Q&A: How can you tell when you’re on the wrong side of change?

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What advice do you have for figuring out when you're on the wrong side of change – when a company is going through some kind of disruption, upheaval, or other change for the worse – and knowing when and how to part ways with an investment?

One out of every three investments won’t work out. Investors have to know that going in. The hard truth is that failure is part of the business. Every investor – including myself – has made mistakes. Instead, success in investing is more like being a great hitter with a strong ratio of successes to mistakes.

One out of every three investments won’t work out. Instead, success in investing is more like being a great hitter with a strong ratio of successes to mistakes.

For me, to bolster that ratio, the number one metric is sales growth. All roads lead to sales. That's how companies pay bills. It's how they exist, how they hire. If sales are holding up, then that's generally a pretty good indicator for the future, no matter what else is going on. If that indicator changes, you need to start paying much closer attention and updating your due diligence.

Let’s say that I own equity in a company and had expectations for a certain amount of sales growth. We're expecting revenue to grow somewhere between 12% and 15%. We're expecting margins, maybe, to grow a couple hundred basis points. We expect EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization, a sort of proxy measure of cash flow) to grow somewhere between 15% to 20%. But then, when that company reports earnings, they guide down. It's not 12% to 15%. They indicate that they might not even grow 5%. Obviously, that's a red flag.

The first step here is information gathering. You want to understand why they're guiding down. What’s really happening? Are they still bringing in new customers? Are they selling more to existing customers?

To get this information, I have a list of people that I can contact. Since this is the primary work that I do, I cultivate these relationships. So, I know people that happen to work in certain industries. People that are more senior level but more frontline. People who are in sales. People who just understand the nitty-gritty of what's happening in different industries. And in this kind of situation, I have a series of questions that I ask them, like, "What are your customers saying? Why are they pushing back? Why are they completing deals? What competitors are you most concerned about? Why?"

At the end of the day, it's about rolling up your sleeves and looking at the mathematics of where the company is and why it’s growing or not, or why things are accelerating or decelerating, whether it's a one-time issue or not. Though I generally recommend a patience mindset in investing, sometimes, at a certain point, you’ve just got to be willing to say, "OK, I was wrong. I bought it because of A, B, and C factors, but now A and B are off the table.”

The hardest thing when the equation changes is the psychological aspect and facing the reality of the situation: "Geez, I have an unrealized loss of 20%." Understanding why is incredibly important, but so is having the humility to correct the error and acknowledge to yourself and others (my clients, in my case), "I got that wrong."

But getting out of a bad investment creates the opportunity to get into a good one. I might say to myself, “I’m taking a loss here, but I know that if I redeploy it into something else, then my risk-adjusted return is going to go up because I know this situation is going down a different path in this new situation."