Selling an Important Part of Portfolio Management
It has been very close to a year I have been writing on this blog. Almost on all occasions I have discussed about buying and holding my position. I have said multiple times that I tend not to sell my positions. There have been multiple questions about why not book profits? Why not sell profitable positions and invest in other opportunities? Before I discuss on selling any positions, let me clarify, I do not blindly believe that buy and hold is holy grail for long term investing. I have no misconception about “not selling” any positions. In any system (eco-system, car, machines, or even our body), there are multiple elements and each have a role to play. Similarly, in portfolio management process, selling a position is also very important, and hence it cannot be ignored. In my process description, I have captured this part as ‘exit plan’.
When do I sell?
Simply put, it is a very subjective process. I could sell for any reason such as:
- To minimize my overall portfolio downside risk;
- To deploy capital in much better expected opportunity; and
- Something changes about the company
Just because I sell a given stock, it does not necessarily mean it is bad company or it will not give future total returns. My decision to sell is very objective in the context of my portfolio alone.
In 2009, I sold two positions, viz., GE Shipping and Reliance Infrastructure. I have already mentioned why I sold GE Shipping. You may read my reasons to sell GE Shipping in my quarterly update and stock analysis. Selling GE Shipping was driven by lack of discipline and correcting missteps.
The close look at my portfolio will show that I have few stocks that are very similar such as NTPC, Power Grid, LNT, and RELINFRA. All of these companies are somehow related to power generation, power distribution, EPC contractors, and infrastructure build-up (roads, ports, metros, etc). In 3Q09, all four of these positions had a combined total market value of 35% in my portfolio and 25% of my dividend income. If something goes wrong, like credit squeeze or economic slow down or delays in infrastructure projects, I will face headwinds which would pose a risk to my portfolio (from both aspects; market value and dividends). So I needed to re-balance. Either I do not buy any new positions, or I sell partial positions, or pick one and sell my position completely.
I did not consider NTPC and Power Grid because both of these stocks have relatively smaller positions and are within my risk limits. On the other hand, LNT and RELINFRA have large positions. When I started thinking about what should I do, I started with an assumption that I will partially sell positions in both stocks and bring both of them down to my risk limits. I looked into both LNT and RELINFRA very objectively. Let me discuss.
Revenue vs. Debt: LNT profile is much better than RELINFRA. LNT has much higher revenue relative to debt on its balance sheet. On the other hand, RELINFRA has very high current debt relative to its revenue. This is primarily because RELINFRA, in essence, is a new company attempting to diversify into infrastructure projects. It was originally focused only on power sector. In last few years, it is getting into roads, ports, metros, urban development projects. Infrastructure projects have longer gestation period, and hence it takes time to realize the revenue. However, at this point in time, LNT has positives (while RELINFA gets negatives).
EPS vs. Dividends: LNT earnings per share have grown at an average of 48% in last five years, while RELINFRA growth was at an average of 26%. Similarly, the dividends of LNT have grown at 29%, while that of RELINFRA it was only 15%. The reason I only look at last five years is because, RELINRA really started diversifying from that point onwards. Here also, at this point in time, LNT has positives.
Revenue and Debt : LNT vs. RELINFRA
Cash vs. Debt: Cash is something that is not very easy to determine for an infrastructure company. There is lot of places/accrual accounting where cash gets locked in before it is realized. Therefore, I assumed that all sundry debtors will pay out their share. I determined total cash = [operating cash flow] + [sundry debtors] + [reserves]. The Chart 2 below shows the total cash relative to debt. One can observe that LNT cash position vis-à-vis debt is much better than RELINFRA.
Cash Flow: LNT vs. RELINFRA
Margins: The Chart 3 below shows gross margins and net profit margins for both companies. Here, also I am only looking at last five years only. The margins at LNT are much more stable. It follows the general observation that gross margin should be more than net profit margins. However, in case of RELINFRA, the gross margins have reduced from 19% to 2%. What I do not understand is the how can net profit margins be higher than gross margin (unless it is typo? – I am open to inputs here from readers of this blog). At this point in time, here also, LNT has positives.
Margins: LNT vs. RELINFRA
Qualitative Perspective:
LNT is pretty much well established in infrastructure business and management has been showing performance over last few years. It has remained focused in its area of expertise i.e. infrastructure, urban development projects, large process equipments. Most recently, it has been attempting to diversify into power equipment, nuclear power plans, defense, power development projects, and forgings. I view LNT as a stable and low risk company in my portfolio.
RELINFRA is part of ADAG group, and focusing on power generation, power distribution, EPC projects, roads, bridges, metros, etc. In my view, this company is entering an exciting growth phase. In last few years, it has made significant investments in multiple projects. It has taken on lot of debt. Thus, the present shows negatives relative to LNT. There is an expectation that once these projects break even and start generating revenue, the profitability will increase and hence the value of its business. I agree to this expectation.
In addition, the company has been buying back shares for last two years. This can be interpreted in two ways (1) in short term; buying back shares increase the EPS. This is pretty much evident in chart 1, where EPS is increasing without corresponding increase in revenue. (2) in long term; it is possible that in present environment, management views its share value as depressed. Buying back now will give it a higher percentage ownership. Three or four years down the line, when the company shows increase revenue and profitability, at that point in time, they will have something to sell at higher price.
Now let me expand this discussion to ADAG group. A much diversified group that includes telecom, infrastructure, capital financing, and entertainment. Telecom, Capital, and Infrastructure are companies with significant debt on their balance sheet which I do not like. Furthermore, I am not a fan of conglomerates with such diversity.
The key observation for me was; RELINFRA has future expectations with debt filled balance sheet. LNT is known performer with a good balance sheet. To top this off, market pricing for RELINFRA was above my fair value price. I decided to sell this stock. Had it been below, I would have continued to hold and would have waited for appropriate time.
All said and done, I held RELINFRA for 4.8 years, with LTD of 136%, XIRR of 20%.
GE Shipping, LNT, portfolio management, RELINFRA, selling stocks
This is a great post, it has changed the way I am thinking now
Very interesting. I also hold the opinion that exiting a position for profit booking may be ok once in a while. But it is just an opinion. It also means you take the risk of missing potential growth of that company.
Hello Siddharth,
I am very intrigued by the concept of profit booking! To me, profit booking is short term, and very much applicable to trader philosophy.
In long term, its the capital allocation, and where you expect to have optimized return (best return w/ minimum downward risk).
Best Wishes,
What I mean is if the stock price is such that it is overpriced, it may make sense to sell it. There may be peers who may be undervalued that are good to invest in. It is somewhere in between value investing and trading philosophies.
got it!
good that u blogged on this topic
i had asked the same question to rohit chauhan
despite reading both ur blogs things are not very clear to novices like me
mylatest resolution is to hold the stock for 3 yrs.trade it partly for consolation.reconsider selling later- a motley fool advice
also introduces patience as avirtue foe long term investing
Madhu,
I do not sell based on time, i.e. how long I hold the stock. Time is not a factor. I sell because of three reasons mentioned in my post.
you should sell based on what is your objective are. what you want to achieve from your portfolio.
Best Wishes,
Hi TIP Guy,
While reading your post I was wondering when you will talk about the current valuations or whether you will skip it altogether. Finally, you did touch upon it in last paragraph.
I have a question though, really how important the valuation is for you to make a sell decision. To me it sounds like it does not matter to make the decision but only matters to decide when to execute sell, did I get it right?
To put it differently, will you ever sell L&T say in next one year if Mr. Market is offering to buy at double/tripple of current price? I know you made it clear many times that profit booking is for trading and not for long term investing so has no place in your strategy, but can’t resist to check once again
I tried to ask you the same question earlier and you suggested that you would anwer through a post. So even after this post I am still looking for that answer. In the case of extreme overvaluation will you sell to book profit
, take advantage of your knowledge of fair pricing and market sentiment, etc?
Thanks for the post!
~Sachin
Sachin,
you got it right. Valuation alone is not very critical to make a sell decision. But yes, valuation does have affect on execution.
I listed three points which trigger sell decisions (portfolio risk, better opportunity, or change in company fundamentals). In above example, there could have been multiple scenarios:
(1) LNT had come on negative side, I would have sold LNT.
(2) LNT and RELINFRA, both came good, I would continue to hold both. I would take risk of took much exposure in infrastructure, because companies are strong fundamentally.
(3) i described in my discussion in the post. RELINFRA was weak, so I sold.
Now, if LNT cuts dividend, or reduces significantly, I would sell it (either partially or fully)
My cost basis in ONGC is zero (it paid me my original capital in dividends), NTPC (approx 25%), pidilite (approx. 55%), LNT(approx 33%), ABB (15%). So if I expect to continue the dividend stream, it would be like investing in a business. My capital is fully returned. And I still continue to reap profits out of it (either dividends or my portfolio value).
If the business is good, and I continue to expect value to increase, I will continue to hold it.
Now, some of my stocks have really given me bountiful LTD returns. Therefore, I have started thinking about taking my original capital off the table by selling partially. Take that cash and add it to the pool of new purchases. Still thinking about it. Working on trying to figure out its implications (lowered dividends, lowered YOC, low capital for dividend reinvestment, etc etc….)
Hope this answers your questions, if not shoot another one.
Best Wishes,
very interesting……one quick question does your XIRR includes dividends as well..
Hello Marshal,
Yes, XIRR includes dividends
Best Wishes,
Hi TIP Guy,
Thank you for response.
~Sachin
hi tipguy,
it looks like there is lot of subjectivity in your selling process. This is quite contrary to your buying process, where you a very meticulously devised method, that you seem to follow with discipline. Is this correct interpretation?
I am still not able to grasp when you book profits. The market value that you have today (say 1000) can reduce in future (to say 700). In that case, you lost an opportunity to compound your returns?
Thanks in advance for your thoughts.
hi tipguy,
i m back again. today was first time i visited your blog via google search. i like your style of experience sharing instead of claiming expertise and clamining to help others.
one request, may be too much to ask. do you have an ebook of all articles, which I can print and read it without internet access? or save it on my computer to be reading later. I do not have alltime internet access.
Thank you
Hi Tip guy,
After having asked for this post for a long time, its not fair that I dont even leave a thank-you note, or….a few follow-on observation / view / notes!
If one were to condense the 3 points above into a single one, its the Risk-return ratio.
1. Risk to portfolio
2. Improve return on portfolio
3. Again, its the risk/return curve here…
In sum, maximise the Return/Risk ratio.
In case described above, the decision path seems to be:
1. Risk to portfolio is high because of concentration
2. Reduce risk and allocate capital elsewhere, with perhaps the same or better return
Everything after that decision is just evaluation of one company versus another to finally arrive at the scrip that will be sold.
So, here Tip Guy can indeed claim that the risk analysis / sale decision is from portfolio angle alone, i.e internal or inward looking with no bearing on external factor.
It would be interesting to see where the discussion would have taken, had we looked at a different transaction from a return perspective. That is, to maximize efficiency in capital allocation. Then, Tip-guy, do you think market price would have played a part? I just tried to make out a discussion on those lines….its very interesting conclusion.
Cheers,
Arun
With reference to Reliance Infra, I have following reference quote from Phil Fisher…
“Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear”
It is for this reason; I am continuing to hold Reliance Infra. Your explain that selling does not necessarily mean it is bad, saved the day for me. I do not hold LNT, but I do have a position in Reliance Infra. I am hoping that based on above quote, this will give me far more profitable returns.
What do you think, does it make sense?
Hello Anonymous,
I think you made a right decision based on your own personal situation. And the important thing is you are trying to practice Phil’s qoute. Unlike many others who just like to quote them (but scared on practicing). Good Luck.
Best Wishes,