11 STEPS TO DISSECT A LOSS Early in my career as a hedge fund analyst I had this naïve and delusional belief that I could avoid big losers. That I would work harder and be more clever than the pack, and subsequently not deal with the losing side of the stock picking ledger.
Oh, the naivety of youth. With experience & maturity, I realized (painfully) that losses, sometimes gigantic losses, are part of the game. As stock pickers we have to accept that reality. That brings me to...
STEP 1. KNOW LOSSES WILL HAPPEN. It's inevitable. You may get a hot hand and avoid big losses for a period. But you won't escape the reaper. Equities are structurally too volatile, too unpredictable to be right every time. Hopefully when you are wrong, if you are respecting
asymmetry, you can take minimal losses in a risk case. But losses will happen. Accept it, and move on with your day. STEP 2. HOW YOU RESPOND IS KEY. Very few of the big losers in my career, or big losers I have observed by peers, have been one day events. Most big losers are
compound mistakes. The proverbial frog becomes boiled and it is death by a thousand cuts, usually with some crescendo despair hate-sell event capping off the awful event. When a loss emerges, staying objective & rational is key. The emotions of attachment & aversion are your
enemies. The "chasing" impulse of "I have to get this loss" back is a sure sign you've lost your objectivity. As a young analyst, a loss can be a tremendous opportunity to build credibility with your PM by responding the right way. Don't be a reflexive table pounder and don't
get emotional (coming from a reformed table pounder who has cried in his PM's office more than once. True story.) STEP 3. KNOW THAT LOSSES WILL CHALLENGE YOUR RATIONALITY. You will learn more about dealing with a loss by studying Buddhism & Kahneman than you will by studying
Damodaran & Buffett. Technical skills are not the issue here. Study the endowment effect, and understand that when you buy a stock at $50 and it goes down to $40, your emotional impulse might be to reflexively defend. That impulse can be your worst enemy.
Simply understanding this breakdown of my own rationality has helped me. But also creating quantitative, objective guard rails around my stock picking has been critical to overcoming this loss of rationality.
For me, it has been rules like "if valuation is my top thesis point, run" and "if I don't see upside to out year EPS, I need to have some other concrete value realization catalyst". Building pattern recognition of losing stocks over time and realizing many losers have a life
cycle has also helped. STEP 4. DOCUMENT YOUR PROCESS. I highly recommend building a research structure where you are documenting your research along the way. Keep a note of earnings calls, mgmt meetings, channel checks in one central repository. Periodically save versions
of your models. In the loss dissection process, the documentation of your process will be critical in identifying process breakdowns. STEP 5. DO A PRE-MORTEM. In the initial construction of your thesis, create some sort of write up. This will be bespoke to your team/firm, but
I've always preferred 50+ page PPT decks. I always guided my analysts as a PM to think critically about how we could lose before the trade was initiated. What is the risk case and what is the probability tree? If we are wrong, what is the likely reason?
This pre-mortem can be critical in the loss dissection process. If I'm an analyst and pitch a stock at $50 that goes to $25, I can pull this down and compare that to our initial conception of the risk case. That doesn't bring the P&L back, but at least that can provide
evidence that our process isn't completely broken, and perhaps this is a situation where simple variance took hold. Compare this to an analyst who pitches a +50%/-25% R/R and the stock goes down 70%. There is something broken in the analyst's process in that case, and as a PM
I quickly lose credibility in the analyst's ability to conceive of R/R. STEP 6. DISAGGREGATE THE SOURCE OF THE LOSS. Why did the stock go down 50%? Did the P/E go from 40x to 20x? Or did EPS go from $2 to $1? I like the bring the simple P/E x EPS framework to bear here.
Was this an error of underwriting valuation or fundamentals? Was there unanticipated dilution that happened? STEP 7. ISOLATE THE SOURCE. Work to get very specific on what happened. Did we expect GMs to go from 70% to 75% and they went to 65%? Why?
Did we expect P/E to go from 15x to 20x on an organic revenue growth acceleration thesis but organic revenue growth slowed, the company did a stupid acquisition, and P/E ended up at 10x? Isolate this. Work to understand and communicate this with as much clarity as possible.
The mindset should be "What did we think would happen. What happened. And why were we wrong." Approach this isolation with a dispassionate, fact-finder's mindset. STEP 8. ON DOUBLING DOWN. Once you are through Steps 1-7, if the stock is still in the portfolio, the right answer
may be "double down & buy more". Stocks do sell off for stupid reasons. All I would say is this...early in my career I assumed 95% of big cracks were double-downs...later in my career it's usually closer to 40%. Stocks have big moves down for a reason, and often it's an early
sign that the thesis is broken. Do your best to see clearly in the fog of war and understand that often "your first loss can be your best loss" STEP 9. UNDERSTAND THE ROLE OF LUCK. Mauboussin has written extensively on this. Honestly, sometimes you just get lucky (or unlucky).
If the process is tight and the isolated source of loss is an unpredictable externality, that might be the end of the process. Not every loss is an indication of a bad process, just as a poker player can get dealt pocket aces, play the rounds perfectly, and still get those
aces cracked. Be careful to be thoughtful in your dissection process and not overfit & extract lessons where they do not exist. As an analyst, particularly a younger analyst, be careful, however, to ascribing a big loss to "bad luck".
STEP 11. SUMMARIZE SUCCINCTLY. You can't put your head in the sand after a big loss. You have to own up, take responsibility, and SHOW your PM and firm that you are not rattled. You are objective, dispassionate, and will make the right decision. Your process is tight,
you just got this one wrong. Do a 2-5 page dissection with pre-mortem, process documentation, issue isolation and succinct summary. STEP 12. THEN....MOVE ON. Don't dwell on it. You struck out. It happens. A big loss can lead to a spiral. BOUNCE BACK. Get the next one right.