Thoughts on Selling and Forward Rates of Return
Knowing when and, arguably more importantly, when not to sell a stock is a topic that often goes under-addressed in the investment world.
How we decide to exit a position is a question we are asked frequently, so we thought it made sense to put our decision making framework on paper.
Three main concepts enter our thinking when deciding whether or not to sell a position, including;
1) Forward returns are a function of more than just a valuation multiple;
2) Having a deep understanding of what you own is a prerequisite to knowing when to sell;
3) Buying or selling a stock is all about opportunity cost.
Whether or not to sell a stock comes down to weighing the forward returns in the position you own versus other investment options, including cash. Having a reasonable grasp of forward returns requires an intimate understanding of the businesses in which you own stock and those you might otherwise own.
Forward Rates of Return
Too often investors oversimplify a selling decision to a valuation multiple. In reality, the valuation multiple is only one leg of a three-legged stool that makes up forward returns.
How a stock will perform in the future depends on:
- At what rate a company will compound intrinsic value;
- The yield an investor will receive on their ownership stake;
- The change in valuation multiple over the course of ownership.
Intrinsic Value Compounding
How a business will grow earnings, or compound intrinsic value, is the most important assessment for investors to make and usually the largest component of future returns. It’s also the most difficult to judge. A business’ intrinsic value will compound at approximately the rate at which it reinvests capital into the business multiplied by the return it earns on that incremental capital. This is a very broad subject, so I’ll be brief for the sake of this article.
Intrinsic Value Compounding = Reinvestment Rate x Incremental Return on Invested Capital
This relationship does not hold precisely true for every business (such as capital-light businesses who need no incremental capital to grow) but is true for most businesses that we study and understand.
Before making an investment and throughout the life of the investment we keep a close eye on what the reinvestment rate and incremental returns on capital should be for our businesses. Not only does this help with estimating expected growth rates, it helps us keep our eye on the key business metrics rather than just the stock price.
Buffett loves baseball analogies and says, “In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.” The playing field is the factors impacting a company’s compounding rate, and the scoreboard is the short-term stock price movement.
Shareholder Yield
Shareholder yield is the second aspect of per share returns and consists of dividends and buybacks. Capital that is not reinvested can be returned to shareholders via dividends or buybacks, and the sum of each will increase per share returns above the base compounding rate (dividends yield a percentage of your cost, and buyback yield is based on the average repurchase price). Occasionally, as we highlighted in the PG&E post, shareholder yield can be negative, which occurs when companies consistently issue significant amounts of stock and dilute existing shareholders and offset any dividends paid.
Change in Valuation Multiple
A change, or re-rating, in the valuation multiple (whether it be price to earnings, price to free cash flow, or whatever metric is most appropriate) can have a large impact on shareholder returns depending on the price paid.
If a stock that should trade around a market average valuation, say 15x earnings, is purchased for 10x, investors will realize a 50% return (or 8% per year over five years) due to the change in valuation multiple alone if the stock re-rates. Conversely, if you pay 30x for a business that is valued at 20x five years later, the multiple contraction will cause returns to decrease by 8% annually which may or may not be offset by intrinsic value growth and yield.
The annual impact of a valuation re-rating depends on how long a stock takes to return to fair value. We like to think in at least five-year time periods for our positions to return to a normalized and conservative valuation.
Over short time periods valuation multiples can become divorced from business fundamentals. But, over several years valuation multiples tend to relate to a businesses’ per share growth rate. This is another reason why we spend the most time on the compounding rate and yield, as they drive valuation multiples over long periods of time.
Forward Returns Calculation
Taken together, a stocks’ forward returns are determined as:
Forward Returns = Intrinsic Value Compounding + Shareholder Yield + Change in Multiple
If you purchase a business for 10x earnings and estimate it will compound at 5%, pay a 1% dividend, buyback 3% of shares, and you believe fair value is 15x earnings, its forward returns are 17% annually for five years.
While the formula is relatively simple, accurately assessing each aspect can be quite challenging, and it all starts with understanding the underlying business.
Know What you Own
The most difficult aspect of estimating forward returns is usually approximating a company’s expected intrinsic value compounding rate. To estimate with reasonable accuracy how a company will compound, investors need to grasp the quantitative and qualitative aspects of a company’s business model. Things like addressable market, what competitors are doing, leadership teams, competitive advantages or barriers to entry, and capital allocation are all critical in understanding how much capital a company will be able to reinvest and at what rate they’ll earn on the incremental capital.
It is only possible to understand these aspects of a business by doing your own primary research. Reading annual reports, conference call transcripts, company presentations, and news publications are all important sources of information. It’s for this reason that we shamelessly discard many businesses into the “too hard” pile. For the vast majority of businesses out there we cannot accurately estimate a compounding rate, which is fine with us given we only need to find a few ideas that we understand and have attractive forward rates of return.
Knowing what you own is also the most important aspect in combating the urge to sell at the wrong time, such as during a general market crash or in an attempt to predict one. Peter Lynch said:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in the corrections themselves”.
It becomes much easier to ignore the fear of temporarily falling prices of a stock if you have a closely held view of what intrinsic value should be over the next several years.
When you intimately understand what you own and can estimate its forward returns, you naturally think like a long-term private owner. During the March coronavirus crash, no private business owners panicked and sold their business at fire sale prices. Only investors in pieces of public companies did that. Why? A) They could (there’s a liquid market), B) everyone else was doing it (humans are a herd anima), and C) they didn’t understand the business they own and therefore looked to the stock price and other investors for what to do.
Once you have a handle on a stocks’ forward rate of return, the decision whether to own it just comes down to what other options you have.
Opportunity Cost
There should never be a predetermined price or valuation multiple at which you must sell a stock, because everything in investing is relative. Selling a stock that has performed well, and therefore has an elevated valuation multiple, to move that allocation to cash does not make much sense. Imagine if Bill Gates sold off an interest in Microsoft as it grew “because it became too large a portion of his net worth.” Unless we believe the company has become so overvalued that cash will outperform that stock over the next several years, or we have more compelling investment ideas elsewhere, we’ll be better off sitting tight.
It seems value investors often cannot accept owning any stock that is more expensive than the market or some predetermined valuation multiple, causing them to cut their flowers and water their weeds. Despite trading up to a healthy mid-20s multiple of earnings, we have not considered selling a share of Facebook because we think forward returns are still attractive. Selling Facebook because it trades at a certain valuation level ignores the other two aspects of forward returns – compounding and shareholder yield. Even if Facebook’s multiple contracts to 20x over the next several years, we think the other two aspects of returns more than offset that potential headwind.
This becomes even more true when comparing our portfolio to alternatives such as other stocks, bonds, or cash. Selling Facebook, which could compound at ~20% annually, which may be reduced by a few percent due to multiple contraction, to hold cash that pays 1% is not a rational decision.
In no way do we advocate for an “own a great business regardless of price” approach. There are loads of great businesses whose stocks are trading for 50x, 60x, or 100x earnings right now (looking at you, WD-40, Autodesk, and Wingstop). These businesses are priced for perfection and offer no margin of safety, so they are of no interest to us at current valuations. At the same time, we are not considering selling our positions in NVR or Autozone simply because their valuation multiples have increased from around 10x when we purchased them in March to 17x or 18x today. These businesses have ample room to continue growing per share intrinsic value and are run by Outsider management teams, a combination that still looks attractive relative to the other opportunities we see. There is a price that may become too lofty for us to hold these positions, but we aren’t close to that today.
Other Considerations
The other important considerations related to opportunity cost are frictional costs, like taxes, and reinvestment risk. When you sell a position in a taxable account you are reinvesting the proceeds at 80-85 cents on the dollar, a very real and quantifiable cost.
Second, if we sell a business that has a long compounding runway because it has become moderately “overvalued” in favor of buying a no-growth “cigar butt” that we hope will re-rate to a higher valuation multiple in the near-term, we may encounter a reinvestment risk problem. When the business of lesser quality becomes fairly valued and does not have an opportunity to compound, we need to find something else to do with our cash.
If we own a growing business that we understand, there is a high bar for selling and the decision is more involved than looking at a P/E ratio at a moment in time.
Summary
Deciding when to sell a stock is usually harder than deciding when to buy. To minimize the impact of emotions and maximize the chances of making rational decisions, we emphasize building a deep understanding of the businesses we own. Knowing what we own allows us to weigh our expected forward rates of return with other investment opportunities and act accordingly. Deciding whether to sell cannot be done in a vacuum as it’s all about opportunity cost. Charlie Munger always puts things more eloquently than we can, and he has said:
“Life is a whole series of opportunity costs; you have to marry the best person who is convenient to find who will have you. Investment is very much the same sort of a process.”
Next time you are pondering whether it is the right time to sell a stock, think about what Charlie might say.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.