When should you sell?

In his book The Dhandho Investor,Mohnish Pabrai,who runs the Pabrai Fund in the US,offers a framework that one could learn from and adapt. The crux of this approach is to buy a stock,which you believe has an intrinsic value of Re 1,at 25 or 40 paise. Often,due to some external circumstance,the market prices a stock at a very low price even though its business is quite sound. To take a recent example,throughout 2008 a lot of good stocks in India were available at very attractive valuations not because anything had gone drastically wrong with their businesses,but because foreign institutional investors had withdrawn funds from the Indian market because of troubles in their mother country.

This approach requires that one learns to determine the intrinsic value of a stock. Discounted cash flow DCF analysis is one way of doing so. Buy stocks trading at around 40-50 per cent of their intrinsic value and sell them when the value approaches 90-100 per cent. Many investors may find it difficult to master DCF analysis. They could use the PEG approach PEG is price to earnings ratio divided by the growth rate in earnings. Buy stocks that are trading at a PEG ratio of around 0.5 and sell when they approach 0.9-1.

A big advantage of adopting the value-investing approach as opposed to the momentum-based investing approach: buying stocks that are rising hoping to capture some of the gains is that since you buy at a depressed price,you minimise your downside risk the risk of what you can lose.

Implementing this approach

The value-investing approach is based on an important premise: that the market may be currently mis-pricing the stock,but in the long run its price will converge upon its intrinsic value.

Give it time. Having purchased the stock,you have to allow time for the mis-pricing to get corrected. Pabrai suggests a time period of three years. Why have such a long holding period? Because,he says,while stock prices change in a flash,real changes in the business world take time to materialise. Moreover,within three years the external factors that had driven the price of the stock low would have disappeared. If the business is intrinsically strong,it will begin to perform well and the stock price will begin to reflect this strength.

Dont second-guess. After you have made the purchase,if the stock price declines further,do not develop cold feet and sell in panic. Have confidence in your approach and continue to hold the stock for the time period you had originally decided upon.

Judgement time

What if the stock continues to languish even after three years? You now need to re-assess your position. Is there anything inherently wrong with the business? Did you over-estimate its intrinsic value? If this is the case,do not dawdle. Admit your mistake,cut your losses,and sell at the best price you can get.

The holding period is not completely sacrosanct. In case the stock achieves the target price equal to its intrinsic value earlier,you may sell.

To implement this approach well,you must become more of a business analyst and develop a sound understanding of businesses and their key drivers. Since that takes a long time to achieve,it means that at any given point of time you can hold only very few stocks in your portfolio. Pabrai suggests that you make infrequent but big bets.