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.

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