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- By Robert Abbott
When and why should you sell a stock? That's the question for chapter 15 of "The Dhandho Investor: The Low-Risk Value Method to High Returns" by Mohnish Pabrai (Trades, Portfolio). The author and hedge fund manager offers the rules he uses for selling a holding, whether it is winning or losing.
The intrinsic value of USAP
Let's start with what he calls the two-to-three-year rule, which states that a company should be held for at least two and preferably three years after purchase. To illustrate the rule, he gave the example of buying a gas station and shortly after buying it, oil prices change substantially, driving down its value.
He wrote, "The gas station has seen dramatic drop-offs in cash flows and the future is murky. We need to allow enough time for the clouds to clear. In two to three years, it should be quite clear whether oil prices are likely to stay permanently at $150 a barrel or higher."
More broadly, Pabrai asserted, "While valuations of public companies can go through dramatic change in a matter of a few minutes, real business changes takes months, if not years."
So if it's necessary to wait three years to see if the situation improves, why not wait even longer, say five or six years? The answer: "It is the opportunity cost of investing those assets elsewhere. Hence, there is a balance between allowing a sufficient time frame for a stock to find its intrinsic value and waiting endlessly." He added we must always be aware of the time value of money.
The two-to-three-year rule also helps investors avoid being scared out of the market at a low price, whether that's because of a sudden decline of an individual stock or a collapse of the wider market.
That rule helped Pabrai avoid making a mistake with Universal Stainless & Alloy Products Inc. (USAP), a company which manufactures specialty steel products for niche applications, including power generation and aerospace. The author discovered the company soon after it bought its third facility.
Research showed the company, formed in 1994, had acquired its manufacturing facilities for $10 million, or "next to nothing". In addition, it enjoyed flexible labor contracts and no legacy costs. The third facility, in Dunkirk, New York, could be scaled up to generate annual revenue of $150 million.
CEO Mac McAninch had been a senior executive in the predecessor company that developed Dunkirk, so he knew its possibilities. He was also someone able to buy mothballed steel mills for very low prices.
Based on this knowledge, Pabrai Funds committed 10% of its assets under management to the company in April 2002, buying shares at $14 to $15 each. If the company could reach $150 million in annual sales, it could turn out earnings of close to $4 per share, which would push its intrinsic value to more than $40 per share.
But a year later, the company was doing worse than before and losing money. The share price had plummeted to $5 per share. Pabrai was very tempted to sell, but he stuck to his rule. He also noted it wasn't Universal Stainless that had a problem, but the whole industry because of a cyclical downturn.
After two years, in April 2004, the company had returned to profitability and the share price was above $10 per share. In addition, it had a growing backlog of orders, the largest in its history. Two years had now elapsed and while his holding was still underwater, he was steadied by Warren Buffett (Trades, Portfolio)'s rule number one and rule number two:
Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
By the time the third anniversary of the purchase rolled around, shares were finally above $15, which moved Pabrai Funds into positive territory. Dunkirk's output, which included further processing of product from the other two plants, had now hit its maximum run rate of $150 million per year and was able to implement price increases. In addition, it had begun making small capital expenditures that would boost earnings significantly.
As the third year went by, Pabrai bought even more shares whenever the price dipped. By the end of 2005, his funds owned nearly 10% of Universal Stainless .
In April 2006, four years after taking his position, Pabrai saw the stock price rise to $31.50 and began selling; in May, the price topped $35. At the time he was writing this chapter, his fund had sold about 60% of its holding. On shares that were held for the duration, the return averaged 19% per year, while the gain was 100% on shares bought in the previous year.
Regarding his two-to-three-year rule, he observed:
"After three years, if the investment is still underwater, the cause is virtually always a misjudgment on the intrinsic value of the business or its critical value drivers. It could also be because intrinsic value has indeed declined over the years. Don't hesitate to take a realized loss once three years have passed."
He also proposed seven questions that should be carefully considered before entering any stock market opportunity:
Do I know and understand this business well; is it within my circle of competence?
How well do I know today's intrinsic value and how it may change in the next couple of years?
Is it selling at a significant discount to intrinsic value; is the discount more than 50%?
Am I willing to commit a major part of my net worth into it?
Does this opportunity have a minimal downside?
Is it protected by a moat?
Are the managers honest and able?
"One should only consider buying if the answer to all seven is a resounding yes. If a well-understood business is offered to you at half or less than its underlying intrinsic value two to three years from now, with minimal downside risk, take it. If not, take a pass... There will be better chances in the future."
If you do make the buy, remember Pabrai's rule: "Any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering."
The latter rule, the author admits, saved him from himself by forcing him to be patient and disciplined.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
The Dhando Investor: Be a Copycat, Not an Innovator
The Dhando Investor: Finding Low-Risk, High-Uncertainty Companies
The Dhando Investor: Margin of Safety
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The intrinsic value of USAP