The Iron Rule of Investing You Must Know

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Sometimes the worst thing you could do in assessing a holding is to pay too much attention to whether you’re up or down on it. In other words, what you paid for a stock at one time does not affect its current intrinsic value. In this episode of “The Morning Show” on Motley Fool Live, recorded on Dec. 21, Motley Fool analysts John Rotonti and Sanmeet Deo discuss how “anchoring” on your past purchase price can hold you back from making the best of the investment in the here and now.

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John Rotonti: What do you think about this, Sanmeet? Focusing on whether you are up or down on a position means anchoring on the past, it distracts from the job of making the best possible decision in the present. Thoughts?

Sanmeet Deo: I think it’s great because what happens is you — and I’ve been very guilty of this — anchor from a price, and then it limits whether you’re going to reinvest or how you’re going to proceed with the position sometimes. And it sits there while you’re doing your analysis on the company, and you’re just thinking, I’m down like 30 percent or 40 percent. This stock is no good. This company is no good. Not necessarily. A stock is down 30, 40, 50 percent even. That’s the stock; it doesn’t mean the business is 50 percent lower in value. It could be, but we don’t know until we do the analysis and we look forward and see what can it produce in cash flow and earnings. Does it have a strong balance sheet, can it survive, what’s going on with the stock that’s making it down? If you anchor too much, it’s a mindset thing, it really messes with your mindset of doing an unbiased analysis. Because you’re already going in there thinking, I hate this company, I’m down so much. I don’t know why I’m even looking at it, and you research it and then you’re like, it’s hard to figure out why it’s down, and that’s not the analysis. The analysis should be, well, why is that down, yes. Then, what can it do in the future, is the market just overreacting? Is the future prospect still good? Is there a bump in the road that it’s hitting that I feel like it can overpass. It’s like you got to turn off your monitors, like your brokerage accounts, when you’re doing a deep dive into a company that you think you might want to buy more of. Not look at the stock price, not look at your gains and unrealized gains or losses, and just look at the company.

Rotonti: I agree 100 percent as well. I separate this into two buckets. One is stocks you already own, which is what this iron rule of investing is referring to. Because it says focusing on whether you are up or down on a position means anchoring on the past. The other bucket is when I’m researching a brand-new company for the first time. It’s a company that I don’t know and that I’m not familiar with. I will go to the end of the earth and back trying to not look at the recent stock chart history, price chart. I don’t want to know if the stock is down over the last year or six months or up over the last year or six months because that will inevitably cloud my judgment. Let me give you an example. I was recently researching a business that I was unfamiliar with. Now I’m very familiar, I’ve just spent a month doing a deep dive. I managed to not look at the stock chart once until I’m learning everything I can about this business from the ground up, liking a lot of what I’m seeing. I think it warrants a valuation. First I tried to understand the business, like what I see, understand management, like what I see. Then I say, “OK, I’m going to try to value this thing.” I value it, and I like what I see, so everything I like. Then I look at the stock chart after a month of work and I see that the stock is up — I don’t want to give it away — the stock is up more than 50 percent in the last year. More than 50 percent, less than 120 percent, in that range. That’s a lot in the last year. That little piece of information, that the stock was up more than 50 percent, less than 120 percent in the last 12 months, gave me pause. Because I was like, “Oh, man, did I miss the boat, blah, blah, blah?” After a month of hiding the stock charts from myself, hiding the stock price from myself. I wanted to value it from the ground up with a blank slate, not knowing anything, and I succeeded. And then I looked at that stock chart and I realized that it was up a lot. It had beat the market significantly over the trailing 12 months. It gave me a slight pause, then self-control got the better of myself and I said, “Damn the stock chart.” If I think it’s attractively valued, regardless of what the stock has done, then I’ll consider buying some or I’ll consider recommending some. Then if it falls and the story doesn’t change, I’ll consider buying more or recommending more. But just spending those three seconds looking at the stock chart gave me pause on a month of research. Then, of course, if it’s something that you already own, anchoring is the worst thing you can do. Oh, my cost basis is $20. The stock is now 70. Why would I buy more? When I originally got some at 20? Well, because the business has grown, the intrinsic value has grown, the earnings and free cash flow has grown. You can’t compare a stock price of 20 to a stock price up at 70. Three years apart, when the earnings and free cash flow power of that business are so much higher three years down the road than they were when you bought at 20. The stock prices are incompatible. You valued the company and decided to buy the company three years prior, it had different fundamentals. Now three years later you’re looking at buying more. Wrap your head around this, Fools. The stock may actually be more attractively priced at 70 than it was at 20. Yes, that is a possibility. You can determine that the stock is trading at a larger margin of safety at 70 than it was at 20. Because the intrinsic value may have grown so much since then. The intrinsic value may have surprised to the upside so much since then, management may have done something incredible that you did not anticipate when you valued it at 20. They may have made an amazing acquisition. They may have brought in an amazing CEO. Anything could have happened. The stock could be more attractively priced at 70 than it was at 20, because it’s not just the stock price of 20 compared to the stock price of 70. It’s the fundamentals of the business at 20 compared to the fundamentals of the business at 70. It’s possible the fundamentals of business at 70 are much stronger.