In writing for the “Battles and Leaders of the Civil War”, a prominent United States Army cavalry officer was asked about the difficulty of making a charge in the time of weaponry such as rifled firearms. In a classic case of inversion he stated, “It isn’t the charge that gets you in trouble. It’s getting out when all hell breaks loose.”
I recite this story because investors face similar problems (though it must be said, selling a position is quite different than dodging saber blows and cannon fire). Several months ago, I wrote an article about when to sell a holding (“Compounding or Confounding: The Agony of the Sale” which can be found here) and discussed the associated difficulties. Similar to our cavalryman, all kinds of trouble can begin when you try to exit a position.
A response to our sale of FactSet Research (FDS, Financial) mirrored a question that comes up regularly with our investment partners. In this case the reader asked a.) where we would put the proceeds of the sale and b.) pointed out the need to take into account the tax impact of the transaction. This question mirrors the issue of the cavalryman – how do we exit our position and where do go we afterwards? To answer this, I thought it might be helpful if I first outline the criteria we use when making decisions like the FactSet sale.
Forgetting What You Are Trying to Achieve
Paul Nitze said, “one of the most dangerous forms of human error is forgetting what one is trying to achieve.” It’s remarkably easy to get drawn into issues that deviate our thinking from our goals. In our case we are trying to achieve adequate returns for our investors – nothing more and nothing less. When we look at making a significant change in the portfolio, we evaluate our decision on three (3) core issues – the investment’s valuation, the transactional tax implications, and its portfolio impact. We believe any additional data can distract us, or as Nitze said, have us forget what we are trying to achieve.
Valuation
Our first item to consider is the valuation of the holding. We rarely exit our entire position on valuation alone but will given certain conditions. When the asset is overvalued by greater than 40% is certainly a case in point. Our inability to make a business case going forward means ownership of the asset puts our goal of adequate returns at risk. If we have to choose between locking in our gains and holding cash versus continuing to hold the asset, we will choose the former every time. We feel the risk of losing significant capital far outweighs earning nearly nothing to hold cash.
Tax Impact
Of somewhat lesser importance to us is the tax implications of the sale. While none of us are ecstatic about handing a percentage of our gains to the US or state treasuries, that is the price we pay for a well regulated market place and profits from our investment decisions. This is, in general, how we look at investment capital gains. For our individual investors we will likely weigh very carefully the impact of such gains on their finances such as calculated Social Security benefits, Medicare Part D premiums, etc. In these situations our sales may be staggered over quarters to minimize the impact on their individual financial situation.
Portfolio Impact
As an investment fund without any particular restrictions we have the ability to seek assets across any industry, country, or company size. This frees us from having to meet any mandatory holding requirements. Currently our portfolio consists of 20 stocks with the following breakdown:
| Value | Core | Growth | Â |
| 3% | 2% | 37% | Large Cap |
| 2% | 12% | 7% | Mid Cap |
| 8% | -- | 26% | Small Cap |
As you can see we are relatively agnostic to the size or investment category of the company in the portfolio. With that said, we do have, over the long term, a preference for small and mid-cap stocks as we believe the greatest amount of mispricing happens in these market caps.
In the choice of industries, we have a tendency to be more focused. Some such as real estate and energy are avoided because we rarely find a company that meets our financial criteria. Our current portfolio fails to have investments in four (4) of the major eleven (11) categories – real estate, communications, energy, and utilities.
| Â | Portfolio % | S&P 500 % |
| Basic Materials | 8.5% | 3.1% |
| Consumer Cyclical | 7.3% | 10.6% |
| Financial Services | 17.2% | 14.3% |
| Real Estate | --- | 2.3% |
| Communications | --- | 3.9% |
| Energy | --- | 8.3% |
| Industrials | 10.8% | 11.1% |
| Technology | 38.0% | 17.7% |
| Consumer Defensive | 1.9% | 9.9% |
| Healthcare | 16.4% | 15.5% |
| Utilities | --- | 3.4% |
Tenuous Connections: Selling So You Can Buy
The second part of our commenter’s question can be answered more succinctly. The ability to put our sales proceeds to work in a new investment plays almost no role in our decision to sell. When we made the decision to sell FactSet, the ability to reinvest (in this case Computer Modelling) played zero impact in pulling the trigger. We think a critical point is that sell decisions should primarily be made for two reasons - valuation or an outdated business case. The linkage between selling and the need to reinvest should not be factor. Very rarely will we sell a current holding to pick up another replacing a low valuation with an even lower – and more compelling – valuation. We simply don’t buy into the argument that we should hold FDS simply because we don’t have a replacement. The potential to permanently impair capital through extreme valuation is a risk we are simply unwilling to take.
Conclusions
Selling a successful investment is never easy. Having a structured investment process allows you to make a decision that – for many reasons – can be extraordinarily difficult to implement. Sell decisions are best made when they are process and fact based. More importantly, being able to focus on data that really matters such as valuation and implied returns is essential to wise exits. By including non-essential data and linking decision points (such as “if I sell what’s next?”) investors can allow fuzzy math and thinking to impede sound investment policy. As a final note, our cavalryman previously quoted was none other than George Armstrong Custer. Certainly no soldier learned a more brutal lesson about the danger of “getting out” than when he violated his own maxim. By focusing on making a well-reasoned exit, investors can benefit immensely by not making Custer’s mistake and truly have all hell break loose.
As always, we look forward to your thoughts and comments.
