Dealing with losses

Every time markets fall sharply, many investors are left holding a stock priced way above its current value and an unanswered question, “should I book losses?” Many small investors become value investors all of a sudden and start talking about the long term. Some go aggressive and resort to dollar cost averaging i.e. buying more to reduce average cost price. Most of them panic and sell. We analyze all these options to help you find the right strategy in a falling market scenario.

Holding a stock for long term is not a sure shot way to returns. Warren Buffett once said, “Time is a friend of wonderful businesses and enemy of lousy businesses. If you are in a lousy business for a long time you are going to get lousy results even when you buy it cheap. If you are in a wonderful business, even if you pay a little too much going in, you will get wonderful results if you stay for long time. ”

If you have bought a stock of a good company, significantly above its fair value, part of the gains in the fair value of your growing business will go to cover the extra price you paid; and but if the company is exceptional, you may get good returns even in such cases.

The following table compares the long-term results of buying a stock at a price substantially above its fair value. Infosys Technologies, a force to reckon with in IT services, was selling 319 times its earnings per share at the peak of the internet bubble in March 2000. Himachal Futuristic Communications Ltd(HFCL), a favorite of speculators, was quoting at even more insane valuations. In the next 1.5 years, the stocks fell by 87.5% and 97.5%, respectively from their peaks.

Company	Price MAR 2000	Price SEP 2001	Price SEP 2007	Price AUG 2008	Sales Growth in 8 years	Net Profit Growth in 8 years
Infosys	1,727.00	269.00	2,439.00	1,693.50	1880%	1420%
HFCL	2,553.00	24.90	27.60	16.75	-75%	127 cr profit to 150 cr loss

If you held both stocks you would have got two different results. Infosys recovered due to splendid growth in its business but HFCL didn’t. This illustrates the point that the key is not investing for the long term, but being invested in good businesses for long times. If you buy a good business but you overpay, you will reduce your returns in the short term but you are still better off holding the stock. If you bought Infosys at Rs 269, your annual returns in the next seven years would have been 30%. If you paid twice that amount, your returns will fall to 17.8% but they are still good enough. If you invested in HFCL though, you were doomed the day you bought that stock.

As you can see, the question is not about time but about the type of business you are invested in. If it’s a speculative stock that you bought because your uncle’s, friend’s stock broker termed it as a gold mine, SELL. (There is one exception to this, which we will discuss in the end).

If the business is outstanding but the stock price falling after you bought, should you not try to bring your average cost down by buying more? Suppose you buy one stock of a company at its all-time-high and it starts falling. For the next three years, you buy one more stock at the day’sclosing price every day. Your buying cost would be the average price of that stock in those three years. If the markets are mostly correct in valuing the businesses, your purchase price would be fair price and then, you can hold for the long term because you have bought a good stock at a fair price.

The argument sounds interesting, but it has a catch. First of all, the market prices do not always reflect the fair value of a business. They can not only be significantly higher (or lower) than the intrinsic value, and they can remain at such high (or low) prices for a significant amount of time.

You should never put your hard earned money in a lousy stock in the first place but if you do, it’s never too late to sell. In 2000, I made a mistake to invest in Global Trust Bank at Rs 80 per share. I repeated that mistake buy buying more as it fell. I was happy that I had managed to reduce my average purchase price to Rs 11 by buying aggressively as it fell. I was increasing my investment in a lousy business all along.

The bank had loaned money to stock brokers who were losing money as the market fell. I kept holding the stock for few years until news reports arrived that the bank’s net worth had been completely eroded. It was sold to Oriental Bank of Commerce. The acquirer paid no price except assuming GTB’s liabilities. Even when it was all clear, the stock was still selling at around Rs 4 which was an insanely high price for a worthless piece of paper. I sold off all my stock for all it was worth and bought few wine bottles instead. I had, finally, made a right decision.

There can be only one case where you can hold a lousy business. That is when it is selling at two thirds or less than its net current asset value. The Net Current Asset value is current assets minus total liabilities, which reflects the money that the equity investors can get out of the business when they liquidate it and pay off all liabilities. However, if the company is running into losses and burning its cash, you may still not gain much because the current assets will be eroded before you manage to find a buyer to buy it above its net current asset value. But in such cases avoiding a panicked fire sale is usually the right decision

The advice is incomplete if I didn’t tell you this: the best way to deal with losses is never to incur one. If you think it is difficult, I disagree.