When to Sell: A Workshop with Ellis Traub
Session 5
Going on the Offensive
The Offensive side of portfolio management is, as you might expect, quite the opposite of Defense. Whether in a war or a ball game, a good defense will keep us from losing; but it takes a good offense to make us a winner.
Offensive tasks have no schedule and can, in fact, be performed any time the spirit moves us. And there is none of the urgency that characterizes the need for defense.
Unlike defense, offense in this context has everything to do with the price of our stocks. And, the higher the market, the more likely it is that you can profit from the effort.
The short-term movement of stock prices, up or down, is caused by the collective wisdom of the universe of investors who make the market; and, as a body, they have precious little! Any event—or rumor of an event—can cause the market to move in either direction, especially if that event happens to scare one of the institutional investors who control large quantities of stock. All it takes is for one respected guru to make a move either way, and the rest of the lemmings will follow blindly. So the market moves when people (not wizards who can predict the future) conjure up opinions as to what effect any event next door, around the world, or out in space will have on the economy.
We are interested solely in the return we can get on our investments. And, when the market goes up or down for reasons other than a change in the fundamentals; i.e., the operational factors that affect earnings growth, the price of the stock can fluctuate as much as 50 percent either side of the average PE at which the stock typically sells.
Since the growth of our investment is tied to the company’s earnings growth, it represents a steady and slow increase. When the market goes irrationally down, the potential return were we to purchase that stock at that time, would go up. Therefore, down markets are good times to buy more of what we own and are confident about.
However, the best opportunity to be aggressive and pro-active in enhancing the performance of our portfolios is when the market is on the high side. Assuming we’re looking to achieve a 15 percent return on our portolio. To make it easy to see the point, let’s assume all of the stocks we own, today, are selling for a price that would give us a fifteen percent (compounded, annual) return should they, in five years, go up to our projected high price (calculated by multiplying the forecast high PE by the projected earnings five years out).
What happens if the market raises those current prices substantially? Suddenly, the difference between our current price and the projected high price for each of those stocks has collapsed. Let’s say that difference is cut in half. In that same moment, the potential return on those stocks is no longer 15 percent. It has declined to only 7-1/2 percent—hardly a return on our investment that is of interest to us!
At the same time the return fell, the risk rose. And the Upside/Downside Ratio or Risk Index will decrease or increase respectively to the point where there is probably more risk to the investment than there is potential reward. Obviously this is not a healthy scenario either.
We are still looking for a 15 percent return on an investment that offers that return at a reasonable risk. If, at that moment, we could find a stock of equal or better quality (growth and efficiency characteristics) that had a potential return of 15 percent and reasonable risk, would it not make sense to sell our stock and put the money into the other so we could make our 15 percent on that money rather than the 7-1/2 percent we would get if you held onto it?
That’s precisely what Offensive management strategy is. When we can realize a substantially better return on our money than we can get from a stock we hold, we are wise to replace it. This is what we must do if we hope to achieve and maintain that 15 percent return we’re looking for.
There is, of course, a simple, coherent process for doing this; and here it is.
- Update the prices. As simple as it is to do in the software, we should update our prices every time we start a session. However, if we’re not dealing with software and are doing this by hand (perish the thought!), we can update the prices only of those stocks in our portfolio. If we're doing it by hand, it isn't difficult to calculate the return and risk based upon the higher price.
- Review the SSG or “TSSW” to ascertain the potential return and risk. Look for returns that are unsatisfactory and Upside/Downside ratios of less than 1:1 (Risk Indices of 50% or higher)—the point where the risk exceeds the potential reward. For such companies,
- Revise your estimates of earnings growth and forecast PE upward. This may come as a surprise; but, when we purchased the stock, did we not deliberately set modest estimates to avoid unpleasant surprises? It was conservative to do so; and, since we now own the stock, it’s conservative to take steps that would help you avoid selling it prematurely.
The odds are that your company was, and has been, growing comfortably above your earlier estimate; and, it is also possible that investors are happily paying a higher multiple of earnings than you chose to forecast they would pay. So, what I do is to split the difference between my modest estimate and what is actually happening. Where I might have capped growth at 20 percent, and the company has been growing its earnings at 30 percent, I might estimate earnings growth now at 25 percent. This will allow me to take advantage of the actual performance and still leave me some room should the growth rate decline.
The same logic serves for the PE forecast. I may have estimated it at 25 times earnings while investors are paying a multiple of 35. I’ll set it up to 30.
There is a very strong likelihood that the return and risk will fall back into a territory where they are acceptable; and you can continue to hold the stock and enjoy the benefit of superior performance. Just remember, however, that there is now much less of a margin; so you will have to be a little more sensitive to further rises in the price and their accompanying decline in return and increase in risk.
If resetting the growth and PE estimates does not alter the reward and risk potential sufficiently, then
- Replace the stock with another company of equal or better quality and having a better potential return with less risk. Obviously, it would be a good idea to maintain a “watch list” of stocks whose quality you have determined to be excellent but whose prices may not have qualified them for purchase. Hopefully, when the opportunity arises to replace those with insufficient return, you will have a good selection to choose from, ready and waiting.
That’s all there is to Offense! Simple enough, isn’t it.
Tomorrow, we’ll take a look at the wonderful tools now at our disposal to handle all of our portfolio management chores.