The writer is an investment manager at Baillie Gifford
As valuations for some of the world’s largest tech companies are being questioned as expensive by some sceptics, I am reminded of a conversation from early 2020, when the terms “lockdown” and “social distancing” were largely unheard of.
My meeting with a chief investment officer was coming to an end. We were discussing Tesla. Its prospects were finally being recognised by the market and being rewarded with massive share price growth. He leaned across the table and said, “tell me you have been selling your shares”.
What struck me was not his belief that we should sell, rather that he appeared to hold it with such absolute certainty. His assertion had nothing to do with the company itself, but rather his ingrained belief that when a share price goes up a lot, you should sell. This was common sense. To do different would be foolish, greedy and undisciplined.
This conventional wisdom pervades much of the financial industry. As the old saying goes, “it’s never wrong to take a profit”. A client is unlikely to be unhappy or indeed notice if you sell a stock that subsequently goes up significantly. The loss of foregone upside is not captured in performance data. Perhaps it should be.
On the other hand, if an investment manager continues to hold the stock in question and its price starts to fall, the drop will be clearly visible in performance data. The manager should expect to be asked, if not chastised, about it. That is why, from the investment manager’s point of view, it is never wrong to take a profit.
What about the client? For the client, equity investing is asymmetric — the upside of not selling is nearly unlimited, while the downside is naturally capped. For the client it can be very wrong to take a profit. Sadly, too few fund managers try to get investment right for investors. Most conventions and practices exist to serve, protect and enrich investment managers’ interests.
In fact, it is often not just wrong to take a profit, but it can be the worst possible mistake.
Research by Hendrik Bessembinder, a professor at Arizona State University, has found that nearly 60 per cent of global stocks over the past 28 years did not outperform one-month treasury bills. That might seem a case for not investing in equities at all.
But the reason equity investing as a whole is thankfully still worthwhile is due to a small number of superstar companies. Bessembinder calculates that about 1 per cent of companies accounted for all of the global net wealth creation. The other 99 per cent of companies were a distraction to the task of making money.
This should shake the very foundations of the investment industry. The entire active management industry should be trying to identify these superstar companies since nothing else really matters.
But, doing that requires a vastly different mentality to that displayed by the financial industry today. It requires focus on the possibility of extreme upside, not the crippling fear of capped downside.
Bessembinder’s research makes it clear that it is the long-term compounding of superstar companies’ share prices that matters. Investing requires patience to deal with the inevitable ups and downs that such companies experience as well as the ability to delay significant gratification.
Sadly, such behaviours are inconsistent with the incentives and annual bonuses of traditional finance. Nevertheless, they are prerequisites. After all, the point of superstar companies is that they can go up fivefold and then go up fivefold again.
Let’s take a practical example. In 1999, Goldman Sachs invested in Chinese ecommerce company Alibaba. Shirley Lin, who worked for its private equity fund, has said she was offered the chance to invest $5m for a 50 per cent stake. Unfortunately, she said her colleagues deemed $5m too risky and so they opted for investing a “safer” $3m.
Five years later their stake was worth $22m, a seven-fold return. At this point, the decision was taken to sell. In many ways this was a remarkably successful investment until, that is, you realise that today those shares would be notionally worth more than $200bn before dilutions are taken into account. That investment alone, if held, would have been worth nearly double the value of the whole of Goldman Sachs today.
When asked why Goldman Sachs sold, Lin gave a predictable answer: “they wanted quicker results”. Though this example is extreme, the point is clear: in investing, it is often not only wrong to bank profits, it can be the worst mistake you make.
Despite this, in almost every client meeting I am asked about our sell-discipline. No one has ever asked me about our hold-discipline. That is a great shame, as the larger cost to clients’ returns comes from the inability to hold on to superstar companies when their returns are ticking upwards.
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