As a young teenager, one of my favourite rock albums was by Led Zeppelin and the title track was ‘Stairway to Heaven’. While the music was truly spectacular, I had no clue about the profundity implicit in the lyrics. Last weekend the penny dropped when my daughter, only half in jest, enquired whether I had managed to acquire any investment wisdom considering my labour of love for the past 25 years. Even though I sheepishly admitted that the ‘Holy Grail’ was nowhere in sight, it struck me that selling smart is probably the single most important element of investment success over the long-haul. In fact, I would dare to go one step further and suggest that accepting losses promptly is the key to investment nirvana.
The current generation of investors has been brought up on a drip-feed of pithy Buffett aphorisms. Among the best known is, “My favourite time frame for holding a stock is forever.” When asked what might be the downside to such an approach, St. Warren commended the methods of the renowned comedian, Will Rogers: “When the stock doubles, sell it.” And in case it fails to double? “Well, don’t buy it in the first place!” Clearly, the appeal of buy-and-hold investing is significant for most non-professional investors with other pressing commitments on their time. Not only does this strategy greatly magnify the power of compounding, it also helps in keeping taxes down and permits the investor to develop a more nuanced understanding of the business over time.
However, more often than not, one is too early to the party and the wait can be fairly embarrassing. In addition, the problem with a truly long timeframe is that in a fair number of cases the dynamics of the business begin to shift gradually which counter-intuitively has a disproportionate impact on price. Read Warren Buffett and Coke or the Washington Post. The experience of your columnist with Infosys has in many ways been equally instructive — the total returns, including dividends, for the eight-year period commencing March 31, 2000 were way less than what the post office had to offer.
Private equity investors looking to buy a business typically have a holding period between three and five years. While too short a horizon typically leads to over-trading and disastrous results, it is vital to establish a finite exit point in order to have a realistic understanding of ‘intrinsic value’ and judge what management can realistically achieve. So, buy-and-hold is a sensible approach provided the fundamentals remain in good shape and in line with what can be reasonably expected but ‘forever’ might stretch both intellect and judgment to the brink.
While remaining disciplined in terms of the process of stock-picking, the seasoned value investor waits patiently for Mr. Market to provide opportunity. Typically, there are just four reasons to sell:
- A clear deterioration in either earning power or ‘asset’ value.
- Market price exceeds ‘fair’ value by a meaningful margin.
- The primary assumptions, or expected catalysts, identified prior to making the investment are unlikely to materialise or are proven to be flawed.
- An opportunity likely to yield superior returns (with a high degree of certainty) as compared to the least attractive current holdings is on offer.
Now that the selling compass is pointing in the right direction, perhaps one needs to come to grips with the tribulations of putting these simple ideas into practice. The longer I think about why this plagues even expert investors, the more I am struck by the fact that ‘selling smart’ is the dark continent of investing. Just to set the record straight, can you think of more than a couple of books with worthwhile insights on ‘how to sell’ as opposed to the countless investment bestsellers on every other conceivable topic of relevance? Two genuinely useful primers I would recommend are The Zurich Axioms by Max Gunther and It’s When you sell that Counts by Donald Cassidy.
The most common failing may stem from having blind faith in Newton’s laws of gravity! It is a fatal mistake to think that what goes down must go back up. Do names like Torrent Cables, Ashapura Minechem, Steelcast et al ring a bell? “Dead money” does insidious damage to the sensible portfolio, not by falling precipitously and then getting stuck in a narrow range, but far more by preventing redeployment of the same capital in distinctly superior opportunities. Another shortcoming plagues those who believe “you can never go bust taking a profit.” Amazingly, you can if you are not equally nimble in trimming the losses.
Typically, the small profits arising from good luck rather than skill are swiftly pocketed, but whenever a paper loss is sustained the normal investor accounts for it as a ‘long-term investment’ and eventually the lack of skill overwhelms the mis-classification. A third, trickier, phenomenon occurs when a stock rises smartly and then slips into a gradual, but steady decline. In this instance, the issue is a loss of profits! This fall causes far less pain, but is just as negative. Two simple rules come to mind. First, what works for me personally, after years of coping with unremitting losses is to sell out completely whenever a new investment shrinks by more than 15 percent. Not only does this deal with my dumber prejudices and blind spots in a ruthlessly efficient manner, more importantly it frees capital. With ‘dead money’ it is probably best to sell one-third, maybe even half the holding rather than the entire position simply because such stocks occasionally experience incredibly short, sharp rebounds. That is probably the moment to get rid of the rest! One final comment: When you are carrying out a portfolio review, resist the temptation to sell the stocks with the best profits. Instead, relentlessly focus on selling the companies which meet the BBBB test — bent, broken or beyond belief!
The other really serious affliction is refusing to sell because of the taxes that need to be paid. In a sense, this amounts to putting the cart before the horse. The idea behind sensible investing is to earn profits, not avoid taxes. My suggestion for dealing with this mental quirk is to chip away at a holding with huge profits by paying some tax on these gains each year rather than watching the profits shrink in future or be paralysed by the sheer magnitude of the gain and corresponding tax liability in later years. Also worth keeping in mind is the idea of using tax losses on stocks that perform poorly to partly set-off the gains from the more profitable decisions. Typically, it is best to check the short-term losses which arise within six months from the initial date of purchase.
If one were to apply the BBBB test in present conditions, the most compelling sell candidates appear to be clustered in the “beyond belief” category. Interestingly, there is neither a sector theme nor a size effect typifying these names implicitly hinting at blind faith in either their growth prospects or managerial genius. Consequently, judging the difference between perception and reality may well open the door to very substantial returns in companies such as Jubilant Foodworks, TTK Prestige, Elantas Beck, ABB, Trent, Gillette and Astra Zeneca Pharmaceuticals. Companies with frayed fundamentals not yet evident in the stock price are Strides Arcolab, Wockhardt, Dish TV, Oberoi Realty and Orbit Corporation. Is the ability to sell rationally just a case of getting greed in check or something beyond that? T.S. Eliot may have been pretty close to home in saying: “What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.” Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.
(This story appears in the 12 August, 2011 issue of Forbes India. To visit our Archives, click here.)