At some point you’re going to buy shares in a company and then that company’s is going to issue a profit warning, stop growing or perhaps even cut its dividend. The question then is: What to do next?
You have three main choices:
- Buy more shares – To be honest this is pretty unlikely unless you’re a hardcore contrarian investor
- Keep holding on – This seems like a sensible option, buy it might make you feel nervous and uncomfortable
- Sell those shares pronto – In my experience this is the option that most investors go for
Exactly what you should do will depend on your overall investment style.
If you’re a defensive value investor like me then in most cases I think it’s a mistake to hit the sell button straight away.
In the rest of this article I’ll explain why I think that, but in essence it comes down to two factors:
- Value investors often invest in companies that subsequently underperform
- Most of those companies eventually turn things around and recover
Why value investors often buy companies that subsequently underperform
Value investing is the art and science of trying to buy companies for less than the true or “efficiently priced” value of their future cash returns to shareholders (mostly dividends and share buybacks).
Why would a company’s shares sell for less than their true value?
There are many possible reasons, but often it’s because most investors think the company’s future prospects are either highly uncertain or poor. As such they expect the company’s future cash returns to be lower and so the share price falls to reflect this opinion.
The key point here is that a company’s share price is a leading indicator.
The share price drops today because of investor sentiment about a company’s future results.
A good example of this is the recent EU referendum.
Immediately after the UK voted to leave the EU (which the market initially perceived as bad news) the FTSE 100 sank below 6,000. Market participants were worried about an immediate recession, which so far hasn’t materialised.
What impact did the EU referendum have on company accounts the following day?
None, of course; one day is far too soon for any impact to show up.
Even now, after a few months have passed, only a few companies are showing any meaningful impact from the vote in their balance sheets and income statements. Given that the actual process of Brexit has barely begun, this should not be a surprise.
So share prices fall or rise today because of expectations about the future, but the realities of that future will unfold in their own good time.
But the market is not stupid. If the market is pessimistic there is usually a good reason, and many companies trading at attractive valuations do in fact run into fairly serious problems.
As a result, value investors often buy “too soon”, i.e. when the share price drops, and then subsequently see the company’s results decline over the next year or two.
However, the fact that many value investments go through a period of underperformance is not necessarily a reason to avoid investing in those companies.
Because if you pick a fundamentally sound business in the first place then most of those that do run into problems will eventually recover, as will their share prices.
Why value investors have to be patient
Have a look at the horribly complicated chart below:
I have a feeling I should explain that picture, but hopefully I won’t need a thousand words to do it.
Basically the chart shows the life of a fairly typical defensive value investment over a number of years. The sequence of events goes something like this:
- The company is growing and the market is optimistic about its future. The company’s earnings and share price are increasing rapidly and everybody is happy.
- Some bad news (perhaps a cautious outlook for the next year) is announced. The share price starts to decline but as yet the company’s earnings (and revenues and dividends) are unaffected.
- The market and the media become pessimistic about the company’s future. The share price declines by 50% over the next few months as earnings growth comes to a screeching halt.
- Value investors begin to buy because the company now has a combination of a solid track record of growth and an attractively low share price. The company is fundamentally sound and value investors assume it can overcome its problems.
- Over the next year or two the company’s earnings decline. This is the first concrete evidence that the bad news is having a serious impact on the company’s performance. The share price continues to fall and value investors (who typically buy too soon) are now 25% underwater on this investment.
- Nervous investors sell at the point of maximum pessimism. The company’s earnings and share price continue to decline, everything looks bleak and the company is considered a basket case. The dividend may even be cut or suspended.
- A new CEO and CFO are brought in. Much of the rest of the board are replaced and a turnaround strategy is announced.
- The market is cautiously optimistic about the turnaround strategy. The share price begins to climb but the company’s results continue to decline, although this is no longer a surprise.
- Over the next two or three years the company begins to turn around. Debts are reduced, efficiency and profitability become the centre of attention and revenues, earnings and dividends begin to climb. The share price is rising rapidly as the market becomes more optimistic.
- The company is growing and the market expects that growth to continue unabated. As a consequence of this optimism the share price and valuation multiples are high. Value investors begin to sell in order to hunt out new contrarian opportunities.
Of course this is a stylised account of a defensive value investment. None will look exactly like this, but quite a few will look something like this.
I would say that my investments can be categorised into three groups:
- Companies and share prices that do well from day one. These are the easiest investments and about half of my investments have turned out this way. Examples are Reckitt Benckiser, Hill & Smith and Cranswick.
- Companies and share prices that struggle but eventually turn around. These are the ones that are similar to the story above. About a third of my investments go through a multi-year difficult patch but eventually come out the other side and perform well. Examples are ICAP, Greggs and AstraZeneca.
- Companies and share prices that struggle and are sold at a loss. These are the ones that don’t turn around either sufficiently or quickly enough for me to want to keep holding. These are the ones I want to avoid, although I accept that investing in the occasional loser is inevitable. About one in six of my investments end up this way. Examples are Chemring, Tesco and Serco.
The key point here is that if you’re a defensive value investor like me then about half of your investments are likely to go through a multi-year rough-patch, where revenue, earnings and dividend growth is negligible or negative.
But, about two in every three of those should turn around and end up as successful investments.
So if you sell out when a company begins to underperform the odds are that you’ll be avoiding more winners than losers.
Of course I can’t tell you what you should do with your money, but here’s what I do:
- Buying: I try to buy shares in fundamentally strong and robust dividend-paying companies (but only when they’re cheap, of course)
- Holding: If the company starts to underperform, I’ll hold on. If I bought a good company to start with it should be able to recover within a few years at most. During this period I would probably avoid adding any new money to this investment given the increased uncertainty about its future.
- Selling at a profit: If the company recovers well and the market becomes optimistic (i.e. the share price increases by much more than the company’s earnings and dividends) then I’ll sell to lock in profits and avoid holding an overpriced stock.
- Selling at a loss: If a recovery never comes or if the company suspends its dividend for more than a year I’ll sell and move on. I always do a detailed post-sale autopsy in order to learn everything I can from my investment mistakes in order to reduce the odds that I’ll repeat them.
Currently the UK Value Investor model portfolio has about eight holdings out of 30 that are in this twilight zone of underperformance. That’s more or less what I’d expect to see.
I also expect to see most of them recover and go on to be successful investments.