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Archive for the ‘When to Sell’ Category

I have the following rules when deciding whether to sell a business     

I must sell a business when its price equals my estimate of its intrinsic value[1]

I have this rule because once a business’s price equals my estimate of its intrinsic value there is no ‘margin of safety’ in owning it.     

How the business’s price can equal my estimate of its intrinsic value

This can happen because:     

  1. The market price of business has increased to its intrinsic value;
  2. The intrinsic value of the business has fallen (for example the business’s competitive advantage has weakened); or,
  3. I have changed my mind about the business’s intrinsic value and it is lower than I had previously thought.

What I must do if I want to sell a business because I think its intrinsic value has fallen

I must make a new estimate of its intrinsic value by doing a rigorous new valuation. In particular, I must:     

  1. Make sure that I have calculated its intrinsic value based on normalised earnings, not cyclically low earnings; and,
  2. Assume that if the business has had bad luck it will probably have better luck in the future.[2]

What I must do if want to sell a business because I think its intrinsic value  is lower than I had previously thought

I must explain my reasons for changing my mind to another value investor. I must do this to help stop me from acting emotionally and selling the business simply because its price has fallen.     

Other circumstances when I can sell a business

I can sell a business if a better investment opportunity arises with that capital.     

Tax Issues

I must decide whether it is worth delaying the sale of a business because of capital gains tax or income tax advantages. However, I will sell a business if its current price compensates for the tax advantages in delaying the sale (for example, its price is 120% of my estimate of its intrinsic value).     

The Two Year Rule 

If none of these reasons for selling a business applies, I must only sell a business after holding it for a minimum of two years.[3]     

Why I have to wait at least two years

Other investors (‘the market’) can undervalue the businesses I own because of irrational fear, or because they have not properly assessed the probability that the business’s fundamentals can improve (that is why they were ‘cheap’ when I bought them!). I must wait for a minimum of two years before selling a business I own because it can take months or even years for this fear to subside, or for the business’s fundamentals to improve. As Pabrai points out you usually need to wait for a business’s fundamentals to improve because:        

“While valuations of public businesses can go through dramatic change in a matter of minutes, real business changes take months, if not years…”[4]       

Why I can sell after two years

If a business’s price has not increased to my estimate of its intrinsic value after two years I can, irrespective of whether the above reasons apply, sell the business. I can sell it because this length of time suggests that I may have overestimated its intrinsic value. In addition, there may be better opportunities for me to invest this capital. This is only an option to sell. I do not have to sell the business if I think it is still a good investment.     


     

[1] Except for tax exception explained below.     

[2] As Pabrai points out, businesses are entities that go through ups and downs just like humans, see P153, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.     

[3] This idea, and the reasons for it, are those of Monish Pabrai. See Chapter 15, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.     

[4] P155, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.

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