Today I’m going to write about something that gets little attention in investing articles, books and speeches, despite being essentially half of my job as an investor: sell discipline.
Everyone loves to talk about what they are buying and how they buy, but few talk about the other side of the trade.
Ideally, I’d like to follow Warren Buffett‘s mantra: “Our favorite holding period is forever.” But finding companies that can be held forever is very rare in one’s career. While I have a relatively low turnover rate at 33%^, in a fund like Trimark Canadian Small Companies Fund, which holds 37 companies (as at April 30, 2013), it still means about 6 companies are sold every year.
Many of you may be familiar with what I look for when I buy: a great business, sound management and a discounted valuation, with an associated big idea. But how do I sell?
There are three reasons to sell a company:
Pulling an example from Trimark Canadian Small Companies Fund, a company like Rocky Mountain Dealerships*, trading today at around 8x forward P/E**, would stay in the portfolio if it traded at 12x because I like the business and management and 12x is still an attractive valuation. However, if Rocky were to trade at 25x, I would sell because at that price I believe all the good news (and then some) would be priced into the stock. In that case, going to cash would be preferable.
The second reason, selling for better opportunities, happened fairly often during the depths of the financial crisis. Back then I was running Trimark North American Endeavour Class (I still do) and was fully invested because valuations were so attractive. In fact, valuations were so attractive that I would sometimes sell a company I liked to buy a company I loved. This kind of sale makes the portfolio stronger.
Mistakes are the final and most difficult reason to sell. If I have made an error measuring the quality of a management team, the competitive position of the business, the likelihood of the big idea coming to fruition or one of a host of other factors, then the correct decision is to sell. Selling at a loss of 30% or 50% may be painful, but not as painful as a 100% loss.
Investment performance can be seriously damaged by something we call “thesis creep” – justifying an investment after the original basis of the decision has changed or failed.
For example, if an investor buys a company believing a new product launch will dramatically boost sales, but that launch fails and the stock goes down, the investor might justify owning that company for another reason, such as “it’s cheap.” Such thesis creep usually generates greater losses. It’s better to recognize the mistake, sell and learn from the experience.
In conclusion, when you see Trimark Canadian Small Companies Fund with 18% cash (as at May 31, 2013), you can rest assured there is a strong and well-considered discipline behind every decision to sell.
^12 months ending March 31, 2013
*The above company was selected for illustrative purposes only and is not intended to convey specific investment advice.
**Source: Bloomberg; Price-earnings (P/E) ratio, the most common measure of how expensive a stock is, is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month period.