If you look for wisdom from people who are dedicated to long-term investing—creating the kind of financial investment situations where you make decisions in 1990 that are still affecting you in 2014, you will often hear them talk about not selling overvalued stocks.
There are a lot of reasons why this is the case—when you sell something outside of a charity, retirement account, or certain trusts, you have to pay taxes so the amount of money that you have available to make a new investment might put you in a worse spot than had you never sold the stock.
Other times, the cost of dealing with the overvaluation doesn’t merit selling—after all, would you really want to let go of Colgate-Palmolive, Emerson Electric, 3M, and Procter & Gamble just because the price of the stock reached a point where the future forward returns from that price point would be 9.5% instead of 10.5%? In short, the decision to hold on to an overvalued stock is this: the quality of the business, and the rewards it provides you on an ongoing basis (usually in the form of dividends) is prioritized over parsing a few dollars here and there.
(Side note: things get more complicated once excellent businesses cross the valuation threshold of 35x profits or so. Someone who bought Coca-Cola stock before the 1973 crash at 45-60x earnings would have compounded at 11.0-11.5% annually since then, turning a typical investment of $5,000 into $481,000 today. On the other hand, someone who paid that same valuation for Coca-Cola in 1998 would be compounding at 2.32% annually since then, turning $5,000 into $7,200. That’s because Coca-Cola was much bigger in 1998 and also had a lower growth rate, and it hasn’t had as much time to “grow out” of the overvaluation).
But there’s another reason why you don’t sell stocks that might be moderately overvalued, and why you don’t short stocks either—an event might happen that causes a significant yet permanent change in price, and it’s something that should always be there at the back of your mind.
Many of you saw the news today that Kinder Morgan, which has traded under four different forms that all contained different assets and incentive structures (Kinder Morgan, Kinder Morgan Partners, Kinder Morgan Management, and El Paso Partners), announced that it will combine into one form that will just be “Kinder Morgan” and cover 80,000+ miles of pipelines and some oil reserves.
It’s announcements like these that should remind you why you don’t short stocks, and why don’t sell something that appears slightly overvalued: El Paso Partners increased over 30% today, Kinder Morgan Management increased over 34%, Kinder Morgan Partners increased over 27%, and Kinder Morgan increased over 20%. Anytime over the next five, ten, fifteen, twenty years when we talk about the historical performance of this midstream pipeline company, a random day in August 2014 will play a key role in the discussions of its historical returns.
You hear investor axioms like “time in the market is more important than timing the market” and it sounds like a throwaway line that may not actually change your life. And then you look at the data, and you see things like this, courtesy of Dow Theory:
From 1990 to 2005 a $10,000 investment would have grown to $51,354 had you just sat tight from beginning to end. However, if you had missed the best 10 days in that 15-year period, your returns would have dwindled to $31,994; if you had missed the best 30 days, you’d be looking at a mere $15,730…
If an investor missed just 40 of the biggest up days in the market over the last 20 years (1987-2007), their return would have totaled 3.98% versus remaining fully invested and achieving an average annualized return of 11.82%.
Kinder Morgan is a company-specific illustration of this principle: Missing the date of a key event can dramatically affect your total returns. Imagine missing out Abbott Labs when it spun off Abbvie. Imagine missing out on Kraft when it spun off Mondelez. Heck, imagine missing out on the old Philip Morris before it spun off Philip Morris International, Kraft (and plus Mondelez), as well as Altria. Imagine missing out on Conoco when it spun off Phillips 66. Imagine selling any type of Kinder-Morgan affiliated investment prior to today’s announcement.
My thesis isn’t that you should hold because random stuff might happen that will make you later regret it, but rather, that the companies I frequently talk about here contain pieces that aren’t fully realized when they are a part of a conglomerate-type of structure.
Take something like Pepsi, an excellent blue-chip holding that has compounded at 12.96% annually if you had overpaid for the stock and bought it right before the crash of 1973.
Someone could reasonably look at the $91 price tag today and say, “This company looks 5-10% overvalued.” Most likely you would revise that conclusion if the Pepsi Board announced tomorrow that Pepsi was smashing itself into dozens of discrete businesses, spinning off Tostitos, 7-Up, Tropicana, Quaker Oats, Lay’s, Ruffles, Aquafina, Mountain Dew, Gatorade, Fritos, Cheetos, Doritos, and so on, all into their own publicly traded companies. The stock would shoot up to $150 or something like that, and someone who owned a thousand or two shares would feel that sensation of winning a lottery, suddenly having an entirely new blue-chip portfolio showing up out of thin air to pay dividends on their own.
When the brands are combined under one corporate umbrella, they don’t get appreciated as much, and this discounting can cause regret if you sell shares under a belief that the stock is expensive but an event that unlocks value (I don’t like that worn-out phrase, but it’s appropriate here) occurs while you were taking a breather from a stock that you already appreciate and have owned in the past but sold for a reason you’ve come to regret.
This Kinder Morgan news give us two other reminders as well: Shorting a stock is dumb because someone could always overpay to take the company private. Even if Kinder Morgan is only worth a third of its buyout price (I don’t believe this but I’m posing that hypothetical), it doesn’t matter: You’ve permanently lost if you’ve shorted the stock and the buyout goes through. Someone irrationally gobbling up the stock makes you responsible for covering, and I would imagine this would be one of the most frustrating experiences an investor can encounter. The other lesson is this: Even if Kinder Morgan didn’t announce this buyout, things would still work out. As I mentioned with Pepsi, the company has still returned almost 13% over the past four decades even if you overpaid at the time and even though the company spent a lot more time collecting businesses than spinning them off or relying on one-time events. Great assets sitting on the balance sheet will always reward owners over time, even if it’s not in short bursts like you saw today with Kinder Morgan.
Note: I’ll try to do a more detailed write-up on the terms of the Kinder Morgan combination specifically when I get a chance, as this article was more of a broad overview on general principles applied in real-time, sticking with my recent theme of taking timeless principles and discussing their application with business events that are actually unfolding in real time.