Using sell discipline to cement returns

Fewer than 5% of analyst recommendations are to sell a stock.

So, portfolio managers must make their own tough calls on when to trade, says senior portfolio manager Barry Hirowatari. “[It’s] the weak spot in portfolio management,” he says. “In 2008 or 2013, it was the same thing.”

Over his 29-year career, Hirowatari, who works at Aventine Management in Abbotsford, B.C., has fine-tuned his sale criteria.

“First, I had a sell signal where, if earnings or revenues miss, then I would exit the stock,” he recalls, “but I learned from the tech bubble that by the time a company misses, the stock could be down 40% or 50%.”

He’s since moved to technical triggers. As manager of a tactical fund, he follows stock prices. If a stock moves lower for a month, he sells.

When buying, Hirowatari screens thousands of North American stocks, and is open to investing in companies of any size, in any sector.

He looks for companies with strong earnings per share, and stock prices on the upswing. Practically speaking, the model tends toward U.S. stocks with market caps of US$2 billion to US$10 billion.

“It’s a good area to look for good companies that are growing at an extraordinary rate,” he explains.

Hit

Ambarella (NASDAQ: AMBA)

A competitive cyclist, in 2014 Hirowatari noticed racers were wearing GoPro cameras.

“I looked at GoPro’s stock at the time, and it was doing pretty well, but I like to look at who’s supplying—the picks-and-shovels angle to the investment—as opposed to investing in something directly,” he explains.

Founded in 2004, Ambarella makes the video chips used in wearable cameras, computers, drones and cars. Rather than GoPro, “I thought it wiser to invest in the company that was supplying the chips to everybody,” he says, noting that Ambarella also supplies GoPro’s competitor Xiaomi, a Chinese smartphone and electronics manufacturer.

Putting it through the process

To qualify for Hirowatari’s funds, a stock must pass two screens. First, a company must have an earnings-per-share ratio that’s in the top-five percentile of all companies. He uses a ranking by Investor’s Business Daily that ranks stocks from one to 99 (99 is the best) by combining a company’s most recent two quarters of EPS growth with its three-to-five-year annual growth rate. Hirowatari only considers stocks that rank 95 or higher

Second, the stock’s price must be on an upward trend. Hirowatari has experimented with using daily and weekly trends, but found that monthly data smooths out day-to-day volatility while revealing the stock’s true direction. Ambarella’s stock had gone up 575% since it went public in 2012.

“Industry group is a significant part of the equation,” he adds, because even a lesser stock in a leading industry will probably make shareholders money, unlike a top stock in a lagging industry.

At the time of the investment, Ambarella’s semi-conductor group was ranked ninth of 197 by IBD. He also cites an IBD statistic stating that 37% of a stock’s price movement is directly tied to the performance of its industry group, while 12% is due to its sector.

“This is a classic stock that perfectly exemplifies the type of company we want to own in the portfolio: phenomenal earnings power, positive analyst revision momentum, increasing management guidance, operates in a niche market, [is] under the radar of most investors, and an excellent medium-term price trend,” Hirowatari wrote in his client newsletter.

He bought shares on Oct. 2, 2014 at US$42.08, with the stock 3% to 4% of the portfolio. At the time, its share price was at an all-time high. “Psychologically, this is a difficult thing for many investors,” he says. “But a stock that has doubled has more chance of doubling again than a stock that [has] halved. It makes intuitive sense: [with] a stock that’s doubled, the company is doing a lot of things right.”

Turning point

By June 2015, Ambarella was Hirowatari’s largest holding, at 14%. He raised his stake in the company 11 times. The semi-conductor group also rose to second in IBD’s ranking.

Company stats

Bank of the Internet

Ticker: NASDAQ: BOFI

HQ: San Diego, Calif.

What: Online consumer and business bank with about US$7.6 billion in assets.

Buy: US$33.17 (Aug. 5, 2015)

Sell: US$20.70 (Oct. 30, 2015)

Current price: US$24.40 (Nov. 23, 2016)

Ambarella

Ticker: NASDAQ: AMBA

HQ: Santa Clara, Calif.

What: Maker of high-definition portable video and image-processing technology.

Buy price: US$42.08 (Oct. 2, 2014)

Sell: US$91.15 (Sept. 1, 2015)

Current price: US$65.36 (Nov. 23, 2016)

“Adding heat” is what Hirowatari calls adding to a position when it’s performing well. “Ideally in portfolio management, you want your largest winner to be your biggest weight,” he explains. “The only way I know how to get close to that objective […] is to average up your position.”

As Hirowatari added heat, Ambarella announced a number of technical innovations and acquisitions that expanded its abilities and potential customer base. Analysts adjusted their target stock prices up, and the stock continued to appreciate. That spring, Ambarella’s earnings were up 184% year-over-year, and revenue was up 74%.

Results

In a widely distributed report, Citron Research short seller Andrew Left argued the stock was overvalued, noting the company’s forward price-to-earnings ratio was 41. He predicted its true stock price would be US$66.

In August, Ambarella’s stock dropped about 17%. The shift from gain to loss triggered Hirowatari’s monthly sell signal, and he sold his stake for US$91.15 on Sept. 1, 2015, representing a 117% gain.

“It’s typical of a trend follower—he can never get the top, because the stock has to trend lower before it triggers,” he says. “You wish you’d got the top, but you know that’s not going to happen.” Near the end of November, the stock was trading around US$65. While it was on an upward trend this summer, Hirowatari says its adjusted EPS doesn’t meet his buy threshold, so he’s not re-purchasing right now.

Miss

Bank of the Internet (NASDAQ: BOFI)

This branchless bank offers chequing, savings and mortgages to Americans. It has about US$7.6 billion in assets.

Putting it through the process

In the summer of 2015, Bank of the Internet met Hirowatari’s criteria for a stock going up in value, with adjusted earnings per share of US$0.40. Since 2007, the bank’s stock had risen 1,600%, and its industry group was ranked a respectable 26 of 197.

“I was looking at fundamentals and trends, and it all lined up at that time,” he says.

He bought on August 5, 2015 for US$33.17, and the stock made up 3% to 4% of his portfolio.

Turning point

Early signs of trouble for BofI came shortly after Hirowatari invested. An August 22, 2015 article in The New York Times raised questions about the bank’s lending strategy. It noted that BofI charged higher interest rates than larger banks in the same mortgage markets. It also raised concerns about whether the bank was doing enough due diligence on borrowers.

The article outlined several alleged cases where the bank lent millions to people who hadn’t paid back previous loans to other banks or were in legal disputes with lenders, and others who had been sentenced for fraud, including two people who ran Ponzi schemes.

The article pointed out that short sellers had been moving in on the bank, arguing that its loans were risker than average. Critics argued BofI was using the same loan model as the mortgages that triggered the financial crisis in 2008. It did note that most of the bank’s loans were for smaller amounts for single-family homes, and that home values would have to drop drastically before the bank would lose money.

In response, BofI CEO Greg Garrabrants said the complaints were part of a broader effort to stymie a deal it was working on to buy H&R Block’s banking business. Hirowatari checked on BofI’s stock when the story came out, and it was still going up, so he stayed invested.

But the allegations became more serious in October 2015. Matt Erhart, a former internal auditor at the bank, claimed he was wrongfully dismissed after telling management about fraud and mismanagement.

He alleged the bank didn’t screen out foreign nationals who shouldn’t have been able to borrow due to anti-money laundering laws. He also alleged the bank didn’t give regulators its customers’ full tax information. In response, the bank said its loans to foreign nationals passed regulatory review, and that it provided regulators with client tax information in a separate document Erhart didn’t know about.

Erhart also alleged that senior management had committed fraud, forgery, tax evasion, breaking and entering, threats and destruction of property. He also claimed just nine people made up 40% of the bank’s deposits.

He filed a lawsuit in U.S. federal court arguing BofI broke whistleblower protection laws by firing him. The bank later filed a countersuit alleging Erhart abused the bank’s private information, stating he was dismissed because he wasn’t doing his work.

In a conference call with investors, BofI CEO Garrabrants called Erhart inexperienced, and the allegations “old, baseless and factually inaccurate […] riddled with evidence of basic misunderstandings, inaccuracies, out-of-context statements and illogical conclusions.”

Hirowatari read a transcript of the call, but generally avoids making decisions based on management statements. “It was always hard for me to objectively sort through the bullish comments—they’re always bullish on their company—so I don’t talk to management,” he says.

On the day of Erhart’s allegations, “the stock fell 30%,” Hirowatari says. “Often in these situations, but not always, the stock will have some sort of recovery rally off the bad news. It didn’t happen.”

Results

“One of the hazards of individual-stock investing is event risk,” says Hirowatari, who adds he’s reflected on whether he could have avoided the loss.

“I have good sell discipline, but it will not catch these types of events. Statistically, you’re going to have some of these things happen to you—but you also get the good side, the great earnings and companies that surprise,” he adds.

In October 2015, three months after he purchased, he sold BofI at US$20.70. “I got my sell signal, and exited on a 37% loss, which was hard,” he says. At the time, the bank was 3% to 4% of the portfolio. “I’ll only add to [a position] if the stock keeps going my way month after month, and BofI didn’t have that kind of longevity,” he says. After Erhart’s allegations, a group of shareholders started what became a class-action suit against BofI, alleging the bank purposely misled investors about business risks.

The suit cites information from nine confidential witnesses. Hirowatari didn’t join the suit, as such cases often take years to be resolved or are unsuccessful. The bank has also continued making headlines.

Investor website Seeking Alpha published an article in April 2016 based on more former employees coming forward. They alleged nepotism, fraud, falsified audits, forged cheques and ties to a Salvadoran gambling ring. At the time, Seeking Alpha predicted that federal regulators would close the bank.

Still, Hirowatari says BofI has had two years of record earnings, and a law firm the bank hired to investigate Erhart’s claims concluded they were unfounded. (Erhart’s suit and the shareholders’ class action are still in court.)

“It would pass my screens right now,” Hirowatari notes, but he doesn’t plan on investing. “Often I won’t go back to something that has a lot of baggage around it. I have so many stocks to choose from.”