What drives a stock price higher? While the question may come across as rhetorical, it ties into the very essence of stock market investing. The answer may shock you for how simple and trivial it is. It’s all about having more buyers than sellers. It’s ideal to be the first person in the stock, but you also need to wonder what’s going to generate more investor buy-in, into the name.
Investing is as much about psychology and intuition, as it is about valuation and fundamentals. John Keynes, the father of Keynesian economics and one of my personal heroes, described the shrewd investor as one who’s able to anticipate the anticipations of others. It requires a high degree of objectivity and clarity. Prior to initiating positions in companies, one would evaluate their business. There are three critical feedback loops that separate the best businesses in the world from everyone else. The best businesses attract the best talent, they have an enduring competitive advantage in attracting customers and they can attract sufficient capital to grow. Valuation alone never makes for a compelling investment case. Clear communication and a wholesome understanding of the investment thesis are critical before any decision is weighed.
Earlier this year, Synchrony Financial, a large-cap US consumer finance company, posted its results showing a whopping 45% increase in its provisioning for credit losses. Were they growing their portfolio at the expense of quality? Possibly, it was a direct hit to earnings. The stock plunged some 16% that day. Panic-stricken investors were quick to hit the sell button, I was one of them. I lost sight of why I had invested in the company in the first place. Credit trends were in its favor, the cycle was in its favor, tax reform would help it out, the emphasis on Big Data and the shift from cash to card would round out all the catalysts needed to make the stock work. It was a growing company that had all the makings of a ‘conviction long’ pick but I bailed, I sold for the wrong reasons. I reacted and moved on impulse, it was a jerk reaction that cowered at the sight of a ‘bad’ number. In peeling the onion, the facts would be made clear. Margaret Keane, the CEO, poorly communicated the rationale for the increase. The reason for the elevated PCL reflected revised underwriting standards, a higher reserve build and organic growth in the loan portfolio, they call it credit normalization. There was little cause for alarm. I sold at $27 and change, it’s currently trading just shy of $39, anywhere between 2.2-2.25x on a Price to book basis.
The toughest investment decision one can make is the decision to sell, specifically, selling investments that have declined in value. It’s a step that involves quite a bit of psychological warfare. It can be crippling, you are realizing a loss. The key is to remain principled and pragmatic, those that try to get even tend to get even worse. That was me. Never be so married to an idea that it clouds your judgement and impairs your thinking.
When Brian Porter took over as CEO of Scotiabank, he made some incredibly difficult decisions to restructure the organization, accept one-time charges, reshuffle the senior management team and spearhead the digital transformation of the bank in Canada, the Pacific Alliance and in Latin America. Prior to making these difficult decisions, Bank of Nova Scotia was spread way too thin, in far too many geographies, they couldn’t leverage the benefits of scale to truly realize the outsized returns that ‘emerging markets’ exposure should theoretically offer. The stock would trade over the years, go through its normal ebbs and flows. Critics of the decision at the time warned of the fallout that would ensue: staff morale would suffer; there would be a talent exodus, and this would dramatically bite into earnings.
Fast forward two years and the reality paints a very different picture. The company is seemingly the flavor of the day and is doing very well, the restructuring of their LatAm business freed up capital for the bank to deploy in accretive opportunities like the recently announced BBVA deal in Chile. It also allowed them to approach their business going forward with a blank canvas, it was a complete reset of the story and of expectations. Instead of treating the symptoms, Porter tackled the cause of the pain. He was not married to any of his business lines, he understood the merits of letting go, even if it entailed near-term pain. Longer term, investors rewarded him for his decisions.
If a stock’s decline is a function of an impairment to your investment thesis, then you should exit the stock if you cannot determine whether the near-mid term headwinds can be mitigated or even reversed.
Investors, as well as people, should learn to let go. A couple of years ago, I invested in Mattel, the parent of Barbie and American Girl. The company was experiencing accelerating growth and was performing admirably, it had an exclusive licensing agreement with Disney that would allow it to sell Disney branded products. The Frozen franchise was a Rockstar by all accounts and was quickly turning into a multibillion dollar empire, all on its own. In late 2015/early 2016, Mattel would issue a statement that would materially derail my thesis: Mattel announced that it had lost its partnership agreement with Disney, to its arch rival Hasbro no less.
Multiples reset lower in a big way, I tried to be too cute and pick a bottom, I rode the stock all the way down. My faith in the name didn’t waver, I trusted that the management would find an alternative solution to replace the Disney sized attrition that it was about to experience. Eventually, the CEO was fired and a new one was brought in. I was optimistic again, I put my faith in a CEO with e-commerce experience at Google. I thought she could right-side the ship, grow the digital channel materially and bring the business to the digital age, she didn’t. It was a show-me story, but I was already invested. They had an investor day that all but reaffirmed their failing proposition.
My judgment was clouded, part of me knew what the outcome would be but the other part refused to believe it, I refused to realize my loss. I was hoping for a change in fortune, but that was wishful thinking. Sometimes ripping the band-aid off is what’s needed before the damage is made permanent.