Friday 30 January 2015

To Sell Or Not To Sell: My View Points And Few Ground Rules: Part II

In the last post To Sell Or Not To Sell: My View Points And Few Ground Rules: Part I, I shared my views on when Not to sell. Once we have established broad ground rules for "when not to sell", we have won half the battle! Now, let's move to the next quandary i.e. When To Sell. 

Even though, many of us assign great importance to what we buy (quality) and when we buy (valuations), I have seen large number of investors erring in making a right decision on "when to sell" due to lack of structured framework for making a sell decision. This shortcoming has deprived number of investors, even many veterans, of serious wealth creation. Even well informed investors who have realized the merit of buying right, have largely ignored the other part of the advise on "sitting tight"! This is my attempt (knowing my limited experience in the market, it is nothing more but an attempt!) to establish some pointers in making right "selling" decision. In my opinion, one should not sell the stock for any other reason than the one of the five reasons articulated below. All other reasons/rationales attributed for making a "sell" decision can be seriously injurious to investor's ability to create serious long term wealth. 

Here are the five  reasons which can lead to a credible and beneficial "sell decision"

When we realize that we have made a mistake in making a "buy" decision:

This is the first, foremost and undeniable reason for selling a holding! I am sure almost all of us have gone through scenario number of times in over investing life span. In spite of all our caution and conservatism, we will end up committing mistake/s while making a "buy" decision. Sometimes, we misjudge the quality of business, management or both!  At other times, we end up paying too much for buying a business compared to business's future earning power and the quality of earnings. And last but not the least, occasionally, in our urge to buy  "statically cheap" stocks, we end up in value traps.

I can enumerate number of such mistakes from my side: Hyderabad Industries Limited, GSFC, GRP Ltd and Sintex (almost all these mistakes are well documented on my blog!) each falling into different category of mistakes (believe me, I have covered the whole range!...:-))

In such situations, the most logical and correct thing to do is to "sell" as soon as we realize that we have made the mistake. Even though selling sounds the most logical course of action in such situations, we seldom take the most rational course of action! Most of the times, in spite of knowing "heart in heart" that we have made a mistake, the innate behavioural traits take the control of our decision making process making us vulnerable to 

  • Commitment and consistency bias: we ignore all the evidences that are contrary to our "hypothesis" for making a buy decision and continue to hold onto our mistakes
  • Loss aversion: We continue to "hope" that prices will recover on good earnings/corporate action at some point and we will be able to exit with reduced/no loss
Clinging onto our "mistakes" cost us dearly either in terms of permanent loss of capital or in terms of the opportunity cost...Thus, the first concrete realization of our mistake is a genuine reason to hit the "sell" button and it has, in the long run, the ability to improve our financial well being  to a great extent!

Due to change in any internal or external factor, if the underlying investment thesis no longer holds true in case of business quality, management quality or valuation

As we all know, the only "constant" in business is change! Hence it is important to re-visit the underlying "investment thesis" for each investment and make a periodic assessment on whether in the present context, the investment thesis still holds true. Even though there is a sound argument for not re-evaluating the merits of an investment very frequently and follow the  "buy and forget" philosophy. I feel lot of investors suffer because they follow the "buy and forget" approach in literal sense and don't keep track of changing dynamics on periodic basis...a mistake that may cost them a lot of money! Again, I am not suggesting that each and every development of the company/industry shall prompt us to "re-visit" the investment thesis. Instead, a more judicious approach of regular annual review with exception of earlier review in case of any major internal/external development may be adopted.

Let me share a current example: 

When I took a position in MPS Ltd with an investment rationale as follows

" MPS Ltd is a well entrenched player in publishing outsourcing industry with strong relationship with marquee list of clients. MPS is one the leaders in this segment. Publishing outsourcing industry is likely to grow at decent rate due to various tailwinds behind it. MPS, which had fell behind in the game, under previous management due to its high cost structure and lack of growth coming through from 2009-2011, seems well on its way to claim its lost glory under new management. New management, which seems competent, focused and shareholder friendly, has proved its mettle in the first phase of "turn around" by completely altering the cost structure and thus improving margins significantly in last 2 years. Thus, realigning of the business model has resulted turned MPS from a mediocre business to a high quality business generating very high return on capital and free cash flows. Management has allocated the capital well by making acquisitions at decent prices while distributing the significant portion of cash to shareholders as dividends. 

Looking at management's rigour on margin improvement and indication about possibility of further improvement in margin, there is still some room for margin improvement. After addressing the margin issue, management is likely to focus growth. Considering the competence of the management and its track record, inherent strength of a strong client relationship and tailwinds for the publishing industry, there is high likelihood that management will be able to deliver decent "growth". At current valuations, the market is pricing in minimal growth and no margin expansion. Hence, the odds are in favour of an investor with limited downside and significant upside, if the hypothesis plays out correctly"

Now let's look at today's scenario:

- Margin improvement story has played out and margins have limited room to improve from here on

- Organic growth has been moderate at best though inorganic growth has been decent
- Valuations have caught up and market is also factoring in 15-20% CAGR

Now, I don't have crystal ball. However, what should I do, if MPS management is not able to bring in the top line growth in next couple of years and valuation remains at level they are today?  I need to "re-visit" the hypothesis every year and see if the business is living up to the key rationale of my investment hypothesis
  • Growth kicking in
  • Management allocating capital rationally 
  • Re-alignment of business model has made MPS a high quality business
Depending upon the assessment, I shall make a decision of either buy/hold/sell

Other such examples where change in investment thesis may lead to "sell" decision: 

  • Change in business dynamics resulting in gradually lower returns on incremental capital (because of higher working capital requirements, higher replacement cost of existing assets, lower margins etc.)
  • Adverse change in management quality either in terms of capital allocation or integrity
  • Unfavourable changes in external environment such as regulations, policy, new technology,substitute product, change in preference of the consumers etc
Here again in addition to the  psychological factors of commitment and consistency bias and loss aversion, "slow contrast effect" may also hinder the rational decision making . Slow contrast effect is evident when there is slow but steady change that is visible to investors quarter on quarter and year on year, however goes unnoticed/is ignored as the quantum of change is too small. Ideally, these small changes happening consistently, without any strong reasons attributable to it shall act as an early signal to re-evaluate the investment thesis for any material changes in external/internal environment (For e.g.working capital as % sales increasing slowly but steadily or After years of constant/increasing margins, the margins are consistently shrinking by a small fraction every year) . However, these early signals get ignored due to the "small quantum" of change and is disregarded due to its marginal effect until the resultant cumulative effect is large enough to be visible. And many a times, it is too late, by this time! 

If in a portfolio, allocation to a single business remains much above the upper limit of allocation on sustained basis

The third credible reason to make a "sell" decision is for "risk averse" people like me. Here, the driving force for making a sell decision is not linked to merits/de-merits of an investment but is linked to an investor's ability to bear risk in case of extreme adversity. I acknowledge that many of the investors may not agree with this approach of hitting the "Sell" button when the decision making process is not "centred" around the attractiveness of an investment on standalone basis. However, I feel that it may be of great importance to people who run a portfolio with small base and are prone to make errors of judgement. In this context, it shall become a credible reason to sell.

All of us adopt different approaches to capital allocation with the portfolio falling into category of highly diverse with more than 30 stocks to highly concentrated with less than 5 stocks. However, in all these approaches, one aspect that an investor must "calibrate" is the maximum allowable allocation to a single stock. This number may vary from investor to investor from 10% to 40% or even for some investors up to 50%. 

Prime objective of setting the maximum allocation to single business in a portfolio is to manage the risk of one or more negative event/s resulting into very large permanent loss of capital. It is a mechanism, to a degree, to comply with an old adage of not putting one's all eggs in one basket. I have come across many long timers in the market who faced extremely severe erosion of their net worth for either not setting the maximum allocation limit right or not being disciplined enough to stick to the limit set in the beginning. 

This situation typically arises, when one of the portfolio's sizeable holdings out performs the other holdings by a large margin thus increasing the initial allocation multi fold to exceed the maximum allocation by a wide margin. Take the example of a portfolio of 10 stocks with each starting with 10% allocation with maximum allocation limit of 20%. In 3 years, stock A  turns out to be a 5 bagger while the rest of the portfolio giving 66% return. Thus the overall weight of stock A in the portfolio becomes 40%, i.e. double the maximum allocation limit. Even though, many people may advise you against selling one's winners,it may be prudent to be disciplined and sticking to the limits and booking some profit to bring down the allocation to the maximum allowable limit (or very rarely, to re-set the maximum allowable limit, in case if the risk appetite of an investor has changed)

If the Investor comes across a much better investment opportunity that offers significantly higher risk adjusted returns than the existing portfolio holdings:

Let me start with a warning. One should tread this path with extreme caution as an investor is vulnerable to mistakes every time he/she makes a decision to switch. This is especially the case when such decision is made in absence of a mistake or change in investment thesis of existing holding. Hence, if one finds that, every 6 months he/she comes across a much better investment opportunity that will necessitate the churn in the portfolio, more likely than not, he/she is not making the right "buying" and/or capital allocation decision.

Having alluded to this pitfall, there are situations in one's investment journey where one comes across extremely attractive investment opportunity but does not have adequate cash available to capitalize on the opportunity . At this point, selling one of the existing portfolio holdings will make sense as risk adjusted "opportunity cost" of not selling may be very high . However, while making this decision to sell, investors may keep following criteria in the mind
  • New opportunity shall be significantly superior both in terms of conviction level, business quality and valuation to the least attractive holding in the portfolio. One should pass away any such opportunity, if the new opportunity is likely to be only "marginally" better than an existing one in any of these aspects, simply because of the re-investment risk involved in the process is too high.
  • Investor shall have a structured framework to arrive at relative merits/attractiveness of each holding in its portfolio (one such excellent discussion is on valuepickr) and then sell the "least attractive" holdings 
Again, I would want to re-iterate that, if one is required to sell one of its holdings for this reason too often, he/she should seriously re-look at the frame work and rigour that he/she is adopting for making a "buy" decision.

The markets pendulum swings to undue exuberance resulting into market valuations (measured through benchmarks) that are more than 2 standard deviations away from the average historical benchmark valuations 

This again is an area where the decision to "sell" is driven by the risk aversion and not through business fundamentals. Hence the central driving force behind "selling" at this time of heightened optimism is two fold 
  • Converting the paper profit (which may evaporate in a jiffy!) into hard cash thus protecting the "net worth" from severe erosion, in case of impending severe crash
  • More importantly, creating a war chest in terms of cash to take advantage of exceptionally attractive opportunity that may arise after the impending crash 
(yes! the underlying assumption is that market will eventually unwritten rule of the market). As Mr.Buffet puts it "Cash in time of crisis combined with courage is priceless"

Here again what percentage of portfolio shall be monetized is a question that isa function of  individual capital allocation approach. However, investor will be well served, if they adopt a structured approach as mentioned above of rating one's portfolio holdings from most attractive to least attractive based on the framework of business quality, conviction level and valuation. Based on the attractiveness of each portfolio holdings, investor may sell the least attractive holdings to generate cash level that he/she is comfortable with. 

Even though, this sounds simple while writing, it takes exceptional courage to take the money off table while the money is literally multiplying and everybody shouting from the roof top that "best is yet to come" and "this time it is different!" Even more painful is to watch other investors make  money  on the same holdings you have sold for a while (This is bound to happen as the market, like a true maniac, moves to extreme and hence may even move higher from already unsustainable elevated levels )! One has to overcome extremely powerful interplay of psychological forces namely greed, envy and scarcity to make these "sell" decisions! Nevertheless, one who displays  strong resolve and discipline in this situation is bound to be rewarded with a bountiful in the long term!

It goes without saying that, this ground rules are based on my limited understanding of how things may work in market and by no means conclusive. At the same time, I also feel that the above five category of reasons cover a broad expanse of credible reason to make "sell" decision. Conversely, any reason not falling under any of these five categories leading to "sell" decision shall be looked with deep suspicion! 

Disclaimer: Nothing in this article shall constitute an advise to either buy or sell to any individuals. I am not a research analyst and the views here shall not be construed as an advise coming from a research analyst. The views expressed on this blog are only for engaging in discussions with like minded people on  various investment related subjects. Individuals shall consult their financial advisor for making any investment decision.