The Principles and Cases of Stop-Loss in Value Investing - Cryptocurrency Exchange

I want to discuss whether value investors should cut losses, and when to do so.

I have previously dedicated programs to the issue of cutting losses.

In principle,

if a company’s stock price declines,

but the company’s operations have not experienced a permanent deterioration,

then the stock price decline is actually a release of risk.

In this case,

you should buy more as the price falls,

rather than cut losses.

Most stock market participants are speculators,

so when stocks plummet,

they often sell out because their funds are damaged,

and they fear further losses.

They do not consider the company’s operational status,

they just cut losses because the stock price has fallen.

We do not advocate this kind of loss-cutting.

The reason for value investors to cut losses is: to judge whether the company’s operations or industry are deteriorating,

or whether the initial investment judgment was wrong.

If the judgment was wrong,

then it is necessary to admit the mistake and cut losses.

The basis for admitting the mistake is not because the stock price has fallen,

on the contrary,

if the price drops,

and the reasons for the initial purchase still exist,

and the company’s operations have not experienced a permanent deterioration,

then you should buy more as the price falls.

Therefore,

cutting losses depends on the company’s operational status.

Taking Buffett’s recent liquidation of airline stocks as an example,

Berkshire Hathaway kept buying airline stocks one or two years ago,

which was actually a decision made by Buffett’s two successors.

They believed that the outlook for airlines would improve,

profits would increase,

industry concentration would gradually rise, among other reasons.

In the end,

it is clear that Buffett agreed with this decision.

Buffett suffered significant losses decades ago from investing in airlines,

so he has always been cautious about this industry.

Because the airline industry is indeed challenging,

labor costs are hard to control, and oil prices are uncontrollable,

it remains a non-differentiated industry.

When Buffett and his team bought in,

they did not know about the black swan event of the pandemic.

Under normal circumstances,

as a value investor facing such an event,

it could be an opportunity,

because stock prices have fallen,

and we should buy as much as possible.

But there is a premise here: does this affect the company’s permanent operational outlook? If it is only a temporary impact,

it can be overcome.

In fact, this pandemic has permanently changed the airline industry,

not just temporarily.

People’s fear of the pandemic,

may diminish within half a year or a year.

But the change in how people work, especially the shift to remote work,

has a permanent impact on the airline industry,

not just a temporary one.

Therefore,

they ultimately chose to admit the mistake and cut losses,

the original reasons for investing in airlines have disappeared,

because of operational deterioration.

Most airline companies have very high debt ratios,

so if the pandemic continues for a year or two,

many companies will go bankrupt.

This pandemic was unforeseen by Buffett and others,

because investing is essentially a matter of probability.

Even a master investor like Buffett

cannot predict such sudden events.

After the outbreak of the pandemic,

the survival of airline companies was under serious threat,

and Buffett realized the risk of bankruptcy in the near term,

so he decided to sell related stocks.

The duration of the pandemic is an unknown,

so he had to hedge against this risk.

Besides the bankruptcy risk,

another main reason Buffett sold stocks

is that the pandemic changed people’s lifestyles.

Taking the US as an example,

remote work has become the norm,

and this change will profoundly influence people’s habits.

Just as Americans were not used to wearing masks before,

after experiencing this pandemic,

their habits of not wearing masks will also change.

In the airline industry,

business class is the main source of profit,

its price is usually three to four times that of economy class,

while the costs are almost the same.

However,

as people become accustomed to online meetings,

the demand for business class will decline sharply.

Maybe a week or two won’t be enough to change habits,

but a few months are enough for people to adapt to new ways of working.

People are beginning to realize that face-to-face meetings are not always necessary,

especially with the increasing maturity of remote technology.

The loss of high-end customers will be a fatal blow to the survival and profits of the airline industry.

The airline industry itself has weak pricing power,

and future profit prospects have become worse and uncertain.

Therefore,

I believe Buffett’s decision to sell airline stocks can be summarized into two main reasons: first, the high debt ratio of the airline industry,

many companies faced bankruptcy during the pandemic,

and the uncertainty was uncontrollable; second, the permanent change in consumer behavior,

leading to the disappearance of demand for business class,

which will cause a significant decline in airline profits.

Buffett once said,

he does not buy stocks easily,

but he also does not sell easily.

Therefore,

his recent selling must have very clear reasons,

and these reasons are not secret.

Today, I summarize these two reasons,

which are likely the main factors behind his decision,

and these analyses do not require advanced knowledge.

Let me summarize for everyone,

when a company’s operational outlook has not experienced a permanent deterioration,

a falling stock price means buying more,

which is completely different from speculators who only look at the stock price decline.

For value investors,

the more the stock price falls, the smaller the risk,

so they will buy more,

but only if the company’s operations do not experience a permanent deterioration.

If the operations do experience a permanent deterioration,

then it is necessary to admit the mistake and cut losses.

The reason Buffett sold airline stocks this time,

is because he believes the airline industry faces high debt levels,

uncertainty about the pandemic’s duration, and the disappearance of business class demand,

these factors have caused a permanent deterioration in the industry’s operations.

Therefore,

he chose to cut losses,

admitting that his previous judgment was wrong.

After all,

the situation has changed,

and this change is permanent.

This case is very classic,

as value investors,

how should we view the relationship between stock prices and company operations,

continuously track and analyze the company’s performance,

and reassess whether the operational changes are temporary or permanent,

to decide whether to exit and cut losses.