Friday, March 9, 2012

Light At The End of the Tunnel, or Oncoming Freight Train?

A Value Investor's Dilemma When They Turn Out To Be Correct

Bottom fishing value investors (among whom I count myself) tend to have a thick skin, a willingness to ignore what everyone and their brother is saying, and the ability to hold their noses while clicking "buy."  In search of superior value propositions, we can look past uncertain business outlooks, messy financial statements, heavy debt burdens and even abrupt management changes.  We are accustomed to going it alone and relying solely upon our own judgement.  Perhaps that is why a persistent failing I see among value investors (myself included) is poor execution when the world comes around to the positive case for your investment.  After living through months or years of nothing but negativity about what you own, it is a bit unnerving to have investors change their view and start clamoring to buy your formerly hated investment.  To make matters even more confusing, if you have held the investment for any length of time you have probably seen brief upturns in valuation that have gone nowhere and quickly dissipated, so it is very tempting to bail out at the first sign of any positive sentiment.  Often value investors sell too early, leaving a lot of money on the table.  So how should a value investor gracefully and profitably exit their winning trade?

A handy example for this sort of dilemma is LOW, which I wrote about here:  I started buying LOW in the second half of 2010 and had completed building my position by the end of that year.  LOW is one of my top 5 positions and I bought into the firm with the view that it had a business that could not be replicated today, a strong balance sheet affording management lots of flexibility, relatively low valuation at under 6X EV/EBITDA, and that the housing and consumer collapse were working themselves out and things would eventually be righted (after a fashion).  I also saw that HD had outstripped LOW's results due to an earlier and more aggressive restructuring effort and that investors would probably put increasing pressure on LOW's management to follow suit.  Of course none of this was guaranteed and there was a ton of negativity about the firm, the economy, housing, the US consumer, etc., but in the absence of another major recession, I thought it was unlikely that I would be at risk of more than a temporary loss and if LOW started to really do poorly the solid balance sheet would allow me ample time to sell ahead of major trouble.

Conveniently, an activist investor showed up in the form of Pershing Square (wich has since sold its position) in late 2011.  Management had obviously been getting some pressure and both ramped up its already aggressive stock buyback program and become more aggressive in its restructuring efforts in the course of 2011.  However, as late as October 2011 LOW could be bought for less than $20/share, about where I had accumulated the stock in 2010.  Investors were preoccupied with the sovereign debt crisis, the sluggish US labor market recovery (yes, the US labor market is recovering), and the still downward (albeit slightly) trend of the US housing market.  As a long-time bottom fishing value investor with a thick (and heavily scarred) hide, I was content to wait for people to realize what was going on at the company and value it acordingly.  In the meantime I had already booked some profits by buying some long dated call options on LOW and liquidating them when the stock made it to 27 or so in early 2011.

Lo and behold, investors seem to have suddenly changed their minds on LOW since about the beginning of October 2011.  All of a sudden the stock began marching higher and higher.  I suspect that the apparent modest quickening of the US economic recovery and the grinding resolution of the Greek sovereign debt problem provided a more favorable backdrop against which the market viewed management's restructuring efforts.  Since we are talking about what other people are thinking, ultimately all I can do is speculate as to their motivations.  LOW is now knocking on the door of the valuation range I had in mind when I first bought the stock, namely $30 to $35 a share.  This poses two problems for my portfolio: 1) increasing concentration in this name, and 2) having to really decide if I was right about my target price.

Increasing concentration as a position appreciates is a high class problem to have, but a concentration fron a stock doing well is just as much of a problem as buying too much of a security that has not appreciated.  In fact, appreciation-related concentration is often a bigger problem because it can happen gradually and without the investor consciously choosing to take this risk.  A good mitigant is to keep good portfolio records and regularly monitor concentrations of individual positions.  Since I sometimes own bonds, equity and other securities issued by the same company, I aggregate all exposures by name and monitor the concentration in each of my top 5 issuers.  Depending upon the nature and riskiness of the company, I generally prefer to keep individual exposures no more than 10% of my portfolio.  When a name goes over that level, I start looking to either sell off some exposure or put on a hedge (sometimes a collar).

The thornier issue is to determine whether one's target price is really appropriate any more, especially is a significant amount of time has passed since the initial purchase or when the company's operating environment has changed materially.  I still think that at $35 LOW is pretty fully valued.  However, if same stores sales growth accelerated and margins remained the same or better and this proved sustainable, LOW could be worth significantly more than $35.  Since all of this tends to happen gradually and my crystal ball is no better than anyone else's, this is very tough to call with any degree of confidence.

Ultimately, the value investor must be prepared to pick a sale price and execute, since companies can go out of fashion just as quickly as they came into it.  It is also worth being a bit humble and recognizing that you are exceedingly unlikely to ever sell at exactly the top, especially when it comes to an equity.  Since value investors are mostly in the business of trying to shoot fish in the barrel by waiting until an attractive opportunity is dumped in their lap at a good price, I think it is reasonable to declare victory and sell at least a healthy portion of your investment when your target price is hit.  You picked that price for a reason and unless there is clear, demonstrable evidence that it is no longer appropriate you should follow your original sales target lest you get lulled into the "another 10% higher" trap.  A reasonable way to sell is in pieces.  If LOW continues to rise and gets into my $30 to $35 per share range, I will likely liquidate my position in roughly equal portions as follows:

- Sell some shares in the lower part of my target range
- Sell covered calls on some of my shares that would exercise in the middle of my target range
- Sell the remainder at the top of my target range

The shares with covered calls are probably the most challenging to execute, since a stock can go up, the calls may not exercise, and then the shares could plumment (leaving you holding the bag).  To mitigate this risk, I will usually buy some puts if the stock rises materially above my covered call strike price (effectively creating a collar after the fact).  Does this method result in the absolute highest price one could get?  Nope.  But it does mean that you capture gains when they occur and you protect yourself from allowing constant upward creep in your target sell point.  As a wise man once said, "you get rich by selling too soon."  You will occasionally miss a real moonshot by selling out too soon just as a short squeeze or other event pushes valuations far in excess of what you thought was reasonable, but that is the price of being somewhat cautious in your selling strategy.

As always, do your own due diligence, consult your advisors, take your own risks, and sell your own stocks as and when you choose.  Be careful.  You can lose money on this stuff.

Disclodure: I am long LOW equity.

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