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Opus News & Insights

Trading Places - Act II: Benjamin Graham vs. Louis Winthorpe III
Thursday, December 27, 2018

Act II: Benjamin Graham vs. Louis Winthorpe III

After his fall from grace, Winthorpe ends up at a pawn shop, and takes $50 for a watch worth $6,955 retail. Talk about a margin of safety for the pawn broker!

In doing so, Louis overcomes a few biases that afflict value investors in particular. Feel free to dust off your CFA exam study guides, a copy of “Thinking, Fast and Slow”, or, for those looking for the USA Today approach, “The Undoing Project”, and remind yourself of things like the disposition effect, loss aversion, the endowment effect, and anchoring.

These biases compel us to keep losers too long, sell winners too quickly, and develop an emotional attachment to companies in our portfolio. If we sell, we admit we are wrong, right?

Ben Graham states, “Never buy a stock because it has gone up or sell one because it has gone down.” While we acknowledge merit in this advice, as mentioned previously, we prioritize those stocks that have not met our return expectations versus the benchmark and find that, on balance, our sell decisions add value.

At the end of each year, we look back at our sell decisions to determine if they added or detracted value relative to the index. While 2018 is not yet in the books, our batting average for the prior two years was in the 75% range, and there was positive asymmetry as well. What we mean here is that the ones we got right underperformed the index by a greater margin that the ones we got wrong outperformed the index.

Graham was right when he said, ”Losing some money is an inevitable part of investing, and there’s nothing you can do to prevent it. But to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money.”

We all stumble into the occasional value trap. We believe our sell discipline is a key way we remain intelligent investors, and avoid the permanent loss of capital lurking within the universe of small cap companies.

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