Worried about giving back your profits? 2 fundies share their exit strategies

A big part of the art and science of being a good investor is knowing when to sell. But even that is often easier said than done. 

Understanding the best time to exit a stock and executing on it can have a marked impact on your performance, and even the experts have spent years developing and honing their own exit strategies. 

So how should you work out when to sell? Should you have a strict strategy you stick to, or should you take a more fluid approach? 

To answer those questions, we've enlisted the help of ClearBridge Investment's Head of Australian Equities, Reece Birtles, and Yarra Capital Management's Head of Australian Equities, Dion Hershan.

What is your exit strategy?

In its Australian equity investment team, ClearBridge employs an exit strategy built around three principles: valuation, the breakdown of its investment thesis, and red flags. It's a discipline built on 30 years of fundamental experience and quantitative testing, according to Head of Australian Equities, Reece Birtles. 

When determining whether to sell, valuations are a primary consideration for ClearBridge. 

"As a valuation-focused manager, we are always looking at discounted cash flows based on quality, growth characteristics and a reasonable price to pay," says Birtles. "After reviewing all assumptions, if we can no longer justify the valuation (i.e. the bottom 40% of Australian stocks), we sell."

This valuation is driven by the investment thesis ClearBridge forms around all its investments, and it takes action when reality no longer aligns with this thesis, according to Birtles. 

"When buying stocks, we have an investment thesis - a view on what we believe will happen to the business over time - which drives our valuation assumptions," he says. "We also aim to understand what is in our insight that is differentiated to what is implied in the market price."

"When a company’s performance fails to align with our investment thesis, it tells us we are not seeing things properly. Therefore, we review our thesis and valuation and sell."

Part of what makes up this thesis is an assessment of the potential red flags around a company, which can cause stock valuations to dislocate. This can create buying opportunities for ClearBridge but also influences when they might sell. 

"As a manager looking to buy undervalued companies, we are used to delving into controversy," says Birtles. "Companies that are cheap now generally have some controversy about their outlook, and this is what we look to have a differentiated opinion on."

"We monitor fundamental and systematic red flag indicators to identify how controversial names are. We find some controversy is good, but when there are too many flags against the name, it becomes a coin toss. In that case, we would also sell."

"A good example of our sell discipline in action is with our previous holding in Woodside Energy Group (ASX: WDS)," says Birtles. 

"We built a significant position in Woodside over 2020 and 2021 when low Covid oil prices, and a good deal with BHP, reduced debt stress. We liked the growth profile of their LNG and Oil field assets that were coming online as they had strong expected cashflow and limited future capex." 

"The stock did go on to recover with the oil price, reducing the valuation appeal for us. Then, they did what we viewed as an investment thesis break deal, buying into a US LNG infrastructure project that relied on the spread between the US gas and Asia gas price, which is low-margin, low-return and volatile and would absorb a huge amount of cashflow. We sold out, and the stock has underperformed ~50% since mid-2023."

Like ClearBridge, Yarra's Australian equities team uses three key principles to inform their decision to sell, says Dion Hershan. 

"We typically exit positions for three reasons," says Hershan. "First, because a stock lacks long-term valuation support. Second, because we have found better relative opportunities elsewhere in the market, or lastly, that our thesis was invalidated (a polite way of admitting ‘we got it wrong’)."

Maintaining focus and discipline is core to Yarra's strategy, says Hershan.

"It’s critically important to avoid the behavioural biases that often plague investors, so having a strong discipline around selling is every bit as important as buying."

Selling is a fundamental aspect of portfolio and risk management, and it's important to treat it as such, he says. 

"Being intellectually honest and having robust debate about stocks avoids small mistakes becoming big ones. This approach has served our investors well. Rather than making a binary exit decision, it can often make sense to trim positions to invest elsewhere and manage the risk accordingly."

Does your strategy evolve or is it set in stone?

Having a clear framework for your exit strategy is the first step, but both fund managers agree it's an ongoing process. 

"It has to evolve, but it does so with some core principles," says Hershan. 

"We have found over time that our biggest mistakes have typically been to sell high-quality businesses that had significant long-term growth potential on the basis of valuation concerns or noise in the short term."

This has meant a change in how Yarra approaches the stocks that remain in its portfolio, with an emphasis on higher-conviction investments. 

"Equally, we are now a lot more focused on the ‘opportunity cost’ associated with holding a stock; being ‘cheap’ or undervalued may not be sufficient," says Hershan. "Our investable universe is wide, and we are focused on owning the best possible ideas and crowding out the more marginal ones."

Their strategy has also evolved to better understand when a stock may re-rate, instead of waiting for it to happen, says Hershan. 

"It is also often difficult for investors to distinguish between being ‘wrong’ vs. ‘early’. Rather than being eternally patient, we dedicate significant time to understand whether there are proof points that suggest the performance or outlook will improve in the future."

"We are always working on testing and refining," agrees ClearBridge's Birtles. "We house our historical and current data in an interactive database that gives constant feedback about what is working and what is not."

One key learning has been that buying the right stocks is what fundamentally drives value, and selling can almost be seen as a mechanism that facilitates that.

"We know from our trade analysis of buys and sells over subsequent 90-day, one- and three-year periods that our most important decisions are buying good stocks. That is where we create the most value, and this in fact swamps the value add from our sell decisions. Selling for us is really about creating space to find next great investment ideas."

Do you ever break the rules, and if so, why?

If you have a watertight exit strategy, should you be flexible about when and where you employ it?

"No," says Birtles, "but rules are about how to handle things."

"Our sell discipline is not simply sell because a stock beat our target valuation from the time when we bought it. We always assess the facts and expectations of each stock using today’s lens."

For Hershan and Yarra, it's a matter of "never consciously" breaking their own rules. But "mistakes do happen", and such eventualities can often serve as learning experiences.

"To avoid repeating a mistake, we focus on having a clear audit trail of our research process and of our thinking. We have transparency which ensures we can track performance and a robust environment to fully debate ideas and then make decisions that are consistent with our principles and the agreed process." 

"Discipline around this is fundamental, and is often where many well-intentioned investors make mistakes."

What advice would you give to investors sitting on big gains with no exit strategy in place? 

If you're currently in the position of wanting to sell out of a profitable position, you should first evaluate the decision in the context of your wider strategy, says Hershan. 

"The first step is to be self-aware," he says. "You need to form a view on valuation and if your overall portfolio lacks diversification – and if it makes sense to reduce the risk – then you should consider either using options or trimming the position. If you are exiting, always look for tax losses that you might have elsewhere which can act as an effective offset."

For Birtles, it's about reassessing the position through the right lenses - and why it's so important to have a robust exit strategy in the first place. 

"Momentum as a thesis to hold onto a stock is great whilst it's positive, but what are you going to do when it turns negative? This is why you need to constantly assess valuation, investment thesis and red flags."