Monday, January 29, 2007

When To Sell? The Case Of Coca-Cola

So, we have discussed what types of stocks to buy and that our holding period is measured not in days or months but in many times years. The question now begs us, when should we sell? There are a couple of scenarios.

Deterioration of Business Environment: Let's compare Coke (we will use Coke (KO) here since it is #1 but any soft drink will do) with tobacco. Currently soft drinks are under fire by health conscious politicians as our national obesity epidemic grows. Pretend for a minute (this is not such a big stretch) that in order to pay for "the health effects and costs of obesity" soft drink makers (like the tobacco companies) are ordered to pay billions to the states. Congress eliminates the companies ability to advertise their products to stop their use by minors and levies oppressive taxes on them to help pay these health costs. This causes the cost of a can of soda in a vending machine (when you can find one) to go from the now $1.50 to $2.50 or more. All soda is eliminated from schools or anywhere a child under 18 can easily purchase it. Unlike tobacco, whose users are addicts (and who seem more than willing to let these costs be passed down to them), the soft drink industry would collapse under this strain as people stopped buying them and switched to cheaper options. Any hint of this scenario would be time to sell any soft drink maker in your portfolio.

Valuation: During the frenzy in stocks that precluded the inevitable crash in 2000 Coke's valuation became, in a word insane. Coke hit a high of $83 a share at the end of 1998 and sported a pe of over 50 times earnings. This is irrational for a company like Coke (I would argue it is irrational for ANY company but that is another post). Coke was a mature company growing in the teens (growth rate) and had typically only ever had high price to earnings ratios in the low 20's. Investors were paying over twice that! Had you considered buying shares of Coke at the time I would have argued that it was too expensive (overpriced) on both a historical and absolute level. Now, if it is too overpriced to buy, ought not we consider selling it if we own it? Our own rule tells us the price must fall to a level commensurate to its growth rate. It did, to about $45 a share and now trades at a pe ratio of 20 times earnings, in line with historical averages. Why not sell it then and wait patiently for it to come to an appropriate valuation and purchase shares again? In this case it would have taken until Jan 2003 until its valuation was something that I would be willing to invest in (it would have been fairly priced, not a value). Coke's largest investor Warren Buffett has several times in interviews lamented the fact he did not sell his stake in Coke during this period.

Odd Merger's: There are many times mergers make sense. Proctor & Gamble (PG) buying Gillette, for instance. Two large consumer products companies coming together to make a stronger one. Then there are merger's that make you scratch your head like AOL (AOL) and Time Warner (unmitigated disaster), Kraft Foods (KFT) and Phillip Morris (MO) or RJ Reynold's Tobacco (RAI) and Nabisco Foods which have not worked out fully for either companies investors. Currently Altria (Phillip Morris) is in the process of spinning off Kraft Foods to "unlock value for investors" (translation: undoing the merger). This merger has dampened the appreciation of the stocks of both companies. The price investors are willing to pay for Altria stock is depressed because the low margin food business was seen as a drag on the highly profitable tobacco business and the tobacco business's constant litigation woes are seen as a drag on the food business depressing the impact of Kraft's contribution to the whole company. Now, contrast this to Altria's purchase of 30% of SAB Miller (Miller beer) which has been a huge success for both companies (booze and cigarettes go together better than cigarettes and mac & cheese). Now, Altria's stock has been one of the best market performers in history but even conservative estimates today place a 20% value appreciation from its current levels to investors after the spin off. Yes I own and would recommend you buy shares of Altria (MO). Coke, and even Pepsi for that matter have been very smart here . They have expanded their product lines in what they do best, non alcoholic beverages. Pespsi (PEP) ventured outside this with its purchase of Frito Lay but I think we would all agree that chips and soda mesh perfectly. Were ether to venture outside of this arena to an area wholly unrelated to their current businesses, red flags for investors should go up.

Note: The merger discussion does not apply to Holding Companies. By their very nature, holding companies set out to acquire a wide variety of unrelated business, take the profits from them and acquire more business. They have mandates from their board of directors to do this as their growth strategy.

I hope you can see that there really aren't many reason to sell a stock IF you purchased it correctly. If you buy a good company with a durable competitive advantage and at great price there are only two real reasons to sell it. A fundamental change to the company (poor merger) or its business that negatively alter its future prospects, or its stock price becomes irrational overvalued. Be careful on price induced selling, there are always tax implications to consider when selling. The level of excess valuation must be far greater than the tax you will be forced to pay on your profits for this to be worthwhile. A poor quarter is not a reason to sell and in all actuality if the underlying business is still strong and the reasons you purchased it still apply, this is a perfect time to purchase more shares if their price falls.

If the stock price stays stagnant for an extended period of time, this too is no reason to sell. During the tech bubble of 1998-99 Berkshire Hathaway (BRK.A) shares fell almost 40%. Investors fled to tech shares and the latest "hot stock" they heard about at cocktail parties. Most of these companies had not yet figured out how to make money but did have fancy websites and a whole new vernacular to impress potential investors. Yet, there was nothing wrong with Berkshire's businesses. They were all performing well and growing. Buffett was called "out of touch" with the new business paradigm because he felt paying 140 times earnings for Yahoo was a bad idea. The inevitable happened, there was no new paradigm, earnings still mattered and Berkshire stock has more than doubled off its lows while tech investors are still underwater with their picks.

The business matters more to you than the stock price. There will be times when there is a disconnect between the current state of the business (its actual value) and its stock price. Both the Coke and Berkshire examples above illustrate this. Do not get caught up in the hype either way. As Buffett likes to say "buy fear and sell greed". When prices are unjustly inflated (Coke in 1999) sell and when they are unjustly depressed (Berkshire in 2000) buy and thus a value investor you shall be (wealthy too).

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