In 2015, Leithner and Company Ltd purchased shares of BHP. In June of this year, we sold them. Over these years, this investment generated an unexpected but gratifying compound rate of total return of almost 30% per year. Using it as an example, this article summarises our approach to selling investments. As a “buy-and-hold” investor, we seldom sell. But long-term investors are relatively few; much more common is rapid buying and selling (“churning”) of securities.
Many people sell frequently, and plenty regard the decision to sell as more difficult than the one to buy. This, I believe, is because they tend more towards speculation than investment. They repeatedly allow emotions of fear and greed to override reason; as a result, their short-term behaviour considerably lowers their odds of long-term success. In contrast, our occasional resolve to sell isn’t merely the final step of a systematic process: it’s the mirror image of the choice to purchase. The eventual decision to dispose isn’t simple; but by our approach it’s no more difficult than the initial one to acquire.
Two Decisions Maximise One’s Results
The ability to invest successfully over the long term involves – among other things, of which character is paramount – two key sets of decisions. The first is the choice of what to buy and when to buy it; the second is the decision to sell. Successful investors purchase at prices which provide a “margin of safety,” and they sell when the risk of holding markedly outweighs the long-term benefits of retaining.
An investment’s eventual return therefore depends – again, among other things – upon its initial purchase price. Indeed, investors’ profits or losses occur not so much when they sell but at the time they buy. Acquiring at an attractive price influences one’s profit, but disposing at an appealing price crystallises it. If you don’t sell sensibly, the benefits of buying astutely dwindle and can even vanish.
Why Is Selling So Difficult for So Many?
“Buying a stock is easy,” one financial adviser wrote last year. “Holding it is a little less easy. Selling it? That’s the hard part.” This is because emotions such as fear and greed drive many decisions to sell. According to Canada’s Financial Post (5 August 2016),
One of the hardest things for investors to do is to actually sell an investment. If a stock is up, they do not want to sell for fear of missing out on more gains. If is down, then they do not want to sell for fear of missing a recovery, or fear of “locking in” losses.
“Many investors have trouble selling a stock,” adds Investopedia, “and sometimes the reason is rooted in the innate human tendency toward greed.” Anxiety and avarice are symptoms of a deeper problem: many people who think they’re investing are actually speculating. The trouble is that speculation is necessarily more prone to allow emotions to cloud judgment than is investment. If you tend to buy and sell frequently in response to fleeting stimuli and in pursuit of quick gains, then it’s likely that you’re speculating rather than an investing. To paraphrase Benjamin Graham: investing isn’t about emulating others at their emotional game; it’s about controlling your emotions, sticking to your principles and thus maximising the odds that you win your methodical game.
A Hypothetical but Realistic Example
Consider a scenario adapted from Investopedia. You purchase a company’s shares at $25 and resolve to sell them if (and, you are confident, when) they reach $30. Before long the stock obligingly rises to $30 – but “experts” opine that it will climb further, so you decide to hold and pocket more gains. The stock soon reaches $32. You ponder whether to sell or wait until it rises to $35 (as its vocal boosters insist it shortly will), but before you decide it plunges to $29. Chastened, you tell yourself that as soon as it rebounds to $30 – which, you struggle to convince yourself, it surely must – you’ll certainly sell. Alas, what you desperately desire doesn’t occur. Quite the contrary: the stock continues to sink. You succumb to your mounting fear and frustration – and the sudden despondency of “analysts” – and sell at $23.
“In this scenario,” says Investopedia, “it could be said that greed and emotion have overcome rational judgment … but the real question is the investor’s reason for selling.” Also crucial is the timeframe over which this scenario transpires. “Time is the friend of the wonderful company, the enemy of the mediocre,” says Warren Buffett. A corollary: regardless of what the speculator does, time is his nemesis.
Transactions like the one in this scenario typically occur within one year – and short holding periods and the desire for quick gains are hallmarks of speculation. Let’s assume that a speculator holds these shares six months and receives one half-yearly dividend. Also suppose that an investor bought shares of this company at the same time the speculator did, but held them for five years, collected dividends and then sold them at $23. Assume as well that at the time of purchase these shares’ dividend yield is 5% and that the dividend remains constant during the next five years. For the speculator, that’s one payment of $0.625; for the investor, it’s a stream of $1.25 × 5 = $6.25 over five years (Table 1). Ignoring several complications (such as tax, the timing of the investor’s receipt of dividends, etc.) which don’t affect the table’s major implication, the investor earns a compound rate of return of 3.2% per year. The speculator generates an annualised loss of 11%.
Table 1: Comparing an Investor’s and a Speculator’s Returns
What if both the speculator and investor sell at $22? The speculator’s annualised loss plunges to -19%. The investor, on the other hand, continues to profit (2.5% per year). If the investor sold at $18.75, then thanks to her dividends she still would have broken even – but the speculator would have incurred an annualised loss of more than 50%! What if they sold at $24.375? The speculator’s loss would disappear and the investor’s gain would lift to 4.2% per year.
Given a particular “buy” price, the speculator’s return depends much more than the investor’s upon the “sell” price. That’s because the investor typically receives a stream of dividends. This stream doesn’t merely increase the investor’s total proceeds; they tamp her long-term return’s fluctuation. The greater is the stream of dividends, the lower is the impact of the “sell” price upon long-term total return. As a result, investors can tolerate much lower sell prices before incurring losses. Speculators, in contrast, must grab every marginal uptick of price they can get. In this key sense, speculators MUST be greedier – and more prone to anxiety and frustration – than investors.
Two insuperable difficulties hobble speculation. First, dividends comprise but a small portion of its total return; accordingly, and secondly, its results are therefore very sensitive to short-term movements of prices – which defy prediction.
A Real-Life Example
For years, what is today BHP Group has been one of the world’s largest exporters of metallurgical (coking) coal, copper and iron ore. If the transaction it and Woodside Petroleum announced in August succeeds, it will no longer rank among the largest producers of oil and gas in Australia and the Gulf of Mexico; but if another project it announced the same day comes to fruition, during the next several years it will develop the world’s largest potash mine. BHP has long been a global leader of its industry; it provides essential goods and services; it boasts a long but not flawless history of profitability and payment of dividends; and it possesses the financial muscle and managerial depth to maintain its strengths and pursue opportunities. In short, BHP epitomises the type of business that Leithner & Company seeks to include in its portfolio.
So why in June of this year did we sell our shares? We acquired them during the July-December half of 2015. Underpinning our purchases was our detailed analysis which concluded that their value significantly exceeded their price. At the time we reasoned that if our cautious assumptions were approximately correct, then we could reasonably expect to earn a compound rate of return of 15% per year for five years.
By the end of the January-June 2021 half-year, the opposite situation prevailed: the price of BHP’s shares greatly exceeded their value. If the assumptions of our most recent analysis were roughly correct, then at the prices prevailing in June of this year we couldn’t reasonably expect to earn a compound rate of return of more than 3% per year during the next five years.
Historical data and long-term rates of total return (that is, including dividends and share buybacks, etc.) provide important inputs into our decisions. Since 1990, BHP has rewarded its investors handsomely. In particular, since the start of the China and mineral commodities booms in the early-2000s, it has mostly – and cumulatively greatly – “outperformed” the All Ordinaries Accumulation Index (AOAI). Figure 1 compares the growth – assuming the reinvestment of ordinary and special dividends, and adjusted for its changing number of shares on issue – of an investment of $100 in BHP and the AOAI. $100 invested in the AOAI in January 1990 grew to $1,547 in June 2021. That’s a compound rate of total return of 9.2% per year. In contrast, $100 invested in BHP in January 1990 rose to $4,076 in June; that’s a compound rate of total return of 12.7% per year. During shorter intervals the investment has ebbed and flowed, slumped and surged. Most notably and recently, it halved from $2,049 to $988 in the ca. 18 months from May 2014 to December 2015. On the other hand, from then to June 2021 it zoomed at a compound return of almost 30% per annum.
Figure 1: Investments of $100 in BHP and the AOAI, 1990-2021
At the time we purchased its shares, BHP was hardly a market darling. In contrast, and compared both to its track record during the quarter-century from 1990 and the low expectations prevailing in 2016, its total return in 2016-2021 was extraordinary – and, I believe, during the next five years is therefore unlikely to repeat. In retrospect, Leithner & Company purchased BHP at just the right time – and without regard to either analysts’ or the crowd’s pessimism. The market value of $100 worth of its shares in December 2015 (again assuming the reinvestment of dividends, etc.) rose to $354 in June 2021; an investment of $100 in December 2015 in a portfolio that mirrored the AOAI, on the other hand, rose to $167 (Figure 2). During this interval, the Index’s compound rate of return was 9.9% per year; BHP’s was three times higher.
Figure 2: Investments in BHP and the AOAI, December 2015-June 2021
BHP’s results during the five years to mid-2021 were stellar; but what about the next half-decade? According to the updated analysis we completed in June, in order to return (including dividends) 20% per year for five years, we had to buy BHP at $21 per share or less. But its price averaged more than twice this amount in June. If a return of 5% per year will suffice, then we had to purchase at $41 or less. If our assumptions are reasonably accurate, then the purchase of BHP’s shares at $48.50 per share (the proceeds from our sale in June, including premiums from call options) will during the next five years generate a compound rate of return of ca. 1.5%-3.0% per year.
Given these prospective returns, we regarded as prohibitive (relative to their value) the price of BHP’s shares in June. But unless we’d sold our stake then, our return over the next five years would’ve been the same as if we’d purchased them. Hence our decision: having bought BHP’s shares from pessimists in late-2015, in mid-2021 we sold them to optimists. Logic and evidence, rather than emotions like fear and greed, drove it.
First, buy low; then patiently accumulate dividends; finally, sell high – and at all times distrust your emotions and ignore “experts,” the crowd and most “news.” Nothing sounds easier, yet few things, it seems, are harder. Investment is a psychological trial and a pitched battle between the heart and the head. Unless it’s conducted with business-like principles that are applied strictly, the heart will conquer the head – and the investor succumb to speculative impulses. Warren Buffett, in his Preface to The Intelligent Investor, counselled that
to invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.
Leithner & Company’s approach isn’t just highly unconventional: at extreme intervals (such as the 18 months since March 2020) it’s been quite contrarian. It’s also deeply conservative, and over 20 years and through three crises (the Dot Com bubble, GFC and GVC) has proved successful. We conduct our own enquiries, undertake our own analyses and act on our own judgement; buy the securities of leading companies in essential industries from pessimists at what we regard as attractively low prices; collect dividends and eventually sell securities to optimists when we believe their prices are unreasonably high. We don’t claim that we’ve conquered fear and greed. To a significant extent, however, we’ve inverted them. As a result, our actions have tended to contradict the crowd’s: over the years we’ve been cautiously conservative (selling what others buy) when the herd was greedy, and aggressively conservative (buying what most others shun) when it was fearful.
William Vinck says
Thanks for this thoughtful article. As I read it, I couldn’t avoid the notion that Leithner & Company has a regard for the concept of intrinsic value, has a means to discover and analyze it, and the discipline to follow it wherever it leads.