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Know When To Add To, Hold, Trim, Or Exit Your Positions

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Whitney Tilson’s email to investors, sharing an excerpt from The Rise and Fall of Kase Capital on knowing when to add to, hold, trim, or exit your positions.

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The Rise and Fall of Kase Capital

1) In my August 17 e-mail, I shared an excerpt on portfolio management from my forthcoming book, The Rise and Fall of Kase Capital.

This subject encompasses many things: How much of your portfolio is invested? Are you sitting on cash or using margin? How much is in stocks, bonds, real estate, cryptos, etc.? How many positions do you hold, and how large is each one? Do you stick to stocks, or are you buying options or warrants? How often do you trade? What do you typically do if a stock suddenly doubles or gets cut in half?

Answering these questions correctly (i.e., practicing effective portfolio management) is critical because it will have as much of an effect on your long-term investment success as your stock picking.

I received a great deal of feedback from my readers, which I shared in my August 19 e-mail. I also promised to share the rest of the chapter... so without further ado, here you go!

Know When To Add To, Hold, Trim, Or Exit Your Positions

The most important – and most difficult – element of successful portfolio management is knowing when to add to, hold, trim, or exit your positions. It's critical to have the judgment, humility, and fortitude (which come from experience) to know when to let your winners run and cut your losses.

I didn't do this well. When I relaunched my fund in January 2013, had I simply gone away on a five-year vacation, I would have done far, far better than I did. It's painful for me to see (and admit) that my management of the portfolio left a lot of money on the table. I took a portfolio that would have crushed the market and significantly trailed it instead. In effect, my portfolio-management strategy was to pull my flowers and water my weeds... a deadly combination.

Specifically, in 2011 and subsequent years, I rode my positions in J.C. Penney and Iridium Communications (NASDAQ:IRDM) lower and lower, taking big losses before finally exiting, and watched Grupo Prisa eventually go to zero.

Position In Tesla

On the short side, I trimmed my 1.5% position in Tesla (NASDAQ:TSLA) as it rocketed upward, but I wasn't fast enough. I had shorted it around $5 a share (split-adjusted) in early 2013 and didn't throw in the towel until after it had soared to $29 a share a year later. It cost my funds $5 million and was the most expensive mistake of my career. This underscores how critical it is to use stop losses on the short side.

I sold finance giants Citigroup (NYSE:C) and Goldman Sachs (NYSE:GS), and blue-chip tech titan Microsoft (NASDAQ:MSFT) far too early, watching their shares march higher for years to come.

Position In Netflix

But ironically, the biggest portfolio-management mistake of my life was in one of my biggest winners: I trimmed and then sold my position in streaming company Netflix (NASDAQ:NFLX) far, far too early. It's so painful to know that had I only done one thing – held the stock of the decade, which I nailed at the absolute bottom – it would have made up for all of my other mistakes... and then some.

Instead, I took some profits when it went up 50%. When it doubled, I trimmed some more. I kept trimming as it went higher and higher, always keeping it a 3% to 5% position. By the time I sold my last shares, it was up 600% from its lows. I was so proud of myself for this super-successful investment...

But since then, the stock is up more than 10 times! I left tens of millions of dollars on the table by being too quick to take profits, focusing more on the rising stock price rather than how well the business was doing... a mistake that still haunts me to this day!

If there's one portfolio management lesson I want to leave you with, it's this: You have to let your winners run. In an investing lifetime, you'll only have a few opportunities to own a moonshot like Netflix. Identifying them and then maximizing the profits can make up for a lot of mistakes.

The opposite is true, too. When you hang on to your losers way too long – or worse yet, average down on your position – your losses can mount quickly so you also have to be willing to acknowledge mistakes and get out.

Fortunately, I learned this lesson early in the late 1990s... I was just getting started investing in the stock market and there were tons of stock promoters out there. It was the early days of the Internet, and a friend gave me a hot stock tip about a company called StreamLogic.

I don't remember a thing about what the company claimed to actually do, but it didn't matter... I had fallen for an absolute scam. (Don't bother looking it up. The company has been dead for decades.)

Though I had graduated with honors from Harvard University and Harvard Business School, I had never actually invested before. My parents were teachers and had never owned a stock. And I hadn't started reading Warren Buffett's letters yet. In short, I was as ignorant as they come.

You can probably guess what happened next...

Position In StreamLogic

As soon as I bought shares of StreamLogic, they started to drift lower. As I watched my money evaporate, I kept feeling worse and worse, wondering what I should do.

Eventually, I came to my senses and realized that, even though I was down a bunch, I still had real money in a stock I knew nothing about. I sold it at a huge loss, but I at least got something back. (The stock, of course, ultimately went to zero.)

If you've had the misfortune of owning any stocks like this in the past – or if you currently do – you should sell them right now and be glad to get even a penny back.

Know that you're not alone. Once again, we're more than a decade into a long bull market, which always brings out stock promoters pitching fraudulent companies to gullible investors.

In fact, it's even easier now for people to pull off scams due to social media and the Internet. In early 2019, someone was on Yahoo Finance's message boards impersonating me. The scammer even used my photo and was commenting on stocks I had recommended in my newsletter. So even if you think you're reading something from a source you can trust, it might not really be that person after all!

StreamLogic was an extreme example (and an outright fraud). It's rather easy to spot companies like them. Simply pull up a company's financial statements... If it doesn't have any material revenues or profits or operating history, and you heard about it through a message board or random e-mail, it's likely a scam and you should sell it immediately, at any price. Don't sit around waiting for it to return to the price at which you bought it. It'll never get there!

It's not always that easy to decide to sell, though.

The more common situation is that you buy a stock, it falls 20% or so, and you have to decide what to do next.

When should you sell? How can you tell if you've made a mistake... or if the market is giving you a great opportunity to buy more?

This is the hardest part about investing.

Some people think that the most difficult decision is when to buy. But that's not hard – buying a stock is fun and exciting! Rather, making the right decisions about stocks you own that have declined in value is what separates good investors from bad ones.

Let's say you buy a stock trading for $10 a share that you think is worth $20... and then it falls to $8. What should you do?

First, you need to set aside the inevitable conflicting emotions. On one hand, your ego is telling you that you're right and the market is wrong, so you should buy more. But losing money causes pain, and there's a simple way to end it – sell the stock and get out.

But then you've permanently locked in a loss and are forced to acknowledge a mistake. If you simply keep holding, you can tell yourself that you're not wrong, just early. There's no worse feeling than selling a stock and then watching it soar. (Just writing that sentence brings back awful memories for me!)

So the easiest thing to do is... nothing.

But then you risk falling into the trap best captured by an old joke on Wall Street about the guy who says, "I've got two kinds of stocks in my portfolio: my winners and my long-term holds!"

It's funny, but there's a lot of truth to it. Look at your portfolio and I'll bet that you have a bunch of stocks in it that are terrible value traps that you should have sold long ago – and should still sell today – but you don't want to admit a mistake, so you've instead called them "long-term holds."

How do you navigate those waters?

I suggest doing the following... Ask yourself, "If I didn't already own the stock, would I buy it today at the current price?" The fact that you bought some earlier at a higher price is irrelevant to the decision of what to do today. As the saying goes, "A stock doesn't know that you own it."

When a stock falls, you have three choices: You can buy more, do nothing, or sell. There is no clear right answer.

Sometimes, when you're losing money on a stock, the market is telling you – correctly! – that you've made a mistake and stumbled into a value trap. If so, sell, hopefully, learn some valuable lessons, and move on.

Other times, something bad – but not fatal – happens to the company, which whacks the stock. If the stock and the company's intrinsic value have declined in tandem, but you still believe in the long-term prospects of the business, you should probably just hold on.

These instances are exactly why I don't use stop losses. (That is, assuming you know what you're doing. If you don't know what you're doing, then you shouldn't own any stocks at all.)

As an investor, your challenge is to figure out when the market is making a mistake and to take advantage of it. So why would you tie your hands behind your back with a crude tool like a stop loss? In fact, when a stock falls substantially from your purchase price (which happens all the time – I don't know anyone who always precisely times the bottom), that could be a great time to double down. It could also, of course, be a good time to hold or get out.

These decisions are what separate the winners from the losers in the investment world. But it's important to realize that they must be a judgment call, rooted in good information and analysis, not emotion – and certainly not a formula like a stop loss.

Lastly, the best (and, unfortunately, rarest) opportunities are when the market totally gets it wrong. The stock was already cheap when you bought it... and then gets even cheaper. This is when you want to add to your position.

Position In McDonald's

That's exactly what I did with McDonald's (NYSE:MCD) back in early 2003.

Shares of the burger chain had fallen from $44 a share to $16 when I first bought them in late 2002. I estimated that its real estate alone was worth $10 a share, and for $6 extra, you got all of the company-owned restaurants plus the hugely valuable franchise fee streams. In total, I was convinced that the stock was easily worth $25, so at a 40% discount it was a screaming bargain.

But it was a big company with a lot of deep-seated problems. I thought the new CEO, Jim Cantalupo, was doing all the right things, but it was like steering a supertanker – changes in direction only happen slowly. So as monthly same-store sales continued to be negative in early 2003, the stock continued falling, eventually dipping below $13.

My instinct was to buy more... But before doing so, I set out to do some more research.

One of my investors introduced me to an old friend of his who was a long-time McDonald's franchise owner. When we sat down for lunch, I expected him to tell me what a big mistake I had made investing in this broken company... how frustrated he was dealing with corporate bureaucracy... and how the company hadn't released any new menu items in years.

But to my surprise, he told me, "Whitney, if I had $5 million today, I would put every penny of it into McDonald's stock." He told me about how Cantalupo was radically shaking things up, introducing new products, repairing relationships with franchisees, and ending the price war with rival fast-food chain Burger King.

That information was worth its weight in gold. It confirmed my initial investment thesis – that this was a great company that had fallen on hard times due to self-inflicted (i.e. fixable) problems. And Cantalupo was urgently fixing them, but the results hadn't yet showed up in the quarterly numbers.

Situations like this are rare... So, armed with newfound confidence, I backed up the truck, doubling my position at $13, making it 10% of my fund, and riding the stock up to the mid-$60s over the next five years.

Now, not every investor has access to the type of information I did about McDonald's. I understand that. To some extent, I got lucky.

But it wasn't luck that I followed a good process. I put my emotions aside, sought additional information, and took a fresh look at the company, as if I didn't own the stock in the first place.

And it wasn't luck that I bet big when I hit the jackpot. That's one of the keys to building a good long-term track record. Recognize when you have valuable information that gives you an edge... and then bet accordingly.

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