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Jason’s Random Words

Jeff and I recorded our October Mailbag episode this past week, and we got a lot of great questions that we weren’t able to answer on the show. Don’t worry! We will get to most of them in a few weeks when we record the November Mailbag.

But there was one question we got via email (it’s [email protected] if you ever want to drop us a note) from Joe really resonated with me. I won’t share Joe’s entire question here, but the gist was, he has a stock that he’s owned for a few years, has added to multiple times, but has done poorly. He has other bigger losers, but this stock in particular stands out because:

• He’s bought a fairly large amount.

• It has underperformed during a great period for the market.

• He still sees a lot of potential in the business.

I am intentionally not mentioning the name of the stock here, because instead of us all forming opinions or racing to whatever our bias is about that stock, I think this is an excellent opportunity to think about this topic, not debate Joe’s stock. Let’s be honest: We all have stocks like this that we own or have owned in the past.

Without giving the whole story, Joe’s question was “how do you two get to the point of deciding to move on?”

Moving on can be hard. There’s a certain amount of ego involved, and quitting anything often involves admitting that you were wrong, or made a mistake, or weren’t good at something. And I think when we own a losing stock, it can be extra hard, because selling is admitting defeat, and locking in those paper losses.

I can’t give Jeff’s answer — and let’s be honest, he’s had a lot of practice making bad stock picks so he’s had time to think about this. But I can frame how I think about it.

To start, I’m pretty glacial as a seller. If there’s one thing I have learned is that it can take time for a company to figure things out, and rough patches happen even for great companies. Starbucks for example has struggled for a few years now, and the stock last hit an all-time high more than three years ago.

Now, it’s possible Starbucks has lost the magic, but this isn’t the only time in its history the business has wandered the desert for a few years before returning to huge success, and it’s not unusual in that regard. Netflix and Microsoft are examples of great companies that struggled for a period before returning to greatness.

There are a few questions I ask when looking at my portfolio and seeing stocks that have been not great for an extended period of time:

• If I was just researching this company today, would I be buying it?

This is often where I start with a problem stock. I’ve learned that I often bias towards holding bad businesses because of my natural optimism, and because of my ego. It’s always easier to find reasons why you’ll still be proven right than acknowledge/admit that the bear case is just stronger. Hope springs eternal, but is not an investing thesis.

Sometimes stepping back, trying to put fresh eyes on a business, and forget what you know gives you enough perspective to see the flaws in your thesis.

• What has gone wrong? Did I have any of this on my radar before buying?

• How different is the business and its goals now than the business I bought x years ago?

Thesis creep is real. In the case of the stock Joe asked about, let’s just say that it’s a very different business and focus than it was four or five years ago. When the business changes, you have to step back and consider whether it’s still what you want to own.

That probably sounds like a bad thing, but it’s not always. I’ll go back to Starbucks, Netflix, and Microsoft again. Netflix and Microsoft have changed in some massively fundamental ways over the past 10-15 years, and for the better. They evolved to where the disruption of their prior business models was going. Starbucks, on the other hand, has lost its way, and its third fourth CEO in three years is now trying to turn it around.

• Was this ever a winning stock?

There are always more great business ideas than great stocks. And while I’ll let a Lemonade have years to try to find the magic formula, I tend to be far more patient with a former winner that underperforms for a while. Winning companies tend to have really strong built-in advantages, and I try to focus on business performance especially during periods of poor stock performance to make sure I know what I own.

• How has the business done, really?

Being honest about this really matters. For most businesses, cash flows per share are the most import measure of shareholder value created. Not the only (book value, net income, funds from operations, etc. depending on the industry) but it’s almost always the thing that drives value. And what I often find with underperforming stocks is a lack of growth in per-share cash flow generation. And in the case of Joe’s stock, free cash flow has increased from where it was five years ago, but has fallen the past several years, while the share count has gone up more than 40%. So insiders have gotten theirs, but external investors have been holding the bag waiting for the business to do the things they bought it expecting it would do.

Your mileage may vary, but knowing what you own, why, and how the business is really performing in terms of generating real value (cash) per share will tell you the truth. Either way, I’m generally talking about giving a company years, not quarters, unless it’s obviously time to sell. When is it obvious? That’s a question for another Sunday morning.

I realize this is a lot of words that don’t directly answer your question, Joe. The short answer is, it really depends. I think the best starting point is to really figure out where your conviction lies, if it’s based on reality, or a busted thesis and hope. If it’s just hope and “potential,” moving on often is the best move. CEOs are very good at telling stories and selling hope.

Real value and returns come with free cash flow per share. If that’s not growing, or trending in the right direction, that’s almost always a clear sign it’s time to move on.

Jason