Hitting the Target

5 minutes reading time

We’ve all heard the phrase “buy low, sell high”. But have you ever though: if you had to pick which part of this maxim investors find more difficult – buying low or selling high – which would it be?

Almost all experienced investors will tell you that knowing when to sell is hardest decision that an investor can make. Take the following quote from value investor Richard Pzena of Pzena Investment Management:

I arrived at a rigid quantitative discipline because otherwise I would have no idea how to sell. It struck me that if you let your emotions dictate when to sell, you risk falling in love with companies that have been doing well and you ride them too long, and then something goes wrong. I guess I have the classic value mentality. Its instinctual for me to want to sell as things go up and I start getting nervous. For me, having something systematic that says this is cheap or this is fairly valued is really, really important.

Notice the language that Pzena uses to describe the sell process. It’s emotional. That’s why Rich’s sensibly chosen to impose a set of rules to make the sale process more disciplined.

For value investors, buying low involves purchasing stock at a margin of safety. The current share price has to trade at a level significantly below their estimate of intrinsic value. Otherwise, they simply move onto the next stock. A disciplined and patent value investor will repeat this process until they find a portfolio of bargain opportunities.

In other words, buying is a reasonably objective process. Selling is very, very different. Legendary stockbroker and author Gerald Loeb explains:

As soon as a security is bought, the buyer loses the power to avoid a decision. It becomes necessary for him to decide whether to hold or sell. As an inexorable consequence, the percentage of correct conclusions must be lowered. Therefore intelligent investors expect to make a great many more errors in closing transactions than in opening them.

As Loeb points out, when you hold a stock you have no choice but to decide whether to keep holding or sell. This results in the number of hold or sell decisions being many times greater than number of buy decisions. More decisions equals more mistakes. Now we understand why smart professionals such as Rich Pzena often use rules to help them make better sell decisions.

It’s important to point out that these selling rules, commonly referred to as a “sell discipline”, aren’t designed to be right all of the time. This is simplify impossible for any investor. Rather, they are designed to help the investor to make sell decisions that are consistently better on average over time.

A common sell discipline used by value investors is to sell a stock at or near their estimate of intrinsic value. Here’s how Bill Nygren describes the sell discipline used by Harris Associates:

We generally sell at around 90 percent of our estimate of business value and we try to be quite disciplined about it. I’ve never understood why value investors who are very disciplined on the buy side become momentum investors when they sell, saying they’ll wait for the market to tell them when it’s the right time to sell…

… Yeah, it’s frustrating to sell names and they go up more, but the flip side is you’ve reinvested that money in something that you feel is more undervalued and should contribute to your returns beyond what you’ll get from what you sold early.

I’m going to dare to disagree with Bill on this point. What if the traditional sell disciplines used by value investors no longer work?

What reason could I possibly have to disagree with a successful investor like Bill Nygren? The reason’s in the second part of Bill’s comments. It’s the belief that selling, even when early or wrong, means that you have the opportunity to buy another stock that’s cheap.

My last post highlighted that cheap value stocks in the S&P 500 are now 30% more expensive (on a Forward P/E basis) than they were during the tech bubble. They are more expensive (on a Price/Sales basis) than they have ever been since 1986.  This is not only true of US stocks. In markets around the world, so-called cheap stocks aren’t that cheap. 

So where’s a value investor going to find an undervalued stock that will offset the effect of selling a winner too early? I’m not sure. Surely its got to be a lot harder now.

The first post in this series considered the skewed distribution of value stock returns. An important consequence of this is that value premium is driven by the handful of stocks that go up in value by 300, 400 or even 500 per cent.

Remember, to beat the market, a value investor needs to:

  1. Avoid the “dogs” and “value traps” and they boost the performance of a value strategy
  2. Hold a more diverse portfolio to increase their odds of capturing some of the big winners
  3. Hold a more concentrated portfolio and make sure they have the stock picking skill to pull it off as the base rate is stacked heavily against them

We can now add a fourth item to this list: don’t sell your big winners too early!

What happens if a value investor sells when the stock price is at or near intrinsic value? They are almost always cutting off their big winners too early! That is of course unless they are buying stocks with a discount to intrinsic value of 75-85 per cent.

If they miss the big winners their results are more likely to be driven by losing stocks.

Somehow I find it hard to believe that there are many stocks currently selling for 15-30% of their value. Johnny Hopkins at The Acquirer’s Multiple recently wrote a fantastic post quoting research by James Montier of GMO.

In Japan and Asia only around 5% of stocks are showing up as extremely cheap; in Europe and the UK the number drops to 1% to 2%; in the US not a single stock passes the screen. Not one single solitary stock can be called deep value.

A margin of safety is also heavily time dependent. So more expensive stocks mean investors have less time to realise a smaller margin of safety.

Value investors are faced with a tough choice:

  1. Stick to a deep value philosophy of buying stocks selling for a steep discount to intrinsic value. It’s pretty clear that it’s very tough to make this work in the current environment with skew, shrinking margins of safety, expensive valuations and reinvestment risk all working against you.
  2. Look for  stocks that are cheap relative to their estimate of FUTURE intrinsic value (i.e. growth). This is what Bill Nygen appears to be doing (with investments in $AAPL, $GOOGL and $V).

There is a third option. Adopt a sell discipline that let’s you keep more of the upside from your winners while still managing portfolio risk. A good example in this regard is Chuck Akre:

We are fully aware when valuations are getting stretched, which often coincides with a position getting outsized in the portfolio. In those cases, we will likely take some money off the table by managing the position size down.

What’s interesting’ about Chuck’s comments?

  1. There’s no commitment to sell the entire position when the stock price reaches a predetermined level (e.g. x% of intrinsic value)
  2. Gradual moves leave room for the portfolio to do OK even if the decision to sell is wrong (remember mistakes are far more common when it comes to selling)
  3. The position is sold to primarily to manage risk, not necessarily to lock in a gain
  4. Chuck’s approach is far less likely to result in succumbing to the Disposition Effect (selling winners and letting losers run).

Akre is a value investor but his investment philosophy involves looking for companies that are profitable with opportunities to re-invest retained earnings (i.e. growth). This is quite different to investing in value traps where growth often destroys value.

The purpose of this post isn’t to say that Chuck’s approach is better than Bill’s or Rich’s. My purpose is to highlight the market conditions and the variables that can affect a sell discipline’s effectiveness.

The common theme of this series of posts is that the current environment is especially challenging for value investing strategies. Value investors would do well to check if their sell discipline is still working for them. 

Other posts in this series:

  1. Value Investing – Don’t get Skewered!
  2. Losers in the Driver’s Seat
  3. Margin of Safety – the Clock’s Ticking
  4. Reinvestment risk – Got any ideas?
  5. Growth – the Enemy of Value Stocks
  6. When cheap isn’t cheap
  7. Hitting the target
  8. We liked it at $10, so we like it even more at $7
  9. Value Investing – Some Suggestions
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