It’s not always easy to own up to our investment mistakes. But the reality is that occasional dodgy stock picks are a fact of life for active investors. Sometimes the facts change after we’ve bought the shares. And sometimes we spot things after we’ve invested that we didn’t see before we hit the ‘buy’ button.
What’s most strange isn’t that we make mistakes. It’s that we become so attached to our stocks, and are often unwilling to act on fresh information. Psychologists call it anchoring. Investors become attached to their original purchase price and to a stock’s ‘story’.
You’ll hear people say things like “I’ll sell when I get back to break-even”, or that “xyz shares are obviously worth at least £2 each”. Unfortunately, holding onto stocks for which the outlook has changed is often a recipe for bigger losses.
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Here’s what you should do
I aim to regularly revisit the shares in my portfolio. What I try to do is to find problems or weaknesses in my investment case. I ask questions like these:
- Does my original valuation still make sense, based on the latest accounts?
- Is the company’s performance improving, or have problems emerged? If so, are they fixable?
- Are broker forecasts rising or falling?
- Have important board members resigned unexpectedly?
- Finally, I ask whether I’d still buy the shares today.
If the answer to any of these questions is negative, I consider whether I should sell.
When considering whether to sell, I try to forget what I paid for the stock. If a share is a ‘sell’, then it shouldn’t matter what you paid for it. Following this rule is tough, but I believe it pays off in the long term by helping to minimise losses.
My latest mistake
I’m going to round off this piece by taking a look at a company where I recently changed my mind and sold, accepting a 10% loss.
The company in question was Royal Mail (LSE: RMG). On the face of it, the stock looks attractive. Consensus forecasts show adjusted earnings of 38.9p per share for 2017/18, putting the stock on a forecast P/E of 11.3. The forecast dividend of 23.8p per share implies a tasty 5.4% yield and appears to be comfortably covered by adjusted earnings.
My concerns started when I noted the big difference between last year’s adjusted earnings of 44.1p per share and the group’s reported earnings — excluding all adjustments — of 27.5p per share. Which figure should I trust? If reported earnings were more accurate, then dividend cover for last year’s payout of 23p per share was very slim.
The adjusting factors were quite complex, but what I noticed was that free cash flow before acquisitions was £275m. This is almost identical to the group’s reported net profit of £273m, so this lower number seemed a reasonable estimate of last year’s cash profits.
Using reported profit puts the stock on a P/E of 16, which doesn’t seem that cheap.
I’m also increasingly unsure about Royal Mail’s growth potential. The group already has 50% of the UK parcel market and must continue to support a declining letters business. Although overseas expansion appears to offer opportunities, I’m concerned that growth could be slower than expected over the next few years.
