Of our most costly mistakes over the years, almost all have been sell decisions.
The mistake, in virtually every instance, has been selling too soon. Reflecting on these mistakes gave rise to this letter, and its title, “The Art of (Not) Selling.”
Taking a step back, our investment philosophy involves concentrating our capital in a small number of what we believe to be growing and competitively advantaged businesses. These kinds of businesses are rare and are only periodically available for purchase at attractive valuations. With that in mind, we do our best to hold on for the long term, so that our capital may compound as the businesses grow.
Holding on means resisting the temptations to sell — and there are many. We tune out politics and macroeconomics. To the surprise of many, neither valuation nor price targets play a role in our sell decisions.
To be clear, there may be times when we believe it is appropriate to sell. In these instances, it is typically because of an adverse change in the business itself.
This determination to hold on is a critically important, and not always well understood, aspect of our investment philosophy. At its core, it relates to the power of compounding. We believe these two ideas — (not) selling and compounding — are inextricably linked. Getting the first wrong makes the second impossible.
Allowing our investments to compound uninterrupted is our North Star.
An illustrative riddle
You are given the choice between two sums of money: one million dollars or a penny that will double every day for 30 days. Which should you choose?
Here are a couple hints. The penny that doubles daily would be worth $1.28 after the first week. After the second week, it would be worth $163.84.
You will probably reason that the penny would be worth more than the one million dollars. (Why, otherwise, all the theatrics?) By just how much, though, might surprise you.
It turns out that after doubling 30 times, the penny would be worth $10,737,418.24!
This is a terrific exercise because it highlights the not-so-obvious power of compound returns (in this case, the penny compounds at 100% for 30 periods).
I say not-so-obvious because you would have been better off taking the one million dollars until the 27th day. But in those final four days, the value of the penny increases from less than $700,000 to more than $10.7 million. Patience and a long-term perspective are required to give the power of compounding an opportunity to do its magic.
Most do not naturally grasp the concept of compound interest. It has been called the eighth wonder of the world (first by Albert Einstein, supposedly) for good reason. Most of us have to learn to appreciate it. And even once learned, we have to remind ourselves periodically of its wonder.
From this riddle, we learn the importance of holding on so that we allow our investments to compound uninterrupted for long enough that the compounding effects we saw in days 27 to 30 have an opportunity to play out in our portfolios.
Politics, the economy, and valuation
We have learned to be very careful about the reasons we sell.
We try hard to tune out concerns about politics and the economy. We read the newspapers, and we work just down the road from Washington D.C. However, it has been our experience that we are at our worst as investors when we allow concerns about these issues, including elections, trade wars, and Fed policy, to influence our investment decisions.
In addition, we try to resist the temptation to sell (or trim, even) on the basis of valuation alone. We are unfazed when our businesses are quoted in the market at prices above what we would pay for them. It might be worth reading that last sentence again for emphasis.
Why? For three reasons…
First, when selling because of valuation, it is often with the idea that there will be an opportunity down the road to buy back in at lower prices. In our experience, it seldom works out this way.
Second, of the thousands of publicly traded companies, there are probably fewer than one hundred that meet our criteria, and opportunities to buy them at attractive prices are few and far between. Unlike average businesses that can be traded like-for-like on the basis of valuation alone, growing and competitively advantaged businesses are just too hard to replace.
Third, the very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.
Valuation plays no role in our sell decisions, and neither do price targets.
The underlying idea behind a price target is that every business has an intrinsic value and that the goal of an investor should be to buy at a discount to intrinsic value and sell when the discount has narrowed. It is compelling to say that you buy proverbial dollar bills for 60 cents and sell them later for a dollar.
With growing, competitively advantaged businesses, however, that proverbial dollar bill may be worth a dollar now, but we expect it will be worth $1.20 next year and $1.40 the year after that. When in possession of these kinds of businesses, we believe that you are much better off holding them for the long-term and allowing them to compound.
More compounding math
Let us assume you have purchased shares in a company and the price has doubled. In this situation, it would be normal to feel an urge to sell — to cash in, secure the gain, and take your victory lap. The following math might help you resist that impulse.
Having doubled your money once already, the next time the stock price doubles your investment will be 4x your cost. The next time after that, 8x. Then 16x. The key idea is that compound returns are exponential.
If your investment doubles 6 ½ times, you will have $100 for every $1 you started with. When this happens, we refer to it as a “100-bagger.” An investment that is worth 100x your cost is incredible to fathom. If you are fortunate enough to experience this firsthand, chances are you will become a true believer in the power of compounding.
The times to sell
Even with the power of compounding firmly in mind, there may be times when we believe it is appropriate and necessary to sell. These include, but are not limited to, when a business (1) is no longer growing at an above-average rate, (2) has had its competitive advantage impaired, or (3) has had an adverse change in management.
Slowing growth. Our foundational idea is that our returns as investors will approximate growth in economic value per share of the businesses in which we invest (whether defined by book value or free cash flow, and always on a per share basis). To generate above-average returns over the long term, we believe we must invest in businesses that are growing sustainably at above-average rates. When growth slows, we expect our returns will as well.
Loss of competitive advantage. Businesses are in a constant state of change. Changes in technology, distribution, or regulation might whittle away at a business’s competitive advantage. Even the most successful companies must reinvent themselves periodically to remain relevant and adapt as the world evolves around them. The moat must be dredged every now and then. Failure to do so may cause competitive advantage to weaken or disappear altogether.
Management. We place heavy emphasis on identifying managers who possess equal parts skill and integrity. A consequence of our long-term investment horizon is that we tend to own businesses for multiple generations of management. Successors are not always up to the task. We have learned over time to withhold immediate judgement to give new management plenty of time to get settled in. However, at some point, we have to make a call, and a new management team that falls short of our expectations might cause us to sell.
This is not an exhaustive list. In very rare instances, we might sell so we can free up capital to invest in what we believe is a better business. Beware, however. Selling something you know well to buy something new that seems better is a dangerous game. We have been bitten by this more than once.
It is also always possible that we just change our minds. The process of getting to know a business takes time, and we sometimes uncover new facts or form new opinions that overturn our original reasons for buying. This usually happens with newer additions to the portfolio.
The antidote to the noise
For the investor determined to hold on and compound, tuning out the noise is essential.
Quarterly earnings (are slide decks and conference calls really necessary every 90 days?), the financial press (cable news, in particular), and Wall Street analysts contribute to the cacophony.
It is important to keep in mind that the financial press and Wall Street live on eyeballs and transactions. They are, by definition, trying to maximize the noise—to convince you to sell what you own and buy what you do not.
In his book “100 to 1 in the Stock Market,” Thomas Phelps advised:
“Never forget that people whose self-interest is diametrically opposed to your own are trying to persuade you to act every day.”
He wrote that 47 years ago in 1972, and it is probably truer today than it was back then. Wall Street trading desks do not earn commissions when you buy and compound, and the cable news channels do not attract an audience by saying “there nothing new to report today.”
Here in our Middleburg offices, our only television is in the conference room, and it gets the majority of its annual usage during NCAA March Madness. (Our CFO is an avid Tar Heels fan!) Cable news is not our ambient noise. We think it is bad for your economic health.
In addition, we try to develop an understanding of what really matters for each of our portfolio companies.
We endeavor to look past the non-essential details. We want to identify the essence of each business’s competitive advantage. It is a challenging process but the rewards are worthwhile. We can far more easily assess the relevance of new business developments once we are armed with our understanding of what really matters and what does not.
Quarterly earnings reports, for one thing, become much less of an event. So do short seller reports, newspaper headlines, and analyst downgrades.
In our experience, this kind of refined understanding is the best antidote to the noise and helps provide us with the fortitude to stay the course and allow our investments in growing, competitively advantaged businesses to compound uninterrupted.
After all, we always try to keep in mind just how much that penny is worth after 30 days.