BI > AUGUST 2002

Selling an Overvalued Company

Always a Challenging Decision

We face a difficult decision when one of our stocks becomes seriously overvalued. I want to make it clear that I'm not talking about companies with declining fundamentals or weakening balance sheets; facing increasing competition or depending too much on a single product; or experiencing an adverse change in management or in its regulatory, political or environmental situation. This column is about the strong companies in our portfolios.

NAIC educates us to invest in high-quality companies when they're available at a reasonable price. Occasionally a company that we purchase performs far in excess of our expectations. Suddenly the price has risen so much that the risk exceeds the reward, the current P/E is far above the historical average and the total return leaves much to be desired. Let's take these parameters one at a time:

• We consider a stock undervalued when the upside potential (our projected high price) exceeds the downside risk (our estimated low price) by 3 to 1. This situation is reversed when the U/D ratio is 0.3 to 1, meaning that the risk exceeds the potential reward. It's a matter of degree, but let's consider the first criterion of an overvalued stock when the risk begins to exceed the reward; that is, the U/D ratio is below 1.
• The relative value calculation compares the current P/E with the historical five-year average P/E. We calculate this ratio to determine what investors are currently paying for each dollar of earnings compared with what they have paid historically. When the two are equal, we consider the stock fairly valued. When the current P/E is lower than the historical average, we consider it an indicator of undervaluation.

When we purchase a stock, we look for some P/E expansion along with growth in earnings to achieve the desired price appreciation. When the current P/E exceeds the five-year average, the likelihood of P/E contraction toward the historical average increases. Many NAIC investors consider a stock overvalued when the relative value exceeds 150 percent.

• The total return calculation takes into account price appreciation from the current price to our projected high price along with any contribution from dividends. To double our investment we look for an average total return of 14.9 percent per year for a five-year period. I begin paying attention when the total return falls below 4 or 5 percent. You can make a good argument for waiting until the total return falls to the current money market or CD rates.
• The price zones in Section 4c of the NAIC Stock Selection Guide are another consideration. Some NAIC-type investors prefer to exclude the sell classification. To encourage thinking twice before selling, they suggest dividing price ranges into "buy and don't buy" or "buy and hold." The use of price zones may be more meaningful if we divide the span from projected high price to estimated low price into quarters rather than thirds. This narrows the buy and sell windows. The three NAIC stock analysis software programs allow users to choose zonings of 25 percent for buy, 50 percent for hold and 25 percent for sell.

This is a more conservative method on both the buy and the sell side. When considering the sell zone as a fourth criterion, our risk-reward guideline becomes more stringent. That's because it takes a U/D ratio of 0.5:1 using 33-33-33 zoning and 0.3:1 using 25-50-25 zoning for the price to fall into the sell zone. Perhaps we should add this criterion for top-quality companies that Value Line rates A or A++ for financial strength.

The Decision Isn't Obvious

Not everyone agrees on what you should do once these conditions are met. Warren Buffett says "the best time to sell is never" (see "Mr. NAIC"). Furthermore, investors often say that their most serious mistake was selling too early.

But others suggest that we should always be looking to improve the upside potential of our portfolios and reduce the downside risk, keeping our money working rather than resting while earnings catch up to grossly inflated P/E ratios. I-Club-List member Joe Smith contributed this comment: "Sitting on a great company that is overvalued by my analysis is akin to putting money under the mattress. For me, that doesn't work. . . . I always say to myself that it's the stock's job to make money for me, but it's my job to keep the gain."

One way to reconcile these views is to prepare a more optimistic SSG before coming to a decision. Before we purchase a stock, most of us use conservative judgments to increase our chance of a successful investment. This includes reducing projected sales and earnings growth rates to what we consider more sustainable than historical levels and eliminating the higher historical P/Es to arrive at more conservative projections.

Being conservative is appropriate when we're contemplating a purchase. But it may not be appropriate when we're contemplating the sale of a strong company. So we can go back and revise the SSG, staying closer to historical trends. Of course, we still want to make sure that we're basing our projections on relevant data and removing anomalous outliers.

And we need to use common sense. If a company's CEO suggests that the growth rate likely will be 15 percent, we shouldn't blindly enter the 25 percent historical growth rate for our projection. But on the revised SSG, we should no longer downplay the historical trends arbitrarily. When a company has been growing sales and earnings at an impressive rate, we can assume it will continue to do so.

Similarly, if the market has been paying high P/Es based on that solid history, we can assume it will continue to do so (within reason, of course). Finally, we might consider the projected relative value. For projected relative value, divide the P/E using the next four quarters of projected EPS (either your estimates or analysts'), rather than the trailing EPS, by the five-year average P/E.

Challenging a Stock

What if an optimistic SSG continues to indicate that we should sell the stock? Unless the projected total return is so low that it vies with a money market fund or CD (about 2 percent these days), it makes good sense to find a replacement before selling the stock. But remember, these are strong companies. There's no real hurry to sell them before finding an appropriate replacement that meets our stringent quality standards.

The replacement company should have sales and earnings growing consistently and increasingly; we hope the growth rates are higher than those for the company being replaced. Pre-tax profit margin and return on equity should be stable or increasing and -- we hope -- among the best in its industry. Once the replacement passes our quality requirements -- and only then -- do we check the value criteria.

Capital gains taxes and the commissions for buying and selling a stock are other crucial considerations. NAIC's Challenge Tree form helps us figure all this out. Investor's Toolkit's version of the form is displayed in Figure 1. Shown is a re-creation of my use of the form in June 2000.

Click to enlarge.

Figure 1. When comparing the prospects for ADC Telecommunications and MGIC Investment Corporation employing Investor's Toolkit's NAIC Challenge Tree form (using the author's numbers from June 2000), MGIC comes out ahead in the long term.

At that time ADC Telecommunica-tions (NNM:ADCT) had become overvalued, so I prepared what I considered a fairly aggressive SSG for the company. Even so, the price fell into the sell zone with a U/D ratio of 0.3:1, a projected relative value of 265.7 percent and a total return of 4.4 percent.

I challenged it with MGIC Investment Corporation (NNM:MTG), a leading provider of private mortgage insurance. I already owned some shares but considered it a high-quality company and was eager to increase my holding. At the time, the price met my criteria for a purchase. I entered the number of shares being sold, the original purchase price per share, a capital gains rate of 20 percent and flat buy and sell commissions of $12. The program drew the rest of the information from my existing SSGs on both companies.

As you can see, the quality criteria compare quite favorably. The results of the switch are presented numerically on the left and graphically on the right. The break-even point, when the capital gains taxes are made up, is where the two line cross; this occurs after about a year. Fortunately, I was able to do some tax-loss selling to offset some of those gains.

The program estimated that in five years, my holding in ADC would grow to $29,014, compared with $47,944 for holding MGIC. Since that time, ADC's price decreased from $39 per share (split-adjusted) to $3.64 recently, whereas MGIC increased from $45.63 to $71.06.

Thank you, NAIC, for the education and tools that worked so well in my favor. I couldn't have predicted the tech wreck that affected ADC's price so drastically, but replacing grossly overvalued stocks protects us from allowing an unforeseen situation to excessively damage our portfolios. The commonly used NAIC phrase "'buy and hold' does not mean 'buy and forget'" certainly applied here.

Consider Diversification

Portfolio diversification is a relevant consideration as well. If a stock really takes off, its price may appreciate to a point at which the stock accounts for an uncomfortably high percentage of our portfolio. My personal rule requires that no single holding can exceed 10 percent of my portfolio.

EMC Corporation (NYSE:EMC), whose business is computer storage, was another company of mine that became grossly overvalued during the technology bull market. My optimistic analysis again showed the company to be overvalued, and it became an uncomfortably large percentage of my portfolio.

Each time it hit 15 percent of my total portfolio, I sold it down to 10 percent. Those sales were placed at prices ranging from $30 to $101 (split-adjusted). The price of EMC recently was $7.52.

The appropriate maximum percentage for stocks in our portfolios varies with the dollar amount of the portfolio, the number of stocks held and the investing style of each person.

Trust Your Judgment

It's difficult to sell stocks that have performed well. We put a lot of time and effort into following them over the years. They become, in a way, old friends. What's more, we take pride in our ability to pick stocks.

Sometimes we fall victim to "analysis paralysis," worrying that we might miss a continued upward spiral. Perhaps the main reason for this is a lack of confidence in our instincts. We should attempt to conquer some of these psychological reasons for holding on to a stock, making sure that our decisions are based on quality and value considerations above all else.

Investing styles differ. Some of us pull the trigger sooner than others, replacing lower total return stocks with new companies that offer greater potential. Others prefer to wait a lot longer, believing superior management is hard to find and virtually impossible to replace regardless of valuation.

A great many conditions have been suggested as prerequisites to selling quality companies. That's by design. "In the final analysis, it is rare that a good quality stock gets so overvalued it should be sold," says NAIC trustee Ralph Seger.

Trust your judgment. Judicious use of portfolio management, which might occasionally include the replacement of an overvalued stock with a company of equal quality and greater potential for return over the long term, can make a meaningful difference in the overall return on your portfolio.

Nancy Isaacs is an individual investor and BetterInvesting member from Toms River, N.J. A recipient of the 1999 Kenfield-Burris Online Service Award, she is a "Sysop"(systems operator) for the BetterInvesting Forum.