In the game of Poker, an oft-spoken adage is “You’ve got to know when to hold ‘em and when to fold ‘em”. Unfortunately, I am often reminded of this axiom at precisely the moment after I needed to hear it. This is but one of the many reasons that I am not playing on the World Poker Tour. Though my Poker knowledge is certainly lacking, I do know that the decision of when to hold or fold depends upon how well one knows two other variables: the odds of getting a decent hand and the behavior of the guy across the table.
Thankfully, the first variable – the odds of getting a decent hand – can be readily quantified. A skilled player knows that a deck of cards is finite and he knows the expected probability that a certain card will be drawn from the deck. Thus, with this information, he can easily determine the odds of making a decent hand and, if he plays these odds well, can probably bring in a decent haul playing online poker.
To become a great poker player, however, one must conquer a variable that is far more difficult to decipher – the behavior of one’s opponent. To do so, one needs to have a mixture of intuition and clear-headedness. Of course, having these two traits does not mean that a player can read his opponent’s mind. What it does mean, however, is that when his opponent puts him on the ropes, he won’t panic or immediately flee the hand. Instead, he’ll coolly and deliberately assess his situation and the previous actions of his opponent, and then make his decision to hold or fold. The same methodology applies to the moments when his opponent is showing signs of weakness, as well.
The same adage – “You’ve got to know when to hold ‘em and when to fold ‘em” – could readily be applied to the world of investing, as well; though its application would be wholly different. After all, unlike the odds of getting a decent hand in poker, the future return of a stock or a basket of stocks is not something that can be easily quantified. In the real world, there is no finite number of possible events that can affect a stock’s price – as many others have pointed out: in the realm of investing, the only certainty is that uncertain things are bound to happen.
Aside: Although devotees of Modern Portfolio Theory might suggest otherwise, an investor cannot simply use historical returns as a basis for predicting the future performance. (Just imagine if a poker player adopted a strategy for his current hand that was solely based upon what cards were drawn in the previous ones.)
Thus, unlike poker, the game of investing is not one that can be played using probabilities. However, it is a one that relies just as heavily – if not more – upon the same ability to remain calm and to reason deliberately that has ensured the success of so many great poker players. This ability to coolly consider the facts that tell what is and suggest what may be is an absolutely essential tool for an investor who is considering whether to sell or hold a stock.
Staying calm and reasoning coolly is, of course, not particularly easy. After all, the market, like a poker player’s opponent, is constantly suggesting to investors its own perception of reality – one that might support or undermine the facts that an individual investor is considering. When the perception of an investor and the market conflicts – perhaps in an instance where the market is saying that a stock is worth far less than an investor believes it to be – a significant amount of pressure is placed on the investor. It’s as if a poker player’s opponent has just gone all in on a decisive hand.
Through their deeds and words, the most successful investors in history have consistently reminded others that the proper strategy in such a tense situation is first and foremost to stay calm. Then, one must deliberately reconsider the facts and fundamentals that comprise a stock. If the only thing that has changed about a situation is the market’s perception of it, then investors needn’t fret. They should just call Mr. Market’s bluff and stay in their positions.
Here are a few examples of this type of thinking from my own investing experiences.
Gulf Resources (GFRE), a Chinese provider of bromine, crude salt and specialty chemicals, is, by far, my most successful pick to date. But if you had asked Mr. Market if it was a successful pick in late 2008, he’d have told a very different story. I originally purchased shares of the company at $3.20 in mid-2008. By December of the same year, they traded at $0.82 per share – almost 74% below where I purchased them. It was at this price that I made my last purchase of the company.
At that point, I was hardly calm, but I was ultimately able to restrain my urgent desire to flee the hand that I had been dealt. I am glad that I didn’t fold. In the year that followed that purchase, Gulf Resources rebounded to as high as $14.94 per share.
Harbin Electric (HRBN) is another hand that I have refused to fold. The Chinese maker of electric motors is expected to make upwards of $3 per share in earnings in 2010. However, the market has made a strong raise against the company, sending it down from its March 52-week high of $26.00 to its current price of just over $17 per share. I think Mr. Market is bluffing and will hold the shares until they reach a fair valuation.
Xyratex (XRTX) is a position that seems to be working out for me. This provider of storage solutions is trading at ridiculously low levels given its large cash position ($1.93/share) and future earnings potential (Forward P/E of 5.62). I’m up, but will still hold. I know how good this hand is, and will only cash in when I can get what it’s truly worth.
Those who play the stock market exactly like they play poker are bound to get busted. But the game does have a few valuable lessons to teach investors – keeping calm and deliberately considering the hand you’ve been dealt are great ones. Studying them and practicing them can help investors know “…when to hold ‘em and when to fold ‘em.”
Disclosure: Author holds long positions in GFRE, HRBN, and XRTX.
I have a theory about horror films: What truly frightens the heck out of so many viewers isn’t so much the disturbing and grotesque imagery – rather, it’s the fact that what appears on screen does not rationally comply with the world that we know.
Consider the following: In the film, Saving Private Ryan, the viewer witnesses the often-grotesque deaths of many soldiers. While these visuals might certainly be disturbing to some, they do not deliver the type of intense fear that interrupts the blissful slumbers of quite a few horror-movie-goers. And why should they? Though the images from Saving Private Ryan may not make us feel warm inside, we expect to see them. In real life, soldiers do perish on far-off battlefields. What we see makes sense.
What doesn’t make sense are the following visuals: a horrifically mutilated girl crawls out of television screens and turns perfectly alive human beings into perfectly lifeless disfigured corpses (The Ring); a child crab-walks down a flight of stairs at a frightening pace and vomits when she reaches the landing (The Exorcist); a children’s doll comes to life and brutally murders people (Chucky).
Get the idea? When expected things happen (soldiers dying) – no big deal. When unexpected things happen (scary girl crawling out of TV) – panic. What really scares us – what really jars our minds – is when things happen that just don’t make sense.
Often, the stock market is a veritable factory for this type of fear. Consider the following example:
Xyratex Ltd., (XRTX) is a British data storage solutions provider whose six largest customers – NetApp, Dell, IBM, Seagate, Western Digital and Data Domain – are practically household names. By any rational analysis of its present financial condition, the company appears to be startlingly undervalued. The current consensus of six analysts expects Xyratex to earn $4.23 per share in FY 2010 on revenue of $1.6 billion. Given the company’s present share price ($11.49), this would equate to a P/E ratio of about 2.72 – or 2.26 if you back out the company’s $1.93 per share cash hoard. Granted, the analyst estimates for 2011 are not quite as rosy – $2.91 EPS on flat revenue – but even when one considers these less favorable forward projections, the company’s valuation remains shockingly low. Why then, does this company’s stock price languish at such low levels?
It just doesn’t make sense.
And that’s just it. When the recent stock market malaise began in late spring, this relatively unknown small-cap company seems to have been unfairly punished by the moody Mr. Market. What resulted was a dizzying 45% drop from the 52-week highs that Xyratex notched in April to the prices that investors see today. And when prices fall, investors tend to get scared.
“The stock price has gone down despite stellar earnings! Something must be wrong!” investors might reason. So they sell their stock, which, of course, lowers the price even more; this, in turn, creates more fear and induces even more people to sell their stock. What results is a self-reinforcing price depression that simply doesn’t make sense.
So how does it end? Well, if one trusts in the wisdom of noted investors Benjamin Graham and Warren Buffett, then the following conclusion to this stock market horror film seems realistic: At some point, the strong fundamentals of Xyratex will be made manifest in its stock price. Of course, there’s no telling when this may occur, but, for now, I am perfectly willing to wait until the end of this horror film.
Disclosure: The author holds a LONG position in XRTX.