“You cannot always sell out when you wish or when you think it wise. You have to get out when you can; when you have a market that will absorb your entire line. Failure to grasp the opportunity to get out may cost you millions. You cannot hesitate”
– Edwin LeFevre – Author, Reminiscences of a Stock Operator

“There have been cases where we own say, 1 million shares and we think we want to sell, but we can only sell 25,000 shares right away. You could say ‘why bother it’s only 25,000 shares?’ but our feeling is that’s silly – it might only help solve 2.5 percent of the problem, but the problem is now 2.5 percent smaller than it was.”
– David Einhorn – Greenlight Capital

We conclude our series on the investment process by looking at the final step, the art of sell discipline, or knowing when to exit an investment. As we noted previously in ‘Go, No-Go – Making the Decision,’  the actual process of “making the decision to invest” is largely brushed over analytically. In our experience, the process to follow when exiting a position is also given little consideration by investors.

From our time in investment banking, we often heard the common-sense wisdom of “You never go broke taking a profit,” or “Pigs get fat, but hogs get slaughtered.” The implication being that if you have made a profit, it almost always makes sense to exit your investment. The saying attributed to George Soros that “it takes courage to be a pig” may have been tossed around as a contrarian retort to these sentiments. Rather than make intuition based decisions using such common-sense refrains, we find it much more prudent to make decisions using a framework that has been thoroughly constructed in advance.

We believe the best place to begin evaluating the end of the investment (i.e., exit) is at the beginning (i.e., well-before you have invested). Prudent investing, if it is to be more than gambling or a coin toss, involves first articulating a specific investment thesis. This thesis clearly describes what the investor believes will happen to the investment being evaluated. It should define in advance what catalysts are going to move shares, an approximate time frame, and the risks and rewards present.

The well-defined investment thesis protects you from stumbling into Alice’s quandary when she encounters the Cheshire Cat.

“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to.”
“I don’t much care where –”
“Then it doesn’t matter which way you go.”
― Lewis Carroll, Alice in Wonderland

That is to say, if you never bother to define a specific investment thesis in advance of investing, you risk not knowing what the correct path forward is as circumstances develop. A well-defined investment thesis constructs a sell-discipline in advance, and is prescriptive about how to manage the investment as time progresses and circumstances develop.

Investment Scenarios

At the risk of stating the obvious, there are four potential outcomes to an actively-managed investment:

• The thesis is correct and the stock rises – “Correct Decision
• The thesis is incorrect and the stock falls – “Incorrect Decision
• The thesis is incorrect and yet the stock rises (for unexpected reasons) – “Lucky Decision
• The thesis is correct and yet the stock falls – “Unlucky Decision

Or graphically, we can represent this as a simple 2 x 2 matrix, as seen below.

table

Below we walk through each scenario and offer a few thoughts about how best to handle each.

Scenario 1 – Exiting the Correct Decision

This may be the clearest of all the scenarios in that the stock performance has corroborated your thesis based on the specific catalysts you described in advance. The exit from a successful position is a process that occurs in stages.

As part of an investment thesis, we define what we think the upside potential is (reward) to a downside case assessment of where the stock could go (risk). At the beginning of an investment, we want to see at least 2-3x upside to downside (reward over risk), or even higher. The reason for this is that we want to be compensated greater than 1 for 1 for each unit of ‘risk’ we are assuming. By insisting on this scenario, we hopefully are skewing the return potential of each idea and the portfolio itself in an asymmetric fashion (i.e., this deliberate skewing of the portfolio is designed to disproportionately reward the investor vs. the risk assumed). For example, why would we accept 50% upside potential vs. 50% downside risk (i.e., 1.0x upside to downside), if there is another investment offering 50% upside, but only 25% downside (i.e., 2.0x upside to downside)?

This asymmetry disappears as the stock approaches our target of intrinsic value (i.e., less upside remains, vs. the same/greater downside risk), and as such we begin harvesting gains / trimming the position. Our target is to be largely complete with our exit within 10% above/below est. intrinsic value.

As the stock nears fair value, the size of the position decreases

chart1
What if the intrinsic value has actually increased? This is a challenging scenario because when you purchased shares originally, you had a clear estimation of what you felt like the shares were worth. Over time, because the stock has performed (and generally this means that the company has as well), your estimation of the intrinsic value may begin to rise (and perhaps rightfully so).

The problem here is that the position has increased in size and you are more likely to regard the business more favorably from a pure psychological perspective (anchoring / recency biases). Our rule of thumb in this scenario is that whenever we increase our intrinsic value estimate, we need to re-evaluate the upside / downside relationship and resize the position accordingly (often back towards the initial size when the idea was first placed in the portfolio).

Scenario 2 – Exiting the Incorrect Decision

“Learn how to take losses quickly and cleanly. Don’t expect to be right all the time. If you have a mistake, cut your losses as quickly as possible.”
– Bernard Baruch – Famous investor of the 1920s

“Market losses are external, objective losses. It’s only when you internalize the loss that it becomes subjective. This involves your ego and causes you to view it in a negative way, as a failure, something that is wrong or bad. Since psychology deals with your ego, if you can eliminate ego from the decision-making process, you can begin to control the losses caused by psychological factors.’
– Jim Paul – Trader – Author – What I Learned Losing a Million Dollars

As an investment develops, circumstances may arise which contradict the drivers of the investment thesis. When this occurs, we believe that an incorrect decision has been made. When your thesis is incorrect and the stock reflects this, we believe the best course of action is a quick and speedy exit. In this situation, your reasons for being involved are no longer valid.

Many investors who do not define a specific investment thesis in advance have fallen victim to ‘thesis creep’ – a debilitating affliction whereby the ‘thesis’ for the investment is changing day-by-day with the direction of the market (‘Of course we bought Netflix because we saw the growth potential in Europe!’).

While it is certainly fatalistic to joke about ‘how much worse’ something could get, we have seen that when companies begin to struggle that the near-term ‘downside’ case can always be greater than anticipated. As such, it is best and prudent to exit and move on.

All good investors will be wrong on occasion and have losses, otherwise you likely are not taking enough risk. More importantly, is what is done after the loss that determines long-term investment success. We engage in a post-mortem analysis after each investment to assess what went right and wrong, with an eye to where we could improve our decision making.

Scenario 3 – Exiting the Lucky Decision

“Better to be lucky than good”

Exiting the Lucky Decision is actually worse than Exiting the Incorrect Decision in which your thesis was wrong and the stock went down. In scenario 3, you were just as wrong about your thesis, but you made money, which provides a tremendous psychological reward. Lest the surge of dopamine lead you to become over confident about your abilities, a quick and timely exit is in order here as well. Again, this is another scenario in which an analysis after the investment will help you determine the underlying drivers of your success or failure.

Scenario 4 – The Unlucky Decision

Handling the “Unlucky Decision” is the hardest of the four to navigate accurately. Inevitably in any investing, and especially value investing, you are going to experience wide swings in a stock’s price. In looking at the moves between the 52-week highs and lows for stocks, it is quite common to see share price swings of 40% or more.

The point being, it can be tough to tell at the time whether or not the investment decision was a bad one, or if it was just poorly timed (i.e., “unlucky”). The recently reissued book, What I Learned Losing a Million Dollars, summarizes this situation well.

Authors Paul and Moynihan note that the stock market is unique in that there is typically “no predetermined ending point” when making an investment. If you were to look at a betting scenario, for example on a sports event, it is clear when the game is over and the balance is to be settled. Conversely, a purchased stock can be held for years or in perpetuity with no determination necessarily being made with regards to the success or failure of the decision.

So what can be done? Paul and Moynihan offer some thoughts we believe to be instructive. Note, they use the term ‘speculation’ here to mean any purchase made where you do not tend to hold till maturity (or for stocks, hold indefinitely).

‘Speculation is forethought. And thought before action implies reasoning before a decision is made about what, whether, and when to buy or sell. That means the speculator develops several possible scenarios of future events and determines what his actions will be under each scenario. He thinks before he acts…Before you decide to get into the market you have to decide where (price) or when (time) or why (new information) you will no longer want the position.

As part of the initial analysis, Paul and Moynihan recommend specifying in advance when you want to sell. This ex ante decision unlocks the key to knowing how to handle the stock that goes down but has not given a sign that your investment thesis is incorrect. Defining in advance the rubric by which the stock is going to be judged against whether it is right or wrong, allows the investor to dispassionately evaluate the stock in the event of an unfortunate decline, instead of reacting emotionally to the pullback in shares.

As the stock moves around due to new information and changes in the business, the investor can engage in a sensible re-underwrite process which compares the new information and changes to the original thesis and catalysts and determine if the ‘exit thresholds’ have been breached. If they have not, a pullback in value may present a wonderful buying opportunity.

So for the “Unlucky Decision”, there is no hard and fast rule about when to exit. Instead, it is going to be defined in advance and is particular to each individual company.

Concluding Thoughts

As we have written previously, “The end result of these steps is an investment process that is self-reinforcing in nature… The investment process itself becomes iterative (i.e., it ‘learns’ and ‘grows’ over time) and we are able to improve over time by cultivating best practices from successful investments and learning from mistakes made.”

A well-defined investment thesis and a well-constructed, carefully applied sell discipline allow the investor to capture the well-earned upside from a stock that performs, and hopefully mitigate the downside risk that can occur when a stock moves unfavorably.