Greetings from Team Carnelian!!!
Just like in poker, knowing when to hold a hand and when to fold is crucial to every poker player’s success, for an investor also, it is important to know when to hold a stock and when to fold (when to sell the stock).
When to sell a stock? Despite being a question as crucial as identifying, buying & holding the right company, this topic is rarely discussed. Surprisingly enough, there is a plethora of books available on how to identify the right companies, what price to pay, holding period, investment philosophy, etc…but finding books talking about “when to sell” are challenging to find as barely any book covers this topic in depth.
In our constant attempt to address investor dilemmas/issues, this time we contemplated writing on our thoughts on when to sell a stock?
The most common dilemmas an investor face are,
What if after I sell the stock, it delivers splendid returns and I end up selling my big winner!
What if after making handsome returns and deciding not to sell the stock, the stock goes nowhere for many years impacting the IRR and the opportunity cost?
Interestingly, an investors psychology always oscillates between greed, regret, fear, validation and complacency. Each investor figures out his own strategy depending upon his conviction, knowledge of his investment and his own emotional stability. Market has its own way of humbling all kind of styles at different points of time.
We are not preaching which approach is right or wrong, but what we follow. When do we sell a stock?
In general, our approach is not to sell businesses & management teams we like for a long period of time as Equity is a perpetual asset class with a potential to generate superior risk-adjusted return. However, in today’s dynamic world, one should consistently track one’s holding to safeguard against any structural changes to the business. Also, listed Equity is an interesting place where availability of a marketplace creates very interesting opportunities as it oscillates between greed and fear of a wide variety of investors. To simplify, sometimes, the market offers a great opportunity to buy when someone is desperate to exit due to a variety of reasons and sometimes the market offers a great window to exit when there is euphoria and complacency in the market despite change in business or stock price.
In our own selling framework, below are the major reasons which makes us sell the stocks we bought:
Material change/deterioration in the original investment hypothesis.
Original investment hypothesis was erroneous
Markets having factored most of the upside, making risk reward unfavourable
Better opportunities outside the portfolio on the risk reward spectrum
Below are a few examples explaining the above situations:
Material change/deterioration in the original investment hypothesis:
“I am not a professional security analyst. I would rather call myself an insecurity analyst.” – George Soros.
In the book, Soros on Soros: Staying ahead of the curve, George Soros highlighted that recognising that one can go wrong in decision making, and thereby being insecure about it, is a strength and a very important one.
Most of the times people collect information that confirms their views on the original investment hypothesis and prefer not to change them. Changing would effectively mean accepting that we were wrong about something earlier. Most of us just want to be proven right, and hence, it is easier to drift towards data that reinforces the existing hypothesis. Opposing data is almost always assumed to weaken the investment case and therefore one avoids the same.
In a dynamic environment, the original investment hypothesis can change on account of many factors. There are many assumptions basis which an investment hypothesis is made, however the same can change over a period on account of many factors, some of which we have listed below:
Emergence of a disruption risk for the business
Capital allocation not in lines with original investment hypothesis
Adverse regulatory changes
Emergence of new competitors with focus on gaining market share impacting profits
Taking this into account, we pro-actively look for facts/information which are counter-intuitive or possess risks to our investment thesis – this, we continuously do by tracking the company and its peers, internal debates whereby others in the investment team challenge the investment hypothesis.
Whenever we find that the original investment hypothesis does not hold true or there is a material change around our thesis, we believe that it is wise to sell the stock irrespective of the price we bought it at. To ensure this, we are mindful of various biases that would stop us from selling.
Examples:
Emerging aggressive competition:
In one of our erstwhile portfolio companies, we observed that all along, competition challenging companies’ products were unsuccessful, but this time two known global brands with good products were entering to disrupt the monopoly of this company. Along with good products, these brands also offered competitive pricing to disrupt the monopoly, which would eventually lead to either loss of market share or impact profitability margins. Also, our initial ground interaction with customers for competitor’s product suggested that since the product is good, with favourable pricing it would for sure attract buyers. The valuations were not factoring this risk at all, which made us exit the stock due to new competition emerging. It might do well in future but changing market dynamics must not be overlooked.
Capital allocation:
We were investors in one of the leading chemical companies having market dominance in the chemistry that it was operating in, with decades of experience to capture import substitution and exports opportunity which was playing out well. However, during our holding period, the company decided to embark upon a large capex programme sensing the business opportunity. Analysing this, what made us uncomfortable was the leverage the company would have to take for the capex and also scale of capex. Considering the above, we exited the stock as our investment thesis changed due to the large capex plan. Post our selling, the company did realise that the debt they would have to take was sizeable, and hence resorted to an equity fund raise resulting into diluting. We continue to remain a fan of that company but the stock is trading ~50% of our selling price. It will take the company ~4 years to reach the same price with no return. If one realises these purple patches in good companies, one can save a lot of portfolio pain.
Original investment hypothesis was erroneous:
To err is human. We make investment decisions post evaluation of various factors within a limited set of information. It might so happen, our original hypothesis was not the best one specially when seen in context of value creation. Our approach is, when we realise our mistake (error in hypothesis), correct the mistake first irrespective of the implication - whether the investment is in profit or loss. The idea is to correct mistake as soon as one realises them.
Examples:
A leading housing finance NBFC:
In 2019, we were bullish on the accelerated demand in the housing sector. We thought it would be better to play the same through mortgage NBFC’s, especially ones with the cheapest cost of borrowing. We bought into a leading housing finance NBFC in the PSU space available at a valuation of less than 1x P/B. While we were right on the cost of funding part, there was a change of management which happened, who we thought will continue to leverage well on the opportunity; unfortunately, it didn’t pan out the same way. The stock did well initially, followed by volatile quarterly results/growth. We sold the stock after realizing our mistake, but we remained invested longer than we should have. Also, we think a better way to have played our view on the hypothesis of housing demand would have been through building material ancillaries.
A Private Sector Bank:
We invested in a private sector bank with the hypothesis of accelerated earnings growth and valuation re-rating. We made certain assumptions about the bank’s technology stack/processes, CASA franchise, customer service, culture, etc... I would say, we rather made a bit of a hasty decision in buying. Few months down the line, our team kept on noticing certain data proving it a relatively weaker franchise than we thought, while we were in the money, we exited the stock, as it never allowed us to sleep well. We are not saying the Bank was bad or good, but our comfort was not so high to remain invested specially in bad times (Covid-19).
Markets factoring in most of the upside making Risk reward unfavourable
Greed and fear drives markets. Markets are ‘forward-looking mechanism’ or ‘discounting mechanism’. In essence, the phrase simply means that the market as a whole is more interested in what the future holds than in what has happened in the past, or even what is happening right now.
In times of exuberance there are many factors at play like fear of missing out, new hot sector leading to crazy growth numbers etc. as a result of which lot of forward earnings get discounted or factored in the price and push valuations to the extremes making the risk reward extremely unfavourable from that point of time. It would be wise to sell the stocks at such extreme exuberances.
Examples:
Leading ERD player:
The IT sector was on a big upswing during the post covid period on account of increased digitization spends and cloud adoption leading to companies having growth rates of ~20-30%. In a single year, the sector added a headcount which was combined of what was hired over the last 7 yrs.
ERD companies, being a better business, started commanding a huge premium in their valuations. The ERD stock which we owned, went on to command 70x PE from 20x PE! With expected growth rate of 15%+ for the next 10 yrs,we found it difficult to get a satisfactory answer to justify the exuberance; consequently we decided to sell the stock which in the hindsight proved to be a right decision.
Leading south based group company having exposure to auto ancillary business and investments in other operating companies:
In case of an auto ancillary company, the new CEO who had an exceptional track record decided to focus on operational efficiencies in the existing business, and at the same time look for new business opportunities to deploy the capital to deliver higher revenue and profitability growth. Considering the past track record and the business plan, we entered this stock. The company delivered exceptional improvement in operational metrics and at the same time acquired and turned around a distressed business – this led to ~4x returns for us. Thereafter, with the cash generated from business, company decided to foray and invest into EVs – 3W, tractors, and MHCV segment. The probability of success being a new entrant was questionable. Add to this, the near perfect valuations - market seemed to be factoring in a rosy picture with little room for failure/delay. While we continued to like the management’s ability to Make in India through new ventures and the overall business profile, in our opinion, the risk-reward had turned unfavourable – and thus, we decided to exit the stock. We will continue to monitor the business and might re-enter at different point in time over next many years but that will be a fresh decision and our knowledge of the business and management will surely be helpful.
Better opportunities outside of portfolio on risk reward framework:
“After nearly making a terrible mistake of not buying See's, we've made this mistake many times. We are apparently slow learners. These opportunity costs don't show up on financial statements but have cost us many billions”. - Charlie Munger
Most of us never consider an opportunity loss as a loss since the same never crystalises in the form of an actual loss. May be the same psychological factors are at play when lot of opportunities we missed in every aspect of our life either went unnoticed or we do not feel the magnitude of missed opportunities.
We are researching all the time, studying trends, meeting companies and finding potential investment opportunities. However, we are also working with finite capital. If we are fully invested and find interesting opportunity, then we evaluate with our portfolio companies in terms of risk reward. If the new opportunity is significantly better on risk reward than existing one for longer term perspective, then we do switch. Here idea is not to trade or evaluate based on short term outperformance, but long-term perspective.
Below are the stocks which we switched to take benefit of better opportunities:
Examples:
IT services company vs ERD company:
We were and are very positive on the IT space in general but our focus is to identify companies which can grow faster than the industry. Post COVID, we noticed a huge change happening in the aviation sector. Boeing and Airbus were receiving huge orders and new programmes were being talked in a sector which saw almost no growth for many decades. Chats with few US consultants confirmed this. Sensing this, we evaluated a leading company in the ER&D space with a very large exposure to aviation. We believed new programmes were being initiated and the sector as known has huge entry barriers. Any other IT company just couldn’t have got the business. We compared this to another company in our portfolio, which already had made 3x returns for us and didn’t have this kind of a strong moat as the one we were evaluating. To make it more interesting, the valuation of the company under evaluation was cheaper than the stock in our portfolio. We decided to switch and are happy holders of the new company. We keep track of the one we sold but are happy with our switch.
This is our framework and with due respect to all styles. We also go wrong in selling just like in buying. Hopefully we will make less & newer mistakes.
While we discussed about how do we go about selling, it is equally important to ride onto stocks which have gone up by 3x – 4x but continue to deliver basis investment rationale and risk reward being favourable. What makes us hold onto that stocks and how we go about thinking is something which will discuss in our coming letters to you.
Happy Investing. Happy wealth creation. :-)