When do I sell? Part 2 – Fundamental Strength
18th Oct. 2017
This is the second part of the series on selling that we started on the 25th of September. It was originally
intended to be a 3-part series on selling. However, we got such a positive response from the introductory
article that we have decided to expand the series and go into more detail. Like anything in the markets, the depth and detail for which an investor can go into is unlimited so at the moment we will say that this is the second part of an unlimited number of articles.
Introduction:
We are not looking for a selling system that gets us out at the absolute top of a stock move nor are we looking for a system that sells immediately before a massive stock crash. While this would be nice, crystal ball technology has not yet been invented and predicting future stock price movements is a relatively futile endeavour. We are therefore looking for a selling method that works okay and captures the bulk of a stock price move as well as avoiding the most treacherous of sell offs. Nothing is perfect all
the time and there will never be a secret sauce. We are aiming for something that over the long term will give us a positive expectancy in our investing.
In the first article we argued that there are two situations for which an investor will sell. Either into strength or into weakness. There is no strict definition of strength or weakness. There is therefore no right or wrong way and it is possible to use combinations of both when selling. What investors must do is define what strength or weakness is. Once it is defined it is possible to identify it when you see it and take
action. The advantage of having properly designed sell rules is that it removes the need
for decision making in the “heat of battle”. Selling criteria should be defined before
buying stock and revisited at least every 6 months.
As mentioned above there are many different definitions of strength and weakness
and the definition is unique for each investor. In this article we will conceptualise one
way in which strength can be defined – fundamental strength. We will provide
examples of situations in the past where selling on fundamental strength has been
prudent. In future articles we will discuss fundamental weakness, technical strength
and technical weakness.
Definition:
Selling on fundamental strength is when the investor deems that business for the company in question can simply not get better and that on the balance of probabilities future share
price appreciation is unlikely. Investors can use both qualitative or quantitative measures to gauge fundamental strength. These are likely to be different for each company, often depending
upon the investment thesis on which you bought the stock.
Qualitative Fundamental Strength: This is when you have sell rules based on qualitative fundamental information, usually this is when things are going so well for a company that it seems impossible for it to get better. It could also be when things are going well for a company in its core business that they decide to change what they are doing, add unnecessarily to a product or expand into a new region.
Ryman Healthcare (RYM.NZX)
There is an old stock market saying that you should sell when you see a company on the front page of the newspapers. In August 2013 then CEO, Stephen Challies stated on stuff.co.nz that it was Ryman’s intention to become the number 1 listed firm on the NZX by market capitalisation. Challies comments were a sell signal for investors and indicated that the great bull run for Ryman’s shares was coming to an end. Since that time the stock price of Ryman has virtually gone sideways and has underperformed the
NZX. The chart below shows Ryman’s share price performance since 2010. It displays the incredible run the stock went on from 2010 through to just after Challies comments. Since that time the stock has largely trekked sideways.
Apple (AAPL.NASDAQ)
The growth story of the century. Apple transformed itself from a business on the brink of bankruptcy to become the largest listed company in the world. This was on the back of tremendous revenue growth. During this period of growth Apple did not pay a dividend to its shareholders. This is because the company felt that the best use of extra cash was to reinvest it in the growth of its business. This proved incredibly rewarding with the shareholders and from January 2001 to August 2012 the stock advancing over 8000%. Then on the July the 24th 2012 the company indicated that they were going to pay their first dividend since 1995. For many investors this heralded the transition of Apple from a growth story to a value investment. The stock then pulled back from a split adjusted $100 per share to nearly $55 per share. Since this time the company has since rediscovered its mojo but astute investors may have considered this a change of character for the stock and therefore seen the dividend as an opportunity to sell.
The Warehouse Group Limited (WHS.NZX)
The red sheds were one of the New Zealand stock market darlings of the 90s and the early 2000s. Their expansion across the country fuelled a fantastic run in their stock price. After being in operations for over 20 years the company began to signal its intentions for expansion into Australia. This was launched in 2003 with 126 stores. At this point the market expectations were that the Warehouse would be able to continue its expansion through Australia. Astute investors could see this character change as an
opportunity to take profits. This proved to be the peak for the stock and it has never regained its previous highs. WHS stock hit an all-time high of $7.89 per share in June of 2002. The stock trades closer to $2.00 per share today.
Quantitative Fundamental Strength: This is gauged using metrics such as price-to-earnings (PE), price-to-sales (PS), dividend yield or book value. When investors buy a stock, they may decide that when or a combination of these metrics reached pre-decided levels then they will sell either a part or all of their position. For example, an investor may purchase XYZ company that is trading on a 10x trailing 12-month PE. They may decide that if the company’s share price appreciates so that the company is
trading on 25x PE that they will sell. The numbers in this situation do not really matter
as they will be different for each company and will be defined differently by each
investor depending upon their interpretation of what strength is for the company.
Xero (XRO.NZX)
The below table shows a situation that investors may have applied this logic. This is a
table of Xero’s (XRO.NZX) revenue and price to sales across the last 5 years. The share
prices are correct as of the financial year end. The share price in this situation was
growing significantly faster than revenue. Between 2012 and 2013 XRO impressively
grew revenues by about 100%. During this time the share appreciated by 179%.
Investors paying attention to the price to sales multiple would have noticed the
expansion from 18.9 to 31.7 during this period.
Revenues grew the following year $32 million to $74.47, or 83%. The share price during this period really took off and appreciated 256% to $40.09. This had become a 10 bagger in two years. Investors watching the price to sales multiple would have seen that it appreciated to 69x sales. To put this into context Amazons share price in March 2013 was around $167 per share and it was trading at this time on a price to sales multiple of about 1.7x (shares have since appreciated 434%). While the A2 Milk
multiple is currently 9.7x sales.
Whatever your definition, the price to sales multiple of XRO in 2014 was hefty. If investors had defined the sales multiple that they were prepared to get out at when initially buying XRO’s shares they would have got out at a profitably without having to endure the inevitable downside that followed. We have marked on the chart below XRO valued at 69x sales.
GoPro (GPRO.NASDAQ)
Savvy investors could have used a P/E ratio breakdown to get themselves out near the GoPro top in 2014. Within 3 months from its IPO the GoPro stock ran up from $28.50 per share to over $90.00. During the same period the price to earnings ratio trended from 24.5x to over 55x at the peak. This turned out to be the all-time high for the stock and it now trades at under $10 per share. Investors that purchased anytime in the two months after the IPO were facing a dilemma.
How can I catch the bulk of the gain without missing out on too much upside or giving
the profits back to the market? They could have set an arbitrary target to get out at say
35 or 40x earnings. This would have got the investor out at between about $54 and
$65 per share, the investor would have banked a nice profit but still left a lot of money
on the table.
So how could investors have used P/E to get out of GoPro at a good time? Since there
is no limit to over-valuation we would argue that in this case investors should wait for
a breakdown or a pullback in P/E before getting out. When the GoPro P/E peaked at
55.01x the stock closed at $90.94 per share. 6 trading sessions later the GoPro stock
closed higher at $93.85 per share but its P/E had contracted to 49.8x. This indicated
that the market was no longer prepared to pay an ever-increasing valuation for the
stock. To alert investors this was a sell signal and they were either able to get rid of
the stock immediately or sell it on the first sign of weakness. On the chart this would
have got the investor out at between $80 and $93 per share. Not the absolute top but
pretty good none the less.
It is important to remember here that there was nothing stopping the GoPro stock from
going higher still, no system is perfect. But one thing for sure is that it would have kept
you in the investment for longer than a standard P/E limit and avoided a substantial
loss.
Benefits of Selling on Fundamental Strength
The great thing about selling on fundamental strength is that when you are right you
often get out at or near tops in the stock price. This is because it is contrarian to what
the market is thinking. If for example you purchased the Warehouse for its New
Zealand growth then you may have defined its expansion into Australia as deviation
from your investment case. This was at the same time as the wider market was
expecting the company to grow through Australia. Investors would have been able to
get out near the top of the market.
Likewise, while many investors were caught out by the decline of XRO an investor that
had defined over valuation through price to sales prior to buying the stock would have
been able to get out with their pride intact.
Another benefit of selling into fundamental strength is that it is usually profitable. If
you have bought a stock for ABC and you have decided that you will sell if XYZ happens
on the upside then you are probably (not always) profitable. This is great from a
psychological perspective for the investor. It can be very difficult mentally to go
through severe price corrections on your holdings.
Finally, it is great for analysts. These are people that like to get into the nitty gritty of
a company and figure things out. Investors that like to dig deep to figure out that Apple
paying a dividend indicated a change in tact from the company enjoy selling into
strength.
Drawbacks of Selling on Fundamental Strength
The biggest drawback from selling into fundamental strength is being wrong. No selling technique will be
right all the time, at the end of the day nobody knows what will happen tomorrow and there could easily be further good fundamental news that drives the stock higher. Psychology this can be challenging. A
comparative example to the Warehouse is Wal-Mart where the company’s virus like growth had no
geographical limits.
There is also no limit to quantitative fundamental strength in terms of multiple overvaluation. For example, with Xero what is the real difference between 69x sales and 80 or even 100? An investor selling out because they defined the company over valued at 30x sales would have been kicking themselves when it hit 50. The derivative of these two points is that selling on fundamental strength is completely subjective and depends on the investor skill and experience. Even the most experienced investors will not get this right all the time, or even most of the time. It is therefore hard work, each stock is different so there is no one size fits all formula. Investors need to define what over extension is through fundamental strength on each of their holdings.
Summary and Suggested Use
Stocks being overextended on fundamental strength is probably the most difficult type of selling but it can therefore be the most profitable. Whether you use it or not we recommend that before investors buy a stock that they define what excessive fundamental strength is for the company in question. Because of the inherent difficulties and the risk of limiting upside we recommend that investors use this selling
technique in conjunction with other selling techniques that we will mention in later articles. For example, when you spot a situation that meets your definition of excessive fundamental strength then you can lock in profits by tightening up your other selling criteria. The key thing to remember is that as an investor you need a system that works okay in most market conditions. Because we cannot predict the future no selling system will ever be perfect.