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+ ?
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