Thoughts, Value Investing

Selling Rules

Recently I had a conversation with a friend who is working as a forex trader in a leading investment bank. He was asking about when I would sell a position.

The typical scenarios in which a value investor would sell a position are:

  1. It is overvalued.
  2. Mistakes were made in the analysis which led to the buy, and it is no longer a worthwhile investment after fixing those mistakes.
  3. Newer events showed that the fundamentals of the company have deteriorated and it no longer meets the buying criteria (e.g. think blue chip stamps)
  4. The capital is better channelled to another better investment (this is a tricky one, you don’t want to end up jumping from one supposedly leaking boat that is getting better, to a supposedly freshly leaking boat. The new boat had better be worth it!)

The discomfort that my friend had was that there is no stop loss point, which meant that a stock could go to $0 while not being sold. Hence if you think a stock has intrinsic value of $100, you buy it at $70, the risk is ($70 – $0) = $70, while the reward is ($100 – $70) = $30, which is a bad risk/reward ratio.

Value investors don’t think of risk in the same way. A position has low risk when the company is in a great business, has good management, and is selling at a great price. In this way, the risk of a position going to $0 is mitigated by multiple factors. In addition, during the valuation, if there is a very volatile and indeterminate liability, or erratic future earnings, resulting in the inability to place a proper value to the company, this should be thrown into the ‘Too Hard’ bin. Without thinking of risk/reward ratio in the same way as a trader, value investors have consistently made good returns from the market.

Of course there is always a pitfall with the approach above. The value investing approach requires the manager to perform really solid research, and fully relies on the ability of the manager to accurately understand the situation and make good predictions. That is what limits the risk, rather than a mechanical stop loss price. We can see this pitfall by what has happened with Bill Miller from Legg Mason (not really a value investor), where he made wrong bets on Enron, Worldcom, Freddie Mac, Fannie Mae, AIG, Bear Sterns, Countrywide Financial, Citigroup. He also once replied in response to a question on when he would stop buying, that “When I can’t get a quote”. Mohnish Pabrai also made a wrong investment in Delta Financial Corp (DFC) which went bankrupt in the crisis.

I would say that both approaches work, however I think the value investing approach is the one that is the most sound, and historically is the one that allows for consistent returns to be made over a long period of time.

One lingering question I still have is that, when you need to liquidate some positions to build up your cash position, should you sell positions that are doing well? or reduce positions that are not doing well?


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