Mohnish Pabrai recently did a great interview with BloombergQuint, the Indian financial news organisation. While Pabrai has said many times that he’s not a fan of stop-losses, in this interview he provides a great example of how stop-losses can seriously hurt your performance.
Here’s an excerpt from the interview:
Pabrai: So just to clarify, we’re not talking about the speculators and traders. More power to them!
But when we come to investors I actually find plenty of pundits on TV who have done fundamental analysis and they give targets and they give stop-losses. I find that really peculiar. One of the reasons why we can make a lot of money in equity markets is because their auction driven, and auction driven markets are very different from almost any other kind of market.
So to give you an illustration. Let’s say I bought a flat in Mumbai for one crore (US $155,000). I don’t know if we can get one for one crore or not but let’s play along. We got one, maybe in the periphery of Mumbai.
Okay so we paid a crore (US $155,000) for the flat and we did research and we found that it’s the right price and we bought it. Now we want to know how the price of that flat changes every day.
So I have a friend who’s a real estate broker and I tell my friend the real estate broker, listen we’re going to have chai with Pabrai every day, you and I are going to have a cup of tea. Every day just come and tell me what the market price of my flat is okay.
So you bought the flat. Next day you invite your broker friend. I ask him, what’s the price of the flat? He’d say, “listen idiot it’s still one crore (US $155,000)”.
Okay, I call him after two days, he still says one crore (US $155,000), and after maybe two months he says, “You know the little change in transactions it’s 1.005 crores (US $157,000). It’s gone up a little bit.
And if you did this every day and you just wrote down the price he was giving you. Did it for 365 days, you would at the extreme end find that it went to somewhere between 95 lakhs (US $148,000) and maybe 1.1 crores (US $172,000) or 1.15 crores (US $180,000), in that range.
Now, let’s say my flat is a listed company on the Bombay Stock Exchange. But the only asset is this flat, and every day the price is doing whatever it’s doing in the market, and we chart that daily price movement.
What we’re gonna find is in a 52 week period the range maybe something between 70 lakhs (US $108,000) and 1.3 crores (US $203,000), and the reason is that auction driven markets undershoot and overshoot, and it is the under shooting and over shooting that creates the opportunity for people like me.
So basically the idea of a stop-loss would be, I bought the flat for a crore (US $155,000) and after six months my broker tells me, “You know prices have dropped about five percent”. I say to him okay that’s my stop-loss and I’m now going to sell you my flat for ninety five lakhs (US $148,000). Please sell it. It would be the equivalent of doing that.
The reason you bought the flat for one crore (US $155,000) was because you thought that it was fairly priced. The second reason you bought it is because you wanted to hold it as a long-term asset. So the same thing with stocks.
If you bought a stock for two hundred rupees (US $3.13) or it has a market cap of 1000 crores (US $156 Million), you bought it because you thought it’s worth two thousand crores (US $312 Million). So if it goes from one thousand crores (US $156 Million) to nine hundred crores (US $141 Million) you will sell it with stop-losses. It makes no sense.
So I own a company called Rain Industries. I bought that stock about two and a half years ago. And when I was buying the stock it was at about thirty rupees (US $0.47) a share. By the time I finished buying it got up to forty five rupees (US $0.70) a share. Went up almost fifty percent because I almost bought ten percent of the business.
After I finished buying it proceeded to go down. Just like everything I buy. The stock knows that I bought it and it decides Mohnish is done now let’s go down.
If I had engaged in stop-losses, Rain went down to forty (US $0.63), even went down to thirty five (US $0.55) after I finished buying, and I did nothing. So now Rain is north off, I don’t know, three hundred and sixty rupees (US $5.64). So that whole opportunity would have been gone. It would have been no sense for me to put a stop-loss at thirty or thirty-five or forty because I thought it was worth a lot more.
I think investors ought to focus on making sure that the stock is within their circle of competence. That it’s worth a lot more than its valued at and, once you have those two things a stop-loss makes no sense.
*Special thanks to Sumanth Culli, one of our readers, who helped me with some tricky crore, lakh, and rupee conversions.
You can watch the entire interview here.
Article by Johnny Hopkins, The Acquirer's Multiple