SIMON BROWN: I’m chatting with Keith McLachlan from Alpha Asset Management, really trying to delve into when to sell. And in particular, there’s upside selling, selling at a profit, there’s downside selling, selling at a loss, valuations and the like.
Keith, thanks very much for your time today. You’re a classic fundamentalist. You will go and do discounted cash flows and the like, and they help you understand when to buy. Of course, there are two components to it. One is price/valuation. The other is actually the business in of itself. How much are those chained to your mind? What is the relationship between them? Are they of equal weight in your mind, or is one at a certain point more important and then later becomes perhaps less important?
KEITH McLACHLAN: Hi, Simon. Good to be here. That’s a very loaded question. I’m going to answer it much like an economist – “It depends.” If we backtrack a little bit – and there are obviously also traders listening to this, not just investors like myself – my perspective of increase versus exit is that a good exit starts with a good entry. What I mean by that is if you know why you bought the stock.
Now, if you’re a trader, it might be price action, momentum, I don’t know, oversold, overbought, whatever. And if you’re an investor, there are the fundamentals, the combination of fundamentals and valuation, and you’re expecting returns and the like. These are the tools that got you into the stock and, if you did your work correctly, they are also the ones that will get your out. You will know at which point to do that. So I go back to your question – It depends. The business, the valuation, all these metrics come together to generate total returns. If you don’t know why you’re in the stock, then you’re going to struggle to know when to get out.
SIMON BROWN: That’s a great point. And it’s something which I always champion, which is “be very clear”. I like to have typically two or three reasons why I’m in the stock. One of them might be valuations, it might be margins, it might be whatever it is – but it tells me very clearly what got me in. Then I watch those and when they start to break down one way or another, I start to think, hey, maybe this is time.
KEITH McLACHLAN: Definitely. And those, in trading terminology, will be your stop-loss or whatever, and in investing terminology that’ll be a deterioration in fundamentals, and so on. Those are key metrics to track, and you’ve got to know why you’re in the stock.
But there are other exit triggers – asymmetrical downsides that appear. What I mean by this is take for instance fraud. Now you may know why you got into a stock and you may have a clear understanding of it and when last you checked, last you knew, all of that was valid. And then a big announcement of fraud or potential fraud comes on. Now, what I mean by asymmetrical downside is if it turns out that there is no fraud in the company, as you had thought, and it was what you thought it was worth, so you didn’t get any upside from it not being a fraud. But if it does turn out to be fraud, then it isn’t quite what you thought it was and there’s the only downside from there. So asymmetrical red flags that come out will definitely trigger exits in my mind.
Say, for example, a major exit by a co0ntrolling shareholder, or there’s a boardroom coup, there’s no upside to boardroom coups and direct disputes. No one wins except for the lawyers there.
SIMON BROWN: Fair point. We were talking about this three weeks and a few days after Steinhoff, which was a classic example of things going horribly wrong.
Well, what about just good old fashioned price? You get into a stock, you’ve done the digging, you really like it and everything, and then it just goes on an absolute tear. You thought you had maybe a 30 or 40% upside and the thing doubles. You still love the stock. The management is there, the margins are there. Everything’s still there, but suddenly it’s just become eye-wateringly expensive. At that point do you take some or all off the table, or do you say, look, I back the management team. We might see reduced or perhaps even negative return over the short term, but long term I still like this stock and want to be in it.
KEITH McLACHLAN: Any investment strategy in the market that doesn’t embrace big winners and the big potential upside is ultimately probably going to turn up quite mediocre. What I mean by that is, if we take a normal distribution of the market and you have a 10-stock portfolio, eight of those stocks probably just track the market, be it slightly up, slightly down. One of those stocks will probably be a bad call and, if you’re lucky, you’ll get one stock that is a superb call.
Now the eight that tracked the market are just giving you beta, so let’s forget about those. And then the one that does badly, the maximum you can lose on that in the absence of gearing leverage is 100%, but the one that does well can do theoretically infinity – practically not, but you can get thousands upon thousands of percent return. Now, even if none of your stocks all go to zero, but one of your stocks goes up a thousand percent, well, you’ve got your money. And then in fact from there you can go up 15 000%, like Tesla that just never seems to end.
Now, a portfolio that has just one of those stocks that runs so insanely can actually generate a pretty good return. Unfortunately, our biggest enemies are ourselves, and we tend to cut the winners and then reinvest into our losers. I’ll go back to my point that any strategy in the market that’s going to generate a good return in the long term has to embrace its winners. That doesn’t necessarily mean you have to do so blindly. One can let a stock run into a maximum weighting, and then from there start to trim. You don’t necessarily exit, you trim down into a more comfortable position size so long as once again – I go back to this – there are no red flags and your fundamentals are still intact.
But I do think it’s very important that you don’t sell your stock that’s up 10% because then you are capping your returns and you’re never going to get 100%. Don’t sell your stock that’s up 100%because you never going to get 1 000%. Let your winners run and embrace that upside, and you need a way to manage the risks around that. That’s where looking at the fundamentals, knowing your stocks, controlling your position sizes – things like that are quite important.
SIMON BROWN: That position size. I’ve told this story before. Capitec – I bought at R20 and R40 back in 2009. And I literally spent the next decade selling it, because it was always overweight in my portfolio. And man, if I just stopped selling it, I could have an island somewhere. So that’s the upside. That 10th stock or the 9th stock, perhaps, that is falling – ideally, you don’t want the 100% down. If the fundamentals are breaking or if there’s fraud or something like that, that’s relatively easy, there’s your giant red flag being waved in your face. Take that money and get out while you can.
But there are other times when you look at this and you think to yourself the market is wrong, and this is a great stock and it shouldn’t be at this price, but that’s a brave call to make.
KEITH McLACHLAN: In those instances, when you’re trying to judge the downside, and you go gosh, maybe I think the fundamentals are still in place, they are what I expected them to be, but the market isn’t pricing them correctly, just make sure whether the balance sheet is sound, the cashflow is good, make sure that you’re not doubling up on a stock that truly can go to zero, in which case this is an analysis of downside. So you’re looking at liquidity, solvency, margins, cash flows – those sorts of things, in which case, absolutely, the market can be wrong for a very long time. But at the same time, what’s the point in doing the work, knowing your stock, if you’re not going to follow your convictions and you’re just going to follow price?
SIMON BROWN: Okay. To me, the downside is often the harder one. In my trading life, it’s easy because I’ve got a hard stop loss. In the investing life often it’s hard to say to myself, you know, I thought this was a good stock, maybe I’m wrong. The market seems to be disagreeing with me. I suppose this all – you mentioned the 10-stock portfolio – kind of sits within that border portfolio. And we’re talking individual stocks here. But broadly it’s actually portfolio management in many senses.
KEITH McLACHLAN: At a portfolio level, if you are controlling your risk, you can let your winners run because you didn’t build a position that was 50% of your portfolio in it. Also, if you are controlling your risk and controlling your position sizes and you’ve got a diversified portfolio, the one that’s falling, well, you probably have a little bit of cash, you can average into it without selling out on the winner. This perhaps even goes beyond my opening sentence about a good exit starts with a good entry. Actually, all of this starts with good portfolio management and good risk management. And as long as you’re within the bounds, you’re comfortable then, and you’ve got a lot of wiggle room with these things.
SIMON BROWN: Yes, you have, and I love that point. A good exit starts with a good entry, and know why you buy. I’m old school, I write it on a piece of paper. I know exactly why I own a particular stock, and when that starts to crumble, that’s my exit. I’m never exiting at tops – that’s wonderful, but it doesn’t practically happen.
We’ll leave that there. Keith McLachlan from Alpha Asset Management, I really appreciated your time today, have really appreciated your early mornings over the course of the year.