This post was originally published on MastersInvest.com.
Let’s face it, it’s hard to find great companies. It’s the veritable needle in a haystack conundrum; there are hundreds of thousands of businesses out there but only very few can be called ‘great.’
Great companies are those that will be worth a lot more many years from now; those with solid balance sheets and cash flow, great management, high returns on capital, pricing power, excellent cultures, and with strong competitive advantages that keep competition at bay with minimal risk of disruption or obsolescence.
I’m sure you’ve noticed that most of the Investment Masters have a preference for buying high quality businesses. These businesses are typically capital light organisations which can reinvest their cashflows at high rates of return. They are often referred to as ‘compounding machines‘.
Like many investors, Buffett started out looking for cheap stocks. Over time, with the insights from his See’s Candies acquisition and of course a little help from Charlie Munger, he realised the best returns were to be found in owning the great businesses.
The questions at hand are should you sell a great business? And, if so, when?
The answer for a long-term investor may actually be never …
“Selling great companies with large growth potential, even at seemingly rich valuations, is usually a mistake.” Allan Mecham
“Our favourite holding period is forever” Warren Buffett
“If the job has been correctly done when a common stock is purchased, the time to sell it is almost never” Phil Fisher
“The question about selling a really great business is never. Because to sell off something that is a really wonderful business because the price looks a little high or something like that is almost always a mistake. It took me a lot of time to learn that. I haven’t fully learned it yet. It’s rare it makes sense. If you believe the long term economics of the business are terrific, it’s rarely makes any sense to sell it” Warren Buffett
“Some of our biggest mistakes have been in selling down positions in great businesses when we thought they were fairly valued, or even a bit overvalued. In our experience, compounders tend to keep compounding, so we’re slow to sell unless something in the business or company has fundamentally changed or if the valuation has just become extreme” Peter Keefe
“The reason I wanted to include my adventures with Ferrari in this letter was to try to reinforce in my brain the importance of just sitting on your ass when you own great businesses run by great managers. It is not a good idea to sell them unless they are egregiously overvalued.” Mohnish Pabrai
“We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply too hard to replace” Warren Buffett
Even when great companies trade at an expensive multiple, it doesn’t necessarily mean they won’t deliver attractive returns.
“If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” Charlie Munger
Many an investor has made the mistake of selling a great business at a high price in anticipation of buying it back cheaper. Getting the timing right is problematic and great companies are hard to find.
“If we believe the business model is going to continue to compound our capital at high rates, and we recognise that number will go up and down for normal business experiences, we want to hang on to the business, because the really great ones are, A, too hard to find, and B, too hard to replace. Every now and again we fool around with taking a little bit of something off of the table because we think it’s gotten too rich. My sort of life experience is that if I sell a stock at $30 because it’s too rich, and I set in my mind that I’m going to buy it back at $23, inevitably, it trades to $23 and an eighth, or $23 and one, or whatever it is. Oh yeah, whereas if it trades at $22.98, you know it trades 300 shares there, or something like that, and I never get it back. And then the next time I look, instead of being $30, it’s $300. And I messed it up.” Chuck Akre
It can be psychologically difficult to buy back in at a higher price if you’re wrong. Even Buffett acknowledges this bias impacts him..
“It’s a little hard when you looked at something at X and it sells at 10X to buy it. It shouldn’t be, but I can just tell you psychologically it’s harder – if you looked at it in the first place and passed at X to buy at 10X. It’s cost people a lot of money. It cost people in Berkshire. People saw it at a lower price and they say ‘if it gets back there I’ll buy it,’ but that’s a terrible way to think.” Warren Buffett
To highlight this point, in his 1995 annual letter, Buffett referenced his experience with Disney shares…
“One more bit of history: I first became interested in Disney in 1966, when its market valuation was less than $90 million, even though the company had earned around $21 million pre-tax in 1965 and was sitting with more cash than debt. At Disneyland, the $17 million Pirates of the Caribbean ride would soon open. Imagine my excitement – a company selling at only five times rides!”
Impressed with his findings, the Buffett Partnership bought a large amount of Disney stock at a split adjusted price of 31 cents per share. If you look back on this, you may think this was an outstanding move, given that the stock now sells for more than $90 per share. In his 1995 letter however, Buffett acknowledged he ‘nullified’ the brilliant buying decision in 1967 when he sold out for 48 cents per share!
Sometimes it might feel like the right thing to do is to sell on bad news. Provided the investment thesis remains intact and the longer term business outlook hasn’t changed, it’s probably best to hold on.
“Selling fine businesses on “scary” news is usually a bad decision” Warren Buffett
That’s not to suggest the share prices of great businesses will be immune to a stock market correction. They more than likely will. Unfortunately, Mr Market won’t necessarily distinguish between the good and bad businesses – even the great businesses can expect to have their prices knocked down.
“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls” Peter Cundill
“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty
“I used to hold Berkshire stock as a proxy for cash and that was a mistake. During times of distress, everything will go down, including Berkshire” Mohnish Pabrai
“You’re deluding youself if you believe your stocks, however cheap they are, won’t temporarily go down when Mr Market decides to correct.” Charles de Vaulx
“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value” Leon Levy
Don’t let a market correction scare you out of holding a great business for the long term. Remember, ‘quoted’ prices can and often do reflect the emotions of the crowd, not the true underlying value of the business.
“When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact market prices are frequently nonsensical” Warren Buffett
Many of the Investment Masters adopt the mindset of a business owner as opposed to a share market trader to help filter out the noise of stock market fluctuations.
“In our view, what makes sense in business also makes sense in stocks: An investor should ordinarily hold onto a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business” Warren Buffett
In light of the above, you have to make sure you can survive the short term fluctuations to achieve high long-term returns. This requires patience, a solid understanding of the underlying business to give you the conviction to hold, the recognition that values and prices can get out of kilter, and an absence of leverage. As Charlie Munger advises, if you’re not willing to experience a 50% decline in a stock you probably shouldn’t be in the stock market.
“This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” Charlie Munger 2009
You’ll note Charlie Munger said that Berkshire shares had dropped in value by 50% for the third time. Had an investor sold out of Berkshire Hathaway during any one of those declines they would have done themselves a major disservice.
The share prices of great businesses also tend to recover from downturns faster as they often emerge in a stronger position – weaker competitors either fail or lose market share through measures taken to survive the downturn.
“From 1932 to nearly the present, the studies confirm that when bad things happen to good companies, they recover – and usually quite nicely in a reasonable amount of time” Chris Browne
“At the end of the day, in order to build wealth, there is a simple approach which we have followed for 17 years at Giverny Capital: investing for the long term in high-quality companies purchased at attractive valuations—investing in companies that will survive the crises of our civilization and the short-term irrationally of our economic system.” Francois Rochon
“People don’t believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it” Jeffrey Ubben
“We think a rigorous discipline of buying quality companies, when priced right and run by honest, intelligent management teams, offers the best defence against challenging macro conditions” Allan Mecham
Clearly the Investment Masters understand the value of holding ownership in great businesses for the long term. Selling at the wrong time can mean forgoing the gains from share prices that recover to levels that dwarf their prior peaks. Those that continue to provide great returns and weather the unpredictable periodic storms that Mr Market tends to throw at us are worth holding, and the idea of selling ownership in a ‘great’ company is usually a mistake.