Why it pays to face up to your investment mistakes

(A note from John: just before we begin this morning – next month I’m pleased to say that I’m going to have the opportunity to chat to Roland Arnold, manager of the popular BlackRock Smaller Companies investment trust, all about his views on the outlook for Britain’s smaller companies. Make sure you don’t miss it – register for the webinar now. It’s free!)

A few months ago, I decided to cut my losses and sell out of Riverstone Energy (LSE: RSE).

It had been a terrible performer. It lost 17% in 2018, 59% in 2019 and 33% in 2020, and although it had doubled from the March 2020 low, it had become my smallest holding. So I decided I should either increase the holding or sell.

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It had changed strategy – switching away from investment in North American hydrocarbon projects, an area in which it had accumulated considerable expertise, into renewable energy, in which it appeared to have no competitive advantage. So I sold.

Since then, the shares have risen by more than 50%.

Even if you sell for the right reasons, it doesn’t always go well

Since I sold out of Riverstone Energy, the share price has been propelled upwards by a steady stream of positive news. And even now, the shares still trade at a 30% discount to the mid-year net asset value.

My reasons for selling were sound, but it was still the wrong decision. “Run your winners and cut your losers” goes one of the best investment adages – but the losers sometimes bounce back dramatically.

Most good investors buy for the long term and trade infrequently, but that does not mean never. For example, an investor in the US who had not traded for 25 years would now own few of the S&P 500’s top ten companies.

So is there a secret to selling “well”? Every presentation by a professional fund manager includes a slide on “selling discipline”. It always lists the same four triggers:

1. When the investment thesis changes

2. When the shares become too expensive

3. To raise funds for a better investment idea

4. To prevent a successful investment becoming disproportionately large

(There should be a number 5 – “recognition of a mistake” – but professional investors don’t like admitting to these.)

Yet following these rules is far less straightforward than it sounds. Companies that do not evolve their business do not survive – but the dividing line between evolution (good) and change (bad) is not clear.

The shares of good companies ought to be reassuringly expensive; cheapness may indicate problems in the business. It is also natural to find new ideas more attractive than old ones, but investors need to resist that bias. Trimming top performers means limiting the gains on the most successful investments.

For a professional investor, taking a profit is often motivated by a fear of looking foolish if the share price goes back down. Internal rules about maximum position sizes, enforced by a compliance department and senior management, provide a convenient cloak for cowardice. “Nobody ever went broke taking a profit”, goes an old adage – to which the best response is “true; they went broke reinvesting in a dud”.

Private investors should exploit their edge over the professionals

Private investors are under fewer constraints: they are accountable only to themselves, they do not need to market to new investors, and they do not need to look busy to justify a job. This should result in a lighter touch and lower portfolio turnover, especially for those focused on investment trusts, who can leave it to the manager to steer through the changing risks and opportunities.

Some of these managers, such as Nick Train, make a virtue of trading as little as possible, but others generate good performance by being relatively active. A bias to low portfolio turnover is usually, but not always, right – it depends on the manager.

With the benefit of hindsight, sales will fall into one of four categories:

1. Those that were right in absolute terms: the share price subsequently fell, so the decision was a good one even if the proceeds were not invested.

2. Those that were right in relative terms: the share price rose, but by less than the shares into which the proceeds were switched.

3. The under-performing switches: those which have not worked in financial terms but may have reduced risk.

4. The mistakes which have gone straight up after selling.

In time, investors should expect to fill all four categories.

What should be done about the mistakes? In the early 1990s, high street retailer Next got into trading difficulties and the share price fell to 17p amid fears of bankruptcy. The shares bounced to 25p and, as a professional investor, I bought 500,000 at the instigation of a stockbroker as a “trade”.

A fortnight later, the price reached 40p, and I was delighted to take a healthy profit. Over the next few years, the share price continued to rise and I eventually re-invested at £4 – my “reverse ten-bagger.” It was still a good investment: the shares are now nearly £80.

I expect I will buy those RSE shares back before long.