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Holding overvalued stocks


LongHaul
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Often stocks go from cheap to fairly valued and then to overvalued and perhaps the cycle repeats. 

 

Does anyone have any experience waiting for stocks to get overvalued and holding them until they are very expensive before selling.  Any thoughts/experience/insights on this matter appreciated. 

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Talk to Warren about Coke... oh, wait, he did not sell.

 

 

Maybe that's the lesson: it only works - well, it doesn't, but let's say it does - if you just hold it forever and you don't sell.

 

Since otherwise you just sell them and they become even more overvalued and you kick yourself.

 

And by the time they are cheap, they are 300B-500B company and the "cheap" means they ain't gonna grow anymore. Say hello to AAPL, GOOGL, FB, MSFT, ISRG, AMZN, NFLX, etc.

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This isn't market timing. If you think about the Mr. Market analogy, market volatility gives you two opportunities to profit. You can buy when Mr. Market is depressed. Or sell when he is euphoric.

 

If you read the academic studies, it is very clear that momentum exists. So if you are holding a great company, bought at a sensible price, that is now "fully valued", it is a mistake to sell too quickly.

 

Once they get rolling, I've had many stocks that go way beyond my rational expectations. Both business momentum and stock momentum take the stock price higher than I could imagine.

 

--

 

But once you start getting nosebleeds, put the stock on a shorter leash. Don't sell just because the stock looks overvalued. Sell because the stock looks overvalued AND is showing weakness. You won't get the top price, but you avoid the perils of selling too early or taking a "round trip".

 

You need to have the discipline to sell with prejudice when an overvalued stock starts looking weak. Don't "wait till it get's back up" before you sell. Or convince yourself that it is now cheap because it is trading 10% or 20% below all time highs. This is a trap. As you implied, overvalued stocks tend to overshoot on the downside once they start falling.

 

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As an example, look at UNP. This is a stock that typically traded at 14-17 times earnings. A value investor might have sold at $80 when it started looking expensive (~18x) in 2013. It then went on an epic run to almost $125 (21x). Then it dropped quickly to $67 (12x). And then bounced back to $90 (17x).

 

With a high quality company like this, I would hold my nose when it was only mildly expensive. But after it got excessive, I would sell aggressively if the stock started to break down.

 

Home Depot is another example. A typical value investor would have sold at $52 in 2012 when it hit ~20x. It is now $127.

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It is a great strategy. Especially if you only use it on great businesses that you are willing to hold. Don't be in a rush to take a profit on a great company.

 

 

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Home Depot is another example. A typical value investor would have sold at $52 in 2012 when it hit ~20x. It is now $127.

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It is a great strategy. Especially if you only use it on great businesses that you are willing to hold. Don't be in a rush to take a profit on a great company.

 

This is why PE alone is not an indicator of over- or under- valued. in this case, buying @ 20x would've been a great investment. i am sick of hearing, it trades at 20x earnings therefore its overvalued.

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Home Depot is another example. A typical value investor would have sold at $52 in 2012 when it hit ~20x. It is now $127.

--

It is a great strategy. Especially if you only use it on great businesses that you are willing to hold. Don't be in a rush to take a profit on a great company.

 

This is why PE alone is not an indicator of over- or under- valued. in this case, buying @ 20x would've been a great investment. i am sick of hearing, it trades at 20x earnings therefore its overvalued.

 

Depends on how you measure value.  PE alone is not a great indicator because you need to both quantitatively and qualitatively assess growth runway -> impacts the terminal discounted cash flows of the business. 

 

KC- I respectfully disagree, your description of holding an overvalued stock to ride the wave of momentum is directly consistent with trying to "time the market" in my opinion.  You're leaving the land of fundamentals and entering the world of speculation.

 

I don't dismiss the fact that there are many examples where overvalued stocks rise and remain overvalued, but I am not smart enough to distinguish between when it will/when it won't happen.  I'm relatively skeptical of anyone who claims they are.

 

I think it's more sensical to be simple and consistent.  Buy when cheap.  Sell when expensive. 

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KC- I respectfully disagree, your description of holding an overvalued stock to ride the wave of momentum is directly consistent with trying to "time the market" in my opinion.  You're leaving the land of fundamentals and entering the world of speculation.

 

It isn't timing the market (all stocks). It is timing your entry and exit points (in a single stock).

 

I am suggesting the opposite of speculation. If you buy a stock when it is cheap and sell it when it is fairly valued, most of your return is from multiple expansion. If you buy at a good price and hold through periods of excessive optimism, my strategy allows you to earn the profits of the underlying business.

 

Buy a stock at 15x earnings, hold stock for 10 years, EPS grows 15% per year, your return is 15% per annum. The fact that you could have sold at 30x earnings at some point in that run is meaningless. You might have had a nasty drawdown but this was still a big winner.

 

Now, if you want to really juice your returns you can try to trade the stock. I'm just suggesting that, if you trade the stock, you let momentum do some of the heavy lifting. Value investors buy too early and sell too early. Don't be too eager to take profits in a great company bought at a good price.

 

--

Obviously, this approach doesn't fit the Ben Graham types. But you should spend some time looking into the research on momentum, trend following, behavioural finance. As Munger says, Graham had a lot to learn about investing.

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I have consoled myself with selling 'too early' often. I don't like holding overvalued stocks. Hell, I don't really like holding fairly valued stocks.

 

There a bright side though: once you sell the fairly valued stock you can redeploy it in another undervalued stock. So while your previous fairly valued stock is overshooting to overvalue territory you are also making money on your undervalued picks.

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We like to buy the 'widow & orphan' dividend payers - just after the dividend has been slashed 65-100%. Eventually the dividend gets restored, continues to grow, & the market price rises back to where it used to be. As we typically buy at 60% off, & are patient; we routinely end up with a rising annual 15-25% cash yield on our investment every year. The overvalued (cash yield) stock problem.

 

We just hedge the material risk events via a sell & repurchase of 50% of the stock. As every repurchase raises the average cost base & reduces the cash yield, our cash yield will eventually approximate the dividend yield - when we permanently exit.

 

If you can repurchase at a lower price, & keep the size of the position constant - every roundtrip will also be returning cash. After 2-4 round trips you've recovered the original outlay.

 

SD

 

 

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There a bright side though: once you sell the fairly valued stock you can redeploy it in another undervalued stock. So while your previous fairly valued stock is overshooting to overvalue territory you are also making money on your undervalued picks.

 

The issue with this approach is that you are selling stocks that are going up to buy stocks that are going down. You are fighting momentum. Fundamental momentum and market momentum.

 

Anyway, selling is a dark art. Focus on buying great companies at good prices and you don't need to be perfect at selling.

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Fischer tries to answer this very question in the chapter When to Sell and When Not to Sell.

The gist of it seems to be that it depends on whether you bought growth or value. If you buy a Graham one-shot gain type deal then you sell as you didn't really like the company quality. It becomes a sub-category of 'special situations'. The situation is over or goes much higher than you thought you're out. Growth on the other hand, if you selected a quality company and management you may be very wrong on your belief in overvaluation. And even if you're not, what are the odds you'll get back in again when the overvaluation subsides? He says in his experience few ever get back in again. In this sort of situation, even if you don't sell and the stock drops, the idea is it may still be considerably above your purchase price in which case you can add more. This is for the long runway, many decades type growth stock.

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I think a good starting point is to keep it simple and just sell half (if the stock becomes overvalued). To each his own.

 

I like running a fairly simple portfolio. I do not like opening my portfolio screen in the morning and seeing 40-50 names there, that just confuses me. So I tend to have 15-20 names there, max. And 5 of those usually account for more than 80% of portfolio value. Running at this level of concentration requires making tricky trade-off decisions about what to drop to make room for something else.

 

 

 

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Interesting comments.  History is that stocks go from cheap to fairly valued and expensive.  If you have a good fairly valued business and it is safe and growing at a modest clip it is certainly not a mistake to hold it.  Assuming no great alternative investment opportunities then it seems like one has a call option on selling an asset at a very expensive price.  It is a different game trying to time the market and when to sell as to the degree of overvaluation.  But it can significantly add to you returns so that is why I asked about it. 

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It can be easy to forget that being greedy about your exit multiple isn't always rewarded

 

This is true. That's why I recommend this strategy for quality growing stocks. Not cyclicals or cigar butts. If a growing stock goes from cheap-fair-cheap (or cheap-expensive-cheap), then you still own a cheap, growing stock. You haven't lost anything (except a bit of opportunity cost). And the rewards can be spectacular.

 

An example of this is Wells Fargo. In retrospect, I wish I had sold at $55 (13x). I actually sold a bunch at $55 but had second thoughts and repurchased.

So I've had a temporary drawdown. And I missed an opportunity to redeploy. But I haven't really lost anything. I'm happy to hold it at $47 (11x, 3.2% dividend).

 

You also need to use judgement. I knew that Apple was never going to get "expensive". I sold Apple at $123 when it was clear that the momentum was gone even though it still looked cheap.

 

A real-time case study in my portfolio is MSM. This jumped from $56 (15x) to $78 (21x) in 5 months. It's now back down to $72 (19x). You could make a strong argument that it is now fairly valued or even over-valued. But I'm willing to bet MSM will benefit from both business momentum and multiple expansion when the manufacturing sector returns to growth. I'm willing to miss the opportunity to sell at $78 to see the hand play out. I'll only know in retrospect whether this was a mistake or not.

 

--

This actually works for cigar butts and cyclicals too but the definition of "expensive" is different. And you need to react quickly to signs of weakness. Jet Blue was very expensive at the end of 2014 even though it was only at 8x 2015 earnings. At $16, it was almost 2x book value (which is insanely overvalued for such a lousy, commodity industry). It promptly went to $27.

 

A really conservative, deep value investor might have bought JBLU at $6 in 2013. And sold at the end of the year for $8.54. That's a very nice 40% return.

 

A more aggressive value investor should have sold before $12 (1.5x book). This would be a 100% return in a single year (from $6). But by letting momentum work for you, you could have earned 350% return. Of course, nobody sells at the peak. But you could have got $22 or $23, AFTER it was very clear that that the business and stock momentum were gone. You would have earned a 267% return.

 

--

This is just a simple momentum overlay. You don't sell just because a stock is fair value. Or even expensive. You sell when the stock is overvalued (or fairly valued) AND the business or stock momentum falters.

 

Selling is a dark art. Do what works for you. Buy early, sell early works for many great investors. But don't be afraid of momentum just because you are a "value investor".

 

--

Caveat: We are potentially in the later innings of this market cycle. I wouldn't be too greedy now.

But don't get blinded by your own conception of "overvaluation". Hussman has been complaining about overvaluation since 2009!

 

 

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In this market I find most stuff compared to historical multiples to be very fairly valued to over priced. My assumption that this "new normal" is due to super low interest rates. When I look at a stock now and find it on the higher side multiple wise in the back of my head I find myself saying... Well interest rates are super low...  Same effect to what was cheap and expensive in the late 70s/early 80s with stocks trading at mid single digit multiples.

 

Not sure if this is right or wrong thinking and then how to account for it? Any opions on this? Who knows how long interest rates will stay low for but if it's "years" my assumption is that most failrly valued to expensive stocks will get even more expensive making It even harder to find fair valuations

 

In an environment with a 3-4% 10 yr treasury yield I bet everyone of my dividend stocks is 25-30% cheaper. Question I struggle with in regards to valuation is when will that occur again?

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+1 excellent post KC, I do the same thing ;)

 

This is true. That's why I recommend this strategy for quality growing stocks. Not cyclicals or cigar butts. If a growing stock goes from cheap-fair-cheap (or cheap-expensive-cheap), then you still own a cheap, growing stock. You haven't lost anything (except a bit of opportunity cost). And the rewards can be spectacular.

 

An example of this is Wells Fargo. In retrospect, I wish I had sold at $55 (13x). I actually sold a bunch at $55 but had second thoughts and repurchased.

So I've had a temporary drawdown. And I missed an opportunity to redeploy. But I haven't really lost anything. I'm happy to hold it at $47 (11x, 3.2% dividend).

 

You also need to use judgement. I knew that Apple was never going to get "expensive". I sold Apple at $123 when it was clear that the momentum was gone even though it still looked cheap.

 

A real-time case study in my portfolio is MSM. This jumped from $56 (15x) to $78 (21x) in 5 months. It's now back down to $72 (19x). You could make a strong argument that it is now fairly valued or even over-valued. But I'm willing to bet MSM will benefit from both business momentum and multiple expansion when the manufacturing sector returns to growth. I'm willing to miss the opportunity to sell at $78 to see the hand play out. I'll only know in retrospect whether this was a mistake or not.

 

--

This actually works for cigar butts and cyclicals too but the definition of "expensive" is different. And you need to react quickly to signs of weakness. Jet Blue was very expensive at the end of 2014 even though it was only at 8x 2015 earnings. At $16, it was almost 2x book value (which is insanely overvalued for such a lousy, commodity industry). It promptly went to $27.

 

A really conservative, deep value investor might have bought JBLU at $6 in 2013. And sold at the end of the year for $8.54. That's a very nice 40% return.

 

A more aggressive value investor should have sold before $12 (1.5x book). This would be a 100% return in a single year (from $6). But by letting momentum work for you, you could have earned 350% return. Of course, nobody sells at the peak. But you could have got $22 or $23, AFTER it was very clear that that the business and stock momentum were gone. You would have earned a 267% return.

 

--

This is just a simple momentum overlay. You don't sell just because a stock is fair value. Or even expensive. You sell when the stock is overvalued (or fairly valued) AND the business or stock momentum falters.

 

Selling is a dark art. Do what works for you. Buy early, sell early works for many great investors. But don't be afraid of momentum just because you are a "value investor".

 

--

Caveat: We are potentially in the later innings of this market cycle. I wouldn't be too greedy now.

But don't get blinded by your own conception of "overvaluation". Hussman has been complaining about overvaluation since 2009!

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Guest longinvestor

There a bright side though: once you sell the fairly valued stock you can redeploy it in another undervalued stock. So while your previous fairly valued stock is overshooting to overvalue territory you are also making money on your undervalued picks.

 

The issue with this approach is that you are selling stocks that are going up to buy stocks that are going down. You are fighting momentum. Fundamental momentum and market momentum.

 

Anyway, selling is a dark art. Focus on buying great companies at good prices and you don't need to be perfect at selling.

 

Nice phrase "dark art".

 

It surely was for me and it also took a long time for me to figure out that I sucked at it. So I gave it up and handed my $ over to guys who buy big and sell little. BRK. They also sit on their a$$es for long periods waiting to buy as well. "All money is made while buying".

 

Working out much better for me now compared to my darker days.

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It's a bit poisonous because it is really a trading book. I disagree with the whole premise of the book. But this book could be helpful:

When to Sell: Inside Strategies for Stock-Market Profits

 

The Art of Execution (not really momentum but discusses tactical strategies)

 

Most of the momentum stuff I've read is more academic and less practical. Like this:

Cliff Asness: value and momentum everywhere

http://faculty.chicagobooth.edu/tobias.moskowitz/research/jf_12021_tmcomments.pdf

 

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It's a bit poisonous because it is really a trading book. I disagree with the whole premise of the book. But this book could be helpful:

When to Sell: Inside Strategies for Stock-Market Profits

 

The Art of Execution (not really momentum but discusses tactical strategies)

 

Most of the momentum stuff I've read is more academic and less practical. Like this:

Cliff Asness: value and momentum everywhere

http://faculty.chicagobooth.edu/tobias.moskowitz/research/jf_12021_tmcomments.pdf

Thanks. Will try and find those books. Started reading that research pierce, but I really hate reading academic stuff.

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Started reading that research pierce, but I really hate reading academic stuff.

 

Wes Gray gives a good summary of the momentum effect in the last Masters of Business podcast. That's probably a good place to start.

Actually, the Cliff Assness episode is good too, IRC. He talked about momentum crashes (the dark side of momentum investing).

 

There are also plenty of blog posts on momentum:

http://investorfieldguide.com/2014512two-ways-to-improve-the-momentum-strategy/?redirect=true

 

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