Position Management using Intrinsic Value

LED exit signThere was an interesting article written a way’s back on the Long Term Value Blog which noted how most value investors spend an inordinate amount of time focused on the entry, and a disproportionately small effort on both the exit and analyzing exit timing. I am going to attempt to dedicate a series of articles towards position management and exit strategy.

Absolutely critical to returning a profit on any investment is proper position management. Entry strategy, position sizing, and exit strategy (both to minimize losses and to capture a profit) are key aspects to a complete system. We’ve already looked at a simple method for entry into a value position, so now let’s look at managing an existing position and eventual exit. Specifically we’ll look at an approach based completely on the stock’s intrinsic value, with action based on how that value changes over time.

Recommended reading: Position management is just one aspect of our Value Investing Workflow. It’s suggested that the entire process be read thoroughly and understood.

A proper exit strategy includes a method for preserving capital in the event of a misjudgment resulting in a loss, and also includes a means of capturing a profit. Andre DesRoches wrote about one of his experiences last week in which he took a ride on Big Lots (BIG) for a complete roundtrip – where the stock appreciated in value considerably, but came back down to the initial entry price. The value-based exit approach we’re going to look at now probably doesn’t offer tight enough control to prevent this sort of experience over short timeframes, but over the long term should work out quite well.

If we follow a 100% value-based approach to stock selection and position entry, then why not carry this further and use the stock’s intrinsic value and/or margin of safety (MOS) define our position management and eventual exit strategy? To recap, in a typical stock valuation process, we first determine the intrinsic value of the company, then apply a discount to achieve a margin of safety and arrive at a target entry price. This gets us into the position. Now let’s use this same mindset moving forward, and let the company’s valuation dictate when we should sell off either part of, or the entire position.

Most position management systems used a fixed percentage or dollar based point to define exits. There is often a stop-loss set perhaps 10-20% below the initial entry price to limit losses, and either a fixed profit objective (ie. 20%) or a trailing stop (ie. 10% below the most recent high) used to capture profits. Let’s instead look at a value-based approach based on the following single position management rule:

  • Exit price is defined as the price which exceeds intrinsic value by 15%.

This intuitively makes sense, since if the primary reason we are purchasing stock in a particular company is because we believe it to be undervalued, then it only makes sense that we should sell when it becomes overvalued. Once a position is initiated, we will continuously monitor the intrinsic value due to changes in the company’s fundamentals and act accordingly. Note the key word always. This rule will serve to limit losses and to capture profits.

Examples

Let’s look at some examples, all based on an initial intrinsic value of $50 / share and a MOS of 20% resulting in an initial entry price of $40:

Example 1 – A simple profit

Price begins to increase immediately after we initiate the position. We continuously monitor intrinsic value, but there is no change of note in the fundamentals, so it remains at $50. Price eventually increases to $57.50 / share, which is 15% above intrinsic value, triggering a sell. We exit the entire position with a simple gain of  just under 44%.

Example 2 – Stopped out for a gain

In this second example, price trades in a range for a few months between $35 and $45. Earnings results are released and come in lower than expected, and a reevaluation of intrinsic value results in a valuation of $36 / share. The stock is currently trading at the upper end of the range at $44, which is now 22% higher than its intrinsic value. We immediately sell for a small simple return of 10% on the investment.

Example 3 – Capital preservation

This time, price immediately drops to $35/share and remains there virtually unchanged. Again, there’s a change in the company’s fundamentals resulting in a new intrinsic value of $30 / share. At $35 we are in excess of 15% over intrinsic value so we immediately sell, this time for a 12.5% loss on our investment, but hopefully preventing a further loss as price tracks down further.

Example 4 – Long term gains

Price climbs to $45, and when earnings are announced our intrinsic value increases to $60 / share. Price climbs further over the next year to $62. The company is still growing steadily however and the latest intrinsic value calculation results in a valuation of $70 / share. This goes on for the next 3 years until finally valuation is at $110 / share and a surge of buying drives price up to $126.50 at which point we sell. The total simple return in this particular scenario would be in excess of 200%.

Example 5 – A catastrophic loss

Earnings are announced and share price drops to $30 / share and also causes intrinsic value to drop to $35 / share. Next quarter’s earnings are also a disappointment and causes share price to drop to $25 and IV to $30. This process repeats until the stock is trading at $10 and is also valued at $10. Price eventually increases to $11.50 resulting in a sell trigger for a devastating 71% loss.

Summary

Four out of the five scenarios played out above are totally realistic and manageable, but the risk of catastrophic loss is also a very real possibility with this position management system and must be dealt with separately. Our single rule system does not protect us from the situation where price and value both fall gradually. In a situation where value is consistently dropping, this is an obvious change in the fundamentals of the company and likely differs from the reasons it was selected for in the first place. We need to add a second rule as follows:

  • Failure of the company to meet the requirements of the initial stock selection criteria will also result in an immediate liquidation of the position

For example, one stock selection strategy I regularly employ is based on high, predictable growth and low debt. If I initiated a position in a company that met this criteria, and subsequently EPS growth dropped off to less than the required 15%, the position would be closed. Likewise if the company took on a substantial amount of debt. My reasons for wanting to own the company for the long term have now changed, and the fact that it is trading for less than its intrinsic value no longer matters.

I’d be interested to hear how others might deal with the potential for catastrophic loss with this position management strategy. Please let me know in the comments below.

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One thought on “Position Management using Intrinsic Value

  1. Eric says:

    Just found your blog, looks really great! I haven’t read much yet but I do have a question about this article. Is 15% based on a certain position sizing, and would this be different on long term vs short term trades.

    I ask because if you have a smaller or shorter term position taxes and fees will eat up a larger % of your return profits. I would think you might want to set a higher exit requirement on short term trades even if the trading fees are negligible (<$10 total).

    Anyway, great blog, will bookmark and read more!

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