During a recent Zoom meeting with a team of highly-regarded industry experts, I was asked about our approach to “top slicing” – the practice of selling down part of your original investment in a company as its share price increases. The question put to me was that if we were “top slicing” were we, in the words of Warren Buffett, “cutting the flowers and watering the weeds”? Were we taking money out of the “winners” we had identified and funnelling it towards the “losers”?
I found myself later ruminating on this question and my initial answer.
It transpires that Buffett had asked to borrow the quote from the famed money manager Peter Lynch. Might I be contradicting the sage advice of, not one, but two of history’s great investors?
Locking in a profit by selling an investment that has gone up provides psychological comfort and makes an investor feel that they are “doing something”. This psychological bias can draw an investor into making bad decisions. Good investment ideas are few and far between and you need to be confident that you have a better alternative before rushing to the exit.
Buffett’s early career as a value investor had a big focus on buying “cigar butts” – part shares of weak companies that were out of favour but that could deliver “one last puff” of financial reward to those who invested in them. He has evolved as an investor to focus on buying great businesses, where their ability to successfully reinvest their profits provides patient investors with a long-term financial reward. The common thread is an analytical focus on paying less than you think an opportunity is worth, whilst the difference is in how reactive you are to market prices.
With all else being equal, we would much rather be investing in great companies for the long-term than scouring the streets for used cigar butts to puff on. However, I believe that the enthusiasm for companies with stable and rising earnings has made owning many of them less attractive at current prices. I think this risks some investors committing an alternative psychological mistake of paying a hefty premium for the perceived comfort of avoiding uncertainty.
Where does this then leave us?
There are two types of alternative opportunity that I currently see.
Firstly, I see opportunity in companies where their earnings are not smooth, but where we believe they will be reliable over the course of an entire business cycle. To again quote Buffett – “I’d much rather earn a lumpy 15% over time than a smooth 12%”. I believe that such companies are often viewed with unreasonable pessimism in the bad years, coupled with unrealistic optimism in the good ones. If we believe that such a company is subject to a bout of extreme optimism, then we will sell our investment if we see better opportunity elsewhere.
Secondly, I see opportunity in low growth companies that have long track records of returning capital back to shareholders via dividends and buybacks. Such opportunities are often associated with mundane industries and provide us with an income stream that we can invest elsewhere. Again, we will move towards the exit if we think that the share price of such a company is implying a level of growth that is ahead of a realistic view of the future.
The share price of a company can rise because its underlying business has improved or because there has been a mood change amongst investors who are rushing to own it. It is hard to untangle the two, but our approach is to attempt to do so. We regularly update our valuation of every business that we own, and for a growing business our valuation will rise over time as that growth is realised. We would be happy to be a long-term shareholder in every business that we invest in but will exit if we feel confident that there is a wide disparity between our analysis and the market consensus.
We will not always get these decisions right, but by having a strong process, we aim to avoid bad psychological habits at all costs. Ultimately, we are trying to balance the risk of selling great investments too soon against the risk of getting drawn into wishful thinking.