Identifying Fundamental Breakdowns

This week we had a discussion on the JustCoveredCalls Yahoo Group, and on our weekly PalTalk chat, on whether to manage losing positions or sell them at a loss and reinvest the proceeds into a new position. There are pros and cons to both sides of this argument, and the discussion provided much food for thought.

My position has always been to only sell a stock when there's been a fundamental breakdown in the company, not based on a declining stock price. As a result of this discussion, I decided to refine my strategy in this area. My prior criteria was somewhat subjective, so I decided that I needed a more objective set of criteria. I developed a spreadsheet to identify a fundamental breakdown based on fair value and margin of safety. As you may know, I use Morningstar fair value estimates as a primary criteria for establishing new positions, so my thought here is to track these estimates over the life of each position.

Morningstar periodically reviews each company they cover, for example after each earnings cycle and at other times when either the company fundamentals or macro economic conditions change. During these reviews the fair value may be left unchanged, raised, or lowered. As a value investor, I try to buy, and subsequently hold, a company's stock that's priced at a discount to its fair value, which provides a margin of safety. Therefore, when the fair value is lowered, it also lowers, or possibly eliminates, the margin of safety.

When each position is established, I'll record the original fair value and calculate my original margin of safety based on the initial purchase price. Whenever the fair value is revised, I'll compare the original fair value and margin of safety to the current fair value and margin of safety based on my current cost basis, including dividends and option premiums. I'll use the following criteria to flag positions for further review and possible sale:

1. Companies that have had their fair value lowered. These positions will be reviewed and put on a watch list.

2. Companies were my current cost basis, including dividends and option premiums, is less than 10% below the current fair value. These positions will be reviewed and either be put on probation or sold. If the fair value gets lowered again they will be sold.

3. Companies were my current cost basis, including dividends and option premiums, is 10% above the current fair value. These positions no longer have a margin of safety and will be sold.

Now some may ask why not just close the position as soon as the fair value is lowered. Well, I take a longer term view of the companies I own. Companies may stumble for a quarter or two, sometimes at no fault of their own, especially in a difficult macro economic environment like the one we’re in. So, I give them more time to work things out, especially if they’re paying a dividend and if there's still a decent margin of safety. Every company will go through hard times, but the good ones will recover. This is one reason I've switched to dividend paying stocks that have a history of increasing their dividends. I tend to give these companies the benefit of the doubt and will continue to hold them as long as the dividend is safe.

Hopefully this new review process will be more objective than the one I previously used and allow me to recognize fundamental breakdowns in the companies I own and help in deciding which positions to hold and which positions to sell.