For as long as I have been in this business a common investor complaint has been that nobody tells them when to sell. In actuality, this may be the biggest complaint investors have against their professional investment advisors. The truth, however, is that knowing when to sell a stock is one of the most formidable tasks investors, professional or lay alike, face. Therefore, we offer this two-part series on how to know when to sell a stock.
With the above stated, there are principles based on fundamentals that can guide investors into making sound sell decisions. However, making perfectly timed sell decisions cannot be done except by chance. Nevertheless, we would argue strongly that sell decisions based on fundamental mathematical principles will get you closer to perfection more reliably and often than mere chance will.
We believe that the best way to improve your selling batting average is first to acknowledge and understand the importance of earnings and/or cash flows. The principle states that a company derives its intrinsic value based on the amount of cash it can generate for its stakeholders. You can calculate the rate of return your expected cash flows represent in order to determine whether or not the cash flows compensate you for the risk you are taking.
Comparing these expected cash flows to riskless cash flows from Treasury bonds is an accepted computation. This is the origin of the generally acknowledged process of discounting future cash flows back to the present value method of determining intrinsic value. This implies that an intelligent way to know when to sell is by running the numbers out to their logical conclusion.
Two Rational Reasons to Sell
We would suggest that the primary reason to sell a stock is when future expected cash flows no longer justify holding on. There are two major causes of cash flow inadequacies. Cash flows can become unjustified either based on overvaluation or fundamental deterioration. In either case, cash flows no longer support their price or value. With overvaluation, price moves above and away from earnings. With fundamental deterioration, earnings fall away from price.
We believe the easiest and most obvious sell signal is pure overvaluation, when the price rises dramatically above earnings justified levels. The more extreme overvaluation becomes, the more obvious it is to see. Our EDMP, Inc. F.A.S.T.™ Graphs (Fundamentals Analyzer Software Tool) were designed to calculate True Worth™ valuation based on earnings (cash flows). Therefore, when using this “tool to think with”, overvaluation becomes graphically evident. It’s important to understand that the vivid pictorial representations that we will present are mathematically based.
Learning From the Past
To best illustrate overvaluation as a sell signal, we chose the irrational exuberant period ending in 1999. We also want to point out that we stopped all updated “c” graphs intentionally in 2006. The reason we did not show these graphs up to current time will become clear in Part 2 of this two-part series. During this time, valuations were extreme and sell signals were flashing brightly. Unfortunately, many investors failed to heed their warnings. Using our F.A.S.T. Graphs™ lets look at five examples of overvaluation and analyze the mathematics behind what the overvaluation means.
Figure 1a looks at EMC Corp Inc. (EMC) at year-end 1999.
EMC is a leader in data storage and at year end 1999, EMC's stock price had risen dramatically above its earnings justified value line. Even though its earnings growth rate at 60.8% was extraordinary, at 95 times earnings, the lofty price was not supported by earnings. Visually it's clear that the price (black line) had not risen above the earnings justified value line (green line with white triangles) since 1991. Therefore, overvaluation is vividly depicted in Figure 1a.
Figure 1b illustrates the mathematics behind Figure 1a.
In Figure 1b, as well as all the remaining "b" charts, we introduce the EDMP EYE (Earnings Yield Estimates) Chart™ that presents the mathematics based on the overvaluation seen in Figure 1a. This simple chart assumes a $100,000 investment in the respective company and compares it to an equal $100,000 investment into less risky treasury bonds. The purpose of this chart is to provide a measurement of risk versus reward. The theory behind the chart is that if you are going to assume the greater risk of owning a stock, then you should expect a much higher future stream of income than a low-risk treasury bond would provide.
As an aside, when utilizing this tool with current charts, earnings growth rates are applied based on consensus estimates by leading analysts reporting to either Zacks or FirstCall. This calculation is made on the idea that those estimates are reasonable. However, when using charts with years ending in the past, the EYE Charts™ calculate the actual growth rate the company achieved from the ending date to current. When used this way, it becomes mathematically clear whether or not the actual earnings growth the company generated supported the ending price or not.
In Figure 1b, EMC generated $15,120 of cumulative earnings per $100,000 investment for the period 12/31/1999 through 12/29/2006. An equal investment in 10 year treasury bonds over this same time period would have generated $66,800 (T-bond rate 6.68% 12/31/1999). Note that EMC's total cumulative earnings provide a measly ratio of 0.2 to 1. In other words, a 10 year T-bond paid more than 4 times as much theoretically “riskless” interest than EMC generated in total earnings. Most importantly, EMC did not pay a dividend and therefore all future investor returns were at the mercy of the market capitalizing the earnings.
Clearly EMC's earnings did not support such a lofty valuation in 1999. We will be utilizing these same EYE Charts™ in the remaining company examples.
Figure 1c illustrates EMC's EPS Growth Correlated to Price ending in 2006.
As can be seen in Figure 1c, although EMC's stock price rose significantly from the lofty 1999 year end value (see price flagged with the red arrow), it ultimately and swiftly collapsed. This is a quintessential example of the true meaning of the words “irrational exuberance” as they applied specifically to technology companies. Therefore, it should also be clear that selling EMC at any point where the black price line was above the green earnings line, representing overvaluation, would have been a sound decision, although not necessarily a perfect one.
Figure 2a looks at CREE, Inc. (CREE) at year-end 1999.
CREE Inc., the leader in LED technology, ended 1999 with a PE ratio of 162.5. Once again, we see a vivid graphic illustration of price ludicrously disconnected from fair value.
Figure 2b illustrates the mathematics behind Figure 2a.
Once again when you run the number using the EDMP EYE Chart™ , the numbers simply don't add up. At almost identically to its technology cousin EMC, CREE's cumulative earnings were not supportive of its lofty valuation.
Figure 2c illustrates CREE's EPS Growth Correlated to Price ending in 2006.
Like EMC, CREE's stock price continued to rise from these lofty levels (see price with red arrow) into the spring of calendar year 2000, before reverting to the mean. The decent was swift, brutal and breathtaking, illustrating the real insidious nature of overvaluation.
Figure 3a looks at Procter & Gamble Co. (PG) at year-end 1999.
With Figure 3a, we look at Procter & Gamble, a blue-chip stalwart, at year end 1999. Although overvaluation was not as extreme as it was with tech stocks, it was still abnormally high. As the graph shows, PG's stock price (black line) had normally tracked or correlated to earnings (green line with white triangles) before the irrational exuberant period, which started in 1995, occurred.
Figure 3b illustrates the mathematics behind Figure 3a.
The EYE ratio chart for PG shows that even though earnings growth of 9.5% closely matched its historical growth, its cumulative earnings generation did not support such a high PE ratio of 34.4 at year end 1999.
Figure 3c illustrates PG's EPS Growth Correlated to Price ending in 2006.
With the example of PG, graph 3c shows that its stock price literally fell off a cliff as it immediately returned to a more traditional valuation. This represented an almost immediate recalibration to value.
Figure 4a looks at Home Depot Inc. (HD) at year-end 1999.
With this example of HD, we find another stalwart that saw its stock price reach unjustified valuation by year end 1999. HD's PE ratio was at 68.4 and was even more extreme than PG. At 68.4 times earnings, its PEG ratio was over 2.4 indicating very high valuation.
Figure 4b illustrates the mathematics behind Figure 4a.
Just like the previous examples, the total cumulative income stream from earnings generated by HD, due to overvaluation, was significantly less than the interest paid on a 10 year t-bond. When overvaluation is extreme, the numbers just don't make any sense.
Figure 4c illustrates HD's EPS Growth Correlated to Price ending in 2006.
As you would by now expect, HD's stock price reaction to overvaluation was conceptually the same as the other examples. The only real difference here, as compared to PG, was the length of time it took HD's stock price to return to justified levels. Interestingly, even though it took longer for HD's stock price to return to value, it actually became more undervalued based on its earnings achievement over this time period, than any of the other examples. This is a testament to how irrational short-term stock price volatility can behave.
Figure 5a looks at General Electric Co. (GE) at year-end 1999.
Our final example is General Electric Company, another blue-chip stalwart. By year end 1999, stock price had clearly deviated from its normal historical earnings justified valuation.
Figure 5b illustrates the mathematics behind Figure 5a.
The EYE Chart™ for GE, sings the same song as the rest. Total cumulative earnings generated from the actual earnings growth rate from 1999 through 2009, simply did not support its 1999 ending price.
Figure 5c illustrates GE's EPS Growth Correlated to Price ending in 2006.
In Figure 5c, we see a similar outcome for GE's stock price as we did for HD. When stock prices deviate from their earnings justified levels, they inevitably revert to intrinsic value.
Conclusion: Part 1
In this Part 1 of a two-part series we looked at extreme overvaluation during 1999 to illustrate the danger of holding an overvalued stock. The two tech stocks, Cree Inc and EMC Corp went up another 100% or more from their 1999 lofty valuations before they ultimately collapsed. However, selling them in 1999 was a sound decision regardless. In both cases the reversion to the mean was brutal and swift during calendar years 2000 & 2001.
Regarding the other three more consumer-oriented blue chips, selling at year-end 1999 would have meant close to perfect timing. Needless to say, the logic of selling when price was not supported by fundamentals is clear. If you buy or hold an overpriced company you’re ultimately playing the role of the “greater fool.” If you didn’t know, the “great fool” is someone who is foolishly willing to pay you more than you foolishly paid in the first place.
In Part 2 we will focus on fundamental deterioration as a sell signal and look at an example or two of currently overvalued names based on fundamentals. Although we also believe that the time to sell doesn’t need to be perfectly executed; we also believe it should be intelligently applied based on fundamentals.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: Long PG at time of writing.