Selling Is Important – Continuing the discussion (II)
In my last post, I discussed about my fair valuation for buying and how it would be likely different than selling value. I tried to make a case that I would like to minimize my cost basis and maximize my sell price. Buying is easy because minimizing cost basis is under my control. Nobody can force me to buy high unless I want to do it, right? However, when it comes to selling I do not have any control. Like everybody else, I would like to sell high, but there has to be somebody willing to pay for it? And hence, it is little bit of subjective.
Furthermore, I identified three companies viz. HDFC Bank, Pidilite, and ABB, as stocks that I would consider as fairly valued for selling. OR likely to be tad over valued. I do not consider them to be extremely overvalued. In this post, I do not intend to discuss (or present an argument) what would I consider over priced or extreme overvaluation. No two people will come up with same conclusion.
For this discussion, I will consider them over valued and hence I will sell. These are around 30PE ratio (assuming 20PE being fair value). Selling them fully will give me a cash position. Selling all three of these will give me close to 40% cash position in my overall portfolio.
Following is the performance metric as of today. YOC is yield on cost, and RofC is return of capital by means of dividends
- HDFC Bank: 4.19% (YOC), 15.5% (RofC)
- Pidilite: 10.5% (YOC), 56.0% (RofC)
- ABB: 3.76% (YOC), 16.2% (RofC)
- Cumulative weighted YOC for all three is 4.23%
When I sell these positions, I will incur long term capital gains tax on HDFC Bank and Pidilite (and not on ABB). Let us say, the total capital I receive from sale of all three positions is 100. The total tax comes to 13% based on weighted contribution. Thus my capital is now at 87 after taxation.
- To get back to my 100 value, I will need 14.5% appreciation, just to get back to my original value. So I will need to find companies that will give me 14.5% return. That is the typical return I expect in one year. So I am already one year behind. If I hold on to cash longer, it will take longer to recover. I am not even considering growth aspect yet.
- Considering the risk profile I have, I will not be putting all 87 that I receive into just one stock. I would like to diversify them into at a minimum three different stocks. This adds to my challenge of finding at least three opportunities that will give me 14.5% return.
- I do not expect to get more than 1.2% dividends on my new investments. The cumulative dividends at 1% is still much lower (about 35% lower) than actual dividends I receive on YOC of 4.23%. So my dividend reinvestment slows down. Total dividends per year is at that critical mass where I buy one stock every year from dividends.
Challenge from me….
It is my desire to buy three to four new stock positions every year based on the new cash that I allocate every month. This adds up to opportunities I need to look for. I will need eight to nine new positions.
- It is highly likely that I will end of holding more cash. I already hold high percentage of new allocated cash. I do not want to add to this cash from portfolio. It will reduce my overall returns in long term.
- I expect that all these existing three companies (HDFC/Pidilite/ABB) will show 14.5% per year average EPS growth over next 5 years or so. So what would I achieve by selling these position? Sell this position (which I expect 14.5% returns) and buy something else with the same expected returns? To refresh, when I buy a new stock, I expect XIRR in the range of 12% to 18%.
- One could argue that the capital base will be higher. So baseline is higher. But wait a minute! The average growth expectation from existing companies is also y-o-y, and not lower capital base of 5 or 10 years back? So what would be the difference?
- I cannot base my decision only on probability of higher returns; one has to look at the downside too. Hence, there is a 50/50 probability that existing stocks or new stocks would give me either higher or lower returns.
- In next four years, I expect YOC from these existing positions will exceed 8.5%. The cumulative dividends that I receive from this 8.5% YOC would be much higher than YOC of new investments in 4 years time. Keep in mind all dividends are tax free.
How much higher capital base?
30PE gives me 100 value (effective 87 cash after taxes)
20PE gives me 83 value (effective 72 cash after taxes)
In short, I will get 15 (=87-72) extra cash which I could use for new stocks or compounding. Now, I already expect that these three existing companies will provide me similar level of growth in next few years. So why would I want to take added risk of looking for new opportunities?
After looking into the extra capital base selling would give me, challenges for me to deploy that extra capital, my risk profile, and my investment strategy, I find it more advantages in continuing to hold these three stocks. I ignored black swan scenarios.
This discussion becomes mute in following cases:
- Belief that 30PE is extreme or insane valuations. I consider it extreme if future growth expectations are in single digits. But not extreme for growth expectations of up to mid double digits.
- Belief that existing three companies will grow in single digits. Belief that 14.5% growth is too high for these companies.
- Belief and high level of confidence that one can deploy cash at expected return of 18%+ with sustainability. Any such higher return expectations should also consider down side risk. My investment process does not capture or identify such opportunities.
- PE of 40+, or 35+ ?
Epilogue
I consider selling a difficult process. I always had a feel (or mental map) of why it makes sense for me to what I am doing. But I had never put it down on paper. The questions/comments/conversation on this blog forced me to. I was surprised by the fact that it comes close to my abstract thought process. This has been one of the most enriching experiences from this blog. I have had few takeaways from writing these articles on selling. They are significant outcome which helped me tweak my investment process and hence, it deserves a separate post.
The key message to take is; look in the context of what makes sense for you, weigh it in from your own risk profile, your own capabilities, etc. Go for it when you have confidence that higher capital base gives you potential for higher overall appreciation. Just be cognizant of downside risk. It is my belief that if I manage downside risk, then upside potential will automatically take care of itself.
selling process, selling stocks
Hi Tip, your thought process is highly appreciated. I have to read the post couple more times to fully understand it. May be a partial sell to increase the capital base and still continue to hold considerable the position would be good… giving the growth from proven stock as well as having bit extra room for any new stock/ even purchase of the same stock at a lower level (In this case you do not have to do a re-analysis, as the stock is already analyzed) thus compounding the effect. Also if you could develop an excel, which is at the whole portfolio level and individual stock level (with may be option for cash positions may be take it as 3.5% return only) decisions could be made faster…. Like in front sheet have the P/E column to check which one getting over-heated (may be high light with some color) and then a column to try a sell (quantity) put diff numbers to which one suits better …. May be these could be helpful… and then may be decisions could be made faster (just a thought)…. I really appreciate your systematic approach and will to stick on to it (which many of us dont have… after a while we go back to trading
)
Hello Young@Market,
I have been looking into partially selling to get my original capital + expected growth. Which is again a concept of profit booking. I tend to look at full capital and not partial. More on this later.
I do have an excel workbook (individual stocks + cumulative at portfolio level). But the question to you is; is PE the only parameter to decide overvaluation?
Best Wishes,
TIP Guy,
Awesome post… number one in my opinion, demonstrating your unique systematic approach. Maybe I liked the most because I have been involved with it even before it was written
Here is some more food for thought….. please look at it as if I am wearing a ‘black thinking hat’ to encourage discussion and learning. (comments are made to the points as in the flow of the post).
1. In long term potfolio why expect 14.5 return in one year. It could be lesser in some years as long as you are able to deploy in a business that is good and has potential for better long term returns. You may have to wait for a while to spot it.
2. Number of positions in portfolio–do you have any guidelines on limit. Your intention of adding 3-4 NEW positions could lead you to larger number of stocks in portfolio. Why have this target on number of NEW positions per year rather than linking it to your risk management?
3. Holding more cash–hey you said it more than once that you are not afraid of doing it
4. You expect these companies EPS to grow by 14.5% or more. Hey don’t forget one of the perspective was to cash on the economic cycles and so the volatality in the market price. I am sure you definitely don’t expect market prices to grow only in one direction by 14.5%. In short, you would get cheaper price for these same companies in future when Mr. market’s mood changes in your favor. Till then you enjoy fixed income that is more than your YOC.
5. Your future YOC of 8.5% – you can not directly compare with YOC on new investments because here the capital base will be much higher.
6. I like you making note of the points that will mute the discussion. It really saved couple of comments from people like me
I think my abstract thought process of ‘sometimes selling makes sense’ is purely with the belief that one can really spot the extreme overvaluation in general market or in specific stocks at the appropriate time. Now it is a good question how true that belief is, frankly speaking I do not know
Your thoughts are welcome!
The discussion has been highly enriching and rewarding. Thanks.
Cheers,
Sachin
TIPGuy
I am in a small confusion over Hawkins or Hyderabad Ind. OR Both.
My calculation & projection for both as follows
Hawkins
- Expected NPAT FY10 35 Crores, i.e EPS 66
- 5 Years AVG Dividend Payout ratio is 60%
- That means 21 Crore payout in FY10
- With 53 lacs Outstanding shares, Dividend can be Rs.40/share making yield of 5.71% on CMP 700.
- Current PE is 20, This has been moving in higher range of 15-20 since recently..
- With conventional PE of 10, CMP 700 is little bit overvalued. But Optimistic PE of 15,EPS 66, CMP is discounted by 40%.
- with EPS 66, PE 15, Hawkins price can be seen at Rs.900 within 6 months.
Hyderabad Ind.
I know this is not in your watch list. but still I am seeking an opinion from you.
- CMP 600, PE 10.20, 5 years avg dividend payout is 20% to NPAT.
- FY10 EPS is expected at Rs.110 hence CMP is at PE of 5.45
- @20% dividend payout ratio, FY10 Dividend should be around Rs.20-25. (Rs. 6 Has been paid already)
- At pessimistic FY10 PE of 8 price would be around 880 and at optimistic PE 10, FY10 EPS 110, price would be anywhere around 1100 within 6 months
- So i feel that in this scrip good returns from 40% to 80% can be earned with good dividend yield.
Your comments please
Thanks in advance.
MIP
Hello MIP,
Regarding Hawkins: Per my calculation, avg dividend payout is 54% (SD 7%) for last five years. I believe looking at last five years only is very optimistic. Based on last ten years, the avg dividend payout is 44% (SD 35%). Extremely high variability. Historically, on basis of average, PE has been in high single digits to low double digits. Average has been PE 7.02 (SD 6.7). Even with EPS66/PE15, I tend to think it would be on higher side for buy valuation based on its historical PE. I do not expect dividend as high as Rs 40. If am correct, last years Rs 20 was due to some landmark in company’s history (can’t recall what?). I think Rs 10 was regular dividend and addition Rs 10 for the celebration event. So four fold increase in a regular year? Not entirely unexpected, but less likely. So I would not use that high dividends (to be conservative).
But one thing that I do not understand: your objectives have been kind of buy in and sell out. I am not sure why you focus on including dividends in your upside?. Assuming you hold when dividends are paid, it is most likely to take care of tax/transaction fees.
Regarding HYD Industries….
I will need to go back to recall my observations. It is not of my list, so I do not read anything about it. Will get back to you.
Best Wishes,