Be Slower To Sell Your Winners And Quicker To Sell Your Losers

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Why IPOs are the best and the worst investment according to Logan Kane (0:40). How can behavioral finance make us better investors? (2:05) When should investors cut their losses and close out profits (10:30). IRAs, tax advantages and constructing a portfolio (20:00). What to buy in a bear market (21:25). Best metric for high quality small caps (25:20). Recorded live at Seeking Alpha’s Investing Summit on June 18, 2024 and originally published with video here.

Transcript

Max Gottlich: Thank you everyone for joining us. I’m Max Gottlich, News Editor at Seeking Alpha. This is Logan Kane, he’s the Founder of North of Sunset Publishing. So let’s kick off the session with a little intro from Logan.

Logan Kane: Hi, so I’ll reintroduce myself a little bit. My name is Logan Kane. I’ve been writing for Seeking Alpha since 2018. And we just recently passed 25,000 followers. Last couple of years, I’ve been able to write, travel the world, play poker.

Max Gottlich: Excellent. Now, so let’s start a little bit broad here. How do you incorporate behavioral finance into your overall investing framework?

Logan Kane: So I’ll start with this because this is kind of where behavioral finance intersects with life. So you guys have been to the grocery store, right? And you go and let’s say you’re looking for some milk or you’re looking for some lettuce, right?

What most people don’t know is that the grocery store actually puts the oldest products on the front of the shelf. If you reach around to the back that’s where the freshest product is.

Do you think Wall Street puts the fresh milk on the front of the shelf? They do not. And the classic example of this is the best investment and the worst investment, which is IPOs.

IPOs are the best investment, pretty much that there is. If you’re able to get in and get an allocation with an investment bank, they give you the stock, and then on the first day, it usually pops 20%. If it’s a popular IPO, you could be popping 70%, 100% or more. If you buy on the first day, the research shows after it opens that you will get a negative return.

But if you have friends at an investment bank or you pay them sufficient amount of commission, then you’re in. And we see this with SPACs and stuff too, where people get a – the institutional investors get a 20% free role on the retail investors. And what behavioral finance essentially is, is we’re combining psychology, economics, and investing.

Max Gottlich: In a recent article of yours, you talked about what you would call one of the most important anomalies within behavioral finance. And that’s what’s called the quality minus junk effect.

Can you explain to everyone what exactly that is and why that’s important for investors to know?

Logan Kane: I can, yeah. And in this recent article, so if you guys go to my author page, I have this article, it’s ‘can behavioral finance make you a better investor and improve your life?’ So if you guys go to this article, you can follow along and I’ve linked to case studies on some of these asset pricing anomalies.

So we’ll start with quality minus junk. So essentially, what they find is that companies that are profitable and growing outperform companies that are essentially junk by about 6% per year. And this isn’t really obvious to a lot of investors, because they have a fatal attraction to the worst stocks in the market. Just the companies that lose the most money, they put out the most press releases, people can’t get enough. But then you get stocks that are just small, profitable, and growing, and they grow, and people don’t give them enough credit and they should.

So if we’re looking to identify a quality stock, the most important signal that you have is a share price over $100. And if you’re looking for a junk stock, the average share price is about $7. The main way that you know this as well is quality companies as a rule are not losing money. Junk companies typically are losing money.

So if you look at like stock returns by credit ratings, you see that stocks with low credit ratings have bad returns, often negative returns if it’s low enough. And you can apply this quality minus junk by selecting the right indexes, or you can tailor your portfolio to avoid junk and to invest in quality.

For example, the S&P 600, the S&P 400, and the S&P 500 represent small, mid, and large-cap companies. They all have a quality screen in it, and most people don’t know this. A lot of broader stock market indexes, they don’t have this quality screen, and as a result, they underperform.

I did a study on S&P 600 versus the broader Russell 2000, and you’re looking at about 2% per year more in return over time. It’s massive. It’s – over the last 25 years, it’s just a massive return that compounds. And the only thing that’s different with them, essentially, is that the S&P 600 doesn’t allow junk and the Russell 2000 does allow the junk.

So invest in quality, avoid junk, live long and prosper, right?

Max Gottlich: How do you – is there any other ways that you normally look at to determine what’s quality, what’s junk?

Logan Kane: Yeah. So I would say junk is the easiest to identify. Like, you know it when you see it. Any company with an operating loss should immediately be a red flag when you’re looking at it as an investment. Any share price below $10 is a red flag.

Data on credit ratings is publicly available in any company. If it’s junk, like let’s say BB or below, you want to tread carefully. If it’s single B or even worse, like C rated or below, just don’t get involved with companies like this. And if you are going to get involved, you can get involved higher on the capital stack. A lot of these companies will have preferred stock, they’ll have convertible debt, stuff like that.

So just either avoid it altogether or invest the way the institutional investors are doing. Because a lot of times they’re using retail investors as cannon fodder. Like they’ll do big secondaries to bail out the convertible debt holders, to bail out the preferred shareholders. So you don’t want to be cannon fodder. Just stay out of the way of stocks like this. And it’s honestly really helpful, and it’s very basic, it’s very underrated. But if you’re able to do this, then your investment returns will be better over time.

Max Gottlich: You had also delved into the Capitalism Distribution study. And so let’s delve into that right now. I mean, what is the best way to avoid poor investments taking into account that study?

Logan Kane: So I didn’t write the study of the Capitalism Distribution, but essentially, what it says is that the top 20% to 30% of stocks are responsible for all of the gains in the stock market. In the long run, about 40% of stocks have negative long-run returns, or at least below the rate of cash. So if you’re investing in these companies, you might as well just have your money in cash.

And what happens is a lot of these companies that are the big winners, they stay big winners. So a lot of the companies that are big losers, they stay big losers. That’s why we call this the Capitalism Distribution. Really successful companies become way more successful. And companies that are unsuccessful just go to zero relatively quickly.

Another thing that you might want to know about really successful companies is that a lot of the most successful companies in the index end up getting acquired. So if you own a small company and it does really well, a lot of times you’re going to get acquired by a bigger company and that’s a good outcome for you. You’re usually getting a 30%, 40% premium.

So just looking at companies that might be good acquisition targets that might be – that are growing…

Max Gottlich: Let’s turn to perhaps the disposition effect, and which you had explained, it’s a tendency for investors to hold on to losing investments and sell winners kind of simultaneously, but it’s a dynamic that kind of seems so obvious to avoid yet so many people fall victim to it. Why do you think that is?

Logan Kane: Yeah. So the disposition effect, this is a classic financial anomaly. So basically, like let’s say, you have a portfolio with 100 stocks in it, right? So we know about this Capitalism Distribution. We know that some stocks are going to go up, and some stocks are going to go down, right? Some will stay the same. The winners are going to be up a lot.

Research from the U.S. and Western Europe over decades shows that investors tend to sell the stocks that are up and they tend to stay in the stocks that are down. They’ll even double down.

And as a general rule what you want to do is you want to hold the stocks, actually, because they keep going up. The stocks that have gone down, and people hold them. You shouldn’t do this.

So like let’s say you have a portfolio and you want to buy a car, right? So what you should honestly do in most cases is you should sell your worst investment to finance new purchases, and you should leave the ones that are winning alone.

Why do you want to punish the stocks that are doing the best for you? You don’t. And the disposition effect is one of the reasons why the premier stock market anomaly exists, which is momentum. So stocks that are going up, they tend to keep going up. Stocks that are going down, they tend to keep going down. And disposition effect and momentum are inextricably linked for these reasons.

One thing about the disposition effect that I think is interesting is that index funds do it really well. Index funds automatically hold their winners and they automatically drop the losers when they get de-indexed. That, in my opinion, actually is responsible for Index Funds outperforming individual investors in large part.

It’s not that the S&P return is a speed limit per se, it’s that if you don’t do the disposition effect well, it really doesn’t matter how good you are at picking stocks. And I’ll be the first to tell you, I’m not the best stock picker at Seeking Alpha, but I’m very good at knowing when I’m wrong and just getting out.

Another point on getting out is taxes. You can do tax loss harvesting when you have stocks that are down. Just get rid of them and you can buy them back 31 days later, and the loss will stay on your books for tax purposes. Once you try this, what you’ll notice is that rarely the stock that’s tanked that you sell and buy back 31 days later, it usually is not soaring in the 31 days. You’re usually buying it back even cheaper.

It’s useful, though. I’ve had years on the tax loss harvesting where I showed a tax loss, but I had an economic gain. That’s good. Most investors, if you have a stock that’s up a ton and you sell it to buy the car, you get a tax bill. And you might not actually have an economic gain if you’re holding onto these losers.

What you can end up doing is poisoning your portfolio over time by getting rid of everything that’s good and just piling into these stocks that keep going down. And that’s not to say that stocks that are down, you should always sell them. I mean, you should usually sell them and just at least try to buy them back if you still like them. Sometimes like stocks that are down become activist targets. Sometimes there’s a real turnaround.

But a lot of times, like if you’re an employee at a company that’s on the — that’s going downhill, like you just leave. So you see talent drain, you see all the stuff and people go to companies that are succeeding and that’s just kind of how capitalism works.

Just kind of understanding the nature of the stock market in that your overall success is going to be driven disproportionately by a few stocks is something that’s really useful to know, because it’ll keep you from inadvertently piling into losers.

Max Gottlich: So, if I may, at what point should investors cut their losses, as well as close out their profits? Is there some kind of thresholds?

Logan Kane: Absolutely, yeah. So I would say just as a general rule, if you’re down a third in a stock, it’s probably worth looking at taking a tax loss. I wouldn’t, I mean, when you look at your portfolio, what you can do with most brokerages is you can sort by gain and loss. So you can look at your biggest losers, and you can be like, all right, what went wrong here?

So if what went wrong is like there’s an investigation over a crash on an airline or something, and you think that the investigation is going to go well, or if you think a company is going to get acquired, or you think they’re going to turn it around, then you can take the loss, or you don’t even have to. About a third, I would say, on losses. And on the upside, you really don’t ever have to sell if you don’t want to.

I will say about the disposition effect that the less famous the stock is, the stronger the disposition effect tends to be. Stocks like NVIDIA (NVDA), for example, are an example of disposition and momentum. But you have this other thing going on, which is that the craziest people I know are all in on the stock. People – if a stock is up 50%, they’ll tend to sell it and cash in, but if it’s up 500%, you get people who are just like, all right, I’m just going to YOLO this and just put all of my money in it.

Max Gottlich: Sounds about right.

Logan Kane: But if there’s one thing that you guys learn from me and Max’s talk here is that you should be slower to sell your winners and quicker to sell your losers.

Max Gottlich: Inflation and interest rates pretty much at the epicenter of investors focus now, it seems the financial markets are becoming increasingly data-dependent, maybe more so than the Fed if that’s possible, but that’s what behavioral finance anomalies could explain such a dynamic?

Logan Kane: So I’ll answer the question with a question here, and I think it’s important for behavioral finance in your portfolios. And the question is, is the market becoming more efficient?

And I would argue that the answer is a resounding no. And the main reason I think this is, is that around 2018, 2019, most brokerages cut their commissions to zero. And this allowed a lot of people to do really crazy behavior with their trades. A lot of retail investors, I mean, they’ve done studies. And they’re all, like 80% of their portfolio is in like five stocks.

It’s Tesla (TSLA), it’s Apple (AAPL), NVIDIA now, and that’s pretty much it. They don’t even like Google (GOOG) (GOOGL). They don’t even like Microsoft (MSFT). The more drama the company has the more attracted people tend to be to it.

This is one thing that Seeking Alpha does pretty well, is there’s a lot of undercovered small-cap stocks that you can invest in, and they’re good. And if you don’t want to take the time to pick the stocks, you can just buy (IJR). It’s been crushed by higher interest rates, because a lot of these smaller companies have variable rate debt.

But over the full cycle, I think, you can get 200 basis points per year extra by investing in that versus the S&P. S&P is really top heavy. So I mean, you’ve got 35% of your money in essentially seven stocks now. And you are going to live and die by the performance of those stocks. So we don’t have to have a recession per se even for those stocks to do poorly. All that has to happen is that their profits are lower than their expectations are.

Historically, when you see markets get really, really concentrated, I mean, you get a wide range of outcomes, because your returns are just kind of dependent on the small group. I would say to try to diversify, the craziest people I know are all in on NVIDIA, so I don’t know if they’re accidental geniuses or if it’s going to go poorly for them. I mean, only time is going to be the judge of that.

If you don’t really love the stock market right now, there’s a lot of alternatives. I know a lot of people in Texas who run multimillion dollar a year revenue businesses, and they don’t even invest in the stock market at all. They just think it’s a casino game, and they might have 25 grand, they’re playing GameStop (GME) with, but all their money is either in cash, or it’s in real estate, or it’s in their business. They’re expanding the factories, or they’re drilling oil wells, they’re buying commercial real estate. They don’t really care, right?

But the stock market is the world’s biggest and richest game. An old favorite of Warren Buffett is merger arbitrage. So what you do is basically you find a company that’s being acquired, you buy the stock and wait for the deal to close. This is working well right now, because there’s deal spreads for one and two, the rate of cash is priced into the deal spreads.

So, you can pick up 5% return in six months. Sometimes you can pick up 10%, 20%, 30% if the deal is uncertain. You got to be a little careful that these deals don’t get challenged and they lose, but just kind of cursory due diligence on like, is the deal friendly? Are there major any trust concerns? You’ll kind of know on the merger arbitrage. I think it’s fun, it’s nice, because you get closed out, and you know whether you’re right or wrong in the end.

Also, another interesting investment for a lot of people is money market. So they did a study, and they said that 93% of people are getting 4% or less interest on their cash. In my view, that’s not acceptable. Half of people are earning less than 1%. I mean, I know people who have $500,000 sitting in Chase earning 0%.

And I’m like, Vanguard, Vanguard. That’s all you got to do. 5.5%, just by default, put it in a money market fund. If you don’t like Vanguard, you can go to Schwab. High interest savings accounts. You can do this. And a lot of people, they’re complaining about money, and they say, this inflation is killing me, but they’re earning no interest on their cash.

Also, like cash back games, you can play with credit cards. Like people who pay with their debit cards are subsidizing people who pay with credit cards. So you can essentially get 2% to 3% on every transaction you do. And over half of transactions are just done with debit cards. Like people really just don’t know this.

Relatively easy to get 2 grand, 3 grand in bonuses just by signing up and opening a few accounts. And if you ever lose your job or anything, it’s nice to have $100,000 in credit card, credit outstanding that you could lean on if you ever needed it.

Other fun economics research I’ve done. I don’t know if you all know this, but rent is cheaper in the winter. It’s cheaper to buy houses in the winter. The highest demand for rent is in the summer. So if you want to sell your house, try to do it in the summer. If you want to buy, do it in the winter, especially around the holidays. At least for rent, like in Manhattan, the data is crazy, on how much cheaper it is. It gives you maximum leverage if you ever want to negotiate as well.

Max Gottlich: I got a question about your sense in active investing? Well, essentially, I mean, what is your target in particular when actively investing in something? Do you have a target percentage that you want to close out on?

Logan Kane: Yeah, it just depends on the stock. I mean, you can only hit the pitches that you’re given. I mean, in some of this crypto stuff, like, there were really good opportunities like, the net asset values of the funds just had no correlation with like what the market price was. So you could buy like the Grayscale Bitcoin Trust (GBTC) for like 60% off. And we did buy that, and it went up like 5x.

On a lot of these merger arbitrage deals, you’re just trying to squeak out 4%, and that’s okay. As a general rule, when people are the most flush with cash is when the opportunities are the worst. And when people don’t have money is when the opportunities are the best. I started trading in 2008 and it was like shooting fish in a barrel.

People probably feel like it is now, but that’s just because the valuations have gone from high to higher. If we ever do get some sort of bear market, you can get a very bad situation where stocks are very expensive and they’re going down.

I think it’s worth noting from behavioral finance perspective that the market went down 50% twice in the last 25-years. So if markets were pretty efficient that wouldn’t happen, you know. You get a lot of people who go crazy with leverage, and they get forced to sell. And I promise you that is happening right now.

A lot of the leverage is implicit. You get a lot of these households that are dual income. And if one spouse loses their job, the house is going right on the market. We’re going to have a recession at some point and I think conservatism is good here.

Can we talk about arbitrage a little bit?

Max Gottlich: Yes, why not?

Logan Kane: So since we’re in New York, something that’s interesting is sports betting. So these bookmakers have come to New York, and they give these big bonuses and stuff, and they all disagree on the prices. And if you know how to do this, it can show you how to do stuff on the market, in the stock market as well. So what you can do is you can bet on the different sides of the same games, different bookies, and you can guarantee profit.

Everybody in this room, if they have the inclination, could probably make $5,000 just from sign-up bonuses. And, you know, I mean, we’re here to talk about investing, but if you do that for nothing else than practice to just spot arbitrage opportunities, you can take that thinking and you can apply it to the market.

Which I think, when you’re in the stock market, you’re competing with a lot of the smartest people in the world. And when you’re in these smaller private markets, like let’s say you have a business in Texas or something, you’re not competing against all the smartest people in the world. That’s historically why the private markets have had opportunities.

I’m not saying to go invest a bunch of money in private equity, because I think that the quality of people and private equity has generally declined over time. Like 10-years ago, the people were brilliant. Now every kid graduates and they want to get into these big private equity funds.

But just as a general rule, the stock market is hard. So we’re often looking for small edges here. I personally want to be flexible and to try to hit home runs later on. I’m pretty conservative by nature with investing. Some people are more aggressive, that’s fine. I mean, there are a 100 different ways to make money in the financial markets.

Do whatever helps you sleep at night, do whatever makes you happy, any asset allocation. You can be a dividend investor, you can do momentum. As long as it works, it’s cool with us. Q&A?

Max Gottlich: Q&A.

Male Speaker: So you were talking about tax loss harvesting as a possible technique for getting out of bad positions. If you have a lot of bad positions that happen to be in tax-advantaged accounts, like an IRA or something, do you have any recommendations for that or any recommendations for how you might construct a portfolio that has both a taxable and a tax-advantaged wing to it?

Logan Kane: Yes, what I would say for that is if you’re going to pick stocks, I would try to do it not in your IRA, but I would try to do it in a taxable account. If you just put the ETFs in your IRA, I mean you can’t do a 401(k), like pick the investments, but just try to do ETFs in the retirement and do your active stock picking. This way, if you have a gigantic winner or two, if you’re older, you might have to pay 40%, 50% in New York. I don’t know if New York taxes 401(k)s when they withdraw them.

But the tax rates can be higher. So a lot of times, like, if you had Bitcoin, for example, and it was going to go up a ton, what you can do is you end up paying less tax in a taxable account than you would in a tax-deferred account.

Male Speaker: I have a question regarding what kind of stock you buy during the hard times, let’s say in 2008 or 2020, and the whole day market’s going down, excuse me. But then how do you pick which one to buy? You buy the cheapest lousy company or you buy the most good company at a fair price?

Logan Kane: Sure. So there’s two schools of thought here in a bear market. And the first school of thought is to buy blue chip stocks at discounts. Like if you can get Coke (KO) and Walmart (WMT) and Procter & Gamble (PG) and stuff like that for 30% off then you might do it.

Another school of thought is to look for forced sellers like if a lot of people are being forced to sell a stock they had were over leveraged then they literally have to pay any price or they have to take any price that you’re offering.

And this was a big thing in 2008. Like Bank of America (BAC) was like $3 a share. You were getting these bank stocks for like nothing. And you knew, I mean, you didn’t know for sure, but they had like pretty solid credit ratings and stuff. So they probably weren’t going to go to zero.

My guess is that in the next downturn, I would say tech is probably going to fall the hardest. And I think you probably are going to have some good opportunities.

I would say international stocks are probably going to be the cheapest, because they’re already pretty cheap and they would get taken down with the whole market if we were to see a bear market here. That’s kind of how I would approach it.

Most people don’t know this, or I think a lot of people do, but the dollar is incredibly strong against the yen right now. So you can buy Japanese stocks for way, way less than you normally could. Eventually it’s my belief that their inflation is going to force them to raise interest rates and fix the problem with the yen. You can look at something called purchasing power parity, and what it says is like, all right, if a dollar buys me this in the U.S., it buys me $2 in Spain, right?

And this is more or less true, right? So for Japan right now, it’s incredibly cheap. And in a bear market, the dollar tends to strengthen. So I think you could set up some trades, like in Japanese stocks, where you might double or triple, just based on forced selling by big macro hedge funds, market being down, the stocks being cheap. And that’s really what you want when you’re looking for investments to buy.

Female Speaker: Hello. Thanks, Logan and Max. I have a question on the impact of the retail investors on the institutional investors. So as you mentioned about the retail investors might chase the momentum. For example, Nvidia, some people just go all in and you’ll own them. But what’s your opinion on those type of behaviors? How would that affect the institutional investors?

Logan Kane: Yes, so institutions do it too. A funny thing about being a mutual fund manager is that you can get fired if you do badly. And like as retail investors, we can’t get fired.

So I look at Nvidia tripled this year and I just laugh. I’m like, all right, I mean, I’m up a little, they’re up a lot, it’s all good. But if you’re a mutual fund manager and you don’t own Nvidia, you can get fired. And people in the industry, you know, there’s people who live in Manhattan and their kids are in private school and like if they don’t buy Nvidia, like they could lose their job so they have to buy Nvidia.

And what I would say is if you can predict what they’re going to be forced to buy six months from now, you’re going to make money. So I wouldn’t think like, oh, well, it’s up 300% or whatever, now I need to buy. I would try to figure out what they’re going to be forced to do later on.

And in the case of some of these people, if they’re over-leveraged, what they’re going to be forced to do is maybe sell. So maybe you can buy stocks on the cheap. Mutual fund managers, when they get redemptions, they have to sell. So that’s perhaps food for thought.

One more question.

Male Speaker: When looking for high quality small caps, do you have, is there one metric that most people don’t look at that you look at to determine whether they’re going to be big winners in the future? Because I know that, at least from my experience, most people are looking at high ROA, low PEG, free cash flow, EBITDA, et cetera?

But do you think there’s like one hidden metric that people don’t pay attention to that will tell you whether this stock will go up 3 times to 4 times in the future?

Logan Kane: Sure, I would say location. When I first got started investing, I bought this company called Cerner. They did medical research, or not medical research, they did medical, like electronic records. And any company that’s far from New York, it’s far from LA ideally, it’s in the Midwest or the South or somewhere people just don’t know about them.

If you can find a company that’s unpopular or kind of unknown then I think you can get higher returns as a general rule. If it’s a Silicon Valley IPO tech company, I mean, you might get high returns if they do really well, but everybody knows about it.

And can we take one more question from the front row here?

Male Speaker: For your benefit. I’m an old guy. I’ve been with a lot of houses over the years. I think I got the best investment advice that I’ve had in 50-years here today.

Logan Kane: That’s awesome. I really appreciate that. I’ll tell my mom you said that.

Max Gottlich: So that’s the perfect way to conclude our session here. And Logan, thank you so much for a wonderful insightful discussion. And thank you all again for coming.