The importance of a proper sell discipline

We have written extensively about what we believe investors should look for in a business before they commit their own capital to that business.

In posts such as "Beautiful Growth Companies" parts I, II, and III we explained some of the criteria we look for in determining whether a business fits our definition of a "Taylor Frigon growth company."

Today we will discuss a subject that is equally as important to investors: how to determine when a company that you own is no longer a growth company. In other words, we will examine the proper sell discipline for a business in which you have invested.

Not only is the sell decision a difficult decision, but it is -- in our experience -- one that is fraught with pitfalls. It is perhaps easier to make an investment error around the decision to sell than it is around the decision to buy.

This is because a company you sell is -- unless you are shorting the company -- by definition a business you have already bought, which means that you have determined through extensive due diligence that it is a business that you would like to own. It is important not to be "hasty" in reversing that decision and thereby robbing yourself of participation in future growth based on an event or condition that turns out to be short-term in nature.

On the other hand, if that company no longer meets the definition of a growth company, it is critical that you identify that as soon as possible, so that you can deploy your capital somewhere else with greater business prospects.

While we have written extensively on the matter of not selling a growth company because of temporary market-driven events (for example in this previous post), our investment process is not a "buy and hold" strategy. It is very easy for those who speak out against the folly of trying to time market cycles to be falsely categorized as someone who believes in "buy and hold forever."

However, the distinction is that we believe that a sell decision should be made based on business indicators, rather than market indicators. We have written about this distinction in a post from January, 2008 entitled "Remaining calm without being blind or obstinate." In that post, we made several important points that bear on the current discussion.

First, we noted that companies have life cycles just as people do, and that owning a company in its growth phase is not only more profitable than owning it during its mature phase, but can be less dangerous as well -- something many investors do not realize. This understanding of the life cycles of companies shows that "buy and hold" is a flawed strategy, because it is simply not realistic. A look back at history and at the record of companies that were once thought to be "bulletproof" proves that point.

Second, we noted that research seems to indicate that the "lifespans" of companies may be growing shorter in recent decades. Thus, while "buy and hold forever" was never a sound strategy, it might have been possible to safely own some companies in the past for two or three decades (a fact which may have contributed to the concept of "buy and hold"). Today, that time period may be much shorter, and the necessity for vigilance even greater than in previous generations.

For all of these reasons, the sell decision requires great judgment and diligence. It is perhaps an area in which extensive experience is most helpful, in order to build the kind of judgment that only comes from years of observation, as well as from reflection on past mistakes. We will briefly outline some the principles underlying our own sell strategy.

We have often used the expression "a well-run business positioned in front of a fertile field of future growth" to describe a company that may meet the definition of a growth company. We would state right at the outset our belief that a good sell discipline is the product of a good buy discipline: when a company no longer meets the buy criteria, it is important to revisit your thesis and determine if it is time to deploy your capital elsewhere.

We can characterize the reasons a company might no longer be a growth company into three areas:

1. It gives an indication that it is no longer a well-run company.
2. Something happens to close off its field of growth.
3. The company pursues its field of growth to the extent that it fills it up.

A change in company leadership requires a re-examination of the situation to determine whether the business still fits the definition of a "well-run company," as would any serious leadership missteps. Likewise, a new paradigm shift might arise that suddenly alters the business landscape and replaces the paradigm shift the business was pursuing. Both of the first two categories require that the investor remain aware of what is taking place at the business itself, and within the business landscape of the company.

Barring one of those two changes, however, the company will eventually fall into the third category. Determining when it begins to do so requires a clear picture of two factors: the size of the field of growth, and the size of the company.

At some point, even a well-run company that has been exploiting a wide field for business growth will grow to the point that it has run out of open field. At this point, it can be called a mature company rather than a growth company. It may certainly continue to be a well-run business, and it may continue to achieve incremental growth, but barring the development of a new paradigm shift which creates a new field for above-average growth, its growth rate will be more in line with the rest of the economy.

The point at which a growth company rolls over and becomes a more mature company will vary from company to company and from one field of growth to another.

We will illustrate using a company that we owned for much of the decade of the 1990s, and sold in the year 2001 because we determined that it no longer fit the definition of a growth company, payroll processing company Automatic Data Processing, or ADP.*

During the 1990s, ADP was taking advantage of a tremendous field of growth, which was created by their innovative application of new technological capabilities (brought about by the proliferation of computing power) to solving business needs that had previously been solved using time-clocks, punch-cards, manual payroll processing, and other systems that had developed when computers were still nonexistent, or so expensive that they could not be used for such mundane tasks.

The company had strong and steady earnings growth throughout the 1990s. In fact, by 1999 the company had amassed over 150 consecutive quarters of double-digit earnings growth -- a feat unmatched by any other firm!

However, by 2001 there were some signs that the payroll process outsourcing business, which ADP had helped to create, was becoming more mature. There were now over 1,000 outsourcing companies, including formidable opponents such as Paychex, Ceridian, and Intuit.** While the technological developments of the 1990s had created a fertile field of growth for the offloading of routine business tasks, resulting in an outsourcing paradigm shift that benefited ADP's business, our research indicated that this era of rapid outsourcing growth could be maturing to a degree that made ADP less immune to business cycles (a feature that previously made the company extremely attractive).

Further, after creating and exploiting this paradigm shift, ADP was no longer a small company. It now sported a market capitalization north of $35 billion, up from just $24 billion only two years before. We have previously discussed the idea that, as companies grow to dominate their field, there is a tendancy for them to switch from "disruptive innovation" to "sustaining innovation," in the words of noted business scholar and author Clayton Christensen.

Some of the fundamentals we have mentioned in previous posts as important business measurements helped confirm our suspicions that ADP might be transitioning from a classic Taylor Frigon growth company into a mature company that had pursued an open field of growth to the point that the field was now full and future growth would be more moderate. One of these indicators was their earnings growth, which in 2001 began to slow notably from the pace of previous years.

It is important to emphasize that these quantitative measures, while important, are only one part of the overall decision. Too often, investors look for an easy quantitative litmus test that will tell them definitively the right moment to sell. The above discussion is meant to emphasize the complexity of the sell decision and the importance for serious judgment and diligence, and the importance of not being "hasty."

We decided that, although still a well-run business, ADP was no longer operating in front of a "fertile field for future growth" and made the decision to sell all shares in the company during the month of August, 2001. It is notable that the company's earnings continued to level off and then decline in 2002, and that ADP has not resumed the kind of growth rate it had during its true "growth phase." The stock has generally been "treading water" since then.

It is important to understand that the sell decision involves an analysis of many different vital signs within a company and the industry in which it operates. It is also important to understand that the sell decision is not driven by the ever-changing winds of Wall Street (the market-related forces) but by fundamental business issues.

In the modern era of increasingly rapid innovation and indications of an increased "topple rate," it is especially important to understand that the "buy and hold" mentality is not realistic, and to develop a robust sell discipline for the companies in which you decide to allocate your capital.

* The principals of Taylor Frigon Capital Management do not own securities issued by Automatic Data Processing, Inc. (current ticker symbol ADP, formerly AUD).

** The principals of Taylor Frigon Capital Management do not own securities issued by Ceridian (private), or Intuit (INTU). They own shares of Paychex (PAYX).

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For later posts on this same subject, see also:


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