When to Sell: A Workshop with Ellis Traub

Session 4

Yay, Defense!

When we speak of defense, we think of protection from harm or prevention of loss, and, whether you’re at war or on a ball field, it is the most urgent need.

So far as your portfolio is concerned, those attributes certainly apply. We are interested in preventing ourselves from suffering any financial harm or loss; and we want to protect our portfolio from loss, don’t we. So it is urgent; and it should be regarded as critical to our success as investors.

What is it that we’re concerned about? Protection from what? While I prefer to regard the venerable “Rule of Five” as a positive thing (the half-full glass, if you will)…”Out of every five stocks you buy, one will do better than you expect, three will do about as you expect, and one will not do so well!” There are, of course, others whose pessimistic outlook would translate into, “Out of every five stocks you buy, one of them’s going down the tubes!” Defense has to do with that one out of five that inevitably threatens your portfolio’s performance if you let it.
When we buy our stocks, we will have satisfied ourselves that the underlying company’s track record of consistent and strong sales and earnings growth has a good chance of continuing as it has in the past. We’ve assured ourselves that the company’s management is capable of continuing that growth because they are operating efficiently (no down-trend in profit margins).

As long-term investors, this is our only concern because our investment will grow at the same pace as the company’s earnings. So all we need to do each quarter is to find out whether the new information that’s now available confirms that the company is continuing to grow as it was when we bought it. If it is, we won’t worry about it until the next time data becomes available. What could be simpler?
Our defensive task has absolutely nothing to do with the price of the stock! I’ll say it again for emphasis: Our defensive task has absolutely nothing to do with the price of the stock! It deals with the Quality issues only: earnings growth and operating efficiency. And we can see that on a growth chart (the SSG or “TSSW”) at a glance.

Those who don’t know any better will want to set a target price. We who do know better set a “target return.” The former is a static target and, when you reach it, you’re expected to sell. The latter is a moving target. and, so long as you hold onto the stock, as the earnings rise, the price of the stock will also rise (with the dips and spikes caused by those who collectively make the decisions for a capricious stock market). And the potential return should remain fairly constant.

Note also that the hypothetical, potential return rises as the price of the stock falls and vice versa. So, assuming all the fundamental quality issues are sound, your reasons for holding it (or buying more) increase as the price falls. Of course, the reverse is true as well; and we’ll talk about that when we discuss Offense tomorrow.

Why don’t we want to sell when the price reaches a predetermined value? First of all, you own good quality stocks whose value will continue to increase as the company’s earnings increase. You’ll always be able to sell that stock at a reasonable multiple of its earnings.

Secondly, what are you going to do with the money you get from the sale? Well, after you’ve paid a commission for the sale and incurred a tax liability on the gain, you’re going to look around for another stock to invest in and pay the commission on the purchase! And they, what are the attributes you’re looking for in the new investment? They’re exactly the same as those of the stock you just got rid of! Does it make any sense, then, not to hold onto it, save the cost of the transactions and defer the tax liability until later? Of course not!

So, what process should we follow, and what tools do we have to work with?
Here’s the simple process:

1. Update the company data. Since the occasion for our doing this is that new data is available, we need to update the data and create a new SSG/TSSW or stock study.
2. Review/update the SSG. Look at the growth chart to see if it looks  substantially as good as it did when you bought it.
3. Keep it, if the growth continues at close to the same rate.

If growth has declined significantly:

1. Check PERT-A (graph) for trend. Or, if you don’t have the PERT-A form available, look at the quarterly sales, pre-tax profit, and EPS data to see if you can spot any kind of downtrend that arouses your curiosity. If you see a small decrease in year-to-year growth (look first at the percentage change between the trailing four quarters and the same period a year ago, then at the quarter-to-quarter change), you might let management have a chance to correct the problem. After all, you went to a lot of trouble to “hire” a management that could handle problems, not just be successful when things are rosy.
   
   Your first item of business should be to look at sales growth. It is the least likely to change abruptly because it doesn’t have the plethora of expenses that can cause such change. And, if you can catch a downtrend before it has reached the earnings line and everyone else has been spooked, you can often save yourself a good bit of money. Next look at pre-tax profits. Again, if you can catch a problem there before the rest of the world is aware of it, you’re better off. Finally, of course, you look at the bottom line. If the problem has caused a decline in earnings growth, it’s probably already too late to catch it before you suffer a loss. So you should sell as soon as possible, cut your losses, and get your money working again as soon as possible.
2. Research the Internet for reasons. Surf the Internet to find explanations for the problem. News items on financial web sites—especially those in which the management has announced their results for the period—will reveal their views of the problem and often tell you what they are doing or plan to do to correct it. Analysts will offer their opinions too. A little common sense is all you need to decide how credible the information is. If the answers make sense to you, then that’s great! You can act accordingly. If they are obscure or don’t make sense, or you think they’re over your head or not credible, when in doubt, throw it out!
3. Sell if it's a long-term/serious problem. If you’re satisfied that the problem is likely to be a long-term or serious one, then sell the stock without delay and put your money into another company in which you have more confidence.
   
   At this stage of the lesson, someone invariably asks, “How many quarters should you give management to correct the problem?” Again, that’s a common-sense thing. When you have lost your confidence and begin to doubt, throw it out! Obviously, the less of a departure from the original growth rate, the longer your patience can last. That’s why I prefer to look at the trailing twelve months instead of the single quarter. Only when a single quarter displays enough of a decline in growth to impact the entire 12 months do I get worried enough to dig into the problem and find out what it is.

Note that we no longer consider it necessary to use the PERT form for these tasks. Since the SSG or “TSSW” contains all of the information you need for these decisions; and, since the PERT does not make any distinction between those companies requiring attention and those that don’t (which makes it very confusing), we will view that form only for its ability to consolidate information and not as a tool for implementing the strategies.

While we don’t want to sell our stocks capriciously or prematurely, we also don’t want to hang on to those that fall into “that twenty percent” any longer than we must.
Tomorrow: Going on the Offensive.

 

Ellis,

Thanks for doing this workshop.  It took hearing this type of explanation of the Pert-A Graph a few

times for me to really understand it.  I'm glad Jeannie asked the question and I think Lowe's makes

a good example to use.  There have been two more quarters of data since the example you used where

sales, earnings, and pre-tax profits have declined quite a bit.  Could you take a look and give us your

interpretation of the Pert-A Graph with those two added quarters. 

Every time I see this explained I learn a little more.  Thanks.

Eric

Keep in mind that with LOW for some past years (FY 2002, for example) the quarterly data does not add up to match the annual data (not even approximately).  So, for example, you won't find the negative EPS growth shown on PERT-A for FY 2002 if you look at the SSG Visual Analysis graph.

-Jim Thomas