By Brett Horn | Associate Director, Equity and Credit Analysis
Knowing when to sell a stock can be just as important as knowing when to buy one. More often than not, though, investors end up selling their winners far too early, while holding on to their losers for way too long. The best way to avoid this type of error is to have a solid sell discipline in place, even if one is a true buy-and-hold long-term investor. At Morningstar, we've traditionally honed in one five different reasons an investor should consider selling a stock: (1) the initial analysis of the firm (or the situation) was wrong; (2) the fundamentals at the firm have deteriorated (and future prospects are less than initially believed); (3) the share price has risen well above its intrinsic value; (4) there are better returning opportunities available for the same level (or an even lesser amount) of risk; and, (5) the stock position currently accounts for a significant portion of the investment portfolio. While our top managers tend to follow a similar construct in their sell decisions, the final point about concentrated stock positions tends not to be a leading driver of sales for more than a handful of them, with seven of our 26 Ultimate Stock-Pickers having more than 50% of their stock portfolio invested in their top 10 holdings, and four of those seven having more than 85% of their stock portfolio invested in their top 10 holdings.
While it has often been noted that Warren Buffet, famed investor and chairman and CEO of Berkshire Hathaway (BRK.A)/(BRK.B), who runs one of the most concentrated stock portfolios among the 26 top managers listed on our Investment Manager Roster, is a true buy-and-hold investor, rarely selling anything once it has been purchased, we would argue that that has tended to be much more the case with the businesses he buys rather than with the holdings in Berkshire's stock portfolio. That said, much of the buying and selling activity in the stock portfolio over the years was done more by Lou Simpson, who ran GEICO's investment portfolio for more than three decades. And the buying and selling activity only increased after Simpson retired in late 2010, with Buffett moving to clear out positions in order to raise capital for his two new lieutenants--Todd Combs (hired in the fourth quarter of 2010) and Ted Weschler (brought in during the third quarter of last year). That said, Buffett has been a willing seller of some of Berkshire's largest holdings (those typically attributed to him based on his past comments) over the last several years, trimming stakes in Procter & Gamble (PG), Kraft Foods (KFT), ConocoPhillips (COP), Johnson & Johnson (JNJ), and even Moody's (MCO) from time to time.
Even so, the turnover at Berkshire (outside of the portfolio changes we saw in 2010 and 2011 in response to Lou Simpson's retirement) has been minimal over the years, which has also been the case for most of our Ultimate Stock-Pickers. While the average turnover rate for Large Cap domestic managers has been in the neighborhood of 80% of late, our top managers are much more disciplined, with the average turnover rate for our 22 fund managers being 25% (with the median turnover rate being just 16%). Only seven of the 22 managers have turnover rates in excess of 30%, while seven of them actually have turnover rates in the single digits. This type of behavior is much more indicative of buy-and-hold investors that stick to their investment disciplines. It also speaks to the quality of the investors represented on our Investment Manager Roster, most of which have put together a solid long-term track record of beating the markets with relatively little turnover in their portfolios.
Similar Sell Disciplines for Many of Our Ultimate Stock-Pickers
While most money managers are fairly open about the processes they use to find stocks to buy for their portfolios, the amount of information that they make available about their sell decisions tends to be much more limited. For those that don't lay out an explicit sell discipline, investors have to rely on hints within quarterly commentaries, and/or a trends in selling activity, to get a clearer idea of what may be behind a particular manager's sell decisions. And while there will always be exceptions in the data, past studies have shown that growth managers are more apt to sell when there is some sort of fundamental deterioration in a business (such that its future prospects are less than what was initially believed), and value managers tend to base their decision to sell more on valuation concerns than any other reason. The most successful money managers seem to have benefited the most, though, when they have a process in place that not only lays out the reasons for purchasing a security, but also the conditions under which a stock will be sold, and sticking to that discipline.
Looking more closely at our Ultimate Stock-Pickers, the growth managers on our list are actually a bit more forthcoming about their sell disciplines than the value managers, with those following blended strategies also being a bit more explicit about the process. Of the growth managers on our list, Jensen Quality Growth (JENSX) is probably the most explicit about its sell discipline, noting that:
"We will sell a company if: (1) its fundamentals deteriorate below our minimum business standard of a 15% return on equity on an annual basis (indicating a possible loss of competitive advantage); (2) the market price of the business exceeds our estimate of full value; and (3) it is displaced by a better investment that allows an upgrade to the portfolio's quality, growth outlook, and/or valuation metrics."
With the managers at Jensen sticking to a very simple and rigorous stock-selection process by only investing in companies that have earned a 15% return on equity every year for the last 10 years, the fund's sell discipline is a natural extension of its buy discipline, with the main point being to limit the holdings in the portfolio to companies that are consistent value creators. While deteriorating fundamentals seems to be the main reason why most of the growth managers on our list will consider selling a stock, we have seen a lot more commentary about valuation than we would have expected from managers of this ilk, much of which we believe is a byproduct of the volatility that has been inherent in the markets since the 2008-09 financial crisis. For example, Ronald Canarkis at Aston/Montag & Caldwell Growth (MCGIX) notes that his fund follows a strict sell discipline that requires a review of any stock that is trading at a 20% premium to their estimate of fair value.
While most of the language from the value managers on our Investment Manager Roster harkens to the valuation-based principles that drive their investment strategies, we feel that Diamond Hill Large Cap (DHLAX) lays out its own sell strategy better than most, noting that:
"Investments are sold when the stock price approximates our appraised intrinsic value. Ideally, this occurs as the stock price has risen and closed the gap with a growing intrinsic value. In a less than ideal situation, our estimate of intrinsic value may be revised such that the market price is no longer at a discount to intrinsic value. In cases where we no longer have confidence we can predict with any reasonable accuracy the business cash flows, the mistake is admitted and the investment is sold. Finally, we may sell one investment in order to raise proceeds for investment in a more attractive alternative."
This notion that the fund will sell when a stock's valuation has reached the manager's estimate of its intrinsic value (either the original value attached to the investment or a revised estimate based on new information), when the initial analysis of the firm (or the situation) was wrong, or when there are better returning opportunities available for the fund, lines up with the five different reasons that we here at Morningstar feel investors should adhere to when considering whether or not to sell a stock.
We would be remiss, though, if we did not point out one other reason that professional money managers might consider selling: investor redemptions. Oddly enough, only one of our 26 top managers-- Tweedy Browne Value (TWEBX)--has even highlighted this as a potential reason for selling. In our view, the need to raise and maintain a certain level of capital to meet investor redemptions has been the driving force behind much of the trimming that has taken place in the holdings of our top managers since the middle of 2008. With 11 of our 22 mutual fund managers reporting net outflows from their funds last year, and slightly more than half of them seeing outflows through the first five months of 2012, the need to raise capital for investor redemptions cannot be ignored.
That said, much of the outflow activity we've seen with our Ultimate Stock-Pickers has been readily covered with cash on hand, which is reinforced by the occasional trimming of established positions. Aside from some of the more drastic selling that took place during the fourth quarter of 2008, when some of our managers purged holdings they felt could fall even further (and used them as a source of cash for redemptions), the only other time that we've been able to make a direct connection between outright sales and investor redemptions has been with Fairholme (FAIRX), which lost more than one third of its starting AUM last year to net outflows, prompting the complete elimination of holdings like Morgan Stanley (MS), General Electric (GE), Verizon (VZ), and AT&T (T) from the fund's stock portfolio.
Ultimate Stock-Pickers' Top 10 Stock Sales (by Investment Conviction) Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Selling Exxon (XOM) 4 Low Wide 80.84 0.89 2 Devon (DVN) 5 High Narrow 58.71 0.53 3 Wells Fargo (WFC) 4 Medium Narrow 31.43 0.77 4 Brkshr Hthwy (BRK.B) 4 Medium Wide 81.36 0.81 2 Intuit (INTU) UR - - 57.00 - 2 News Crp (NWSA) 3 Medium Narrow 19.44 0.97 3 Diageo (DEO) 3 Medium Wide 98.61 1.08 3 Nike (NKE) 3 Medium Wide 108.64 1.09 2 Google (GOOG) 4 High Wide 580.45 0.74 4 Mattel (MAT) 4 High Narrow 31.69 0.83 3 Data as of 06/08/12. Fund ownership data as of funds' most recent filings.
As you may recall from last week's article, five of the top 10 sales made during the most recent period-- ExxonMobil (XOM), Devon Energy (DVN), Wells Fargo (WFC), Intuit (INTU), and Mattel (MAT)--involved at least one or more of our top managers completely eliminating their stake in a company. Of our 26 top managers, Hartford Capital Appreciation (ITHAX) stood out the most, as the fund completely eliminated 15 stocks--including ExxonMobil and Wells Fargo--from its portfolio during the first quarter. The only other manager that was even close to that tally was Columbia Dividend Income (LBSAX), which (as of the end of April) had eliminated eight stock holdings since the start of the year. The sales from Hartford Capital Appreciation were not too surprising, given that manager Saul Pannell has been quick to shed names when prospects dim, or better investment opportunities become available, with turnover at the fund ranging between 70% and 112% during the last decade. Pannell also has one of the more interesting mantras that we've come across as part of his sell discipline, which is: "when in doubt, get out."
As for the selling that took place at Columbia Dividend Income, it was a little out of character for managers Scott Davis and Richard Dahlberg, with the fund's annual turnover averaging around 20% for much of the last several years. That said, the managers did note that they were repositioning their bets in the utilities sector during the first quarter, with more than half of the holdings they sold outright during the period having some connection with energy and utilities. The managers also offered up some thoughts about their recent elimination of Target (TGT) from the portfolio, noting that the firm's "free cash flow from operations has been declining due to the elevated capital expenditure from their Canadian expansion," and that the retailer has "not been clear regarding the long-term strategy with their store brand credit card." Columbia Dividend Income used the capital raised from these outright sales to establish positions in five new names, four of which were more regulated utilities-- CMS Energy (CMS), Dominion Resources (D), Northeast Utilities (NU), and Wisconsin Energy (WEC)--and the other being another retail name, Macy's (M).
Recent Outright Stock Sales by Our Ultimate Stock-Pickers Star Rating Fair Value Uncertainty Moat Size Current Price (USD) Price/Fair Value # of Funds Selling Apollo (APOL) 5 High Narrow 34.98 0.59 1 Corning (CLW) 4 High Narrow 13.13 0.69 2 Devon (DVN) 5 High Narrow 58.71 0.53 3 Exelon (EXC) 4 Medium Wide 37.41 0.69 1 Halliburton (HAL) UR - - 27.96 - 1 Hwltt-Pckrd (HPQ) 5 Medium Narrow 22.31 0.56 1 Intuit (INTU) UR - - 57.00 - 2 L-3 Comm (LLL) 3 High None 69.62 0.93 1 Mrsh&McLnnn (MMC) 2 Medium Narrow 31.98 1.14 2 Prgrssv Waste (BIN) NR - - 18.11 - 1 Sara Lee (SLE) 3 High None 20.13 1.12 1 Transocean (RIG) 5 Medium Narrow 42.05 0.63 2 UnitedHealth (UNH) 4 Medium Narrow 58.00 0.89 3 Data as of 06/08/12. Fund ownership data as of funds' most recent filings.
When assessing the level of conviction that one of our top managers has when either buying a stock or trimming back an existing position, there can be no higher conviction signal that a manager can send than completely erasing a position from their portfolio. While much can be said (and has been said) about new-money purchases, which we believe provide investors with valuable insight into what managers think are the most attractive buying opportunities in any given period, outright sales are even more telling. As we noted above, our top managers will consider eliminating a stake when its valuation reaches or exceeds their estimate of its intrinsic value, when the initial analysis of the firm (or the situation) was wrong, or when there are better returning opportunities available for their fund, reasons that speak volumes about how they feel about the attractiveness of a stock when it is sold.
In the table above, we highlight a list of 13 securities that were sold outright by our top managers during the most recent period. In each case, the name represents a meaningful sale by a fund, and in two instances-- Corning (GLW) and Transocean (RIG) )--there were actually two funds eliminating stakes. The list is presented in alphabetical order so as not to give added weight to one name over any other, as all of the sales we've highlighted above were high-conviction sales by the managers involved. Given the limited amount of disclosure that some of our top managers provide, it was difficult to get to the rationale behind all of these sales, but we've collected what we can from the managers that have communicated their reason for selling, and left out explanations for those that have not offered up a rationale (so as to hopefully avoid misinterpreting their motivations).
Looking more closely at the list, it was surprising to see several cases where a manager completely exited a stock that our analysts continue to find attractive. While the timing of these sales (which could have taken place anywhere between January and March, and in a few cases during the month of April) can explain away some of the disparity, it is more likely that there is some difference of opinion in relation to either valuation or the future prospects of the firm. It is also interesting to note that in some of these instances, the stocks that were sold outright continue to be widely held by other Ultimate Stock-Pickers, which again points to the notion that the selling managers have a different point of view (this time in relation to some of their peers) about the valuation or the future prospects of the firm whose shares they were selling.
In the case of Apollo Group (APOL), the stock was held by two managers at the start of the year-- RS Capital Appreciation (RCAPX) and Yacktman (YACKX)--with the former completely exiting its position during the quarter (after having cut its position in the for-profit education company in half during 2011). In their quarterly letter, the managers at RS Capital Appreciation noted the following:
"We concluded that the conditions required to support our already adjusted expectations for the company's growth were becoming less predictable. Though we had reduced the exposure in prior periods and had identified the position as a target for elimination, our analysis suggested a less dramatic near-term scenario. Our decision to retain even this small remnant exposure was unnecessarily unprofitable during the quarter. In this instance our process worked just fine, but our execution was less than satisfactory."
Based on insight provided by Morningstar analyst Peter Wahlstrom, the managers at RS Capital Appreciation may be giving up on Apollo at the wrong time. While he believes that the for-profit education industry has entered an era of slower growth, lower normalized margins, and added governmental oversight, and is the first to admit that the near term could be difficult, the shares are currently trading well below his fair value estimate. RS Capital Appreciation's elimination of Apollo from its portfolio means Yacktman, which continues to generate the best long-term performance out of any of our top managers, holds the only stake in the name. With the stock looking "very attractive" to the managers during the first quarter, the fund increased its stake in Apollo by close to 25%.
While Apollo did not work out so well for RS Capital Appreciation, the fund did take a bit of a victory lap with its sale of Intuit during the first quarter, noting that:
"We eliminated the Fund's Intuit position during the quarter as the company shares have advanced meaningfully in recent periods and our valuation objective was realized. The company's share price essentially doubled during our holding period of just over two years. While we are pleased with the holding's contribution to the Fund's returns during this period, we are equally pleased with the company's fundamental operating results. These results have been impressive and its shareholders have been rewarded. Our decision to sell the holding is based solely on valuation. In our opinion, it remains a growing and advantaged business."
The managers at Diamond Hill Large Cap were a bit more succinct in explaining why they sold Marsh & McLennan (MMC) and Mattel during the quarter, noting that "we eliminated our positions in Marsh & McLennan Cos. and Mattel, Inc. as their stock prices reached our estimates of intrinsic value." This was in in line with their sell discipline, which states that "investments are sold when the stock price approximates our appraised intrinsic value. Ideally, this occurs as the stock price has risen and closed the gap with a growing intrinsic value." If only all investment success were this simple. We'd be surprised, though, to see the same rationale used by Diamond Hill Large Cap to explain the complete elimination from the portfolio in April of UnitedHealth Group (UNH), which has performed only marginally better than the S&P 500 so far this year.
While seven different managers held shares of Corning at the beginning of the year, two of them-- Amana Trust Growth (AMANX) and Oakmark (OAKMX)--had exited their stakes in the technology firm by the end of the first quarter. With Nicholas Kaiser at Amana Trust Growth being fairly tight-lipped about his trading activity, other than noting in the past that his fund (which is run in accordance with Islamic law) shuns frequent trading as a form of gambling, and that he is apt to sell when a firm falls short of the expectations that he and his team have set up for them, we've had to rely on Bill Nygren and Kevin Grant at Oakmark to give us some insight into their sale of Corning during the quarter. Oakmark had three outright sales during the period, as Corning, Fortune Brands Home & Security (FBHS), and Western Union (WU) exited the portfolio. Of these transactions, the managers noted:
"Fortune Home came to the Fund as a spin-off. We kept our shares, even though the business is smaller than we would normally purchase, because we believed it was undervalued. The stock subsequently performed well and was sold. Western Union and Corning both underperformed our fundamental expectations, and because we could no longer see a clear path for these businesses to reach our long-term targets, we opted for other opportunities. We added three new positions during the quarter: Parker Hannifin, Franklin Resources and Goldman Sachs."
While Oakmark appears to have lost patience with Corning, it remains a widely held name among our Ultimate Stock-Pickers. Our analyst Grady Burkett would like to see a larger margin of safety, but he believes the shares are materially undervalued. He thinks Corning's narrow economic moat is based on the firm's display business, which benefits from dominant market share (and thus economies of scale), and difficult-to-match manufacturing capabilities. The display glass industry is controlled by three firms--Corning, Nippon Electric Glass, and Asahi Glass--that collectively own more than 90% of the market. While the firm is struggling with lower prices in certain areas, Burkett notes that Corning's recent decision to take a significant portion of its glass manufacturing capacity off line appears to have mostly alleviated the recent oversupply situation.
Even though the top 10 sales list this quarter was populated with a couple of energy names--ExxonMobil and Devon Energy--the majority of the weight behind those sales was coming from Alleghany (Y), which has been clearing out portions of its own stock portfolio to raise capital for its purchase of Transatlantic Holdings, which the insurer had acquired for $3.4 billion. Aside from whittling down its stake in ExxonMobil further to just 30,000 shares (from 3 million at the end of the last year and 8 million at the end of the third quarter of 2011), Alleghany completely eliminated Devon Energy, Progressive Waste Solutions (BIN), and Ecolab (ECL) from its stock portfolio. The insurer was not alone in selling ExxonMobil, though, as Hartford Capital Appreciation included it in the list of 15 stocks that were eliminated from its portfolio last quarter.
Halliburton (HAL) popped up on the list by virtue of the fact that Aston/Montag & Caldwell Growth completely eliminated its stake in the oil field services name in April. This followed moves by the manager during the first quarter to move Emerson Electric (EMR) and Fluor (FLR) out of the portfolio. Of these sales, manager Ronald Canarkis noted the following:
"Given its successful quarter Fluor approached our estimate of fair value, prompting us to exit the position as the uncertain economic outlook is unlikely to lead to an expansion in its price/earnings multiple. Also within Industrials, we eliminated Emerson Electric from the portfolio as the company is struggling with both internal execution issues (specifically its Network Power business unit) and mixed-end market trends (particularly in Europe)."
The sale of Transocean by both FPA Crescent (FPACX) and Columbia Dividend Income reduced the number of holders of the oil and gas drilling firm to three at the end of the first quarter. As we noted above, Columbia Dividend Income was selling energy and utility names during the period, and repositioning their bets in the utilities sector on more heavily regulated utilities. While FPA Crescent said little about its elimination of Transocean and Pfizer (PFE) during the quarter, the fund has shown a propensity to sell during strong markets, similar to what we saw during the first quarter. That said, Pfizer was a bit of a laggard during the period (rising just 5% through the end of March), while Transocean saw a more than 40% increase in its stock price.
Looking more closely at Exelon (EXC), the name was completely eliminated by Sound Shore (SSHFX), which noted that the stock was one of its biggest detractors in the quarter, due to lower natural gas and power prices. While Sound Shore had apparently tired of the situation at Exelon, both Columbia Dividend Income and Parnassus Equity Income (PRBLX) remain positive on the industry, with Todd Ahlsten, manager of Parnassus Equity Income, noting that "the fund's utility investments offer attractive long-term growth and income, [even though] they clearly weren't in favor during the first quarter." While Parnassus Equity Income did not own share of Exelon during the period, the fund did demonstrate the conditions under which it would sell, namely a significant narrowing of a company's competitive advantage (and the discovery of a better investment opportunity). In this case, the fund had the opportunity to switch from one technology firm-- Hewlett-Packard (HPQ)--for another-- Applied Materials (AMAT)--with manager Todd Ahlsten explaining the swap in this manner:
"There have been two significant changes to our technology investments since the last report; I sold our Hewlett Packard (HP) position and bought shares of semiconductor equipment-maker Applied Materials. My key concern regarding HP is that its printing and PC businesses face secular headwinds. On the other hand, Applied Materials has sustainable long-term competitive advantages and is undervalued due to cyclical weakness in its solar and display segments. Going forward, Applied Materials should outperform HP."
Morningstar analyst Andy Ng agrees that Applied Materials is deeply undervalued, and with the semiconductor giant trading at a similar discount to the fair value estimate that one of our other technology analysts, Michael Holt, currently ascribes to Hewlett-Packard, it seems like a fair swap, in their view. That said, Hewlett-Packard remains a widely held name among our other Ultimate Stock-Pickers, and we've seen a lot of buying activity in the name over the last year or so.
As for the final two outright sales that we can comment on-- L-3 Communications (LLL) and Sara Lee (SLE)--the manager doing the selling, Oakmark Equity & Income (OAKBX), noted the following:
"As you might expect in a strong quarter for stocks, several issues attained their sell targets, and the Fund sold L-3 Communications, Martin Marietta Materials, Sara Lee and Tractor Supply."
Looking back, Oakmark Equity & Income and the rest of our Ultimate Stock-Pickers may now wish that they did a bit more selling during the first quarter than they actually did. Even so, the outright sales by our top managers can essentially be put into one of two buckets. In the first bucket, managers exited positions that worked out nicely, putting that money into other ideas. In the second bucket, managers threw in the towel on names that our analysts and some of the other Ultimate Stock-Pickers still think are attractive. Only time will tell if they were right to do so.
Disclosure: Brett Horn owns shares in the following securities mentioned above: Apollo Group
Greggory Warren owns shares in the following securities mentioned above: Amana Trust Growth, Procter & Gamble, and Western Union. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.