Equity Investing: When is it Time to Sell?
Timing the sale of a security is arguably the most important aspect of any successful investment strategy. The most common trigger point used by the industry today is the price target, which is an estimate of intrinsic value derived from a valuation model that uses such methods as a multiplier of discounted cash flows.
However, price targets are only as good as the models from which they are derived, and these models are highly sensitive to a few key variables that are selected by human input. For instance, changing the terminal growth rate or cost of capital can significantly change a given model’s output.
The Larger Problem
These variables are entirely subject to human investment bias. For example, during times of euphoria, valuation multiples can easily be expanded and justified by clichéd claims. One of the famous ones is “things are different this time.”
At the end of the day, the static variables of the model become the ultimate determinant of where a security should be trading in traditional investment analysis as well as in modern practice. However, given the volatile times that we live in, these input variables can be dramatically influenced by other factors, such as the macro economy, geopolitics, and structural shifts in market investment bias.
For example, what P/E multiple do you use to value a Japanese real estate company that has historically traded at an average of 20 times over the last 10 years? On the one hand, inflation expectations in Japan are much more optimistic this year, vacancy rates in Tokyo’s five central wards are on the decline, and risk appetite among Japanese institutional investors is up sharply.
On the other hand, the European financial crisis was not weighing on valuations for the majority of the last decade, Japanese debt to GDP is at a historical high, and the particular company you are analyzing has a new chairman who has a habit of purchasing sports teams. Is a P/E of 20 times a fair way to value this investment? Because these types of issues will continue to influence valuation differently each year, it is virtually impossible to accurately and consistently time the sale of a security using a static valuation model.
Overcoming the Challenge
One way to overcome this challenge is to execute sell decisions based on information catalysts, or “information targets.” Assuming that markets are generally semi-efficient, each investment thesis has a set of information events that may positively or negatively impact share price once the news is announced to the market.
These information targets may include a better-than-expected earnings report, a meaningful order announcement, or even a strong monthly sales figure. The moment all of the positive information catalysts have been disseminated into the market and exhausted out of the stock, the sell trigger should be executed, regardless of share price. This way you are allowing information flow, which is genuinely free of human bias, to play its natural course in dictating how the security is valued by the market. You also avoid the pitfalls of “fighting the tape” and the ineffective exercise of assigning a static price target in an ever-changing and fluid market.
For example, say Company XYZ is set to report quarterly results, with consensus expectations estimating an EPS of $2. The stock is trading at a P/E of 10 times, or $20 per share. There are two investors, one using a valuation-based price target and the other using information targets. Both investors predict EPS to come in strong at $3, or 50% ahead of consensus estimates. The investor using price targets values the company at $30 per share based on a P/E of 10 times. When the company releases its earnings report, sure enough, EPS comes in at $3, and the stock proceeds to rally by 35% to $27 per share. The investor using the valuation-based price target will continue to hold onto the stock because the model clearly argues that the investment is still intrinsically undervalued. However, the investor using information targets will conclude that the market has discounted the news and will execute the sale of the investment, whether the stock is trading at $27, $30, or even $22.
Assuming this was the final piece of news anticipated for the time being, the investor no longer has any particular insight or edge over the market. By using a static price target, the investor must now depend on the market to “do the right thing” and trade higher to the model’s suggested price target, which is arbitrary and may or may not pan out. Investment bias usually begins to kick in at this point, and the investor may also think that he knows more than the market or that the stock just seems “too cheap.” In reality, the stock may have just lost its momentum because there are no longer any remaining information catalysts to drive the share price to higher levels. It is also likely that the model simply did not pick up on several unknown factors affecting the market’s perception of the security’s value.
The only true, unbiased indicator of where a security should be trading is information itself. That said, there is still value in using price targets — but only as the initial reference point or rough guide as to where a security should be valued, not the final sell trigger. Information-based price targets provide a much more accurate, simple, and most importantly, unbiased solution in timing the sale of a security in any abnormal or volatile market environment.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.