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Out with the old

Out with the old

Buying shares is fun. You do your research, think you've found a winner, and hope that you just have to sit back and watch the share price rise.

Sometimes you find that elusive winner and elation and greed ensues. Other times, the stock falls and you worry another plunge is nigh. Indeed, some behavioural economists have shown that the psychological pain from a loss is twice as powerful as the enjoyment derived from an equal gain. Consequently, we often sell too quickly to stop the pain, potentially robbing ourselves of longer-term gains.

Similarly, we must wrestle with regret aversion when we consider a sale. We agonise over questions like: "What if I sell and the share doubles next week?" or "What if I do nothing and the stock falls?" The result is often indecision, but there is no room for indecision. Even if you do not make a buy or sell decision, you are still, in fact, making a decision to hold. Whatever you choose, you need to understand why you're making the decision to act or not act. We do not learn if we bury our heads in the sand.


Simple, not easy

Selling stocks isn't easy, but that doesn't mean it has to be overcomplicated. Plenty of ink has been spilled on strategies for buying stocks, yet investors commonly struggle with knowing when to sell. At its core, a good selling strategy should aim to both preserve capital and enable your capital to be allocated to the best available investments.

Traders have their own selling strategies that include using stop-losses and hard rules for profit-taking. Such rules are put in place to maintain the speculator's discipline. On the other hand, investors wanting to own pieces of wonderful businesses that they plan to own indefinitely should be sceptical about hard trading rules. Too much tinkering entirely defeats the purpose of being a business-focused investor. For this type of investor, there are three situations when a sale could be warranted: the story has changed, the stock is materially overvalued or you have a better place for the money. Let's explore each of these reasons in greater depth.


The story has changed

Before making any investment, investors should naturally conduct due diligence. Take pieces of information from various sources, stitch them together and develop a thesis for why you are buying shares of the business. Bear in mind, of course, that during this process there's a strong likelihood that you'll misinterpret or miss something important.

This is not a tragedy, but when it occurs we need to understand what we missed, own up to it and determine whether or not what we missed is significant. This sounds easy; it is much harder in practice. Either we're unwilling to acknowledge the mistake or we rationalise it away as being less important than it really is.

This is called 'thesis creep': we adapt our old thesis to the new information rather than use the information to challenge our old conclusions. One way to avoid thesis creep in your process is to keep a thorough journal. Before buying a new share or adding to an existing one, write down at least five reasons you want to own shares of the business and three reasons why the business could struggle.

Here's an example. Let's say you wanted to buy business software company, Sage (SGE). A few lines of your investment journal entry could be:


Reasons to buy:

1. Sage's accounting and payroll offerings are mission-critical tools to the small- and medium-sized businesses they serve. Competitors would have to show significant productivity gains or cost savings to convince a Sage customer to switch to their service.

2. Sage has a high customer renewal rate of 86 per cent, which has increased in recent years and is evidence of the company's durable switching cost advantage.

3. Sage has robust free cash flow margins above 15 per cent, which contributes to its ability to fund and grow its dividends for years to come.

4. Even in a recession, companies need to process payroll and manage accounts. Sage's products are likely to be one of the last things to go in a downturn.

5. Sage consistently generates more free cash flow than net income, suggesting healthy earnings quality.

Major risks:

1. Companies have taken notice of Sage's strong returns and high profit margins and competitors' cloud-based offerings are getting better.

2. As Sage moves into new international markets, it faces entrenched market leaders with their own sets of switching cost advantages.

3. Sage has a mixed acquisition track record, so be sceptical of any major deal made outside of its core competency.


With these entries on hand, you can more objectively evaluate future changes in Sage's business. If customer retention ratios begin to decline, for example, the company's switching cost advantage may be diminishing. If this occurs, it's time to re-evaluate your investment.


The stock is materially overvalued

Buy low, sell high. That's what we're supposed to do, right?

Naturally, each investor has his or her own method for determining when a share is under- or overvalued. Some are as basic as comparing price/earnings ratios - although this is more 'pricing' the share than valuing it - while others employ discounted cash flow models. All valuation approaches have one thing in common, though: they're wrong. It's just a question of to what degree the valuation is wrong.

I say this for two reasons. First, most valuation work suffers from the malady of false precision. In a discounted cash flow model, the investor makes bold assumptions about cash flows and growth rates a decade into the future, discounts them back to the present at another assumed rate and concludes the share is worth precisely '623p per share'. If the share in question is trading for 500p today, the investor may think it's cheap, buy it and look to quickly sell it when it trades near 623p. Sounds like a reasonable approach, right? In my investing career, however, it's been the cause of some costly mistakes.

I have no problem with investors making explicit forecasts - in fact, I encourage it since the share price already implies certain growth rates and risk factors - but some humility is needed when valuing a company. This can be achieved by considering a wide range of potential outcomes and weighing them against the current stock price. Using the previous example, the investor tests various growth and cash flow scenarios to determine that the stock is worth somewhere between 530p and 725p. The low end of the range assumes a bearish scenario and the high end a more bullish one. By using this approach, the investor can more reasonably conclude that if the share is trading close to, say, 800p there's a high likelihood that all the good news is already priced in. A sell may be in order.

Too much tinkering entirely defeats the purpose of being a business-focused investor”

The second reason all valuation models are wrong is that a company's intrinsic value changes every day while models are static. In the owner's manual for Berkshire Hathaway shareholders, for instance, Warren Buffett writes: "As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised."

In theory, every time a company wins a new customer, retains an existing customer, reduces its production cost, or enhances its brand perception, the valuation model should be updated. As an outside investor, though, you aren't aware of these day-to-day changes. Further, your intrinsic value estimate should increase each day (assuming no forecast changes) due to the time value of money. Far too often, investors use stale models to make sell decisions and should instead review their assumptions before making a final call.

In general, investors have better odds of determining whether or not they own an attractive business than if a company is overvalued in the market. Before selling due to valuation concerns, then, consider a range of potential outcomes, try to determine what the market might be pricing in to the share today, and make sure your work is up to date. If you still find that the share is more than 25 per cent above your fair value range, it might be a good time to sell.


You have a better place for the money

The final 'good' reason for selling a share is if you want to reallocate your capital elsewhere. This could be for personal reasons - eg buying a house or paying for a child's education - or for investment reasons. Satisfaction can indeed be taken from selling a well-performing share to help fund something important in your life. No shame in that whatsoever.

On the other hand, if you're selling a stock just to swap it for another one, be sure to set a high hurdle for making the switch. Investing in a new share can be more exciting than simply holding on to or adding to a current position, but good investing is rarely exciting. If anything, boring is better.

Still, there can be times when it makes sense to sell a low-conviction current holding for a high-conviction opportunity. Your conviction level can be determined by considering the two shares' relative quality and value characteristics. For instance, if a share you currently own is of high quality but is trading on the expensive side of your valuation range, and you think the new share is of equal quality and trading at a more compelling valuation today, that could be a fair swap. On the other hand, trading down on quality for a mediocre company with a slightly better value proposition may not be worth the effort.


The case for not selling

Overconfidence kills investment returns. The longer I invest, the more I believe this to be true. We think we can consistently outfox the person (or machine) on the other side of the trade, but the reality is that we have at best a 50/50 chance of being right in the short term after we make a trade. And even if we sell and are right straight away, we run the risk of being wrong in the long term if the share price ultimately rises higher.

The late legendary Wall Street trader and columnist Lucien Hooper neatly summarised the flaws of overtrading and the benefits of patience this way: "What always impresses me... is how much better the relaxed, long-term owners of stock do with their portfolios than the traders do with their switching of inventory. The relaxed investor is usually better informed and more understanding of essential values; he is more patient and less emotional; he pays smaller capital gains taxes; he does not incur unnecessary brokerage commissions; and he avoids behaving like Cassius by 'thinking too much'."

Hyperactivity in our portfolios moves us from the camp of investors to speculators. Your unfair advantage as an individual investor is your ability to be patient. You aren't worried about career risk or clients pulling their money if you underperform over a few quarters or a year. Make the most of this advantage.

"Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised"”

This isn't meant to be an endorsement of a 'buy and forget' strategy. If you're 100 per cent passively managing your investments with trackers, 'buy and forget' is preferable, but if you buy individual shares it's neither practical nor businesslike to not pay attention. Instead, I advocate a 'watchful patience' approach, as exemplified by the unheralded but highly successful individual investor Anne Scheiber. After leaving work at the US Internal Revenue Service in 1944, Scheiber invested $5,000 (about $68,000 today) in blue-chips of the day. At the time of her death in 1995 at age 101, she had amassed a portfolio worth about $22m, which she donated to Yeshiva University.

A New York Times profile of Ms Scheiber noted the "boundless vigor" with which she tore through earnings reports, considered product quality and researched management philosophy of the companies she owned. Despite her passion for understanding her businesses, the New York Times noted: "Her investment strategies were simple, if not old-fashioned. Forget about market highs and lows on any given day, month or year. Reinvest your dividends. Hang tough and seldom sell." Sadly, few investors adhere to this timeless advice.


How to get better at selling

Even if our goal is to "seldom sell", we should still be prepared for the possibility. Here are a few ways I've found helpful for improving my selling discipline.

Do a 'pre-mortem' before buying. Always ask yourself: "If the stock price falls 30 per cent, 40 per cent, or 50 per cent, what happened?" While a weak market may certainly play a role in any share's sharp decline, the point of the question is to determine what could go wrong - new competition, a failed product, a poor M&A decision - ahead of time. Not only does this process make you appreciate downside risk in the share, but can also provide objective reasons to sell if one of those ugly scenarios comes to pass.

Review every sell decision, regardless of the outcome. In my experience, every investment provides at least one valuable lesson that you can use to improve your process. Review each closed investment and determine what went right and wrong with your thesis and where you could have been more thorough. Indeed, you may be quite content with your process and conclude it was simply bad luck. This happens. Either way, this exercise helps make you a more thoughtful investor.

Create a 'sold portfolio' and track its performance. One of the most helpful tools I've employed in the past five years is my sold portfolio. Using a Google Docs spreadsheet, I measure the performance of the shares I've sold relative to the S&P 500 over the same time period. Fairly quickly, I began to notice some positive and negative themes.

Some of my better sales - those that subsequently underperformed the market - were those in which my original thesis was broken. Even though I lost money on some of those investments, I ended up saving capital that would have shrunk further had I held on.

On the other hand, some of my worst sale decisions were made for emotional reasons. In July 2008, for example, I bought Home Depot (US:HD) shares as they were being beaten up by US housing market and consumer spending concerns. I calmly held Home Depot for more than two years despite a turbulent market and enjoyed a reasonable 26 per cent return, but ultimately sold it following a poor customer service experience I had at a Home Depot store. My original thesis was still intact, yet I didn't behave rationally. My penance has been to watch Home Depot shares more than quadruple from my sale price. As painful as that's been, the mistake has been seared into my mind and it's one I'm far less likely to repeat.

You'll notice that the common thread among these exercises is to keep good records of your investment decisions. That's the key to improving any decision-making process as it reduces hindsight bias - 'I knew this all along!' - and conservatism (ie slow to incorporate new information or clinging to prior views).


Bottom line

There are far more emotions brewing when you sell a stock than when you buy one. Like buying, however, selling is done best when it's most rational. Whether you're considering a sale after strong gains or a sharp drop, go for a walk, meditate, sleep on it - whatever you need to do to calmly consider your options. Once you've made the decision, no regrets.


Todd Wenning, CFA, is an equity analyst based in the US. He owns shares in Berkshire Hathaway. The opinions expressed here are his own and not those of his employer

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By Todd Wenning, CFA,
30 December 2016

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