Compounding or Confounding: The Agony of the Sale

Compounding or Confounding: The Agony of the Sale

We've received many great questions over the past few months as we've laid out Nintai's investment policies and examples of some of our mistakes. The question most often asked is "OK....I see how you BUY a stock...but what makes you SELL a stock?"

We've thought long and hard about this over the years. Our solution has been to break the question into two parts. First, we sell a stock where the business case has fundamentally changed for the negative. This includes taking on large amount of debt, decreasing free cash flow, poor allocation of capital, or loss of competitive advantage. And all this is well and good. The real dilemma is our second part of the question. When do you sell a stock that has been remarkably successful and its price has stretched uncomfortably beyond its valuation? A stock hasn't done anything wrong but simply excelled.

The first thing to note is we will not sell until certain conditions have been met - and these are all based on changes to the price versus valuation ratio. We will not sell simply because the price has doubled or we've made an exceptional return of the stock. If the company remains sound we will hang on like a tiger. And that's key to our position - as long as the amount of free cash we are able to extract from our investment predicts a reasonable return we will hold on to that position for infinity.

The truly difficult time is when the company is hugely successful but the stock price has risen to such a level we are not guaranteed an adequate return. We've all held one (or hopefully many) of these. In the inimitable words of John Foster Dulles this is the moment of an “agonizing reappraisal” of the situation.

Everyone likes to either believe in Warren Buffet's "forever" as a holding time or take the opposite side of the coin with the "you never go broke from taking your profits" argument. We all know Buffett would sell an asset if it doesn't guarantee an adequate return - usually by finding another investment that does or simply holding cash until he can find one. And the second has no basis in fact – what’s it worth and what will it return?

No, the answer in our humble opinion is - and must always be - based on the price versus valuation ratio. If at any time the calculation of fair value drops for any type of reason then the price cannot continue to increase. More importantly if the stock does not provide an adequate return to price ratio then it cannot be an asset worth acquiring. Prices can always go up, but the corresponding valuation must increase as well to assure an ongoing chance at adequate returns in the future.

To get a better understanding of this I thought I’d contrast two stocks that are or have been in our portfolio. One that has remained in it for 11 years - Factset Research Systems (FDS, Financial) and one we sold after 18 months - Intuitive Surgical (ISRG, Financial).

We first purchased FactSet Research Systems in 2004 at the price of $26.16 per share. Today the stock trades at $142.20 per share (as of December 19th, 2014). This comes out to an average annual return of roughly 16% versus a return of roughly 8% for the S&P 500 TR. So far so good. Our investment doubled the average return of the index for an extended period. If only all our investments did this.

But the really critical question is why hold on to the stock? Why didn’t we sell during this run after it had increased 80% rather than say 120%? The answer to this lies in the valuation to price ratio. Seen below is a chart of the stock price from 2004 – 2014. Laid on top of this is Morningstar’s fair value estimate. As you can see with this chart, the price of the stock increased at a similar rate to the valuation (Nintai’s valuation was similar to Morningstar so for ease of use we use the Morningstar estimates). To us this is the perfect compounding machine that deserves to remain in the portfolio. We decided not to sell for the criteria I cited previously and summarize below:

1. The business case for the company remained compelling. From 2004 – 2014 Return on Capital averaged roughly 46%. Return on Equity averaged 32% over the same period. From our perspective the company’s competitive moat and management’s capital allocation skills remained outstanding.
2. The Valuation to Price ratio remained ranged from a low of 71% below fair value (in 2008) to a high of 16% above fair value in 2014. At no time did the company become so overvalued to lead us to think it was not going to produce an adequate return in the future.

For these reasons FDS has remained in our portfolio for the past 10 years and barring a burst of market irrational exuberance, management gaffe, or unseen competitive strength, it will remain in the portfolio for the foreseeable future.

But not many companies can produce both operative success and maintain a valuation to price ratio. The better a company performs the more people want to own it. And when that company becomes a darling of the markets, it will almost always fail to meet the second condition.

A case of this was our ownership of Intuitive Surgical (ISRG, Financial). We first purchased the stock in 2010 for the price of $281 per share. We sold the stock at $491 per share in early 2012. We purchased the stock at a roughly 20% discount to fair value. By the time we sold it roughly 18 months later the stock was trading at a 40% premium to its valuation. The question we faced by early 2012 were the same we faced with FDS. However, we came to some very different answers to the same two questions:

1. The business continued to produce extraordinary results. Return on Capital was steady at 38% and Return on Equity was roughly 21%. The company still had no debt, produced enormous free cash, and had significant cash on the balance sheet. However, being in the healthcare industry we were hearing the company had become too commercial, too aggressive in their sales tactics. As well there were the first meta-analyses of their procedures calling into question their value. While impressed with the company we had some concerns about the future.
2. Trading at 40% above fair value gave us absolutely no margin of safety in the case we were wrong about our assumption. Hell, at that rate we couldn't be wrong about anything. Most importantly, at those valuation levels it was impossible to find out how we could get an adequate return going forward.

With those two answers we made the decision to sell the stock. Since we greatly admired the company we put it on the watch list to see how both the company and price worked out over the next few years.

Conclusions

In many ways Nintai feels it’s easier to decide when to buy a stock rather than sell a stock. The most difficult sale is the stock you probably love the most – the one that made your profits/returns possible. We believe the discipline to stick with your investing framework and keep an eye on the valuation to price ratio is vital. It can give you the moral clarity and objectivity to make the sale (or not) dependent upon cold hard facts. A final note: in both cases we didn't get in anywhere near the bottom or get out anywhere near the top. But we made (and kept) an adequate return for our investors allowing everyone to sleep well at night. And isn’t that what every investor wants?

We look forward to your thoughts and comments