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By Rupert Hargreaves Deciding when to sell a stock is often a more complicated process than buying it in the first place. Indeed, holding onto a loser for too long can severely curtail long-term returns. The same can be said if you hold onto a winner for longer than needs be as a sudden shift in market sentiment might see the majority of your gains erased. With this being the case, refining your selling process is a vital part of developing your investment strategy. This is a topic the February 29 issue of Value Investor Insight looks at in an interview with Danny Bubis, Ben Ellis, Jay Hedstrom and Amar Pandya of Tetrem Capital Management , which has produced an annualized return for investors of 8.9% since 1997, vs. 7.1% for the S&P 500. When To Sell A Stock? Investment strategy: When To Sell A Stock? Tetrem seeks out companies using a value approach: beaten-down stocks reflecting an unwarranted pessimism over the persistence and sustainability of their businesses. Of course, the selling process starts when the fund first buys an investment and research on each company is focused on modelling each potential investment’s fair value on the basis of normalised earnings in the base case, bull case, and bear case and the justified multiple for earnings in each of those scenarios. When these scenarios have been calculated, the fund’s analysts assign probability weightings to each case, and then use this probability weighting to calculate the potential upside the security. Generally speaking, the fund is looking for $3 of upside for every $1 of downside. Why does Tetrem Capital use a probability-weighted fair value calculation? Well, according to Danny Bubis this approach helps the fund better frame things in terms of risk versus reward and results in better investment decisions. When it comes to selling, Tetrem’s team has decided to refine their selling process after observing that many of the fund’s missteps have involved sticking with losers too long or not letting winners run long enough. To counter these mistakes, the fund’s team is making a more concerted effort to have high conviction buys push out more marginal ideas. The key test here: if the stock in question fell 10% to 20%, would the fund step in and aggressively buy more? If the answer is no, then there could be better ideas out there. Another rule the fund has introduced is that when something happens, which puts the original investment thesis at risk, the weighting in the fund is immediately reduced to 1.5%, a normal weight the fund is around 3% – no matter what the stock price does. These two parts of the firm’s investment strategy help Tetrem manage the downside; when it comes to the upside, the fund also has a rule in place to ensure that it does not get caught out by letting a winner run too long. Upside management technique Tetrem’s upside management or profit taking method is based on its fair value probability calculation. In the interview with Value Investor Insight, one of the fund’s current positions, Microsoft (NASDAQ: MSFT ) is used as an example. Originally, Tetrem acquired Microsoft when it was a beaten down by the market due to its entrenched management, reliance on PC and weakness in consumer markets. However, over the past two years, the company has transformed itself and successfully adapted to a mobile-first, cloud-first world. The stock is up 100% in five years, excluding dividends and Tetrem’s probability fair value estimate has increased alongside the stock price, as the company has grown and developed with the market, the probability of the bull case is higher, and the probability of the bear case is lower. This floating fair value probability estimate helps Tetrem’s team stick with compounders longer than it might have done without the floating calculation. Disclosure: Rupert may hold positions in one or more of the companies mentioned in this article. Scalper1 News
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