Tuesday, October 09, 2007

Knowing When To Sell

I have been asked to blog about the above, therefore I shall devote this entire posting to the perennial question asked by almost all investors and speculators: “When Do I Sell ?”

For value investors, the answer is of course radically different as compared to a speculator/punter. Value investors research into the business of the companies they invst in and their role is to be a business analyst. Speculators, on the other hand, observe purely price movements and the psychology of the market and try to make money by “outsmarting” the pack. The modus operandi of the value investor and the speculator are different, thus each has different cues which will tell him when to sell. For the speculator, it seems simple enough; sell when your gain or loss has hit a certain % above or below your cost (respectively). This may be 10%, 20% or even 50% depending on one’s personal preference. Taking profit and cutting loss have almost the same rules for punters because they are usually short-term by nature; and some even engage in risky contra trading which makes this cut loss or take profit rule all the more crucial.

That is all I will be commenting in terms of selling for speculators. On value investing, an article on The Motley Fool sums up pretty well the reasons when value investors should sell. The article states: “Value investors sell for four basic reasons. The first case is where the investor comes to the conclusion that the initial intrinsic value estimate is flawed. Value investing requires intellectual honesty, and errors must be acknowledged early. The second reason to sell is when another, even better value comes along that requires some capital to be freed up. The third case is when the business fundamentals upon which the initial purchase decision have deteriorated to the point where there is no margin of safety in the current price. The final reason to sell is when the stock price has moved up to a point to where the business is being fully valued and no longer offers a margin of safety.” I will now explain each point in turn and give my own views on them, and see if they are applicable to any investments which I had sold recently.

1) Flawed Intrinsic Value Estimate – This reason would imply that the value investor had made incorrect or flawed assumptions regarding the business which he studied, to the extent that those errors now have a material impact on the intrinsic value estimate. It could also be the case where certain factors were overlooked while doing a detailed study of the company in question, and these omitted factors seriously compromised the margin of safety for investing in the company. One example I can think of is Trek 2000 International which I sold some time back. I had incorrectly presumed that the company had a wide economic moat with its many patents for its Thumb Drive, but technology which can rival or replace this would easily erode their competitive edge. Thus, as a result, I purchased without the requisite margin of safety.

2) Better Value Comes Along – This reason to sell obviously correlates to a situation where a value investor sees one of their companies being severely over-valued, while at the same time one which is significantly under-valued comes along. Suffice to say that the right thing to do would be to sell the over-valued company and purchase the under-valued one as it would provide margin of safety and also guarantee a good expected rate of return (which the over-valued company now does not provide). However, in reality, such situations rarely if ever arise and one’s timing, luck and circumstance must be impeccable in order to take advantage of such an opportunity (because as a whole, over-valuation usually occurs on a broad market level and is seldom confined to certain companies only. The converse is true for under-valuation in a bear market).

3) Deterioration of Fundamentals – This reason to sell is fairly common and will surely be encountered at least once (I think) in a value investor’s lifetime. We can use history to show how once strong companies succumbed to competitive forces and lost their competitive edge, causing revenues, margins and hence profits to fall. A good example is Creative Technology, which was recently excluded from the revamped STI (as well as the mid-cap stock index). During its heyday in the dot.com boom, Creative traded at a high of S$65 per share and was garnering the lion’s share of revenues for its world-beating Sound Blaster Pro. Now, the company has made 4 consecutive quarters of losses and its products (the Zen player) cannot compete effectively against Apple’s iPod and Microsoft’s Zune. For a value investor, this deterioration should best be detected early, otherwise the investor would suffer a large fall in the value of his/her holdings. This is why I advocate keeping close watch on a company’s plans, strategies, margins, earnings and industry to monitor for possible sighs of decline.

4) Fully Valued Business – I do not fully agree with this given reason to sell. How does one know when a business is “fully valued” ? I guess the best answer to that would be to say that the business has no prospect of growing at a rate higher than the inflation rate. This means that the business may be stagnant or stagnating, and the products or services offered by the company may be close to a decline (due to obsolescence). So maybe we should modify the reason to make it read “sell if you feel the business cannot grow faster than the current inflation rate”. Unless you are a value investor who goes for dividend yield (i.e. your investment turns into a “cash cow”, dropping from a “star”; according to BCG’s matrix) , it is advisable to sell and look for another potential company with a good margin of safety.

Keeping these 4 reasons in mind, a value investor should continually monitor the companies he owns to see if any of them are in “danger”. This would fit Benjamin Graham’s idea of an active investor; one who knows his investments well and puts in time and effort to maximize his investment returns.

14 comments:

Anonymous said...

Dear musicwhiz,

You wrote:

"4) Fully Valued Business – I do not fully agree with this given reason to sell. How does one know when a business is “fully valued” ? I guess the best answer to that would be to say that the business has no prospect of growing at a rate higher than the inflation rate. This means that the business may be stagnant or stagnating, and the products or services offered by the company may be close to a decline (due to obsolescence). So maybe we should modify the reason to make it read “sell if you feel the business cannot grow faster than the current inflation rate”."

I beg to differ on your definition of a fully valued business. For most value investors, the reason why a fully valued share is sold off is because the shareholder believes that on a risk adjusted basis, the company's growth prospects no longer cover the cost of enterprise capital.

This is sometimes described as not having enough franchise / economic value to justify whatever market premium that is embedded in the stock price.

Quite often enough, a company might well be forecasted to grow above inflation rate for quite some time and yet still be considered "fully valued". As there is a lack of franchise opportunities to justify the specific equity risk premium, the share is considered fully valued and not having any potential to generate returns that cover the opportunity costs incurred.

Of course, I have to caveat that how one determines the cost of capital or future profits is really more of an art than science.

Best regards,

Mr X

musicwhiz said...

Hi Mr. X,

Thanks for your enlightening explanation ! After reading it a few times, I must say I really did not see it that way initially. I learnt something new again today....

So I guess "fully valued" means that the company cannot generate returns to cover opp cost. Nice way to think of it, and I think that makes a lot of sense. I will adjust my thinking about companies to incorporate this new info.

Regards, musicwhiz

Anonymous said...

Dear musicwhiz,

Glad to be of help! ;)

For the avoidance of doubt, just one thing I would like to clarify: What I mean by opportunity cost isn't like I've got $100, so if I put $100 in fixed deposit, I can get annual interest of 2%. So the 2% becomes opportunity cost.

You can probably see it as a form of target growth rate, i.e. the minimum cashflow / profit growth that I demand from the company in order to justify my taking the risk in ploughing money in its stock.

Best regards,

Mr X

Anonymous said...

Fully value hinge on some form of forcast, mainly from analysts, which in the current state of human knowledge about economics is not possible to apply in practice. The chances of being right are not good enough to warrant such methods being used as a basis for risking the investment of saving. As a true value investor, one would have select the company with great care and when you really need to sell, it can't be more than the 3 reasons mentioned before the fully value one.

musicwhiz said...

Hi Mr. X,

Thanks again, yes every investor would expect some meaningful measure of growth from the companies he invests in, thus the price paid should reflect this growth already; otherwise a value investor should look for other under-valued companies with stronger growth prospects (that are accompanied by earnings clarity, of course).

Regards, musicwhiz

musicwhiz said...

Hi Anonymous,

I would agree with you to a certain extent. I think the 4th reason is something which is either hard to forsee, or comes about through the passage of time. A company's "attractiveness" may change depending on whether it has a strong economic moat in the first place. While Buffett does buy companies with consistent growth and strong franchises, this effect is less pronounced for Singapore companies as most of them are not "global" brands or household names yet.

Thus, the way a value investor selects companies is to go for one with reasonable growth and earnings clarity so that it will appreciate in the mid to long-term. Value investing, I feel, must be taken into the context of the specific countries in which it is applied. Taking too rigid a view may result in inflexibility and hence, limited success.

Regards, musicwhiz

Anonymous said...

you can take ezra, few hundred % gain, or any companies in your portforlio with big gain, to me they are arguably fully value, to you they have long way to go. there lies the subjectiveness of forcast... is not a science, whether in s'pore or global. the good point is on "rigidity", as one grows in the investment journey, he/she becomes wiser. regards.

musicwhiz said...

Hi Anonymous,

I think I would like to clarify: it does not mean that "big gains" automatically equates fully valued. The fair value of a company is the sum of all expected future cash flows from the company; and depends on future conditions as well as competitiveness of each company. With companies such as Swiber, they are just starting out thus the risk is higher, but I won't say it is close to fully valued as yet.

For Ezra's case, it is more interesting. I do see more potential moving forward when I spoke to Management as they have Ezion to scale up their ops, as well as their Vietnamese Fabrication Yard. EOC is in a unique position to raise funds to capture more value from the FPSO market too. Thus, I see more value ahead in FY 2009 and FY 2010, though a lot depends on how the company builds up its competencies in the next FY (which is crucial IMHO).

I think the extent to which an investor understands the business of the companies he invests in also influences his idea of valuation and allows him to determine (albeit subjectively) whether a company in his portfolio is fully valued.

Regards, Musicwhiz

Anonymous said...

sure, one way to check is propably their p/e ratios, but that have to do with how the market, esp the financial community feels about the coy itself. granted you know the coy better when you are vested and as time goes by. let take for example, hypothetically, at what price would you consider the 2 coy you mentioned fully value, and at that price, would you sell? and if you do, when would you buy them back, if fundamentals all these while have not change? are you then participating in the fad and folly of the market? would you then, still consider yourself as a value investor?

musicwhiz said...

Hi Anonymous,

Generally, when companies move towards their fair value, it would not be possible to "buy them back at a cheaper price". Unless one employs technical analysis and some luck (which value investors do not use), otherwise it is not an option I would pursue. As you mentioned, if a business is fully valued then it will be time to sell.

As for the "value" of the company, this is also a subjective measure for which there is no wrong or right. Every value investor is entitled to their own opinion of the intrinsic value of a company and at what point it is considered "fully valued".

Regards, musicwhiz

Anonymous said...

well well, search your heart, my fellow investor, rigid or not, "fully value" don't seems to be a good reason to sell.

musicwhiz said...

Hi,

I think when the time comes, it should be clear to the value investor if he should sell or not. If the reason is not compelling, then, as you say, it may not be a "good reason to sell".

Regards, Musicwhiz

Anonymous said...

Please allow me to reproduce your articles to my clients.
Thank you

musicwhiz said...

Hi there Anonymous,

Could you kindly provide more details of yourself, what you do and who your clients are ? It would certainly be more helpful if I have more information regarding your request.

Many thanks, Musicwhiz

P.S. - Just a note, this posting was written with the assistance of The Motley Fool website, so please give them credit as well (I cannot take 100% credit for this posting).