Nick Train is a highly respected fund manager in the City. A lot of you probably hold money in one of his investment trusts. He’s one of the few active managers that has beaten the market comfortably over a long period of time.
But he’s had a bit of a nightmare with one particular stock. Pearson has been in the middle of a transition from publishing powerhouse to educational specialist for a while now, and it’s fair to say that the process has not been smooth.
The company has issued five profit warnings in the past four years, starting in October 2013. The fifth one happened last month. The share price dived by 27.5% on the day.
We’ve all bought dodgy stocks in our time. And we’ve all looked at “falling knives”, and wondered if they’re worth trying to grab.
So what can we learn from how Train has dealt with this particular dud?
The never-ending story of Pearson’s profit warnings
Nick Train has been having to make excuses on Pearson’s behalf since at least 2014. He was sounding quite fed up at an AGM I attended last year, when Pearson’s latest annual profit warning had battered the stock once again. And I can imagine he was even more irritated at this year’s.
But he’s decided to stand by the stock. According to Citywire, he and co-manager Michael Lindsell “have decided to stick with the trust’s position [in Pearson] and say they will look to add to it when they see evidence of improving cash flows and a stronger balance sheet”.
Now, I’m not going to try to second-guess one of the most successful managers in the market. I will say right now – and it’s hardly a controversial view – that it was clearly a mistake to hold on to Pearson for this long.
Equally, however, I think Train is quite right to buy more.
Why? Because the only way you can justify not selling out of a major loser, is to be willing to buy more of it.
That might sound a bit odd, so let’s talk about it in more detail.
No one buys a stock (or any other investment) in the expectation that it is going to issue a series of profit warnings and halve in value before it reaches the promised land of epic returns. If you thought a stock would fall by 50%, you’d wait for the fall first.
So if this happens to a stock that you have bought, then one thing is very clear: you were wrong. Whatever reason you bought the stock for – be it a well-considered analysis of the accounts, or off the back of a tip you got down the pub – that rationale has been proved wrong.
This is why you should have an investment journal – so that you can revisit your decisions and double-check your rationale for buying in the first place.
In short, you made a mistake. You might find that uncomfortable to acknowledge, but sticking your head in the sand and your fingers in your ears won’t make your money magically come back.
So you need to get over it. At the end of the day, who cares? Investing is an uncertain business. We all make mistakes. It’s annoying, but it happens. Accept it. Move on.
The one thing you need to do if you’re holding a big loser
The important thing is what you do now. There’s one thing you very specifically shouldn’t do, and that is ignore it.
There’s a short but informative book on the topic of buying and selling stocks called The Art of Execution by Lee Freeman-Shor. (It really is short though, as my colleague Cris pointed out in his review – if you want to pick it up, get a second-hand copy).
Freeman-Shor runs through the habits of expert investors and how the most successful ones (in his experience) deal with both stocks that go up (when do you take profits?) and ones that go down (should I stay or should I go?).
His main point reflects Train’s philosophy: there are no “holds”. If a stock has gone down heavily, then you need to make a decision. You either cut your losses and sell out, or you buy more. You can do either one – but you have to act.
How does that work? It’s simple. If you look at the stock afresh, and think: “Would I buy this today?” and the answer is “no”, then you had better sell out. There are better opportunities for your (albeit) diminished capital elsewhere.
If you look at the stock and think “Would I buy this today?” and the answer is “yes”, then good for you. But then you had better follow up on that view and invest more money in the stock.
Why? Because firstly, if it was a “buy” when it was double the price, and you believe it’s still a “buy” now, then why wouldn’t you load up?
Secondly – and perhaps more to the point – being forced to confront the idea of putting new money into the stock will really focus your mind and force you to be honest. Do you really think this stock is still a buy? Or are you just saying that because you don’t want to admit that you were wrong and crystallise a loss?
It’s good discipline. And having good discipline is the only way to make sure that your inevitable mistakes in investing don’t irreparably damage your portfolio.
I can’t say whether Train’s decision to double-down on Pearson is the right decision or not (it hasn’t been so far). And I also wonder if at this point, it’s simply less painful cognitively to buy more of Pearson than to throw in the towel. After all, Finsbury is essentially built on a “buy the right stocks and hold them forever” strategy.
I might take a more in-depth look at Pearson in a future MM – my gut feeling is that it has further to fall, but that’s an impression, not informed analysis.
It’s encouraging to see a fund manager sticking to his process. And that’s the main lesson to learn. You can never guarantee a good outcome in investment. But you can increase your odds greatly by making sure that you have a method, and that you stick to it – even when you’d rather not.