Value Investing

On Selling

The Two Positions

Buffett and Munger advocates buying into a great business at good (or even fair) price, then hold forever, so that they do not have to worry about when to sell and also get the benefits of not paying taxes on each sale, which works out to be significant over the long-run. Most other value investors however will sell a position when it is fully priced (e.g. Mohnish, Klarman, Zeke Ashton). [this discussion is on the good case when the investment does well, rather than the other obvious situations to sell where there is no contention.]

Why You Should Hold Great Companies Forever

There are obvious pros and cons to each approach. In Buffett’s approach, if the business value can grow at 15% each year, the value of the investment follows. In addition, good things happen to businesses with good economics and good management, many of which are difficult to anticipate. For example, who would have thought that Google will use their cash flow to branch out to all sorts of different areas like autonomous cars, operating systems, etc.? If you value a business based on what you can see, which is strongly influenced by what the company is currently doing, then you might miss out on unexpected positive value additions.

Why You Should Not Hold Great Companies Forever

Zeke Ashton made a point during an interview that he does not buy and hold a great company, rather he would be going in and out, buying when undervalued and selling when fully valued. Seth Klarman made a point that if you hold a fully priced security, then your risk of capital loss is higher. All of which are valid points.

What Really Is the Right Question?

If you think of the price chart of a company, if you sell when the company is fully valued, then you will essentially be grabbing the portions when the company is undervalued. The question then becomes, during the time periods when the company is fully valued or overvalued, what could you be missing? and does the potential reward justify the potential risk? The potential reward could come from unexpected actions taken by the company, or it can come from market exuberance.

What Is The Right Answer?

There is no blanket answer. Assessing the potential reward from unexpected actions taken will depend on the particular company. Market exuberance depends on macroeconomic conditions, the timing of which is hard to predict. What’s the risk? I would say that the risk of permanent capital loss is low if it is a great business. You just need to make sure you have the capital and income to hold the position or buy in to take advantage of lower prices. So on the one hand, the risk is low, on the other hand, the rewards are uncertain to substantial. To me, to hold a great business at fair price seems to be a good approach. Naturally if there are better bargains around, and there is a lack of capital, then such fully priced securities can be sold.

How Do You Define a Better Bargain?

Note that one important phrase in the last sentence is “better bargains”. What is the definition? Imagine you bought something with IRR of 20%, and its dark clouds slowly cleared and lowered the IRR to 15%. Then you chanced upon a new stock with new dark clouds with an IRR of 20%. Is this a better bargain? Should you switch? Are you jumping from a seemingly leaking ship that is slowly being repaired to a new seemingly leaking ship? and is that wise?

I recently chanced upon a really great quote from Sir John Templeton, “I spent many years on that problem myself,” [Templeton] replied. “Several years ago I came up with what I believe is the right answer of when to sell. The solution is never to ask when to sell a stock. Instead, you should sell a stock only when you have found a new stock that is a 50% better bargain than the one that you hold.”

This “rule” is insightful for a few reasons:

  1. It prevents jumping around from one seemingly leaking ship to another. If you are always in a leaking ship, you’ll never be surfing the waves.
  2. It takes the question of “when to sell” away, and puts the focus on relative opportunities available.
  3. It sets a certain threshold that the new comer better be a bargain.

My own view on this is that, whether you should switch from one leaking ship to another depends on the circumstances at that time. If your original leaking ship is showing signs of recovery, then by all means I would adopt Sir John Templeton’s threshold of being a 50% better bargain. However say you just boarded a leaking ship, and when you compare the timing of when the dark clouds on the existing ship and the dark clouds on the new ship will dissipate, you find that you can’t really tell which set of dark clouds would dissipate first. Then in that case, I think it makes sense to switch over to the new leaking ship if its IRR is only slightly better (take note to look into the probability distribution for the outcomes as well), and the level of conviction in the investment thesis in both cases are comparable.




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