Having gone years without selling out of a position, it feels odd writing about my second share sale so quick after my first one. Making my second stock sale all the more remarkable is I didn’t think it would be Burberry. Since initiating my position in Burberry back in July 2016, I imagined that I would be holding these shares for years and years – even though I didn’t see it as a legacy position.
Whenever I make a stock purchase, the company I am investing in either has to be a serial compounder of wealth or is fundamentally undervalued. The biggest opportunities for large returns are by buying into undervalued stocks. As one’s time horizon increases, serial compounders make much better investments and that is why I intend to hold my legacy purchases like Royal Dutch Shell and Unilever forever.
Even though I would ideally like to only make purchases in the companies I have identified as being the best in the world, it is not always possible. Just because I think Visa is a wonderful company does not mean that I would buy it at any price. This is where undervalued companies fit into my portfolio as I can juice my returns by buying them. But make no mistake, I don’t buy undervalued companies with the short term in mind. I purchase every stock with the intention of holding it for years to come as I am fully aware that cheap stocks can get cheaper. That is to say when I buy an undervalued stock, I look at the companies quality as well to ensure I am contempt holding it.
As you can tell, I bought Burberry due to it being undervalued in the wake of Brexit. The company is truly a wonderful business with great Free Cash Flow generation and high Returns on Capital Employed. It is a stock that I would have been happy owning for decades. But since my purchase, Burberry stock price has shot up. It has gone up from my purchase price of £12.10 to £18 on Friday when I sold. An increase of close to 50%.
Initially, when the stock price of the company went up, I thought the market finally appreciates how great the company is and the price is moving to intrinsic value. But once the price got there, it just kept going upwards. In the past three months alone it has shot up close to 25%. And this has nothing to do with the business fundamentals changing. The run-up in price is solely because an activist investor has taken a stake in the company and the market thinks Burberry will be approached for a takeover. I have sold Burberry because the share price reached my fair value and then shot past it.
This is not to say that Burberry shares cannot go higher. I do think that it is a great company but at current prices, I am not comfortable owning it. Sure, the company could receive a takeover bid and the share price could go higher but this is not how I invest. I invest in the knowns as opposed to the unknowns. I invest with the facts at hand rather than in the hope of something happening.
Before selling the stock, I asked myself “ based on what I know currently, will I be disappointed that I didn’t take the opportunity to sell the stock at current levels if it trades 20% lower a year from now?”.
My answer is yes and that is why I sold.
Sell When A Stock Becomes Expensive
I basically sell non-legacy stocks when it becomes expensive. But in the investment world “expensive” is a relative term; no different than you would see in a grocery store. A £10 price tag doesn’t tell you much unless you also know what underlying value you’d be receiving in exchange. That amount for a single orange? Much too high. The same amount for a big bag of oranges? Now that might be more interesting.
Furthermore, the quality of an item also has an influence. This concept carries through with investing as well. And one of the most common errors that results is uniformly applying earnings multiples. Two securities could be trading at the exact same price and even exact same valuation. However, this alone does not mean the deals are equal.
It’s not enough to see a P/E ratio of 20 or 25 and think “expensive.” Likewise seeing a security trade at 8 or 10 times earnings does not automatically denote “cheap.” That’s half of the equation, but the other side is the underlying quality of a firm and growth prospects.
How I Decide When To Sell A Stock
Let me note at the outset that this discussion will focus solely on investments that have soared past intrinsic value (moved higher). The approach to failed investments, while clearly important, is worth its own article at some point in the future.
When I buy shares that are fundamentally undervalued, the annualised return I am hoping for is 12% – 15% over a period of 5 years. From a starting stock price of £100 per share, an annualised return of 12% – 15% implies a future price of £175 to £200 per share in five years.
I would usually start selling some of the position as the expected forward rates of return fall into the mid-single digits. From the numbers above, let’s say the stock shot up to £150 per share over the first two years; relative to my original expectations, the expected return for the ensuing three years has now been reduced to a mid-single-digit percentage (annualised). While this decision would largely depend on the opportunity cost of the capital employed, this is a good example of when I would almost certainly start reducing my position in a stock bought purely because it was cheap. Even if I can’t find a replacement that meets my return objectives, I’m unlikely to hold onto a position pricing in ~7% a year for too long; I’d rather move to cash (discussed further in a minute, though I see why some might disagree with that).
Apart from the financial aspect, there is an emotional aspect of selling a stock. As mentioned earlier, I like to ask myself the question ‘“ based on what I know currently, will I be disappointed that I didn’t take the opportunity to sell the stock at current levels if it trades 20% lower a year from now?”. I need to know if I would feel disappointed that a share price dropped 20% without any fundamental change in the business. In the sale of Burberry, this fear of potential disappointment played a role in my decision. I’m willing to substitute an equity investment priced for a mid-single-digit annualised returns for cash simply because I’m not comfortable with the drawdown risk associated with sticking to the equity position.
Thinking this way about non-buy and hold forever stock helps keep me grounded. As the market keeps rising, the biggest fear many investors start to have is missing out on continued gains, especially when they look easy (and your friends/competitors are getting rich); fear of actually losing money starts playing second fiddle. As an investor, I think you must question your thinking constantly to ensure you’re not being lulled into a false sense of complacency by endlessly rising stock prices.