Thursday, February 7, 2013

When A Good Investment Goes Bad

When the facts change, I change my mind. What do you do, sir?

                                                            -John Maynard Keynes

One of the hardest parts of investing, it seems to me, is to admit that an investment has gone sour.

None of us like to make mistakes. When it comes to stocks, selling a stock at a price lower than it had traded in previous days is painful, particularly if the sale results in a realized loss.

There have been numerous academic studies trying to understand why investors are quick to take profits, yet slow to realize gains.  One study I read actually measured the brain waves of participants with regards to stock trading, and found that taking even small losses caused psychic pain.

Yet losses are part of investing.  No matter how diligent the manager, or how thoroughly a particular stock idea is studied, inevitably some of the ideas will not pan out.

In general I will sell a stock for one of three reasons:
  1. If a stock has risen to a level where further upside seems limited compared to other stock alternatives;
  2. If facts are uncovered that prove the initial evaluation incorrect;
  3. If something has fundamentally changed at the company.
This week has been a painful example of how a good investment can go bad.

Last November I bought shares of CH Robinson Worldwide (CHRW).  CHRW is one of the largest third-party logistics companies in the United States.  It provides global multinational transport and logistics solutions.  CHRW maintains the largest network of transport carriers in the U.S., with a heavy concentration on trucking.

For years, CHRW had been a "growth" story.  Investors loved high return on equity (anywhere from 25% to 30%) and huge free cash flow (CHRW has no debt).  The company could maintain margins because of its dominant position in the logistics business.  Most importantly, company management consistently emphasized its belief that it could grow its business at +15% per year without sacrificing margins.

Because of its strong pattern of consistent revenue and earnings growth rates, the valuation of CHRW always traded at a premium to the stock market. 

Historically the P/E multiple of CHRW had traded in a range of 20x to 30x earnings.  When the stock traded at the lower end of the range - as it was last November - it normally was a good time to be buying the stock.

There were other reasons to buy CHRW last November.  Without going into too many details, the company had exited some slowing growing parts of its business, and made a major acquisition that held great promise to help achieve its +15% per annum growth rate.

So I bought the stock for clients in the low 60's, and watched it climb to nearly $68 a share by the end of January.

But then the company reported earnings earlier this week.  While I typically don't like to sell on quarterly results, there were too many red flags to ignore.

Margins continue to be under pressure, and management seems to have shifted its attention from profits to maintaining market share.  More importantly, management's long term mantra of +15% per annum growth rates was noticeably absent from its comments to Wall Street.

In short, it now appears that the story for the company has fundamentally changed (please see rule #3 above). And so, much to my chagrin, I have sold the stock, mostly at a small loss.

The agony that I now feel is very familiar to behavioral psychologists.  We berate ourselves for missed opportunities, or for losses that we feel that we should have been able to foresee.  And in doing so, we often miss the whole picture; namely, when something changes, so should your opinion. Selling a stock at a small loss, and looking for the next opportunity, is how investors should react when situations like CHRW arise.

Nobel Prize-winning psychologist discusses all of this in the video above.