Taking Losses: Focused Investing Newsletter #18

At dusk yesterday.

This week I sold a position at a significant loss. This violates Warren Buffet’s Rule No. 1: “Never lose principal” and Rule No 2: “Never forget Rule number one.” We are not here today to analyze the times when Buffet himself has broken these rules. Instead let’s discuss the challenge of thinking well about doing so.

We’ve all seen the familiar plot. This example is from OneDigital, referenced by Crews Bank:

The average investor, from 1996-2015, did not even keep up with inflation and had returns far below those of most asset classes. This is generally attributed to violating Buffet’s Rule, and specifically to panic selling.

That makes sense to me. Only an emotional, irrational decision process can lead one to consistently buy high and sell low.

One implication is that we all should scrutinize our own decisions and performance at regular intervals. I do it annually.

[An aside on REITs, the “winners” in the plot:

The modern REIT industry began in the early 1990s and improved its quality a lot across and following the Great Recession. Plus REIT prices benefited from the multiple expansion that floated all boats.

The quality REITs produce mid-single digit growth of cash earnings per share on a long-term basis. Add a dividend yield of a few percent and you get high single-digit total returns.

But only the best REITs sustain that. The sector as a whole will not, without multiple compression.]

Selling or Holding Losers

At the same time, some studies find that individual investors often reduce their returns by holding onto losers too long. Most of those studies, like most noise about investing, are done from the perspective of a momentum investor trying to time the market. Those are of little use to a value investor.

There is a long quote from one of Warren Buffet’s letters in this article. Excerpts:

Berkshire’s newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire’s valuation, and problem companies require more managerial time than winners.

Any management consultant or Wall Street advisor would look at our laggards and say “dump them.”

That won’t happen. For 29 years, we have regularly laid out Berkshire’s economic principles in these reports (pages 93-98) and Number 11 describes our general reluctance to sell poor performers (which, in most cases, lag because of industry factors rather than managerial shortcomings).

Please understand, however, that Charlie and I are neither masochists nor Pollyannas. If either of the failings we set forth in Rule 11 is present — if the business will likely be a cash drain over the longer term, or if labor strife is endemic — we will take prompt and decisive action.

While I don’t think that perspective is entirely relevant to us as individual investors, there are some features that are.

1. Don’t just dump losers. Think about their actual value and whether and how much it has changed. Always remember that the market is a short-run voting machine but a long-run weighing machine.

2. When you assess that losses reflect industry factors that are likely to reverse, selling is likely unwise. This certainly comes up with resource extraction companies, whose earnings reflect commodity prices. The markets are likely to over-react both to the downside and to the upside as prices fluctuate.

3. If you conclude that the earnings growth or especially earnings themselves are now threatened over the longer term, it may well be time to get out.

One item I would add is this: If you conclude that the risks are higher than you had thought, rising above your risk tolerance, then it is time to sell. I did that with Clipper Realty (CLPR) in 2023.

My Decision

The stock I just sold was Safehold (SAFE), a rather unusual REIT. The assets they hold (ground leases) are accurately described as being like very long-term bonds with an increasing coupon.

Such assets are very highly levered to interest rates. In 2021 I described that stock as an investment that would flourish if interest rates stayed low. Well, they did not and it did not.

By now the investment thesis has changed from an expectation of very rapid portfolio growth to an expectation that when interest rates fall the stock price will respond strongly.

There was a growth story related to expansion of the portfolio in 2021 and Safehold is now reporting signs of life. But they remain a long way from their 2021 rate of more than $1.5B per year.

With a bit more focus, I would have realized in mid-2022 that the change in thesis made SAFE a bet on macro-economic developments. One of my investment principles, following Howard Marks, is to avoid investing on the basis of macroeconomic expectations.

But that is what the thesis had become. It would have been sensible to sell in mid-2022.

Today getting back to the highs of early 2022 is unlikely. But that never should matter; one should invest looking forward rather than backward.

SAFE is up more than 40% from its October low, but still not back to the December peak. Meanwhile, the 30-year Treasury rate is down from a peak of 5% to 4.2%. To my mind, the price of SAFE is already anticipating further rate reductions.

If Fed-funds rate reductions come hard and fast, long rates still likely don’t drop below 3%. Based on my past analysis of their securities, that would justify a doubling of the price from here.

If construction activity in commercial real estate picks up strongly, that will produce opportunities for growth. But counting on rapid progress seems unwise to me.

So my view of SAFE long term does remain positive. But how long will the upside take? And how certain is it?

Among my holdings, my conclusion was that SAFE might quickly get upside but that it was likely to be the slowest growing of my upside positions.

Raising Cash

Other factors also entered.

1. There was a need to raise cash, not related to investing as such.

2. Parting instead with any of my other upside positions did not make sense to me.

3. Selling my income positions, reducing dividend income, also did not make sense.

I can rebuild the upside portion of the portfolio from those dividends, going forward.

So I sold SAFE to raise cash. Selling was not just “giving up on a loser.” It was a choice of what to sell when something had to be sold.

Recent News (Drawing my attention)

Forthcoming:

The research takes how long it takes, but typically I get through a deep look at one company per week. Soon you will see deep dives on

• BSR REIT (HOM.U), hopefully next week.

• Sun Communities (SUI)

Midstreams & Producers:

• TC Energy (TRP) lost their claim to damages over the cancellation of Keystone XL early in President Biden’s term, on a technicality.

• It is never a surprise when summer fires temporarily impact Canadian production. Looks like Canadian Natural (CNQ) will get hit this quarter.

REITs:

• NNN REIT (NYSE:NNN) declares $0.58/share quarterly dividend, 2.7% increase

• Everybody else is preparing for quarterly earnings releases.

Personal News:

The rest of the family cleared out Tuesday, leaving me with less company but more peace. It is also always bittersweet every year when the Tour de France ends, which happens tomorrow. Great races this year.

Member News

This week featured

items that went to all members over the past week:

• A weekly newsletter .

• An deep dive article on Pembina Pipeline.

Items that went to paid members:

• Brief Note on Rates and REITs

• A Trade Alert about raising cash.

The Google Sheets (for annual members):

• The main attraction on the Google sheet is full disclosure of my portfolio.

• There are also a REIT assessment sheet and a Midstreams assessment sheet, each a tab.

Also:

• A lot of ongoing random discussions occur on the Focused Investing chat. One can also post items of interest, which I do often. Check it out and post your own items, please.

• Annual paid members should have access to the live, real-time portfolio showing all my stock-market investments. (If you don’t have that access, DM me). Comments and questions are welcome.