Monday, April 7, 2014

Why hold on to a overvalued high quality company (and when to sell it)?

Some of my readers have noticed that I keep saying hold on to it at this price but don't buy it here. Shouldn't an overvalued security be sold period? There is good rationale behind that - I promise you its not my gut!

One of Buffet's reasons for not selling an overvalued good company is based on long term capital gains tax and trading costs. If you keep trading in and out of the same good business you keep paying taxes and brokerage on the trades. Whereas if you simply held it through you would avoid doing so and while at it save lots of time watching the ticker tape. Much like you cannot time the market,  you cannot time a single stock either.

In India, you would argue, the long term capital gains tax is zero so if you are outside the long term capital gains period then why not sell overvalued moat companies? As a value investor you are not into market timing. You are looking for a good business at a good price. Now if you already have a good business that you bought at a good price then why sell it? Value investing Buffet style will also say that you should look at the business in a manner such that you are going to hold it forever. If the business turns out to be as you analyzed it be, there is little reason to get rid of a good thing.Another facet of good companies that are growing and have great returns on capital is that they can surprise you by their ability to do good things - you don't want to miss out on those. 

The second major factor is inflation. Before buying a security its sensitivity to inflation is paramount in markets like India where high inflation levels north of 5% are a given. Good companies by definition should be able to expand earnings by the inflation % in the absence of growth. If you hold such a security and inflation picks up you will not end up loosing out on inflation losses in fixed deposits.

Some securities might remain consistently overvalued for decades on end. One cannot assume that timing the entry back into the security will be accurate. This is the biggest fear I have of selling current positions in overvalued high quality moat companies.

Does that mean that we don't sell any part of a good company at any price? Strictly no. The way I would like to look at that is that almost every decade has a market crash. So if I sell an overvalued security today I should be able to buy it at a cheaper valuation during the next decade. My target annual return is 20% which means a 6.2 times increase in price over a decade. Assuming an FD rate over the same time to be 7% I would get 1.96 times my money invested in the FD after 10 years. So if the security is overvalued by 3.15 times or so (6.2/1.96) I would recommend selling it when held long enough to be covered under long term capital gains, putting the capital in an FD and buying it at a higher discount later over the next decade. This action takes a lot of discipline and is much easier said than done!

If the investment is still under the short term capital gains treatment it should not be sold as a matter of discipline but mathematically considering 35% tax rate it should be (2.15 / 0.65+1) = 4.301, rounded up to 4.35 times overvalued to be sold in the short term zone. Yes I mean 335% more than what you determine as fair value.

If at any point it is conclusively determined that a mistake has been made on the quality of the business then it should be gotten rid of as soon as the determination.