When do you give up on a stock?

In most houses there is a closet, or a cabinet where miscellaneous things are stored.  And by stored I mean they're shoved into this space carelessly and needlessly never to be used again.  When people are placing objects in this space it's common to think "I might need this again so I can't throw it away, but I don't need it now, and won't for a while so I'll store it.."  Depending on ones discipline these storage spaces can vary in size from somewhere small such as the corner of a desk to consuming an entire house.  Portfolios mimic these storage spaces with positions that we haven't given up on yet, but just haven't realized their potential yet.  Maybe we'll need the position later, but surely it isn't doing anything now.

Deciding on when to give up on a stock is a difficult choice.  But to get there we need to have a short discussion on liquidity.  In true John Kerry circa 2004 fashion I'm about to conduct a "flip flop."  In the past I've claimed that a stocks are/can be cheap because of illiquidity.  I've come to realize that illiquidity isn't something that manifests itself on its own, it isn't a force like gravity.  Instead illiquidity is a symptom of something wrong with a company.

The narrative in the market is that companies become illiquid because they're boring, old fashioned, or "too small".  In a minority of instances there are structural issues that results in the lack of liquidity.  A structural issue might be one where an insider owns 95% of the outstanding shares and the shares trade for $1,000 per share each.  But these situations are true outliers.  Most illiquidity is due to company specific issues.

What causes investor excitement and creates a situation where someone might want to trade a stock?  Why is GE liquid?  Why is Fastenal liquid?  They are both boring industrial companies that most investors would have a hard time explaining.  Fastenal makes nuts and bolts.  I've never witnessed someone standing in the bolt aisle of Home Depot pondering which brand of bolt is the most rugged.  I've never seen marketing material that proclaims "We use Fastenal bolts which leads to superior quality."  I guarantee if I went down to my garage and examined every nut and bolt in my tool chest I wouldn't find a brand name stamped on any.  But somehow there is excitement around this brand and the stock is liquid.

If a company can generate repeatable returns and shows growth it creates investor excitement regardless of the industry or product.  That excitement is quickly socialized throughout the investor world and other investors want to buy into that excitement.  The increased interest provides a ready source of buyers for current stock holders creating liquidity.  Sometimes it isn't excitement that investors crave, it's a dividend yield, or stability, or a historic brand name.  But there is a factor that generates interest, and the interest leads to a positive feedback cycle.  This is liquidity.

Illiquidity is the exact opposite.  The company has a deadly sin that they're carrying around with them.  Some investors discover this sin before they buy and decide to pass.  Other investors don't recognize the gravity of the situation before they purchase their shares.  A few quarters or years later they realize the error of their ways and look to sell, but there are no buyers, most everyone else has identified the cardinal sin and refuses to buy.  They refuse to buy unless the price is low enough to overlook the sin.  And even then most investors won't buy.  This "sin" can range from withholding information to overpaid management and anything in between.

A friend and I were recently discussing how people have different perspectives on potential deals depending on where they live geographically.  In general when presented with a deal people who live in the East and in cities have the following response "This looks too good to be true, I wonder what the gotcha is? How am I being played?"  They approach a deal skeptically until it can be proved otherwise.  Whereas in the Midwest and South when presented with a good deal most people think "that's so nice of them to give me an offer like that."  I've lived both experiences, and while the 'nice' attitude has never led to any ruffled feathers the cynical attitude has left more money in my pocket.

This same attitude is true for small, cheap and illiquid stocks.  Seasoned market veterans see something that rarely trades with a low multiple and think "what skeletons are in the closet?"  Whereas less informed investors think "wow, what a great deal! It's undiscovered!"

I can identify with both attitudes.  When I first started looking at these stocks I had the second attitude.  I thought I was discovering gold for the first time in Alaska.  I was finding these giant nuggets laying on the beach.  What I found out was starving grizzly bears roamed those same beaches full of gold and I was blissfully unaware that they were empty because everyone else knew it.

Now as a skeptic I look at these illiquid situations differently.  I'm cynical and think "what's wrong?" But there's a caveat to all of this.  Most investors pass on a stock if there is a bit of hair, I will buy a stock with hair if the price is right.  And if the price is that good I will wallow and roll in that hair and enjoy it because I got such a good deal.

Let's just say you purchased a stock with a whoolly mammoth amount of hair, but you also barely paid anything.  Maybe the seller even threw in a "free" operating businesses on top of that discounted cash you paid.  And you're sitting on this pile of assets for years and nothing is happening.  Then one day a tiny thought occurs in the back of your mind "what if nothing will EVER happen?"  Thoughts like that are easy to ignore when they're small.  But over time a thought repeated becomes magnified until suddenly one day you are convinced that nothing will ever happen to the stock...ever.

It's at this point when you realize you own a stock frozen in time that you're faced with the decision on whether to give up on the name.  Sometimes it's hard to give up, maybe the stock is illiquid and you are afraid you can't sell.  It's probably illiquid because everyone else knew it was going nowhere already.  What do you do?

The starting point on giving up on a stock is the same starting point for purchasing a position.  Why did you initially buy the stock?  What was the attractive feature?  If the original thesis is no longer intact, or it's changed, or morphed, or you forgot why you purchased then it's time to re-evaluate.  Look at the company with fresh eyes.  Would it earn a spot in the portfolio today?  Could you pitch the stock to a friend and by the end of the pitch your friend is getting out their phone to purchase?  This "friend test" is only valid if they weren't getting out their Blackberry or Apple Newton the first time you pitched the stock.  Pitch a stock to a disinterested friend.

Pitching a stock verbally to someone carries a significant advantage.  It forces you to be concise, few friends are going to listen to a rambling treatise.  In communicating verbally one needs to get to the most important facts first and elaborate on them with just enough detail to carry the argument.  We naturally organize our thoughts in an efficient manner.  We start with a hook and then back the hook, or the most important piece of information up with details and fill in gaps.  Yet when most pitch a stock in writing readers need to to use a magnifying glass and an hour searching for the point of the pitch.

If a company has completely changed during your holding period it's valid to sell.  It doesn't make sense to become sentimental about a stock.  Sometimes the company doesn't change at all, but the company's story becomes stale or outdated.  A great example of this is a potentially ground breaking company that spends years testing and trialing their product.  In the meantime their ground breaking developments are surpassed by other companies in the industry with similar inventions.  The failure of the company to release their product quickly led to a situation where other competitors developed a similar product and beat them to the market.  The company and their product might be the same, but the opportunity set has shrunk.

I want to deviate and discuss an item of importance related to the last point: companies that have trouble shipping products.  Businesses can't make money from promises, they can only make it via shipped products and services.  If a company has issues executing and releasing their products the company has a cultural issue, potentially a cardinal sin.  Unless a company is developing a new type of rocket engine or advanced satellite system it should be able to ship frequently.  But even rockets aren't an excuse, there are startups in the space industry that are frequently releasing new rocket designs.

When a company can't ship a product it's a failure of the personalities involved.  I've personally been involved on teams that both release products regularly, and others that fail to do so.  The ones that fail to ship are either plagued with poor quality team members, or have high level management issues.  If a company hires low quality workers it's a sign of the quality of management.  Low quality management hires low quality workers.  It requires a complete management cultural shift to change the hiring process.  This shift is about as common as snow in July.  The best way to hire quality workers is to have a high quality management team that is not intimidated by their subordinates that hires people smarter than themselves.

The single largest reason for a company's failure to ship products is a failure in management.  I've seen situations where management is like a piece of grass swaying in the wind.  One week they're heading one direction and the next week they've changed directions.  Without a steady direction a product team has a difficult time executing, they are always chasing their tails.  Another common scenario is when management team members are perfectionists.  Companies need to be satisfied releasing products that aren't perfect initially but then continually working to refine the product.  No one can release a perfect product on the first try, but that doesn't stop hordes of product managers from trying.  Beware of perfectionists, they can destroy a company.  Sometimes a product is just "good enough."

The best reason to consider giving up on a stock is when the value proposition isn't as good as the alternative.  Imagine a situation where you buy an undervalued stock with the expectation that it could appreciate a certain amount, say 50% and four years later the stock has barely budged.  Now as you evaluate the holding you're confronted with a similar situation that has the potential to appreciate 100%.  Given this scenario it's reasonable to give up on the first position and use the proceeds to purchase the second position.  The caveat to this is to beware of your forecasting ability.  Anyone can create a "fair value" out of thin air.  Look back at your prior predictions and evaluate how they turned out.  If you always expect a stock to appreciate 50% and instead they settle at a fair value 25-30% above your purchase price then you over estimate fair value and should revise your estimates downwards going forward.  My sense is most investors fall in this camp.  They expect everything they buy to appreciate 3x/5x/10x and then two years later sell once it's appreciated 103%.

It's better to be consistent with lower returns verses less consistent with higher returns.  Consistency is what generates long term results.  Likewise it's better when your accuracy in forecasting the probability of a loss is higher.  Long term returns are the direct result of the lack of losses.  This concept won't find many followers in a raging bull market, but it'll become the siren song as the market crashes.

To summarize at this point if you're holding a stock where the story changed, the company changed, the company failed to execute on plans or you have better opportunities it's time to sell.  Now let's talk about the hardest time to hold.

There are dozens of small companies off the radar that are selling at extremely low valuations with low liquidity and anemic progress.  These are the classic "value traps" where investors whittle away opportunity cost for years.  They're illiquid, so as mentioned above they have issues with them reducing investor interest a well.  I own a few of these in my portfolio.  The types of stocks where if someone discovered them they'd be worth 3x-4x their current value.  The problem is the story hasn't changed yet they still offer excellent value.  What's an investor to do?

I can have extreme patience when a holding is unfairly valued and the company is moving in the right direction.  I don't have much patience, and will actively avoid situations where a company is a melting ice cube.  If a company is eating outside capital, or eating their own capital in an effort to stay afloat or transform then time is positioned against the investor.  The company is hoping their transformation or new products will outrun their limited time frame.  Sometimes this happens, but often it doesn't.

The best situation is one where a company is growing, even very slowly and can fund themselves out of profits.  If a company is profitable but the market doesn't recognize their current plight shareholders who are patience accrue value to their investment by doing nothing.  When a company pays a dividend and returns cash to shareholders it makes being patient much easier.  The hardest time to own a stock is when nothing is happening quarter after quarter and year after year.  Even if a company is slowly growing and paying a dividend, the lack of inaction cultivates seeds of doubt in our minds.

Most of the time investors give up on stocks because nothing is happening.  It's a crazy premise when considered.  Do farmers give up on corn because they don't see it growing daily? Investors are like my kids who will sometimes ask "did I grow last night? How much taller am I today?" as if each night they add an inch or two.

To carry with the farming analogy.  Plant your investment seeds and wait for them to grow.  If the plant is on track and healthy see it through to harvest no matter how long it takes.  If at some point during the growing season you notice the plant isn't growing, or something is wrong with it then it's time to cut loose and move on.  But otherwise stay the course.