You invest in the stock market to make money. The choice of companies to buy and the price at which we buy them are key to this. Fund managers devote much of their marketing efforts to explaining their investment principles and processes. Analysts spend an enormous amount of time identifying and analyzing their bets.
But the decision to sell is just as important to long-term returns. This decision, or failure to make it, can have a significant impact on portfolios. If a stock falls by 50 percent and you hold it, it then needs to rise by 100 percent just to recoup your investment. If it falls by 75 percent, it will need to rise by an unlikely 300 percent to avoid losing money. The share price of the big banks over the last 15 years is a good example, despite the rerating of the last two years.
Selling requires a discipline of disinvestment that is rarely discussed.
The business, not the stock price
There are several reasons behind any decision to sell. It can be a question of opportunity cost: we may prefer to invest the money in more attractive investments with higher risk-adjusted returns. In other cases, we sell in response to specific price rises or falls, setting price levels or percentage changes that trigger the decision to sell. Another criterion may be a manager’s own fundamental valuation of the company. When the share price reaches this fundamental value, it should be sold.
These are price-based decisions. Perhaps most important is to understand why the stock was bought in the first place and to review the original investment thesis. The company’s business model or growth drivers may become outdated over time and lose their competitive advantage. European telephone companies have seen their business fundamentals deteriorate over the past 20 years, and with them their stock market value. Companies need to be seen and understood as a business, not just a price.
The emergence of new technologies, changes in regulation, evolving consumer behavior and new competitors lead to a constant adjustment in the relative position of companies – Kodak, BlackBerry and Nokia are all clear examples of this.
Supermarket sales are affected by the number of weekends in a quarter or by weather-related motorway traffic, especially in winter. We need to be able to tell whether these blips are the result of one-off problems or a progressive change in trend and usually there are warning signs in a company’s results, such as a deterioration in sales growth, earnings or cash generation.
IR in an awkward position
Companies often do not like it when their investors reduce their positions or sell all their shares. CEOs of many companies do not like to hear feedback from investment managers if they do not share the company’s strategy or do not believe the company’s growth claims or promises. This sometimes puts investor relations departments and brokers in a difficult position. If the latter clearly convey investor criticism, they risk the CFO or CEO refusing requests to meet them or not giving them another company roadshow.
The IR team’s position is not easy, either, though an IR team should not be in love with its own company. It is important not to lose sight of the fact that no company is a permanent buy and that all companies have their low points. Reputation with investors and personal branding are achieved by being extremely realistic at times when companies are at their weakest.
On the other hand, IROs also need to be able to deliver market messages without incurring the wrath of their bosses. For an investor, a CEO is a means to an end, to understand the company better and make money relative to other possible investments. A manager may meet with three or four CEOs a day in earnings season. On many occasions, no investor will argue that the stock will be worth more in the long run. But that is not necessarily the case over the next 12 months – the horizon over which analysts or investors tend to price.
‘Forever’ investors
Management decisions can also lead to a reconsideration of holding a stock in the portfolio. Successful companies are often seen as moving away from business models where they have a competitive advantage but the pursuit of continuous growth – often understood as volume growth or empire-building strategies rather than value expansion – may lead to unwise capital-allocation decisions. Companies are often investing when their core, underlying business is slowing down.
The message is wrapped in the idea of future growth and cost synergies – but history shows most of these deals have been detrimental to the share price. In other cases, such growth is achieved, but at the cost of diluting shareholders through continuous capital increases. Experience also shows that companies with poor corporate governance tend to produce negative surprises at some point.
So-called value managers, which invest for the long term in companies with solid fundamentals and depressed share prices, often say their preferred holding period is forever. This is a phrase that hardly reflects reality. In recent months, Warren Buffett has sold more than $100 bn worth of shares, substantially reducing his positions in Bank of America and Apple and selling at substantial capital gains. Any company that has had such shareholders knows that, with honorable exceptions, they too will sell at some point.
Low portfolio turnover is not in itself a good factor, nor does it guarantee profitability. Each stock has to earn its place in a portfolio on a day-to-day basis. A professional manager or individual investor should not fall in love with a company: in a rapidly changing world, it is increasingly necessary to monitor the relative position of each stock in relation to others in which one might be invested.
The problem is that sometimes those value investors have very concentrated holdings, and their exit from any company leaves a gap that can be difficult to fill. IR departments should therefore not be complacent but should always be on the lookout for the next marginal buyer.
The big bluff
Other investment styles involve more short-term buying and selling – trading – very quickly. Or there are speculative investments based on the news generated by a company. In both cases, as in gambling, you need to know when to fold and when to let your hand go.
Norges Bank Investment Management is a major investor in the Spanish stock market. It recently invited Annie Duke, a professional poker player, to give a talk to its employees on how to manage risk and when to fold a bet. The book The Biggest Bluff by Maria Konnikova, a former world poker champion, emphasizes the same theme.
Susquehanna is a US trading firm with more than 3,000 employees and a 22 percent share of the US equity derivatives brokerage sector. Its training program for new employees includes 100 hours of playing poker in casinos.
Buying and selling have one thing in common: both involve predicting future outcomes. But the buying process seems to be more underpinned by investment processes and analysis, whereas a selling decision is often influenced by psychological aspects of investor behavior.
To make money in the stock market, you need to know how to buy and sell. And IR needs to talk about it all.
Ricardo Jiménez Hernández is strategic adviser at Harmon and a former director of investor relations at Ferrovial. He is also a member of the IR Magazine editorial board
