One of the more difficult aspects of investing is knowing when to walk away from an investment. Selling, as they say, is the hardest part.
Not only because of the numerous biases investors face after an investment is made, but the impact of change — the kind that destroys companies — is difficult to recognize in the moment.
Selling is tough enough if investors are saddled with over-optimism, groupthink, confirmation bias, endowment effect, status quo bias, and the always difficult sunk-cost fallacy, to name a few. If you’re confident the company is fine, surround yourself with people that think the same, only look for affirming evidence to the fact and ignore the rest, overvalue the investment simply because you own it, and let all the time, money, and emotion you’ve “invested” in a single stock infect your decisions, then selling will be a grueling experience.
To complicate things further, the value of companies change all the time. Not always at the same rate as its stock price. It gets especially confusing when the company’s value and stock price move in opposite directions. To sum it up, selling is hard!
More to the point, though, businesses change. Management, competition, customers, innovation, regulation, the economy, and more impacts businesses in, sometimes, unforeseen ways. And it’s not always for the better. Which happens to be a key reason to sell.
The question then is what do investors need to do to recognize when a company changes for the worst? Bernard Baruch has a simple three-step approach to evaluating companies that might help.
This fact, that the value of an investment can never be counted upon as absolute and unchanging, is one reason why I urge everyone to make a periodic reappraisal of his or her investment position… Time and energy are required to come to a sound judgment of an investment and to keep abreast of the forces that may change the value of a security…
In evaluating individual companies three main factors should be examined.
First, there are the real assets of a company, the cash it has on hand over its indebtedness, and what its physical properties are worth.
Second, there is the franchise to do business that a company holds, which is another way of saying whether or not it makes something or performs a service that people want or must have.
I have often thought that perhaps the strongest force that starts an economy upward after it has hit bottom is the simple fact that all of us must somehow find a way to live. Even when we are sunk in the blackest despair, we have to work and eat and clothe ourselves; and this activity starts the economic wheels turning anew. It is not too difficult to determine the things people must have if they are to continue to live. Such fields usually open up investments which are likely to hold their value over the long run.
Third, and most important, is the character and brains of management. I’d rather have good management and less money than poor managers with a lot of money. Poor managers can ruin even a good proposition. The quality of the management is particularly important in appraising the prospects of future growth. Is the management inventive and resourceful, imbued with a determination to keep itself young in a business way? Or does it have a sit-and-die attitude? I have learned to give less weight to big financial names at the head of a company than to the quality of its engineering staff.
These basic economic facts about various enterprises, to repeat, must be checked and rechecked constantly. Sometimes I have made mistakes and yet, by abandoning my position in time, still was able to emerge with a net profit.
The goal with constant evaluation is two-fold: to prevent a big gain from turning into a loss and to limit the number of small mistakes that become huge losses. Getting out the moment you recognize something’s amiss can save you a fortune. Of course, that requires more than a surface-level knowledge of the company.
Baruch added two tips in his evaluation steps that should be helpful for those willing to put in the extra work.
The first tip is where to place bets. There are two clear paths to investing that work — a bet on change or against it. Venture capitalists are constantly betting on change. They’re looking for companies that will disrupt the status quo by transforming an industry with a new technology or creating a new industry entirely.
A guy like Warren Buffett bets against change. He wants companies built like fortresses, impervious to changes in competition, innovation, consumer habits, and economic conditions. Baruch suggests a similar path — invest in companies that are more likely to retain their value — least likely to change.
Look for things people are highly dependent upon on a day-to-day basis because the companies behind those products or services not only have a better chance of retaining their value, some will continue to grow. The lack of change adds a layer of protection to your portfolio. You can take it a step further and look at the products or services those companies rely on to run their day-to-day business. Then do a deep dive into the company.
The second tip is about management. Does management “keep itself young in a business way” or “does it have a sit-and-die attitude.” How many companies have sealed their demise because management was overconfident and failed to change with the times?
Two infamous examples come to mind. Blockbuster refused to buy Netflix for $50 million and failed to foresee the transition to digital. Then there’s Yahoo! It’s the epitome of management failure. Management failed to recognize the future of search engines and social media. They failed to buy Google twice (first for $1 million, then later for $5 billion) and Facebook (for $1.1 billion) by undercutting their offer price. They finally sealed the company’s fate after rejecting Microsoft’s buyout offer of $44 billion.
In both cases, the shareholders who suffered the most failed to see management for what it was, failed to sell the instant they noticed, and/or never bothered to put in the work to find out.
Investing in individual companies requires significant effort and open-mindedness compared to, say, index funds. Of course, to do that, you actually have to follow what Baruch and other investors have preached. Dedicated study. It means knowing the company, the industry, and any potential risks so well you know when it’s no longer a good investment.
The mistake is believing a company will always be great.
Baruch: My Own Story
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