Is it the right time to exit good businesses?

Dec 6, 2014

In this issue:
» Is HUL overvalued?
» Half of the oil production projects unviable at the moment!
» Greenspan: Better to clean up mess after bubble has burst...
» Chinese stocks led the gains in the week gone by
» and more....

'Is it the right time to exit good businesses?'

This is a key question that often comes to mind when the markets are booming.

Well... we would like to take help of some of the investing legends to address this question. One on side, we have individuals such as Philip Fisher and Warren Buffett.

Philip Fisher's take on this topic goes as follows:

    "Even if the stock of a particular company seems at or near a temporary peak and that a sizable decline may strike in the near future, I will not sell the firm's shares provided I believe that its longer term future is sufficiently attractive...

    My belief stems from some rather fundamental considerations about the nature of the investment process. Companies with truly unusual prospects for appreciation are quite hard to find for there are not too many of them. However, for someone who understands and applies sound fundamentals, I believe that a truly outstanding company can be differentiated from a run-of-the-mill company with perhaps 90 percent precision.

    It is vastly more difficult to forecast what a particular stock is going to do in the next six months...For these reasons, I believe that it is hard to be correct in forecasting the short-term movement of stocks more than 60 percent of the time no matter how diligently the skill is cultivated. This may well be too optimistic an estimate.

    So, putting it in the simplest mathematical terms, both the odds and the risk/reward considerations favor holding."

As for Warren Buffett's takes on this subject... some of his famous quotes are:
  • "Our favorite holding period is forever"
  • "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes"
  • "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."
Clearly... the above mentioned investors are in for the long haul.

Then, on the other side we have individuals such as Mr. Peter Lynch. Mr. Lynch's approach to investing is more to do with sticking with businesses which have a particular story backing them. And as long as they remain intact, it makes sense to hold on. Once they go haywire, the exit route would be one of the key options.

'Buy in doom and sell in boom' would be a good way to sum up his approach...

When comparing these two styles, an aspect that also needs to be considered is redemption needs. While that would have been more so the case with Mr. Lynch as compared to Mr. Buffett, given the former's profession of being a fund manager.

So one key takeaway here would be that while different investing approaches work, it all boils down to an investor knowing himself in terms of his holding capacity, temperament and capital requirements when it comes to investing in - or for that matter exiting - businesses.

In conclusion... know thyself.

What approach do you follow when it comes to exiting stocks of high quality businesses? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
If two companies have similar growth rates, which is the other important factor that will decide what multiples these two companies should trade at? It is indeed the efficiency with which the companies use their capital. Or in simpler parlance, their respective ROICs. Now assume one of the companies to be the Sensex and the other one the FMCG behemoth Hindustan Unilever Ltd (HUL). It certainly goes without saying that by virtue of its great capital efficiency, Hindustan Unilever should certainly command premium valuations than the Sensex. But how much more? And this is what we are trying to answer in our today's chart of the day.

HUL vs Sensex: PE widens

As the chart highlights, the gap between HUL's P/E and the Sensex PE has been the highest it has been in recent years. So does this mean HUL's future growth rates to be much better than what it has managed in the recent past? At least this is what the market seems to be implying. And taking a call on this is what it will eventually come down to, we believe. If the stock disappoints in terms of growth over the next few quarters, do expect the gap to reduce. If it doesn't, then the gap should persist we reckon.

Going by the economic data, the Indian economy seems to be coming out of the woods. A lot of this recovery is backed by the tailwind of lower commodity prices, oil being the crucial one. It was lower crude prices that finally led to diesel deregulation this year. Lower oil import costs and subsidy burden are a further relief on the fiscal health front. In short, low oil prices have been a boon for India, a country that imports around 80% of the crude oil requirement.

It is difficult to say how long the trend will last. As we all know, oil prices in the past have more been a function of speculation and adhoc production controls rather than supply and demand. That said, at current levels, oil prices are likely to render half of the oil production projects unviable. And the resulting lower supplies may lead to a reversal in the oil price decline. Until that happens, consuming countries like India are likely to benefit at the cost of producing nations.

Every time we read about Alan Greenspan's non-committance to the core duty of central banking we get appalled. The veteran central banker has always evaded the responsibility of having fuelled the asset bubble in the US that burst in 2008. He has even supported the notion that money printing has helped the US economy recover post bubble burst. And that the US Fed has no blame to take for the meteoric rise in the government debt to GDP ratio over the last few years.

In his recent speech Greenspan explained why only the bubbles that are financed by leverage need to be preempted. For the others his advice is - "Better to clean up the mess after a bubble has burst rather than prevent it!"According to Greenspan bubbles are act of human nature and one cannot really prevent them. Especially when the speculative boom is not financed by debt, like in the case of 1987 stock market crash. Now this brings us to the question, as to what is it that a central bank is supposed to do if not maintain systemic balance in the economy? And at least in the case of Greenspan, he left the dirty job of cleaning up the mess after the bubble burst to his successors. We are glad that the RBI governors are paying no attention.

World markets largely remained positive in the week gone by. The US reported a better than expected jobs report with the number of workers added in November being at a three-year high thereby pointing towards better economic growth. The US markets ended positive (up 0.7%) for the week. Even the European markets closed firm.

Among Asian markets, the Chinese market continued to rally, riding high on the central bank's interest rate cut last month and expectations of additional stimulus measures. In fact the index was the biggest gainer (up 9.5%) for the week. The Japanese markets posted robust gains as the weakening yen favored the country's exports. The Indian stock markets remained volatile on mixed signals. While interest rate cuts were once again given a miss by RBI, the passenger car sales registered a robust rise in November. The BSE-Sensex closed lower by 0.8% for the week.

Among the sectoral indices this week, FMCG and consumer durables stocks were the top performers, while oil and gas and IT stocks were the biggest losers.

Performance during the week ended December 05, 2014
Data Source: Equitymaster & Yahoo Finance

 Weekend investing mantra
"There's a clarity that comes with great ideas: You can explain why something's a great business, how and why it's cheap, why it's cheap for temporary reasons and how, on a normal basis, it should be trading at a much higher level. You're never sitting there on the 40th page of your spreadsheet, as Buffett would say, agonizing over whether you should buy or not." - Joel Greenblatt

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat.

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