Great companies always make it look easy. You never have to rationalize your investment. Management does it for you by executing. Vishal Khandelwal of Safalniveshak.com was kind enough to ask me to write about “selling” for the readers of his Value Investing Almanack. I thought I would share and expand a bit on these thoughts here. Before I dive into my four basic rules for selling, I’d like to give them some context.
As many of you know, I’m a full-time microcap investor investing in the smallest 5% of public companies. My goal is to own the smallest, most illiquid, least institutionally owned, best businesses I can find that are run by intelligent fanatics. All great companies started as small companies, and I want to find and buy great companies early.
Over the last ten years I’ve bought and sold over two hundred companies in my portfolio. When I look back at my tax records from just seven-eight years ago, greater than 75% of my capital gains income was short-term (bought and sold within 12 months). Although I looked for similar business characteristics as I do today, I wasn’t concentrating on sustainable businesses and my holding period was much shorter. I was looking for unique businesses within a trend or fad that would create a scarcity in the market place that would propel the stock price over the next 12-months. I would sell the positions when I felt the run in the stock and valuation was overextended. Often times it would occur within a year of my initial purchase.
Many of the companies I bought and sold back then were similar to cigar-butt companies where their businesses were tied to one product or a fad that lasted 2-4-8 quarters and then fell apart. During this time period I also watched a few companies do extremely well long after I had sold them. It didn’t take me long to realize these companies had high quality sustainable businesses which seemed like a much better, healthier, and fun way to invest.
Many microcap investors today invest the way I did several years ago, and I don’t blame them. It is really hard to find high quality sustainable businesses in the microcap space. But this also provides a real edge to someone with a business quality focus combined with a longer time horizon. Many investors say they focus on the long-term but their actions-communications prove otherwise. Most are incredibly nearsighted, investing for the next quarter or two. This gives the longer-term investor, willing to put in the work, a huge advantage. Qualitative analysis and field based research acts like corrective lenses that will let you see further. You will have an edge on most investors if you make investments based on expected 3 – 5 year returns instead of 3 – 12 month returns.
“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffett
Over the last two years roughly 80% of my capital gains income is long-term. The amount of activity in my portfolio has dropped significantly. In fact, in the last two years I’ve only purchased one new company in my portfolio. This phenomenon is partially due to the current bull market that is reducing great buying opportunities, but also because I’m becoming more disciplined as an investor.
All successful investors have two things in common. They are extremely disciplined and they understand the downside of their investments. Extraordinary returns follow extraordinary discipline in buying, holding, and selling. It’s not what you do randomly that will produce long-term returns; it’s what you do consistently. You need to have the right mental models and framework to sell for the right reasons.
One of the biggest mistakes or wrong reasons to sell a stock is boredom. Don’t be a bumble bee buzzing around from one position to the next. Find a few great companies early and FOCUS on evaluating their business performance, not stock performance. The hardest part of achieving multi-baggers is having the patience and conviction to hold through multi-year periods of under-performance. Successful investors can disconnect emotion from investment decisions and can differentiate business performance from stock performance.
I was asked in a recent interview, “Do I believe in holding forever?”. The principle of holding forever is good in theory, but it’s likely not realistic for microcap investing unless you truly find that rare 100-bagger. The unfortunate truth is that most microcap successes are often 3-5-10-20 baggers that occur over a five-year time horizon. Then the company ultimately outgrows the management, mistakes occur, and the business and stock descend back to mediocrity.
Microcaps are small, emerging, often times impressionable companies. They are like Children. You can’t let your four-year-old child alone for several hours or days because you don’t know what will happen. You need to watch them. The same can be said for microcaps. You need to be constantly watching and conducting maintenance due diligence on microcaps so you are aware when things change for better or for worse and can react before others. You have to anticipate how other people’s thinking is going to change before they know it themselves. This is also why the most important thing for microcap investors is to know your positions better than most.
I sell a position for four main reasons:
- Sell when the story changes: My experience has taught me that when you start to see cracks in your investment thesis, you sell immediately or someone else will. What constitutes the “story changing”? Normally it’s timelines being continually pushed out or scuttlebutt research that has unearthed something. It could also just be the tone or body language of management. 70% of communication is transmitted by body language, 23% voice tone & inflection, and 7% spoken words. This is why periodically talking to management on the phone or in person is very important. The “story changing” could also be a transformational acquisition involving lots of equity dilution. Lastly, it’s easy to fall in love with your positions when you spend hundreds of hours getting to know them. It’s OK to fall in love with your positions, just be prepared to divorce quickly. When the facts and story change don’t let your ego get in the way of selling.
- Sell when you find something better: When evaluating new opportunities, you are constantly evaluating them against what you already own. Often times the best opportunities are already in your portfolio. You already know them. There is a real time value in accumulating knowledge on a position. A new opportunity can’t have similar upside to your stable of investments, it needs to have considerably more upside to replace the “trust” in what you already know. Keep your hurdle rate high for new investments. Eventually, you will find something that is so compelling that you’ll need to sell an existing position to buy it.
- Sell at the first sign of management incompetence or unethical behavior: The management team is the head or brain of the company. The operations ie sales, marketing, distribution, product, service is the body. If the head is deaf, dumb, and blind, the body is useless. Life is too short to be investing in management who aren’t rational and trustworthy. The biggest test of management’s rationality is the decision on how to allocate cash. Leadership author and speaker John Maxwell says, “Most people have uphill dreams but have downhill habits.” You want to find and invest in intelligent fanatics that have the habits of winners.
- Sell when the company gets overvalued: I’ve never believed in selling strategies based on stock performance (i.e. sell half when a stock doubles). Holding on to your winners and cutting your losers is the key to investment success, but there are times when reality and expectations become too imbalanced. On a few occasions (not often enough 🙂 I’ve owned companies trading at single digit PE’s that got discovered by institutions and all of a sudden they were trading at 80 PEs (priced for perfection). In my experience, almost all stocks that go up 10x in a short period of time will have at least a 50% pullback at some point. It’s just what happens. In these times it’s ok to sell and buy back when the valuation is right.
There will be some instances when the best checklist or mental model won’t stop you from making a wrong decision. Warren Buffett says, “A checklist is no substitute for thinking”. These four rules for selling are no different. I use them like guardrails and as I’ve gained experience they become more defined and help me stay on the road of financial freedom. My judgements on selling will never be 100% correct just like my batting average in picking winners will never be 100%. But selling is very important. The overriding theme is you sell when you start rationalizing your investments. I’m “still” a full time private investor today not because of the gains I’ve made but because of the losses I haven’t taken.
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