Should I trim this big stock market winner?

"It's like déjà vu all over again..." Yogi Berra

What should you think about when a stock rises so much, and so quickly, that you become worried about its valuation and your level of exposure? Join me on another painful journey into my investing past and hopefully a better decision this time around.

A well timed punt

Texas Pacific Land (NYS: TPL) is a land, oil and gas royalties, and water business that owns around 900,000 acres of land in West Texas. I first bought TPL in 2020 using a method that you shouldn’t copy: I cloned the holding of an investor that I respect highly. It has been quite the journey since.

My purchase in April 2020 was well-timed. As it turned out, oil prices didn’t stay at zero forever. By mid-2021 my TPL shares had tripled in value and ballooned to a 30% weighting in my nascent equity portfolio. I became concerned about my concentration in TPL and the stock’s valuation. So I sold.

Act 2: Another lucky entry

I bought back into TPL on March 28 2024, shortly after the company had finished a 3-for-1 stock split. This meant that I could establish a reasonable portfolio weighting, as opposed to buying at a price of USD 1500+ per share and it instantly becoming a 10% position.

My initial purchase was little more than a punt based on somebody else’s conviction and research. My purchase three years later was different. By this point, I had come to know TPL’s business and realised that it epitomizes the kind of asset I want to own.

It is an easy business to understand.
It has world-class assets.
It is debt-free and highly cash generative.
Demand for its main product (prime oil and gas producing land) isn’t going anywhere soon.
It is highly resistant to inflation due to its capital light business model.
It is the kind of asset I would happily hold forever without a market quote.

TPL’s stock has gone up 2.6 times since my purchase nine months ago. It has risen to an 11% position in portfolio and here I am – again – wondering whether I should trim my holding on valuation grounds. An example of the conversation going on in my head:

“The performance of TPL’s business (especially the water segment) has been great. But it hasn’t been 2.6x in nine months good? The shares have also benefitted from non-fundamental things like TPL’s inclusion in the S&P 500 index and excitement over AI data centre development in Texas.

I find myself concerned by the stretched valuation and some of the reasons for it. I’m afraid that I’m about to give back a lot of the gains that have been pulled forward in recent months.”

In many ways, this feels like 2021 all over again. So we should probably start by going over what happened in 2021 and how much it ended up costing me.

Not my first Texas rodeo

As I mentioned before, I sold my TPL holding in 2021 because I got scared about how much the shares had run up and how big a chunk of my portfolio they had become. How much did this cost me?

I started off with two TPL shares. I sold one in March 2021 for USD 1512 and the other in May 2021 for USD 1513. After trading commissions and FX charges, I netted USD 2700. Because of the 3-for-1 stock split, those 2 TPL shares would be 6 TPL shares today. At the recent closing price of $1569 per share, those six shares would be worth USD 9414 today.

That is roughly 25% of my portfolio’s value today. And they say you never go broke taking a profit.

A learning opportunity

I don’t think you can blame me for what I did in 2021.

This stock I had taken a punt on had become 30% of my portfolio and it had run up a hell of a long way in no time. I also couldn’t have known that the stock would go up another 3x after I sold. But that doesn’t mean I couldn’t have thought things through better.

In the hope of making a better (or at least better informed) decision this time, I asked myself the following questions:

What mistakes did I made last time?
What is my investing strategy today?
Does this holding still meet my criteria?
How ridiculous is the valuation?
What are the costs of selling?
What will I do?

What mistakes did I make last time?

Take the financial result out of it. Instead, let’s look at a couple of the mistakes I made in regards to my process.

I never considered the decision through the lens of a broader strategy. 2021 is a long time ago and I can’t remember everything about this decision. But I can say this confidently because I hadn’t written down a proper strategy until I joined Morningstar this April.
My assessment of valuation was dominated by what the stock price had done in the past and how its past earnings related to the market cap. But as Bill Miller once said, “100% of the information you have about a company represents the past, and 100% of the value depends on the future.” Could I have done a better job of thinking about TPL’s valuation in 2021?
My concerns about concentration at the time might have been over-egged. Yes, the position had grown to roughly 30% of my portfolio. But that was a static view of things. I was only 18 months in to running my own portfolio and was making regular cash contributions. The portfolio would naturally have become more diversified over time anyway.

How does my proposed action fit with my strategy?

Every investing decision you make should be in tune with a deliberate investing strategy. The investment strategy I aim to follow is based on the investment policy statement that we recommend every Morningstar reader writes for themselves. Mine goes something like this:

“I want to buy and hold shares in companies with moats that I readily understand or world class assets. I aim to buy great companies and assets at reasonable prices, or good companies/assets at excellent, highly depressed prices that I feel reflect overblown poor sentiment”

We also recommend trying to pinpoint an edge that you will exploit to achieve better than average market returns. Otherwise, it makes little sense being an active investor.

“I aim to exploit a structural edge, either by buying things that professionals do not want to tell their clients about due to poor near-term sentiment, or by holding my positions for longer than most professional managers can, given their dependence on short-term performance”.

Why have I have been tempted to trim TPL? Mainly because I am scared that a lot of growth has been pulled forward, and it looks vulnerable to performing poorly in the near future. In other words, I am being tempted into the short-term thinking that I am supposed to try and avoid.

Another component of forming your investment strategy is to set criteria for investments. If you are investing in individual shares, this will require you to pinpoint the qualities you want your portfolio holdings to have and maintain.

Does this holding still meet my investing criteria?

Seeing as these are essentially guardrails for buy, hold and sell decisions, they seem like a good thing to call on here. Does TPL still meet my investing criteria? From a business sense, yes – absolutely.

It is still an easy business to understand.
It still has world-class assets.
It is still debt-free and highly cash generative.
Demand for its main product still isn’t going anywhere soon.
It is still highly resistant to inflation due to its capital light business model.
It is still the kind of asset I would happily hold forever without a daily quote.

How ridiculous is the valuation?

I have talked a lot in the past about my tendency to overtrade. To guard against this, I laced my investing strategy with a rule that no position could be sold within 3 years. That rule had one exception: if a company’s valuation became obscenely high. Is TPL’s valuation obscene?

Last time I looked, TPL was trading at around 80 times the free cash flow I expect it to generate this year. Whatever way you slice it, that is very high. High versus the market. High versus TPL’s history. Probably higher than anything I’ve ever owned before.

An 80x multiple could seem a lot cheaper if the business was primed for huge growth. But while the business certainly has good growth prospects, this sets a very high bar. Even if free cash flow doubled and the shares stayed flat, it would still be at a rich 40 times!

This is the core issue for me: I am uncomfortable with how expensive the shares have become and what it might mean for future returns. I feel that at least some of the lofty valuation stems from excitement around data centres and land/water supply deals that may or may not be overdone.

What are the costs of selling?

Something I haven’t mentioned yet are the costs of selling. For most people in a situation like this, tax will be the number one consideration here. Not only is this a big winner, it is a big winner that has occurred over a very short period of time. That usually means capital gains tax without a discount.

I say “usually” here because my TPL shares are held inside my old UK pension wrapper, where capital gains tax does not apply. As a result, my only costs would be transaction and FX costs that I estimate would be around GBP 40 or AUD 75 thanks to my broker’s exorbitant fees.

I appreciate that is a rather unique situation, so let’s pretend I held the shares in an Australian shares account or an SMSF instead. As it stands, the capital gain on my TPL shares would be AUD 3050. My holding period is under a year so no discounts would apply.

If I held my TPL shares in a normal brokerage account and sold them tomorrow, I would pretty much be locking in a 20% haircut straight away. In other words, I would be betting that I could achieve a better return elsewhere, even if TPL had a 20% head-start.

That is a fairly big hurdle and would involve reinvestment risk. If you are holding a winner in a taxable account, you must consider the impact of CGT.

What should I do?

I am leaning towards doing nothing. After all, I bought this as a long-term if not permanent holding. The business still meets all of my criteria perfectly and I am supposed to be buying and holding. In 30 years, which is the time horizon of my investing strategy, how TPL does from 2025-2028 probably won’t matter.

The returns of most successful investors (and indeed, stock market indices) are dominated by a very small handful of huge winners that were left to run. Maybe this is my big winner. At the same time, though, am I being overly influenced by my past experience with the very same shares?

There are, after all, some compelling reasons to sell. First of all, there is no CGT to pay and therefore no immediate haircut to my portfolio. The stock’s valuation looks high from every angle, with a lot of future growth pulled forward.

I hate to end this article by saying I’m undecided, but it’s the truth. At least I’ve spent a lot more time thinking it through than last time, and perhaps I should just stop looking at my portfolio so often.

For a step by step guide to forming an investing strategy, read this article by my colleague Mark LaMonica.