Why we expect to sell too early!
As a fund manager, one of the most frustrating aspects of the job is to sell a share in a business and then have to watch the price continue climbing. There is some truth in the view that you only remember the ones that got away, but they often cause more personal pain than the investments that worked to plan. We have had several examples of this incidence this year, when we sold Apple, LVMH and Microsoft, all at very healthy profits, only to watch the shares keep rising above our selling price.
The inverse is also annoying: when you buy a company when the share price has fallen, just to watch it keep going down. I would argue that both events are completely unavoidable and while we all have the “if only” moments, they are actually far less damaging than potential errors involved in attempting to call the peaks and troughs.
Indeed, the errors of not buying when shares are cheap and not selling when they are expensive are potentially much more serious and can be disastrous. Over the years, I’ve watched fund managers try to time their purchases to the trough of a share price decline. Ignoring the retrospective perspective of this issue, the intention may seem noble and even common sense. However, the reality is quite different; once you leave behind the valuation piece, then you enter the speculative zone and even the finest minds cannot predict random market movements.
A typical occurrence is a fund manager setting a low-price target on a falling share. This usually has more to do with a level that is not related to valuation. Unfortunately, once they are set, the manager is often anchored to this target and if the price rallies, the long-term purchase opportunity is lost, sometimes for the sake of a per cent or two.
More dangerous is the resetting of price targets into a rising market. This is more common than one might think! Price targets are raised because of the price, not the prospects! This can result in a manager losing objectivity and with increasing confidence, moving from traditional valuation measures to other less demanding or tested metrics: ‘the share is just cheap and has a long way to go!’ Memories of the tech bubble and more recently crypto currencies should highlight the dangers of this approach!
Process is important and clients are rightly concerned when managers appear to allow some drift to take account of ‘market conditions’ or invest in areas where they have little track record or obvious expertise.
Valuation: where we feel the share price fully reflects the prospects for the business.
Worst Case: where are increasingly concerned about the deterioration in our Worst Case estimates and probability of occurrence.
Portfolio Upgrade: where we can find a similar business with lower risk characteristics, such as lower valuation, stronger balance sheet, and less severe or likely Worst Case.
While there are dangers in blindly following one valuation metric, we tend to view a 5 year PER of over 15 times as expensive. History has shown that investors overpay for growth. While we also adjust for cash generation and balance sheet strength, our rule of thumb is that if a company cannot reach this level after 5 years, then investors are unlikely to achieve an equity like return.
Microsoft is a fine company. It makes impressive returns on capital, achieves high operating margins and has a cast iron balance sheet and attractive prospects. This was true over our entire period of share ownership. The market capitalisation of Microsoft is now around $880bn.
Fund flows to tech remain strong and the share price may continue to rally. We know we cannot predict with any confidence in which direction the share price will move with the equity market. If we had to guess, we would probably estimate it will drift higher! Nevertheless, the forward PER is now over 26 times earnings and the yield is less than 1.6%. The shares are expensive on our assumptions of earnings growth. We do our best to avoid speculation and unnecessary risk; accordingly the shares were sold.
Inevitably, there are occasions where we do get it wrong and sell too early. We tend to be conservative in our assumptions and sometimes our forecasts are too low and reported earnings continue to positively surprise. We made a healthy profit from our investment in LVMH, but earnings continued to be upgraded and the share price has responded accordingly.
As noted previously, we also sell when the worst case is becoming increasingly unpalatable and more probable. The reported earnings may still justify a rising share price, but the increasing risk in the investment may result in the disposal of the shares.
The benefit of a strict process is that it gives managers the confidence at times of stress to buy cheap shares and sell expensive ones. There is still a large margin of profit between the two actions. In practice, this means we often buy and sell before the troughs and the peaks.
While this can be an uncomfortable practice, especially as we wait and watch share prices drift higher, it avoids the irrational exuberance and ‘it’s different this time’ mentality that is always present in some business valuations during the latter stages of a bull market.