Three signs you’re holding onto a money-losing stock

“The first rule of an investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.” — Warren Buffett

As the stock market keeps rallying into the new year in many parts of the world, we have seen an increasingly challenging time for enterprising investors in two ways. First of all, higher valuations reduce prospective returns in general; secondly, and probably more importantly, it has become easier for stock pickers to fall into value traps now than this time last year, which is to say that one may be more easily tempted by some seemingly low-priced businesses and jeopardize the quality of a portfolio.

Over time, but particularly during a time like this, we would like to constantly remind ourselves of behavioural biases and disciplines by identifying and checking against a few risk factors to evaluate a potential opportunity. These factors are literally the absolute no-go areas that help us “kill” an investment thesis.

Unproven business economics

Humans are strongly influenced by storytelling, which most corporate executives are trained to do. That’s why we prefer to see a consistent track record before hearing the story. Someone recently brought Celsius Holdings CELH-Q, a challenger in the U.S. energy-drink industry, to our attention for our biannual portfolio management webinar. The brand positions itself as the front-runner among healthy, functional alternatives to more conventional energy drinks. The strategy seems to have worked well on one front; the company has been rapidly expanding its presence in the most booming beverage category of the largest consumer market on this planet, doubling its market share in each of the past three years. Nonetheless, profits barely show up on its financial statements. The story of Celsius looks appealing – disruptive, proprietary products capitalizing on health and wellness trends through innovation and with significant brand awareness, as pointed out in management’s latest investor presentation. However, we’d like to pass on the stock before it shows us the money.

Speaking of the energy-drink industry, Monster Beverage MNST-Q provides its owner with totally different business financials (and risk profile, as a result). We are looking at a one-of-a-kind, decades-long track record of persistently earning superior returns on capital with a strong balance sheet. No wonder this is the best-performing stock for the past 30 years (ending July, 2023), as shareholder returns follow business performance in the long run. Sorry, Apple, Amazon, Nvidia and Netflix! Compared to Celsius Holdings, we would much rather own Monster Beverage – at the right price, certainly.

Loss of competitiveness

Attractive business economics alone may not treat us as long-term shareholders. We also look for proven success in maintaining or even gaining competitiveness in front of customers over time. Market share is a helpful indicator in our view. Here, cybersecurity is an interesting example demonstrating that simply a high return on capital may not work well for shareholders. The industry has been mostly dominated by three major players: Check Point Software, Fortinet and Palo Alto Networks. Check Point, one of our previous holdings, has delivered high returns on equity year in and year out, but achieved so primarily through “disposing” cash to repurchase shares. At the same time, the business consistently underperformed the industry average in terms of growth for many years and clearly loses market share to industry leader Fortinet and major challenger Palo Alto over time. That told us a lot about the evolving competitive edge among the three, as well as how dynamic and aggressive the industry could get. It should be no surprise to see that shares of Check Point (despite the company’s decent returns on capital) have considerably underperformed those of Fortinet and even loss-leading Palo Alto in recent years. We learned our lesson and exited our investment in Check Point earlier, with our concern on the narrowing moat.

One more lesson here: When management shies away from discussing the market share while major competitors talk a lot about it, watch out.

Misalignment of interest

We would like to regard the management of our invested companies as our partners. Of course, corporate executives are paid through shareholders’ money. But we would prefer to see them motivated by the long-term share performance (i.e., the interest of average shareholders) instead of the compensation package. What better way to make executives act in the best interest of owners than being owners themselves? There have been many outstanding businesses that we have passed on over the years owing to a lack of meaningful insider ownership or strong evidence of an owner mindset – Diageo (the largest British spirits company), Domino’s Pizza (the world’s No. 1 pizza brand) and Chemed (the leading operator of end-of-life hospice care and plumbing services in North America), just to name a few. We expect to remain highly selective and uncompromising in this regard.

It is worth mentioning that we may miss out on some high-returning opportunities by staying miles away from the red zone, as exemplified above, and we are perfectly fine with this. Our foremost job is to invest to not lose money instead of speculating in hopes of seeing substantial gains.

Jason Del Vicario, CFA, is portfolio manager, and Steven Chen, MBA, analyst, at HillsideWealth | iA Private Wealth Inc.

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