Zombie Investors

The Walking Dead

I have always found that cocktail parties provide a nice laboratory for studying some investor psychology, particularly when the gears of conversation are greased with a few rounds of Bombay Gin, and if you're willing to stir the Petri dish a bit. It sometimes doesn't even take the alcohol to relax the inhibitions enough to bring out the bragging rights. Finding a winning stock apparently triggers the same part of the brain as hooking a 40 pound striped bass or bagging a ten-point buck--something to do with evolutionary psychology, perhaps, and that "hunter-gatherer" genetic wiring. I have witnessed various forms of a conversation that goes like this. Some guy is talking to a group of his fellow guests (typically men, as these parties seem to self-segregate by gender), and he is regaling them with a tale of a certain stock. He first discovered the stock when it was trading at $10, and within a few months it was at $15, then within another few months it had jumped to $20. He seems to know just about everything about it. Since this subject engages my attention, I ask him, as my role in this experiment, whether he still holds his entire position, or if he has taken any profits. His reply, like air whooshing out of a deflating balloon, is that he never bought any of the stock in question--but he sure has been watching it.

Here we have exposed the hallmark trait of the Zombie Investor: inaction. Investing is not a spectator sport, and you can't make any money in stocks without actually buying some. Our zombie in this case has likely acquired his inaction tendency from experience. He doesn't have a true portfolio, but has instead been a serial speculator, fixating on one particular stock at a time, buying at the wrong time, and selling in an emotional frenzy of fear. The hunter has become the deer in the headlights. The more literal, albeit fictional, zombies that grunt and growl their way through AMC's Sunday night gore-fest The Walking Dead (my wife's favorite television show at the moment) are anything but paralyzed, however. Their problem--and the central problem for all of the non-zombie characters in the story--is that something has disabled a large part of their formerly human brains, leaving them governed by their primordial, reptilian brain stems. Today's Zombie Investor suffers not just from inaction, but also from making decisions based on emotions, as if something blew the circuit breakers in their brain compartments for logic and reason.

A familiar case is the investor who will not take a loss in a stock because he is determined to wait for the stock to go up enough to get out at breakeven or better. Now, I want to emphasize that inaction can indeed be the best course of action in some cases--Don't do something, just sit there! as the reversed saying goes--but we need some guidelines for when, and when not, to take action. The first step is to determine whether a stock's decline is due to something company-specific or merely part of an overall market sell-off. I don't like to sell stocks in broad market declines, and that is why I don't like stop-loss orders. As a primer here, a stop-loss works as follows. Let's say you buy a stock at $20 and want to limit your losses to 20%, so you place a stop-loss order to sell the stock if it drops to $16. The thinking goes that small losses can turn into bigger losses, so this is a way of enforcing the discipline to go ahead and take those (hopefully smaller) losses. If the outcome is positive, though, and your stock goes up, then you can raise the stop-loss in tandem with the stock's advance--it goes to $30 and you raise the stop to $24; it goes to $40 and you bump up the stop to $32. The problem with this strategy is that your stop-loss order doesn't know the difference between a change in your company's prospects and a broad-based swoon in the market. We can consider the so-called "Flash Crash" of May 6, 2010, as a cautionary tale. For some reason, the Dow Jones average dropped suddenly by about 1,000 points before quickly erasing most of that decline. Proctor and Gamble (PG, $80), which opened the trading day at $61.91, traded as low as $39.37 before closing at $60.75. So, a stop-loss order here likely would have resulted in your selling the stock at a very unfavorable price. Rather than turn your investment decisions over to "automatic pilot," an alternative would be to use "mental" stops, where you don't place an official order. Instead, you have a price in mind of when you must consider selling the stock. At least this practice gives you time to evaluate the reasons for the decline and whether you should continue holding the position.

Some times, of course, a stock just doesn't work out as we expected, and there are indeed fundamental reasons why it may no longer be a good fit for our portfolios. Let's look at the case of Cree (CREE, $56), the maker of those LED light bulbs, which last week committed the unpardonable sin of failing to hit the "trifecta" with its latest quarterly earnings report. Earnings per share came in right at the consensus estimate, but revenues fell short, and the company's forward guidance for earnings was below the prevailing consensus. That might not be the kiss of death for all stocks, but CREE is (was) a high-flying momentum stock with a P/E (price-to-earnings) ratio that priced in a near-perfect future of growth. The stock took a drubbing, falling now some $20, or about 25%, in the four trading days since the report. Bank of America/ Merrill Lynch chimed in with its assessment that the stock is still over-priced and reiterated a $26 price target, citing the inevitable competition that CREE will face in the retail market for those new bulbs. Predictably, some analysts said the growth thesis was still intact, but the prevailing response was lowered ratings and price targets. Is this a buying opportunity? I don't think so. The stock is in that no-man's-land now, technically broken from a momentum perspective but still too expensive to be a value stock.

I sold my CREE shares at just about breakeven, as my experience has taught me that such high-flyers don't rebound quickly or easily. More important, though, is that one chief reason to sell any stock is when the reasons you bought the stock in the first place no longer hold true. That's a company-specific assessment, of course. I bought CREE as a growth and momentum stock, fully aware that even the slightest stumble would negate the case for owning it. As part of my diversification discipline in the accounts I manage, I am a firm believer in diversifying across investment styles--some value, some traditional growth, some momentum. And in the momentum category, LinkedIn (LNKD, $230) saw its analyst ratings and price targets move up following its earnings report. Despite all indications that CREE would perform in similar fashion, it did not. I "hired" the stock to do a job for me, and when it failed to deliver I let it go.

Maybe an investor has invested, say, $12,000 in a particular stock, and maybe there has been some development that has called into question the case for owning that stock. So now the position is worth $10,000. The investor can talk herself into waiting for the stock to get back to her cost basis, or she can view that $10,000 position as a source of funds. Is the current holding really the best place for that $10,000? Maybe she focuses on what is still there and available instead of the loss. A rose by any other name, to be sure--no amount of wishful thinking or redefinition is going to change the bottom line. Investing, though, is all about what's going to happen in the future, and sometimes our reality checks that come in the form of financial reports tell us that the future may not be as bright and smooth as we had initially thought. There will always be another opportunity knocking.

So that we can end on a more positive note, we'll revisit the television zombies. The AMC Network (AMCX, $65) has managed to pull off at least three shows that are both highly popular and critically acclaimed: Breaking Bad, Mad Men, and The Walking Dead. That would have been unthinkable for a cable network not so long ago. I think the investment case here is all about content, because something has to fill all of those channels that come through our cable boxes and our computers. In a future post we'll look again at some content companies such as Disney ($62), Lionsgate (LGF, $34), and CBS (CBS, $51). The way we receive media content may change over time, but someone is always going to be creating new programs and movies; that's the American Way. In the meantime, watch out for zombies--and don't turn into one. You want your bragging rights to be about something other than the one that got away.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of AMCX, LNKD, CBS, DIS, LGF, and PG. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.