Seeking Alpha

Intrinsic Valua...'s  Instablog

Intrinsic Valuation
Send Message
James is the Founder and Chief Analyst at www.intrinsic-valuation.com, a website dedicated to providing Value Investing tools and analysis including the unique Return on Equity valuation system. James firmly believes that the only way to invest in a stock is to conduct detailed analysis on the... More
My company:
Intrinsic-Valuation.com
My blog:
Value Investors Free Blog
  • When to Sell

    A lot of time and effort must be put into finding the right business to invest your money in. And endless literature is available on picking stocks and analyzing businesses which helps educate the investor. Waiting patiently for the right time to buy into the business is important also, to ensure you give yourself a large enough margin of safety. But there seems to be much less effort devoted, and much less reading available, in regards to selling. So when do you sell? It is a great question, and one not easily answered.

    Warren Buffett has famously said that his favorite holding period is forever. But throughout his career even Warren Buffett has sold many positions and bought others when it has made good sense to do so. And though some companies, such as Coca Cola, may remain great companies for generations, all companies have a finite life, particularly in regards to their growth phase.

    Firstly, if you have a stock or 2 in your portfolio that you accumulated because of a hot tip, or from an uneducated guess that the shareprice might go up, or from any reason other than the business is a quality business with sound prospects and the buy price represented good value, then you need to seriously consider selling without delay. This is especially true if the share price is well above the Intrinsic Value as calculated by USAStockValuation.com, or another reputable source.

    We at USAStockValuation.com love quoting Warren Buffett. We find his words both enlightening and humorous. With regards to holding poor quality businesses in your portfolio, 2 of Warren’s quotes ring true to us:

    "The most important thing to do if you find yourself in a hole is to stop digging."

    And

    "Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

    A popular and valuable tool we recommend our subscribers adopt is to keep an investing log book or diary. At the time of purchasing shares in a company, list the reasons why you want to buy a part ownership of that particular business. What makes it worthy of your hard earned money? If at any time in the future you are considering selling, review those buy reasons – if they still ring true then the business is probably still in good shape and a sell consideration may be unwarranted. At the time of buying it is important also to list the risks or threats to the underlying businesses. Re-assess the risks regularly for as long as you own the stock.

    For example if you identified a risk to a retail business to be the possibility that their online shopping platform will not compete with other online vendors, and after holding the stock for a period of time you discover that their online sales are not growing, then you may want to consider selling. Another example might be a defense contractor that you invested in and you identified the risk that the US military’s budget will be cut in the future. You accepted that regulatory risk when you bought into the company. But if after holding for a while you discover that indeed the military budget is being cut, you may need to conduct some analysis on the implications of the budget cut – will it be temporary? What area of the military will the budget cuts apply to? Will it affect the company’s earnings? If so by how much? Is it a temporary challenge that the company is likely to work through? If you assess that the implications on the business are considerable and permanent then you will need to sell.

    Sometimes a regulatory change that seems at first to negatively impact a company, may actually make the company stronger: If the company is a big player and has a strong balance sheet, chances are it may be able to buy out some of its weaker competitors during an industry wide downturn, making the company even bigger, stronger and better placed to capitalize on the next industry upswing. And during an industry wide downturn, shareprices fall offering attractive opportunities for investors. So you need to do your research on the individual company in question.

    Some other reasons to consider selling:

    • Management begins to make some poor decisions, or other indications point to a deterioration in the quality of Management

    • The quality Management that was in place has resigned

    • Regulatory or macro-economic forces are acting negatively on the business, deteriorating its long term performance or competitive position

    • You need the cash! Of course we don’t recommend selling and using the cash to go on holiday at the expense of your investing and financial goals. But if the holiday sits within your overall goals, not at the expense of them, then enjoy!

    • A better opportunity has come to exist (be careful on this one – see the example below!)

    • The shareprice has risen above the Intrinsic Value – perhaps a good time to sell and lock in your profits

    As a rule, you should never sell on market panic. If the company’s economics are still sound, there is no reason to consider selling. Selling after a bad quarter or after a profit guidance downgrade is typically a bad idea. Conduct your own research – is the profit downgrade a sign of things to come, or is it due to a temporary occurrence?

    Of course, selling creates a capital gains tax liability. One must have a high degree of confidence when selling in order to invest in a better opportunity, that the new opportunity will provide a better return that the existing. If the new opportunity is not better than the existing, let’s say it is exactly the same, the difference can have a compounding effect. Let’s look at an example:

    Let’s look at Christina and Anna. Christina and Anna both have investments that they purchased a few years ago for $10k and they are now worth $20k. Both investments are making a 15% annual compounded return. Christina decides to sell her investment because she reckons she can make more than the 15% return elsewhere. As it turns out, Christina was wrong, and her new investment produces just the same return – it also makes 15%. Using a capital gains tax of 20% for both, not considering brokerage fees, let’s compare their situation 10 years on:

    Christina:

    • Sells at $20k for a $10k profit, and she pays 20% capital gains tax on the $10k profit. Tax = $2k

    • Buys a new investment with her $18k returning 15%

    • After 10 years her $18k compounded at 15% is worth $72.8k

    Anna:

    • Keeps her investment worth $20k returning 15%

    • After 10 years her $20k compounded at 15% is worth $80.8k

    Anna is clearly better off than Christina in this situation, simply because she held. The above example is amplified if Christina buys and sells frequently (i.e. “trading”) while Anna simply holds. The difference in returns can be significant. The above example is something that all investors should be aware of and it goes a long way to explaining why Buffett’s favorite holding period is forever. If you are invested in a good company that is making you, say, 15% per year, you need to be very sure that another opportunity is a truly fantastic one before you switch.

    If a company’s competitive position is deteriorating, you need to sell out ASAP. Websites such as yahoo finance or seekingalpha.com etc that provide you with information on the company in question are invaluable – you can keep a close eye on each of your holdings. You can get news releases on your stock holdings delivered to your inbox for free, and you can view immediately on your phone or at your computer. Many people each day look at the share price of their holdings: “oh wow XYZ’s shareprice is up almost 1% today”! But what they should be looking for are any announcements or news articles on the business or industry conditions of the underlying company.

    Some people say that the question to ask if you are not sure on whether or not to sell or hold is “would I be willing to buy into this business if I didn't already own it?” We at USAStockValuation.com believe that while this strategy has merit, we don't agree with all of it. We like to buy a great company when it is trading at a discount to Intrinsic Value and sell when it is trading at a premium to Intrinsic Value. There is a window in between where the stockprice might be trading for example at about its Intrinsic Value where we would not be interested in buying into the stock, but we would be happy to hold. But as mentioned above, keeping an investing diary and regularly revisiting why you bought into the company in the first place is valuable and important.

    And remember that knowing when to sell is far more difficult than knowing when to buy, and you will make mistakes. Focus on making informed, rational and well thought out decisions.

    Nov 14 10:23 AM | Link | Comment!
  • Discipline and Value Investing
    Discipline is an area of investing that gets little attention. Yet there is probably no aspect of investing that more separates successful Value Investors from all other market participants. It is also an area that everyone believes they are good at. Everyone likes to believe that they are disciplined of mind, and you will rarely hear someone confess to the opposite.

    We are all tempted early in our investing life with the latest company that will “revolutionize the manufacturing industry” or “revolutionize the mobile phone industry” etc. You have read the books and heard from investment experts such as Peter Lynch and Warren Buffet (and perhaps even USAStockValuation.com!) to ignore the noise - ignore the latest fad, ignore the latest “Hot Stock”. But eventually your herd mentality (which is an evolutionary phenomenon – a survival mechanism present in every human stemming from thousands of years ago) gets the better of you and you buy some shares in said company because you don’t want to be the only one missing out. Many people are guilty of this when they are young – even those who have since evolved into disciplined and successful Value Investors.

    Of course, you may have conducted your own independent research and concluded that the “Hot Stock” in question is a great looking growth story with at least a few years proven sound track record, trading at a reasonable price, and a GARP (Growth at a Reasonable Price) approach is warranted. But this is rare. As I write this, LinkedIn (NYSE:LNKD), which is the latest “Hot Stock”, is trading at over 400 times earnings. The herd mentality has pushed the price of the stock into the stratosphere, and it’s just a matter of when (not if) the stock price will come crashing back down to earth. Irrational exuberance exists – it always has, and always will.

    In this example, if an individual recently bought shares in LNKD at, say, 300 times earnings, then that individual in a short period of time has seen his position appreciate. But let’s be very clear – the fact that the shareprice has gone up in the short term does not make this individual an intelligent stock picker (especially at buying in at 300 times earnings!). In the short term, no one knows if the stockmarket as a whole will go up or down, or if any of the constituents that make up the stockmarket will go up or down. This is contrary to what people will try to tell you.

    If you bought a stock last week and it has since risen in value, and I bought a stock last week that has since declined in value, it doesn’t make you a clever equities investor, and me a poor one. If anyone knew what the stockmarket or any individual stock was going to do in the short term, they would be filthy rich. Warren Buffett has amassed incredible wealth from equities, to the point where he is one of the top 5 richest men in the world. He has done this by taking advantage of the short term stock market unpredictability – i.e. by buying undervalued stocks as the opportunity arises. He has made it very clear over decades of writing his informative and detailed annual Letter to Shareholders that he has no clues what-so-ever what the stockmarket or any stock will do in the short term. He conducts sound analysis on businesses to the point where he has a high level of confidence that the company whose stock he has bought will produce strong financial results for the coming years or decades. He is not concerned with the stockmarket – he knows that over time with the rising performance of the underlying business, its shareprice will (eventually) follow.

    It is absolutely vital that you understand this point. You don’t aim to hold a position for a long period of time because: “um.. I heard that the buy and hold strategy is the best, and so I guess that is my approach…”. No, the reason that you should hold a position for a period of time, is because it can take a long time for the market to recognize the value of the stock. But be sure, it always does. You look at any company that has been financially successful over, say the last 10 years or 20 years, and have a look at its shareprice graph. Over a period of time if a company performs well as a business, its shareprice will eventually follow. There are no exceptions to this rule.

    In any given week, the following could be the market news headlines:

    • Monday: “Stocks rise on solid retail data”

    • Tuesday: “Market in sell-off on negative jobs growth data”

    • Wednesday: “Stocks fall on fear of a double dip recession”

    • Thursday: “Stocks rise on a positive Obama jobs speech”

    • Friday: “Stocks tumble on fear that Greece will default”

    Of course, the news writers have to write something. They are paid to come up with headlines. But no one has any idea if the market dropped because of poor jobs growth data or because the stars were misaligned, or simply because it was the month of September. On some days there may be an equal amount of positive and negative news – will the market go up or down on those days? It is very difficult to make money in the short term, unless you know in advance what the jobs growth data will be, and the retail data, and the likelihood of Greece defaulting, and….. The exception to this of course is day-trading. In the short term there is so much human emotion in the markets – predominantly fear and greed – and traders aim to exploit any patterns of market behavior caused by these emotions. But I am guessing that if you are reading this article you are not a short term trader.

    Part of being disciplined is tolerating ridicule from your peers. When you invest in what you have uncovered to be an extraordinary business trading at well below its Intrinsic Value, there is a reason why it is trading at well below its Intrinsic Value. The market has developed a distaste for the stock for some reason or another, and no one knows when the sentiment of the stock will turn. If you are lucky, the market will start to look at the stock in a new light soon after you purchased it, but you should be aware that it may take months, a year or even years for the shareprice to turn around. No one knows when. It is during that period of time when the shareprice goes side-ways, or the shareprice declines from the point where you bought it (presenting an opportunity to buy more) that you need to be disciplined. Your friends and family will tell you that you have made a horrible mistake and that you should get out of the stock ASAP. You need to be steadfast in your approach – do not second guess your analysis. Instead, focus on the economic performance of the business of which you bought the shares – is it performing well? Does it still have sound Management, and promising prospects for the future as per the analysis you initially conducted? If the outlook for the company is the same as when you first completed your analysis and bought shares in the company, then there is nothing you can do except be patient, disciplined, and continue to monitor the underlying business – not its shareprice. Your friends and family can monitor the shareprice, you monitor the business.

    As Warren Buffett says, “you should be willing to look foolish, so long as you don’t act foolishly”. You must be disciplined and rational, regardless of how it might look to others.

    When your friends are buying dot com stocks in 1999 and 2000 and bragging how “smart” they are because their shares have appreciated in value in the short term, you need to stay disciplined in your approach. When your friends are telling you that they recently bought a trading system that allows its users to easily make “100% Return per Year!” simply by buying when the system tells you to buy and selling when the system tells you to sell, you need to stay disciplined in your approach. Remember that the vast majority of human beings want something for nothing. People want to take a diet pill instead of exercising. People want to make money from the stock market instantly without having to think, and certainly without having to exert any effort in conducting analysis of any kind. Don’t be one of those people.

    All aspects of life involve effort to achieve success. Though we at USAStockValuation do not pretend to know much about trading, we do know that the best traders in the world such as George Soros devote long hours of analysis every day to their craft. Soros looks for global macroeconomic anomalies producing mispriced assets – and his success has come on the back of an enormous amount of macroeconomic analysis over a long period of time. And those that make money from trading systems do so by undertaking months or years of full time effort developing their own system and learning from the process. To be successful in any pursuit, effort discipline and the requirement to “think” cannot be substituted.

    Warren Buffett often says that successful Investing is “simple but not easy”. To be successful, one simply needs to discover wonderful businesses, and buy a part ownership in each of those businesses at a reasonable price. Simple. Being disciplined is the “but not easy” part of Buffett’s phrase.

    Successful Value Investors make disciplined, rational decisions based on sound analysis. They are able to block out the “noise” and focus on the process of discovering extraordinary businesses trading at very attractive prices. Value Investors enjoy and focus on the process, not on the outcome. Perhaps ironically, by not focusing on the outcome, the outcome ends up being very pleasing – an abundance of long term wealth.

    Nov 08 9:22 PM | Link | Comment!
  • Earnings per Share & Return on Equity

    In looking for extraordinary businesses, there is no more important measure to a Value Investor than Return on Equity. A great company cannot be termed a great company unless it is one that consistently achieves a high ROE (>20%) over a number of years and does so employing little or no debt. ROE is the ultimate measure of the profitability of a company - how much return the company is making on its equity base.

    Consider you can set-up 1 of 2 business ideas, both who produce $1M in net profit per year. Business Number 1 costs $10M to set-up, producing a return on your equity of 10%, whereas Business Number 2 costs you $5M to set-up, giving you a return on your equity of 20%. Obviously you would choose Business Number 2 because it only costs you $5M to produce the same result. This simple concept is the basis for identifying high performing companies. If a company can produce a consistently high ROE with little or no debt then that company very likely enjoys a competitive advantage and warrants consideration as an investment.

    ROE vs EPS growth: In the short term at least, earnings growth largely drives share prices. But a company can always increase its earnings. For example if a company retained all earnings from the previous year, gave none out to shareholders, and put those retained earnings in a fixed interest account earning 4%, they could use that extra money and declare to the world that they have achieved a “record profit”! But this would be terrible for shareholders.

    In this example, if instead of retaining the earnings, the company distributed the earnings as dividends to the shareholders, then an individual shareholder could have taken the money and invested it wisely to achieve a better return than the 4%. So in this case, by retaining all earnings, the company’s management has done a massive disservice to their shareholders. This is touching on what Warren Buffett means when he is speaking of the importance of the capital allocation abilities of management.

    Another way a company can increase EPS is through acquisition. If a reasonable price is paid for an acquisition, it can both increase EPS and maintain ROE, benefiting the company and its shareholders. Unfortunately though, most of the time the result of an acquisition is a lower profitability of the parent company. Executive management love the idea of acquisitions –running a bigger ship, an increased sense of importance. Far too often though, the high price paid for an acquisition results in lower profitability (lower ROE), and once again the shareholders are wronged by management. A company whose earnings per share for the recent reporting period has risen but return on equity has fallen typically is one who has spent money on an acquisition or expansion that has provided a relatively poor return. When we say relatively, we mean relative to the return that the company was achieving prior to the acquisition or expansion. A falling ROE basically means business performance is declining, and before long the EPS and shareprice will follow.

    Maintaining a high ROE is much harder for a company to do than increase EPS. This is especially true of a company that retains much of its earnings and reinvests them back in the company. Let’s say a company has $100M in equity, it achieves a ROE of 20%, and it distributes half of its net earnings to shareholders via dividends. In this case, looking 1 year ahead, the company will have $110M in equity. To maintain the 20% ROE, the company not only needs to achieve 20% return on its last years’ equity of $100M, but it also has to achieve 20% return on the $10M that was retained. So the company needs to continually employ the retained earnings in ventures which in turn provide a high return. A manufacturing company, for example, may use its retained earnings in purchasing latest technology machinery which will increase output for a lower cost. A retailer, for example, may use its retained earnings in opening a new store perhaps in a neighboring city, and that new store will provide continuing good returns.

    All companies start small. The best ones grow and expand through reinvesting their earnings, as opposed to using debt. Many of the great well known American companies first used their retained earnings to expand throughout America, before expanding globally. Regardless, a company needs to make smart decisions on how its retained earnings are employed to ensure that good returns are made and high profitability, as measured by ROE, is maintained.

    To take ROE a step further, Normalized Return on Equity (NROE) is where abnormal gains or losses are ignored in the calculation of net earnings. NROE is preferred over the standard ROE as it allows us to consider profits from continuing operations only.

    Great companies achieve consistently high returns on equity while employing little or no debt. If a company does not display good ROE and low debt, then without exception, it is not worth consideration of investment to the Value Investor.

    Nov 07 10:19 AM | Link | Comment!
Full index of posts »
Latest Followers
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.