Using the spectrum to sell
Continuing in our theme of answering unanswerable questions, we last week reviewed a model which can aid investors in entering a position, but what about getting out?
As we discussed previously, it makes sense for an investor to enter a position on the basis that the growth prospects for the stock upon a careful review of the available information are well in excess of what the market price implies.
The reverse of this process is to sell when the market price implies growth expectations well in excess of what the competitive environment would allow/what the firm has capacity to deliver. For example, if we make an assessment that our base case for the firm is around $10 a share based on an anticipated earnings growth rate of 10 per cent p.a. for 10 years and suddenly the price rises to $15 which we find would require 15 per cent growth for 15 years – then we might feel less comfortable with the investment.
If we then consider that such growth would require say (hypothetically) a competitor to leave the industry – of which there doesn’t appear to be evidence for, then clearly we’ve got a strong case for liquidating our position.
The entry/exit decision for a position in not necessarily however a binary decision (i.e. either you’re in or out). The rational investor would be inclined to own more stock as we move down the spectrum and less as we move up, i.e. owning more or less stock on a quasi-continuous basis.
Institutions such as Montgomery and others are able to this sort of action since, transaction costs are relatively low and done on a percentage basis. For the average retail investor the process is more difficult since it’s costly to sell down say 20 per cent of a $5K investment and pay $20-$30 in brokerage (i.e. a transaction cost of 2-3 per cent just to partially exit). In this case, the frequency of such actions is simply reduced.
We’ve discussed our case for selling so far only with respect to the base case. The other case that we must give regard to is the low case. Clearly if we have two investments, A & B both with valuations of $10 but A having a $8 low case valuation and B having a $5 low case valuation, clearly we’d sell B more quickly if it rose through $12, $13, $15, etc since our exposure to capital loss on the downside is higher.
Our utilisation of $15 in the above example isn’t intended to be a hard and fast rule, indeed there’s some theory we can speak to about high cases….stay tuned for the next post.
Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.