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Dominos and the bottom drawer

Picking stocks is an exercise in predicting the future. No matter how intelligent or hard-working, no-one knows the future with certainty. In both strategic and tactical terms as investors we make our best estimates based on the available information. It is inevitable that at times our choices will lead to poor investments.

Putting stocks in “the bottom draw” is a classic investment mistake. Sitting on losing positions until they “come good” not only drags on a portfolio’s value, it ties up capital that is better deployed elsewhere. There are techniques available to help avoid this error. The most popular is the use of stop loss orders.

Stop loss orders recognise the limitations of forecasting. Essentially they ask investors “at what stock price will I say this a poor choice?” The best time to make this decision is before the investment is made. Ideally a sell stop loss order is placed with the buy order.

However like any risk management techniques the use of stop loss orders has its own risks. This brings us to Domino’s Pizza (DMP).

When Domino’s fell below $40 in August last year and then stabilised around $43 it came onto my radar. Earnings growth slowed – from near 30% to around current guidance of 17%-20%. The PE to Growth ratio was around 1.5x – attractive in my view. The risk management aspect also worked. The clear low at $39.50 gave a line in the sand. Buying at $43.30 with a stop loss sell order at $39.30 fits my investment strategy.

Alert readers can see what’s coming. The results delivered on February 13 were largely in line with consensus, or potentially a small miss. However the share price reaction was extraordinary. The shares were smashed over the next few weeks, from close to $50 to a low at $38.11. Naturally this triggered many stop loss orders.

DMP is consistently ranked as one of Australia’s most shorted stocks. The current short position is around 16% of the issued capital, or 12 million shares. With the event risk of the results announcement out of the way it’s possible the selling was related to existing shorts. In my view the current share price represents an opportunity to gain exposure to a higher growth stock. However, maintaining portfolio discipline is even more important to long term investing success than stock picking. Under my rules I can’t buy DMP until a clear uptrend is described. At the moment that means a move over $50. What do your rules say?

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