To Sell Or Not To Sell — January 2014

January 23, 2014

Dow Jones Average: 16,373
S&P 500 Index: 1,845


To Sell Or Not To Sell


One of the more important decisions investors face is when to sell a holding that has gone
up in value. It is certainly tempting to secure the gain and avoid a reversal of good fortune.
Studies show that most mutual fund managers sell frequently, turning over the entire value
of their funds every twelve to eighteen months. Hedge fund operators are known to have an
even quicker finger on the sell trigger. On the other end of the spectrum is Warren Buffett,
who has often said that his preferred holding period for a stock is forever.

We have typically held stocks for between one and five years before sharply reducing or
eliminating the position. Our buy and sell decisions have been based on the stock evaluation
scale developed by us some thirty years ago. The objective has been to find significantly
undervalued stocks, and hold the shares until the price fully reflects the value of the business.
Our mathematical model and further, in-depth research, has identified a large number of
undervalued companies over the years, and has also signaled a good exit point for many of
those holdings. By cycling from one undervalued holding to the next, we believe that we
have reduced the risk of a sudden drop in portfolio value. While our carefully controlled,
prudent approach has been the appropriate strategy for many holdings, it has led to a
premature exit in a few, significant situations. We have closed the book on some companies
when there were still many, dramatic chapters left in the story.

The decision to sell or hold a stock is more complicated than the buy decision for us.
When buying a stock we are looking for a company with a compelling product or service,
an ethical, intelligent management team, and a mathematically undervalued stock price
relative to its business at the time of purchase. If the stock subsequently gains in popularity,
we are faced with the decision of when and whether to take a profit on the holding. We find
the sell decision more difficult because the time frame for estimating full or fair valuation
is indeterminate. While the stock price may have risen to a point that fully reflects the
business success of the company at the time one is contemplating a sale, it may be low
relative to the size of the business far off in the future.

With the benefit of hindsight we have concluded that companies, which fit a certain
profile, should be held for a longer period of time than five years. The average holding
period for these somewhat rare companies should be about 15 to 20 years in our opinion.
Companies that fit the profile are generally smaller to mid-size companies that have a
product or service that addresses a major economic/social trend or theme. The company
needs to have a competitive advantage that may come from a product that is hard to copy, or
growing brand awareness and customer loyalty. A strong balance sheet and a management
team focused on long-term results will help the company navigate shifting economic
conditions, and product transitions. In our experience only a small minority of publicly
traded companies fit the profile, and finding them at a cheap starting price is even more
unusual. While we have found more than our fair share of such companies over the past
couple of decades, and have taken good profits on them, we would like to go back in time
and reverse some of those sale decisions.

Holding companies for long periods of time can be a challenging experience for an
investor. It means giving up a measure of control that comes from owning companies that
are clearly and presently underpriced. In a holding period of 15 to 20 years it is virtually
guaranteed that a stock will appear frequently overvalued relative to its operations at any
given time. As a wider audience of investors becomes aware of the company’s success,
the share price may run well ahead of underlying business operations. The share price is
likely to be volatile with strong gains to the upside followed by some deep selloffs. There
will be many changes in the business over a span of two decades, competitive threats, and
plenty of mistakes made by even the best management teams. Long-term relationships of
any kind are difficult to sustain. If one is overly sensitive to movement in the share price
or too critical of decisions made by management, the holding is not likely to last five years,
let alone 15 to 20. The reward for remaining in certain stocks for a long time is a possible
compounded return seldom seen in holdings of shorter duration.

We have retained several very successful holdings for fifteen or more years, and look
to increase the number of such positions going forward. Our vision is to have about seven
such holdings, representing approximately one third of a portfolio at any given time. We
are value oriented, bargain hunters, and as such we often start a new position at a price well
below what other investors are eventually willing to pay. After the first double in price
some of our better stock picks are still barely visible on the radar screen of other investors.
An unusually low starting basis is a reason to delay taking profits on a stock position.
We do not intend to change our strategy on the buy side, but are planning to lengthen the
holding period for companies that fit our preferred, long-term growth profile.

Current Strategy

The stock market had a strong finish to 2013, after the Federal Reserve announced in early
September that it would continue to pour about a trillion dollars per year into the financial
system. The stock market has been a prime beneficiary of the Fed’s unprecedented bond
buying program, which is the Fed’s mechanism for suppressing interest rates and pumping
up stock prices. Therefore, it was somewhat surprising when the market continued to
advance in December, after the Fed made it clear that they were finally going to turn down
the flow from the money spigot. Perhaps investors were relieved that the reduction was
going to be small, or perhaps everyone was just in a buying mood after a good year for
stocks. We are not sure why stocks continued to rise through December 31, without so
much as a pause, in the face of rising interest rates and somewhat muted corporate earnings
growth, but rise they did. Stocks may remain on a high plateau for a while,as there is no
apparent, near-term catalyst that could trigger a serious price correction.

Even in an elevated market environment there are buying opportunities, brought on
by occasional, company-specific announcements that negatively impact an individual
stock price. We evaluate many of those moves and decide whether the drop is likely to be
temporary or long lasting. Over the years we have found dozens and dozens of temporarily
depressed situations. A modest readjustment in price, back to a more normal level for the
company, is often the extent of the gain on such holdings. We see money earned on such
purchases as important additions to the capital foundation of an account. These gains
of modest size can be parlayed into a smaller company with more dramatic, long-term
prospects, or used to build a larger, fixed income base for a portfolio.

We purchased both treasuries and municipal bonds when interest rates reached the
three percent level a few months ago. There has been little change in rates since that time.
With short-term rates still at zero, and likely to remain close to zero for several more years,
capturing some yield from longer dated paper makes sense, in our opinion. We do not
intend to buy more treasuries unless interest rates climb to the 3.5 to 4 percent area, but are
considering more municipal bonds, as they are tax-exempt and already yield close to
4 percent in some cases.

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