There’s been no shortage of surprises in the past month. The biggest involved our holding Take-Two Interactive Software (TTWO) and their western epic Red Dead Redemption. I suggested in April that the consensus analyst estimates (that the game would sell between 2 and 3 million copies) were certainly reasonable, but that because of extremely positive previews and canny promotion, were more likely to be at the low end of a probable range that could extend as high as 10 million. Well, in one respect, we got lucky. When figures came out after the game’s release, they revealed that it had shipped 5 million copies in less than a month! This exceeded even my wildly bullish expectations and guaranteed that Take-Two has another blockbuster franchise on their hands to put next to Grand Theft Auto, which shipped 17 million of its last version.
A funny thing happened on the way to gaudy returns. The stock went not up, but down 15% in the following month, handily outpacing the market’s decline and giving us a hit we would have avoided if we hadn’t been holding it.
So I want to use this example as a case study, to consider our possible options for reacting to such a situation.
1) We can defer to the market’s judgment and assume that, because it is wiser than us, it knows something we don’t. This reaction is characteristic of subscribers to the efficient market hypothesis, which argues in a nutshell that markets instantly incorporate all publicly available information into share prices and are thus impossible to beat with only public information. Some version of this deference to the market’s intelligence explains why journalists claim that markets declined “because of worries about the Euro” or rose because of “confidence in the employment numbers.” Such a view to me seems misguided, and more than a bit paranoid. Why should markets always have a reason to do what they do when the people that comprise them don’t? This is exactly the critique made by behavioral finance professors, whose popularity seems to be inversely correlated with the level of the S&P 500.
2) We can decide that the market is crazy and market prices are random, ignore the decline and buy more. This is a common view as well, and is drawn from the value approach with which I wholly identify. But it is an extremely dangerous view. There are a handful of companies I would blindly buy into a decline, but the list isn’t long. The reason is that sometimes things do indeed go wrong, and the fact that there is frequently no good reason for a decline doesn’t mean there is never a good reason. Sometimes people with an informational advantage really are selling because they know something others don’t. In our case, Take-Two has a couple of things to worry about that would not be concerns with WMT or JNJ: inventories have been on the rise, management does not inspire confidence, and these or any number of other problems could mean that there is actually something to worry about in a decline.
3) We can take a more pragmatic view. We can see opportunity in the decline and still intend to hold the company for a long period, but refuse to allow our confidence in our position run the risk of bankrupting us. As you might guess, this is the line I have taken. I’ve opted to cut back the position to the point at which a further decline would not be catastrophic, with the intention of adding to the position if it declines further. This compromise allows us to take advantage of market declines while still being careful not to leave ourselves vulnerable to a crippling capital loss.
This decision is also conditional on the kind of company involved. If TTWO were a battleship like Coca-Cola or Church & Dwight (or WMT or JNJ, for that matter), I would be more inclined to buy aggressively. The reality is that it is a software maker with excellent products, but with some real problems as well that shouldn’t be revised away.
