Thursday, 6 November 2014

To Sell Or Not To Sell: My Viewpoints And Few Ground Rules: Part I

"To be or not to be"... are the opening words of the world famous Shakespearean play Hamlet in the context of quandary that Prince Hamlet faces with respect to weather to live a miserable life or to end the life and embrace the unknown after death.The dilemma that an investor faces is no less perplexing and multi-dimensional than the words of prince Hamlet. I am reasonably convinced that making a correct decision to Sell is as important as making the decision to Buy for generating above average returns over a long period of time. There is ample material and thorough discussions around how to make a prudent buying decision, however, I have yet to come across  a well developed and comprehensive framework on "how to sell". 

In absence of any structured framework and principles/ground rules, the decision to sell is many a times arbitrary even for seasoned investors. However such arbitrariness is counter-productive to the very objective of generating above average returns for investors. I have formed some ground rules while making a decision to sell which I refer to while making the decision to sell. Obviously, I am just a beginner in this long journey of investing world and as one progresses through this journey, these rules are likely to evolve/change based on the real-world  experiences that I will live through in the market. It goes without saying that I will end paying some hefty tuition fees in the process as well!  Notwithstanding,  stick my neck out and adhere to these rules till proven wrong...

When not to sell:


Before we start discussing when an investor should sell, it is extremely important to understand when NOT to sell. I have in my initial years made a very costly mistake because of not knowing "when not to sell". However the only solace I can have is that I have the esteemed company of some very senior and serious investors in this! I have come across many investors who have spent enough years in the market and still continue to sell for the wrong reasons. Many a times, this "cashing out early" results into a huge opportunity loss for an investor, especially if he/she has bought into a high quality business at right price. So what are some of those reason where investors feel compelled to sell without realizing that they are making mistake? Here they are




Though the business seems to be doing well, it is fairly valued at this price hence it is prudent to exit:  

For a value investor, fair/high valuation is a perfectly justified reason to sell because the primary driver for a value investor for making the investment decision is the differential between price and value! Hence, as the gap narrows down between price and value, margin of safety gets eroded and thus the investment becomes riskier. Looks perfectly logical and in-line with value investing philosophy. However, in my opinion, this comes with a big caveat! 
The thought process described above, is perfectly justified for a business/investment where primary driver for investment was undervaluation and not the business quality. However, the same decision making process will look distorted (and hence produce undesirable results), where the investment thesis is based on superior quality of business available at fair/reasonable price.

Let me explain this through two example from my own portfolio:

I invested in company called Narmada Gelatine. It was one of the largest and oldest pharma and food grade gelatine manufacturers in India. In early 2013, it was available at 20% discount to net working capital at price of around 100 and market cap of 40 crores.  While analysing the business, it was evident that it is a commodity business with possibility of volatile margins. It was also clear that management was complacent and was reluctant in pursuing growth with vigour. Hence topline/bottom line growth, at best, can be pegged at 10-12% on normalized basis. However, market was pricing in negative growth as it was selling much less than liquidation value. On the other hand, business was generating steady 10-11 Crore positive cash flow and company was paying distributing decent part of this cash generated as dividend. So, the business was highly undervalued by the market. Circa, 2014, due to persistent bull run and some investor friendly move by the management, it's market cap has tripled with only 30% increase in bottom line. In other words, valuation has caught up. It is trading at P/E multiple of 7.5 and P/B of 1.4. The top line growth is minimal while bottom line has expanded marginally due to increase in finished product price in last 3 years. In such situation, it makes sense to sell the investment as underlying thesis of undervaluation no longer holds true.

One the other hand, another example is of Cera Saniataryware. I bought the stock in Mid 2011, when it was trading in the range of 180-200 with market cap of 220-250 crores. Business had following characteristics (for details, read my post my 2011 post on Cera Sanitaryware)

  • Operating in oligopoly market (branded sanitaryware addressing middle/middle-high income group segment) and steadily gaining market share from leaders 
  • One of the top 3 players in branded sanitary ware market
  • Focused efforts on building a strong brand and incresing distribution reach 
  • Consistent topline and bottom line growth of 30%+ for last many years
  • Consistent ROCE/ROE above 25%+ for last many years
  • Pro-active management with ability to do things differently and carve a new path (using of gas as fuel, snow white category, style galleries) 
  • Addressing a large opportunity size and was key beneficiary of long term shift in psychology of moving from unbranded to branded products for Indian consumers 
  • Attractive valuation with stock was trading at trailing P/E of 7-8 
Thus, Cera, when bought was a  good quality-high growth business run by a clean and forward looking management and trading at low valuation. However, the investment thesis was based on not only the low valuation but also on impending growth and quality of the business. Today, Cera has market cap of close to 2100 crores (almost 10 bagger!) and trades at trailing twelve month P/E of 35. However, Cera continues to grow at more than 30% while generating same ROE. Shall I sell the stock and book profits or continue to hold? In my opinion, it is best advised to hold onto such investments for following reasons
  • It is not easy to find high quality businesses having predictable (with somewhat certainty) and consistent growth run by decent management at low valuations. Hence, if you have been lucky enough to find the business, hold onto it! 
  • Company is continuously investing to strengthen competitive advantage it has gained i.e. brand equity and distribution reach
  • Typically, the intrinsic value of high quality businesses (high return ratios/good cash flows/low debt)  continue to compound over a period of time and catches up with price. Hence, in hindsight, high valuation on trailing basis, seems very reasonable if the investment thesis and judgement about quality of company turns out to be accurate 
  • One always run the risk of making a mistake while re-allocating the money to some other investments! 
Another reason, where an investor may make a wrong decision to sell is  

The business is passing through unanticipated rough patch while the long term investment rationale remains intact.

It doesn't matter whether one is running a large or small enterprise, every business is likely to encounter difficult period as it moves through business cycles. Any businessman having experience for reasonably long period of time will for vouch for this fact. Hence, it is perfectly natural for any business to encounter one or more rough patch/es during its lifetime, even if it is a high quality business. During the difficult times, number of things, which are interdependent on each other, seem to go wrong for a business. This eventually leads to lower earning growth or de-growth in earnings and may even shrink the return on capital for a while. 
 
These unusual and unanticipated events lead to different reactions for different companies in the stock market depending on various factors such
    • Inherent strength of the business
    • Valuation that it commands and expectations priced in the valuations
    • Duration for which it is likely to face headwinds
    • Visibility on improvement in business fundamental down the road. 
However, most of the times, for fairly priced companies, market reaction is extreme, severely punishing the businesses and irrationally. In most circumstances, the value erosion is order of magnitude higher than cumulative erosion in earning power of the company. The pendulum swings in favour of extreme pessimism. Hence, it creates highly conducive psychological environment for investors to sell the investments. 

However, it is extremely important for investor to recognize, before agreeing with the judgement of market, to independently and objectively assess following two factors 
  • Is the change in business environment permanent? 
  • Is the change large enough to kill the key investment hypothesis? 
If the answer to the above two question is unequivocal NO, then definitely not sell. 

Contrary to that, if the value erosion suffered in the market is far higher than the impact of change on earning power of the business, it becomes a strong candidate for increased capital allocation in the portfolio. 

Take an example of Ipca Laboratories. It is one of the highly respected mid-sized pharma company. It is one of the largest API manufactures in the world for number of APIs and is the largest player in anti-malarial segment in the world.  It has and exemplary track record of execution and capital allocation. It is reflected in numbers too! 10 year top-line has grown 18% CAGR, 10-year bottom line has grown 23% CAGR while generating average ROE of 25%. Management is top notch in terms of ethics, capital allocation and transparency. It has earned praises from marquee value investors like Ramdeo Agrawal and Sanjoy Bhattacharya. 


Look at what happened to it post USFDA observations on Ratlam API plant in July 2014 and more recently due to reports on USFDA observations on Indore SEZ facility. Market cap shrunk by 25% or the tune of Rs. 2400 crore.  However, without getting swayed by the negativity prevailing in the surrounding an investor must try to answer following pertinent questions

- Will some negative observations by USFDA affect the long term potential of Ipca to sell in US and/or regulated market ? Are these glitches correctable? 

- Will the interruptions in supply for US customers, result into permanent loss of customers for the company considering the context that inspite of being one of the very late entrants it has garnered substantial market share due to lowest cost producer advantage? How long is it estimated to take back the market share, once it re-starts its supply to US market? 

- To take corrective action for USFDA observations, is company likely to incur substantial capital outlay? If yes, how much?

- What is the likely impact on earnings for the company considering that 13% of business comes from US market and the likely time for re-starting the shipment to US market is 18 months? How will it compare with 2400 crore value erosion that market is factoring in? 

The answers to above questions shall decide whether to sell or buy or hold.

After we have aligned our thinking on when not to sell, we can move to the next quandary which is when to sell! More about that in the next part






17 comments:

  1. Hi Dhwanil,

    Nice post.

    You have hit the nail on the head by first writing about when not to sell. Will wait for your thoughts on when to sell.

    Regards
    Ankur Jain

    ReplyDelete
    Replies
    1. Hi Ankur,

      Thanks for your comment and feedback. Will post the "when to sell" part soon.

      Delete
  2. Hi Dhwanil,

    Good to see a post from you..after long time :-)

    Loved the way you used different ideas/examples to support your thought process.

    Good work.

    Thanks,

    Vikas

    ReplyDelete
    Replies
    1. Hi Vikas,

      Thanks for your comment. Yes, I indeed posted after quite some time.
      Good to know that you liked the post

      Delete
  3. Very insightful.

    Brings on the question of how one defines value? valuation discount vs. business quality.

    Also, if possible can you share you thoughts on what should one do "after" selling a valuation discount bet. Typically at that point of time, if its a bullish run, other similar bets may have become scarce. Do you think having a "minimum" invested (or "maximum" cash) constraint is also relevant.

    Would love to read more of your views on Capital Allocation.
    Hoping Part-2 is under works :)

    Gunjan

    ReplyDelete
    Replies
    1. I meant Part-2 of Capital Allocation is also under works.
      :) Gunjan

      Delete
    2. Hi Gunjan,

      To answer your query on valuation in philosophical sense "the value lies in the mind of the beholder"!! :-) However, on more serious note, what I have realized is that many a times, while defining value, relying "only" on quantitative aspects is not good enough. There is enough evidence in the market about "quality" stocks which by all measures of traditional valuation would look overvalued, however turns out to be highly undervalued in medium term. I am sure you may have read Prof. Bakshi's paper on the subject which has dealt with it beautifully.

      In terms of what to do after selling a "valuation discount" bet, it becomes a capital allocation question. I personally feel that it is not advisable to keep "minimum" investment or "maximum" cash limits while making investment decision. Because, it forces one to take an sub-optimal decision and hence increases the risk. The key question to be answered is whether at the time of "surplus" cash, does one encounter an attractive investment opportunity or not? If the answer is resounding yes, one should deploy cash else it is better to remain in cash.

      I acknowledge and accept that due to limited bandwidth on my side, I have not been able to put up the Capital allocation part-2. However, will definitely work on it and put it post part-2 of "To sell or Not to sell".

      Delete
  4. "Even the most thoughtful and steadfast investor is susceptible to the influence of
    skeptics who yell ‘Sell’ before it’s time to sell…We’ve all been taught the same
    adages: ‘Take profits when you can,’ and ‘A sure gain is always better than a
    possible loss.’ But when you’ve found the right stock and bought it, all the evidence
    tells you it’s going higher, and everything is working in your direction, then it’s a
    shame if you sell. A fivefold gain turns $10,000 into $50,000, but the next five folds
    turn $10,000 into $250,000. Investing in a 25-bagger is not a regular occurrence
    even among fund managers, and for the individual, it may only happen once or twice
    in a lifetime. When you’ve got one, you might as well enjoy the full benefit."
    -- Peter Lynch, One Up on Wall Street, p. 253

    "The investor cannot pinpoint just how much per share a particular company will
    earn two years from now. As a matter of fact, the company’s top management
    cannot. Under these circumstances, how can anyone say with even moderate
    precision just what is overpriced for an outstanding company with an unusually rapid
    growth rate? If the growth rate is so good that in another ten years the company
    might well have quadrupled, is it really of such great concern whether at the moment
    the stock might or might not be 35% overpriced? That which really matters is not to
    disturb a position that is going to be worth a great deal more later."
    -- Philip Fisher, Common Stocks and Uncommon Profits, p.83.

    ReplyDelete
    Replies
    1. Thanks Bharat for posting very relevant thought from the investment greats! They are very relevant indeed.

      Delete
  5. Dhwanil, very well written, enjoyed reading this post

    Vinod MS

    ReplyDelete
    Replies
    1. Hi Vinod,

      Thanks a lot. You appreciation makes the effort of writing more rewarding!

      Delete
  6. Hi Dhwanil,

    It is a pleasure reading your posts. Please post more often.
    I keep visiting/checking your blog at least once a day and get disappointed most of the time for not seeing anything new :)

    Gouri

    ReplyDelete
    Replies
    1. Hi Gouri,

      Thanks for the complements. I do acknowledge that due to limited bandwidth the frequency of writing new posts have gone down. Will try to get up to speed and increase frequency as much as possible.

      Delete
  7. Good one Dhwanil

    Am too working on similar one for long time though still WIP.. fully agree on not selling a quality business on fair valuation & temp prob grounds..

    ReplyDelete
    Replies
    1. Hi Anil,

      Thanks for the comments. Look forward to get your views on the subject as you complete your work on the same.

      Delete
  8. could u read 100 to 1 in stock market .... any lessons for us from that book

    ReplyDelete
  9. Thanks for this nice article.
    With your experience, how many good quality business stocks prices would come down 20% to 30% or more from their top when all parameters are in place?
    if the answer is say less than 20% than do you feel it is good idea to sell the stock if it goes more than 30% with all parameter reflecting good (downtrend may start that reason may come to know later)? Your thoughts would be helpful.

    ReplyDelete