The Quality Series · part 12 of 13
The first clock: the business, and the valuation the market places on it
There are mainly two reasons I sell a stock.
The first is that the thesis is broken: the characteristics that made it a world-class business in the first place are gone. The warning signs are the checklist characteristics in reverse: gross margin slipping, market share starting to go, a sustained slowdown in sales, and falling operating leverage as returns on capital decline. If and when this happens, it is no longer a quality company, and the reason I owned it has gone. That for me is a sell, and I sell unemotionally.
This is not the same question we asked in the last part, where a great business stumbles and there is a judgement call to be made on whether the damage is temporary or permanent. Here the evidence of deterioration in the fundamentals makes that judgement for us: it no longer qualifies as a high-quality business.
The second reason to sell is price (free cash flow × multiple). As I said in part 10, all investing is expectations investing: the multiple reflects the growth expectations the market has already priced in. Benjamin Graham described the market as a moody business partner he called Mr. Market, and Buffett has used the image ever since. When Mr. Market is feeling optimistic, he pushes the multiple of a great business so high that the growth expectations priced in run far ahead of anything the business can realistically deliver. When he is feeling pessimistic, he does the opposite. The first extreme is a reason to sell, while the second is when I want to be buying.
Adobe shows both extremes in a little over two years. In November 2021 the shares were $699, about 50 times free cash flow. By September 2022 they were $275, about 17 times. By January 2024 they were back at $633, about 42 times. Through all of it the business barely moved: free cash flow per share was $14.31 in 2021, $15.71 in 2022 and $15.12 in 2023. Everything that happened to the price was the multiple.
Expensive comes in degrees, though. A stock a little above fair value may not be a reason to sell or trim the position. A price that implies growth the business cannot deliver is. In between, the deciding factor is opportunity cost: whether to keep holding the position or move to a more attractive opportunity.
The second clock: macro
I am not a market timer, and macro never chooses the business. But it decides how much cash I hold and when great businesses are likely to be on sale. I held an unusually high cash position in 2019 as my macro view darkened, and was fully invested within days of the Federal Reserve announcing unlimited quantitative easing in March 2020.
A few of my tweets from the time, before and after:
October 2019. The Fed was cutting rates and the market cheered. My message: rate cuts are not a cure-all, and they would not stop the fall in stocks; there was more pain to come. The chart shows the last two times the Fed cut like that, in 2001 and 2007: stocks kept falling for more than a year after it started cutting. This time, the S&P 500 closed at 2,919 on the day of the tweet; by the bottom on 23 March 2020, the day the Fed announced unlimited QE, it was at 2,237, 23% lower.
1 March 2020. Almost every Treasury yield had dropped below the Fed’s own interest rate. When the bond market does that, it is telling the Fed it will have to cut.
The same day, in one sentence. A reader asked what it meant. My answer: it’s not a question of if, or even when, only of by how much. Two days later the Fed made an emergency cut. Two weeks later rates were at zero.
26 March 2020, three days after the Fed announced unlimited quantitative easing. I wrote that we could see a bubble in financial assets like never before. The Nasdaq-100 closed at 7,897 that day. It had more than doubled by November 2021, and on 6 November 2026 it closed at 26,990, more than three times higher.
What this chart shows. The green line is how much money the Fed has added to, or drained from, the banking system compared with a year earlier. The amber line is the Nasdaq-100 over the same year. When the Fed flooded the system in 2020, stocks soared. When it drained money in 2022, they fell. When the draining eased in 2023, they recovered. That is why I watch the Fed’s balance sheet more closely than interest rates.
Next, and last: all eleven questions on one page.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
- Part 5: The secret sauce
- Part 6: Why return on capital decides it
- Part 7: A moat is the power to raise prices
- Part 8: Three engines, and the people driving them
- Part 9: What I won't own
- Part 10: Am I overpaying?
- Part 11: A temporary dislocation, or a permanent impairment?
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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