CHIEF CONCLUSION
Buying an investment may be only half the battle. What about when to sell? We think the ability to sell well is one of the rarest and most valuable skills in investing. Our research team reached the conclusion, after many years of hard experience in the markets, that we believe a disciplined approach to selling is the best one. We have three pillars upon which our sales discipline depends when it’s time to exit: valuation, thesis creep, and unexpected fundamental change.
“Certainly, it hurts. The trick, William Potter, is not minding that it hurts.” – T. E. Lawrence’s “Seven Pillars of Wisdom” upon which the movie “Lawrence of Arabia” was based.
My first mentor in the investing business gave me my big break out of Wharton. I was really a lucky guy, because he had one of the best long-term track records of any value investor anywhere, and for some reason he believed in me. But my biggest lesson from him was not about value investing, it was about discipline.
He told me there is no one right way to be a successful investor. In his opinion, there are many roads to heaven in investing. Both brilliant growth investors and value investors can succeed, but success only comes to those with discipline.
I thought about his counsel the other day, when our sell discipline led us to exit what had been a long time holding of ours. I thought it might be worth writing a few lines about our sell discipline, because it is such an important part of our risk-management framework. Also, in my experience, it’s one of the most frequent topics of conversation we have with our clients and friends.
"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk.” – Seth Klarman
When to Sell? Three Reasons…
“How do you know when to sell?” is probably the most common question I get about investing. The answer is we typically sell for three reasons.
1. The first pillar of our sell discipline is valuation, selling when a security reaches what we think is fair value.
Our research team knows that we can never fall in love with our investments. Rather our investments are only tools, a means to an end, that are useful only to the extent that they can be held prudently on a risk-adjusted basis.
Here the key phrase is “risk-adjusted.” The easiest way to think about this is to understand that we constantly evaluate what we might gain if we are right, versus what we may lose if we are wrong. Valuation is the tool that helps with that.
When our research team thinks about what this means to us, it comes down to the expected upside we anticipate for the risk of continuing to hold an investment versus the downside that we might reasonably expect. Since we don’t know the future, we think a reasonable way to handicap the unknown is to examine what we do know.
We do this by examining how our holdings are valued on a whole host of financial metrics. Oftentimes, this discipline leads us to sell when the news is rosy, and everything seems amazing. After all, it’s during just such times that people lose their discipline, fall in love with an investment, and pay too much. Even a great company can be a lousy investment if you pay too much for it. Just ask anyone who overpaid for a condo in South Florida at the peak of the Housing Bubble. They still may be losing money, even after almost fifteen years. So, the price you pay for your investment matters.
The specific valuation tools we might use often include price to cash flow, price to book, enterprise value to sales, and the trend in revenue to share. More complex tools we often rely upon may include asset value measures, where we add up what we think the parts of a company might be worth if viewed separately, sometimes referred to as “replacement cost” or perhaps “sum of the parts.” At the same time, we examine the valuation of comparable assets and similar companies globally. It’s about having a broad enough tool kit to match the right methodology for the right investment. It’s part art and part math.
This exercise might sound stuffy or boring, but we believe that it is neither. Rather, our team’s view is that the core of our process is valuation. After all, the stocks or bonds that we own are far more to us than just flickering lights on a computer screen, sometimes red, sometimes green. These are investments that represent shares in business enterprises with dynamic operations in the case of equities or, in the case of bonds, senior claims on future cash flows.
The Dark Arts of Valuation are informed both by a knowledge of accounting, that explains assets and cash flows, and finance, which teaches methods by which these may be valued. The literature dedicated to both can and does fill whole libraries. I have devoted twenty years of my life to them. This brief letter, sadly, is unworthy of doing them justice. But it is worth highlighting that valuation is the chief pillar of our sell discipline.
2. The second pillar of our sell discipline is to consider selling if the thesis changes.
This can take two forms. First, our team’s view of the investment’s fundamentals may change. Second, the actual fundamentals themselves may change.
Our research team calls the first “thesis creep.” Consider, for example, an investment in a cyclically depressed sector made with the view of a turn in the cycle rather than longer-term fundamental improvement. Such an investment could be an excellent risk/reward at the right price and the right time but would still have many hallmarks of strong cyclicality. Therefore, it could have growing downside risk as we got deeper into the cycle.
These characteristics could make it a great multi-year trade but suggest that the best way to enter it is with the goal of selling at the right price (valuation driven) and keeping a wary eye on the economic cycle. If our team’s view morphs over time to consider the investment capable of more, perhaps of being a long-term investment rather than a trade, then we should closely examine the facts. We most often see this late into a cycle when a trade has been a good one, and the easy trap laid for the unwary is to keep holding the investment, even though its objectives have already been achieved.
Unexpected fundamental change in a company’s business is another such example where the facts may change materially from our earlier expectation. For example, we do not own any newspaper stocks in our model portfolios. The rise of the Internet since the late 1990s seems to have irreparably compromised the business model of local newspapers. This industry was once a prominent holding of Warren Buffett’s Berkshire Hathaway, who once extolled the merits of these “local monopolies.” However, just a few days ago Mr. Buffett eliminated his holdings in this once core investment.
3. The third pillar is when we disagree with the direction taken by a company’s management team and cannot resolve that disagreement.
Without question, in my experience, the single most frustrating situation in which to find yourself as an investor is to awaken to the unpleasant reality that a company’s management team has acted to irretrievably alter the entire basis upon which you made your investment. The unfortunate example I described at the beginning of this letter, which motivated our recent sale of a long-time holding, was driven by this discipline.
Just think about how hard it is to identify an investment that our research team can get behind. How difficult is it to find the rare combination of a great business, capable of defending its profits over the long run, priced at an attractive valuation? For our research team to develop such conviction in an investment, our team must understand why the market made such a profoundly flawed assessment of a security and its future. After all, we believe the market is the most efficient tool ever devised by man to allocate resources and forecast the future. To us, this means that we never take lightly our disagreements with the market.
The above example of our sales discipline was motivated by how radically the new management team was growing what had been once only a small, and what we believed to be a much weaker and more competitive business line. Management was deploying more and more capital into what our research team believed was an inferior business. That we didn’t like at all. But still, the core existing business, that motivated our investment in the first place, was humming along and meeting our expectations. We were torn. What to do? We sold.
What would we have preferred to see management do? The outcome we were hoping for was continued investment in the core business, augmented by opportunistic share repurchases at favorable prices. That had been the company’s strategy under its prior management team. This can be an excellent strategy even in a market of subpar growth, because the cash flows from that business can fund opportunistic consolidation among competitors or favorably priced buybacks that grow investors’ per share interest.
I have seen this formula work before, many times, and am constantly seeking out those that execute upon it. I thought our research team had found it again. We were wrong. Or rather, management decided on a different direction in which our research team had little faith. This tortured the logic of our initial investment beyond our tolerance. It’s not the outcome we were hoping for, but again, we think it’s vital to never fall in love with your investments.
“Our favorite holding period is forever.” – Warren Buffett
In Conclusion
We agree with Mr. Buffett. Our favorite holding period is forever too.
Such a strategy is not only tax efficient but far easier to execute, because “all” you must do is buy. But what happens when something changes, and your sell discipline tells you it’s time to leave? We think the ability to sell well is one of the rarest and most valuable skills in investing. Our research team reached the conclusion, after many years of hard experience in the markets, that a disciplined approach to selling is the best one. We have three pillars upon which our sales discipline depends about when it’s time to exit. What’s your sell discipline? If you don’t have one – or if you can’t explain it – you might want to up your game, because our view is that disciplined execution of sales is one of the keys to what separates great investors from others.