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Apr
17
Jeff pointed out that the overwhelming majority of the posts on F Wall Street have discussed the "buy side" of being an investor. (And, of course, psychology and when not to buy.) Okay — now we own businesses. What's the next step? (Grab some coffee; this is a looooooong post):
In his January 1962 letter to partners, Buffett talked about his strategy for asset allocation and for selling "generals" — individual stocks purchased at what he believed to be a substantial discount to intrinsic value.
First, let's talk asset allocation:
Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 100% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.
THE LESSON ON ASSET ALLOCATION
In his early years of running the partnerships, Buffett was extremely focused with the partnership's assets. The lion's share of the "generals" portion of the portfolio was split between just five or six stocks, and he would go on to focus it even further in just a few years (changing the terms of the partnership to allow him to put up to 40% of the assets into a single stock).
BUFFETT DISCUSSES HOLDING PERIODS
He then goes on to discuss his expectations for short- and long-term gains:
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.
...and volatility (and losses):
The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage‐wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.
BUFFETT'S LESSON ON VOLATILITY AND UNREALIZED LOSSES
What's most interesting (to me, at least) about these two simple paragraphs is their straightforward simplicity. You can practically hear him saying, "I don't give a damn about volatility, short-term price movements, or unrealized losses. I care about making smart decisions, regardless of the result. Doing so, we should be handsomely rewarded over the years."
AND FINALLY, BUFFETT TALKS ABOUT SELLING
Nestled between the two holding period paragraphs above are two simple sentences that explain Buffett's selling process:
Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.
It's pretty simple: When you buy a piece of a business, you have an idea of what it should be worth to a private owner. (If you don't have an idea of what it should be worth, you shouldn't buy it.) Then, you have to let time and the markets do their thing.
Except when something glorious or horrendous happens to a business, intrinsic value does not usually change all that quickly. What is "glorious" or "horrendous"? I think it's best to look at some examples:
- Joe's Painting, with $2 million in annual sales, secures a major contract for $8 million, thus making the company a "player" in the industry. Glorious Joe's Painting would be hard pressed to get a contract with CVS; but, once he has CVS under his belt, Subway and others are more willing to work with Joe's Painting which completely changes the nature of the business. Assuming the business and management is sound (i.e., assuming the new sales can convert into greater owner earnings) the value of the business has increased.
- Joe's Painting loses CVS as a customer and CVS sues Joe's Painting for using lead-based paint and illegal immigrant workers. Other major customers run. Horrendous. There was no way to know Joe's Painting was such a shady operation. The zero-customer, lawsuit-laden business is now virtually worthless.
HOW TO SELL IF AND WHEN VALUE, OR PRICE, CHANGES
As Buffett said, "Sometimes these work out very fast; many times they take years." When "generals" work out very fast, it's tough to know if and how the intrinsic value changed. As such, be content to sell at "some intermediate level" between your purchase price and what you regard as "fair value to a private owner".
THE "VERY FAST" GENERAL
Example (because Jeff asked): A recent purchase of Graham Corporation (GHM), which I discussed briefly in this comment. On March 11, 2008, I began purchasing GHM at $36.28. The goal was to start acquiring shares each week so long as the price stayed at or below my margin of safety. I pegged it as a $60-$65 per share business. Three weeks later, the company reported record quarterly orders and the stock soared to more than $50.
My Dilemma: Do I hang on to GHM? Or, do I sell, content with this "intermediate" price?
The Business: I bought GHM because it was a very simple business with rapidly increasing owner earnings selling at what I believed to be a substantial discount. Assuming it was "business as usual" at Graham Corporation, I would be content to hold this company until the markets adjusted the price to reflect its intrinsic value.
The Valuation: GHM didn't offer much in the way of a "steady" past. Lackluster revenue growth. Negative earnings at times. Not the "ideal" company if run through a spreadsheet. Still, 100% of the value of a company lies in its future and it's our job to predict the future, no matter how delightful or ugly the past was. (Remember: Investing is 99% art, 1% science.)
Graham Corporation was one of those buy-and-sell-type investments — perceived as underpriced relative to its intrinsic value, but not a buy-and-own-forever wonderful business. Why? Because of its erratic past, I didn't know if GHM was a truly wonderful company; still, I felt confident that it was good and that it was underpriced.
The Decision: I chose to sell. Graham Corporation was not my best idea, and thus represented a small portion of the portfolio. I had wanted to acquire more, but didn't. And at the end (to give you an idea), I put less money in Graham than I did in the Tribune and RTSX workouts.
The Result: On this particular position, I was quite content to take a 32+% gain in such a short period. Though I was very confident buying in the mid-$30s and lower, I wasn't as confident holding in the low-$50s and higher, trying to squeeze "the last nickel" out of this position.
THE "SLOOOOOOOW" GENERAL
Then there are those positions that are priced below the purchase price, but that are still at a substantial discount to intrinsic value. Hoping that price soars towards intrinsic value, we can't do much more than simply watch the value and quarterly and annually revalue the business to determine its "fair value to a private owner". Sometimes the intrinsic value will grow and the price won't immediately follow; sometimes the value will start to deteriorate and you have to start asking questions:
- Is the business deteriorating or is this simply a bad quarter or year (remember: think in multiple-year timeframes)?
- Do I own a wonderful business in a tough environment (think: what is a wonderful business if not one that can survive the tough times and thrive in good times)?
- Is the intrinsic value getting close to the current price?
And, of course, the key question: Will this business be making more money and generating greater owner earnings five years from now? (Ask this every year, not just from the time of purchase.)
PRICE AND VALUE — IT'S NOT JUST THE PRICE THAT MOVES
In question three (above), you ask yourself: Is the intrinsic value getting close to the current price? Though we always hope to buy underpriced businesses and watch the price soar towards the intrinsic value, this isn't always the case.
Sometimes the business changes, and intrinsic value heads south towards or below the price you paid...and even below the current market price. And that's when you should think about selling.
HOW I DECIDE TO SELL A "GENERAL"
To decide whether or not I should be selling, I mentally ask myself:
- What is the intrinsic value?
- Am I comfortable with and confident in my assessment of intrinsic value?
- What is my current margin of safety?
- Am I comfortable with and confident in holding this position at the current margin of safety? (Obviously, if there is no margin of safety because (i) the price has risen too much, or (ii) the value has fallen too much, I'm selling.)
Then, I take the action I feel is most appropriate from a business perspective.
YOU WILL TAKE SOME LOSSES, AND SOME BIG ONES AT THAT
Investing in stocks, businesses, workouts, etc., you will lose money — and sometimes, a lot of money — because things don't always work out the way you expected. That's just the way it is.
Sometimes you'll have to watch as your unrealized losses mount on a stock that was, and still is, underpriced to the business' value; sometimes you'll have to sell and take a real loss. You can only control your actions — the markets, your companies, and other investors and speculators will do their things regardless of your actions and expectations.
Don't get me wrong — like you, I hate to lose money. Still, it goes with the territory. And if you can't (or won't) accept that reality, you should consider rethinking your psychology and strategy.
So, when should you sell? When it makes sense from a business perspective.
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by Jeff on April 17, 2008 at 12:35 PM