Bill Miller Letters Archive

1998 Q2 – Market Commentary

“It is odd to watch with what feverish ardor the Americans pursue prosperity and how they are ever tormented by the shadowy suspicion that they may not have chosen the shortest route to get it…. They clutch everything but hold nothing fast, and so lose their grip as they hurry after some new delight”

– Alexis de Tocqueville (1885)

How Much is Too Much; or When to Sell?

One of the common questions we get from pension consultants, brokers, and shareholders is “when are you going to sell your Dell or America Online (“AOL”)? In the Value Trust, the average cost of our Dell position, acquired in early 1996, is about $4.00 per share. The shares trade today at about $115. The average cost of our AOL position is about $20; the stock trades now around $125 per share. At the end of the second quarter, Dell made up over 8% of the assets in Value Trust, AOL just over 7%.

There are several issues implicit in the question of when to sell. First is the generic strategy question: What general criteria drive the process of deciding when to sell? The second has its origin in the usual behavior of money managers, whose average portfolio turnover approximate 100% per year. In a world where investors appear to be frantically trading shares in response to or in anticipation of short-term price moves, multi-year holding periods are atypical. Investing in a company for many years, instead of speculating on a stock’s price action, has become unusual enough to warrant an explanation. Why have you held the stock for such a long time and when are you going to sell? Third is the question of risk. How much of a portfolio’s assets should be concentrated in a single holding? How large can a holding become without subjection the portfolio to undo risk?

A variation of the first question has to do with strategy. We are value investors who invest in shares of companies trading a large discounts to our assessment of the intrinsic value of the business. How can a company’s stock go up 25X in a few years and still be trading at a discount to intrinsic value? How can anything selling at 75 X trailing earnings (Dell) of 100X-estimated earnings (AOL) possible be considered a value? Haven’t the shares gone from value to growth to outright speculation?

Our selling strategy is simple: we sell when a company’s share price has reached fair value; we sell to replace an existing holding with a better bargain, and we sell when our original investment case is no longer applicable. “Fair Value” means that the market has, in our opinion, correctly priced the stock. It understands and has adequately discounted the future free cash flows of the business so that we can no longer earn an excess return by holding the shares. Put differently, fair value means that the risk adjusted rate of return available by holding the shares long-term is no greater then that of the market as a whole, and may be less. Second, if we are full invested and our research uncovers a security we believe has more value than something we already own, we will replace the lesser bargain with the greater. Finally, we sometimes find that our analysis was wrong, either because we uncover new information, or because we interpret our existing information differently, or because the world changes-new legislation is passed, new regulations are promulgated, the competitive landscape changes and so on. We will sell securities when we believe we are wrong, whether the share price is above or below our purchase price.

You may have read recently about the estate left by Don Othmer, a professor of chemical engineering at a small school called Brooklyn Polytechnic and his wife Mig. In the late 1950’s they put all of their money with Warren Buffett and it all subsequently went into one stock. Berkshire Hathaway. Had they consulted other advisors, they no doubt would have been told they had way too much in one stock, and they would, as many investor s do, have continuously cut back their position as it went up to diversify into other investments. They also would not have been worth $800 million when their estate was settled.

In 1956, J.L. Kelly, Jr. published a paper in mathematical information theory that dealt with the transmission of information over a phone line. In it Kelly devised a formula that subsequently was shown to have general applicability for any problem that seeks to maximize a growth rate per unit of investment. Using Kelly’s formula, we can calculate that if Buffett has 37% of his portfolio in Coke. He believes that the probability of being right about Coke is 70%. More generally, Kelly’s formula would indicate that the growth rate of a portfolio is maximized with no more that 5 stocks, assuming the returns of each security are independent and one believes that probability of out performance is greater than 50%. Kelly’ s formula, which is not well know among investors (it also serves as the basis to fixed fractional betting strategies among gamblers), provides a clue about why the largest fortunes are made by concentrating, not by diversifying, and also would suggest that the new category of focus funds is likely to prove quite rewarding to investors, assuming managers can generally distinguish their best ideas for the rest.

The question of how much is too much and of when to sell have no perfect answers; they depend on imperfect information and on judgments, which are often wrong. We cannot promise we will be right about these issues, but we do promise to think carefully, critically, and diligently about them, and to use our best judgment to try to add value to your investment.

We have attempted to be exhaustive in these remarks on selling and on concentration, but to provide some insight into our thinking on these complicated subjects. As always, we appreciate your support and welcome your comments.