The best time to sell…is ‘Never’
Some of best investors and Gurus who I ardently follow with religious devotion, like Munger, Buffett, Phil Fisher, Peter Lynch…taught me to think long term and to find and invest in great businesses run by very high quality management teams. It is no different from getting into a business partnership with these high quality management teams, where they are taking up the operating role, and I am playing the role of a passive owner of a slice (however small) of that business. As a passive business owner, I am very happy to trust these exceptional managers to manage the operations of the business and allocate capital judiciously. These are the kind of businesses that I would ideally never want to sell.
The greatest ‘Aha moment’ of my early investor life was when I realised that this was the right way of looking at an investment, rather than looking at it as a stock (with minute by minute ticker updates). This of course involves a lot of conviction, once I have identified the business for investment. It is a level of conviction that does not come overnight. It is possible to make a quick buck based on some “stock tips” which could turn out to be winners, but it is not possible for everyone to share the same conviction that can be developed over a prolonged period of thorough research. This is the reason why most investors feel the urge to exit an investment once it shows some gains…as they are only focussed on the stock and are unable to bear the possibility of giving back their paper gains due to short term market volatility. This demonstrates lack of the kind of conviction that a passionate business owner typically possesses. Imagine Jeff Bezos deciding to sell his Amazon shares just because the share price has run up..and he is worried that the price might drop :). For a passive investor, while locking some short terms gains might still end up being a profitable strategy, significantly superior results could be obtained by letting these great businesses compound wealth over a long period of time….and not worry about the share price. If the fundamentals of the business remain strong, the stock price will reflect that over time. This compounding of wealth happens when a great business reinvests its earnings and continues to deliver excess returns (over and above the opportunity cost of capital) on the invested capital over a long period of time.
How do we find such great businesses?
I have consolidated some of the learnings from these great investors mentioned above and created a back-of-the-envelope & easy to understand list of criteria. I have listed the criteria in a qualitative manner to encourage discussions. I will explain each of these criteria in detail with examples & numbers in subsequent posts over the next few weeks.
These criteria not only serve us well while looking for great businesses, but they also act as a checklist in evaluating the continuing strength of fundamentals of our portfolio companies. If any of our existing investments show permanent deteriorations in more than one of these criteria over a period of time (never to be judged based on a single quarter’s results), then it could be a good reason to exit the investment.
I am not claiming that this is the only way to find & keep great businesses, but this is a method that works great for us. (If you wish to be updated when we publish the subsequent posts in this series, Kindly subscribe to this blog with a valid email id…)
The filters for finding and keeping a ‘Great Business’
- High Return on Invested Capital over last 5 years
- High Return on Equity (not aided by high levels of debt)…..so ROE being >> cost of capital over last 5 years enabling compounding capital at a high rate
- High gross margin and net margin…..While having high net margins would be ideal, we should not necessarily reject companies with temporarily depressed net margins. Sometimes businesses have high Opex (SG&A), but as long as the gross margins are relatively high and growing…these businesses with depressed net margins can be potentially turned around by able management. The high Opex can also be due to conservative accounting, which we will discuss in detail subsequently
- Very healthy & growing Free Cash Flows. We love good earnings but we love the cashflows even more. We prefer to use ‘Owner Earnings’ (as explained in Berkshire’s Shareholder Letter of 1986) over FCF and we will delve into this in more detail in our subsequent posts.
- Steady growth in the above 4 metrics over the last 5 or more years
- A strong moat and pricing power….ability to pass on price increases to customers without affecting volumes….can be reflected by steady / increasing gross margins
- Low payout ratio….this coupled with 1 & 2 above, will ensure that the business is able to reinvest a large % of it’s earnings at a favourable rate of return…leading to compounding of capital. Another important factor that investors (e.g. those of us based in Singapore) should keep in mind is that dividend payments from companies in foreign jurisdictions are taxed in investors’ hands or are received after the deduction of withholding taxes….so while we love dividends, this double leakage in form of taxation affects the long term compounding adversely and we could be better off with the management reinvesting the earnings in the business on our behalf…if they can do it in without destroying value
- Easy to understand and is in our circle of competence….for example some of us investors may not understand the nuances of a high-tech or a mining business….however almost all of us can understand a business like Amazon
- Very strong management with high standards of integrity…..and solid track record of success in the same company or industry…compensation structure should be reasonable and not over the top
- Balance sheet clean of debt or has very low debt relative to the equity. The interest cover should be more than adequate and this allows the business to withstand shocks during recessions when the revenues & EBIT may suffer over a period of time
- Relatively asset light…..the business does not need to incur a lot of capital expenditures to grow
- The business should be good at managing working capital. We love businesses which are able to improve their inventory days, receivables days and payables days over the years. Some of our favourite businesses enjoy negative working capital (Payables days > inventory days+receivables days) and are able to fund their entire capex using their change in working capital (negative number) consistently
- Global or multi-country footprint….offering a large market to derive growth from, rather than being geographically restricted
- Very long runway….easy to clearly identify a very large market (as above) for the company and there is no chance of market saturation in short to medium term
- Clearly identified asymmetric/exponential growth potential…some businesses e.g. platform based businesses with strong network effects display exponential growth characteristics and we love these…when the nature of growth is non-linear, it is very common for the markets to under-estimate their long term potential. Most forecasters are not good at estimating or comprehending the effects of non-linearity (will discussed in detail in subsequent posts)
- Skin-in-the-game….preferably high % stake is still owned by the founder of the business and the founder is acting as the main driver. External managers often do not display the same levels of passion and deep understanding that founders demonstrate (though there are notable exceptions)
- Operating leverage….Scalability with little addition to opex….revenue increases directly flow down to the net profits
- The business is successful in growing it’s new customer base year over year and is also successful in growing it’s product portfolio
Once we find businesses that satisfy most of the above criteria, we look for opportunities to build positions in these companies when they are available at favourable valuations. This is probably the more important reason for keeping an eye on the stock price….looking for a time when the market is offering the business to us at a discount or at a good price.
It may not always be possible to tick all the above boxes, but the above criteria can be used as the guide rails for the research process. This can significantly increase the chances of finding our ‘Great Business’….and within our portfolio, as long as our businesses satisfy most of the above criteria, there should not be any reason to sell…unless of course we find something that is an even better business.