In my year-end 2012 investor letter, I confessed the following mea culpa. “My biggest mistake during the year was clear: selling Visa Inc. (V) in June for $120 as prevailing market prices neared my initial valuation estimation. While the Fund netted a 62.7% profit taxable at long-term rates on the sale, Visa was selling for about ~$150 per share at year end 2012. After accurate analysis and prescient investment, I sold Visa as the Fund captured the “low hanging fruit” yet the market continued to increase Visa’s price. Great businesses compound valuation as they grow and I neglected to adequately account for this phenomenon when I sold Visa. I have incorporated this lesson into my sell methodology and plan not to repeat the error.”
Afterward, I received two questions from investors regarding the sale of Visa:
(1) Can you describe more specifically how your thought process is adjusting to allow your best positions to continue to increase?
(2) Why was selling Visa an error if the company’s valuation reached your target of value?
This blog post will address both questions by delineating the differences between selling an average company and a great company (defined below).
At GrizzlyRock, I invest in mispriced corporate securities on behalf of clients. Portfolio investments are in a diverse set of industries and each business has a unique set of economic attributes. For me, a business must be 40% or more mispriced before purchase (or sale if we are discussing a short).
However, the current price of an investment is independent from the fundamental economic attributes of the business. For example, both of the following scenarios could produce a 40% or more mispriced security (1) an investment in a business with average economics is selling at an extremely low price or (2) a business with superior economics is selling at a moderate price. Either security can be an attractive candidate for purchase. The Holy Grail is finding a great business selling at an extremely low price. If that happens, buy as much as you can and then call me! That extremely rare occurrence is fortuitous yet infrequent at best.
What Defines a “Great” Business?
A “great” business is able to grow over time with limited capital investment in a large, expanding industry. Thus, a great business will generate significant cash available to owners over time and either reinvest in areas of adjacent growth or return cash to shareholders. Return on asset metrics will be high and the business will create an economic moat over time. One example of a great business is Coca-Cola (KO, Financial). For 150 years, Coca-Cola has been producing refreshing beverages, expanding around the world, and returning cash to owners while building its brand.
A great business can generate above-average returns when its market price is cheap to appropriately priced. This is because of the superior economics of the business – a great business compounds its value over time.
What Defines an “Average” Business?
While many businesses aspire to greatness, most are average. An average business has a reason to exist but usually can only grow during economic expansions or through intensive capital allocation. An average business may be excessively cyclical or fail to create a durable competitive advantage. Return on asset metrics will be around the cost of capital (perhaps below) over the long term.
Much like a cigar butt may give a few delicious puffs but will soon flicker, an average business can increase in price to its true value but will not compound over time. As such, an average business can only generate exceptional returns when its price is drastically below its inherent business value.
Why Does the Difference Matter in Sell Methodology?
Previous to this exercise I managed the portfolios as follows: Find inexpensive (reverse for shorts) securities, calculate true business value, purchase securities at 40% or more mispricings, sell them when the price and value nearly converge, rinse, repeat. Happy investors, happy manager.
And this does work well for average businesses and securities which cannot compound (especially the high yield credit market which comprises much of my investing background)
As I readily admitted regarding Visa, my error was in selling to soon. I briefly highlighted the reason: “Great businesses compound valuation as they grow and I neglected to adequately account for this phenomenon when I sold Visa.” If Visa can compound upon itself, why sell it when I estimate it to be near fair value? The short answer is investors likely should not. A more nuanced answer would be: an investor should not sell a compounding business at a fair valuation unless other investments can compound faster.
Resultant Update to GrizzlyRock’s Selling Methodology
For average & slightly above average businesses (the vast majority of investments), there will be no change to the methodology of selling when market price reaches my estimation of base-case value. The change will be in the handful of businesses that are truly great businesses with exception long-term prospects, the ability to compound over time, and continually earn free cash flow.
At the onset of each investment, I will delineate the “great” businesses. For those select few businesses, I will only sell for a price significantly in excess of my estimation of base-case current value before selling. The sales price will be determined by my estimation of upside-case current value. Secondly, I will incorporate decision-tree steps regarding great businesses on my selling checklist.
This method would have caused me to retain Visa shares at $120 and continue to enjoy the fruits of the prescient analysis to its current $150 price. This would have caused the investment to double as opposed to simply making 62%!
Afterward, I received two questions from investors regarding the sale of Visa:
(1) Can you describe more specifically how your thought process is adjusting to allow your best positions to continue to increase?
(2) Why was selling Visa an error if the company’s valuation reached your target of value?
This blog post will address both questions by delineating the differences between selling an average company and a great company (defined below).
At GrizzlyRock, I invest in mispriced corporate securities on behalf of clients. Portfolio investments are in a diverse set of industries and each business has a unique set of economic attributes. For me, a business must be 40% or more mispriced before purchase (or sale if we are discussing a short).
However, the current price of an investment is independent from the fundamental economic attributes of the business. For example, both of the following scenarios could produce a 40% or more mispriced security (1) an investment in a business with average economics is selling at an extremely low price or (2) a business with superior economics is selling at a moderate price. Either security can be an attractive candidate for purchase. The Holy Grail is finding a great business selling at an extremely low price. If that happens, buy as much as you can and then call me! That extremely rare occurrence is fortuitous yet infrequent at best.
What Defines a “Great” Business?
A “great” business is able to grow over time with limited capital investment in a large, expanding industry. Thus, a great business will generate significant cash available to owners over time and either reinvest in areas of adjacent growth or return cash to shareholders. Return on asset metrics will be high and the business will create an economic moat over time. One example of a great business is Coca-Cola (KO, Financial). For 150 years, Coca-Cola has been producing refreshing beverages, expanding around the world, and returning cash to owners while building its brand.
A great business can generate above-average returns when its market price is cheap to appropriately priced. This is because of the superior economics of the business – a great business compounds its value over time.
What Defines an “Average” Business?
While many businesses aspire to greatness, most are average. An average business has a reason to exist but usually can only grow during economic expansions or through intensive capital allocation. An average business may be excessively cyclical or fail to create a durable competitive advantage. Return on asset metrics will be around the cost of capital (perhaps below) over the long term.
Much like a cigar butt may give a few delicious puffs but will soon flicker, an average business can increase in price to its true value but will not compound over time. As such, an average business can only generate exceptional returns when its price is drastically below its inherent business value.
Why Does the Difference Matter in Sell Methodology?
Previous to this exercise I managed the portfolios as follows: Find inexpensive (reverse for shorts) securities, calculate true business value, purchase securities at 40% or more mispricings, sell them when the price and value nearly converge, rinse, repeat. Happy investors, happy manager.
And this does work well for average businesses and securities which cannot compound (especially the high yield credit market which comprises much of my investing background)
As I readily admitted regarding Visa, my error was in selling to soon. I briefly highlighted the reason: “Great businesses compound valuation as they grow and I neglected to adequately account for this phenomenon when I sold Visa.” If Visa can compound upon itself, why sell it when I estimate it to be near fair value? The short answer is investors likely should not. A more nuanced answer would be: an investor should not sell a compounding business at a fair valuation unless other investments can compound faster.
Resultant Update to GrizzlyRock’s Selling Methodology
For average & slightly above average businesses (the vast majority of investments), there will be no change to the methodology of selling when market price reaches my estimation of base-case value. The change will be in the handful of businesses that are truly great businesses with exception long-term prospects, the ability to compound over time, and continually earn free cash flow.
At the onset of each investment, I will delineate the “great” businesses. For those select few businesses, I will only sell for a price significantly in excess of my estimation of base-case current value before selling. The sales price will be determined by my estimation of upside-case current value. Secondly, I will incorporate decision-tree steps regarding great businesses on my selling checklist.
This method would have caused me to retain Visa shares at $120 and continue to enjoy the fruits of the prescient analysis to its current $150 price. This would have caused the investment to double as opposed to simply making 62%!
