My BUY/SELL decision is mostly based on a reverse DCF approach.
I typically buy when I see a big difference between the growth rate implied by the current price and what I think the base growth rate for the business can be. If the implied growth rate is 6% and I think the business can do 10-12% I BUY. Selling framework is the inverse of the above. I also use some base heuristics like Operating Cash Flow yield vs the 10 year G-Sec and FCF yield (where applicable)
Needless to say this calls for some excel modelling and discipline to make a distinction between the base case, optimistic case and pessimistic case. A pure PE approach does not work for me, nor does the funda that a stock needs to grow earnings at 20% to justify a 25 PE which is a very lazy approach that is too easy to provide insights.
Practical example - When Cera peaked out at 2950 in May 2015, my reverse DCF told me that the company had to do 20% earnings growth over the next 10 years and get an exit multiple of 35 at the end of the period to justify the price. Low probability event and I did sell some though my execution wasn’t ideal, I do keep a tail in such scenarios if I believe the business has a long enough runway ahead.
The type of business also is an important input to the reverse DCF process, if the business serves segments like FMCG where the range of outcomes is not very wide, it is not meaningful to sell out for minor incidents of overvaluation since the Terminal Value is where the juice is, not the earnings visibility for the next 2-3 years.
However if it is a cyclical business, one needs to be more conservative even at the risk of selling out too early. Classic example being Sanghvi Movers which went from 70 to 400 in 1.5 years as the company became profitable again. However the stock price is now back to 150 range since the company did a massive capex and the wind energy segment saw a fall in demand. Such businesses where the end demand is cyclical and can suddenly change has a range of outcomes that are far wider, in such cases I am happy selling out prematurely. It is another story that I could not execute very well here as well but I saved myself a whole lot of trouble by being conservative.
I always ask myself - is my valuation thought process for a business consistent with my evaluation of the quality of the business? If not mistakes will eventually be made that will cost me. If I believe something is a high quality business (irrespective whether the market prices it that way) I will give a longer rope to the business than to a business which may not rank very high in my evaluation.
This thought process is my conclusion from -
- reading most of Michael Mauboussin’s papers
- The investment checklist I have developed that is optimized for my own thought process and style of investing
- Borrowing ideas from Morningstar framework on classifying businesses into wide/narrow/no moat
Unless all of these tie in it is very tough for me to take a conclusive call on selling. Buying I admit is way easier and something that I am more confident about