Protecting Your Porftolio – Sino Forest Debacle
if you are a serious investor, the events that imploded SIno Forest should be very troubling! Muddy Waters, an independent equity research firm issued a sell recommendation with a $1 target price on June 2, basically accusing the company of inflating assets and falsifying financial statements. This on a stock that was trading at 20.
http://www.muddywatersresearch.com/research/
What shook me about Muddy Waters' allegation against SinoForest is that one can't even trust the company's financial statements anymore. As an independent analyst, I am only privy to information provided by the company and if they are false to begin with, then god help us.
So I'm writing this post to tell you how to can protect yourself (The retail investor) against serious losses to your portfolio:
Below are some guidelines that are invaluable to any serious investor. I'll discuss each point in more detail.
Concepts/Tools
- VAR and Portfolio Impact
- Use of a Stop Loss
- Technical Analysis & (Skeptical) Fundamental Analysis
- Follow the analysts and General Market Direction
- Every stock must be sold! period!
- I don't believe in Buy and Hold but rather in BUY and continuously sell.
- One Mantra that should continuously ring in your head is "sell sell sell sell sell sell" always be thinking about selling
- Now, before you quote me Warren Buffet, Let me emphasize that buffett buys companies not stock certificates like you and me. He can control the company, influence the board, force them to issue dividends etc. This is why he states that he couldn't care less if the stock exchange closed for several years.
- But for you and me, EVERY STOCK MUST BE SOLD!!!
That being said, Here are a few methods that could help you protect your portfolio against substantial declines:
VAR and Portfolio Impact
- A stock in one's portfolio should never be so high that a substantial decline can adversely affect your overall returns.
- If a stock encompasses say 40% of a 100K portfolio. And stock declines 20%, that's an -8% impact on your overall returns.
- My Rule: No Stock should impact a portfolio by more than 5% (generally 2 – 5%)
- This is a great (stress) test that needs to be performed before the purchase of a stock and also performed continuosly as the stock price fluctuates.
- Whether you're a long term investor or a short term trader, I believe everyone needs to have a stop loss setup of each stock in their portfolio.
- This acts as a backstop, an insurance policy to make sure your losses are limited to a certain amount of the portfolio (like the 5% rule stated above)
- My Rule: I set my stop loss between 8 – 10% from where I bought the stock or If I have a substantial gain, sell half if it drops 8 – 10% from it's high and sell the other half if it continues to drop.
- Always be thinking of an exit strategy; continuously think of sell sell sell sell sell sell
Here's a chart of TRE.TO:
Yes, It sounds ideal to have set the stop loss there. But if you are a serious investor, you would have planned for it well before this debacle.
- For a fund manager, Performing fundamental analysis is a lot easier. They have access to analysts reports, access to management and sophisticated tools that enable them to make investment decisions.
- But if you're an independent trader/analyst, you have to exclusively rely on financial statements provided by the company. And we learned from Sino Forest that financial statements are not to be trusted even if they have been signed off by a reputable accounting firm.
So,What's the solution?
- I believe all investors must incorporate some technical analysis in order to protect themselves from adverse downturns in a stock. It's simply not worth one's time to hold on to a stock that's falling in price no matter how rosy the story behind the company maybe.
- Remember, Every stock must be sold! period!
- Take a look at the chart below, it should give you an idea of how you should have a plan to either cut your position or cut your losses
Here's a chart of TRE.TO a day before the debacle (June 1):
Follow The Analysts
- Following consensus estimates for stocks is an invaluable method to see if a company is being upgraded or downgraded.
- You can find this information any website. In this case, I went to globeinvestor.com (click here).
Here's how to interpret Analysts Ratings:
- Generally, you'd like to see analysts go from Hold -> Buy -> Strong Buy (i.e. A company's earnings are getting better and better).
- What you are now seeing for Sino Forest is the beginning of a downgrade cycle (i.e. Strong Buy to Hold and eventually SELL)
- Remember, typically analysts are behind the news. Very rarely do you see an analyst upgrading ahead of earnings or downgrading ahead of warnings.
- You as an investor must anticipate what the analysts will do in light of the news disseminated by the company. This is the only way you can either make money or minimize losses.
Lastly, Follow Market Direction
- Remember 80% of a stock's move is attributed to market direction. so, if the market is in correction mode or in a general declining, almost all stocks follow suit. Your imperative is to either cut losses or cut positions ahead of time.
- Remember it's not worth holding onto a losing stock as the market declines. Many stocks never come back even if the market recovers.
Ok, I've presented a few methods that should help you protect your portfolio from substantial losses. If you are unfamiliar with any ideas here, I urge to read more and educate yourself.
Remember, every stock must be sold1
