Thursday, 15 January 2015

When to Sell And When not to ?


Should I sell ? 

This question has been baffling me for quite some weeks now. The valuations of the stocks I hold looked fair a few months back, they looked stretched a few weeks back and they look super stretched now. To find an answer to this question, I searched for what great investors have written about this. After reading and thinking about this, I feel that what Philip Fisher wrote in 1957 in his book "Common Stocks and Uncommon Profits" is by far the best treatise written on this topic. Reading and careful re-readings of  Chapter 6 [When to sell and When not to?] in that book helped me crystallize my thoughts and clarified a lot of doubts in my mind. For my own benefit and the benefit of the readers, I thought of putting up the excerpts of that chapter in a post. What more ? I borrowed the title of the chapter as well. I couldn't think of a better title !

The following is an excerpt from the book.
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Start
 
I believe there are three reasons, and three reasons only, for the sale of any common stock which has been originally selected according to the investment principles already discussed in the book. 

  1. The first of these reasons should be obvious to anyone. This is when a mistake has been made in the original purchase and it becomes increasingly clear that the factual background of the particular company is, by a significant margin, less favourable than originally believed.
  2. Second reason. Sales should always be made of the stock of a company which, because of changes resulting from the passage of time, no longer qualifies in regard to fifteen points [reasons why you bought the stock in the first place] outlined earlier to the same degree it qualified at the time of purchase.When companies deteriorate in this way they usually do so for one of two reasons. Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its products in the way it formerly did. When any of these things happen the affected stock should be sold at once, regardless of how good the general market may look or how big the capital gains tax may be. Similarly, it sometimes happens that after growing spectacularly for many years, a company will reach a stage where the growth prospects of its markets are exhausted. From this time on, it will only do about as well as industry as a whole. It will progress at about the same rate as the national economy does. Hence, if after years of being experts in a young and growing industry, times change and the company has pretty well exhausted the growth prospects of its market, its shares have deteriorated in an important way from the standards outlined while buying the stock. Such a stock should then be sold.
  3. The third reason why a stock might be sold seldom arises, and should be acted upon only if an investor is very sure of his ground. It arises from the fact that opportunities for attractive investment are extremely hard to find. A word of caution may not be amiss, however, in regard to too readily selling a common stock in the hope of switching these funds into a still better one. There is always the risk that some major element in the picture has been misjudged. If this happens, the investment probably will not turn out nearly as well as anticipated. Therefore, before selling a rather satisfactory holding in order to get a still better one, there is need of the greatest care in trying to apprise accurately all elements of the situation.   
 End of excerpt
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In all 3 reasons, Fisher has not talked about valuation. So, in essence EVALUATION of the business before VALUATION of the business. The same thing we do while buying should be considered while selling. Sounds very crisp and clear.

We should be asking questions to ourselves about the companies we own before considering selling the stocks.

Is the competitive advantage of the business better than before ? Any deterioration in the bargaining power of the business ? How are the growth prospects ? Any foolish diversification attempted by the management ? Can the business continue to scale up and deploy large amounts of capital at attractive rates of return ? Change in the competitive landscape ?  Is it a better, larger and a stronger company now than when I bought the stock?  If the answers to these questions are largely in favour of the company in question, we know that the company is on the right track.

Now comes valuation. One reason which usually becomes predominant in our minds is about the stocks becoming overpriced. This is what Fisher wrote about stocks of good companies being overpriced, temporarily.

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Another line of reasoning so often used to cause well-intentioned but unsophisticated investors to miss huge future profits is the argument that an outstanding stock has become overpriced and therefor should be sold. What is more logical than this ? If a stock is overpriced, why not sell it rather than keep it?

Before reaching hasty conclusions, let us look a little bit below the surface. Just what is overpriced ? What are we trying to accomplish? Any really good stock will sell and should sell at a higher ratio to current earnings than a stock with a stable rather than an expanding earning power. After all, this probability of participating  in continued growth is obviously worth something. When we say that the stock is overpriced, we may mean that it is selling at an even higher ratio in relation to this expected earning power than we believe it should be. All of this is trying to measure something with a greater degree of preciseness than is possible. The investor cannot pinpoint just how much per share a particular company will earn two years from now or whether a sizable increase in average earnings is likely to occur a few years from now. Under these circumstances, how can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate ? If the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 percent overpriced ? 

That which really matters is not to disturb a position that is going to be worth a great deal more later. If for a while the stock loses, say 35 percent of its current market quotation, is this really such a serious matter? Again, isn't the maintaining of our position rather than the possibility of temporarily losing a small part of our capital gain the matter which is really important ?

Perhaps the thoughts behind this chapter might be put into a single sentence: If the job has been correctly done when a common stock is purchased, the time to sell it is- almost never.

End
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 Well, I am not sure of myself of not selling a stock ever but I am sure that with the Fisher's frame work in mind, atleast for some of my stocks, the time to sell it will not be now.

6 comments:

Anonymous said...

I believe there are 3 kind of scenarios
1)Business where Intrinsic value is Declining: These companies generally sell at low PE and induce value investors to buy at cheap price and it becomes a value trap
2)Business where Intrinsic Value is stable: Typical Ben grahm Type of Stocks –if you purchase at right price, need to sell it when the price and value converges within a 2-3 year time frame. If the vale doesn’t converge in the given time frame , there is opportunity cost of holding dead beat.
3)Business where Intrinsic value is growing: Typical buffet kind of companies (Coke / Walmart ) . I agree that these kind of companies , the time to sell is- almost never. But we need to be careful , there could a stupid manager making mistakes (like Microsoft purchasing unlreated business / Buffet selling of Fraddie Mae / Fannie Mae stocks)

Ankur Jain said...

Thanks Anon.

You are right. Fisher has also asked the investors to be careful about deterioration in the quality of the business and/or the management.

//

Ankur

Manish said...

Hi Ankur,

Do you still take part in risk arbitrage opportunities? I have read some of your analysis and those are fantastic reports, though 3-4 years ago I couldn't understand much :)
I am reading some stuff on that now including Joel Greenblatt's book. Could you give me some suggestions on how to improve??

Ankur Jain said...

Hi Manish,

Happy to know that you liked my analysis of some special sits. Undoubtedly special sits provide one hell of an excitement. But the problem is that it's difficult to deploy large amounts of capital in them for long periods of time.

So, I do invest in special sits but I have become very selective in my approach. I mentioned a couple of rules which I framed for myself when it comes to special sits. You can find them in the post on Shree Rama Multi Tech.

How to improve ? Well, it's like driving a car. The more you drive, the better you become. So, participate in a lot of special sits and you will improve.

You can also read Buffett's letters [parts of special sits]. He talks about Arcata Corporation case, also a large number of insurance deals are special sits only. Richard Zeckhauser's paper on UU opportunities also throws good light on special situations.

Best wishes

Ankur







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Puneet Kataria said...

Nicely written piece of investor wisdom.

Cheers
Puneet