Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Should I sell this high flying share?

“Choices are the hinges of destiny.”

– Pythagoras

I have a dilemma. A good dilemma. But nonetheless a dilemma. The largest position in my portfolio has gotten a little too large. Or perhaps the rest of my portfolio is a little too small. Either way I need to figure out what to do.

I like to think that I know a bit about investing. I like to think that knowledge makes me a more rational and confident investor. And I yearn to act decisively as that is how knowledgeable and confident people are supposed to act.

Yet none of that means there is an easy solution to my dilemma. I bring the baggage of a big mistake I made as my largest holding imploded during the global financial crisis (“GFC”). I bring my aversion to sell anything in my portfolio which perhaps is the defining feature of my investment strategy. There’s no tabla rasa when it comes to investing.

Let your winners run     

US listed Automatic Data Processing (“ADP”) has been on a great run. In the part year it is up 27.24% in US dollar terms and over 30% in Aussie dollars. Over the past 15 years ADP has outperformed the S&P 500 by a little more than 2% per year. It has grown to represent just over 7% of my portfolio.

My wife and I own two tax lots of ADP. One was a gift to my wife from her parents when she was two years old in 1981. The cost basis of that lot is $1.50. I bought a second lot in 2008 during the GFC with a cost basis of $37.39. The shares were trading at $306 on the 11th of March.

ADP pays a dividend of $6.16 annually. That is a yield at cost of 410% for the 1981 lot which means I get over 4 times the purchase price in dividends annually. It is 16.47% for the 2008 lot.

The impact of compounding is evident as a 1% rise in ADP’s share price results in a 204% increase in the total return on the 1981 lot. As I said – this is a nice problem to have.

Avoiding catastrophe

I’m an advocate for introducing as much structure as possible into investing. And I have an investment strategy that outlines the criteria I use to find new investments and rules around when to sell an investment. I also have rules around position sizing to make sure I’m diversified.

My goal is to keep single share positions below 5% of my total portfolio and 5% of my total investment income. Yet my goal is also to never sell unless an investment no longer fits my thesis because I know the biggest risk to my success is poor behaviour and trading too much.

The purpose of my 5% rule is to avoid a catastrophic loss in my portfolio which woud prevent me from achieving my goals. That is the whole reason I diversify. It isn’t some academic exercise. It is to make sure I achieve my goals.

It is underappreciated how often investors suffer catastrophic losses. JP Morgan put out a study called The agony and the ecstasy which explores this topic.

The study focused on the Russell 3000 which represents the entire US stock market. The researchers found that 40% of all stocks suffered a permanent 70% + decline from their peaks. The “permeance” of the loss means that these 40% of companies never recovered past 60% below their peak.

The return on the median stock in the Russell 3000 compared to the index was -54%. Two-thirds of all shares underperformed against the index. For 40% of shares in the index their absolute returns were negative.

Read that again. It is sobering. My goal is to generate income. Yet I still want decent price appreciation and any company falling more than 70% is not going to be paying a growing dividend.

This study by JP Morgan focuses on the losers. There is also research on the winners. Hendrick Bessembinder has done extensive research on the US share market. He explored how many shares create shareholder value. Shares that generated shareholder value were those that exceeded the return on short-term US Government Treasury Bills.

Bessembinder’s study covered 26,000 US listed companies between 1926 and 2016. Only 90 companies account for half of all shareholder wealth. That is 1/3 of 1% of the total listed companies. The top 4% or 1000 companies account for all shareholder wealth. That means 96% of all US listed shares had a return equal to or below the US Government Treasury Bill rate.

I think we can all agree that John Bogle’s famous quote about searching for a needle in haystack was not an exaggeration. And this is ultimately my dilemma. What do you do when you’ve found the needle in the haystack? And how can you tell if strong performance will continue.

Adding context to my decision with my goals

I’m not a professional investor trying to outperform an index over the short-term. I don’t particularly care if I underperform an index even if it happens for multiple years. My goal is to generate a sustainable and growing stream of passive income while avoiding a loss that puts my long-term goals at risk. It is not volatility that I worry about. It is permanently losing capital that I need to generate income.

It is through this lens that I judge individual positions in my portfolio. A professional investor trying to beat the market assesses each share based on the likelihood of outperforming the index over the short-term.

For a professional investor it is a zero-sum game. Will investment A do better or worse than investment B in the short-term? There generally aren’t other considerations. Most professional fund managers don’t care about taxes. Taxes don’t impact their returns and the end investor pays them.

That is not how I see things. If I sell either of my two lots of ADP I will owe a significant amount in taxes. A new investment doesn’t just have to be better than ADP. It has to be better than ADP and the taxes I will owe.

The following chart shows the percentage I would be underwater if I sold both lots of shares. I’ve added in different marginal tax rates for reference. Just to break even whatever I buy would have to outperform ADP by this amount plus transaction costs. It is a high hurdle rate.

A (hopefully) rational assessment of ADP

Successful investors strive to inject rationality into a decision-making process that is often fraught with emotion. All too often we succumb to biases and subjectively see value where it doesn’t exist.

Anchoring is one of these biases. Anchoring involves the use of irrelevant information in decision making. Am I anchoring to the enormous gains in ADP? Have I grown too attached to a share in my portfolio? Am I too drawn to the story of a position that was purchased in 1981?

I need to acknowledge that there are many things that may influence my decision making while trying to be as rational as possible.

ADP provides payroll management and administration services to companies. The shares are trading at a reasonable valuation. Our analysts have a $290 fair value estimate. On a price to earnings perspective the shares are trading at around the average over the previous 5 years. It certainly isn’t cheap but that isn’t really my concern.

I am fine with the price fluctuating, and I am fine with holding great companies as they bounce between different valuation levels. My focus is on dividend growth and avoiding catastrophic losses. That is how I will judge ADP.

Will the dividend grow?

Historically ADP has more than achieved my goal of growing my income. The dividend was raised for the 50th consecutive year in November. Over the past decade the dividend has increased an average of 12.53% annually.

There are good reasons to believe that growth will continue. The dividend payout ratio is below 60% and given the capital-light nature of the business that provides flexibility for management to maintain and grow the dividend. Our analysts expect dividend growth of 8.5% annually for the next 5 years.

Will I suffer a catastrophic loss?

I regard ADP as relatively safe. It is a large and established company with a stable and predictable business. ADP’s clients are spread across 140 countries. Our Risk and Uncertainty Rating is a proxy for the risk of the overall business. ADP has a rating of Medium which is our second lowest level.

ADP has a Wide Moat Rating which means we view ADP’s competitive advantage as sustainable for at least 20 years. ADP carries a negligible level of net debt which lowers financial risk.

ADP’s profits fluctuate based on overall employment but I’m confident it can survive a downturn. This is an important consideration because one finding in the JP Morgan study was that companies can be riskier than they appear during strong economic conditions. To paraphrase Buffett, I’m confident that when the tide goes out ADP will not be swimming naked.

I don’t think ADP is a risky company in a traditional sense. Yet I also know there are always unknown risks. AI and new technology are always a threat. Poor decisions by management. Outright fraud. The list goes on. No company is bullet proof. That is why I diversify. That is why I worry when a position becomes too large.

The decision to end my indecision

I have few options other than selling to reduce the size of ADP in my portfolio. I’ve already turned off the dividend reinvestment. There isn’t a realistic way for me to save my way out of this.

As I’ve gotten older the relative size between my portfolio and what I can save has shifted. My position in ADP is higher than my annual salary. This raises the stakes and increases the pressure to not make mistakes.

This happens to everyone. As we age we tend to turn inwards and protect what we have instead of striving for what we want. I’m not young anymore but I’m not old enough to not want more. I fall in a grey area.

I have an investment strategy to impose discipline on my decision making. But there is a difference between structure and automation. My results are still dependent on my decision making within the parameters I’ve set. This decision also falls into a grey area.

My decision comes down to one thing. Do I sell and pay a significant amount of tax or do I hold on with a larger position than I’m comfortable with. I’ve chosen not to sell.

This wasn’t an easy decision and I’ve been debating it since January when I did my last portfolio review. Ultimately, I just don’t want to sell and break the chain of compounding.

Confidence and decisiveness are admirable qualities. But it is also important to acknowledge that these decisions are hard. And anyone responsible for managing investments for their family understands the pressure that comes from people counting on you.

All we can do is make the best decision we can given the circumstances and the information at hand. That is what I’ve tried to do with my ADP position. I think it is the right decision but make it with the humility of knowing the future may prove me wrong.

Please share any thoughts or topic suggestions with me at [email protected]

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What I've been eating

I made a disparaging remark about pizza in Australia on a recent podcast. A few listeners strenuously disagreed. I think we can all agree that the pizza at Bella Brutta in Newtown very good. They have a clam pizza with fermented chilli which is amazing. It reminds me of the famous white clam pizza at Frank Pepe in New Haven which is up there with the best I’ve had. Below is the Bella Brutta clam and pepperoni I ordered during a visit this week.