The sell discipline is one of the most complex, and least understood parts of the investment process.
Don’t let conviction become complacency
An investment manager’s analysts should conduct deep research that includes onsite meetings with a company’s senior leadership, customers, suppliers and competitors, and should also evaluate financial statements. All of this information will inform the manager’s fundamental outlooks and earnings models.
For example, Jennison Associate’s global equity team focuses on the magnitude and duration of the long-term growth drivers for each company the portfolio holds. The team is willing to accept short-term stock price volatility as part of the price that needs to be paid for the potential to create significant growth in value over time.
Evaluating a company’s fundamental prospects requires a deep understanding of its competitive advantages and growth potential, especially for emerging growers in their early stages. Usually, these take a long time to develop and become entrenched, which makes a long-term mindset essential.
However, this long-term mindset should not be misconstrued as complacency or a plan to buy and hold for a long period. The sources and nature of growth drivers are continuously evolving and changing over time, and so the best global growth equity portfolios must reflect and mirror that all the time.
Effectively identifying early indications that a company’s growth expectations might not be met is also a critical component of generating attractive long-term returns. Long-duration growth companies, after all, are not common, and identifying in advance the companies that will deliver high and sustainable growth can be extremely difficult.
Historical data shows that most companies fail to live up to consensus growth expectations (figure one). To demonstrate this point, the MSCI All Country World Index has been grouped into quintiles using historical five-year earnings growth—companies in quintile 1 had the highest earnings growth and companies in quintile 5 had the lowest earnings growth.
Figure one highlights consensus earnings estimates of companies in quintiles 1 and 2 compared to realised earnings growth five years later. Companies that remained in the quintiles after five years were “hits.” Companies that dropped out of the quintiles were “misses.” In both of the top quintiles, less than 20 percent of companies lived up to consensus expectations for earnings growth.
MSCI All Country World Index data from June 2005 through December 2023. Companies with expected top quintile EPS growth (according to consensus) contrasted with the actual constituents of those quintiles five years later. Companies that met earnings expectations are “hits;” companies that did not meet expectations are “misses.” For this analysis we used company data going to back to 2005, the first year in our view with enough data to ensure thorough and meaningful analysis. In addition, we sought 19 years of data (versus a more standardised 15 year period) to have enough context for the Global Financial Crisis in 2008–2009.
The market’s errors in predicting growth stocks fall into two categories:
- overly optimistic – trees really can grow to the sky
- overly pessimistic – this can’t go on, returns will revert back to the mean soon.
Global stocks that suffer from over-optimism need to be weeded out of a portfolio, while stocks experiencing over pessimism can turn into long-term winners. These ought to have more capital allocated to them in the portfolio. For this reason, a strict “buy-and-hold” approach to investing does not always deliver the best investor outcomes.
In the ideal global growth portfolio, holdings must earn their place in every day. Further, “low portfolio turnover” is not an inherent virtue. On the contrary, the more rapidly the world changes, the more it can be seen as a detriment to long-term outperformance.
Conviction cuts both ways
The pitfalls of a strict buy-and-hold approach are obvious after considering the history of the corporate world.
For example, many growth darlings that dominated industries for many years eventually lost leadership because of new technologies, new competitors, or a new macroeconomic environment – for example, Blackberry and Yahoo. It would be an act of complacency—if not arrogance—to assume that the holdings in a global portfolio at any point in time will justify the investment teams’ theses and always represent their view of the best growth ideas in the world over the subsequent three-to-five-year periods.
Ideally, investment teams are open minded and rigorous in their global portfolio construction. This means the team is constantly “weeding the garden,” identifying and exiting stocks where the growth may be maturing, new competition may be emerging, or execution may be failing to deliver on its initial promise. This allows the investment team to be patient over the long term with potential” flowers”—companies that the team believes will blossom and have the potential for high returns and high growth over the long term.
In many global portfolios, portfolio holdings will offer this potential at any given time but, at the time of purchase, it is impossible to know which ones will continue to earn their place over several years.
The most successful companies over the long term have been able to innovate, evolve and reinvent
themselves. They string a sequence of great business ideas together to create wave after wave of strong growth. For example, Mercado Libre, Latin America’s largest online marketplace, continued to innovate by creating an ecosystem of additional product offerings around its e-commerce platform, including payment solutions, logistics, financing, advertising and software services.
Sell discipline: both an art and a science
Most investment teams have a rationale for their sell discipline. This might include selling a position for reasons such as:
- to fund more attractive growth opportunities
- to realise gains
- to reflect a change in fundamentals that alters the analyst’s investment thesis.
A rigorous approach to portfolio management should see an investment manager not satisfied holding a company—even if it is successful—if it believes there are more attractive opportunities available. It is important that the investment team constantly evaluates what the opportunity set is relative to the risk/reward in other stocks it does and can own.
There are times when the idea that fuels a company’s growth runs its course, the “new” market gets saturated, and the company appears to have no promising ideas in development. Alternatively, a manager can elect to exit a position because the company’s strategy is sound, the management is effective and the market appreciative. The stock reaches its price target and the investment thesis is fulfilled.
Another reason to sell is a deterioration in the company’s fundamentals. An obvious sign of trouble is a shortfall in earnings and revenue, but this can reflect several issues—not all of them negative. For example, many earnings disappointments do not reflect a company’s longer-term potential and investors will need to ride out these speed bumps toward higher growth. Orders and revenues may be pushed into later time periods, but this represents growth deferred rather than growth lost. Other times, however, revenue and market share growth falls below expectations for salient issues, which might reveal flaws in the investment thesis. Investment teams rely on deep fundamental analysis to distinguish between the different types of disappointments.
There are several factors to consider when making sell decisions, and their relative importance will vary according to the circumstances. Accordingly, it is important to measure the success rates of those decisions, over the short, medium, and long term.
Using the example of Jennison’s Global Equity Opportunities strategy, figure two illustrates the percentage of the team’s sell decisions that go on to subsequently underperform the market (blue bars) or the rest of the portfolio (green bars). This data is for the Global Equity Opportunities representative portfolio and is based on the final sale only.
As figure two highlights, more than 50 percent of the stock sold underperformed the global portfolio in the subsequent one-year period following the sale. Over the subsequent five-year period, the percentage of companies that underperformed the global portfolio (after sale) increased to 74 percent.
Short-term rigor enhances long-term focus
Great growth ideas can deliver strong returns for long periods of time, so it is crucially important that a sell discipline accounts for the risks of selling too early as much as holding a stock after its key growth drivers have matured.
There is a need to focus on both risks equally: for example, a significant portion of Jennison’s long-term returns have come from stocks the manager has held for greater than four years (figure three). The aspect that isn’t visible in the chart below is that Jennison’s team is able to allocate more capital to these long-term winners (“the flowers”) because the team is quick to exit those stocks where the thesis is not working (“the weeds”).
Finding growth
Many business models and growth ideas today are lumped together under the “growth category,” but they may not offer exposure to pure growth. Understanding the differences one business model at a time—one growth driver at a time—can reveal enormous disparities. Some business models become more cyclical as they grow and mature. Others accelerate as adoption rates and the size of addressable markets increase simultaneously.
Investors need to understand this evolution in real time, determine the market value, and make a judgment on whether to buy more, hold, or sell a security.
A critical part of investment success
The sell discipline is one of the most complex, and least understood parts of the investment process. Jennison believes it is essential to keep “weeding the garden” by constantly monitoring the viability and investment thesis of each holding. Long-term growth companies are rare, and many fail to fulfill investor expectations.
Each holding must continuously justify its place in Jennison’s global portfolios. The manager’s sell discipline is a critical element to its investment success: it eliminates the companies that fail to fulfill our investment theses and offers us the capital to devote more resources to “flowers”—companies that the team believes have the potential to compound their growth over time and deliver long-term outperformance to investors.