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SELL DISCIPLINE

Most investors, if asked, would say that knowing when to sell is much more difficult than knowing when to buy. We agree. We have defined criteria for selling, although we retain conviction in owning great companies for long periods of time. Despite what happened to stocks in the 1930's, the 1970's and in the severe downdraft of 2007-2009, there are numerous companies whose earnings streams have expanded powerfully over decades and have made large amounts of money for their long term shareholders.

Despite our wish to reduce risk and to avoid loss of principal, we remind investors that being largely in cash is a terrible way to face the prospect of the risk of inflation that will likely be the result of the enormous jumps in government deficit spending and the expansion of the monetary base by the Federal Reserve. Under similar circumstances cash became worthless in 1920s Germany. The value of the 1965 U.S. dollar is about 10 cents. We therefore remain advocates of owning important amounts of equities, notwithstanding the need to hold a prudent degree of other liquid assets whether it is bonds or other liquid short term assets. Nonetheless, there are times to sell stocks.

Certainly, stocks of companies in more cyclical industries need to be trimmed or sold when times are ebullient and such stocks have one of their typical, cyclical big advances in earnings. Otherwise, like Sisyphus, it will be the investors' fate to push the descended stone back up the hill again. Industries such as autos, housing, steel, mining and chemicals fit this category. Normally, we have only limited exposure to companies in these fields because they do not generally possess the investment criteria we seek; for example, sustainably strong ROIC or operating margins, high barriers to entry, and lots of free cash flow, among other things are not found abundantly in these industries.

Stocks can become overpriced just as they can occasionally become undervalued, for long periods of time. We do not concern ourselves if a stock we like experiences modest over-valuation. A 10%-20% over-valuation does not bother us much. To exit a stock for a short time, and to try to reenter a few points lower is too much like trading and cannot be done consistently by anyone we know. On the other hand, when a stock is discounting earnings expectations several years into the future or where the P/E ratio is substantially higher than its historical range, we may cut back the position materially or completely exit the stock.

Then, sometimes our judgment is just plain faulty, and we have to admit a mistake was made in the initial analysis and decision to invest. This tends to happen where the research we have done missed some important consideration, or we missed a change in competitive conditions. In such instances, we will cut our losses to live for another day.

Of course, sometimes we come up with a new idea that is better than something we already own.

We footnote this discussion with the statement that in decades of investing, the opportunity cost of exiting stocks too early has far outdistanced the losses sustained in owning stocks that simply went down after we invested. Patience is still a necessary ingredient of successful investing.