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Rejecting risk

The principles of successful investing are very straightforward. Cut losses, run profits. Any investor that can jump out of losing positions cheaply, while sticking with winners, will do well over almost any timeframe.

The challenge is in implementing the principles. Cutting losses and admitting we’re wrong runs against our nature. Similarly, it’s human nature to jump on a profit, rather than allowing it to run. Overcoming our own instincts is one of the single most important challenges on the path to a high performing portfolio.

It’s one of the reasons that some market professionals seek “asymmetric risk”. An investment where potential losses are limited, and potential gains are significantly larger, offers a better opportunity to cut losses and run profits. While many of these one-sided investment exposures are constructed using options, investors don’t need a degree in rocket surgery to identify these types of opportunities. A good example is the current situation in The Reject Shop shares (TRS).

In an announcement on 21 November the Allensford Unit Trustee announced an on-market takeover bid for TRS. Apart from stirring nostalgia in still extant older brokers (most takeovers are off-market bids these days) it raised a number of important considerations.

Naturally TRS shares immediately rocketed higher. However an on market bid means the bidder will stand in the market at the bid price ($2.70 per share) until a specified date, which in this case is 7 January 2019. That date may be extended, at the discretion of the bidder. The TRS board has recommended that shareholders reject (*ahem*) the takeover bid.

TRS shares are trading around $2.75. The backstop of the takeover bid means investors buying at this price have a limited loss potential of 5 cents per share, at least until 7 January. They can simply turnaround and sell into the on-market bid at $2.70. However if another bidder emerges, or the shares simply recover some ground lost over the last 9 months, a TRS shareholder may see significant further gains. This limited loss, higher potential profit structure is a neat example of the one sided risk that can deliver portfolio outperformance over the long term.

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