Selling in a bull market

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In the midst of a bull market, there’s no shortage of commentators, brokers, and friends with the latest tip on what to buy. However, nobody ever says much about selling. Baron Rothschild said the secret to his success was “I never buy at the bottom and I always sell too soon.” Picking the exact top is nearly impossible, but sensible risk management is essential to being a successful investor. In order to better understand how to think about this issue, we asked three fund managers what a ‘sell’ looks like, what would cause them to ‘pull the trigger’, and for some examples in the current market. Responses come from Steve Johnson, Forager Funds; Ben Clark, TMS Capital; and Garry Laurence, Perpetual.

Two lessons about the current market

Steve Johnson, Forager Funds

We don't let the market dictate our behaviour. So, the trigger for selling is the same today as it was four years ago: the returns on offer no longer meet our required rate of return. That can be because the share price has run up. It can also be because our original estimates of the business's profitability were wrong.

I have learned a few lessons the hard way about markets like this, though.

The first is that you don't want to be caught holding low quality businesses because they are "relatively" cheap. The returns from some low quality businesses have been excellent in recent years - and we have done well out of them - but you want to be paying screamingly low absolute prices, not relatively low.

“Don't be caught holding low quality businesses because they are "relatively" cheap… You want to be paying screamingly low absolute prices”

Second, try to avoid drifting into extreme amounts of cash. Have the discipline to sell over-priced businesses and be prepared to hold cash if you can't find anything to replace them with. But the case for owning equities over the long term is strong. So, try to hang on to that core portfolio of good businesses trading at reasonable prices and keep working hard to find new ones.

Two major risks and the stocks exposed

If I inherited a portfolio of the ASX 100, the first stock sold would be Fortescue Metals Group (FMG), closely followed by the banks.

Fortescue's singular focus on iron ore leaves it completely exposed to a slowdown in Chinese demand for the commodity. That slowdown has been a long time coming and I would never short the stock, but the risk/reward trade-off looks lopsided at today's prices.

“I don't think you are getting compensated for owning the banks given such a fragile status quo.”

And speaking of a long time coming, Australia's house prices have levitated for decades. You would be braver than me to predict an imminent collapse, but maintaining the levitation requires interest rates and unemployment to stay low and the financial sector to keep lending copious amounts of money. Again, I don't think you are getting compensated for owning the banks given such a fragile status quo.

A recent change in our portfolio

Ben Clark, TMS Capital

Although slightly out of the equity camp, listed debt securities are an area of the market we spend considerable time analysing and investing in looking for either equity style returns (CWNHB being a recent example) or attempting to generate stronger income returns. It is in this area we have made one of our larger adjustments over the past week, having rapidly sold out our entire longer dated hybrid exposure.

By way of some background, hybrids have been a fairly divisive area of the market, maligned by many professional investors. However, the reality is these securities have delivered on their objectives over a sustained period of time. Even through the ultimate test of the GFC all investment grade companies (predominantly banks) called in their securities on time, at face value, without missing a single distribution.

Change, however, is potentially afoot. Bill Shorten’s announced changes to franking have triggered huge debate, but one area that has barely been discussed is the impact it will have on the $30bn + hybrid market. There is little data on this but anecdotally and from first-hand experience, we know that this market is heavily invested in by self-funded retirees. In their view, the franking credits attached to the cash distributions are as good as cash and part of the overall pitched income return.

So, what happens if franking credits can’t be utilised? Although we have seen some commentators suggest companies may have to pay the distribution in straight cash or APRA may ‘carve out’ the existing listed series we believe this is highly unlikely. Far more likely is that the dominant class of holders will have to accept a much lower yield through to maturity.

Our concern is that as this dawns on investors a significant number may hit the door at the same time pushing prices lower. Prices may trade at a decent discount to face value for a sustained period of time. Those whose maturity is further away should come under greater pressure. What has added to our concern is as we’ve been selling we’ve noticed a pronounced lack of buying depth on fairly low volumes. If just 2% of shareholders of many of these issues all decided to sell at once it will cause real issues.

"Prices may trade at a decent discount to face value for a sustained period of time."

There are, of course, many investors who can still utilise the franking and the income returns will be as promised. But will they be happy holders in the face of selling pressure from others?

When the ‘Selfies’ run for the door

ANZ recently issued its latest hybrid ANZPH onto the market which was large, raising close to $1bn. To put this into context this issue is 3 x larger than the market cap of Myer, a company producing countless headlines despite the fact very few of us own it.

ANZPH and several other similarly dated securities look highly vulnerable to a Shorten election win (currently paying $1.57 at the bookies) or even the threat of a win due to their margin and duration. We again suspect that the largest holders of this security are likely ‘Selfies’ who are faced with the prospect of earning a 4% net income return for five years if the changes come in as pledged before their first call date as at March 2025. If the bank elected to let them trade through to maturity it will be seven years.

The reality is a 4% return does not adequately compensate investors for the risk of these securities. There are a number of subordinated notes trading on the market or shorter dated hybrids that offer healthier returns for now far less risk. The question is, if a reasonable number of holders realising this to be the case start selling, what is a fair price?

What a “sell” looks like

Garry Laurence, Perpetual

The trigger points for selling a stock as value investors, is generally when a stock goes above what we think is fair value. For example, we might start selling a stock when we think its 5% overvalued and average out until its 20% overvalued.

The decision about what is fair value for a stock is probably one of the hardest investment decisions, many investors prefer to take the complacent approach and hold onto expensive stocks because they are good companies. We are value and quality managers and therefore will sell out of an expensive quality stock and find a better valued quality stock.

"We have been rotating into more defensive industries like consumer staples."

In the past 12 months we have sold out of cyclical businesses in the industrials sector where valuations have significantly re-rated. These businesses can have large volatility in their earnings stream when there is weakness in the economy. Given that we are at the latter stages of a bull market, we have been rotating into more defensive industries like consumer staples.

Finally, the last trigger point that would cause us to sell a stock is when the fundamentals change and the reason why we bought the stock in the first place is proven to be wrong or just that the situation for the company and the industry has changed since we bought it.

Beware high prices and high leverage

I would sell stocks that are over-geared, especially if they are in cyclical industries as that is the worst combination for weaker markets. The fund I manage also doesn’t short, however, the ideal short is when you identify a change in the company’s fundamentals which the market isn’t pricing in. I don’t spend my time looking for these bad companies, but I would be weary of over-geared retailers in developed markets. The growth of online and Amazon is a big headwind for these businesses.

We did recently sell out of General Mills, which we think has a wonderful collection of brands like Haagen Daaz and Yoplait. The reason for our sell was that they geared up the balance sheet to buy the natural pet food company, Blue Buffalo, for an embarrassingly high enterprise to EBITDA multiple of 25x.


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