The following was published at RealMoney, but I don’t know the date.
“I can always find good stocks to buy, but figuring out when to sell is harder.” (My Mom, when I was much younger.)
In some ways, my career in investing has been a happy accident. Much of my career has been in the insurance industry, working as an actuary. Being a generalist, with a focus on investments, this helped me to learn a great deal about institutional investing, before doing it myself.
At Provident Mutual, now a part of Nationwide Financial Services [NFS], I was the one financial analyst on a committee that chose the managers for a series of multiple manager funds for our pension clients. I ended up interviewing 30-40 top money managers over a three-year period. The similarities and differences were interesting. Two areas that we would always ask about would be their buy and sell disciplines.
On buy disciplines, the answers varied considerably. But sell disciplines were usually pretty similar, falling into three groups:
- Price target met
- Failure of momentum
- Fundamentals deteriorate
The last of these is squishy, and I would usually ask, “How can you detect fundamentals deteriorating ahead of everyone else?” This would usually elicit the intelligent equivalent of a mumble.
There were a few of the better managers who used what I later called “The Economic Sell Rule.” The economic sell rule says that if a manager finds an asset that he likes better than one that he presently holds, he should swap. That means the manager either intuitively knows what he likes better, or estimates the anticipated rate of return (adjusted for risk tolerance) over the time horizon that he manages, to appraise the desirability of new assets.
I ended up calling it the economic sell rule, because each of three rules listed above had problems of their own. In a market where valuations are crazy, like the late 90s, many price targets get hit. If the manager is a “long only” manager, and has to stay fully invested, he can begin to run out of ideas on where to put money to work. For managers that can go both long and short, there is the problem that as price targets get hit on the long and short side in a sustained market rally, the portfolio gets shorter and shorter. And in a sustained decline, the portfolio gets longer and longer.
This is an implicit bet on mean-reversion, which no doubt happens, but often not soon enough for the clients of the manager, who can lose assets under management as underperformance persists.
Failure of momentum could take two forms: valuation-driven managers with price declines below original cost, and momentum-driven managers that would sell when relative strength weakened. Some valuation-driven managers would often sell any stock that declined more than a threshold percentage, whereas others would do a review at such times to check their investment thesis. After all, if a manager liked the company before, certainly he should like to buy it cheaper, no? Unfortunately, the pressure for instant results, measured on a monthly or quarterly basis, can force decisions that are less than fully rational.
As one manager said to me, “If it goes down more than 20% from where we bought it, we obviously didn’t get the story right, so we sell it and move on.” This is a recipe for turnover and underperformance. It is normal for stocks that are good long run performers to have 20% drawdowns once a year or so. Even with good research analysts, the odds of a 20% drawdown are decent, even immediately after a recommendation. In my own portfolio, after reviewing my thesis, I view 20% drops as buying opportunities.
Because I don’t manage money that way, I can’t comment as competently on the momentum-driven managers. I will only note that they have high turnover rates, and that their trading tends to demand liquidity, rather than supply it. In future articles, I will comment on the tendency for those who supply liquidity to be rewarded for it.
Though I never heard a good explanation for having a competitive edge in detecting deteriorating fundamentals, following the fundamentals is the most useful way for developing a sell discipline. Absent surprises, companies and industries perform better or worse as investors change their estimates. As the forward-looking estimate of future returns for a company falls below that of prospective purchase candidates, it is time to swap out. As the forward-looking estimate of future returns for a company rises compared to other companies in a manager’s portfolio, it is time to buy more.
Consider when a “surprise” happens to a company. Surprises can be positive (e.g., possible takeover, good earnings), or negative (e.g., bad earnings). After a surprise, is it time to sell, buy more, or wait? It boils down to how much the surprise affects the manager’s estimate of value for the stock. (And to some degree, how much it has affected the estimates of others.) How much has the long-run earning power been affected? For how much could the company be sold off?
Answering questions like these will lead to the estimates of value that can properly inform sell decisions in volatile times. Using a discipline like this forces a manager to re-estimate a forward-looking estimate of return, rather than let greed or regret drive decision-making.
In my next article, I will show how this process has worked in practice for me, together with another technique that some managers use to pick up some incremental return, and reduce risk.