Winning and Losing
When you realize it’s a toss of a coin whether you make money on a stock, and that’s the average of the best investors in the world. Then it hits you what matters most is how you react when you are winning and losing.
In the book, The Art of Execution, portfolio manager Lee Freeman-Shor invests $25-$150 million ($1+ billion total) in 45 of the world’s top investors. His instructions to them were simple as there was just one rule. They could only invest in their ten best ideas. Over several years he tracked their positions, trades, performance and was amazed at what he saw.
The average hit rate (% of winning stocks) for the best stock pickers in the world was only 49%. Analyzing 1,866 investments from top fund managers, he found that most ideas actually lost money. In fact, the investor that made the most money for Shor only made money on 30% of his stocks.
Lee Freeman-Shor was recently interviewed on “The Art of Investing” podcast. One of the co-hosts is Chris Fellingham who ran George Soros’s London Office.
Fellingham said:
“I would hear Soros ranting in the background about how useless he was, how he got things wrong all the time, how terrible it was. How he lost it. And then he would suddenly come in with the most amazing numbers. I chatted with him once about this and he reckoned he got three out of ten right. But on those three he ran them and he ran them and he ran them. And the seven he got wrong, he got out quickly. So just reiterating, it's all about execution.”
When stock pickers are asked about their hit rate no one ever says 40%. It sounds like you’re a moron. At the same time 80% sounds like you're too confident. So most say 60%. When in reality, your hit rate doesn’t matter. What matters is how much money you made on the winners and how much money you lost on your losers.
When you realize it’s a toss of a coin whether you make money on a stock, and that’s the average of the best investors in the world. Then it hits you what matters most is how you react when you are winning and losing.
The Three Tribes of losers
When an investment goes south, as it will at least half the time, Shor says stock pickers tend to fall into one of three psychological "tribes". Identifying which tribe you belong to is the first step toward survival.
The Rabbit: The Rabbit is the most dangerous category. When a stock drops, the Rabbit freezes like a creature in headlights. They do nothing, hoping the market will eventually prove them right. This leads to the "math of despair": if a stock drops 90%, it requires a 900% gain just to break even. Rabbits often find themselves stuck in "holes" so deep they can never climb out.
The Assassin: Most successful professionals strive to be Assassins. These traders have no emotional attachment to their positions. If a stock drops 30% to 40%, they simply kill the position and move on. By limiting the damage and preserving capital, they ensure they live to fight another day. The Assassin understands that hope is not an investment strategy.
The Hunter: The Hunter is the rarest breed, requiring a strong constitution and immense psychological discipline. When a high-conviction idea goes against them, the Hunter doesn't just hold. They add more capital. However, this is not mindless averaging down. It is a calculated move based on the belief that the original thesis is still valid. For many this is torture because of the mental toll of doubling down on a losing position.
Chris Fellingham, added about the Hunters,
“You've got to be really well psychologically set up for that because if you think about that, I've got my position, it goes down 25%, I double that position, now it goes down another 25 or 30%. My loss is really starting to stack up. I'm probably not sleeping at night, I'm having trouble seeing straight and I can't see this company as anything other than if it fails, I've ruined my career. But if it hasn't failed, it's still going to be a problem sitting and languishing where it is. So what you are saying is it's really difficult to find anybody who can be a really successful hunter.”
The Two Tribes of Winners
Success is not just about keeping losses small; it is about how you handle the rare "home run".
The Raider: Shor says you don’t want to be a Raider. Raiders are tempted by the dopamine kick of a quick win. They sell the entire position and take profits at 10% or 20%. While this feels good, it mathematically doesn't work over the long term because small wins cannot offset the inevitable big losses.
The Connoisseur: The Connoisseur is the "boring" investor who embraces low turnover. They hunt for big winners and have the discipline to sit on their hands while the stock climbs 1,000% or more. They don't use arbitrary price targets that force them out of a winning position too early.
“All my research showed basically it's a handful of big winners which determine your success or failure and you need to have a process of which embraces winning big.”- Lee Freeman-shor
Microcap stock pickers can take some valuable lessons from Shor's research.
Due to the illiquidity and fragile nature of microcap businesses, when a position is losing a successful microcap investor must be a blend of assassin and hunter. The key is knowing the businesses you own so intimately that you can spot the signs of your investment thesis cracking before others so you can kill a position and take a small loss before it becomes a large loss. If a stock is dropping and the business is performing, you potentially become a hunter and add to the position. I talk about this here.
When a microcap stock is rising over months, quarters, years you must be nimble and be a mixture of Raider and Connoisseur. Most microcap stocks only win for a season. They have shorter shelf lives than midcaps and largecaps. A microcap stock picker must live in this reality and take profits as they rise. If a winning stock is pulling forward 3-4-5 years of valuation to the present, you sell more aggressively, but I think the key is to never completely sell out of a winning position. We never know how long a winning stock will win.
Shor says the most powerful tool is the “Blank Piece of Paper” Test which acts as a daily reset. Every morning, an investor should look at their portfolio and ask: "If I had a blank piece of paper today, would I buy this stock at its current price?". If the answer is no, the only rational move is to sell, regardless of how much was originally paid. This helps to combat endowment bias (valuing something more just because you own it) and sunk cost bias (the reluctance to walk away after investing time and money).
In bull markets 8 out of 10 stocks work. In bear markets 1 out of 10 stocks work. I think it’s important to remember your hit rate probably has more to do with the macro situation than you think. Most long only managers benefit by being "beta jockeys" riding the market's natural uptrend. When you average your hit rate over a full economic cycle, a hit rate of four or five out of ten is likely accurate.Where I differ slightly from Shor is I do think hit rate matters and we should all strive to have "higher" hit rates.
Ultimately, successful stock picking is finding stocks in your flavor of investing where the odds are stacked in your favor. A big part of this is buying at a low valuation and understanding the upside to downside ratio of every position in your portfolio. Next, initial position sizing is crucial, so the weight of the position doesn’t lean too hard on your emotions. Most microcap investors size positions too large in the beginning. Appropriate initial position sizing frees you up mentally to do the right thing when you are winning and losing.
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