the market multiple is flawed. When Charlie Munger (Trades, Portfolio) said “A great business at a fair price is superior to a fair business at a great price”, I think that’s partially what he’s getting at…

I’ll save that discussion for another day.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.5/5 (19 votes)

Voters:

Comments

jtdaniel
Jtdaniel premium member - 2 months ago

Hi Science,

Thank you for a great article that is just loaded with practical wisdom. Here is another type of inversion that I have come to embrace: rather than buy and hope for immediate gratification, decide in advance to hold tight and average down. In fact, this is how most of my larger positions have become, well, my larger positions. For instance, I held American Express shares through the 2008 financial crisis and then loaded up at great prices when AXP converted to a bank holding company in order to accept TARP money. I know it was just a lucky break, and in hindsight an obvious buying opportunity. But in real time, I had to hold and then buy AXP when some much smarter folks were selling it. If only something like that would happen with one of my small growth stocks!

The Science of Hitting
The Science of Hitting premium member - 2 months ago

Jtdaniel - Agreed; said another way, you should hope that the business becomes cheaper. If you are really making an investment, you should be excited by the opportunity to buy more at a better price. It's so logical, yet counter to the way almost all of us react (myself included at times); we see green or red the next day and suddenly care entirely about Mr. Market's opinion - when we were calling him an idiot a few days earlier. Congrats on your (presumably) huge success with AXP; if you need any help spending the proceeds let me know :) thanks for the comment!

jtdaniel
Jtdaniel premium member - 2 months ago
Science, thank you the kind reply. AXP has worked out nicely, but I could tell a different story about averaging down on Radio Shack in 2011! It is the personal experiences over time that make the grunt work of investing worthwhile. Plus, the odds of long-term success are tilted in our favor.

I often wonder why so many investment writers can recite every detail of some investment Warren Buffett (Trades, Portfolio) made in the 1950s or 1960s, but have no stories of their own to share. I would prefer to read what you think about Wal-Mart right now, than what Mr. Buffett may have been thinking about during the Eisenhower Administration. I appreciate all your good work.

The Science of Hitting
The Science of Hitting premium member - 2 months ago

Jtdaniel - Sure thing. And that's true, there are the scars as well as the big wins; I don't know about you, but I have my fair share of the former! Your story wish Radio Shack is similar to how I feel with Staples, as well as Weight Watchers - in both cases, I would be happy to buy more if they got cheaper, but up to a limit; much different than how I feel about something like Berkshire (would put 50% or more in at the right price). What were your thoughts on my WMT article - is it something you own or have looked at? Would be interested in hearing - thanks for the kind words!

snowballbuilder
Snowballbuilder - 2 months ago

Hi science . I apprecciate your article as usual.

I m also a focused long term investor and , as munger point out , if you stretch your time orizon the quality of the company become more important then the price (tom russo is another great example of LONG term investor in great company , he said "stretch your time orizon both for tax purpose (no taxation of unrealized gain) and both becose there are not so many really great business") .

As jtdaniel point out is also important to remember and learn from our mistakes so i ll share one of my biggest : one of my firsts investment was an italian solar panel maker "kerself" in wich i ve invest ~ 10 % of my net wort ... When the price become to collapse a i ve buyed more until around ~ 20 % . Then i started to ve some dubt on the quality of the balance sheet and the quality and fairness of the management so i finally exit the position whit an avarage 50% losses . That was ~ 10% of my net worth burned in a single trade. (The company finally filed bankrupties ~1 year later)

After that , before every investments, i become to study really careful the balance sheet of a company , is debt , the quality of his management and the quality of his cash flow ... At the end of the day cash is all you can spent .

now i ve just 6 holding. They are all leader in their sector , have strong brand, produce a lot of cash and 4 of this are net cash positive .

I m invested in 1 from 2009 , 1 from 2010 , 2 from 2011 and 2 from 2012 .

I ve some big unrealized gain but i dont care ... I actually ve no exit price ... I m in for the really long term .

If the company and managent continue to do their job great as they ve done i will never sell any share ("time is friend of the great company") .

On the other side if the market collapse i m ready to buy more and aggressively couse i ve study the company really carefully so i m confident with any of the six .

The Science of Hitting
The Science of Hitting premium member - 2 months ago

Snowballbuilder - Thanks for the personal story; I actually got burned by some solar companies as well, back when I had absolutely no idea what "investing" really was. It was a painful learning experience - and as you note, those tend to be the most valuable ones. Thanks for the comment and the kind words!

jtdaniel
Jtdaniel premium member - 2 months ago

Hi Science,

I really liked your Wal-Mart article because you nailed the key factors that are likely to allow the company to maintain its dominant position in retail -- at least in North America. Improving its international operations is an obvious opportunity area. Odds are Wal-Mart will find a way.

I also appreciated that you objectively considered the likely impact of Amazon on Wal-Mart, as compared to Target and Costco. I agree with your assessment, but it certainly bears monitoring. Amazon is slowly losing its sales tax advantage, which can only help the other three operations.

I do own Wal-Mart, having bought shares in 2006 and 2011. Ameritrade shows my cost basis at $50.33 per share, so I guess it has done okay when adding in the dividends. I would certainly consider buying more -- a P/E around 12 would be very attractive.

The Science of Hitting
The Science of Hitting premium member - 2 months ago

Jtdaniel - Glad you liked it, and agreed with your thoughts: it will be interesting to see what McMillon brings to the CEO role as the former international head; this is a clear opportunity for WMT going forward. It will also be interesting to see what happens with Amazon as the playing field is likely leveled nationwide in the coming years.

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