Why it's always sensible to review the positions in your portfolio
Rupert Hargreaves
Apr 27, 2020
One of the most significant advantages we have as individual investors is the ability to say no to any investment. We are never obligated to take an investment opportunity. If we're offered something we do not like or understand, we don't have to buy.
Many institutional investors do not have this level of flexibility. If an institutional investor with substantial ownership of a particular business declines to participate in a fundraising or dumps a holding without much warning, it can raise some very serious questions.
The 'too hard' pile
Warren Buffett (Trades, Portfolio) is well known for having a 'too hard' pile for investments he does not understand. This is something every investor should have. Sometimes it is impossible to understand a company and how it makes money. That's ok, even if the business goes on to outstanding profits. If you don't understand enough about the company in the beginning to invest, you are exposing yourself to more risk than potential reward.
Let's take Amazon.com (AMZN, Financial) as an example. There are probably tens of thousands and investors around the world who are kicking themselves for not investing in the retail behemoth earlier and riding its success over the past two decades, but this ignores survivorship bias. How many other thousands of online retailers have collapsed over the past two decades? If you don't understand the sector, there's no guarantee you'll pick a winner. Even if you do understand the industry, this continues to be the case.
Pabrai sells 'too hard' investments
I recently read Mohnish Pabrai (Trades, Portfolio)'s latest letter to his investors. Like many other hedge fund managers, over the past few weeks, Pabrai's portfolio has suffered significantly.
He hasn't been afraid to make some adjustments to his portfolio during this period. One significant change the value investor made to his portfolio this year has been the sale of the holding in Fiat Chrysler (FCAU).
Pabrai first invested in the automaker in 2012, when the stock was trading for around a price-earnings ratio of 1.0 (based on management's projections). This was one of Pabrai's typical "heads I win, tails I don't lose much" style investments. According to his calculations, there was a small risk that the company would collapse over the following years. However, he saw the potential for a four or fivefold return in the base case if management met their growth objectives.
Over the next few years, the company did meet its growth objectives. The stock went up to ten times the buy price, excluding the effects of several spinoffs that also took place.
Before the Covid-19 crisis struck, Pabrai was still optimistic on the outlook for the business as it pushed ahead with peer PSA. Hhe started to divest some of the holding towards the end of last year to take advantage of opportunities appearing in other markets, notably in Turkey and India, but according to his investor correspondence, Pabrai was planning to keep the bulk of the holding through an intended merger.
Then, everything changed in the first quarter of 2020. As uncertainty started to spread throughout the global economy, the outlook for the auto industry started to deteriorate. Pabrai decided to jump ship due to the industry outlook.
In his first-quarter letter to investors, he said that he decided to take this course of action because it was becoming too difficult to understand how the crisis would affect Fiat and the demand for its vehicles. Even though he was still optimistic about the business outlook just a few months ago, Pabrai made the tough decision to sell.
Sometimes, this is the best course of action. If something becomes too difficult to understand, it is better to walk away rather than hope for the best. If you cannot work out how a situation will impact a business, it becomes impossible to value that enterprise. Buying a stock without understanding what it is worth is not investing; it's speculating.
Disclosure: The author owns no share mentioned.
Read more here:
- Warren Buffett's 4-Step Investment Checklist
- Seth Klarman on 'Value Pretenders'
- Seth Klarman and George Soros: Reflexivity and Stock Prices
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