If you invest in individual stocks and own more than a handful, it's likely that one is a ticking time bomb. And if, like me, you own 30 or so, the probability is virtually 100%.
The problem, of course, is that you never know which one until you see a mushroom cloud, even if you are the world's best investor. In fact, virtually every superstar money manager I know has been burned by at least one stock implosion in the past year or two.
Tuesday morning, I awoke to a headline that included the name of one of my favorite stocks (and a modest holding in my fund), and the dreaded words "investigated by the SEC." The next thing I noticed was a very large, red number next to the stock symbol on my computer screen -- King Pharmaceuticals
James Gipson, who manages the Clipper Fund and writes some of the best letters in the mutual fund business, discusses this topic in his shareholder letter dated June 30, 2002:
Our assumption is that at least one of our current holdings is a problem; the issue is to find which one. Mikhail Gorbachev stated the same concept in a different context: "They say that Mitterand has 100 lovers -- one with AIDS, but he doesn't know which one. Bush has 100 bodyguards -- one a terrorist, but he doesn't know which one. Gorbachev has 100 economic advisors -- one is smart, but he doesn't know which one.
Forewarned is forearmed
I find it helps to assume there's trouble lurking in every portfolio -- trouble that can't be readily identified through even the most stringent research. That forces the conservative investor to look for ways to reduce the risks he can identify.
In my own practice, I try to eliminate the companies that carry the obvious danger signs: excessive debt, negative cash flow, weak balance sheets, and so on. Sometimes, the nature of the business itself is dangerous to shareholder wealth. Anyone with a portfolio full of property and casualty insurance companies, sub-prime lenders, development-stage biotechs, or airlines is just asking for trouble. The most obvious way to avoid risk of loss, of course, is to not overpay for stocks.
The first step to avoiding catastrophic loss is making every attempt to reduce the risks one can identify. The second step is portion control, by which I mean limiting the size of positions based upon the risk/reward profile of each individual position. I used to be a big believer in running a very concentrated portfolio, but if you have only eight stocks, and one of them turns out to be a fraud, you can really get hurt.
The myth of the worry-free portfolio
In the same shareholder letter, James Gipson writes about the natural human desire to avoid worrying:
There is no such thing as a riskless stock or worry-free portfolio. We worry about every stock in your portfolio in case we are wrong, which occasionally, we are.
The psychological need to avoid worry often creates a religious-like faith in some stocks, a faith that few (if any) real-world companies can justify over time. AT&T and IBM were warm, fuzzy, and worry-free stocks to a previous generation of investors. No one regards them that way today. Cisco and GE were more recent additions to the pantheon of worry-free stocks, at least until the recent declines in their share prices turned their faithful followers into angry apostates. Since "safe stocks" generally carry premium prices, an investor who holds them faces two related risks -- the business may falter and the valuation premium may shrink. Investors often pay a high price for the understandable but unattainable goal of a worry-free stock.
The morning after
While the news about King came as a big disappointment to me, I didn't immediately dump my shares. With the stock already down 23%, there's no point. Unless more bad news emerges immediately after you sell, the damage has probably been done in the short term. And, since you're going to suffer the loss anyway, you might as well try to determine if the loss is only short term and unrealized, rather than locking in a permanent and realized loss by selling. Instead, the only rational thing to do is gather as much information as possible, and then consider the alternatives.
I tend to look at the company's behavior in the face of adversity to help me determine my next move. King's executives held a conference call at 9:00 on the morning the news broke, and appeared to make every effort to share the information available and answer all questions. On Wednesday, Standard & Poors issued a comment that the recent news would not change the ratings on King's bonds, noting that King is one of "several companies that have received subpoenas related to Medicaid pricing." S&P noted that it is "too early to judge the business and financial impact" of the SEC inquiry. For me, the only reasonable thing to do is to wait for more information.
A quick update
Speaking of risks, in my last article, I advised you to pass on a stock if you find anything that makes you uncomfortable with the business, the management, or the industry. As an example, I used American Safety Insurance
I received a note from CEO Steve Crim shortly thereafter, informing me that the company has discontinued its related-party activities and that, "there are no remaining reinsurance agreements between American Safety and any company owned by a senior officer of the company, nor are any such agreements anticipated in the future."
I'm glad American Safety Insurance has taken steps to eliminate these transactions, which weren't material in size, but created potential for unnecessary conflicts of interest. Given the new information, I'm inclined to view the company more positively than I did in my recent article.
Zeke Ashton has been a long-time contributor to The Motley Fool. He is the managing partner of Centaur Capital Partners, LP, a money-management firm in Dallas, Texas. At the time of publication, Zeke held a long position in King Pharmaceuticals. Please send your feedback to firstname.lastname@example.org .