Category Archives: Practice Patience

A Framework for Selling a Stock

Determining a good strategy for when to sell a stock is both important and difficult. In simple terms, your returns are going to come from two primary sources: 1) the reappraisal of an undervalued holding to its intrinsic value and 2) growth in intrinsic value. Many investors sell their holdings if the price appreciates to fair value. Others, like Buffett, Russo, Greenberg, etc. hold their stocks for the long-term and look for gains from growth in intrinsic value.

Both of these approaches work and have generated a great deal of wealth.

In September, I posted a 1999 interview with hedge fund manager Morris Mark. Mark began his career at First Manhattan, an investment advisory firm founded by Sandy Gottesman, a large shareholder ($2 billion) and board member of Berkshire Hathaway.

Here’s what Mark said about selling Coca-Cola.

“We sold it three years ago because the valuation it was trading at in relation to our anticipated rate of earnings growth on a near to long term basis seemed to be well discounted versus our rate of return objectives. Generally, we would sell a position when something bothers us, otherwise the sale is likely related to valuation.”

This strikes me as an immanently rational framework which I would tweak only slightly:

Sell a stock when, after due consideration of taxes and opportunity costs, its anticipated rate of total return is well discounted versus your rate of return objectives.

This framework works for all types of investing and allows for the fact that different investors have different hurdle rates. Of course, considerable judgment is involved in making this determination, but these are the type of issues that should have been considered carefully before making a purchase. If you can’t figure out how much intrinsic value will grow in the long-term, the stock should probably be sold when it is no longer undervalued.

I would love to hear your comments about when you sell a stock.

Patience Plus a Great Franchise Can Make You Wealthy

The 2nd tenet of my investing blueprint is Act Like an Owner. The 8th tenet is Practice Patience. A great business generates wealth over time. Owners of privately held great businesses know they have something special that is worth holding on to and passing on. They are likely to be naturally patient in holding on to their businesses. I recently came across an example that powerfully reinforces this lesson and shows that the rewards of private business ownership are also available in the stock market.

I saw a comment on an investing forum where a contributor noted that Berkshire Hathaway now enjoys a 27% dividend yield on its original purchase of Coca-Cola. The stock currently pays a dividend of $1.76 on an annualized basis and Berkshire’s cost in the stock is $6.50 per share on a split-adjusted basis ($1.76 / $6.50 = 27%).

It’s amazing to think that you could have put $1,000,000 in Coka-Cola stock in 1988 and today, on top of your unrealized capital gains, you would be receiving annual checks totaling $270,000. Moreover, the $270,000 would be likely to grow at 5-7% as far as the eye can see.

Buffett’s purchase of Coca-Cola is highly celebrated and studied. Buffett invested $1,299 million and it is now worth $11,176 million based on the August 31, 2010 closing price. That is an average annual return of 10.3%, assuming a holding period of 22 years. Buffett purchased shares of Coca-Cola during 1988 and 1989.

What’s interesting to me is not only Buffett’s Coca-Cola purchase and its results, but also how well you would have done if you had purchased shares in other leading franchises at the end of 1988.

Johnson & Johnson

  • Price 12/31/1988 – $3.45
  • Price 8/31/2010 – $57.02
  • Average annual return – 13.8%
  • Current dividend – $2.16
  • Dividend yield on cost – 63%

McDonald’s

  • Price 12/31/1988 – $4.42
  • Price 8/31/2010 – $73.06
  • Average annual return – 13.8%
  • Current dividend – $2.20
  • Dividend yield on cost – 50%

Exxon Mobile

  • Price 12/31/1988 – $5.48
  • Price 8/31/2010 – $59.11
  • Average annual return – 11.6%
  • Current dividend – $1.76
  • Dividend yield on cost – 32%

Pepsico

  • Price 12/31/1988 – $4.18
  • Price 8/31/2010 – $64.18
  • Average annual return – 13.42%
  • Current dividend – $1.92
  • Dividend yield on cost – 46%

Total returns would be considerably higher if the calculations included the reinvestment of dividends.

It is worth noting that these companies were very well established and widely followed in the late eighties. Their strong economics and competitive advantages were on display for any investor willing to take a look. In short, they were hiding in plain sight. Moreover, I could have found many other examples of companies with similar performance.

Most investors missed them because they were not “hot” or “exciting”.

Also, it is important to understand why these businesses were able to produce such impressive results. These types of businesses earn high returns on equity, typically 18-20% or higher. After paying dividends and repurchasing shares, they are able to increase their equity by 10-15% per year. This reinvested capital, in turn, earns a high rate of return owing to the businesses’ durable competitive advantages. The mathematics are the same as those in play if you kept adding money to a savings account; the unusually high rate of return is a function of the moats these businesses enjoy.

Finally, don’t forget that if you invest outside of a retirement account, the tax benefits to this type of investing are huge. Buffett points out that the deferred capital gains tax amounts to an interest-free loan from the government.

Today, many world-class global franchises are available at very reasonable prices. Smart investors have taken notice and are buying large numbers of shares. Take a look at the holdings of leading investors at gurufocus.com.

Remember, as we have learned from Buffett, sins of omission can be every bit as costly as sins of commission.

Patience and Finding an Edge

In the world of Star Trek there is a simulated training exercise called the Kobayashi Maru that presents Starfleet cadets with a no-win situation in order to test their character. As Wikipedia describes it, “The cadet is faced with a decision:

– Attempt to rescue the [freighter] Kobayashi Maru’s crew and passengers, which involves violating the Neutral Zone and potentially provoking the Klingons into hostile action or an all-out war, or

– Abandon the Kobayashi Maru, potentially preventing war but leaving the crew and passengers to die.”

As a cadet, James T. Kirk secretly reprograms the simulator and thereby rescues the freighter. Kirk is commended for his originality. Kirk did not play the game in the conventional way; he played it in a way that he could win. (Want to beat Bobby Fisher? Play him in anything but chess.)

Imagine going to the Harvard Business School and being invited to play a complex game with ninety-nine MBA students. Imagine that the rules of the game were comparable to bridge and that some students had been playing the game for many years. Finally, assume that it is played individually, takes an hour to play a round, that the game would be played each week, and that at the end of a round all hundred players would be ranked 1 to 100. How would you fare? Do you think you would be above average and, if so, based on what? I think for most, it would be hubris to imagine even being in the top 50%.

But what if you discovered in the rules that there was no rule you had to play each round. Further imagine that the game was such that every so often a scenario would arise that would give you near certain odds of being in the top 10%. Why would you play every round when you had such an advantage? Why would you continue to play every round against opponents who were either smarter or more experienced, when the key to victory was simply waiting for the right opportunity.

As Munger has pointed out, most of the time the market is like a parimutual horse race where the payouts accurately reflect the odds of a given horse winning. Yet, according to Munger, there are a select few who both do the math and wait (and wait) for the right opportunity and then bet in scale when it develops.

In Atul Gawande’s book The Checklist Manifesto investor Guy Spier speaks about a phenomenon called “cocaine brain” which occurs when an investor begins to fall in love with a stock. This can lead to irrational thinking and mistakes. This condition is opposed to patiently waiting for an obvious winner. Yet the greed that a certain stock will get away is a siren song that lulls us into making sub-optimal investments.

There is no magic to having the patience to wait for the perfect fat pitch, although honest self-awareness and understanding are a good place to start. Each investor must devise systems that will develop this essential virtue of value investors.

Some Thoughts on Selling

Selling is an important part of the overall discipline of value investing. At the risk of oversimplifying things, value investors generally fall into one of two camps: those who sell their holdings when they reach intrinsic value and those who hold indefinitely, as long as the intrinsic value continues to grow.

Examples of investors in the first group are David Einhorn and Seth Klarman. Investor and writer Vitaliy Katsenelson has written a book called Active Value Investing which argues that investors should sell stocks when they reach intrinsic value because we are likely to be in a long-term range-bound market. His argument is worth considering.

Klarman has said that he frequently sells too early. I suspect that this due not only to his aversion to speculating, but also because of his understanding of intrinsic value. Klarman, like Graham before him, sees intrinsic value not as a specific precise number, but as a range of values. Therefore, it makes sense to sell as the stock price move up into the lower end of this range of values. Otherwise, the higher the price goes, the more you become dependent on the “greater fool” to bail you out.

The best known example of the second camp (buy and hold) is Warren Buffett. Another example is the Tweedy, Browne Company. A major incentive for this approach is that it defers capital gains taxes into the future, in effect getting an interest-free loan from the government. (Obviously, this is only an advantage for taxable holdings.) Buffett did not practice this approach in his partnership and would typically sell when a holding reached intrinsic value.

Why the change for Buffett? I think there are several reasons. First, the opportunities for Graham style asset plays diminished with time as the shock of the great depression faded and equities regained popularity with a new generation of investors. Second, Buffett began to focus on “good” businesses that had the capability of growing intrinsic value at a high rate over a long period of time. (During the Buffett partnership, most of the money was made from the stock price closing the gap between the purchase price and intrinsic value as opposed to growth in intrinsic value.) Also, as Buffett’s capital ballooned it became increasingly impractical to jump in and out of stocks. In addition, as Buffett became very wealthy he began to value the relationships with the management and owners of his holdings, for example with Kay Graham at the Washington Post.

Buffett has long favored the outright purchase of a business, if possible, because it allows him to control capital allocation. His emphasis on buy-and-hold has allowed him to create a competitive advantage vis-a-vis competing buy-out firms. He is able to attract and be first-in-line on a number of deals because the sellers know Berkshire will allow management to stay in place and run the business as they see fit and they needn’t fear the business will be dismantled or leveraged up.

So, how can we reconcile the two camps? I don’t think we need to. They both can work. The important thing, as with all investing, is to carefully think through your position in advance. Having a sell strategy will then help provide a framework against emotional reactions in the “heat of battle”. Also, it doesn’t need to be an “all or nothing” proposition. It would be perfectly rational to have mixture of long-term holdings that were increasing intrinsic value over time and event driven asset plays that you intend to sell when they reach your estimate of intrinsic value.

Also, regardless of which approach you adopt, there can be times when selling is the only rational thing to do. This occurs when a stock reaches a state of extreme overvaluation. In this case, take your profits. It makes no sense to hold a stock whose price anticipates a decade or more of robust growth in the intrinsic value of the underlying business.

Another time to consider selling is if you find a stock that is materially more undervalued than an existing holding. There is no set rule of thumb here, but, as a general guideline, I would say that it makes sense to do if, all else being equal, you can double your earnings yield. For example, if a given portion of your investing capital is earning X, redeploy it if you can find an opportunity where it would earn 2X. This should more than cover capital gains taxes, especially if they are long-term, and provide you with some margin of safety in your decision.

Poker and the Mentality of a Value Investor

In his book “Poker Wisdom of a Champion”, Doyle Brunson writes about a time he went to a neighborhood party with another professional poker player named Harvey and his wife. All the neighbors decided to strike up a friendly little poker game, all that is except Doyle and Harvey, who were just observing.

At one point, Harvey’s wife had to go to the ladies’ room, so she asked Harvey if he would sit in and play a few hands while she was gone. He agreed, but the moment he sat down he felt apprehensive because of the pressure to perform, seeing that he was a professional. The cards weren’t going his way and he began to press. After all, he had something to prove, or at least he felt he did. By the time Harvey’s wife returned, Harvey had managed to lose the better part of her chips.

Brunson draws an important lesson from this simple story. “Some nights you’ve got to wait hours to get a decent hand. Poker skill is something that works for you in the long run.”

And so it is with investing. You can’t press. It is simply not given that on any given day you are going to find a good company, which you understand, with a clear competitive advantage, selling at a meaningful discount to its intrinsic value. Making money is not that easy. You have to go to work everyday and patiently focus on the process. It can be frustrating, but there is no other way, unless you want to resign yourself to, at best, mediocre returns.

Sure, there are paid services that value thousands of companies and that are always ready to serve up a number of undervalued securities. There are articles everyday on the Internet and in the papers offering up the latest “undervalued” stocks. Be very careful here. I’m not saying that these can’t be sources of ideas, but the idea that it is this easy probably doesn’t stand-up to a serious critique. These paid services must produce recommendations, just like financial journalists that cater to investors must produce articles that recommend stocks. Buffett is happy if he can come up with one, or maybe two, good ideas each year.

I’ve read that there are people who make a good living betting on the horses. They don’t bet though like the “average Joe”. They carefully study the stats and odds, and then wait very patiently – days or even weeks – until a situation arises where the product of the odds and the payoff create the mathematical expectancy of a winning bet – and then they bet in size.

“Some nights you’ve got to wait hours to get a decent hand.” Investing is no different.