As Donald mentioned, most of us have faced this dilemma in the past and probably will continue face the same in future. Even though it may sound too overarching…indeed there is no one size fits all approach possible. In my opinion this has to be case specific both in terms of the business that one is holding and one’s investment style and/or return expectations.
For me what has worked is, typically, overvaluation is not a good reason to sell a high quality business where I see strong entry barriers and growing strength of business model. However, any change in my underlying assumptions about the quality of business/business model/industry dynamics is DEFINITELY a trigger point for sell decision.
One of the reasons I feel that overvaluation is not a good reason to sell,especially for high quality business, is…if we look at past history of all high quality business franchises, even if they have not traded cheap in the past, they have generated an alpha by a wide margin without taking commensurate risk (of generating alpha by participating in stories where business model is still evolving or competitive advantage is yet to be established/confirmed). I did a small exercise where I looked at some high quality businesses (Asian Paints, Nestle, Pidilite, Dabur, Emami) going back to Circa 2006, I did a 10 year DCF analysis based on 2006 numbers, with some very optimistic assumptions on topline growth, margin expansion and profit to cash flow conversion, 3% terminal growth rate and 12% discounting. In most of the cases,in 2006 market cap was much above/near the DCF number even under very optimistic assumptions. Hence, if one would assume that, odds would be against one to invest in those companies at such high valuation and make high risk adjusted returns. However, contrary to that, in ensuing 10 years, those companies would have generated 20-33% CAGR + dividend.
Here is the excel file:DCF_Undervalues_Good_Businesses.xlsx (16.7 KB)
As I mentioned, most of these five companies in 2006, market was factoring in very optimistic assumptions and hence were richly valued, however, inspite of that, one could have generated significant alpha over market by remaining invested (or even buying!!) at that point of time.
Now the cache here is to figure out…the quality of the business and ability for the business to grow for long period of time. So, if one is confident about high quality of the business, it may make sense to stay put.
Having said that, I feel, the decision above is also a function of what is the hurdle rate for investment that one have in mind. So, for a mircocap investor, who has hurdle rate of 35% CAGR, this approach may not make sense while someone with more modest expectation of 20-25% CAGR over longer period of time, it make make lot of sense. One tool that has been immensely helpful to me, and weeds out this dilemma, is the expected return framework as suggested by Prof.Bakshi. I have been clued into that as it does not look at valuation in isolation. It combines,expected growth rate, entry multiple and exit multiple, to provide a picture that is wholesome. If according to one’s assessment, the expected return is lower than hurdle rate, one can sell otherwise, one may hold.